Dumb question...

KD,
You keep referring to the ABX chart and how the different tranches keep deteriorating. I understand that higher is better for those that are trying to schlepp ABX stuff.

Question: What EXACTLY is the ABX? Is it the secondary market for a bunch of raw mortgage backed securities, or is it the price for the insurance on those mortgages?

It is my understanding that certain organizations "insure" MBSs and collect premiums until there is a default. When the default rate is 1% (or whatever the model is based upon) the insurer makes more money in premiums than he has to pay out in claims. As the default rate goes above "breakeven" he starts to lose money, thus to sell that contract on the secondary market, you would have to discount it so the buyer can make his ROI. If the default rate goes high enough, no discount would be enough to offset the payouts, thus it becomes "Toxic waste."

Right?

Thanks in advance. I know the entire mortgage market stinks, but I was wondering what the ABX is.

Its basically a model valuation based on the market's perception of risk.

The CMBX works the other way (that is, higher is worse)

For the ABX, what you're looking at is cents on the dollar. When bonds are issued they are at "par" value (or sometimes above or slightly below)

The ABX is, basically, what (in theory) those bonds are worth on a principle basis now. Since the coupon is (at least over short periods of time) fixed, it is a rough indicator of default risk.

Over longer periods of time to the extent that the components are floating-rate (e.g. indexed off LIBOR) you can have moves in the index that are related to interest rate changes as well, just as you do with Treasuries.

Since the ABX is the only publicly published daily information on the ABS market, we all look at it with great interest because it is one of the only places we can get a look of what is happening to asset-backed securities bond spreads/prices. However, it is a few steps removed from the actual opaque ABS market, but it is the best we can do.

You are correct that it is the cost of insuring ABS bonds in the credit default swap market. Each ABX series is a basket of 20 or so ABS deals broken down by their rating level (AAA, AA, A, etc.). On a daily basis, big investment banks (listed on the left side of the Markit page) mark the bonds and submit them to Markit who filters and averages them. the bonds are marked using the current yield curve (LIBOR) and index rates and the following assumptions: credit spread (yield above libor that is paid to compensate for riskiness of the bond), prepayment speed, default rate and severity (how much you recover after a default). Future cashflows are projected using these assumptions and discounted at the yield (credit spread + interest-rate level). This produces a "price" which is a percentage of par. The result sets the rate for the particular "tranche" of protection in the ABS CDS market.

We look at a the ABX to get a clue as to where bonds of the particular type are trading, but, it can't be used in any detailed way for the following reasons:

1. It is a price-based index which means that the level of interest rates matters, so it can't tell us directly if there is spread-widening or not. A spread-based index (like the CMBX) would be much more useful because anyone holding ABS bonds usually hedges the interest-rate risk with IR swaps or Treasuries.

2. It is the price of insurance, so it does not tell us directly where those types of bonds are trading in the market. This has been a complaint since Markit started the ABX.

3. Again, since it is price-based, we can't tell how the default/severity assumptions are changing either.

4. The reference portfolio is based on securities backed by subprime Home Equity loans. You might know these as "second-liens" or "piggyback" loans. They are not first-liens.

However, you can find it useful when you see large moves. I look at it every day because it is the only estimate I can get of the pain in the mbs/abs market. You can bet that if the prices drop, credit spreads are probably going up and that is probably happening across the subprime market first-liens as well.

I also check the CMBX and LCDX spreads too. The LCDX is a leading indicator of trouble in the PE/LBO market, as if you can't syndicate the deals at a good profit you're dead.

The LCDX moves have been very troubling for the LBO market, but nobody's listening to it - yet.

Why is the AA going down the waterfall but AAA is just teetering on the Markit ABX graph. Better quality?

Yep. AA has to be wiped out first. Each tranche provides "insurance" for the ones that are "better".

The confusion for me is on Feb 23rd they both nosed dived. Why isn't AAA following like it did then?

My other question/comment is shouldn't there be a significant correction very soon judging by the similar drop in AA and AAA in late Feb. It plunged one point and we are about at a one point drop already or is it not that tightly correlated? Thoughts?

Its not that tightly correlated.

Basically the bottom line is that the credit markets have to "filter through". When the margin calls start the **** hits the fan.

Right now it appears that MIGHTY efforts are being made to hide it. It won't succeed - it never does - but they won't give up easily.