I was quite
rude about the ABX.HE indices this morning, but, like all hedging mechanisms,
they do serve an important purpose. They allow investors to hedge their subprime
exposure, and they bring some measure of liquidity to a market plagued by its
absence. It’s a very bad idea to assume that ABX.HE prices directly reflect
the value of underlying bonds – but they do at least move in the same
direction.
So I’m confused by Bob Lezner’s latest
column at Forbes. He seems to think that ABX indices and other such animals
are bad things precisely because they allow investors to hedge their
exposures. He never quite comes out and says as much, but his language is full
of scorn, from the headline ("Profiting From The Meltdown") on down:
A consortium of the nation’s leading investment banks have quietly created
an index that is not only protecting them against the recent market meltdown
but also promising to make them bundles of money in the process…
The indexes that CDS has been quietly creating are tools for the repricing
of the entire credit market. First, it was the residential housing market,
then the debt of European companies just barely investment grade, and more
recently the mortgages in the commercial real estate market. Some observers
believe, though, that the volatile price movement in these indexes the past
few weeks is the result of market players being able to take both a negative
and positive stance, without having to take any clear position on how serious
the crisis in the credit markets might be or could become…
There are a lot of folks quietly making a bundle of money while the markets
crater. Moreover, no regulatory authority has to approve the creation of these
indexes. Nor is there widespread transparency of the trading or price action
in these indexes.
These indices are undoubtedly a very good idea, and I really don’t understand
why Lezner seems to be calling for them to be regulated. As for the transparency
issue, I’m at a loss to see what Lezner’s worried about – does he think
that the owners of the indices will manipulate price data to their own ends?
And Lezner’s language elsewhere doesn’t give me a lot of confidence that he
really understands what he’s talking about.
In early 2006 a small number of firms led by Deutsche Bank, Barclays, Bear
Stearns and Goldman Sachs formed the ABX index (a credit default swap of asset-backed
mortgages) of 30 most liquid mortgage-backed bonds. The savviest players like
Deutsche Bank (which reportedly made $250 million) and several hedge funds
on both sides of the Atlantic began shorting that ABX index in early 2006
at par. It now sells at 35, implying that the value of those mortgage-backed
bonds and others of their ilk have lost 65% of their value, a potential loss
in the tens of billions of dollars. Which means, of course, that smart money’s
made up to 65% on this one trade.
First, the ABX index is not itself a credit default swap: it’s an index of
where a group of credit default swaps is trading. Second, as we saw this morning,
the fact that a certain ABX index is trading at 35 does not imply that
the underlying bonds have lost 65% of their value. And third, the return you
get by shorting an index at par and covering at 35 is entirely a function of
how much margin you had to put up initially; it’s likely to be much greater
than 65%.
I think it’s great that banks are able to hedge their loan exposures using
the LCDX index. Banks are the weakest link of any financial system, since they
have so many counterparties: a single bank failure can have devastating systemic
repercussions. Anything which serves to improve banks’ risk controls and help
them actively manage their loan portfolio has got to be a good thing. So I’m
very happy the LCDX index exists – just so long as people don’t start
using it unthinkingly as a proxy for the value of the underlying loans.