The flight to liquidity which is upsetting the credit markets at the moment
is hard on reporters. They want to show how the prices of illiquid securities
have dropped – but the problem is, of course, that those securities are
illiquid, so it’s very hard to get prices for them. As a result, they’ve more
or less stopped looking for actual price data. Instead, they go straight to
Markit’s hugely popular ABX.HE indices, especially when they’re writing about
mortgage-backed securities.
The ABX.HE indices are a pretty weak indication, however, of what mortgage-backed
bonds are actually worth.
The main reason is that they’re not based on bond prices, but rather on credit
default swap prices. In times of volatility, like now, credit default swaps
tend to gap out much more than bonds. And you certainly can’t say that a 1-point
drop in the index corresponds to a 1-point drop in bond prices.
But there’s another reason, too, as uncovered
by Alea. A typical mortgage-backed security doesn’t just have one AAA tranche,
one AA tranche, and so on. It’s got a whole series of securities, each with
a different level of credit support – and the ratings agencies then throw
a bunch of tranches into each ratings bucket.
It turns out that when Markit chooses a "typical" AAA or AA or A
or BBB tranche for its index, it actually always chooses the weakest
tranche with that rating. It’s not clear why: Alea speculates it might have
something to do with the bonds’ required average life. But using one particular
bond as an example, there are five different AAA-rated tranches, ranging in
size from $77 million (the least safe) through $399 million (much safer) to
$219 million (the safest). Markit uses the $77 million tranche as the one it
puts in its benchmark. Says Alea:
The Class A-2d included in the ABX.HE AAA 07-2 sub-index grossly misrepresents
the AAA classes themselves, it is fifth in the “waterfall” and
represents around 8% of the AAA classes capital.
So what does it mean when the “AAA” index drops ? Nothing other
than the bottom 8% of the AAA classes has a very long shot chance of being
impaired.
Actually, it means even less than that. People are buying protection on those
tranches not because they worry about the credit risk, necessarily, but because
they want to hedge their AAA exposure more generally. Since credit default swaps
gap out more than bonds do, the CDS is a good hedge against market risk, even
if there’s no credit risk at all. Remember that a flight to liquidity can impair
the prices of AAA-rated bonds even if there’s no chance at all they will default.
So its doubly misleading to not only use the AAA tranche with the weakest credit,
but to also use the smallest – and therefore most illiquid – AAA
tranche.
Which would all be fine, if the ABX.HE indices were simply another exotic product
traded by sophisticates. But now they’re being picked up by the punditocracy,
it’s worth pointing out how weak they really are.