Thursday, March 27, 2008

Synthetic ABS. Who needs 'em anyway?

Plans to create an auto loan ABS (asset-backed security) index, similar to the now infamous ABX index except for auto loans instead of home equity loans, were quietly scuttled last week. Creation of such an index would have allowed investors to buy and sell credit default swaps on a basket of auto loan securitizations, in effect, betting on the credit performance.

Why was it canceled? Partially because of the severe drop off in securitizations of consumer loans generally, there aren't a lot of recent auto loan deals to put into an efficient index. But there is a deeper issue. Many market participants are now questioning the value of these CDS indices. It was once thought that a more easily traded index of CDS would help improve price discovery in the asset-backed market. But is that what's happening now?

The market is only going to efficiently price a security when there is reasonable two-way flow. In other words, when a price is reached where there is a reasonable number of traders on both the short and long side. Is this what's been happening with the ABX index? No. Whatever you think of where actual value is on various ABX contracts, it certainly isn't a two-way market. Buyers of protection have dominated that market for about a year now. Of course there has to be a seller if there is a buyer, but I've persistently heard that sellers of protection have overwhelmingly been either paired trades along the capital structure (e.g., long the 2007-1 BBB and short 2007-2 BBB) or short covering.

Now one can look at any of the specific structures in the ABX library and make a case that the price should be higher or lower. That isn't the point. The point is that the ABX never developed natural buyers of risk. Once home equity structures became distressed, there were some buyers of cash bonds. But these are the kinds of buyers who want to comb through the structures and carefully analyze every dollar of cash flow. That kind of buyer is looking for a cash-flow diamond in the rough. Selling protection on the ABX is a bet on home equity spreads in general tightening. That's not the kind of bet distressed buyers like to make.

Meanwhile, with so few home equity bonds actually trading, the ABX became the only means of estimating a market value on home loan bonds. So right or wrong, the ABX became the "mark to market" for pricing many different types of mortgage-related paper. Buyers who were careful to buy higher quality home equity paper complained, as they believed they had better structures than those on which the ABX is based. But it didn't matter since there were no new deals with which to compare, the ABX is all auditors had to use as a base.

The negative feedback was severe. (Notice I didn't say it was a "loop") Any real money buyer who tried buying high quality home equity paper saw their marks based on the lower-quality ABX. Portfolio managers are hard-pressed to buy bonds, regardless of the fundamental value, if the mark is going to be substantially lower. With no real money buyers and liquidity very poor, it became impossible to securitize any mortgage-related paper.

What would have been better for all involved is if the market had been allowed to price bonds individually based on individual risk characteristics. Perhaps the dislocation in the mortgage market was too severe for that to have realistically happened. But the ABX caused everything to be priced on a lowest-common-denominator basis. That really didn't help anyone other than the shorts.

So given all this, it seems obvious why various market participants aren't too eager to create another ABX monster. Its true that default rates on auto loans are likely to rise significantly, both due to normal recessionary pressure as well as the weak housing market. But its also true that auto loan deals have been priced to take much greater losses than home loan paper ever was. Home loans were always modeled with the assumption that the collateral was an appreciating asset. Car loans never made this assumption. In fact, Fitch estimates that most AAA-rated auto loan deals can withstand 20% unemployment.

So the street would rather auto loan securitizations stand on their own cash flow results, rather than suffer the slings and arrows of outrageous technicals. There is a right price for ABS risk. Maybe, just maybe, finding that right price will allow the securitization market to make a slow comeback, at least outside of home loans. That will be a critical next step for solidifying market liquidity.

20 comments:

gramps said...

My favorite quote (which I have heard many places so not sure who to attribute it to) is this:

INVESTORS buy things for the cashflows (and don't really care about mark to market) -- while SPECULATORS buy things with an eye toward selling at a higher price (hence mark to market is the whole game).

So what your whole post is really saying is: there are few if any investors in ABS, its mostly just speculators...

Anonymous said...

Here is some interesting commentary on the success of the Fed's actions:

The FDIC is hiring 138 additional people to handle anticipated bank failures going forward.

Not even the US government is drinking the kool aid!

AnonX said...

I think you just hit on the problem with theoretical mark to market using credit derivatives. I don't know anyone all that upset by mtm if there are reasonably well behaved markets.

Some firm just bought back its own debt at 80 cents on the dollar. I wouldn't want to see liabilities marked to market, however theoretically logical it might be.

proton said...

ABX indices cover subprime market pretty well.

Now, it is true that there are bound to be some deals/tranches that are much better than the "average" represented by ABX indices.

By the same token, there should be those with even worse characteristics!

I would not trust on the statements of those saying their portfolios are much better quality than what ABX marks indicate. This could be true for small select portfolios, but probably not for large portfolios.

James I. Hymas said...

Now, it is true that there are bound to be some deals/tranches that are much better than the "average" represented by ABX indices.

By the same token, there should be those with even worse characteristics!

Nope.

Econbrowser referenced (in the comments) Felix Salmon's critique quoting Alea's investigation [nb: I love the Internet]:

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.

TallIndian said...

Wow! If Fitch says something, it must be true! I don't think they've been wrong in the past.

Anonymous said...

Guys/Gals, we should not dwell in the past, it is history. We had the tech bubble on the late nineties and now the housing bubble of the past few years. I don't know about you, however I have missed out on both of them (too young for one, too broke for the other).

We should focus our energy on finding / predicting what the next bubble is going to be and get on the ground floor now. This whole housing thing with work itself out, why worry...

proton said...

If you rely on half-truths reported in Internet, you are bound to draw wrong conclusions.

The selection criteria for ABX is objective. AAAs in ABX are selected over other shorter-term, first-pay AAAs because they have higher average life. When a professional compares ABX versus the general market, he would control for the credit support, rating, average life etc.

The issue is whether you should trust on the words of those monoline companies, banks, brokers, insurers who claim their portfolios are better than what the ABX marks indicate. Not everyone can be better than "average". Especially, when they have huge portfolios.

Accrued Interest said...

I think the point isn't whether the ABX is the right benchmark for one bond or another. More that it can't possibly be the right benchmark for all subprime securities. And yet because nothing is trading, its the only thing we can use.

James I. Hymas said...

When a professional compares ABX versus the general market, he would control for the credit support, rating, average life etc.

True enough. But is this really how mark-to-ABX happens in real life? Or are all AAAs marked to the ABX level holus bolus?

I haven't seen any commentary on that one way or the other.

The issue is whether you should trust on the words of those monoline companies, banks, brokers, insurers who claim their portfolios are better than what the ABX marks indicate. Not everyone can be better than "average".

But ABX is not an average - as you have said, there is a selection process and the index composition is deliberately skewed towards longer-term, later-pay instruments.

newbie said...

I thought ABX is highly liquid and much more transparent than regular ABS bonds. When i say highly liquid, it is great that i could goto markit website and check prices. I couldn't do it for any ABS bond. I would have to call multiple dealers to establish price for a bond.

I still think, it is very good thing for ABS market.

Anonymous said...

Your broker will ruthlessly mark all your holdings to market -- and send you a margin call when needed. Excuses that the market price doesn't reflect the "true" value are ignored and even ridiculed.

But when the same thing happens to a Wall Street firm, everyone from AI to the Fed says its not fair that Wall Street firms should have to meet margin calls because market prices do not reflect "true values".

What a crock of ^&*(

People who can't swallow their own medicine are justifiably ridiculed and ignored. Wall Street is naive to think it will be spared this outcome.

Already, California has rejected Warren Buffet's offer to "insure" their bonds. Its not insurance, its more like a street gang charging "protection money". And Buffet is one of the "good guys".

Why would anyone care about synthetic ABS indexes? This blog can debate the merits pro/con, but the facts are that Wall Street won't take its own medicine -- so why should anyone else?

Sell side firms are going to go the way of the department stores of yesteryear -- they all too obviously don't understand the products (or risks) they are selling. They only provide liquidity when it isn't really needed -- but when liquidity is needed, Wall Street wants the Fed to provide it. NYSE Specialists are already a dying breed for the same reason -- they only provide liquidity when it isn't needed.

So who needs synthetic ABS anyways? The bigger question is, who needs Wall Street in general?

When all the dust settles, Wall Street is going to be a LOT smaller... its not just ABS indexes

Anonymous said...

anon 3:49pm

you sound like a person who wanted to make it to wall street, didn't and now bashes the wall street...and claim of a time when wall street will be 'useless'...

Michael said...

ABX was the right index for speculators at the right time. Unfortunately for anyone who would want to sell protection, the street likes these sort of indices because it allows them to hedge their pipeline. Because the natural player in these things is necessarily a short, a protection seller is squeezed from the start.

And then the cash bond guy gets leaned on, which, plainly, sucks. Ditching this idea was sensible, but only happened because the street has no pipeline to hedge, and knew they would have to take a mark to market loss when the inevitable speculative shorts came in.

Kudos to fear, 'spose

James I. Hymas said...

I think the point isn't whether the ABX is the right benchmark for one bond or another. More that it can't possibly be the right benchmark for all subprime securities.

Benchmarking can be kind of wild and is subject to manipulation. The virtually universally used Scotia Capital Canadian Bond Indices (now the "DEX" indices after being bought by the Toronto Stock Exchange, which is a much cooler name) include Innovative Tier 1 Capital - which have the risk profile of perpetual preferred shares, but are dressed up as bonds.

I will insist to my dying day that they were included in the indices in order to help sales.

Back to the original topic - what was it again? Oh yeah, sythetic ABS - I suggest that one thing missing from the contract is an Exchange for Physicals mechanism, which on expiration of the contract becomes delivery.

Cash settled contracts are evil; this is a problem with the CDS market as well.

Anonymous said...

Anon 9:15

I do work on Wall Street. I am embarassed that my fellow colleagues are such hypocrites and cowards.

We spent the last 20yrs trying to get the government out of our hair -- but now thanks to a bunch of greedy morons who can't spell risk much less understand it, we will now have a massive over-reaction by regulators to keep simpletons like you out of the business.

Stop whining for the Fed and everyone else to bail you out of your losing position. If you were practicing good risk management, you don't need the Fed to "provide liquidity"

The fact that you lashed out at me for pointing out the obvious (lack of ANY risk management due to complete failure to understand the product you are selling) tells me you are one of the people who screwed up Wall Street for the rest of us.

gramps said...

There is a really good blog entry over on Seeking Alpha that explains the housing problem (and the inflation problem) really well.

I have no idea who the author is; I haven't read anything else he may have written -- but on this particular topic, he applies some really simple common sense.

I would encourage everyone to read it.

Anonymous said...

Anon 9:15 ... since you decided to make a personal attack on an earlier poster-- without providing a shred of evidence or even anecdote one way or the other, please explain the following acts of Wall Street leadership:

1) Chuck Prince stating in July 2007 that everything was fine and Citi was "still on the dance floor"... Real estate had topped out a year and a half earlier and subprimes had already been blowing up, taking out two Bear Stearns hedge funds, as well as the UBS prop trading operation.

2) Treasury Secretary (and former Goldman Chairman) Paulson telling people around the same time that the subprime problem was contained

3) Merril CEO Stan O'Neal playing golf while Merrill lost hundreds of millions of dollars

4) Citi CEO Chuck Prince also absent while Citi burned

5) Bear Stearn's CEO playing bridge while Bear collapsed.

6) Credit rating agencies continuously rating issues AAA only to see the same declare bankruptcy

7) Fed Chair Bernanke saying repeatedly last summer that the subprime debacle was contained, then saying repeatedly during the fall that each Fed Funds cut was the last and things looked OK, and then saying in January everything was fine before making an emergency inter-meeting cut because he wasn't in the loop about a French bank's complete lack of position monitoring

Does this sound like an industry with great leadership?

And while the financial markets burn, the great blogosphere debates whether ABS indexes contain all tranches or just the longer dated stuff rated AAA by discredited rating agencies.... kind of like arguing which china-ware should be used for dining while the Titanic is sinking

Accrued Interest said...

Tone down the personal stuff guys. You should all know my low tolerance for that stuff.

Now, while I do think the ABX has problems, its obvious that Wall Street firms bet way too heavily on housing particularly and low volatility generally. All I'm saying is that when we go to mark-to-market, the ABX can't possibly represent every HELOC bond.

Patrick said...

Interesting post. Would you be interested in syndicating your content on the home page of my site? It's an online community of finance professionals ( http://www.wallstreetoasis.com ). I could add an RSS feed that will allow me to promote your blog posts to my home page (when i think it will lead to a good discussion and/or is appropriate), but I wanted to make sure you were comfortable syndicating first. The syndicated post would have a link back to your original post. Thanks, Patrick (you can reach me at wallstreetoasis@wallstreetoasis.com if you have any questions)