Joe Haubrich and Brent Meyer are busy out-blogging me these days, at the Cleveland Fed website. This time, they go about the business of describing credit default swaps, ABX.HE indexes, and why they are among the sharper tools in the current forecasting box:
... the ABX.HE index... is based on credit default swaps on different tranches of subprime mortgage-backed securities (MBS).
... the ABX.HE index is telling us something about credit default swaps (CDS). A CDS is like a derivative that gives you insurance. For example, a bank may wish to buy protection against default by RiskyCorp (perhaps because they’ve given RiskyCorp a loan). They do this by entering into a contract where they pay another firm (who is selling protection) a fixed amount, periodically, as long as RiskyCorp doesn’t default on its corporate bonds. (In general, the “credit event” might be something else, such as a major downgrade, missed payments, or so forth.) If RiskyCorp does default, the seller of protection makes a payment to the buyer of protection.
... the ABX.HE is a series of five indexes that track CDSs based on tranches of mortgage-backed securities comprised of subprime mortgages and home equity loans. The tranches differ by their ratings, from AAA (best credit) to BBB-, (least good credit). See MarkiT, which produces the indexes for the real details. For an example of how indexes work, see here.
The prices of the riskier tranches started moving down in late 2006, but the real action started in late 2006, so a closer look is appropriate. There’s not a lot of movement among the top-quality tranches, the AAA and AA, but February (when New Century Financial and HSBC, the number-three and number-two subprime lenders, announced problems) was rough on the lower-rated indexes, with the BBB- dropping from 90.85 to 64.46. That’s a 29 percent drop in only one month. Since then, there’s been a rebound, up over 10 percent, but the market seems to be anticipating continuing large losses in the subprime market.
Here's the picture:
As Joe and Brent note:
... because the CDSs are more standardized and generally more liquid than corporate bonds, you can see why Federal Reserve Vice Chairman Donald Kohn states that “instead of looking to the bond market to measure default risk, we are increasingly turning to the market for credit default swaps”...
Advice taken.