BIS Piles into ABX Debate, Says Subprime MBS Index is Overstating AAA Losses

More than a few analysts have argued in recent months that the ABX index is overstating subprime losses, to varying degrees of success; the Bank for International Settlements, however, made wide headlines Monday for suggesting that ABX trading prices might be overshooting actual losses on AAA-rated securities by as much as 60 percent.

The BIS report essentially amplifies the same findings put forth by Standard & Poor’s Rating Services credit analysts in late May; at the time, the report was the first major report to suggest that AAA ABX rolls weren’t reflective of actual loss experience for most AAA investors in subprime mortgage-backed securities.

That S&P report did not attempt, however, to quantify the degree to which the ABX was missing the mark.

The BIS report said its estimate of AAA-related subprime losses totaled just $73 billion, less than 15 percent of the roughly $600 billion in subprime MBS issued between 2005 and 2007. The ABX indexes suggested a AAA loss experience of $119 billion, in contrast, according to the report.

Much of the criticism of the AAA ABX rolls has centered on which AAA-rated tranches are used — the typical ABX AAA series uses AAA tranches that are in the so-called “first-loss” position relative to more senior debt with the same rating. Oftentimes, a single securitized transaction would possess more than one AAA-rated tranche.

“As prepayments and losses build over the life of a transaction, the classes with an early claim on principal repay,” said credit analyst Andrew Giudici, a director in Standard & Poor’s U.S. RMBS surveillance group. “Longer-dated ‘AAA’ classes remain outstanding as losses build and reduce available credit enhancement. As mortgage pools season, prepayment and loss trends provide insight into relative credit quality among all classes, including those rated ‘AAA’.”

To combat some of the criticism of its index, MarkIt Group — which introduced the ABX roughly two years ago — recently rolled out the ABX.HE.PENAAA tranche sub-index series, or the “penultimate” AAA sub-index, which references AAA-rated bonds that are second to last in principal distribution priority.

The two existing rolls of the penultimate ABX AAA sub-index hit all-time lows on Friday, with an 07-1 roll closing at $72.79, while a 07-2 roll closed at $61.55.