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There’s triple A and there’s triple A

Has our blessed Bank of England got in a bit of a muddle over how the credit markets work?

We are not being facetious. The question was being asked widely on Friday as the markets digested the latest Financial Stability Review and its central proposition that credit markets have “overshot” on the downside.

Here’s the nub. The bank projects cumulative credit losses on US subprime and compares them with the implied losses on tranches predicted by current market prices - as measured through the benchmark ABX indices.

Extrapolating observed delinquancy data forward, the Bank assumes seriously delinquent mortgages default with a least a 75 per cent probability after one year and have a ‘loss given default’ (LGD) rate of 50 per cent.

It charts those projected losses thus - and makes the bold statement that triple A tranches remain unscathed:

1176.jpg

Yet triple A tranches of subprime - as measured by the ABX indices - are anything but unscathed by such default rates.

What the Bank has not expanded upon is the fact that triple A comes in various flavours of risk - from junior to super-senior. And the ABX indices, produced by Markit Group, only include the most junior tranche.

This ‘junior triple A’ would typically run between the 85 to 70 per cent marks of the underlying collateralised debt obligation. At a 75 per cent default rate and an LGD hit of 50 per cent, around 37 per cent of the collateral would be wiped out - which would indeed eat right into that ‘junior’ triple-A tranche. The loss suffered by holders of supposedly super-safe AAA debt is very real indeed.

That explains this chart, of ABX implied prices, which the Bank suggests is all down to “market panic” factors, rather than the market actually pricing in likely future losses:

1178.jpg

Indeed, just this week Markit acknowledged that the ABX only reflect the riskiest ‘junior’ tranche of triple A, adding a “Penultimate AAA Sub-Index” to the ABX series so as to reference triple A paper that is “2nd to last in principal distribution priority.”

All of which is a bit alarming. Britain’s central bank is implying that the banks it regulates should perhaps mark their dud assets to model, rather than to market, on the basis that market prices are unreal.

In fact, in terms of when the ABX measure, the market is probably stone cold accurate.

It may, or may not, be right for banks to mark-to-model - but that is because they tend to be holders of the more senior tranches of triple A subprime, rather than the junior stuff currently included by Markit.

But extending that thinking to a declaration that credit markets generally have overshot is dangerously misleading.

This entry was posted by Paul Murphy on Friday, May 2nd, 2008 at 10:59 and is filed under Uncategorised. Tagged with . You can follow any responses to this entry through the RSS 2.0 feed. Responses are currently closed, but you can trackback from your own site.

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Comments

  1. May 03   22:53 Posted by zaphod [report]

    It would be interesting if anyone had any input on the LGD 50% ratio. I would think that this could probably become much larger, given that a lot of new developments has been placed far from cities. With higher gas prices and long commutes, they could end up as worthless gost towns.

    Also given the water shortage in the western US, large developments in Nevada and Arizona, may face similar issues, where some developments will simply not be worth living in at any cost.

    It seems quite common in real estate busts, that the marginal properties will excibit the greatest volatility in prices, and can become unsellable when times are tough.

  2. May 02   22:51 Posted by cs [report]

    Paul: Just want to say thank you. This kind of error gives us “trying to understand what is going on here” folks a much better understanding of what is going on.

  3. May 02   14:43 Posted by t2k [report]

    Paul: I’ll be standing in a corner too. However I expect that this discussion shows why many won’t invest in such stuff - it’s just too hard to understand like most derivatives. t2k

  4. May 02   14:35 Posted by c [report]

    WH, you are right. But prepayment in 2006 and 2007 vintages is much lower than in 2005 and is thereore a less important factor to consider compared to delinquencies. For instance, for the said ACE 2005-HE7 deal, prepayment was 13.2% of balance after 8 months from issuance; for ACE 2007-HE4, it is only 6%. The impossibility for house owners to refinance, and the incentive for them to walk away being in negative equity, means that pre-payments will be even lower going forward. Much more important is to focus on delinquencies which, even when adjusted for prepayment, are simply mind-boggling. Once again, ACE 2005-HE7 had 5.49% delinquencies after 8 months from issuance; ACE 2007-HE4 has 41.17%. That’s 7.5x as many.

  5. May 02   14:26 Posted by Paul Murphy [report]

    Ok, I clearly screwed up with this. i was way out of my depth and I will now spend the rest of the afternoon standing in the corner.

    But I will leave the post up for now because the debate is interesting.

    Murphy/Alphaville

  6. May 02   14:19 Posted by WH [report]

    Cicero,
    How relevant is the delinquency rate you rare citing in this situation? As I understand it the delinquency rate will continue to rise as delinquencies remain high but as good loans get paid down, the denominator shrinks. Your maths would be right if there were no prepayment in the ACE 2005-HE pool, which I assume isn’t the case.

  7. May 02   14:15 Posted by t2k [report]

    How does any “insurance” get taken into account in valuation bearing in mind monolines are unlikely to be able to pay out?

  8. May 02   14:06 Posted by G Cox [report]

    Cicero ,
    Thanks for your stuff to the extent we all can understand the complexity.

    When i see someone say a mortgage group is 47% delinquent, and a pessimist (you) assumes only a worst case outcome of 60%, it looks optimsitic given that in the areas that are generating the bulk of the problems (eg San Diego), prices are only now arriving down to the point in relation to earnings where previous booms topped out: ie there is still along way to go. Is there something special about these tranches that stop them going to 70 or 80 % serious delinquencies given the ease of walking away and the possibility of anti-lender foreclosure legislation or are you assuming that the bulk of the sub-prime area defaults are genuinely in? Any comment would be appreciated

  9. May 02   13:05 Posted by cicero [report]

    I think the BofE is wrong. Take the ACE 2005-HE 07 deal, whose A-2D tranche is in the ABX AAA 06-1 index. Delinquencies are running at 50.53%, serious delinquencies at 47.21% - and growing.

    Assuming final 60% serious delinquencies, 80% of which convert to defaults, a LGD of 50% gives you 24% losses. With an attachment point of 21.52% and detachment at 26.09%, it means that half of the A-2D tranche would be wiped out.

    Extreme assumptions? I don’t think so. The AAA 06-1 index, which is where the tranche above is referenced, trades at 94.59. This is way better than the 58.11 of the AAA 07-2. Why? Because the performance of the collateral pool of the 2006 and 2007 is MUCH WORSE than 2005’s.

    Interestingly, the BofE doesn’t show a comparative chart of subprime delinquency by vintage. It’s figure 1.2 (!!!) in the IMS’s Global Financial Stabiity Report.

    I would not be surprised at all if junior AAAs of the 2006-2007 vintages had 0 recovery.

  10. May 02   12:58 Posted by WH [report]

    You are confusing default given delinquency % with default %. j kommer is spot on. You also seem to be confusing a collateralised debt obligation with a RMBS tranche.
    You are correct that the ABX AAA is worse than the average AAA subprime RMBS, but at a 15% loss rate, but the ABX is pricing in worse than that.

  11. May 02   12:17 Posted by t2k [report]

    If BofE is correct why are they still calling for banks to come clean and fully detail these wonderful assets?

  12. May 02   12:12 Posted by Paul Murphy [report]

    Fair enough Mr Kommer. We’d welcome further comments on this - even if it proves that one P Murphy is muddled - and not the Bank of England.

  13. May 02   11:42 Posted by j kommer [report]

    Paul:
    The default rate of 75% is to be applied to the “serious” delinquency rate not the whole pool,[see page 18] so if you have say 42% delinquency, 75% prob of default and 50% LGD, that kills 15.75% of principal collateral. That’s not enough to hit even the junior AAA. Subprime RMBS have strong overcollateralization and excess spreads are higher than expected because of slower prepayment.
    The BofE is correct IMHO.

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