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:
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:
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.
