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Dow vs ABX

I'd say that the success of business television (CNBC and the like) in the US, is built on one fundamental insight by those producing it: if you can make it sound like sports coverage, then it feels engaging.

And we all know that Americans love their statistics - in sport, obviously. And in finance too.

Yet one of the problems in covering the sub-prime debacle is that the usual scoreboard measuring US financial health is the Dow Jones Industrial index. And although it has had its ups and downs this year, it really doesn't tell a very interesting story of near financial meltdown.

We need another way of scoring the financial sector, to better reflect the way the game is going.

With that in mind, I today went to get a lesson on the ABX indices. These have had some recent prominence in the financial pages and get mentioned on CNBC, but I'm surprised they haven't made it much beyond. Because if you think a financial crisis of the magnitude we have endured deserves graphs diving in a downwards direction, then the ABX is what you want.

There are lots of ABX indices actually, so take your pick. You can find them here.

I had them explained to me today by Robert Pickel, chief executive of the International Swaps and Derivatives Association. And I made sure we had a photo of a couple of the graphs so you can get the general idea.

Essentially, there is one index for each vintage of sub-prime mortgage backed assets; and there is one for each level of risk. So for example, there is one index for AAA ultra-safe sub-prime assets, from each half of both 2006 and 2007.

Graphs

In the picture with my fingers in, you are looking at the performance of AAA securities, from the second half of 2006. In the picture without my finger, you looking at BBB- of the most recent vintage.

I won't go into much detail, suffice to say that the index is always constructed to perform like a bond price, so that par value is 100. Expected defaults in the assets underlying the index lead to prices below 100 (but you can't read the value of the index as a percentage default rate; it's more complicated than that).

But there are two fascinating things about ABX.

First is the rating of those AAA ones. They were worth about 100 until May and you can only describe the performance since then as a crash.

Yes, a crash.

And secondly, it is noteworthy that the 2006 mortgages seem to perform better than the 2007 ones. The longer the sub-prime boom went on, the more reckless was the lending and the higher the expected defaults.

So the first AAA index from early 2006 is worth about 90 now; a pretty awful performance for a AAA rated product. But the most recent sub-prime AAA securities are trading at 67.

Now I'm not index mad. But I do like an index to reflect the story, and the stock market is not doing that.

Obviously long term, the fate of the entire corporate sector of the US - encapsulated in share prices - matters more than the fate of one kind of sub-prime asset-backed security market.

But in the short term, it is the exotic paper that is driving things. Why?

Because of the degree of bank exposure to sub-prime mortgage assets. When stocks fall, wiping hundreds of billions of dollars off share prices, the people who own shares are poorer. So, that happens from time to time.

But when hundreds of billions of dollars of losses are being made by banks (or their off-balance sheet profit-centres), well that affects their capital, and their ability to lend. And as banks lend a big multiple of their capital, when the capital falls only a even a small amount, their lending can fall a lot.

And when lending falls a lot, the economy can stumble. Just as it did in the great depression for example.

Of course, when the stock market wakes up to that possibility, it might fall a lot more than it has, and then it to will tell the tale of what's going on.

But at the moment, it is our relatively new friend the ABX to watch.

Comments   Post your comment

  • 1.
  • At 02:51 PM on 27 Nov 2007,
  • SC wrote:

But ,this is history. That is ,it's a known if unquantified problem.The stock markets chewed it over as far as it can based upon the available data which was not exactly fortcoming. If you don't believe stocks anticipate ,or reflect economic reality then throw up a chart of the UK Bank sector from late spring last year...note ...LAST YEAR . The bear market you are looking for is right there !

Now to keep you interested why don't you have a dig on corporate debt and high yield 'junk' bonds. The scale of that and implications for similar lousy lending practice should keep your readers awake a few nights.

  • 2.
  • At 03:30 PM on 27 Nov 2007,
  • Stan Halse wrote:

... but in 1929 industry was capital intensive, and thus sensitive to bank lending. Today it is much more knowledge intensive, and much of it is self-funded and growing organically, on the back of the clever uses of cheap software, and trusted networks of customer and stakeholder relationships.

Apart from M+A, investment trading, and consumer credit the banks' role as economic drivers is being marginalised.

  • 3.
  • At 03:30 PM on 27 Nov 2007,
  • Tom wrote:

The reason the 07 vintage of the ABX is performing worse than the 06 vintage is not that the 07 loans were "more reckless". It's simply that loans made in early 07 were made at the very top of the housing market, which has been falling all year. Therefore far more of the 07 vintage loans are now in negative equity - which of course is the reason they are defaulting in huge numbers.

As the housing market has continued to fall, expect the defaults on the 06 loans to catch up with the 07's, and then probably overtake them in the next 18 months as the adjustable rate mortgages contained therein reset to higher interest rates. The borrowers, of course, will mostly be in negative equity and hence unable to remortgage.

  • 4.
  • At 03:40 PM on 27 Nov 2007,
  • john thomas wrote:

I knew it, I knew it, I knew it!

I've being saying this in my responses to various of Mr Preston's blogs since the begining of September. Why aren't the markets reflecting the increasingly dire economic indicators. It's almost like they are wilfully ignoring the data and rather than price IN the credit cruch they have sought to price it OUT.

So, according to Mr Davis, what's happening is that while the on balance sheet merde is well on its way to be accounted for, it is the off balance sheet AAA+merde with go faster stripes that will do for us all!

And because the markets have no way of putting a realistic value on this (cos if they could the dealing screens would be deep deep red for weeks) they have simply chosen to ignore it. Brilliant!

we're doomed I tell you....all dooooomed!

  • 5.
  • At 04:23 PM on 27 Nov 2007,
  • Scamp wrote:

#2

"but in 1929 industry was capital intensive, and thus sensitive to bank lending. "

That's because then we built lots of things and today we don't.. That's why we have a trade deficit in goods equal to the GDP of a small country!!

"Today it is much more knowledge intensive"

So is making things.. In fact even more so.. Much of this "making things" knowledge is now being exported as fast as the City can move by selling off all our "making things" companies to overseas buyers. Bye bye Jaguar and Land Rover.

".. and much of it is self-funded"

Because a lot of it is service based... e.g. web design stuff based on mainly US "manufactured" software which they just love to sell us.

"and growing organically, on the back of the clever uses of cheap software, and trusted networks of customer and stakeholder relationships."

Jolly hockey sticks...

"the banks' role as economic drivers is being marginalised."

Tell me about it... The banks could solve the risk equity gap at a stroke but won't. We need new banks.

  • 6.
  • At 04:53 PM on 27 Nov 2007,
  • Orcan wrote:

Wow! finally somebody is reporting this.

If the major holding banks marked these assets to market they would effectively be insolvent.

The is VERY VERY scary indeed!

Just look at exactly who is holding this stuff.

  • 7.
  • At 05:02 PM on 27 Nov 2007,
  • Tom wrote:

John Thomas, the reason the realities of the credit market ills are not being reflected in the stock market (at least not fully, yet) are because the market actors are still hoping that this is a short term 'blip', like the Long Term Capital Management fiasco in 1998. When they realise it isn't just a blip, then reality will begin to set in.

There is also a misguided belief that Fed rate cuts will save us all - absurd seeing as it was interest rates being too low that got us into this mess in the first place.

  • 8.
  • At 07:08 PM on 27 Nov 2007,
  • Simon Stephenson wrote:

Tom - Comment 3

Thanks. You beat me to it. Did it take you more than 5 seconds to work it out?

How can we even begin to make sense of this UNLESS we realise that the reason this has been allowed to go on for so long is that rising property prices have made payment defaults painless - they've taken away the risk of the lenders losing money, because repossessions generate sufficient money to pay off in full the loan in default. In fact, a nice high level of pain-free defaults is good news for the lenders, since it allows them to clean up on the charges made to "cover" the cost of repossessions. Trebles all round!

The difficulty comes when property prices don't behave themselves - they stagnate, or even fall - so there is no longer collateral cover for the defaulting loans. Whoops! Oh, but it's OK because we'll just release some of the contingencies built in to cover for just this eventuality. Whoops! Because the assumption was that property prices would never fall, so all these contingencies have been released as profit and bonuses, so what could have been used to get us through this problem has largely been urinated against the walls of the champagne bars of Wall Street and the Square Mile.

  • 9.
  • At 07:59 PM on 27 Nov 2007,
  • Colin Smith wrote:

Meh. It's only money.

Stop borrowing it into existence and start printing it into existence.

The financial services sector have long since stopped being an asset to the US and UK. For 30 years they've been running in spirals increasing the lending to themselves and thereby the proportion of the economy which they represent. What're we up to now? 30%?

It's time to stop the roundabout.

Bring on Full Reserve Banking... You Know It Makes Sense.

  • 10.
  • At 09:58 PM on 27 Nov 2007,
  • Pete wrote:

'Experts' talked up the markets in the last 10 years convincing people that things were far better than they actually were. Many ordinary people have been feeling slightly worse in the pocket off each year. Now 'experts' are in search of the 'facts' to convince people that things are really bad. When markets lose a lot of points in a day - headlines. When they go up as today in the US - nothing. I get the impression that the BBC 'experts' are trying to manufacture panic rather than report what is going on and point#2 is a perfect example of pointing out the need to think about what is actually happening now rather than 1929.

  • 11.
  • At 01:46 PM on 28 Nov 2007,
  • Geoff Brown wrote:

We keep reading that the credit crunch is far from over because there might be as much as one trillion dollars worth (maybe more maybe less) of useless bonds circulating around the world money markets.

However the real problem is the fact that none of the financial smart arses who caused this problem and pay themselves obscene sums of money because they believe they have exceptional financial skills and abilities, knows where quite what thes bonds look like or where they are being kept. No one seems to know if these are distributed evenly around amongst the institutions at a manageable level or are just a small number of institutions hiding them because the amount of debt they incur is unmanageable.

So now we have reached the stage where CEO's appear to no longer have any idea of the true worth (or if they have any value at all) of the company's they are managing. So now they are burying their heads in the sand hoping the problem will go away or perhaps someone else will sort out the mess.

Now it's time for these financial whizz kids to earn their big fat saleries by showing their mettle and ensuring the wheels of the financial markets continue to turn and do not grind to a halt. If they let that happen then the free market financial model, that got us into this mess, might well be replaced by the older and more draconian banking model.

If that happens then we all be in trouble for some time to come.


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