There was cheery talk of the rally in Treasuries Monday, but that was in large part due to a continued flight from risk. One symptom was that the riskiest ABX index, ABX.HE 7-01, which is a proxy for recent vintage BBB- subprimes, took a nosedive and then recovered, Traders used swords like “panic” rather than technical factors, to explain the market action.
From the Wall Street Journal:
A record low on a closely watched derivative index that measures risk of home loans made to borrowers with patchy credit histories pushed U.S. Treasurys sharply higher as investors sought a haven for their funds.
A lack of economic data meant there was little to distract investors, but concerns continue to deepen that subprime woes will spread further to the far corners of the credit markets.
The riskiest, BBB-minus slice of the subprime derivative index, known as the ABX.HE 07-1, hit a record low of 45 cents in yesterday’s trade, according to Alex Pritchartt, a trader at UBS. The index, which stood at 49 cents late Friday, edged back up to 46 cents in heavy afternoon trade, but the mood in the market remained dour.
“People are panicked,” Mr. Pritchartt said, noting that there was no specific news driving the declines.
The ABX index, which contains slices of risk ranging from the safest AAA-rating to the riskiest BBB-minus, is renewed every six months and measures the credit risk of select loans originated in the prior six-month period. The current index is influenced by mortgages originated in the last six months of 2006 when lending standards were especially lax.
The decline in the BBB-minus portion of the index encouraged some investors to snap up U.S. Treasurys, pushing the 10-year benchmark note back toward the key psychological level of 5%.
Some investors fear the drag of subprime mortgages will eventually hurt the broader economy and other asset classes not directly linked to such loans. Those concerns have boosted Treasurys on and off for the past month.
Treasurys yesterday were “at the feet of subprime,” said William O’Donnell, rates strategist at UBS. The market’s reaction is surprising, however, said Mr. O’Donnell, who thought investors had already “come to grips” with a declining index. “But I guess people are still on tenterhooks” about anything subprime related, he said.
It isn’t just the closely watched BBB-minus tranche of the ABX index that is suffering under growing subprime concerns. Andrew Lahde, managing partner of Lahde Capital Management, a hedge fund in Santa Monica, Calif., pointed out that the A tranche is trading at about 70 cents on the dollar, compared with 90 cents on the dollar just a month ago. Mr. Lahde has positioned for declines in the index. “I think people are betting on a bloodbath,” Mr. Lahde said, adding that he is surprised the higher tranches are “coming unglued” already.
Barry Ritholtz of the Big Picture also used the word “panicked” but said the cause might also be hedge fund liquidations. And remember, we have heard tales of hedge funds suffering 30%-50% losses, which pretty much means they have to wrap up, so this could be a short-lived phenomenon. But even so, if you have price discovery at a low level, and no trades taking place at higher prices (simply because the paper doesn’t trade on a routine basis), what is this going to do for how investors view (and more importantly, mark) their holdings?
Ritholtz also provided these charts:
Triple A
2007
2006
Double A
2007
2006
I’ve never seen anything embody a free fall so perfectly before.
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It won’t end up looking like a free fall: looks like a market adjustment that hasn’t found the new support level yet. (I’m guessing that will be around 85-87.)
Calling a support level of 85-87 would require a model that would fairly price a security that is in unprecedented territory and could predict how subprime loans behave in a negative HPA environment (if you can do that please do everyone a favor and start a new rating agency) – the only way these get a support level is when the shorts decide to start covering – with a high level of panic I really can’t see too many ‘highly confident’ investors willing to step in and take the opposite side at any level (unless they are covering). The problem here is that we haven’t seen how a RMBS will play out over the next few years. Looking at remit reports at this point on a 2006 vintage gives you about enough information to predict how many hurricanes we will have next year. So there isn’t much fundamental analysis going on here on a single index basis – (this is evident in the fact that the 07-01 AA index spread is 266 basis points wider than the actual cash bonds, and yes they don’t trade frequently but you get the point, BBB- is 1168 basis points wider as of close yesterday) However there may be fundamental trades being put on based on a relative value basis between different vintages – hence the reason why the 06-01 isn’t moving with the later vintages as much anymore. The fundamental reason behind this is that the 06-01 has had seasoned months with decent (lower but decent) prepayment speeds – therefore the current support for the lower tranches is growing on a percentage basis of the outstanding balance, which would require higher default rates and higher severity rates to generate losses to the tranche – I have been short the ABX BBB- since ~99 – I have heard time and time again there will be a support here – and I have almost convinced myself sometimes – but then I remember – predicting this market is like predicting weather on another planet.
The ground is always the support of last resort.