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Generational Dynamics Web Log for 25-Feb-07
How to interpret and price the ABX derivative table. (Corrected)

Web Log - February, 2007

How to interpret and price the ABX derivative table. (Corrected)

As investors panic over the rapid housing bubble collapse in the subprime mortgage loan market, analysts are closely watching the the daily postings of the ABX index as they appear around 3 pm ET each business day.

The collapse began in December, accelerated slightly in January, and turned to total panic at the beginning of February.

Here is the complete table, posted on Friday, February 23, 2007:

23-Feb-07 Overview
|Index   Series    Version   Coupon RED ID   |Price|High  |Low	|
|----------------- --------- ------ ---------|-----|------|-----|
|ABX-HE-AAA 07-1   7       1   9    0A08AHAC6|99.15|100.09|99.15|
|ABX-HE-AA 07-1    7       1  15    0A08AGAC8|99.15|100.09|99.15|
|ABX-HE-A 07-1     7       1  64    0A08AFAC0|92.50|100.01|92.50|
|ABX-HE-BBB 07-1   7       1 224    0A08AIAC4|75.21| 98.35|75.21|
|ABX-HE-BBB- 07-1  7       1 389    0A08AOAC1|68.50| 97.47|68.50|
|ABX-HE-AAA 06-2   6       2  11    0A08AHAB8|99.15|100.12|99.15|
|ABX-HE-AA 06-2    6       2  17    0A08AGAB0|99.15|100.12|99.15|
|ABX-HE-A 06-2     6       2  44    0A08AFAB2|92.69|100.12|92.69|
|ABX-HE-BBB 06-2   6       2 133    0A08AIAB6|76.80|100.58|76.80|
|ABX-HE-BBB- 06-2  6       2 242    0A08AOAB3|69.39|100.94|69.39|
|ABX-HE-AAA 06-1   6       1  18    0A08AHAA1|99.54|100.38|99.54|
|ABX-HE-AA 06-1    6       1  32    0A08AGAA9|99.76|100.73|99.76|
|ABX-HE-A 06-1     6       1  54    0A08AFAA7|96.20|100.51|96.20|
|ABX-HE-BBB 06-1   6       1 154    0A08AIAA4|88.50|101.20|88.50|
|ABX-HE-BBB- 06-1  6       1 267    0A08AOAA2|85.17|102.19|85.17|

Here's the definition of the various columns:

Index. This is ABX-HE, the index for mortgage loan insurance derivatives.

Series. This incorporates two subfields:
- Tranch. The values are: AAA, AA, A, BBB, BBB- . These are the investment grades. "AAA" is the highest investment grade, representing loans to the most creditworthy corporations. "A" is the investment grade for standard prime mortgages (the old fashioned kind, where you put down a 20-30% down payment, and then make monthly payments based on a fixed interest rate). "BBB" and "BBB-" are the investment grades for the riskiest subprime mortgage loans, with "BBB-" being the riskiest.
- Version. The values are: 06-1, 06-2, 07-1. 06-1 refers to loans made prior to the first half of 2006 (H1 2006 or 1H2006). 06-2 refers to loans made prior to the second half of 2006 (2H2006). 07-1 refers to loans made prior to the first half of 2007 (1H2007). (Corrected 23-Jun-2007)
  The launch date for the index is determined by the Version: 06-1 was launched on January 19, 2006; 06-2 was launched on July 19, 2006; 07-1 was launched on January 19, 2007.
Coupon. This is the annual payment. When you purchase this insurance, you have to pay this percent of the amount being insured at the beginning of each year.

RED ID. This is the index code identifier.

Price. This is the current index value, and it represents an additional premium price above the Coupon percentage. This price index is always 100 on the day that the index is launched. As investor confidence changes, this value increases as confidence increases, and decreases as confidence decreases. This is the value that analysts are watching, because it's been dropping like a stone.

High and Low. These are the high and low daily values of the index price since the index was launched.

Now, let's take an example. Let's suppose that you're a bank, and you have $10 million in high-grade "AAA" mortgage loans on your books, and another $10 million in "BBB-" subprime mortgage loans. You're afraid that some of your borrowers won't be able to pay, and you want some insurance.

If you buy that insurance on the day that the index is launched, July 19, 2006, then you pay only the Coupon price. In the case of the highest rated "AAA" loans, the Coupon value is "11", and so you pay (0.11% x $10 million), or $11,000 for $10 million in "AAA" loans.

The rest of your loans are "BBB-" quality, and there the Coupon value is "242", and so you pay (2.42% x $10 million), or $242,000 for the same kind of insurance on your "BBB-" loans. Quite a difference.

That's what happens on the first day (July 19, 2006), because the Price index is always 100.

Index price of ABX-HE-AAA 06-2 from August 2006 to Feb 23, 2007 <font face=Arial size=-2>(Source: Markit.com)</font>

Index price of ABX-HE-AAA 06-2 from August 2006 to Feb 23, 2007 (Source: Markit.com)

But now let's suppose that you waiting until this past Friday, February 23, 2007, to buy the insurace. (These are still loans that were granted in the second half of 2006, and so the "06-2" version is still what we want.)

On Friday, February 23, the price index for ABX-HE-AAA 06-2 (from the table above) was 99.15. You still have to pay the $11,000 Coupon price, but you also have to pay an additional ((100% - 99.15%) x $10 million) = $85,000. So, if you bought the insurance on Friday, you would pay a total of ($11,000 + $85,000) = $96,000.

Index price of ABX-HE-BBB- 06-2 from August 2006 to Feb 23, 2007 <font face=Arial size=-2>(Source: Markit.com)</font>

Index price of ABX-HE-BBB- 06-2 from August 2006 to Feb 23, 2007 (Source: Markit.com)

Now, what about the subprime "BBB-" tranch? On Friday, February 23, the price index for ABX-HE-AAA 06-2 (from the table above) was 69.39. You still have to pay the $242,000 Coupon price, but you also have to pay an additional ((100% - 69.39%) x $10 million) = $3,061,000 So, if you bought the insurance on Friday, you would pay a total of ($242,000 + $3,061,000) = $3,303,000.

Here's a summary of all four computations:

Date 	   Index           Coupon Price  Total payment computation
---------  ---------------- ---- ------  --------------------------------------------
19-Jul-06  ABX-HE-AAA 06-2   11  100.00  $10M x (0.11% + (100%-100.00%)) =    $11,000
19-Jul-06  ABX-HE-BBB- 06-2 242  100.00	 $10M x (2.42% + (100%-100.00%)) =   $242,000

23-Feb-07  ABX-HE-AAA 06-2   11   99.15  $10M x (0.11% + (100%- 99.15%)) =    $96,000
23-Feb-07  ABX-HE-BBB- 06-2 242   69.39	 $10M x (2.42% + (100%- 69.39%)) = $3,303,000

What this computation shows is that even hiqh quality tranches are being affected. The price for the "AAA" quality insurance went from $11,000 to $96,000, a factor of a little less than 9. The price for the "BBB-" tranch insurance went from $242,000 to $3,303,000, a factor of 14. Both of these changes are exceptionally high.

What makes them have the appearance of a "panic," though, can be seen from the two graphs shown above. As you can see, the huge drop in both these indexes has occurred mostly in the last couple of weeks.

Generational Dynamics has been predicting since 2002 that America is headed for a new 1930s style Great Depression. As happened in 1929, this crash will begin with a panic, with the stock market falling to Dow 3000-4000. This panic might occur tomorrow, next week or next year. There's no way to predict exactly what will trigger it, but the current collapse in the ABX index bears close watching. (25-Feb-07) Permanent Link
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Generational Dynamics Web Log for 25-Feb-07 How to interpret and price the ABX derivative table. (Corrected)

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Generational Dynamics Web Log for 25-Feb-07
How to interpret and price the ABX derivative table. (Corrected)