How Did the ABX Index Behave During the 2008 Subprime Mortgage Crisis?

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How Did the ABX Index Behave During the 2008 Subprime Mortgage Crisis?

The ABX index was developed by Markit Group Ltd. as a synthetic basket of products to provide insight into the subprime mortgage market. The ABX is divided into many sub-indices, each of which is a “tranche” of 20 credit default swaps, sometimes referred to as credit default obligations, which are backed by subprime mortgage loans.

Credit ratings for the tranches, which range from AAA to BBB-minus, are grouped. A fresh series is released every six months based on the biggest current offers. Lower subprime mortgage risk is correlated with higher values in any specific ABX index.

Coincidentally, the ABX was introduced on January 16, 2006, shortly before the subprime loan industry collapsed in 2007–2009. The ABX indexes “trade on price,” which means that an index is purchased and sold at the value of the securities it is backed by. Because of this, the indices’ performance during the financial crisis was extremely dismal and largely reflected the performance of credit default swaps.

The ABX does not, however, indicate the value of any one particular credit default swap, which is something that has to be noted (CDS).

Key Takeaways

  • The ABX Indices were introduced by market intelligence company Markit in 2006 as a means for investors to increase or decrease exposure to subprime residential mortgage-backed securities (RMBS).
  • A family of synthetic, tradeable indexes called the ABX indices.
  • Each index uses 20 subprime RMBS bonds or transactions that adhere to the standards for that particular index.
  • Each RMBS transaction consists of securities tranches that are organized according to credit ratings that range from AAA to BBB-minus.
  • Some observers saw the sudden drops in the ABX indexes as a harbinger of escalating instability in the housing and financial sectors prior to the 2008 financial crisis.
  Junior Mortgage

ABX as Indicator of 2008 Crisis

Prior to 2008, several observers believed that the abrupt drops in the ABX were early warning signs of the impending financial catastrophe. Spring 2007 saw a brief rebound, but it was quickly followed by even more drastic falls. The AAA index, which in theory ought to have been the safest and most valuable of all the ABX indexes, had a value decline of more than 30% between June 2007 and June 2008. The bottom tranches had a far bigger decline; by June 2008, the BBB-minus fell below 10, representing a value decline of more than 90%.

The greatest bank failure in American history happened at the height of the financial crisis when Washington Mutual, a significant savings and loan institution with assets of $307 billion, went under and was taken over by the Federal Deposit Insurance Corporation (FDIC).

Subprime Mortgage Lawsuits

Citi cited the ABX index as one of the elements it considered when calculating the value of its collateralized debt obligations in its 2008 annual report (CDOs).The company’s decision to incur significant write-downs for the year, totaling $20.7 billion in net write-downs, was influenced by the index.

The relevance of the ABX index as a gauge that should have warned banks and other financial institutions of the hazards arising in the subprime market is also mentioned in various lawsuits brought in the wake of the financial crisis.

Boston Retirement System claimed in a class-action complaint against Morgan Stanley that the value of the company’s $13.2 billion swap position was “inherently connected” to the ABX BBB index. Between May 31 and August 31, 2007, the index dropped 32.8%, and the value of Morgan Stanley’s swap position also declined by a same amount. However, Morgan Stanley only marked down their investment by $1.9 billion as opposed to $4.4 billion. The lawsuit claims that by taking this action, Morgan Stanley was able to fulfill third-quarter market expectations while delaying the disclosure of the company’s real financial situation.

  Secondary Mortgage Market Players

A lawsuit brought by a number of retirement funds against the Swiss bank UBS also mentions a drop in the ABX index as a warning sign. UBS wrote down $10 billion in subprime mortgages on December 10, 2007. According to the complaint, UBS began shorting the ABX index in September 2006 and ultimately built up a net short position because it was aware that the subprime and Alt-A mortgage markets were losing value. According to the complaint, the bank ought to have informed investors about its short position and the rising concerns in the subprime market.

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