Thursday, March 27, 2008

Synthetic ABS. Who needs 'em anyway?

(Accrued Interest) Plans to create an auto loan ABS (asset-backed security) index, similar to the now infamous ABX index except for auto loans instead of home equity loans, were quietly scuttled last week. Creation of such an index would have allowed investors to buy and sell credit default swaps on a basket of auto loan securitizations, in effect, betting on the credit performance.

Why was it canceled? Partially because of the severe drop off in securitizations of consumer loans generally, there aren't a lot of recent auto loan deals to put into an efficient index. But there is a deeper issue. Many market participants are now questioning the value of these CDS indices. It was once thought that a more easily traded index of CDS would help improve price discovery in the asset-backed market. But is that what's happening now?

The market is only going to efficiently price a security when there is reasonable two-way flow. In other words, when a price is reached where there is a reasonable number of traders on both the short and long side. Is this what's been happening with the ABX index? No. Whatever you think of where actual value is on various ABX contracts, it certainly isn't a two-way market. Buyers of protection have dominated that market for about a year now. Of course there has to be a seller if there is a buyer, but I've persistently heard that sellers of protection have overwhelmingly been either paired trades along the capital structure (e.g., long the 2007-1 BBB and short 2007-2 BBB) or short covering.

Now one can look at any of the specific structures in the ABX library and make a case that the price should be higher or lower. That isn't the point. The point is that the ABX never developed natural buyers of risk. Once home equity structures became distressed, there were some buyers of cash bonds. But these are the kinds of buyers who want to comb through the structures and carefully analyze every dollar of cash flow. That kind of buyer is looking for a cash-flow diamond in the rough. Selling protection on the ABX is a bet on home equity spreads in general tightening. That's not the kind of bet distressed buyers like to make.

Meanwhile, with so few home equity bonds actually trading, the ABX became the only means of estimating a market value on home loan bonds. So right or wrong, the ABX became the "mark to market" for pricing many different types of mortgage-related paper. Buyers who were careful to buy higher quality home equity paper complained, as they believed they had better structures than those on which the ABX is based. But it didn't matter since there were no new deals with which to compare, the ABX is all auditors had to use as a base.

The negative feedback was severe. (Notice I didn't say it was a "loop") Any real money buyer who tried buying high quality home equity paper saw their marks based on the lower-quality ABX. Portfolio managers are hard-pressed to buy bonds, regardless of the fundamental value, if the mark is going to be substantially lower. With no real money buyers and liquidity very poor, it became impossible to securitize any mortgage-related paper.

What would have been better for all involved is if the market had been allowed to price bonds individually based on individual risk characteristics. Perhaps the dislocation in the mortgage market was too severe for that to have realistically happened. But the ABX caused everything to be priced on a lowest-common-denominator basis. That really didn't help anyone other than the shorts.

So given all this, it seems obvious why various market participants aren't too eager to create another ABX monster. Its true that default rates on auto loans are likely to rise significantly, both due to normal recessionary pressure as well as the weak housing market. But its also true that auto loan deals have been priced to take much greater losses than home loan paper ever was. Home loans were always modeled with the assumption that the collateral was an appreciating asset. Car loans never made this assumption. In fact, Fitch estimates that most AAA-rated auto loan deals can withstand 20% unemployment.

So the street would rather auto loan securitizations stand on their own cash flow results, rather than suffer the slings and arrows of outrageous technicals. There is a right price for ABS risk. Maybe, just maybe, finding that right price will allow the securitization market to make a slow comeback, at least outside of home loans. That will be a critical next step for solidifying market liquidity.

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