“While we believe the ABX provides insight into the U.S. residential subprime mortgage market, we think its indices provide only limited insight into class-level creditworthiness among ‘AAA’ rated U.S. RMBS,” said credit analyst Andrew Giudici, a director in Standard & Poor’s U.S. RMBS surveillance
“The ‘AAA’ tranches that were included in the original ABX indices were the last-pay ‘AAA’ bonds in their respective deals, which are relatively more exposed to losses than ‘AAA’ classes with a priority claim on cash flow.”
Giudici and the report’s other authors argue the ‘AAA’ classes share equally in any losses on a pro rata basis once credit enhancement is exhausted, structural subordination does exist in the form of payment priority — and that subordination often serves to protect senior-most bondholders.
Typically, all principal prepayments are initially directed to pay down the first ‘AAA’ class until it is paid off in full. Once that class is retired, all future principal is directed to repay the next class in sequential order (performance triggers may temporarily alter this payment priority, but we’ll avoid more complex issues here for now).
“As prepayments and losses build over the life of a transaction, the classes with an early claim on principal repay,” Giudici said. “Longer-dated ‘AAA’ classes remain outstanding as losses build and reduce available credit enhancement. As mortgage pools season, prepayment and loss trends provide insight into relative credit quality among all classes, including those rated ‘AAA’.”
S&P’s research comes on the heels of a very recent introduction of the ABX.HE.PENAAA tranche sub-index, or the “penultimate” AAA sub-index, which references AAA-rated bonds that are second to last in principal distribution priority.
It’s worth noting that the 2007 roll of both new penultimate sub-indexes — the ABX-HE-PENAAA 07-1 and ABX-HE-PENAAA 07-2 — settled at all-time lows Friday. The second 2007 series closed at $66.92, according to data provided by MarkIt, which administers the ABX index.