Pricing ABX index for Newbies

Got asked this from one of my friends today. I thought I would put this article together for future reference in case someone (or myself) may get asked this during an interview with some of the credit rating agency or hedge fund working with mortgage portfolio.

All data reference is from MarkIt website since I have used their data service before.

What is ABX.HE index?

When Markit Group Ltd. started indexes of the subprime-mortgage market in 2006, there was no fanfare. They were called the ABX.HE indexes, and for many months, most investors had no idea of the market measures with the wonky name. The ABX, launched in January 2007, serves as a benchmark of the market for securities backed by home loans issued to borrowers with weak credit.

“Creating visibility and transparency was a goal of the index, but not everyone knew it would be so closely followed,” said Ben Logan, a managing director at Markit Group, a London-based company that specializes in credit derivative pricing and administers the index.

Now, the indexes are some of the most closely watched barometers on Wall Street. They are a focal point for trading in the U.S. subprime-debt markets — which lately have come to dominate attention on Wall Street because of problems at two big Bear Stearns Cos. hedge funds.

What do the numbers in ABX series mean?

How does MarkIt collect ABX.HE index data?

From offices in London, Markit collects credit-default-swap pricing data from about 80 credit-market dealers. Markit’s computers then compile and clean those data and distribute them early the next morning to clients

How does MarkIt publish ABX.HE index data?

Any given ABX.HE index comprises just 20 names, all of which are mortgage-backed securities with the same credit rating, and all of which were issued within six months of each other. Each name carries a 5% weight in the index.
The level of the index reflects not the price at which those names are trading, but rather the price at which credit default swaps on those names are trading. (The MBSs themselves barely trade.)

How does ABX.HE index data look like?

Source: abx page
If you click on each index name, it will show the constituents (20 mortgage-backed assets).

What does each column mean?

Here’s the definition of the various columns:

1. Index. This is ABX-HE, the index for mortgage loan insurance derivatives.
2. Series. This incorporates two subfields:
3. 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.
4. Version. The values are: 06-1, 06-2, 07-1, 07-2. 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). 07-2 refers to loans made prior to the second half of 2007 (2H2007). 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; 07-2 was launched on July 19, 2007;
5. 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.
6. RED ID. This is the index code identifier.
7. 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.
8. High and Low. These are the high and low daily values of the index price since the index was launched.
9. Factor. The portion of principal currently outstanding is expressed as a Current Factor, which is initially 1.

How ABX is priced?

The ABX.HE indices trade based on price rather than spread, with a pre-determined fixed coupon (i.e., Fixed Rate) unlike the indices of corporate CDS, such as the DJ CDX and the iTraxx, with the exception of EM and HY. The fixed coupon is determined before the launch of the new series. If the quoted price of an index is different from par, the seller and the buyer of protection settle the difference when they enter into a transaction.
If the quoted price is below par, the protection buyer makes a payment to the protection seller. Over the life of a contract, the protection buyer pays the Fixed Rate Amount14 to the protection seller, based on the current notional amount of the index. As in the cash bond market, a market price above par means that the market spread is tighter than the fixed rate, and vice versa.

As in a single-name ABS CDS, the notional amount of an index is adjusted as any of the reference ABS (1) amortizes or prepays, (2) is written down, (3) defaults, or as (4) previous floating amount events are “reversed” (i.e., reimbursements occur). Unlike the single-name case, however, the index notional reflects change in the notional amount of all reference ABS in the index portfolio, which are initially equally weighted.

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, 2007, then you pay only the coupon price. In the case of the highest rated “AAA” loans, the coupon value is “76″, and so you pay (0.76% x $10 million x Factor), or $76,000 for $10 million in “AAA” loans. 
The rest of your loans are “BBB-” quality, and there the Coupon value is “500″, and so you pay (5% x $10 million x Factor), or $500,000 for the same kind of insurance on your “BBB-” loans. Quite a difference. 
That’s what happens on the first day (July 19, 2007), because the Price index is always 100.

But now let’s suppose that you waiting until today, Dec 2, 2008, to buy the insurance. (These are still loans that were granted in the second half of 2007, and so the “07-2″ version is still what we want.)

On Tues, Dec 2, the price index for ABX-HE-AAA 07-2 (from the MarkIt table above) was 30.34. You still have to pay the $76,000 coupon price, but you also have to pay an additional ((100% – 30.34%) x $10 million x Factor) = $6,966,000. So, if you bought the insurance on Friday, you would pay a total of ($76,000 + $6,966,000) = $7,042,000.

LOOK AT THE DIFFERENCE YOU HAVE TO PAY TODAY VERSUS OVER A YEAR AGO. THIS SPEAKS VOLUME FOR THE QUALITY OF MORTGAGE SECURITIES.

Let do the same thing for our BBB- tranche.
On Tues, Dec 2, the price index for ABX-HE-BBB- 07-2 (from the table above) was 3.65. You still have to pay the $500,000 coupon price, but you also have to pay an additional ((100% – 3.65%) x $10 million * 0.861757612) = $8,303,034. So, if you bought the insurance on today, you would pay a total of ($500,000 + $8,303,034) = $8,803,034.

Here’s a summary of all four computations:

Date           Index          Coupon  Price   Total payment computation
---------  ------------------ ------ -------- ------------------------------
19-Jul-07  ABX-HE-AAA 07-2     76    100.00   $10M x (0.76%)= $76,000
19-Jul-07  ABX-HE-BBB- 07-2    500   100.00   $10M x (5%) =   $500,000

02-Dec-08  ABX-HE-AAA 07-2     76    30.34    $10M x (0.76% +(100%- 30.34%)*1)
                                                           = $7,042,000
02-Dec-08  ABX-HE-BBB- 07-2    500   3.65     $10M x (5% +(100%- 3.65%)*0.861757612)
                                                           = $8,803,034

• Conclusion

Now, armed with this newly found knowledge, let try to understand mortgage lingo talks in serious financial publication like Bloomberg.
During my google search on this instrument, I found a few people commenting that they couldn’t understand the calculation found in this piece on Bloomberg published Feb 21, 2007.
http://www.bloomberg.com/apps/news?p…d=avEt.7ldbFGM

Here is the calculation:
To buy protection for $10M of ABX-HE-BBB- 07-1 tranche in Jan 19, 2007, you would have to pay $10M * 3.89%= $389,000 using the data from the Markit table above.

Tags: abx.he, markit, MBS, mortgage backed security, pricing abx index