ABX widening stokes credit fears

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Credit market neuroses loomed large during February, as conspicuously widening spreads on US subprime home equity securities spilt elsewhere throughout the US and European credit markets, leading to substantial market moves.

At one point on February 28, the five-year iTraxx Europe Crossover index widened to 238 basis points, up 37bp on the previous night's close, according to Deutsche Bank. Within the first hour of London trading on February 28, one dealer estimated there had been around EUR10 billion-15 billion of trades across the iTraxx Europe, Crossover and HiVol indexes. Meanwhile, on February 27 closing, the Dow Jones CDX Crossover Index had widened to 146bp, a rise of 32bp from February 26.

Traders in London mostly remain confident the widening spreads represent a temporary correction. "We've seen a very big move in the iTraxx Crossover Index in particular, but that seems to have settled down now," says London-based Andrew Whittle, head of credit derivatives at Barclays Capital.

Volatility in the iTraxx and CDX indexes follows a sharp drop in the ABX.HE indexes over the past month. Since the last index roll in mid-January, the ABX.HE. 07-1 BBB index (which tracks credit default swaps referencing 20 US subprime home equity securities rated BBB) had fallen over 30 points to 67.12 by February 27. The ABX.HE. 07-1 BBB- index fell even further - by almost 35 points to 62.25 by February 27. Aggregated spreads on the underlying reference securities of the BBB- index, meanwhile, had ballooned to 1,478bp by February 27, according to figures from Lehman Brothers.

The dramatic move reflects growing delinquencies in US subprime loans. The Federal Reserve reported at the end of February that the proportion of banks' residential real estate loans with payments at least 30 days overdue rose to 2.11% in the fourth quarter of 2006, up from 1.72% in the previous quarter. Faced with burgeoning losses, just under two dozen subprime mortgage lenders have either been sold or closed their doors to new business over the past six months, according to Bear Stearns.

However, concerns that subprime losses herald the beginning of a contagion effect that could cause widespread selling across credit markets are overdone, say dealers. "It's too small a market to have an impact overall," says Robert Lepone, London-based executive director of fixed income at Morgan Stanley.

Barclays Capital's Whittle says the subprime market was one of a number of factors that caused unwinding of long positions across the credit market, and was not the sole cause. "Everyone's been looking for a catalyst because valuations have been so tight for so long now," he says.

Nonetheless, the growing perceived risks associated with home equity loans in the US will lead to lower prices for corresponding subprime residential mortgage-backed securities (RMBS) tranches. It will also hit some US collateralised debt obligations of asset-backed securities (ABS CDOs), which normally include a substantial volume of subprime RMBS tranches in their underlying loan pools.

Richard Huddart, structured credit analyst at Dresdner Kleinwort, says: "We expect this to hit CDOs of mezzanine ABS more so than CDOs of high-grade ABS, as it is the BBB/BBB- home equity loan tranches in which CDOs of mezzanine ABS invest that have repriced the most."

Analysts say increasing spreads within BBB/BBB- US home equity loans has also led to greater segmentation in the market for individual RMBS tranches, with a greater focus on issuers and collateral pools. Huddart believes such segmentation may also spread to BBB/BB tranches of US mezzanine ABS CDOs. "This will make due diligence on the underlying collateral increasingly important," he adds.

- Mark Pengelly.

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