New ABX index under threat

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A shortage of new issuance in the residential mortgage-backed securities (RMBS) market could threaten the next series of the ABX.HE index, causing problems for dealers and investors that had relied on the indexes to value collateralised debt obligations of asset-backed securities (CDOs of ABSs).

Rising delinquencies in the US subprime mortgage market, combined with mass downgrades of RMBSs and CDO tranches in July, and a drying up of liquidity, has caused investors to flee the securitisation market. New primary issuance has consequently dried to a trickle.

Of the 25 new RMBS transactions so far brought to market in the second half of 2007 - the eligibility period for the next series of the index, the ABX.HE 08-01 - only three would have met requirements for entry into the index, according to research from Wachovia published in October - significantly fewer than needed to build the index.

Each series of the index comprises five sub-indexes (AAA, AA, A, BBB and BBB-), made up of a basket of 20 credit default swaps (CDSs) on US home equity loan ABSs. A new series is launched every six months based on securities issued over the previous period.

Wachovia research noted that few new RMBS issues were large enough to meet the deal size requirement of $500 million. Few also met the weighted average life requirements. That varies depending on the rated sub-index, but is measured in years of constant payment rate (CPR).

Analysts suggest the company may be forced to either ditch the 08-01 series or lower its eligibility requirements - potentially a major issue for those that use the indexes to value CDO of ABS portfolios, and for structured products referenced to the ABX indexes. An official from Markit, the London-based data vendor that acts as administration and calculation agent for the ABX indexes, confirmed the company was aware of the situation and that the index was under review. However, she added that nothing had been decided as yet.

Meanwhile, rising delinquencies in the subprime sector has caused ruptures in the existing ABX indexes, creating problems for traders who use them for hedging and valuing trades. In October, Moody's reported the rating integrity of both the 06-1 and 06-2 series was under threat, with negative actions taken on 90% of the assets comprising the BBB and 95% of assets in the BBB- sub-indexes. In fact, the deteriorating performance of the indexes - launched in January 2006, just before delinquencies in subprime mortgages started to soar - means the product is beginning to be unusable as a proxy for the wider subprime market, the agency said.

"The mortgage loans backing the underlying transactions were originated in an increasingly aggressive underwriting environment, resulting in weaker-quality borrowers over the course of time," says the Moody's report.

The problem is the static nature of the ABX pools. Unlike the iTraxx and CDX indexes, which reference CDSs on corporate names, the underlying assets cannot be easily substituted because of both vintage and eligibility shortfalls. Indeed, Markit announced a shortage of eligible bonds in the 06-1 index in November.

Dealers using ABX to mark CDO of ABS tranches to market have seen the value of their investments fall dramatically in recent months. The ABX.HE.BBB- 06-2 index plunged from 32.54% on October 1 to 16.63% on November 26, while the ABX.HE.A 06-2 fell from 70.42% to 34.22% over the same period. Some analysts suggest the ABX may not be a good basis for portfolio valuations in the current environment. Fitch Ratings, for instance, stated in research published last year that the 20 CDSs underlying each index means the ABX is significantly less diversified than even the most troubled of CDO of ABS portfolios.

Radi Khasawneh.

KFW INCREASES RISK PROVISION FOR IKB

German bank KfW has increased its risk provision for the troubled bank IKB Deutsche Industriebank, in which it holds a majority stake, after default risk on IKB's Rhineland Funding conduit rose significantly.

KfW increased its risk provision for IKB from EUR2.5 billion to EUR4.8 billion on November 27, saying it had received "crucial new information of material relevance to valuation" regarding Rhineland. "The latest capital market developments have led to a dramatic worsening of the fundamental market assessment of the actual default risks in the subprime segment," the bank said.

Rhineland Funding started trading in 2002, with the aim of raising funding in short-term asset-backed commercial paper and investing in the structured credit market. But Rhineland's investors refused to rollover some of the conduit's EUR14.39 billion in outstanding commercial paper after the subprime crisis developed in July. This meant Rhineland had to turn to the liquidity facilities provided by IKB and others.

However, doubts emerged over IKB's ability to honour these commitments, prompting a bailout by KfW, a state-owned bank with a 39% stake in IKB. KfW subsequently organised further liquidity lines from a group of German banks (Risk September 2007, pages 105-107).1

The increase in provision implies the total losses from IKB could now be as much as EUR6.9 billion, assuming the other banks involved in the bailout have also increased their risk provisions proportionately (as part of the bailout agreement, KfW assumed 70% of the IKB risk and the other banks 30%). The announcement also means IKB represents the bulk of KfW's general bank risk fund, which contained only EUR5.3 billion at the end of October.

On October 30, KfW said it would "look seriously" at selling its stake in IKB, but no plans for a sale have yet been announced.

Alexander Campbell.

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