Thursday, March 11, 2010

Not even your AAA-ABX is safe anymore

An implied writedown is a type of monthly floating payment that is unique to CDS on ABS. These payments are intended to standardize writedown payments across CDS of ABS by creating a mechanism for the swap to writedown, even if the reference cash security cannot. An implied writedown occurs when a trustee is prohibited from writing down a bond by the deal documentation and there is a discrepancy between the remaining collateral balance and the bond principal balance. In order to correct this discrepancy and realize the loss more quickly at the swap level, the CDS will recognize an implied writedown, which will decrease the reference obligation notional amount of the swap even though the bond principal balance remains unaffected.

That’s from Markit, who also own the ABX.HE indices; baskets of CDS based on 20 US subprime bonds.

There are a bunch of ‘em, grouped by bond-ratings and loan vintage. The indices basically allow investors to take positions on subprime MBS without having to actually hold bonds — and they fluctuate up and down based on where people think subprime housing is headed.

Until this month, implied writedowns had yet to occur at the top-rated AAA classes of the ABX.HE. But lo and behold, the ABX.HE.AAA.06-2 and the ABX.HE.PENAA.06-2 have both experienced implied writedowns; principal losses have managed to reach the highest-rated ABX indices for the first time.

Oh dear.

Note, however, that this is not a huge surprise. Markit was warning of the possibility of an implied writedown in at least one of the indices back in September:

The concept of implied writedown, while familiar at the single name level, has never occurred for an ABX.HE constituent. However, given the performance of the below deal, it looks as if implied writedowns could potentially hit the ABX.HE.AAA.06-2 index. Currently, the A-2d bond below is a constituent of the index, and does not have a mechanism to write down. Because of this, the A-2 bond is at risk of an implied writedown if the trend of losses continues. Currently, the MSAC06-WMC2 has almost 65% of collateral more than 60 days delinquent, and almost 23% of those have already been foreclosed.

Subprime stress still lingering then. . .

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