Markit Group Ltd. created the ABX index as a synthetic basket of goods designed to provide feedback on the subprime mortgage market. The ABX itself is broken into separate sub-indexes, each of which represents a “tranche” of 20 credit default swaps, also known as credit default obligations, that are secured with subprime mortgage loans. The tranches are grouped by credit rating, ranging from AAA to BBB-minus. Every six months, a new series is issued based on the largest present deals. A higher value in any given ABX index correlates with decreased subprime mortgage risk.
Coincidentally, the ABX was launched on Jan. 16, 2006, just before the collapse of the subprime lending market in 2007-2009. The ABX indexes “trade on price,” meaning that an index itself is bought and sold at the value of its underlying securities. Because of this, the performance of the indexes roughly mirrored the performance of the credit default swaps during the financial crisis, which was very poor. It is important to note, however, that the ABX does not provide the value of any one specific credit default swap (CDS).
Key Takeaways
- Market intelligence firm Markit launched the ABX Indices in 2006 as a way for investors to gain or hedge exposure to subprime residential mortgage-backed securities (RMBS).
- The ABX indices are a synthetic tradable index family.
- Each index references 20 subprime RMBS bonds or transactions that meet the criteria specified by the index rules.
- Each RMBS transaction includes tranches of securities that are grouped by credit ratings ranging from AAA to BBB-minus.
- Prior to the 2008 financial crisis, some analysts saw the sharp declines in the ABX indices as a sign of growing instability in the financial and housing markets.
ABX as Indicator of 2008 Crisis
Some analysts considered the sharp declines in the ABX to be leading indicators of the coming financial crisis prior to 2008. There was a temporary rally in spring 2007, but that was followed by even sharper declines. The AAA index, which theoretically should have been the most secure and most valuable of all of the ABX indexes, dropped by more than 30% in value from June 2007 to June 2008. The lower tranches dropped far more dramatically; the BBB-minus was below 10, a drop in value greater than 90%, by June 2008.
During the height of the financial crisis, the largest bank failure in U.S. history occurred when Washington Mutual, a major savings and loan bank with assets of $307 billion, collapsed and was taken over by the Federal Deposit Insurance Corporation (FDIC).
Subprime Mortgage Lawsuits
In its 2008 annual report, Citi discussed the ABX index as one of the factors it looked at when determining the value of its collateralized debt obligations (CDOs). The index played a role in the company’s decision to take sizeable write-downs for the year, which amounted to $20.7 billion in total net write-downs. Additionally, several lawsuits filed in the aftermath of the financial crisis mention the importance of the ABX index as a barometer that should have alerted banks and other financial institutions of the dangers developing in the subprime market.
A class action lawsuit filed against Morgan Stanley by the Boston Retirement System alleged that the value of Morgan Stanley’s $13.2 billion swap position was “inherently linked” to the ABX BBB index. Between May 31, 2007 and Aug. 31, 2007, the index fell 32.8%, a decline mirrored by an equal decrease in the value of Morgan Stanley’s swap position. Rather than taking a $4.4 billion mark-down in its position, however, Morgan Stanley only took a $1.9 billion mark-down. According to the complaint, this move allowed Morgan Stanley to meet market expectations for the third quarter and delay the discovery of the company’s true financial state.
A decline in the ABX index is also mentioned as a red flag in a lawsuit filed by several retirement funds against Swiss bank UBS. On Dec. 10, 2007, UBS took a $10 billion write-down related to U.S. subprime mortgages. The lawsuit claimed that UBS knew the subprime and Alt-A mortgage markets were declining in value and started shorting the ABX index in September 2006, eventually acquiring a net short position. The lawsuit claimed the bank should have provided investors with disclosure regarding its short position and the growing risks in the subprime market.