Seasoned asset-backed securities investors are set to start trading the synthetic ABS indices. They believe that once they begin trading in size, macro hedge funds and corporate credit correlation traders will find their default correlation models have taken the wrong approach to the underlying credits. This is because two distinct philosophies have taken hold in the market regarding what drives mortgage defaults. One view, adopted by corporate correlation traders, is that mortgage-backed securities default when the equity of a deal is underwater. The other approach, standard among ABS portfolio managers, is that mortgages default when affordability for mortgage borrowers is a problem. Traders pointed to Ellington Management Group, CBASS, and the mortgage desks at Bear Stearns, Lehman Brothers and Citigroup as leading this approach.
Corporate correlation traders have chosen their approach to modeling ABS correlation because it is simple to plug in constant mortgage prepayment numbers and also because it is similar to the model they use for pricing corporate default correlation. ABS portfolio managers, however, are critical of this approach because they do not think mortgage prepayments can be treated as a constant number and also that there are many more factors that affect mortgage default correlation than corporate credit correlation, such as servicing and geography.
Some ABX watchers believe the arrival of ABS-focused portfolio managers is helping to stabilize the ABX. Last Tuesday, for example, the ABX 07-01 BBB index widened only five basis points during the market-wide sell off. Others, however, believe that the stronghold of non traditional players will continue to dominate ABX trading. "These are bond traders. They go where the value is and where they can get paid. They are not just in this market, they are this market," noted one ABX market maker.
