Subprime Mortgage Credit Derivatives

CHAPTER 8

Relationship among Cash, ABCDS, and the ABX

Market participants can take on subprime mortgage risk in three different forms:

1. Traditional cash tranches of subprime mortgage deals
2. Single-name credit default swaps referencing cash tranches
3. Indices of credit default swaps

Prior to 2005, the only way to take subprime exposure was in the form of cash bonds. The single-name ABCDS market grew rapidly after the International Swaps and Derivatives Association (ISDA) released (June 2005) a standard pay-as-you-go (PAUG) template. The ABX index (an index of 20 credit default swaps) debuted in January 2006. Trading of standardized tranches off the index (TABX) began in January 2007, although there had already been considerable activity in customized tranches. The introduction of these derivative instruments completely altered the nature of the subprime landscape, and enabled the rapid growth of the ABS CDO business. Synthetics simply allow risk transfer, which ultimately enables subprime credit risk to be distributed more broadly than it would otherwise have been absent the synthetic market.

In this chapter, we look at how the three different forms of subprime mortgage risk listed above differ, and what drives their relative spreads. We explain spread differences from two perspectives: (1) given their credit and cash flow characteristics, how the forms of subprime risk should trade relative to each other, and (2) given supply and demand technicals, how they actually traded relative ...