Subprime weakness erodes higher-rated ABX indexes

By Nancy Leinfuss - Analysis

NEW YORK (Reuters) - Investor anxiety over the U.S. housing downturn is spreading to the highest-rated mortgage securities, upsetting the expectations of some that the crisis in the subprime bond market would be contained.

Weakening credit quality in the $575 billion U.S. subprime mortgage market is eroding the value of "AAA" securities, heightening anxiety among investors and raising the cost of insuring that debt against default.

While lower-rated "BBB" and "BBB-" securities are designed to take the first losses in a securitization structure, recent declines in "A" and higher that have a bigger cushion for losses suggest investors are bracing for a prolonged downturn in the housing market, analysts said.

The most recent index of subprime mortgage bonds, the ABX 07-1 series, contains indexes rated "A" to "BBB-" that are tied to subprime loans made in last year's second half. Those indexes have posted the worst declines this year and all are trading at record lows as of Monday's close, according to ABX index administrator Markit.com.

Analysts said the first line of defense on a cash home-equity or subprime ABS transaction, where losses are allocated from the lowest-rated tranches on up, is the excess spread, then overcollateralization. If losses exceed those two layers of protection, then bottom tier-rated "BBB-" tranches begin incurring losses before the weakness spreads higher into the credit spectrum

While the bottom-tier "BBB-" index has posted the bulk of the losses, tumbling by 53 percent this year, more pristinely rated segments of the market have succumbed to selling pressure over recent weeks.

The ABX 07-1 "A"-rated index, which references loans made to risky borrowers in last year's second half, ended down 10.3 points last week. On Monday, the index hit a record low after sliding an additional 3 points to 69.35, traders said.

Investors are beginning to price in the threat to better-rated segments of "some of the worst deals in the ABX 07-1," said Alex Pritchartt, ABX trader at UBS Securities. Some of the weakness is technical he said.

A slew of downgrades and reviews of more than $12 billion in subprime mortgage securities originated in late 2005 through 2006 by Wall Street credit rating agencies triggered a downward spiral in the ABX to record lows last week.

Fears rose further when selling ensued at the top of the capital structure in the "AAA" ABX 07-1 index, the segment most insulated from losses.

"It felt like the world was ending as AAA's traded off more than a point," said one trader, referring to Friday's session.

Unlike February's sharp sell-off, which was led by sharp declines in the "BBB-minus" index, this time around there has been persistent selling in ABX "AAA" through "A" indexes.

The ABX 07-1 "AAA" index has fallen from a high of 100.09 to 95.53, while the "AA" index closed at a low of 88.17, down from 100.09 this year, according to Markit.com.

The "BBB" index slid 9 points while the "BBB-" index fell by 6.6 points last week, according to JP Morgan Securities.

"The "BBB-" index is pricing in significant losses after rating agencies increased their expectations for cumulative losses on subprime securities to between 11 percent and 14 percent," said one home equity ABS analyst.