PrimeX Index Shows Weakness In Prime RMBS Market, Three Indexes Below Par (Charts)

PrimeX.FRM.2 via Markit
It's starting to get interesting again in MBS CDS land (the most interesting indexes in the world). Markit's synthetic CDS (credit default swap) indexes "referencing" buckets of residential mortgage-backed securities have been falling in value since February (ABX, PrimeX). Credit fund managers (or speculative hedge funds) can trade RMBS without actually buying or selling the securities (synthetically) via credit default swaps (RMBS insurance contracts). It's really trading "exposure" on RMBS. Listen to Goldman Sachs' CFO David Viniar explain to Senator Carl Levin that GS's mortgage desk had synthetic positions on to offset cash long positions. There needs to be a synthetic credit trading show on CNBC (boo-yah!²).

I remember Jeff Gundlach, founder of DoubleLine Capital, alerted CNBC viewers in May that the ABX index, which references subprime RMBS, dropped 20% in 3 months (link has chart). Remember when ABX.HE.AA.07-2 went from a high of 97 to a low of 3.75? It currently trades at 6.23. Crazy times, and we still haven't recovered from the housing and mortgage crash.

Now the action is in Markit's PrimeX CDS index, which references a basket of non-agency prime RMBS issued between 2005 and 2007, and backed by jumbo mortgages that couldn't be financed by GSE's (Fannie Mae and Freddie Mac). There are four PrimeX indexes; two that reference fixed-rate loan securitizations and two that reference hybrid-ARM securitizations (PRIMEX.FRM.1, PRIMEX.FRM.2, PRIMEX.ARM.1, PRIMEX.ARM.2). Here are closing prices on 10/14/2011 via Markit's website.

For more info, I found a guide: Pricing ABX index for Newbies

Buying the PrimeX index allows someone to "synthetically" gain short exposure to non-agency prime MBS and selling PrimeX allows someone to "synthetically" gain long exposure to non-agency prime MBS. If you're reading this and have no idea what I'm talking about, read the description at Markit or read their presentation from early 2010 on the PrimeX indices. You can see 7-month charts of CDS indexes on their website for free. I found an article from 2006 at that explains why the ABX Index (ABCDS) was introduced ("Synthetic ABS is hot property"). Interesting stuff.

Paulson & Co., run by billionaire John Paulson, started buying the ABX Index in 2006 and ended up making his firm billions of dollars when the subprime mortgage market crashed (and CDS spiked). When ABX indexes first dipped below par in 2007, some say that was the initial catalyst that fueled the financial crisis. When the PrimeX index was first announced, Bloomberg noted:
"Wells Fargo & Co. analyst Glenn Schultz suggested investors consider selling jumbo-mortgage securities because PrimeX trading could drive down their prices, as happened with subprime bonds and the ABX indexes he had called “Frankenstein’s monster.”

"Analysts such as Schultz said that in 2007 and 2008, more investors wanted to use the indexes to short subprime notes than take the opposite bets because the banks and asset managers already owned enough housing debt, allowing them to tumble."

As of Friday's close, three of the four PrimeX indexes have dipped below par. Look at the charts below. FT's Tracy Alloway talked about this risk in a video on 10/10/2011 and Zero Hedge had a post on 10/7/2011 with multiple follow-ups thereafter. FT Alphaville has been all over it as well, see the PrimeX linkfest below.

I was searching for an ETF with non-agency Prime MBS, and all I found was an Invesco PowerShares index that didn't exist yet: "The PowerShares Prime Non-Agency RMBS Opportunity Fund will seek to provide total return by investing, under normal market conditions, at least 80% of its assets in non-agency mortgage-backed securities collateralized by pools of Prime residential mortgage loan" (pdf, 1/28/2009).

On October 5, Fitch Ratings, in a press release promoting their report, said that 1 in 3 U.S. prime mortgage loan borrowers were underwater.
"Recent analysis by Fitch shows that more than a third of all prime borrowers in private-label securitizations are currently in a negative equity position, or as it is commonly referred to, 'underwater', on their mortgages.

Despite some recent modest gains, home prices have further to fall before any sustained recovery takes hold, according to Managing Director Grant Bailey. 'With home prices likely to decline another 10%, roughly half of prime borrowers will wind up underwater on their mortgage,' said Bailey.

Fitch also found over 12% of all prime borrowers are seriously delinquent on their mortgages. 'Prime mortgage default rates will stay elevated as home prices fall further and unemployment remains high,' said Bailey."

With unemployment above 9% (U6 underemployment at 16.5%) and a potential "triple dip" in housing ahead ("Experts predict US property prices will fall in rest of 2011 and beyond" (Property Wire); Clear Capital's® First Look into 2012: A Market Flirting with Triple-Dip by Spring (Clear Capital), it doesn't surprise me that prime mortgages originated during the bubble years have taken a hit.

PRIMEX.FRM.1 (source: Markit)