One of the most important developments in the credit derivatives market in 2005 and 2006 has been the growth of credit default swaps referenced to asset-backed securities (ABCDS). Asset-backed securities (ABS) are the bonds that are issued when a bank securitises assets such as mortgage loans, car loans and a host of other, retail-oriented asset types.
Source: B&B Structured Finance Ltd |
Asset-backed securities are very similar to CDOs in that they sell a portfolio of assets into an SPV and issue a series of securities (or tranches) which rank sequentially in order of priority. When the underlying portfolio of assets is related to mortgages, the market also uses the term mortgage-backed securities (MBS). But, the generic name for the whole market is ABS. CDOs and ABS are considered the two largest subsets of the broader securitisation market.
The first credit default swaps referencing individual asset-backed securities were traded around 2003. However, as far back as 1999 some synthetic CDOs had included asset-backed securities in their reference portfolios.
Although there are many different types of securitisations, most trading in ABCDS (also known as synthetic ABS) has been concentrated in one sector of the market – US sub-prime mortgage (or home equity) securitisations. These are securitisations of mortgages to less creditworthy borrowers or second loans secured on a single property.
The original impetus for the growth of the market came from investment banks that act as securitisation underwriters. They were concerned about the amount of risk they were holding on their balance sheets through this business – particularly given concerns about a possible downturn in the US housing market – and wanted to use the market to hedge their pipeline of upcoming deals by buying ABCDS protection.
On the other side of the market, managers of CDOs of ABS were the main sellers of protection. In 2003 CDOs of ABS were becoming very popular. The trend was generally to issue cash CDOs of ABS on mezzanine tranches of ABS and synthetic CDOs of ABS on senior tranches of ABS, generating greater demand to sell ABCDS protection on senior tranches of ABS.
Since the early days, the range of trading strategies using ABS credit default swaps has expanded. CDOs have remained among the biggest sellers of protection. However, hedge funds and other active traders have taken advantage of the fact that the instrument allows them to take a short position in asset-backed securities for the first time.
How an ABS credit default swap works
ABS indices