Remember ABX? Wall Street Said to Test New Mortgage Index

  • Unlike subprime era, underlying mortgages are high-quality
  • An index could help GSE reform by enlarging market for bonds

A bond-market startup is a step closer to reviving crisis-era derivatives that let investors bet on U.S. homeowner defaults.

JPMorgan Chase & Co., Bank of America Corp. and Credit Suisse Group AG have given price data to the startup, New York-based Vista Capital Advisors, which rolled out the latest version of its pilot initiative this month, according to a person with knowledge of the matter. Vista has been working on the project for the past few years with Intercontinental Exchange Inc. The firm plans to use that data to create indexes of mortgage securities, which in turn would become the basis for the derivatives, said the person, who asked not to be identified because the matter is private.

Those three banks may not ultimately participate in writing the eventual derivatives, the person said. Representatives for JPMorgan, Bank of America and Credit Suisse declined to comment.

The derivatives would work much like ones created in the run-up to the U.S. housing crisis. Those products, known as the ABX indexes, were blamed for amplifying risks as big traders like American International Group Inc. wagered that subprime mortgage bonds would perform fine. After losses surged and the government had to bail out the financial system, demand for ABX bets faded.

The new derivatives, however, would be tied to higher-quality mortgages that are less likely to default. The indexes Vista is building are linked to mortgage bonds issued by Fannie Mae and Freddie Mac known as "credit-risk transfer" securities, which force investors to bear losses when borrowers default on their loans, said Richard MacWilliams, Vista’s co-founder. The underlying loans are safer, but the bonds are still riskier for their owners than standard Fannie Mae and Freddie Mac mortgage bonds, which are fully supported by the government.

Testing Demand

Derivatives linked to these notes could be a test for how open investors are to new mortgage products a decade after the financial crisis. Fund managers in recent years have shown some signs of being willing to re-embrace risky securities and derivatives tied to home loans, such as subprime mortgage bonds. But these markets are still a fraction of their size pre-crisis. 

Vista Capital, which calls itself a "financial products innovation company," has some high-profile backers, including David Booth, co-founder and co-chief executive of Dimensional Fund Advisors; John Reed, former chairman of Citigroup Inc.; and Robert Merton, a professor at the Massachusetts Institute of Technology who won a Nobel Prize in 1997 for his work on the Black-Scholes formula for pricing options. Vista was previously known as eBond Advisors LLC.

To be successful, derivatives linked to the indexes would have to help major banks manage their capital requirements, said Mike Edman, a former Morgan Stanley executive who helped invent credit derivatives on subprime mortgage bonds.

"At a high level, it can make sense, but it seems regulatory capital is what the big banks focus on most," Edman said.

Reducing Exposure

Credit-risk transfer notes are an important mechanism for the government to reduce its support for Fannie Mae and Freddie Mac, which were bailed out by taxpayers during the crisis after losing access to funding. While it is unclear how U.S. President Donald Trump will look to reform the two companies, Steven Mnuchin, nominee for Treasury Secretary, said in his confirmation hearing last week that "we shouldn’t just leave Fannie and Freddie as is for the next four or eight years under government control without a fix."

Since 2013 when Fannie Mae and Freddie Mac began selling credit-risk transfer notes, the companies have offloaded nearly $40 billion of risk to bond investors. Derivatives could help boost these sales and lower taxpayer risks, ultimately, by making it easier for dealers to hedge their exposure to the notes, and by increasing the trading activity in the securities, Barclays Plc wrote to housing regulators last year.

Freddie Mac’s Mike Reynolds, a vice president in the credit-risk transfer program, agreed that the idea has merit. A tradeable index could be "favorable, as it could alleviate the capital constraints that broker dealers currently have," and serve policy makers’ goal of stepping back from the two government-backed housing companies, he said.

But there is also a potential drawback to the derivatives, he said: investors may decide to bet on the credit-risk transfer using derivatives instead of the cash securities, which could end up reducing demand for the bonds. The U.S. government could end up detracting from securities’ popularity if it were to endorse derivatives. 

"That’s definitely a risk," Reynolds said.

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