The Great American Housing Bubble by What Went Wrong & How We Can Protect Ourselves in the Future

Author:What Went Wrong & How We Can Protect Ourselves in the Future
Language: eng
Format: epub
Publisher: Harvard University Press

The ABX Indices

It was possible, starting in 2006, for investors to go short on the mortgages derivatively by taking a position on the ABX, a series of indices that track the pricing of CDS written on PLS.74 CDS pricing in the dealer market had been opaque, and because CDS involved counterparty risk, they were bespoke and seldom traded. The ABX was supposed to provide a transparent measure of pricing of risk on PLS than the dealer market, as well as a more liquid, tradable asset in which investors could express both long and short positions. In other words, the ABX was designed to complete the incomplete housing market both addressing informational problems and simultaneously creating an investment vehicle to act on that information. Yet even if it had worked perfectly, the ABX would have been reflecting not just the risk on PLS, but also the counterparty risk in the CDS market.

The ABX failed to deliver on its promise. In its first year, 2006, there was no significant movement of the ABX, despite the growing risk apparent in house price declines in mid-2006 and the rise in early defaults. That is, the cost of insurance against defaults was static, even as risk, including counterparty risk, was increasing. The obvious reason for the lack of movement in the ABX was the continued sale of CDS protection on PLS at prices unrelated to risk.

On July 10, 2007, the rating agencies announced the first mass downgrade of subprime PLS. The ABX indices began a dramatic descent, and CDS spreads soared, as the entire market could see the risk rising, not just the smart money, and the synthetic CDO market—and demand for long positions on CDS collapsed.75 The ABX indices ended up being reactive, rather than predictive.

An information failure enabled the inflation of the housing bubble, and once investors did catch on, the incomplete nature of the housing finance market meant that their attempts to go short on PLS increased counterparty risk through the growing CDS market making the entire market more leveraged and fragile. This is the fundamental market failure underlying the Great American Housing Bubble. We now turn to the question of what has been done to remedy this market failure since the bubble burst.

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