The Bear's Lair: Indexed Credit Default Swaps and the Subprime Mortgage Crisis

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Abstract
ABX.HE indexed credit default swaps on baskets of mortgage-backed securities are now the main benchmark used by financial institutions to mark their subprime mortgage portfolios to market. However, we find that current prices for the ABX.HE indices are inconsistent with any finite assumption for mortgage default rates, and that ABX.HE price changes are uncorrelated with changes in the credit performance of the underlying loans. These results cast serious doubt on the suitability of the ABX.HE indices as valuation benchmarks. We also find that ABX.HE price changes are significantly related to short-sale activity in the option and equity markets of the publicly traded builders, the commercial banks, the investment banks and the government sponsored enterprises (GSEs). This suggests that capital constraints, limiting the supply of ABS insurance, may be playing a role here similar to that identified by Froot (2001) in the market for catastrophe insurance.

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