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Dow vs ABX

• Evan Davis | Stars and strife |
• 27 Nov 07, 01:20 PM

I'd say that the success of business television ( and the like) in the US, is built on one fundamental insight by those producing it: if you can make it sound like sports coverage, then it feels engaging.

And we all know that Americans love their statistics - in sport, obviously. And in finance too.

Yet one of the problems in covering the sub-prime debacle is that the usual scoreboard measuring US financial health is the Dow Jones Industrial index. And although it has had its ups and downs this year, it really doesn't tell a very interesting story of near financial meltdown.

We need another way of scoring the financial sector, to better reflect the way the game is going.

With that in mind, I today went to get a lesson on the ABX indices. These have had some recent prominence in the financial pages and get mentioned on CNBC, but I'm surprised they haven't made it much beyond. Because if you think a financial crisis of the magnitude we have endured deserves graphs diving in a downwards direction, then the ABX is what you want.

There are lots of ABX indices actually, so take your pick. You can .

I had them explained to me today by Robert Pickel, chief executive of the . And I made sure we had a photo of a couple of the graphs so you can get the general idea.

Essentially, there is one index for each vintage of sub-prime mortgage backed assets; and there is one for each level of risk. So for example, there is one index for AAA ultra-safe sub-prime assets, from each half of both 2006 and 2007.

In the picture with my fingers in, you are looking at the performance of AAA securities, from the second half of 2006. In the picture without my finger, you looking at BBB- of the most recent vintage.

I won't go into much detail, suffice to say that the index is always constructed to perform like a bond price, so that par value is 100. Expected defaults in the assets underlying the index lead to prices below 100 (but you can't read the value of the index as a percentage default rate; it's more complicated than that).

But there are two fascinating things about ABX.

First is the rating of those AAA ones. They were worth about 100 until May and you can only describe the performance since then as a crash.

Yes, a crash.

And secondly, it is noteworthy that the 2006 mortgages seem to perform better than the 2007 ones. The longer the sub-prime boom went on, the more reckless was the lending and the higher the expected defaults.

So the first AAA index from early 2006 is worth about 90 now; a pretty awful performance for a AAA rated product. But the most recent sub-prime AAA securities are trading at 67.

Now I'm not index mad. But I do like an index to reflect the story, and the stock market is not doing that.

Obviously long term, the fate of the entire corporate sector of the US - encapsulated in share prices - matters more than the fate of one kind of sub-prime asset-backed security market.

But in the short term, it is the exotic paper that is driving things. Why?

Because of the degree of bank exposure to sub-prime mortgage assets. When stocks fall, wiping hundreds of billions of dollars off share prices, the people who own shares are poorer. So, that happens from time to time.

But when hundreds of billions of dollars of losses are being made by banks (or their off-balance sheet profit-centres), well that affects their capital, and their ability to lend. And as banks lend a big multiple of their capital, when the capital falls only a even a small amount, their lending can fall a lot.

And when lending falls a lot, the economy can stumble. Just as it did in the great depression for example.

Of course, when the stock market wakes up to that possibility, it might fall a lot more than it has, and then it to will tell the tale of what's going on.

But at the moment, it is our relatively new friend the ABX to watch.

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