Fisher Center for Real Estate and Urban Economics

Current pricing of ABX.HE indexed credit default swaps (CDS) imply levels of forecasted losses for sup-prime residential mortgage backed securities (RMBS) that are substantially greater than realized credit events in these securities. Regression results, controlling for the correlational structure of the common underlying mortgage pools, indicate that the credit performance of the referenced sub-prime RMBS is uncorrelated with observed fluctuations in the ABX.HE indexed CDS returns. Although we find some evidence that volatility shocks, as measured by VIX, have also negatively impacted ABX.HE returns, these effects are not consistently associated with devaluations on higher credit rated ABX.HE indexed CDS. Instead, the returns on ABX.HE indexes of all credit qualities are consistently and statistically significantly related to short-sale demand imbalances in the option and equity markets of the publicly-traded builders, the commercial banks, the investment banks and the government sponsored enterprises (GSEs). The combined effect of the unique settlement structure of the ABX.HE indexes, the lower short sales constraints in the indexed credit default swap market, and the important supply limitations in the cash market for BBB and BBBtranches appear to have significantly amplified arbitrage imbalances between the cash market for tranches and the ABX.HE indexed derivatives. Our results indicate that dislocations associated with aggregate short-selling imbalances in the mortgage related capital markets rather than credit events in the outstanding stock of sub-prime RMBS, per se appear to be central to the substantial price devaluations of the ABX.HE indexed credit default swaps. Our finding that the short-selling strategies of arbitrageurs have exacerbated the effects of negative economic shocks in the sub-prime RMBS market leads us to conclude that the ABX.HE indexed CDS are imperfect benchmarks for marking-to-market mortgage portfolios because the indexed market does not efficiently aggregate information concerning the credit performance of referenced sub-prime mortgage obligations.