The Use of ABX Derivatives in Credit Crisis Litigation

Tue Jan 03 15:24:38 EST 2012
By Dr. Faten Sabry with Dr. Ethan Cohen-Cole

Since 2007, the losses and write-downs resulting from the credit crisis have reached over $2 trillion worldwide. As the losses have mounted, securities litigation has followed and over 450 related securities cases, both class actions and others, have been filed. Of particular interest to the litigation are a set of credit default swaps (CDS), or credit derivatives, known as the ABX indices (ABX). Plaintiffs have cited the ABX indices in a variety of credit crisis cases, where they allege that the ABX indices should have been used as market indicators to mark subprime-related securities -- including mortgage-backed securities and collateralized debt obligations -- to foresee additional losses on subprime investments, and to revise loan loss reserves. In addition, the ABX indices have been cited in various court decisions.
 
In this paper, NERA Senior Vice President Dr. Faten Sabry and Dr. Ethan Cohen-Cole examine the ABX indices, explain their economic functions, and explore how these indices are currently used in related litigation. The authors begin with a brief introduction about the non-agency mortgage market, the CDS market, and how CDS became a mechanism through which to participate in the non-agency mortgage market. The authors then focus on a specific type of CDS, the ABX indices, and how they are administered, priced, and traded. Then, the authors discuss the allegations and decisions involving the ABX. Finally, they assess the current academic literature that analyzes the role of the ABX derivatives in the liquidity and valuation of securities that are backed by subprime mortgages.
 
This is the ninth installment of the NERA Insights series of articles dedicated to the analysis of the credit crisis. The others are available on the right-hand side of this page.