Wall Street firms began taking bets on the default risk of pools of prime jumbo-mortgage bonds Wednesday as trading started on four new credit-default-swap indexes.
The PrimeX indexes, administered by Markit Group Ltd. of London, are similar to the ABX indexes tied to subprime debt that made their debut in early 2006, allowing easier wagers on the subsequent record defaults among homeowners.
When a plan to create the PrimeX indexes was announced in December, Wells Fargo & Co. analyst Glenn Schultz suggested investors consider selling jumbo-mortgage securities because PrimeX trading could drive down their prices, as happened with subprime bonds and the ABX indexes he had called "Frankenstein's monster."
The four PrimeX indexes are each linked to 20 originally triple-A-rated securities from 18-month periods, ending June 30, 2006, and Dec. 31, 2007, according to a document on Markit's website.
Two of the indexes are tied to fixed-rate loans and two track adjustable-rate mortgages. All the underlying loans are larger than the limits for Fannie Mae and Freddie Mac.
The contracts will trade on a "price" basis, with the cost of buying default protection ranging from 442 basis points to 458 basis points a year plus an up-front payment equal to the difference between 100 and an index's level. Negative up-front amounts would be paid by the seller of protection to the buyer.
Credit-default swaps on structured-finance securities offer payments if the debt isn't repaid as scheduled, in return for regular insurance-like premiums. A basis point equals $1,000 annually on a contract protecting $10 million of debt.
In a hearing Tuesday in Washington with Goldman Sachs Group Inc. executives, U.S. Sen. Claire McCaskill, a Democrat from Missouri, called at least one type of credit-default swap a "La-La Land of ledger entries."
"It's not investment in a business that has a good idea," she said. "It's not assisting local governments in building infrastructure. It's gambling. Pure and simple, raw gambling."
Also Tuesday, Moody's Investors Service Inc. downgraded $35 billion of "synthetic" jumbo-mortgage bonds, or securities filled with credit-default swaps instead of actual loans, mainly lowering debt previously cut to noninvestment grades. The transactions were underwritten by banks including Bank of America Corp. and Lehman Brothers from 2005 through 2007.
The ABX indexes may have contributed to the financial crisis by both highlighting the falling value of subprime debt and weakening banks and bond buyers as speculators drove down the indexes.
Analysts such as Schultz said that in 2007 and 2008, more investors wanted to use the indexes to short subprime notes than take the opposite bets because the banks and asset managers already owned enough housing debt, allowing them to tumble.
Last week Redwood Trust Inc. and Citigroup Inc. partnered to create the first new-mortgage securities without government guarantees in more than two years, selling $222.4 million of triple-A-rated jumbo-loan bonds with initial coupons of 3.75%, lower than initially offered in marketing to investors.