Indexes as Market Indicators

An index is just a collection, usually weighted by some variable, of assets so as to provide an average that observers of that index can use to evaluate general trends in the underlying market for those assets. This implies a very important concept: an trending indicator is not an indicator of underlying value.

For some reason, people (including sophisticated investors) are tempted to view indexes as representative of the value of the assets that they represent. The credit default swaps market and indexes like ABX, CMBX (any kind of X, really) is an ideal example. According to accounting principles, companies must use such indexes to value securities, like swaps, that are traded irregularly or for which there is limited liquidity. Why is this important? Simple. Like any other market index, it is susceptible to volatility resulting from investor speculation; as investor excitement grows for the underlying assets, the value of the index can climb completely unrelated to the underlying growth of the assets that they represent. Of course, the opposite is true as well and this has proven to be a big problem in the face of the persisting troubles resulting from the sub-prime mortgages.

It became a self-fulfilling prophecy. As concerns over mortgage back securities, collateral debt obligations and other new acronyms abounded, investors began speculating the market (and its index) downward. As the index crashed, companies around the globe relying on them as representations of underlying value were forced to write-down the value of their holdings in those assets. A vicious circle emerged with more and more news of write-downs spurring greater and greater downward pressure on the market indexes and even further declines in the representative value of the assets held by financial institutions.

Suddenly, banks were losing tremendous amounts of money and reporting lower performance in their reports. To protect themselves, they started selling-off the assets that caused them problems and, more importantly on an individual basis, began to tighten their lending making it more difficult to obtain loans. As credit shrank, the economy began to slow further when companies could not borrow the funds they needed to finance their growth plans. As banks looked to cover their butts, foreclosures ramped-up driving even greater pressure on homeowners already facing higher prices and growing unemployment.

Fortunately, nothing lasts forever. The price of anything can only fall to zero and no lower; there is a lower limit. Yes, many of these sub-prime mortgages will default, but not all. Eventually the market will stabilize and banks will resume business-as-usual. As this happens, new legislation will be passed and new accounting principles written to help avoid a similarly vicious circle in the years ahead. It's all a learning process for everyone involved. The politicians and policy makers that write the laws and regulations we all follow are only human and they too learn from their mistakes... sometimes.