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The Next Financial WMD?

The creators of an index that some say gave hedge funds the fuse they needed to blow up the subprime mortgage market may do the same for prime mortgage securities.
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Updated from Tuesday, Nov. 16

The creators of an index that some say gave hedge funds the fuse they needed to blow up the subprime mortgage market postponed the expected launch of a new benchmark to track U.S. prime mortgage securities.

Markit, a 1,000-person financial technology and data firm that is highly influential among derivatives dealers such as

Morgan Stanley



Goldman Sachs



JPMorgan Chase



Deutsche Bank


, said in a statement Wednesday that it had "put on hold" the launch of an index of synthetic U.S. prime mortgage-backed securities after "extensive discussions" with major market participants.

Markit had been expected to disclose further details on the new index on Wednesday, a source close to the talks had told

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. The company acknowledged the talks, but not the timing of an announcement. Market participants held a vote on the potential launch Tuesday evening, after

reported on the index.

Markit said it would reassess the index's launch in 2009.

Financial companies around the world, including large banks such as




Bank of America



Wells Fargo


, collectively hold trillions of dollars worth of prime mortgage securities on their books, but they have a great deal of latitude in how they price them. A prime mortgage index would take away a lot of this latitude, as banks carrying mortgages on their books at a significantly higher price than the index would have a lot of explaining to do to their auditors. That could lead to new writedowns on a massive scale.

A similar issue arose in 2006 when Markit created series of indices known as the ABX, which tracked the subprime market. Prior to that, it was much more difficult for hedge funds or other investors to express a bearish view of U.S. subprime housing. By shorting the index, hedge fund managers such as John Paulson made billions of dollars for themselves and their investors. While a fall in housing prices was inevitable, many believe the ABX caused it to be far more sudden and drastic than it would have otherwise been.

Blaming an index for bank writedowns may seem like an obvious case of shooting the messenger, but if the index is not properly put together, it can provide a dangerously distorted view of the market.

"We do not know what the details are for this possible new product," says James Callahan executive director at Greenwich, Conn.-based financial consultant Pentalpha Capital Group. "Conceptually, this could be a huge advancement in a great way or a negative way. I just hope someone in government takes a look at it first. It could have a huge impact on the markets if all of the short sellers drive the index down because of a macro opinion on the economy instead of the estimated performance of these types of loans. It is critical for the index to accurately identify what a prime loan is and what is not actually prime."

Some market participants criticize Markit's ABX indices. One, who does not want to go on the record because he did not want to damage relationships with Markit, notes the ABX does not draw a distinction between mortgages originated at the retail level or through what is known as a "correspondent channel," effectively a wholesale method leaving more room for problems. He says some of the mortgage backed securities used to create the ABX turned out to have mortgages that were fraudulently obtained or sold.

Ben Logan, managing director at Markit, argues it would be impossible to make a distinction between retail or correspondent distributed mortgages because the mortgage-backed securities Markit uses to create its indices do not make any such distinction. If some of the mortgages inside those securities have fraud-related issues, they were approved by the appropriate regulators and sold to investors. In essence, he says, they are part of the market, and the index merely reflects this.

"They were sold to investors under a process that has been established and monitored by the

Securities and Exchange Commission

," Logan says. He declines to say whether Markit is talking to regulators about the new index. "We're talking to all interested parties. I don't want to go into specifics."

If there is danger, it would not be in the index itself, but in derivatives designed from it. Warren Buffett famously called derivatives "financial weapons of mass destruction," and that view seems to have an influential ear in Washington.

Senate Agriculture Chairman Tom Harkin (D., Iowa), for one, has openly asked whether

credit default swaps

and perhaps other derivatives should not be banned altogether. Harkin has since introduced legislation that, while not so draconian, is sure to raise the hackles of the dealer community.

The debate likely to emerge over the index will be similar to the current one over what is known as mark-to-market accounting -- assigning market prices to assets. Many companies argue they should not have to assign a price to highly illiquid assets they have no intention of selling, but which would command a meager price in the current environment.

Michael Greenberger, a law professor of the University of Maryland and director of the division of trading and markets at the Commodity Futures Trading Commission, which regulates the futures markets, is unsympathetic to those who oppose marking assets to market, as well as to those who are concerned about the potential new index from Markit.

"Virtually the entire market is deregulated, and deregulated with the enthusiasm of people trading mortgages, the asset-backed securities, the collateralized debt obligations and the credit default swaps," Greenberger says. "They cannot now

complain that somebody in this deregulated market is giving it value. That's what these markets are all about. If they're doing it shoddily, well, a lot of stuff was done shoddily here."

Further, Greenberger argues the prices assigned to illiquid assets still tend to be too rosy when marked to market or against a broad index. "The value assigned to these securities tend to be overly optimistic, not overly pessimistic," he says.