UPDATE 3-Fed rejects AIG bond offer, sets auction plan

Wed Mar 30, 2011 6:26pm EDT

* Fed will auction mortgage-backed securities over time

* AIG had bid $15.7 bln for Maiden Lane II on March 10

(Adds background, market comment)

By Kristina Cooke and Al Yoon

NEW YORK, March 30 (Reuters) - The Federal Reserve rejected a $15.7 billion bid from insurer American International Group (AIG.N) for a pool of mortgage-backed securities on Wednesday and said it will sell off the bonds over time instead.

The news is a blow to AIG, which has been trying for months to buy the bonds for the investment portfolios of its insurance units. AIG took its bid public on March 10, offering cash for the assets, which are housed in a vehicle called Maiden Lane II.

The Fed created the entity during the depths of the financial crisis to take the securities off AIG's hands and help prevent the collapse of what was then the world's largest insurer.

The Fed said Wednesday the public interest in maximizing returns and maintaining market stability would be better served by selling the assets in the portfolio "individually and in segments over time as market conditions warrant through a competitive sales process."

AIG's March 10 offer started what amounted to a public auction for the assets, with Wall Street sources pointing to heavy bid interest from a number of banks.

There were no other formal bids, but there was interest by multiple parties, said a source familiar with the matter on Wednesday.

"I'm hearing there is big interest in this portfolio from high yield strategies within money managers, insurance companies, hedge funds and PPIP guys," said Paul Norris, head of structured assets at Burlington, Vermont-based Dwight Asset Management , which oversees $54 billion. "And I do believe AIG will have a strong bid."

AIG said it was "highly disappointed" in the Fed's decision, which it said would "prevent AIG from delivering on its goal that U.S. taxpayers earn a profit on their investment." "That the Fed, which has been such a constructive partner over the last two years, would hurt the very company in which U.S. taxpayers own a 92 percent stake is very difficult to understand," Mark Herr, vice president of AIG Media Relations, said in an emailed statement.

AIG shares rose 8 cents to $36.13 in after-hours trading after the Fed news.

The Fed said BlackRock (BLK.N) would run the sales process, which will start next week and has no fixed timeframe.

Dwight Asset Management's Norris said the amount and low quality of the bonds could hurt prices in the residential mortgage-backed securities market.

Investors have piled into the $1.3 trillion residential mortgage-backed securities (RMBS) in the last two years despite the high defaults and foreclosures that plague the sector.

Many investors and Wall Street dealers are advocating the assets because of a rising scarcity value, and because RMBS at loss-adjusted yields near 7 percent are offering higher returns than junk-rated corporate debt, where expected losses are few.

"It maximizes value. It makes sense," said Jesse Litvak, a managing director at Jefferies & Co. in Stamford, Connecticut.

Dan Nigro, a Montclair, New Jersey-based bond consultant and former mortgage portfolio manager said it is usually easier to sell parts of a pool of bonds as it can attract a broader variety of investors and meet their specific needs.

"Usually you get the best bids for bonds when you let individuals buy individual pieces of bonds. It's hard to get all or none," he said.

"The fact that they are not going to sell it back to AIG is a big story (and) the fact they will parcel it out means the market is healthy to digest a steady stream."

(Additional reporting by Ben Berkowitz, editing by Richard Chang, Gary Hill)

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