by Adam Tempkin
NEW YORK, June 24 (IFR) - With an announcement widely expected on July 6 to clarify the specific timing of its next auction of Maiden Lane II (ML2) residential mortgage-backed securities (RMBS) assets, the Federal Reserve Bank of New York is grappling with a significant strategic dilemma: What is the correct pace to proceed with its ongoing piecemeal open-auction to unwind the portfolio of former AIG assets in order to optimize value for taxpayers?
And perhaps more to the point of what's on everybody's mind: Given the current depressed bid for subprime-mortgage bonds, will the central bank's selling program ever raise an amount equal to the $15.7 billion AIG offer for the entire portfolio in March, which the Fed spurned?
And if so, how long would that take?
The answers are not yet clear; but fixed-income researchers studying recent secondary-market RMBS prices have done the math, and found one thing is for certain - the Fed is not reaching $15.7 billion any time soon.
"Unless the Fed changes its strategy, the ongoing auction process will not match the $15.7 billion offer from AIG," said Ying Shen, an RMBS research analyst at Deutsche Bank.
By Shen's estimate, the $9.5 billion sold in nine auctions so far between April 6 and June 9 - or about one-third of the Fed's entire ML2 portfolio - had an average dollar range for bonds of just $43 to $47, well below the approximate $50 price that AIG was willing to pay in its March proposal.
"In the short-term, it will be very difficult for the Fed to achieve that level of pricing," Shen said.
Depending on market conditions, it is possible that on July 6 the Fed will further delay the next auction. "The Fed is not a distress seller, and we expect that the Fed will change its piecemeal strategy of unwinding ML2 in order to generate optimal return to taxpayers," Shen added.
A spokesman for the New York Fed declined comment.
Other market observers generally agree with Shen's ballpark estimates.
"Per our calculations, the average cover price on bonds sold so far is $45.75," said Adam Murphy, president of Empirasign Strategies LLC, a capital markets data provider that closely tracks MBS and ABS bid-wanted lists. "That's a bit below what AIG offered to buy them all back before the auctions started."
NOT JUST ABOUT THE PRICE
The added supply of subprime mortgage paper from the Maiden Lane IIML2 auctions helped precipitate a credit-market sell-off and de-risking event in the first half of June, although macroeconomic and global volatility, as well as a slowing U.S. economic recovery, was perhaps equally responsible.
"Our view is that this spring's spread-widening is a function of more than just ML2 supply weighing on the market," Murphy said. "The double dip in housing and spreads being too tight at the beginning of year are the main factors, as well as general risk aversion. It also does not help that Europe continues to play 'kick the can down the road' with Greece.
"But those who have been caught long spread product - in other words, everyone -have been rumbling that the Fed should have sold it all direct to AIG and been done with it," he added.
But then again, the optics of such a move would have been questionable from the public's standpoint, and certainly wouldn't reflect the Fed's "best practices" approach to disposing of AIG's legacy non-agency RMBS. After all, the central bank bought the securities at the height of the financial crisis to rescue the troubled insurer.
"I think the perceived political risk of taking AIG's offer outright to buy back the portfolio in March was influential in the Fed's decision. People would have said 'AIG got a gift,' even if they overpaid for it," said a New York City-based underwriting manager at a direct mortgage lender. "It looks better for the Fed to go with the 'market' auction approach."
The federal bank is quite mindful of public perception now, other sources said. "So here we are in the final innings of this 'too big to fail' game, and all the people in the stands - the public - have an opinion, and feel they know how to win this game," added James Harrington, an investor and former ABS portfolio manager. "So that is why I think that everything has to be done in a fair and open procedure.
"All that AIG's bid did was set a level that the Fed has to respond to."
According to Harrington, the Fed had to consider whether AIG's price was the best bid it was every going to see, or whether it could get the open market to pay more.
"Going through an open-market process, the Fed must ask itself, 'Did I answer all the questions, doubts, and look-backs from the spectators?'" Harrington said.
But the cost of avoiding a charge of inside-dealing with AIG is the risk that the market wouldn't pay more than the AIG bid.
However, the Fed has time on its side.
It has indicated that it never committed to any timetable or schedule for winding down the assets, and is only looking to achieve the best execution possible. In fact, it rejected several bids that it did not find compelling during the auctions. There is no target date for disposing the assets.
But if the Fed decides to drag out the process longer, and perhaps even delay the July auction, it runs the risk of other issuers - such as the Franco-Belgian bank Dexia SA - beating it to market with a different RMBS bid lists and perhaps stoking demand if bond prices start to heal.
Dexia is slated to sell about $8.4 billion of U.S. RMBS in order to clean out its lowest quality U.S. assets.
Moreover, given the relative failure of the Fed's strategy so far, and the bank's willingness to be opportunistic as the market's tone recuperates, investors might decide to wait for better buying opportunities.
"[Investors] might think to themselves, 'Why should I buy now? I can just wait'," said Deutsche Bank's Shen. "I can buy cheaper at a later time."
The Fed needs to weigh all of these factors over the next two weeks, market participants say. "I think the best solution is to slow the auctions down a little, but the Fed needs to keep its place in the bid-list line," said Harrington.
"The bid for the remaining assets may not recover this year, but I think that given time, the yield buyers will continue to drink at the RMBS beer tap."
(Adam Tempkin is a senior IFR analyst)
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