June 24, 2011 / 5:49 PM / 8 years ago

IFR-US CREDIT-Fed's Maiden Lane II gambit may be drawn-out

 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
 "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
 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
 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
 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)
 (adam.tempkin@thomsonreuters.com; Reuters Messaging;
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