Sunday, February 26, 2012

The Fed stands to make good money on AIG assets, assuming the assets (Maiden Lane II & III) can be sold

The Fed stands to make good money if it could liquidate its holdings of the AIG rescue facilities. The table below shows what the Fed needs to get back in order to break even ("Current Senior Loan Balance") and "fair value" of assets supporting it. After the loan gets repaid, the Fed and AIG split the proceeds on the collateral sales, with the Fed keeping lion's share of the proceeds as profit.

Maiden Lane I and II ($mm, source: NY Fed)

But there is one little problem. Liquidation of these assets is challenging, to put it mildly. The Fed has been focused on Maiden Lane II, which is easier to sell. The assets are mostly subprime and Alt-A mortgages, with a bit of option ARM sprinkled in.

Maiden Lane II ($bn, Source: NY Fed)

These assets are ugly, but even this wonderful stuff could be sold if the price is right - mostly because these pools of loans can be analyzed. The Fed started selling early last year, but these sales were visibly pressuring the ABS/RMBS markets. As the ABX (CDS on senior tranche of asset backed securities index) price chart shows, ABS assets were declining in price in the first half of 2011. The Fed decided to stop in June after the sales impact spilled over into other credit markets such as HY corporate credit.

ABX (synthetic ABS) senior tranche price (Bloomberg)

Since then the Fed tried utilizing a form of Dutch Auction by inviting only the dealers who knew how to place this paper without disturbing the market (via large global client networks). In spite of the criticism for keeping the process limited to the biggest dealers, the process seemed to have been successful so far.
Bloomberg: The New York Fed was criticized for damaging credit markets with the regular sales, and halted them in June after disposing of about $10 billion in face value of the assets. It resumed the sales on Jan. 19, when it unloaded about $7 billion of assets in one block to Credit Suisse, after receiving an unsolicited bid for the securities from Goldman Sachs. Only Barclays and Bank of America were invited to also participate in that auction. Goldman Sachs won the auction for $6.2 billion of bonds this week after Credit Suisse placed an unsolicited bid for the assets. Barclays, Morgan Stanley (MS) and RBS Securities Inc. were also included in that sale. Barclays presented the second- highest offer in both auctions this year, according to a person familiar with the process.
Maiden Lane II balances have come down sharply as the result of these sales. (Note that under the new Volcker Rule, these sales could not be accomplished.)

Fed's assets of AIG rescue facilities (Source: The Fed)

Yet Maiden Lane (ML) III balances continue to remain high, and based on the valuation (table above), that's where the real "juice" is. The coverage ratio (ratio of assets to loan amount) is over 180%.

Coverage ratio for Maiden Lane III (Source: NY Fed)

So why not focus on selling these assets first? The answer has to do with the types of assets held in ML III  - the asset mix is just slightly different from ML II. As a bit of background, ML-III assets were acquired by the Fed via the settlement of AIG's CDS it has written. Unfortunately unlike the Treasury's settlement in the cases of GM and particularly Chrysler, where debt holders took a huge haircut, this earlier settlement was a bit more generous. With some negotiation the Fed could have acquired these at a discount and would have an opportunity to make even more later. The assets on which the CDS was written were tranches (mostly "senior") of CDOs and they now sit on Fed's balance sheet.

Maiden Lane III ($bn, Source: NY Fed)

Subprime and Alt-A mortgages have been a problem in ML-II, but at least investors understand them and at the right price these assets can be placed. That's why ML-II is nearly unwound. But when it comes to the CDO tranches of ML-III, it's a whole other story. There is little appetite for structured credit these days among institutional investors. Therefore even dealers with the best client networks will have a tough time absorbing this paper. Indeed the Fed could make good money on this, but it may take years and strong credit markets to unwind this portfolio at a profit (particularly at current marks). However the Fed better move fast because under the Volcker Rule, the dealers can no longer hold this much inventory (unless they get a special exception), and these sales will stop altogether.
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