Friday, June 10, 2011

Sale of Maiden Lane II securities shows that without asset-level data there is no real market for subprime securities

The Wall Street Journal ran an article on the Fed's sale of the securities in Maiden Lane II and the drop in the prices for subprime mortgage backed securities since the sales began.

The article makes it sound like the tail wagged the dog.  When the Fed began the sale of a de minimus amount of securities ($31 billion par amount or approximately $17 billion at today's prices into a market that at its peak had over $2 trillion in bonds outstanding), prices on securities dropped by 15-20%.

This is not suggestive of the idea that the tail wagged the dog, but rather evidence that there continues to be no real market (with price movements like that it is obviously not deep or very liquid) for subprime mortgage backed securities.

Your humble blogger has been telling anyone who would listen that there is no real market for these securities since before the start of the credit crisis.  Regular readers of this blog know the reason that there is no real market for these securities is the current asset-level data needed for independently analyzing and valuing these securities is not available.
A steep decline in prices of bonds backed by subprime mortgages has spread through the riskiest segments of the credit markets, ending rallies in high-yield corporate bonds and commercial real-estate debt. 
... The market for subprime bonds started falling in early April, around the time the Federal Reserve Bank of New York launched an effort to sell pieces of a multibillion-dollar portfolio of subprime bonds it has been holding since late 2008. 
Since April, prices of many subprime mortgage securities have declined between 15% and 20%, sparking concerns from traders and investors that the Fed's sales are pressuring a weakening market.
On Thursday, the New York Fed sold only half of a $3.8 billion batch of bonds it sought to auction off this week....  
"The timing couldn't be worse for the market," said Marina Tukhin, head of asset-backed securities trading at Gleacher Descap in New York, referring to the effect of the Fed's auctions on the mortgage market, which she calls "oversaturated" with troubled assets. 
... The decline in subprime mortgage bonds accelerated in the last two weeks with prices of some bonds falling roughly nine to 10 cents on the dollar from their April highs. Soon after these bonds started falling, an index known as the CMBX, which tracks commercial mortgage debt, also headed down and has declined substantially. 
The New York Fed has so far sold off roughly $10 billion of bonds it inherited from the bailout of American International Group Inc., about a third of a portfolio known as Maiden Lane II, at discounts to the bonds' face value. 
The regional Fed bank held weekly auctions for pieces of the portfolio in April, but recently decided to slow down the pace of sales after getting market feedback. Thursday's auction was the first in three weeks, and the next one will be after the July 4 holiday. 
Wall Street traders groused that the Fed's sales have been a big reason for the latest downdraft in prices of risky U.S. debt. An index known as the ABX, a proxy for prices of subprime bonds, recently traded at about 47 cents on the dollar, a level last seen in March 2010, according to data from Markit. It is still well above its crisis low of about 29 cents on the dollar. 
Analysts say the price declines have created a negative feedback loop in the credit markets, with weakness spilling over to derivatives on commercial mortgage backed securities and now junk bonds. 
Traders said investors are buying credit protection in the derivatives market to hedge their investments, and this occurs more as prices continue to fall. As the cost of protection against defaults rises, so do yields on many bonds. Bond prices and yields move in opposite directions....
When the Fed began the sales, it reasoned that the mortgage-debt market had stabilized and conditions were "right" for Maiden Lane II to begin "more extensive sales while taking appropriate care at all times to avoid market disruption."
Is a 15-20% decline in price a market disruption?
From the Fed's perspective, the sales have gone relatively well so far and the bank has been able to be a selective seller, accepting only bids that it likes. It has so far sold about 75% of the $13.4 billion in bonds it put for sale over the last two months....
We can assume that the bids the Fed accepts meets or exceeds either BlackRock's valuation of the securities or the current value that the Fed carries the securities on its balance sheet.

The problems the Fed now faces are

  • how to continue selling the subprime securities without incurring a capital loss; and
  • what to do now that without a real deep, liquid market it has exhausted the available investor pool while not liquidating its entire portfolio.

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