Tuesday, February 7, 2012

For sale: AIG's subprime bonds

A Wall Street Journal article reports that the NY Fed is seeking to sell an additional $6 billion of subprime bonds that were acquired during the bailout of AIG.

In keeping with its policy of maximum opacity, the Fed is limiting the number of market participants who can see what is for sale and bid on the bonds to five large Wall Street firms.

Personally, your humble blogger is more troubled by the opacity than the idea that the Fed might not realize the maximum price for the bonds.

Remember, so long as the Fed receives a high enough sale price for the bonds that when combined with all the interest payments it has received from the bonds the total exceeds the price the Fed paid for the bonds, then the Fed will not incur a loss on the bonds.

An example might help.  Imagine that the Fed acquired the $6 billion in bonds for $4 billion.  Since the time of acquisition, the bonds have paid $1 billion in interest.  If the Fed realizes $3 billion on the sale, it will not incur a loss ($1 billion of interest plus $3 billion of sale proceeds equals $4 billion purchase price). Other than BlackRock's management fee, the Fed does not have any material costs (like interest expense) to holding the bonds.

I can hear you say, but what if those bonds are truly worth $4 billion today.

Then the Fed is transferring $1 billion in value that belongs to the taxpayers to the banking system.  Naturally, the bankers will take their 50% share in take home pay and the remaining 50% will flow through net income to the equity account.

While I find this troubling, it is less troubling than the fact that the Fed is hiding this transfer of value.  Why is the Fed hiding the transfer of value?
Five Wall Street banks have been invited to bid this week for another multibillion-dollar bundle of risky mortgage bonds held by the Federal Reserve Bank of New York as a result of its 2008 rescue of American International Group Inc. 
The invited firms are the U.S. securities arms of Barclays PLC, Credit Suisse Group AG, Goldman Sachs Group Inc., Morgan Stanley and Royal Bank of Scotland PLC, according to people familiar with the matter. They said the New York Fed is seeking bids by midweek for residential mortgage-backed securities with an unpaid principal balance of $6 billion, or about half the remaining bonds in a vehicle called Maiden Lane II.... 
In mid-January, Credit Suisse bought bonds with a principal value of $7 billion from the regional Fed bank following a similar exercise, in which the Swiss bank's U.S. unit won out over bids from Barclays Capital, Goldman and Bank of America Corp.'s Merrill Lynch securities arm. Credit Suisse quickly resold the securities to investors including hedge funds, insurers and real-estate investment firms.... 
The New York Fed's sales of large pools of bonds are a change from its auctions last year of individual securities from Maiden Lane II. Those auctions helped trigger a tumble in market prices of structured-finance assets, including commercial-mortgage debt. The selloff prompted the New York Fed, run by President William Dudley, to halt the sales in June.
Why would auctions cause a tumble in market prices now?  Wouldn't auctions provide the Fed with a better price? 

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