Bloomberg News

Fed Plays Wall Street Favorites in Secret Bond Deals: Mortgages

February 21, 2012

Feb. 10 (Bloomberg) -- The Federal Reserve secretly selected a handful of banks to bid for debt securities acquired by taxpayers in the U.S. bailout of American International Group Inc., and the rest of Wall Street is wondering what happened to the transparency the central bank said it was committed to upholding.

“The exclusivity by which the process has shut out smaller dealers is a little un-American,” said David Castillo, head of sales and trading at broker Further Lane Securities LP in San Francisco, who said he would have liked to participate. “It seems odd that if you want to get the best possible price that it wouldn’t be open to anyone who wants to put in the most competitive bid.”

After inviting more than 40 broker-dealers to take part in a series of auctions last year, the Federal Reserve Bank of New York asked only Goldman Sachs Group Inc., Credit Suisse Group AG and Barclays Plc to bid on the full $13.2 billion of bonds offered in two sales over the past month. The central bank switched to a less open process after traders blamed the regular, more public disposals for damaging prices in 2011. This week, Goldman Sachs bought $6.2 billion of bonds in an auction.

The selectivity has irked firms that weren’t also given the chance to profit from the auctions, and raises the question of whether the Fed got the highest price for U.S. taxpayers, who gave insurer AIG a $182.3 billion bailout. The New York Fed resumed its sales of the assets in January after the market recouped a portion of last year’s losses.

‘Crony Capitalism’

“The purpose should be to get the best price for the taxpayer,” said Robert Eisenbeis, a former research director at the Federal Reserve Bank of Atlanta who’s now chief monetary economist for Sarasota, Florida-based Cumberland Advisors. “Anybody knows the more bidders the better, so it’s a little hard to understand why they would essentially pick potential winners and losers. That smacks of crony capitalism.”

Andrea Priest, a spokeswoman for the New York Fed, declined to comment.

The New York Fed announced in March that it would sell the bonds held in a vehicle called Maiden Lane II LLC, created in 2008 to buy holdings that AIG handed the Fed in exchange for a cash injection. The portfolio includes bonds backed by the types of home loans with some of the highest default rates, such as subprime, Alt-A and option adjustable-rate mortgages that helped fuel the housing boom and bust. Those securities, which can be difficult to value, offer a chance for a bigger profit to a savvy investor.

‘Competitive Sales’

The regional Fed bank said in a March 30 statement that it would “dispose of the securities in the ML II portfolio individually and in segments over time as market conditions warrant through a competitive sales process,” and that it would also “entertain investor inquiries to acquire specific parcels of securities where these offer superior value.”

It announced that it would undertake the sales after rejecting a $15.7 billion offer from AIG for the entire pool. “Offering the Maiden Lane securities for sale individually and in segments rather than as a single block will give a larger set of investors opportunity to bid for the assets,” the regional Fed bank said in the March 30 statement. “This will maximize sale proceeds.”

Twenty-two dealers bought bonds in the New York Fed’s Maiden Lane II auctions last year, with Bank of America Corp. and Citigroup Inc. topping the list of buyers. Before each auction, the regional Fed bank posted on its website the amount it planned to sell and when. Dealers widely shared the names of individual securities that were being offered and the second- best bids that were reported.

Damaging Credit Markets

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 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.

The New York Fed didn’t announce either auction until after they closed, and said the broker-dealers it included were chosen based on the strength of previous bids. The Wall Street firms, and their clients who wished to bid on the assets, were required to sign non-disclosure agreements forbidding them from discussing the offerings. At least one investor opted not to participate for that reason.

‘Chinese Wall’

“Our compliance people took a very conservative view of the non-disclosure agreement,” James Keegan, chief investment officer at Seix Investment Advisors LLC in Upper Saddle River, New Jersey, which manages about $30 billion. “Since we don’t have 20 securitized traders, we couldn’t put someone behind a ‘Chinese wall’ and continue to conduct business.”

The Fed’s less-transparent approach didn’t drag down markets like their more public auctions did last year, and analysts at Morgan Stanley and Bank of America said the first sale contributed to gains by highlighting demand.

Further Lane’s Castillo, whose broker participated in the auctions last year, said “it seems like the process has been working for the New York Fed.”

Typical prices for the most-senior bonds tied to option ARMs climbed to 55 cents on the dollar last week from 49 cents in October and November, according to Barclays Capital data. That’s down from last year’s high of 65 cents in February. Option ARMs allow borrowers to pay less than the interest they owe by increasing their balances.

Following Dexia

“Limiting it to the dealers that in the New York Fed’s opinion they trust to be the best cuts down on the price discovery that’s important in illiquid markets like this,” said Jason Weaver, an analyst at Sterne Agee & Leach Inc. in Nashville, Tennessee. At the same time, those dealers were ones that “they had the confidence had the ability would get the transaction done and done quickly and without any problems.”

The Fed followed an approach undertaken by other firms looking to unload billions of dollars of assets without roiling markets. Dexia SA, which said in August it sold $8.8 billion of mortgage bonds, and State Street Corp., which sold $11 billion in assets in December 2010, also turned to a limited number of dealers rather than widely distributed auction lists to dispose of holdings. Dexia, the lender now being dismantled by Belgium and France, had publicly announced its intention to sell; State Street, the third-largest custody bank, hadn’t.

Goldman Holds Bonds

“You certainly don’t want to lose that one buyer because you feel a need to go through with all the formalities,” Joseph Vitale, a partner in New York at Schulte Roth & Zabel LLP, who said he wasn’t involved in the transaction.

Goldman Sachs held onto almost all of the bonds the New York Fed sold to it for at least a day, rather than mainly fulfilling client orders as Credit Suisse did last month, based on data from Trace, the transaction reporting system of the Financial Industry Regulatory Authority.

Goldman Sachs told some investors who bid on the bonds through the bank that, while they had offered the best prices on individual securities, the firm had bought the debt for itself, according to three money managers with knowledge of the matter. Goldman Sachs then offered the securities for sale to the investors, they said. The prices were between 1 and 3 cents on the dollar higher, said one of the people, who declined to be identified because the transactions aren’t public.

Willing Market

“Our intention has always been to distribute the portfolio to our clients globally and we are in the midst of doing that,” said Michael DuVally, a Goldman Sachs spokesman.

The method the New York Fed employed may have been less important than market conditions following a slump in prices, as signs of a strengthening U.S. economy, fading European debt crisis and change in the calendar year embolden investors and dealers, said Ken Hackel, head of securitized product strategy at CRT Capital Group LLC.

“More than anything else, it’s that they’re selling to a very willing market at this point,” said Hackel, whose Stamford, Connecticut-based bond broker was one of the dealers that participated in last year’s auctions.

Public Fashion

It’s not clear that the Fed’s approach resulted in higher prices than if the bonds had been sold in a more piecemeal and open fashion, said Adam Murphy, president of Empirasign Strategies LLC, a New York-based provider of data on securitization-market trading.

“I fail to see how running a limited participation, secret auction is any way beneficial to the owners of these bonds, the U.S. taxpayer,” Murphy said. “Not to mention these bonds are now trading 15 to 25 cents” on the dollar “cheaper compared to when they were last auctioned in a more public manner.”

This week’s $6.2 billion sale to Goldman Sachs allows the repayment of the central bank’s loan to Maiden Lane II, which was originally $19.5 billion. While the Fed hasn’t disclosed the prices paid, it was owed about $6.7 billion on its loan to the facility as of Feb. 1, not taking into account proceeds from last month’s transaction. About $6 billion of assets remain in the vehicle, based on Fed disclosures.

The New York Fed said Feb. 8 that it “will dispose of the remaining securities in the ML II portfolio individually and in segments over time as market conditions warrant through a competitive sales process, while taking appropriate care to avoid market disruption.”

A separate facility, Maiden Lane III LLC, helped retire credit-default swaps that were sold by the insurer to protect banks from losses on securities tied to subprime mortgages. AIG said in March 2009 that Goldman Sachs received $12.9 billion from the insurer to settle securities-lending and credit-swap contracts from the 2008 bailout. The Fed was owed about $9.6 billion as of Feb. 1 from its loan to Maiden Lane III.

--With assistance from Dan Kraut in New York. Editors: Pierre Paulden, Rob Urban

To contact the reporters on this story: Caroline Salas Gage in New York at csalas1@bloomberg.net; Jody Shenn in New York at jshenn@bloomberg.net

To contact the editors responsible for this story: Christopher Wellisz at cwellisz@bloomberg.net; Rob Urban at robprag@bloomberg.net.


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