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Fed Weighing AIG's Bid to Repurchase Subprime Mortgage-Bond Portfolio

Source: WSJ - Serena Ng

Posted on 21 Mar 2011

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Putting the Federal Reserve central bank in the position of weighing taxpayers' interests against those of the government-controlled insurer, American International Group Inc. (AIG) is trying to force the hand of the central bank on a large portfolio of subprime-mortgage bonds it wants to repurchase.

AIG earlier this month disclosed an offer to pay $15.7 billion, or roughly 53 cents on the dollar, for mortgage securities it once owned that have been on the Fed's balance sheet since late 2008, after AIG was bailed out by the U.S. government.

The formal bid followed months of what AIG executives perceived to be wavering by central-bank officials over whether to sell the bonds.

AIG wants the securities for their high yields. It believes they will help boost the company's financial position ahead of a planned stock offering that will allow the Treasury Department to recoup some of the bailout money it put in during the financial crisis.

For the Fed, however, the choice isn't clear-cut. It bought the bonds as one of several steps it took to help stabilize AIG in 2008, and wasn't expected to hold them indefinitely. But the Fed has faced criticism for not being tougher on the insurer and the banks that benefited from the AIG bailout. In deciding whether to sell the bonds, the central bank will need to show it is doing well by taxpayers.

At the same time, any effort by the Fed to seek bids from outside investors for the subprime bonds could weigh on the prices of similar securities, an outcome that could hurt banks holding such securities.

A day after AIG's latest offer, the Fed said any sale of the assets would have to maximize proceeds to U.S. taxpayers and meet its goal of "fostering financial stability." It is unclear when a decision will be made.

AIG's formal bid followed a preliminary bid that it submitted in December, people familiar with the matter say. Since September, AIG's insurance units have sold some municipal bonds and stockpiled billions of dollars in cash in their investment portfolios in anticipation of buying the subprime-mortgage bonds early this year. Tired of waiting, AIG executives decided to go public with their offer.

"We put the portfolio in play to see whether others would bid more," chief executive Robert Benmosche said in an interview. The move, he said, has created "a de-facto public auction" for the bonds in a vehicle known as Maiden Lane II LLC, which the Fed set up during the financial crisis to buy AIG's troubled assets.

"We've built up a significant cash position here, and time is of the essence," Mr. Benmosche added.

The urgency from AIG stems from its continued efforts to try to extricate itself from control by the government, which soon will begin selling its significant ownership stake in AIG to investors through a stock offering. Ahead of that, AIG wants to be able to show investors it is putting its cash to work and boosting investment income in its insurance units. This deal could help achieve that given the relatively high yields the bonds offer, projected by AIG at 8% to 10%. AIG's offer letter said that if the Fed doesn't accept, that could potentially slow down plans for Treasury to sell its stake.

The Fed, analysts say, needs to determine whether AIG's offer represents the best price for the portfolio, or whether more value can be gotten either from holding the securities for a few more years or from selling some or all of them to other investors.

"This is an opportunity for the Fed to get rid of some particularly unappealing securities, but it needs to be an arms-length transaction," said Vincent Reinhart, a resident scholar at the American Enterprise Institute and a former senior Fed official. "The Fed is going to be more cautious than any other seller as there's a suspicion that a deal in the interest of AIG may not be in the best interest of the Fed."

AIG's $15.7 billion offer is close to the bonds' $15.9 billion "fair value," which is an estimate of what they could be sold for in an orderly market, according to a note on the Fed's web site.

And the price would represent a $1.5 billion profit for the Fed, which originally provided $19.5 billion to Maiden Lane II for the bonds. Since then, the bonds have generated about $7 billion in income, which has reduced the balance on the Fed's outstanding loan to Maiden Lane II to $12.8 billion.

The question for the Fed is whether it could do better. It is possible that some investors may be willing to pay more than fair value for individual securities in Maiden Lane II, and there has been talk that hedge funds are interested in bidding for some bonds. But if the Fed tried to sell or seek bids on the entire portfolio, or large portions of it, that could push down prices of other mortgage securities, an outcome the central bank wants to avoid.

Mr. Benmosche said AIG expects others to bid on the securities, and the company understands that four banks have looked at the portfolio and at least one bid could emerge that exceeds AIG's. He added that a sale by the Fed to AIG would benefit taxpayers' majority stake in AIG, but a sale of part of the portfolio to hedge funds or banks could expose the insurer to greater risk.

Before AIG's formal offer, the Fed had sold a very small number of individual bonds in Maiden Lane II after receiving voluntary bids from investors on those specific securities that offered compelling value, according to people familiar with the matter.

AIG has eyed the subprime bonds for nearly a year, Mr. Benmosche said. Having previously owned the securities, it is familiar with them and has closely analyzed their cash flows and the default trends of the mortgages backing the bonds. And thanks to changes in the way state insurance regulators size up the risks of mortgage bonds, AIG wouldn't have to set aside a lot of capital to own these bonds, because their values have already been written down significantly. AIG recognized a $20 billion loss on the bonds when the Fed bought them in 2008.