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Saturday, 21 October 2017

Backdoor bailout 2.0

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The Maiden Lane III vehicle was once labelled a back-door banking bail-out, as the Fed stepped in to buy up AIG’s toxic CDOs. Now, as RMBS and CMBS have started to outperform the broader markets, those very same banks are battling each other to win bids on these highly sought-after securities.

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When US insurance giant AIG was on the brink of bankruptcy in 2008, the Fed’s Maiden Lane III vehicle eased some of the insurer’s obligations by buying toxic CDOs from its counterparties. In exchange for being bought out at 100 cents on the dollar, the counterparties agreed to terminate the swaps. That deal was widely criticised as being a back-door bailout of the banks with which AIG conducted business.

Now, as legacy US non-agency RMBS and CMBS have started to outperform the broader markets, those very same banks are battling each other to win bids on these now highly sought-after securities. Wall Street is winning a second time, critics say, as dealers buy the complex bonds back at a discount – and profit handsomely by flipping them to investors.

A strong rally this year in the most battered crisis-era US non-agency RMBS has buoyed this broken asset class, generating tremendous secondary market interest in the sector, which is now considered a potentially lucrative long-term investment, offering rich loss-adjusted yields, sometimes up to 15% for some sub-prime bonds.

Investors once again covet these distressed securities because they believe that the US housing market may soon hit a bottom, and bonds are often priced cheaply given that the beginnings of housing recovery might be under way.

Not surprisingly, therefore, as the asset class outperformed equity and corporate credit during the first five months of this year, there has been keen interest in the Fed’s ongoing sales from its Maiden Lane II and Maiden Lane III portfolios of toxic mortgage-linked assets assumed during the 2008 bailout of insurer AIG, which cost US taxpayers US$182bn.

The distressed securities helped bring down AIG, then the largest US insurer, and are largely backed by the kinds of toxic residential and commercial mortgages that came to symbolise the financial crisis.

Yet this year’s sales of these assets from Maiden Lane II and III have been a resounding success.

This success represents a complete turnround from one year ago, when the Fed’s open, public auctions of RMBS from Maiden Lane II saturated the market to the point where supply could not be absorbed, helping to trigger a capital markets swoon – coupled with uncertainty over the eurozone crisis – that lasted the rest of the year and pounded down prices on the bonds as a risk-off environment ensued.

Given the waning demand for the securities and the supply problems they caused, the Fed immediately halted the Maiden Lane II sales in June 2011 after nine auctions, saying it had no set timetable to liquidate the remainder of the portfolio, and would only continue if it generated “good value for the taxpayer”.

The district bank was wisely biding its time, and would only start selling again when it made sense.

It made sense again in January this year. A rally in risk products that started in December, after the LTRO was announced, is all that it took. 

New strategy

This time around, the Fed changed its tack for selling assets from Maiden Lane II: based on reverse enquiries, it would now only offer the securities to a limited group of hand-picked broker-dealers who would place competitive bids for securities they were hungry to acquire.

The change in strategy has worked.

After three more auctions early this year, the district bank finally completed its liquidation of the US$39bn Maiden Lane II portfolio of RMBS, with a net gain to US taxpayers of US$2.8bn. And since April, it has so far used the same strategy to conduct four limited auctions of CDOs from its US$47bn Maiden Lane III portfolio.

Competition has been fierce for these securities. Banks are squaring off against each other to acquire the offered tranches, and in some instances even teaming up to offer stronger collective bids.

But as with all things on Wall Street, there is a strong profit motive here: banks lined up their own bids from groups of investors prior to each auction, charging them a steep step-up for flipping them the same bonds that many of the dealers were made whole on back in 2008.

The investors are willing to pay up, however.

In many instances, it is not the CDOs themselves that offer the most value, but the underlying RMBS or CMBS backing the securities.

However, not all bidders are able to break down the CDOs into their component parts. Typically, only banks that either owned junior pieces of the deal or were swap counterparties are able to break them down into their mortgage-bond components.

So other bidding banks – who may not have such ties to the securities – have been trying different methods to attract investor clients; for instance, in the run-up to each of the CDO sales from Maiden Lane III so far, several banks have pitched preliminary resecuritisations of the CDOs to investors.  This so-called “re-remic” product restructures the debt into senior and subordinate pieces so that a new Triple A bond is produced.

Re-remics are now fairly common investment vehicles offered by broker-dealers, who have tried to re-sell the toxic assets that helped spur the worst crisis since the Great Depression.

Because of new capital regulations put in place since then, banks have an urgent need to replace the downgraded assets on their balance sheets with investment-grade holdings.

At the same time, high-grade ratings would open the door to institutional investors that are prohibited from investing in junk-rated bonds – that is, they would widen the pool of potential buyers.

But while the enhanced ratings help boost investor appeal, these sophisticatedly repackaged re-remics can be hard to discern from the original toxic securities out of which they were created – and many have not performed well in the market.

Some banks have advantage

In late April, three groups of powerhouse Wall Street banks banded together to vie for a US$7.5bn chunk of Maiden Lane III, the so-called “Max” CRE CDOs. This was the Fed’s first auction out of the Maiden Lane III portfolio.

The team of Barclays and Deutsche Bank ultimately won the auction, as those two banks already had a vested interest in the two complex securities on offer, and were able to take early bids from investor clients on the underlying CMBS backing the CDOs.

Deutsche Bank owned junior tranches of the two CDOs being sold and, along with Barclays, now holds majority ownership in the structure.

Barclays, meanwhile, was counterparty to a swap that was tied to the CDO, and this swap needed to be unwound before the deal could be “unlocked” and broken into the individual CMBS assets, market participants said.

Barclays and Deutsche Bank’s plan to dismantle the CDOs differed from the approach taken by two other consortia of banks (Citigroup/Goldman/Credit Suisse, and Bank of America/Morgan Stanley/Nomura), which banded together and planned to sell the securities either in their current form as CDOs, or as a repackaged product, which would allow a new investment-grade bond to be formed.

The individual CMBS backing the CDOs are valued in the markets at more than the CDO tranches themselves.

“Egregious” fees

The three following auctions of CDOs in May also saw several bidders – none of which were the ultimate winner – pitching preliminary resecuritisations of the CDOs to investors. These CDOs, unlike the Max CDO, were mostly backed by RMBS issued between 2005 and 2007.

Securitisation specialists say that the banks wanted to give investors options for the format in which they’d buy the securities, in case they won the auction.

But some sources say that in lieu of being able to break down the securities into their underlying mortgage bonds, the banks are trying anything to offer a more attractive product – in this case, a Triple A rated resecuritisation.

Market sources familiar with April’s Max CRE CDO auction said that the bids from each of the partnerships were very close in price, and on the high side compared with what the Fed was expecting. Moreover, Barclays and Deutsche Bank won the bonds by a small margin, not a large gap.

Several investors complained that the fees charged by the consortia to investor clients for aggregating their bids for presentation to the Fed were “egregious”.

The Citigroup/Goldman Sachs/Credit Suisse group and the Bank of America/Morgan Stanley/Nomura consortium were asking investor clients to compensate them 25bp more than the dollar price of each bond.

“Implementing the large bid-aggregation fee transformed the consortia winning bid into a losing bid and kept them from winning the auction,” said one trader.

While Barclays and Deutsche Bank did not mention a bid-aggregation fee in its partnership announcement sent to clients, traders said that the banks would ultimately charge a fee to unwind an embedded swap tied to the CDOs on which Barclays was a counterparty.

Despite the criticism of greediness, however, the Maiden Lane sales have turned out to be a success. There has been substantial demand for the assets, and the resale value of the underlying securities has been somewhere between 77% and 85%, according to analysts at Sanford C Bernstein & Co.

Moreover, analysts said the Fed and AIG booked a gain, and it is clear that the central bank is going to move quickly to sell additional assets from ML III, including nearly US$13bn worth of CDOs of RMBS.

The aggressive bidding also showed that the remainder of the portfolio might be valued higher than expected and that deals to enable the Fed to exit its AIG rescue are possible.

 

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