By: Italia Almeida
In 2008, amidst the financial bailouts of many Wall Street firms, one of the biggest and most controversial moves by The Federal Reserve was the creation of special financial investment vehicles to buy toxic assets held by AIG – a move that prevented the insurance giant from completely collapsing. The Fed was able to unwind these assets by buying parts of CRE CDOs (commercial real estate collateralized debt obligations) from counterparties, mainly Wall Street banks, at 100 cents on the dollar, far above the then market value. In return, the banks agreed to cancel credit default swaps they had entered into with AIG to hedge their investment in CDOs. This move insulated Wall Street from suffering losses on their investment and prompted some lawmakers to refer to it as a “backdoor bailout.”
Three years after the move, the Fed announced plans to unload large blocks of these CDOs in auctions back to banks, leading to sizeable asset auctions. The latest portfolio sold at auction was Maiden Lane III which held tax payer-owned CRE CDOs with a $3.1 billion face value and was sold to Credit Suisse, Bank of America and Royal Bank of Scotland . This last auction fully repaid the Fed’s loan and unwound their entanglement in the center of the economic meltdown.
The sale of Maiden Lane III was not the first move by the Fed to unload the assets, as open auctions were conducted in 2011, and closed auctions took place earlier this year in a sale of securities know as Maiden Lane II. However, the sale of Maiden Lane III specifically was a change in investment strategy from the original plan of a slow unwinding of the portfolio. According to the Fed, the sale of Maiden Lane II led to a $2.8 billion gain on the $19.5 billion taxpayer loan/investment and prompted Federal Reserve spokesman Jack Gutt to announce that the Fed was encouraged by the sale and “improving market conditions.”
Gutt’s use of the term “improving market conditions” was likely a reference to the 2012 market currently devouring high yield debt sales and thus maintaining their high prices. The once “toxic” CRE CDOs are now market gold and were in hot demand as the big banks battled to win the assets in the Fed’s closed auction. Unlike Maiden Lane II, the majority of Maiden Lane III’s portfolio contains illiquid CDOs. All the buyers are likely looking to “collapse” the CDOs to get to the underlying collateral and separate the commercial mortgage-backed securities in hopes that the “pieces trade for more than the value of the whole” in a resale to investor clients. The sustained high prices for these assets show that the 2012 trend for the sale of high-yield debt is not slowing any time soon, and it suddenly seems that sales can barely keep pace with demand. This appetite is understandable considering that interest rates hover at zero, thanks, of course, to the Fed.
The fed was able to announce in mid-June that it had been fully repaid (with interest) for its role, equaling $53.12 billion. The Fed deserves a lot of credit for pulling off a profitable reduction of government investment in one of the most toxic set of assets in recent financial history. According to Fed President William C. Dudley, the Fed fully executed its policy objective of protecting the U.S. economy during a time of great distress.
While it could be argued that the real winners were just big banks who were protected from sustained losses due to government intervention, and not the economy at large, it is hard not to see some mastery in the Fed’s handling of the assets, including a quick ability to read changing market demands and change strategy. According to one researcher, this move may set a precedent for the varied ways in which the Fed can step in to help markets during times of distress – something investors, politicians and economists will look to as the U.S. economy explores stimulus options.