The Fed’s bubblicious AIG turnaround

March 25, 2011, 8:54 PM UTC

If the party goes on long enough, bubbly debt markets can make even toxic housing assets look tasty.

That explains why the AIG (AIG) bailout, long an albatross for Ben Bernanke & Co., is on the verge of producing an actual cash-on-the-barrel profit for the Fed – while lighting up dollar signs in the eyes of Wall Street.

On the upswing

AIG offered this month to buy back a portfolio of troubled mortgage bonds. Reports this week say groups led by Barclays, Credit Suisse and Morgan Stanley are sniffing around, pointing to a possible bidding war.

You could see this frenzy as an endorsement of Bernanke’s efforts to chase funds out of cash and into riskier investments by holding down rates and buying Treasury bonds. QE2 is working, the AIG revival says.

Just the same, growing demand for distressed housing paper could also be a sign of an approaching bond market collision with reality. Those who take this view say the current run will end badly – particularly for those buying pricier, supposedly safer bonds.

“The Fed is taking us on a pro-inflationary journey,” says Tad Rivelle, chief investment officer for fixed income at TCW, which has invested as much as a third of one fund in non-agency mortgage-backed securities. “The way to avoid the distorted situation in the Treasury market is to buy what’s cheap, and the market is saying that is legacy non-agency mortgages.”

That’s where AIG comes in. The New York Fed is on the verge of auctioning off the residential mortgage-backed securities it acquired from AIG in October 2008. The Fed bought the AIG portfolio, now known as Maiden Lane II, to prevent the collapse of AIG’s securities lending business.

The bonds were low-rated and widely disparaged as unsalvageable. But AIG offered this month to buy back the Maiden Lane II bonds for $15.7 billion. That price would give the Fed a $1.5 billion profit and the insurer a portfolio of bonds producing an expected 8%-10% return – which is not an easy thing to come by nowadays.

Rival bids, if they emerge, could push the price higher, which would be good for the Fed but could trim the buyer’s return expectations. Those have been coming down already: Rivelle says non-agency RMBS returned 20% to 25% last year, counting yields and prepayments, but his expectation for 2011 is perhaps half that.

“We have the potential for double digits this year,” Rivelle said.

In any case, anyone who predicted a year or two ago that the Fed would be in the driver’s seat on this portfolio would have been laughed out of Lower Manhattan.

“I wouldn’t have suggested the government’s recovery on these assets would have been anywhere near this good,” said David Merkel, principal at Aleph Investments in suburban Baltimore and an avid follower of the AIG saga. “But risk assets have done so well while the Fed has been buying.”

The question now is badly markets for risky assets might be hit this summer, when the Fed is scheduled to stop buying $75 billion a month in Treasury bonds. Pimco’s Bill Gross has been predicting a Treasury market turkey shoot, while others suspect the selloff might take place in the riskier asset markets that have been big beneficiaries of Fed-provided liquidity.

Merkel says he sees some signs of bond market froth in the premium values on some closed-end income funds, for instance. But he says it’s early to say how or when the market might actually adjust to a reduced Fed presence.

“Yield seeking goes on for longer than you expect,” says Merkel. “I’m reluctant to stamp an expire-by date on this.”

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