Sunday, June 12, 2011

Failed Fed Auction an Early Warning?

Not widely reported except by Bloomberg, the Federal Reserve (Fed) had a rare failed auction last week of mortgage-backed securities (MBS) "purchased" by the Fed from AIG during its $182.5B bailout in 2008/9. The Fed bought a total of $52.5B of MBS from AIG as part of the bailout package, forming the "Maiden Lane II" portfolio of distressed crisis assets on its balance sheet. Why should investors and traders care about this event? Keep reading.

In a June 8 dutch auction, investors only bought $1.9B of $3.8B of debt offered, causing market spectators to question the quality of MBS assets that AIG dumped on the Fed (or that the Fed overpaid for). The byline is that the Fed ended up selling the assets into a weak(ening) market, a casualty of bad timing. The irony is that the Fed was offered $15.7B from the rescued-and-lingering AIG for repurchase of the remaining $31B Maiden Lane II portfolio in March. Perhaps the Fed saw such a discount repurchase (reverse repo, actually) as a giveaway that would get too much press attention as a taxpayer loss, and decided that selling into the open market was a more tenable option. Credit markets in February-March were at a 2-year "high" of health, but have since deteriorated somewhat, with both MBS and corporate high-yield (junk) debt spreads increasing along with the price of credit default swaps for major banks and bond insurers.

So why should investors and traders care about this event? First, failed Fed auctions are a rarity. Second, the Fed has some $2.8T of "crisis assets" on its balance sheet [1], with ~$2T collected since fall 2008. Yes, the majority of those assets are Treasuries bought via quantitative easing asset swaps, and are AAA-rated, of the very highest quality debt (for now). Likely, the Fed won't be unwinding its balance sheet anytime soon, given some show of recent economic weakness and calls for even more quantitative easing from some quarters. The questions that arise are: Is selling into a weak market a destabilizer for credit/debt markets, and what is the risk of more failed auctions as the perception of quality deteriorates? Could those failed auctions ever be mint-Treasury auctions by the Treasury [2], forcing the Fed to continue loading its balance sheet and monetizing debt? And then there's always the question of all that muni-debt...

Note I am not just another "chicken little" on the issue of failed auctions and bond market turmoil, as the quality of debt has always been, and always will be, the paramount concern. If the 2008 crisis taught us anything, an oversupply of debt in the market can have destabilizing consequences, especially if quality of that debt declines. Investors and traders need to be vigilant of any signs of worsening conditions.

[1] Public view of the Fed's balance sheet can be found HERE.
[2] Newly-issued Treasury auctions can be tracked HERE.

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