Maiden Lane Sales Trigger Stampede to Dump Risk: Credit Markets

Federal Reserve Building
The U.S. Federal Reserve building stands in Washington, D.C. Photographer: Joshua Roberts/Bloomberg

Federal Reserve auctions of mortgage securities that the central bank assumed in the rescue of American International Group Inc. are fueling a selloff in credit markets as Wall Street rushes to hedge against losses on stockpiled debt.

Declines in credit-default swaps indexes used to protect against losses on subprime housing debt and commercial mortgages accelerated this month, reaching almost 20 percent in the past five weeks as the cost of the insurance climbs, according to Markit Group Ltd. The plunge this week started infecting everything from junk bonds to the debt of financial companies.

The Fed has been selling the $31 billion Maiden Lane II portfolio piecemeal after rejecting a $15.7 billion bid from AIG for the entire pool in March. Since then, Europe’s sovereign debt crisis has deepened and the U.S. recovery has shown signs of slowing, with unemployment rising to 9.1 percent, the highest level this year, and the economy growing 1.8 percent in the first quarter, less than forecast.

“Dribbling risk into the market makes sense if everything is good and continues to improve,” said Ashish Shah, the head of global credit investments in New York at AllianceBernstein LP, which oversees $214 billion in fixed-income assets. “But when you get yourself into a position where the Street suddenly feels they’re long inventory and the macro backdrop is weaker, now you’re selling into weakness.”

Hedging Strategy

Wall Street banks, which through May 25 increased their holdings of corporate and asset-backed debt to the highest level in 13 months, have been using both so-called Markit ABX and CMBX indexes to hedge against the deteriorating values of mortgage debt, said Christopher Sullivan, chief investment officer at United Nations Federal Credit Union in New York. That’s contributing to the drop in prices of the underlying bonds and helped push up relative yields on speculative-grade, or junk, corporate bonds to the widest level this year.

Elsewhere in credit markets, the extra yield investors demand to own company bonds worldwide instead of similar-maturity government debt rose 1 basis point to 159 basis points, or 1.59 percentage points, according to Bank of America Merrill Lynch’s Global Broad Market Corporate Index. Yields averaged 3.761 percent. Spreads have widened 14 basis points since touching 145 on April 11, the tightest level of 2011.

Markit CDX Index

The cost of protecting corporate bonds from default in the U.S. rose. The Markit CDX North America Investment Grade Index, which investors use to hedge against losses on corporate debt or to speculate on creditworthiness, climbed 1 basis point to a mid-price of 99 basis points as of 11:06 a.m. in New York, the highest level since Nov. 30, according to Markit Group Ltd.

The index typically rises as investor confidence deteriorates and falls as it improves. Credit swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.

Following suggestions it was roiling markets with the AIG asset auctions, the Federal Reserve Bank of New York, which is being advised by BlackRock Inc., began slowing their pace and boosting the size of the sales.

The central bank, which this month plans to conclude its purchases of $600 billion of Treasuries in a program meant to bolster markets, had typically been offering about $1 billion from its Maiden Lane II portfolio once or twice a week until early May. In its ninth auction yesterday, the first since May 19, the New York Fed offered $3.8 billion of debt. Investors presented accepted bids for $1.9 billion, the smallest share yet.

‘Vulnerable State’

“The manner in which the sale of the Maiden Lane II portfolio has been conducted put the market in a vulnerable state,” said Bryan Whalen, the co-head of mortgage-backed bonds at Los Angeles-based TCW Group Inc., which oversees $120 billion in assets. Falling mortgage swap indexes and bond prices are “reflective of levered money, dealers especially, taking risk off the table, which is feeding on itself,” he said.

Jack Gutt, a spokesman for the New York Fed, declined to comment.

One Markit ABX index tied to subprime mortgage bonds that were rated AAA when issued in 2006 has dropped to 47.2 from 58.8 on April 1, declining from a more than two-year high of 62.7 on Feb. 15. A similar index tied to junior AAA ranked commercial-mortgage bonds created in 2007, known as the Markit CMBX, has plunged to 68.7 from 80.4 at the start of April and more than two-year high of 85 on Feb. 15.

‘Looking Pretty Good’

“I imagine the original $15.7 billion bid from AIG would be looking pretty good right now,” said Clayton DeGiacinto, who manages about $200 million as chief investment officer of New York-based hedge fund Axonic Capital LLC.

Investors are also bracing for more sales from non-U.S. banks after Dexia SA on May 27 said that it would take a charge to accelerate its sales of toxic holdings, including $8.5 billion of home-loan securities, DeGiacinto said. “Europe has never gone through the disgorging process that we’ve gone through here,” he said.

Actual securities backed by subprime or second mortgages issued from 2005 to 2007, the years that produced the most-toxic loans, have lost 4.2 percent over the past three months on average, Barclays Capital index data show. Reflecting the difficulty that remains in understanding the bonds’ values, Ellington Financial LLC Chief Executive Officer Larry Penn said at an investment conference in New York on June 8 the debt’s prices have probably fallen 10 percent to 15 percent.

Ellington is considering buying more of the bonds after previously focusing on the smaller amount of safer, older subprime debt.

“Hopefully we’ll be able to pick some good securities” in the Fed’s sales, said Penn, whose Old Greenwich, Connecticut-based company is run by hedge fund manager Michael Vranos’s firm.

‘Outsized Impact’

So-called mezzanine AAA commercial-mortgage bonds, originally carrying top grades, are yielding about 600 basis points more than the benchmark swap rate, up from 325 basis points over swaps in the first week of May, according to Deutsche Bank AG data.

“A lot of dealers did go into May and June a bit heavy and they have been using CMBX and ABX to hedge their inventories, said Philip Weingord, the head of Seer Capital Management LP, the hedge-fund firm that oversees $400 million. “As the indexes continue to go down, it’s bringing down the cash bonds.”

Swaps indexes on securitized-debt don’t transact in large volumes, so “a little bit of trading on the CMBX can have an outsized impact on prices,” said Andrew Solomon, a managing director in New York at Angelo Gordon & Co., which oversees $24 billion.

Spilling Over

Primary dealers’ holdings of fixed-income assets including corporate debt, commercial-mortgage bonds and home-loan securities without government-backed guarantees swelled to $94.9 billion in the week ended May 25, according to Fed data. That total, which includes only notes maturing in more than one year, was up from $85.7 billion at the end of 2010 and a six-year low of $59.8 billion in April 2009.

The drop in the mortgage-bond markets began spilling over to corporate credit, which already had started to weaken from the deteriorating economic picture and disagreement among European leaders over who should bear the burden of rescuing deficit-plagued governments including Greece.

In addition, S&P put a “negative” outlook on the U.S. government’s credit in April, citing a “material risk” the nation’s leaders will fail to deal with rising budget deficits and debt. Congress is locked in a stalemate over increasing the government’s $14.3 trillion debt ceiling.

Spreads on junk bonds, rated below Baa3 by Moody’s Investors Service and lower than BBB- by Standard & Poor’s, have expanded to 538 basis points, the widest since Dec. 31, Bank of America Merrill Lynch index data show.

High Yield Index

As the mortgage-linked swaps indexes dropped, an index that protects against losses on junk bonds headed for its biggest weekly decline in seven months.

The Markit CDX North America High Yield Index, which falls as investor confidence deteriorates, has fallen 1.2 percentage points to 99.9 percent of face value since June 3, Markit data show. It reached as low as 99.6 yesterday.

“Somebody who trades these indexes sees that kind of movement in CMBX and reacts,” Angelo & Gordon’s Solomon said. “That is the mechanism that leads these indexes lower.”

Bank Default Swaps

Default swaps on the six largest U.S. banks have gained an average of 19.4 basis points to 137.2 basis points since May 31, according to data provider CMA, which is owned by CME Group Inc. and compiles prices quoted by dealers in the privately negotiated market.

Five-year swaps insuring against a default on MBIA Inc., whose bond insurance unit guaranteed some of Wall Street’s most toxic mortgage-debt securities, jumped to the highest since July through yesterday.

The contracts have climbed 3.8 percentage points to 19.8 percent upfront since May 31, CMA prices show. That’s in addition to 5 percent a year, meaning it would cost $1.98 million initially and $500,000 annually to protect $10 million of MBIA obligations for five years.

“You almost have a perfect storm of events,” said Shah of AllianceBernstein. “ You have both the fundamental justifications for the market going lower and you have the technicals being created by Maiden Lane.”

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