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AIG Toxic Debt Coming to a Money Fund Near You: Street Whispers


Before congratulating the New York Federal Reserve on turning a profit on the bailout of insurer American International Group (AIG) and unloading billions of subprime debt back onto greedy Wall Street bankers, think again.

You are likely going to own that once toxic paper in your sleepy money market fund in the near future.

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New data from Fitch Ratings signals that the subprime securities removed from AIG's balance sheet via Maiden Lane II and Maiden Lane III as part of the 2008 bailout are being prepared by money managers for a return to the financial system, with big risks that touch Main Street investors and savers.

Both the US government and AIG have been crowing over the success of Maiden Lane as part of the insurers' financial redemption, arguing the assets unloaded by AIG during the financial crisis and hoisted onto the New York Fed's balance sheet are a major triumph.

AIG will likely pitch the recent repayment of the Fed's bailout loans to investors as a success in its second quarter earnings due after the market close on Thursday. The Fed has already sent out self congratulatory press releases that it has a realized net gain of nearly $4.5 billion on the sale of Maiden Lane loans to some of the biggest Wall Street banks like Goldman Sachs (GS), Credit Suisse (CS), Barclays (BCS), Citigroup (C), Bank of America-Merrill Lynch (BAC), and Royal Bank of Scotland (RBS).

But banks didn't hold onto those assets, which are made up of subprime residential mortgage backed securities, or RMBS, and collateralized debt obligations, or CDOs. Instead, they broke them up, stripped them down, and quickly sold them off.

And in the ever-present ironic Wall Street circle of life, those assets are now moving into prime money market funds, which are accepting them as collateral for short term loans as they begin to add riskier and higher yielding securities to portfolios, according to Fitch.

Prime money market funds are a seemingly safe way for savers and corporations to lend out money for short periods, earnings a higher yield than near zero interest rate savings accounts. The funds subsequently use those loans to hold high rated debt like government, agency and corporate bonds, equities and -- at times -- securities like RMBS and CDOs through repurchase agreements, earning a yield that is returned to individuals and corporations with their principal when repo agreements expire.

During the crisis, structured finance securities like RMBS and CDOs fell out of favor for prime money market funds and comprised 0% of their overall repurchase holdings. Now they're back, consequently so too are the constituent assets of Maiden Lane.

A coincidence? Likely not.

After vanishing from money market holdings in the first half of 2009, Fitch Ratings calculates that structured securities now comprise 18% of total holdings -- matching 2006 levels and eclipsing the 11% that funds held in the first half of 2008. In the second half of 2008, money markets and repo markets froze with the failure of Lehman Brothers, in large part because of the opacity of the underlying assets within RMBS and CDO securities -- and because of the counterparty risks that come with taking repo collateral from investment banks.

It's the reason that some might want to sound an alarm bell on AIG and the Fed's Maiden Lane exit.

The assets at the heart of the credit crunch appear poised to return to fickle repo markets, with the prospect of new risks.

In analyzing the types of repo collateral swirling into money market funds, Fitch notes, "[Approximately] 60% of structured finance repos within Fitch's sample were conducted with three institutions: Credit Suisse, Royal Bank of Scotland, and Bank of America (Merrill Lynch). Interestingly, each of these institutions has been active in the Federal Reserve Bank of New York's 'Maiden Lane' auctions," the agency wrote in its August 1 report.

While prime money market funds should be lauded for cutting overall risk -- one of the seminal moments of the 2008 crisis came when the $62.5 billion Reserve Primary Fund "broke the buck" after writing off Lehman bonds and collateral in its collapse -- the system might not be fully repaired, and possibly riskier that some expect.

Currently, the Securities and Exchange Commission is pushing for money market funds to recognize losses if the collateral they hold falls in value, and institute capital buffers and withdrawal limits, in a so-far tortured effort. Meanwhile, money market funds may be relying on risky structured securities like Maiden Lane collateral to earn back yield that can't be achieved by holding Treasury securities and other high-rated and transparent debt.

"For money market funds (which act as lenders in the triparty repo market), repos backed by structured finance securities generate markedly higher returns than repos on traditional forms of collateral, a potentially significant motivation in the current low yield environment. Median yields on repos backed by structured finance collateral (72 bps) were four times higher than Treasury and agency repo yields (18 bps)," notes Fitch Ratings.

While the agency calculates that riskier collateral has fallen to 35% of overall money market holdings as of February -- a sharp drop from 60% levels prior to the financial crisis -- structured securities are nearing a pre-crisis 20% level of total holdings.

Martin Hansen, a director of macro credit research at Fitch who conducted the repo collateral study is hesitant to draw conclusions on risk just yet. "When you see trends in the proportion of riskier collateral, it could a sign of risk appetite but it could also be the cause of technical aspects," he says, noting fast changing market conditions and holdings in money market funds.

Riskiness aside, was Maiden Lane really such a win, even if the Fed and AIG come out with healthier-than-expected finances? If you are an investment bank or AIG, the short answer is yes. For everyone else, the jury is still out.

Maiden Lane II, AIG's first Fed backed bailout, was constructed to purchase $20.5 billion in RMBS assets that the insurers' US subsidiaries bought from investment banks who packaged the securities in the housing boom, and which faced severe losses during the crisis. After bundling them and selling them to AIG for a fee, many of those investment banks like Barclays are now buying the securities back, with the prospect that they re-package the assets and sell them to insurers like AIG -- again for a fee.

If that's not a cause for concern, consider Maiden Lane III. The $24.3 billion vehicle loan was created so that AIG could buy up collateralized debt obligations that its London-based AIG Financial Products subsidiary had guaranteed by way of credit default swaps (or CDS).

When AIG faced a September 2008 ratings downgrade, the insurer was liable for tens of billions in payments on those swaps to investment banks around the world, all but guaranteeing its demise. With Maiden Lane III, AIG could buy the CDOs it had guaranteed -- paying investment banks somewhere near face value for securities that were quickly declining in worth -- in a move to retire the toxic CDS it had written.

After being effectively paid on the insurance in 2008, investment banks spent the first half of 2012 buying back the assets at a discount. The securities are likely to then be resold to buyside investors, or used as collateral in repurchase agreements. Clearly, banks won.

So too will AIG, according to July 31 calculations by Sterne Agee & Leach research analyst John Nadel. Because not all Maiden Lane assets have been sold, AIG and the Fed stand to reap billions in the sale of the remaining securities included in the program.

Since July 17, when AIG received a $5.6 billion windfall on the Fed's on its successful auctions, Nadel calculates that AIG likely will receive $1.2 billion to $2 billion from auctions held at the end of July. Now, of the remaining $7.3 billion in Maiden Lane assets still owned by AIG and the Fed in a 30% - 70% profit split, the analyst calculates that AIG could still earn billions more, putting its total Maiden Lane profit at $9.3 billion.

There is a silver lining: AIG still owes roughly $30 billion to the US Treasury as a result of its record $182.3 billion bailout. Maiden Lane profits could yet be a benefit to taxpayers, who still own 60% of AIG's shares, and eagerly await a full bailout repayment.

With AIG poised to report a successful exit from Maiden Lane in its second quarter earnings and eventually repay its bailout, investors should take any cheerleading with resent. Instead, while Maiden Lane should be seen as crucial bailout program, it also should stand as a prime example of the billions in illicit profits that were attached to "too big to fail" financial institutions.

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