04.03.2012
Economic Trends
New York Fed Breaks Up with Maiden II
Back when the financial crisis was in full swing, a number of simultaneously exploding problems struck at AIG (American International Group). The Fed’s response was swift and varied. One particular response was Maiden Lane II, created to deal with problems in AIG’s securities-lending program.
AIG is a big conglomerate comprised mainly of insurance companies. The trouble started in some of these insurance subsidiaries. Insurers collect premiums from customers to insure them against some adverse event. The premiums are generally invested in securities that the insurer buys and holds in its portfolio. Instead of holding the securities, AIG’s insurance subsidiaries had lent some of them out using repurchase agreements (repos). Under the repos, the securities were lent out for cash, and AIG was obligated to repurchase them at some specified point in the future. The cash collected from repos was then invested in “safe” AAA residential subprime mortgage-backed securities (RMBS). Effectively, investors lent cash to AIG with the securities acting as collateral.
After market participants started to suspect that AAA was not AAA after all, and after AIG’s own rating was downgraded, lenders demanded more collateral to cover their cash lending. AIG had two choices: come up with more collateral or sell the RMBS and return the cash to the lenders. Neither choice turned out to be possible. The AAA RMBS were losing value and proved illiquid, and AIG had problems trying to borrow money in the capital markets. At this stage a severe liquidity crunch ensued.
The New York Fed initially lent AIG subsidiaries $20 billion in cash, with the RMBS serving as collateral. Under this arrangement (called the Securities Borrowing Facility), AIG still owned the securities and was subject to the effects of their possible losses on its balance sheet. This arrangement did not prove potent enough to contain the problems.
In November 2008, two new special purpose vehicles (SPVs), Maiden Lane II LLC and Maiden Lane III LLC, were created to address the capital and liquidity pressures on AIG. The SPVs gave AIG more time and greater flexibility to sell assets and repay the government loans. Maiden Lane II was designed to deal with the securities-lending portfolio of AIG’s insurance subsidiaries. Instead of loaning AIG money, the New York Fed lent $19.5 billion to the Maiden Lane II, with its assets acting as collateral. With that loan, Maiden Lane II purchased approximately $39.3 billion in face value of AIG’s RMBS. AIG deferred the receipt of $1 billion of the sale price till after the Fed was paid back in full. This essentially provided AIG with cash and got the problematic securities off its balance sheet, limiting AIG’s exposure to those securities to the $1 billion deferred purchase price. The New York Fed bears any losses that surmount the $1 billion mark.
As it happened, the last securities in Maiden Lane II were sold off at the end of February 2012, and the New York Fed ended up benefiting to the tune of $2.8 billion. It is clear, ex post, that collateral in Maiden Lane II was adequate to secure the New York Fed’s loan; however, the transaction did involve hard-to-measure risks that could have resulted in losses to the New York Fed if the RMBS prices declined significantly.Maiden Lane II’s portfolio consisted mainly of high-risk RMBS. Initially, 57 percent of the total asset value was collateralized by subprime mortgages, 28 percent of the portfolio by Alt-A ARMs, and 15 percent by other types of loans, including option ARMs. Without going into many details, we just mention here that “toxic” is the prevalent adjective for these kinds of loans. The composition of the portfolio stayed relatively stable up to the time that Maiden Lane II was unwound.
California and Florida mortgages initially made up more than 45 percent of the loan balances underlying the RMBS in the portfolio. California mortgages made up the largest fraction at over 30 percent. Over the time that the assets were held, the geographic distribution of the loans remained relatively stable. Roughly, loans from California made up around 30 percent, Florida around 13 percent, and New York about 6 percent.
Percentage of Remaining Loan Balances by Geographic Location
|
|
As of 12/31/2008 |
As of 12/31/2009 |
As of 12/31/2010 |
As of 12/31/2010 |
|
California |
32.5 |
30.7 |
30.0 |
28.6 |
|
Florida |
12.6 |
13.0 |
12.8 |
13.1 |
|
New York |
N/A |
5.5 |
5.9 |
6.3 |
|
Other |
54.9 |
50.8 |
51.3 |
52.0 |
Note: New York was included in the “Other” category in 2008 because it made up less than 5 percent of the total.
Source: Federal Reserve Bank of New York.
The ratings of the securities held in Maiden Lane II experienced fast and deep deterioration. At the time they were purchased from AIG in the last quarter of 2008, 40 percent of the securities (based on market value) were still rated AAA, 15 percent were rated between AA+ and AA-, and only about 19 percent were rated BB+ or lower. After only three months, just 13 percent were rated AAA. The percentage rated BB+ or lower jumped to 64 percent. By the end of 2010, prior to any sales being made from the portfolio, 86 percent of the portfolio was rated BB+ or lower, and only about 5 percent was still rated AAA.
Critically, Maiden Lane II’s securities were bought at only a fraction of their face value. The face value is the principal balance remaining on the underlying loan pools. Originally, the portfolio’s face value was about $39.3 billion. The face value decreased over time for three reasons: monthly mortgage payments (only the principal part of the payment affects face value, not the interest part), mortgage defaults, and security sales by the Fed. The face value declined steadily from the time of purchase up to the first round of sales in 2011. The first large drop-off was in April 2011 and reflected both mortgage payments and security sales. The second large drop-off was at the start of 2012 and reflected the second round of sales.
The fair value of Maiden Lane II’s assets is tricky to calculate. Its RMBS were not traded liquidly, so there are no ready market prices for them. Fair value calculations would definitely include subjective assumptions about market participants’ behavior were they to actually buy them. Nonetheless, Maiden Lane II periodically reported its estimated fair value. The fair value appeared to drop initially but remained relatively steady, increasing slightly up to the first security sale in April 2011. The face value was decreasing during that time period, implying an increasing fair value estimate.
We next plot the ratio of fair value to face value. The ratio gives us the fair value of $1 of assets of Maiden Lane II. An increase in this ratio means the securities become more valuable and the New York Fed’s loan to Maiden Lane II becomes safer. The ratio initially dropped off just after the purchase until about the end of 2009. This drop shows that the drop in fair value exceeded the drop in face value over that time period. Then, the ratio increased steadily from about October 2009 until about June 2011, around when the first period of sales was ending. The increase was caused by a steady fair value, coupled with a decreasing face value. The first sale period started with a spike in the ratio. The sale seems to have caused downward pressure on the ratio by negatively impacting “market prices.” The second sale occurred after another spike in this ratio, but this time the New York Fed was able to dispose of these securities without significant market disruption.
Since the fair value computation is fairly idiosyncratic and depends on assumptions not fully observable in the market, we constructed a market-based measure that tracks the value of Maiden Lane II’s portfolio. This construction serves two purposes. First, it allows us to check if the assumptions used to calculate the fair value are truly reflected in actual market transactions. Second, it allows us to see if there were any market disruptions around the time the securities were sold by the New York Fed.
We used the ABX.HE indexes published by Markit. These indexes measure the prices of credit default swaps (CDS) on subprime mortgage-backed securities. Although the indexes do not directly measure the prices of the securities, they are still commonly used to evaluate the value of RBMS. A CDS is basically “insurance” against the default of a security. So an issuer of a CDS is practically betting that the security will not default, similar to actually buying the security itself. The buyer of a CDS, on the other hand, is protected by the seller against the security’s default. A rise in the index is a drop in the cost of this “insurance,” and it implies a market perception of less risky securities. Therefore, a rise in the index is correlated with a rise in the price of the security.
Each of these indexes tracks the CDS prices for a bunch of similarly rated RMBS issued in a specific six-month period. For example, the ABX.HE AAA-07-02 index tracks CDS prices for RMBS issued in the first six months of 2007 that had a rating of AAA at issuance. Since the Maiden Lane II securities were issued in several different six-month periods, not one of these indexes is a good representation of the whole portfolio. Based on the face value of the portfolio as of 10/31/2010, approximately 30 percent of the portfolio’s assets were issued during the first half of 2007, 28 percent in the second half of 2006, 21 percent in the first half of 2006, and the remaining fraction from other six-month intervals. The chart below is an index of the weighted average price from the various ABX indexes based on those calculated percentages.
This index followed a similar pattern to the ratio of the fair value to face value, confirming that the fair value assumptions appear to be shared by market participants. There was an initial drop in the value of these securities in the months immediately following the purchase. Then the value steadily increased until the first round of sales, then it dropped off immediately after, and finally it increased again during the last round of sales. This shows that the fair value of Maiden Lane II securities appreciated above the initial purchase value. It also shows that there was a drop in the value of the securities around the first round of sales and no significant downward disruption during the second round of sales this year.
[Note: paragraphs 4, 5, 6, and 10 were updated on 4/18/2012.]