Last Friday, The Wall Street Journal reported that large banks are interested in buying the “toxic assets” the Federal Reserve Bank of New York (FRBNY) acquired as part of the AIG bailout. Specifically, Goldman Sachs, Barclays, and Credit Suisse have all expressed interest in buying the FRBNY’s $47 billion portfolio of collateralized debt obligations (CDOs).
The demand for these assets is partly a reflection of the current monetary policy environment, which has flooded the market with liquidity and substantially reduced expected returns across virtually all asset categories. The FRBNY’s CDO portfolio is one of the few places investors could buy assets with yields near 10%. According to the WSJ, the banks’ plan to buy the assets and then re-securitize them to create additional CDOs to meet their clients’ return targets.
The FRBNY previously sold some of the mortgage-backed securities (MBS) it acquired from AIG in mid-2011 and then again in January 2012. These securities were relatively straightforward and easy-to-value, as they represented claims on a well-defined pool of mortgages. The MBS were backed by low-quality mortgages, like subprime and Option ARM, but the securities themselves were based on a structure that has been around since 1968. CDOs, by contrast, are relatively new innovations.
They are collateralized by (or reference) the tranches of a large number of different MBS deals that are each backed by thousands of mortgage loans. Instead of a claim on a pool of mortgages like traditional MBS, structured finance CDOs are claims on the junior claims on pools of mortgages. This makes them much more difficult to value and much more risky.
The CDOs owned by the FRBNY were quite literally at the center of the financial crisis. AIG had provided financial guarantees on the CDOs for a number of banks, including Goldman Sachs (NYSE:GS), Societe Generale, and others. When the value of the CDOs dropped due to the rise in mortgage default losses and uncertainty about who was likely to bear the losses, these banks demanded collateral from AIG like Treasuries and high-grade corporate securities. As AIG’s credit rating fell, it had to post more collateral and eventually ran out of eligible securities. Absent intervention, AIG would have filed for bankruptcy at this point and the value of the financial guarantees it provided on the CDOs would have collapsed. Instead, the Fed rescued AIG with a loan and later spent $25 billion to purchase all of the CDOs from the banks at par (100% of their original value).
According to the WSJ, the current market value of the CDO portfolio is just 37 cents on the dollar. This means that an investor could buy the entire $47 billion portfolio for just over $17 billion. (The original principal balance of the CDOs was $62 billion. In addition to the $25 billion payment from the Fed the banks were allowed to keep the $35 billion in collateral previously pledged by AIG. The remaining sum was provided by AIG to complete the transaction.) Despite dropping in price since the original bailout (the CDOs were valued then at 50 cents on the dollar), the Fed is unlikely to suffer losses because of the size of the interest and principal payments made since 2008.
For example, if you paid $50 for a bond with a face value of $100 that pay 8% interest, you would receive $8 per year in interest payments, which is equivalent to receiving 16% of your investment back each year. If $24 of the initial $100 in bond principal is repaid, then over a three year period you would receive $48 of your $50 investment. These figures are roughly analogous to where the Fed stands with the AIG CDOs. This sizable cash flow is also what is attracting banks to these assets. There are few, if any, securities available that have the potential to generate so much current income at such a low price.
As shown in the graph below, the yield-to-maturity on B-rated corporate bonds – two levels below investment grade – are barely above 7% today. This is the return an investor would receive in a best case scenario, if they invested in these risky bonds and they paid off at par with zero default losses. Less than six months ago, these same bonds were yielding nearly 10%. Moreover, the spread on these bonds relative to Treasuries has fallen from about 800 basis points (8%) to 550 basis points over the same time period.
The collapse in spreads on B-rated bonds is part of a broader narrative in the market right now where investors are scrambling in search of riskier assets. Stock prices are now at pre-crisis highs as well. This shift in portfolios is the natural consequence of today’s monetary policy, which has pushed risk-free rates deeply into negative territory. In February, the consumer price index increased by 0.4%, or a 4.8% annualized rate.
In the twelve months ending in February, prices increased by 2.9%. During the same month, the yield on the one year Treasury bill averaged 0.18%. This means current risk-free interest rates are negative in real terms: inflation exceeds interest rates, and a dollar saved today is worth less than a dollar tomorrow, after accounting for changes in prices. The only way investors can avoid seeing their savings fall in value is to assume greater risk, which explains banks’ interest in buying the AIG insured CDOs.
Since 2009, the Fed has consciously adjusted its balance sheet in an effort to push investors into riskier assets. As explained by FRBNY Vice President Brian Sack in a 2009 speech and again by Fed Chairman Ben Bernanke at Jackson Hole in 2010, Fed policy is premised on the existence of a “portfolio balance channel.” As the Fed buys “safe” assets like Treasuries and government-backed MBS – reducing the expected returns on these assets classes – investors are left with no choice but to move into riskier assets to achieve desired returns. As Sack explained:
By purchasing a particular asset, the Fed reduces the amount of the security that the private sector holds, displacing some investors and reducing the holdings of others. In order for investors to be willing to make those adjustments, the expected return on the security has to fall.
Simply put, Fed policy is designed to make it so unattractive to hold low-risk assets like Treasuries that investors will have no choice but to move into riskier assets “such as corporate bonds and equities.” This policy has been frustrated, or slowed, at times by the risk of collapse in Europe and a weaker and unsatisfying recovery in the U.S. But, as has clearly been the case since September of last year, investors are once again rushing into riskier assets at the slightest hint of good news, further pushing down their yields and lowering the premiums investors earn for bearing more risk on the margin.
The goal or objective of the policy is often described in noble terms in that higher stock prices generally mean better capitalized corporations, more investment, and more spending from wealthier (feeling) households. Lower yields on risky debt translate to better financing opportunities for young or risky businesses that need the capital. But the current financial system, which is supposed to translate these accommodative liquidity conditions into financing for growing businesses, may not be up to the task.
Most of the gross issuance volume of new debt to take advantage of the low rates has been from large companies refinancing existing debt. The banks with the large trading portfolios of Treasury bonds and MBS assets to sell the Fed are not the smaller banks that serve as the lifeblood of small business lending. And the cash balances of businesses remain at record levels, suggesting that the uncertainty generated by aggressive monetary easing may largely offset the benefits of cheap and abundant liquidity. But perhaps the best evidence that the financial system is not able to translate lax monetary policy to productive investment is the fact that large banks want to buy and repackage the AIG CDOs rather than find promising small businesses deserving of the low-cost capital.