The April 26 sale of Maiden Lane III (ML III) assets caused some disruption in CMBS spreads.

Deutsche Bank Securities and Barclays Capital won the bidding process, which was conducted by the Federal Reserve Bank of New York. The two banks now own the roughly $7.5 billion of super-senior CRE CDO bonds that include the entirety of MAX 2007-1 and 2008-1 A1s, which were part of ML III.

In April, the New York Fed announced a change in its investment objective for the Maiden Lane III portfolio of assets acquired from AIG during its 2008 bailout. In November 2008, the Fed and the U.S. Treasury announced the restructuring of the government's financial support to AIG to provide the company with more time and greater flexibility to sell assets and repay the government. The Fed created Maiden Lane III to alleviate capital and liquidity pressures on AIG associated with credit derivative contracts written by AIG Financial Products (AIGFP).

The Fed revised its investment objective last month to improve market conditions. In a statement, the agency said that in light of the better market conditions, it would explore selling assets in the ML III portfolio. There is no fixed timeframe for the sales. At each stage, the Fed "will sell an asset only if the best available bid represents good value for the public, while taking appropriate care to avoid market disruption."

On April 18, the Fed announced that it had asked eight dealers to bid on April 26 on $7.5 billion of assets from the portfolio. The eight dealers include Barclays Capital; Citigroup Global Markets; Credit Suisse; Deutsche Bank Securities; Goldman Sachs; Merrill Lynch, Pierce, Fenner & Smith; Morgan Stanley; and Nomura Securities. Interestingly, ahead of the bidding deadline, the banks paired off into three groups to conduct the bids.

Nomura joined the team of Merrill and Morgan Stanley; Citigroup, Goldman and Credit Suisse formed an alliance; and Barclays and Deutsche became the third group.

The pairing off could be explained by the sheer magnitude of assets that are on sale, said one market source. The supply out of ML III comprises senior CRE CDOs, with most of the collateral backed by residential and commercial real estate bonds.

What particularly concerned the CMBS market is how readily it would be able to absorb the approximately $7.5 billion worth of collateral, according to JPMorgan Securities' April 16 CMBS weekly report.

The tranches of the CDOs causing the most concern are the MAX 2007-1, A1 tranche and MAX 2008-1, A1A tranche, which together have a face value of roughly $7.9 billion. However, per the ML III financial statements as of and for the years ended December 31, 2011 and 2010, the MAX 2007-1, A1 tranche and MAX 2008-1, A1A tranche were marked at roughly 55 cents on the dollar as of the end of last year for a value of roughly $4.3 billion.

This deal, according to JPMorgan's April report, is backed primarily by later-vintage AM and AJ tranches, with some A4 bonds and a limited allocation to cash CRE CDOs. "The Deutsche Bank group seems to have the advantage there since they control the junior piece of that deal, and Barclays controls the interest rate swaps embedded in the deals," said one investment banking analyst.

The uncertainty around the latest Maiden Lane sale initially set off pricing reminiscent of the widening trend that followed the Fed's Maiden Lane II portfolio sales last year. TreppWire, a publication of CMBS data provider Trepp, reported that the Fed's announcement at the beginning of April had led to a deep sell-off in the CMBS market. Legacy super-seniors saw spreads move out eight to 15 basis points on average, TreppWire said.

While the better names and older vintages withstood the widening pressure, weaker names were hit hard, according to the report. The benchmark GSMS 2007-GG10 A4 bond closed Thursday, April 5, two days after the Fed's announcement, at 236 basis points over swaps. This is 15 basis points wider than Tuesday, April 3's closing level, which was when the Fed announced its policy change. Further down the credit curve, stronger AM paper widened by 15 to 20 basis points, but weaker names went wide by about 50 basis points, the Trepp data showed.

"In the AJ market, paper with decent collateral sold off by a point or two, but with 'dented' AJs, the damage was twice as much," according to Trepp's report released April 6. "The consensus was that weaker AJs were off two to four points in price, but one trader thought the losses were even bigger."

Even the more recent vintage deals issued in the CMBS 2.0/3.0 market experienced spread widening at the top-rated classes by five to 10 basis points. The double-A and single-A bonds widened by 10 to 20 basis points, and triple-B bonds widened 20 to 25 basis points.

But ahead of the April 26 bid, legacy spreads had come in by 10 basis points from where they were when the Fed made its announcement at the beginning of the month, according to an investment banking analyst. "A lot of the widening was due to Maiden III supply fears, and the tightening means that has reversed," he said.

In terms of the market comfort level with the assets, the pricing trends over the last few trading sessions indicate that investors have grown more comfortable with the idea. "There has been talk about the dealers that are bidding doing so aggressively and soliciting customer interest in advance of the bid," said the investment banking analyst.

According to several news reports ahead of the bidding deadline, Merrill, Morgan Stanley and Nomura said that they plan to repackage the CDOs into a re-securitization that would allow a new investment-grade bond to be formed. "Rather than unwinding and having all the separate tranches, they could re-securitize and then have higher-quality and lower-quality tranches to sell," the investment banking analyst said. "The strategies are going to differ based on the customer interest they get on the other side of this sale." The analyst added that other options would be to keep the CDO intact or to liquidate it. The winning bidder could end up employing more than one of those strategies.

Even though spreads have come in, it has been on lower trading volume in the CMBS space. "Once the bids are in we expect to see the activity pick up some, and that will give the market a better idea of where spreads will go," said the investment banking analyst. "I do think that in terms of the trading volume there has been a 'wait and see' attitude, and there is a need to get this Maiden Lane III issue behind us."

The fact that the Fed is selling the assets should not come as a surprise, said Walter Schmidt, manager of structured product strategies at FTN Financial, in an e-mailed statement.

"I'm not surprised by the change in stance from the Fed regarding the remaining ML assets," he said. "After all, ML II sales went much better this year than last. I am a little surprised they actually changed the language on the mandate. It seemed unnecessary to me."

JPMorgan analysts stated in the bank's CMBS weekly report that the wording in the Fed's latest announcement also highlights that it likely learned a lesson from initial Maiden Lane II lists, which last year set off a significant sell-off across securitized credit.

At the time, the Fed was pushing around $1.7 billion weekly of ML II supply, according to market reports. This comprised 43% of the $4 billion weekly BWICs and liquidations in the market between February and March 2011.

Up to ML II's sixth bid list, bonds traded at or above expectations and were net positive for the customer.

At its seventh auction, however, the Fed sold only 34 of the 53 bonds as a result of prices not meeting reserve levels.

Traders said that of the $2.08 billion listed, roughly 34% did not trade, 43% traded below talk, 12% traded above talk and 11% traded near talk.

"As a result, we believe [the Fed] will only move forward with negotiated placements at a sale price in excess of their Q4 fair value marks," the JPMorgan analysts said.

As such, it is likely that the ML III sales won't disrupt market pricing like the first rounds of MLII. The Fed's announcement means that it might be unwilling to sell the CDO bonds cheaply enough to maintain the economics of collapsing the CDO, JPMorgan analysts reported.

"Specifically, their insistence on 'good value' suggests to us that they will be unlikely to entertain bids that are not noticeably higher than their mark of $55 back in December," they said.

They explained that a sale in a $60 context leaves roughly 10 points of margin ($85 collateral value, which is equivalent to $15 swap termination payments and $60 purchase price). This is despite the buyer unloading the collateral securities at current levels, which is unlikely with so much secondary supply hitting the market.

As such, the recent technical pressure that the potential ML III sale has put on the CMBS is probably short-lived, although market volatility is likely to remain elevated for the next couple of months, according to the JPMorgan analysts.

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