It has been a month since the Federal Reserve Bank of New York began selling off its Maiden Lane II (ML II) BWIC list.

However, the combination of consecutive months of housing price declines, a softer GDP number, and the big question of what will happen to the economy and rates when the Federal Reserve's second round of quantitative easing (QE2) ends has made pushing the government inventory out the door extra tricky.

The $1.7 billion weekly ML II supply, according to market reports, has accounted for 43% of the $4 billion weekly BWICs and liquidations in the market between February and March. 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 only sold 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.

List number six, comprising a smaller number of bonds worth $458 million that went out just two days earlier, traded significantly better: 93% were sold - 31% above price talk, 12% below talk and 50% near talk. The Alt-A portion priced the strongest while the subprime bonds traded the weakest.

Mixing Lower-Quality Paper

What the seventh list in the series of sales has so far highlighted is the relative weakness in subprime versus other sectors. As the sales go on, the asset mix has increasingly incorporated more of the 2006/2007 paper with generally ugly profiles.

Scott Buchta, managing director at Sandler O'Neill & Partners, said the credit curve has steepened as prices on higher-quality bonds (i.e., fixed-rate prime and seasoned Alt-A bonds) have increased while prices on lower-quality assets (i.e., 06/07 subprime and pay-option ARMs) have pulled back somewhat.

However, Buchta said that while ML II supply has compounded the negative technicals in the dented residential space, the fundamentals in the distressed non-agency markets have been weakening for some time.

"Extensions in the liquidation timelines, rising severities and falling home prices have all played a part in the weakening of this sector," he said. "From a broader perspective, the housing market continues to struggle. Longer liquidation timelines and higher severities have had an impact on the prices, especially for subprime and pay-option ARMs."

Subprime also has more price/credit volatility these days as a result of servicing advance issues and the future of servicing practices - post-dual tracking.

"We have had many discussions surrounding which servicers specific clients like when buying bonds, which ones they hate and which ones they can't form an opinion on quite yet," a market trader said. "I think this will continue to be a prime topic, as there have been no major surprises in terms of the pure market fundamentals. The surprises have occurred in the speed of liquidations and the number of servicing advances and modifications happening, and this is simply determined on a servicer-by-servicer basis."

All these factors combined make the future less certain and affect risk taking across spread sectors.

"We are in a period of the year where technically equities fall under some pressure. Equity markets reflect the economy as a whole, and so people have become more concerned about that and QE2, and then you have a big seller," said Dan Nigro, chief executive of Warfield Consultants in Montclair, NJ. "On the other hand, for the first six lists you also had big buyers like AIG moving into the marketplace."

What is undeniable is that during the ML II auctioning process prices have slipped and there has been more credit tiering - good quality bonds are now tighter and the stuff that is weaker is now off by five to 10 points.

"Initially in the first six list the Fed saw aggressive price talk and that has changed because buyers are more cautious," Nigro said. "The chatter isn't as aggressive and you may not have as many bids moving things up. There has been a further decline in prices and further tiering between clean bonds and dirtier bonds and dirtier bonds have fallen more in pricing."

Nigro also noted that some of the leveraged buyers have begun to pull away from the market. "The fast money has started to sell and pull away from bidding," he said. "The guys who trade faster and move in and out of the market more often are more cautious and hesitant."

ML II - Good or Bad for the Market

While it can be argued that the sales have pushed spreads wider, they have also added structure and price discovery to the market - both welcome additions to those who are not knee deep in these bonds every day.

An aspect of the equation that is not mentioned is that for the last two years, since the bottom of the market, the Street has been able to buy bonds, mark them up, hold onto them when necessary and re-sell. "They knew there was a finite supply, they had low-cost financing and they had already been deemed too big to fail, so they took the risk on trade," Nigro said. "What has happened with ML II is that all of a sudden investment firms are not the drivers of supply and control as they were in the past, and when they lose a bit of control they get funny about pricing."

The Street, he explained, when it controls supply, front runs and marks up bonds and talks about technicals. "The Street is getting noisy because they can't control/dominate the action as they did over the last six months," Nigro said. "Markets don't go in one direction forever. The market has had a very healthy run since last August's QE2, and generally in securities prices since spring 2009. A pause or retracement is healthy and shouldn't be unexpected."

Adam Murphy, president of Empirasign Strategies, believes that anyone complaining about how the sales have been handled is way off base.

"They announced the auctions a few days ahead of time and have been pretty forthcoming with the color," he said. "Other lists are discreet with color and give sellers only a few hours heads-up. The ML II auctions with their long lead times add structure to a very unstructured and disjointed marketplace. I think you'll find those dealers/pm's long spread product before the ML II sales started hate it, and those under-allocated love it."

It's All in the Strategy

The Fed's strategy of selling the bonds on an incremental basis as opposed to a one-off asset sale has been met with some opposition from several ABS traders who claim that the drawn-out process has created some pressure on subprime bond spreads.

Jesse Litvak, a managing director at Jefferies, last month in a letter addressed to the Fed pointed out that of the assets still left to sell, the majority are similar to those assets the Fed was unable to trade in its 7th list.

If the Fed continues to pump $1.5 billion to $2 billion of ML II bonds into the market on a weekly basis, it will take another 11 to 15 weeks to unwind the remaining ML II portfolio. The concern is that it's likely to continue pressuring spreads on subprime paper.

"At this point, we think the ML II bid process has become somewhat of a burden on the non-agency market," Bank of America Merrill Lynch analysts said.

"There seems to be a high degree of bid fatigue on the part of investors and also a bit of hold up in the market each time a list is released, as investors take time to work up bids on the list and then wait for afterward. In addition, with the bulk of ML II bonds yet to hit the market and slated to come out over the course of the year, some investors have likely adopted the mindset "why pay up now?" analysts said.

Deutsche Bank Securities analysts said that the kind of volume that has been issued from the ML II portfolio is sufficient to dislodge the fragile balance between supply and demand in the non-agency market.

"Demand remains strong for the higher-quality assets, and yields continue to tighten in this sector," Buchta said. "Subprime and pay-option ARMs continue to offer very attractive yields relative to other high-yielding assets, but supply issues may continue to dampen prices in this sector for the foreseeable future."

According to JPMorgan Securities analysts, they expect to see spreads trend sideways for prime and Alt-A fixed-rate paper, but leak wider for distressed floaters, on the heels of overall market pressure from Maiden Lane II and other sellers.

Fed Revisits Strategy

Barclays Capital traders said that the ML II supply-related uncertainty has contributed to the flood of "did not trades" (DNTs).

"Rumors are starting to surface about a potential pause in ML II selling until June," they said in a commentary. "The news has yet to be confirmed by either the Fed or BlackRock Advisors. While we believe a one-/two-week pause would be a net positive for the market, the lack of true confirmation debilitates intended positive effects."

Litvak believes that the Fed should reconsider its strategy and instead sell off the assets in a large chunk or give other counterparties the ability to bid large pieces of what is left to sell from ML II.

"By taking the approach of pulling the bandage off nice and fast, I think what [the Fed] achieves is getting the best possible price for the remaining assets, and [the Fed] rids the rest of the market of the dark cloud that hangs over it," he said in an e-mailed comment to ASR.

Nigro believes that Litvak's concern over the overhang hurting the market has some validity to it, but only when placed in the context of the current economic backdrop.

"When you have a seller that is going to continue to keep coming back into the market place it's hard for people to be aggressive in bidding," he said. "The psychology behind everything is different because the backdrop is different. If it were one of improving fundamentals then people would forget about it and welcome the supply. The supply only matters because people are getting concerned about the economic backdrop."

Meanwhile, BofA Merrill analysts suggested a similar strategy and said that the Fed should consider releasing a single very large list, double-digit billions in size, and give the market two or three weeks to bid it. This process could capture the attention of the market and lead to robust execution. Yet it is unclear if given the deteriorating fundamentals, buyers would be able or would want to absorb a large auction. There is no evidence that at this point the a one-off sale would work better than a week-by-week smaller auction strategy.

"Until some change occurs or it is evidenced that the NY Fed is considering a new process, we may have to muddle through with ML II for the foreseeable future," analysts said.

New Twist to Sell Off

The good news is that the Fed has always maintained that it would base its strategy on market conditions and at its most recent sale, the eighth auction from ML II, it unveiled the newest twist to its auction strategy.

For starters, at $878 million in current face credit IOs, the latest list was significantly smaller than the $1.5 billion to $2 billion per week the Fed had been putting out. The Fed did sell 100% of the assets, but it was on the back of the low dollar price of the assets, so buyers didn't need a lot of cash to play and there was limited downside risk. "From what we can tell, the $878 million in assets generated about $50 million in proceeds," Buchta said.

However, the main indication that the government agency may now be considering another way to sell off the ML II portfolio is the Fed, sources said, held a conference call with traders that followed the eighth auction. According to market sources, the New York Fed during the call said it would offer no more bonds from its ML II portfolio until June 6. For the next two weeks the ML II asset sales will cease, giving investors more time between lists. The Fed plans one sale on June 6, and then none until after July 4.

At this revised rate of sales, one dealer projected the portfolio will not be completely unwound until the end of August.

Nigro emphasized that the latest move signals the Fed's willingness to adapt its strategy based on market conditions and its willingness to adjust accordingly. "In the end if they feel that they are hurting the market on a regular or permanent basis they will pull back because their job is to have the market function properly first and foremost. The Government's objective is to get a return to the taxpayer but to also, and more importantly, de-risk and keep a sense of market order."




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