The National Credit Union Association (NCUA) and the Federal Deposit Insurance Corp. (FDIC) each priced sizable CMOs in mid-September that are unlikely to be the last because of their incremental yield and issuer financing benefits, and because more banks are destined to fail.

In fact, the offerings may just be the right paper at the right time, at least for some institutional investors, and should ultimately save taxpayers lots of dollars.

While the agency MBS market has continued apace, the only new-issue offering completed this year was Sequoia Mortgage Trust in late spring. The bank regulators' offerings, which follow four FDIC deals completed early this year, provided investors with somewhat better yield than agency MBS. But they're also riskier, given that their underlying assets are non-agency mortgages.

Scott Buchta, a managing director at Braver Stern Securities, which specializes in MBS, said the non-agency bonds the regulators have collected from taking over failed banks are trading today in the vicinity of 70 cents to 80 cents on the dollar. Or, instead of accepting that discount, the regulators "can wrap them with an FDIC or NCUA guarantee and sell those bonds at par, at a much lower yield," Buchta said.

So, for example, if the underlying securities can be sold today at 80 cents on the dollar, and if the offering has a 3% credit enhancement and models predict a default rate of 10%, then the issued bonds should take an approximately 7% loss. Consequently, the regulator "can literally take in $200 million more in premium today for selling this asset, and it might cost it $70 million over time, because these losses are going to occur over 30 years," Buchta said. "Plus, packaging the bonds under the regulator's name should increase liquidity and credit support."

In addition, the government guaranty enabled the banking regulators' underwriters to structure a yield that's only 25 basis points to 50 basis points more than an agency CMO, when investors would likely demand far more if the risky assets were sold outright.

The $1.4 billion FDIC deal, run by Goldman Sachs, was split into three tranches, with a $356 million portion priced at one-month Libor plus 50 basis points, another $297 million portion at one-month Libor plus 70 basis points and a third $757 million slice priced at swaps plus 125.

Barclays Capital, which ran the FDIC's four earlier offerings, priced a $3.3 billion tranche of the NCUA's $3.8 billion offering at one-month Libor plus 45 basis points, and the rest at swaps plus 100 basis points.

"The big thing for the FDIC and NCUA is that they need the cash upfront to bail out these failed institutions," Buchta said. "They're taking the risk that the bonds perform better or worse than the models predict. But their assumptions are probably pretty conservative, so they'll likely come out ahead."

Buchta said the regulators' paper is probably of most interest to banks, thrifts and insurance companies, and the floating-rate portions priced over Libor could attract asset managers with funds designed to invest in short-duration paper.

The government guaranty essentially removes credit risk, leaving duration risk as the main concern.

Jon Thompson, vice president of structured finance at Advantus Capital Management, said that despite the government guaranty, the CMOs should behave like the non-agency securities they comprise. The guaranty, however, removes the credit risk, so investors must focus on the risk of borrowers prepaying the underlying loans.

"When you combine a number of existing securities that each have their own unique cash flow paths that could occur, it becomes a very cumbersome exercise to determine what the actual timing of the cash flows will be," Thompson said.

He added that analysis of deals like NCUA's would require finding the CUSIP for each security, and then analyzing the pool of underlying residential mortgage loans. "So simplistically, you can look at it as a CDO, except that it's a presumably unmanaged, static pool of securities."

With few investment options out there currently to capture incremental yield over agency MBS, even if meager, investors appeared willing to accept the prepayment risk, since both deals were completed without a hitch.

Michael Youngblood, a principal at Five Bridges Capital, said he was disappointed that the government agencies chose the semi-private 144A market over the public market. The 144A market has fewer disclosure requirements than publicly registered deals, but, Youngblood said, it might hurt their liquidity in the secondary market. "One of the virtues of the now-defunct, non-agency securities market is that the transactions were public - the trustees and/or servicers posted monthly remittance reports and we've been able to monitor performance of these securities over time."

Even so, until other MBS options emerge, investor appetite for such securities is likely to remain strong , which is important given that both the FDIC and NCUA are expected to approach the market again with similar CMOs. The NCUA, in fact, has established a $35 billion program led by Barclays that's anticipated to roll out deals between $3 billion and $5 billion every month or so.

That the two banking regulators have become such major issuers, however, should not be surprising. "The collateral from most of these deals is coming from failed banks," noted Michael Kagawa, portfolio manager at Payden & Rygel, a $50 billion investment management firm headquartered in Los Angeles, adding, "And it's not like we've seen the end of failed banks."

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