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Crony capitalism alleged in Fed’s debt swaps

Does the Federal Reserve bank really have taxpayers’ interests at heart? The Fed has secretly selected three banks to bid on American International Group, Inc. (AIG) debt securities that were acquired during the 2008 bailout. This move has critics and Wall Street seeing red over the failure to live up to the bank’s promise of transparency, Bloomberg News reports.

The secret auction is a stark contrast to an auction last year, where the Fed invited over 40 broker-dealers to participate. This year, however, the Federal Reserve Bank of New York only invited Goldman Sachs Group Inc. (GS), Credit Suisse Group AG (CSGN) and Barclays Plc (BARC) to bid on $13.2 billion of bonds offered in two sales this month. Last month, Goldman Sachs bought $6.2 billion of bonds in an auction.

Traders blamed regular and public auctions for damaging bond prices in 2011, prompting the Fed to switch to this closed process. The New York Fed was criticized last year for damaging credit markets using regular sales, and it promptly ceased these sales in June 2011 after selling $10 billion in face value of the assets.

On Jan. 19, sales resumed when the bank sold $7 billion worth of risky mortgage bonds to Credit Suisse Group AG. The Wall Street Journal estimates the bonds were sold for over $3 billion, based on comparable debt.

Goldman Sachs won the latest auction. The Fed sold $6.2 billion in face value of mortgage bonds from Maiden Lane II, meaning the rest of the outstanding balance of the $19.5 billion loan given to Maiden Lane II can be repaid.

Firms not included in the bidding, however, were annoyed at being left out. Many have questioned whether or not the Fed is getting the best price for taxpayers, who gave AIG $182.3 billion in bailout funds.

“I fail to see how running a limited participation, secret auction is any way beneficial to the owners of these bonds, the U.S. taxpayer,” said the president of a New York-based market data analyst. “Not to mention these bonds are now trading 15 to 25 cents” on the dollar “cheaper compared to when they were last auctioned in a more public manner.”

“The purpose should be to get the best price for the taxpayer,” explained Robert Eisenbeis, a former research director at the Federal Reserve Bank of Atlanta who now works at Cumberland Advisors. “Anybody knows the more bidders the better, so it’s a little hard to understand why they would essentially pick potential winners and losers. That smacks of crony capitalism.”

“The exclusivity by which the process has shut out smaller dealers is a little un-American,” David Castillo, head of sales and trading at broker Further Lane Securities LP, said.

Maiden Lane II, LLC was created in 2008 with the sole purpose to buy holdings that AIG handed the Fed in exchange for a cash injection. Its portfolio includes bonds backed by some of the riskiest home loans with the highest default rates, including subprime mortgages.

Despite critics claims that the private, selective auction may not be good for taxpayers, the Fed turned a $2.8 billion profit from selling Maiden Lane assets, according to CNN Money.

The good news of the $2.8 billion surplus is dampened by the fact that the Fed still holds a separate portfolio, Maiden Lane III, which contains the insurer’s credit default swap business. When acquired, the portfolio was worth $29.3 billion, but it is now worth $17.6 billion. As of Feb. 1, the Fed was still owed $9.6 billion from its loan to Maiden Lane III.

The government currently owns 77 percent of AIG, down from 92.1 percent.

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