American International Group's bid to take back $15.7 billion in risky mortgage bonds may inject fresh confidence in a market where investors had started to question a nearly two-year rally.

AIG said on Thursday it made the offer to the Federal Reserve Bank of New York for the residential mortgage-backed securities it gave up at the height of the financial crisis. The Fed on Friday confirmed it received AIG's offer for the bonds, held in Maiden Lane II, an entity formed in late 2008 as part of AIG's bailout.

For more than a year, the insurer has been preparing the offer on the bonds, whose values have soared despite rising foreclosures on the underlying loans. An index of top-rated subprime securities has rallied more than 50 percent since the depths of that market in April 2009, according to Amherst Securities Group.

The New York Fed would make a profit of about $1.5 billion on the portfolio, AIG said.

It shows you how far we have come from the fall of 2008, said Jesse Litvak, a managing director at Jefferies & Co. in Stamford, Connecticut.

I also think that this is far from being final, and I imagine a lot of others are scrambling to see what the value of this portfolio could really be worth.

Many investors have resorted to taking on more risk across mortgage, corporate and emerging market bonds to meet desired returns -- opening debate over whether the rally in prices has gone too far. A deteriorating housing market and more onerous foreclosure procedures may result in greater-than-expected losses on the bonds, some investors have said.

An investigation of loan servicing at banks may produce a settlement that could prolong foreclosures, reducing cash flow to bonds. But changes sought by states attorneys' general may be too difficult to apply.

SWEET SCARCITY

Selling in RMBS has picked up since the start of the year but prices haven't softened much as they are still attractive relative to other assets, like high-yielding corporate bonds.

The non-guaranteed mortgage market is the best part of the credit market, Jeffrey Gundlach, chief executive officer of DoubleLine Capital, told Reuters on Thursday. To Depression era-outcomes, the non-guaranteed mortgage market has a higher yield than the best possible case for junk bonds.

Junk bond yields are near 6.75 percent today, or about 4.75 percent after accounting for expected losses. Non-guaranteed mortgage bond yields are around 7 percent after factoring in defaults and liquidation risk, Gundlach said.

Scarcity value in the $1.5 trillion market is also rising as the bonds are paid down far faster than new issues are sold. This would make finding bonds in any large size difficult, said Scott Buchta, head of investment strategy at Braver Stern Securities in Chicago.

AIG nearly collapsed in late 2008, partly because of excessive bets on mortgage securities.

The federal government owns 92 percent of AIG. The U.S. Treasury is expected to begin selling its stake in May.

With the scarcity, they realize 'here's a block of $16 billion of bonds that we can buy in one fell swoop,' versus in the open market, where it might take six to 12 months to acquire the same quantity of assets without driving prices significantly higher, he said.

The Fed said it has been aware of AIG's interest in those assets for some time.

Any decision on a possible disposition of these assets will be made in a way that maximizes the proceeds to the taxpayer and that is consistent with the goal of fostering financial stability, the Fed said on its website.

(Reporting and writing by Al Yoon; Additional reporting by Ben Berkowitz and Paritosh Bansal)

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