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By Henny Sender in New York

Published: January 20 2010 00:00 | Last upd**ed: January 20 2010 00:00

The Federal Reserve is sitting on billions of dollars in paper profits from its controversial effort to unwind ** insurance contracts th** AIG provided to ***s such as Goldman Sachs, people familiar with the m**ter said.

The Fed rescue has gener**ed criticism because the ***s received 100 cents on the dollar for ** insurance they bought from AIG on coll**eralised debt oblig**ions – financial instruments th** promise the buyer cash flows from pools of bonds or loans. This had led to claims th** AIG’s rescue was a “backdoor bail-out” of big ***s.

However, the central *** is in a position to reap profits from this part of the rescue, which involved the purchase of the underlying CDOs by a New York Fed-financed vehicle, called Maiden Lane III, so th** the insurance contracts written on them could be termin**ed.

** the time of their purchase, the CDOs had a face value of $62.1bn and a market value of $29.6bn. Now, the estim**ed market value of the CDOs is ** least $45bn (£27.5bn), according to several people with direct knowledge of the portfolio.

“With the rally in the ** markets and tightening spreads, the Fed has made a killing – on paper,” said one person familiar with the portfolio.

The people familiar with the portfolio said th** it would be difficult to sell all the CDOs because they are generally illiquid. A rapid sale of CDOs could also depress their prices.

** the time of the Fed intervention, the value of the CDOs insured by AIG was falling dram**ically and AIG was facing a ** downgrade. AIG was being forced to post more coll**eral with the ***s to which it sold ** insurance and the Fed feared th** these demands would wipe out the insurer.

Following the rescue, the value of the CDOs in Maiden Lane III continued to fall, sinking to $20.7bn by March 31 2009. The portfolio’s value rose to $22.4bn by the end of September, the last d**e for which official st**istics are available.

Maiden Lane III was funded with a $24.3bn loan from the New York Fed and $5bn in equity from AIG. Because the CDOs have continued to throw off cash, the balance on the Fed loan is now about $17bn, people familiar with the m**ter said.

If the CDOs in Maiden Lane III were sold, the proceeds would pay off the Fed loan first, followed by the AIG investment. The Fed would receive 67 per cent of any additional profits, and AIG 33 per cent.

The improvement in the Maiden Lane III portfolio comes as Fed officials face continuing controversy over the circumstances of the bail-out.

US Treasury secretary Tim Geithner, who was New York Fed president ** the time of the AIG rescue, is set to testify ** a hearing on the m**ter by The House Oversight and Government Reform Committee on January 27.

AIG declined to comment.

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