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Monday, September 8, 2008

Fannie and Freddie: CDSs, $1.47 Trillion Triggered


“Derivatives are weapons of mass destruction, carrying dangers that while now latent, are potentially lethal.” –Warren Buffett

Well, this should be fun. Really, equity markets shouldn’t be this excited. By the end of the month a few more dead bodies will float to the surface.

You see, moving Fannie Mae (FNM) and Freddie Mac (FRE) into conservatorship, constitutes a ‘credit event’. Simply put, the rescue counts as if FNM and FRE failed to meet their financial obligations. More importantly, $1.47 trillion in Credit Default Swaps (CDS) just got triggered.

This has NEVER happened before. This is the largest CDS ‘credit event’ ever. Considering that a lot of hedgies thought FNM and FRE could NEVER go ‘bankrupt’, you have to wonder how many of the counterparties are going to be good for their end of the CDS. A favorite game of the hedgies was to write CDSs on these names because they ‘could never fail’.

Fannie, Freddie Credit-Default Swaps May Be Unwound (Update2): “Investors may be forced to unwind contracts protecting $1.47 trillion of Fannie Mae and Freddie Mac bonds against default after the U.S. government seized control of the companies in a bid to bolster the housing market.

Thirteen “major” dealers of credit-default swaps agreed “unanimously” that the rescue constitutes a credit event triggering payment or delivery of the companies' bonds, the International Swaps and Derivatives Association said in a memo obtained by Bloomberg News today. Market makers for the privately traded contracts will discuss how to settle them in a conference call at 11 a.m. in New York, the document said.

A settlement of credit-default swaps would probably be the biggest attempted in the market's decade-long history because Fannie and Freddie are members of the benchmark index of U.S. credit risk, Percy-Dove said. The index comprises the most frequently traded contracts in the U.S.

Credit-default swaps are financial instruments based on bonds and loans that are used to speculate on a company's ability to repay debt. They pay the buyer face value in exchange for the underlying securities or the cash equivalent should a borrower fail to adhere to its debt agreements. An increase indicates deterioration in the perception of credit quality; a decline, the opposite.”

Although a little late, I still recommend everybody read A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation (Click Book image to learn more).

17 comments:

S said...

what's another $500 billion or so. add it to my tab...

Anonymous said...

I have a feeling the "credit event" may turn into a "crater event" after the conference call is concluded.

-Mike "Pissed Off That Treasury Ruined My Beautiful BAC Short" J

Ben Bittrolff said...

Could be that the credit event just fizzles out since the bonds should trade at par now that they're guaranteed...

"The actual money exchanged may be limited, though, according to analysts at CreditSights Inc. Buyers of the contracts are paid face value in exchange for the underlying securities or the cash equivalent.

"If bonds rally and trade close to par, recovery could be close to 100 percent, with protection sellers having little to pay out despite a technical default,'' analysts Richard Hofmann and Adam Steer wrote in a note to clients."

tim73 said...

Welcome to the Brave New World of Neoconism!

Put a little bit of communism, a little bit of fascism, a little bit of capitalism and a touch of Orwellian '1984' and HELLUVA LOT plain old GREED into the mix!

Mark said...

Any predictions Ninja?

Doug said...

I predict no money will be paid out, otherwise these bond insurers will have to be bailed out by the taxpayer also.

Anonymous said...

What the Fed did was nothing short of criminal. Paulson and Bernanke should be ashamed of their foolish and reckless behavior! As a matter of fact, I'd go so far as to say they should both be arrested!

It's a sad day for taxpayers(and democracy)...

Anonymous said...

Ben,

Having been comforted by the words of CDs trader, would you say you are a bit less bearish on financials now?

Thanks.

DaveK said...

Harry Markowitz in an interview years ago with the American Financial Association remarked that there was another 1929 out there somewhere. Is it closer than we think?

energyecon said...

Recovery close to 100% is still going to be interesting on $1.4 trillion and change of notional...this would seem to imply that for each $0.01 off of par $14 billion changes hands...

dougiefreshhh said...

well...so much for SKF.

Thanks for rewriting Econ 101 Ben/Paul -

I wonder how much $ their friends made knowing they would reverse normal economic cycles.

Bastages!!!!

Anonymous said...

$1 or 1% off par is 14B, not $0.01.

Anonymous said...

I came to the realization yesterday that the CDS market is what drives the bailouts. The Bear Stearns action was taken to avoid cascading effects of counterparty failure. Had a TRUE credit event occurred with F+F, you can bet that the $1.47T would have completely sunk the global financial system.

Can anyone find the total notional for Washington Mutual CDS? I know they are part of some of the indices that Markit tracks/produces. (What I'm saying is that WaMu will be the next to receive a bailout).

-Mike J

Rob said...

good post

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