naked capitalism

We had said a couple of days ago that while the conservatorship of Fannie and Freddie looked to be a credit event for credit default swaps, meaning they would trigger payment, we did not see this being a financial event (presumably there would be no loss, with the Treasury assurance to prevent a negative net worth) but it could be a very ugly operational event given the large number of contracts involved and the largely manual nature of CDS processing.

We spoke too soon about the “no loss” notion. The Financial Times says there will be losses on Freddie and Fannie CDS settlement. Although the payment per contract is comparatively small (5% of face value), the amount of contracts outstanding is so large that the collective hit will be significant. Indeed, the Financial Times article suggests that this settlement process is placing stress on the CDS market, when the whole point of the Fannie and Freddie rescue was to reduce risk and prevent a systemic event.

From the Financial Times:

The default of up to $500bn of Fannie Mae and Freddie Mac credit derivatives contracts triggered by the US government’s seizure of the mortgage groups could result in billions of dollars of losses for insurance companies and banks who offered credit insurance in recent months.

The potential losses, as well as uncertainty about exactly how the derivatives contracts will be settled and unwound, is putting strains on the unregulated $62,000bn credit derivatives market, which has been a target of regulators worried about the hidden risks it could hold for the financial system….

The exact number of credit default swaps – a kind of insurance against debt default – outstanding on Fannie Mae and Freddie Mac are not known, reflecting the private nature of the sector. However, according to the latest estimates from dealers and analysts, there could up to $500bn of contracts outstanding.

Michael Hampden-Turner, credit strategist at Citigroup in London, estimates there are $200bn-$500bn of outstanding CDS and other credit derivatives referencing Fannie and Freddie.

This would make their default the biggest the market has encountered. The previous record was held by Delphi, the US carparts maker that went bankrupt in 2005 and which had about $25bn of CDS.

Currently, the recovery value of the Fannie Mae and Freddie Mac CDS is expected to be about 95 cents in the dollar, leading to a potential 5 per cent loss for insurance companies or banks who offered protection against a default. On CDS worth $200bn-$500bn, losses would come to $10bn-$25bn.

Hedge funds will also take a hit, although for a different reason: many will have to reverse profits previously booked. Reader Marshall sent us this message from Bull’s Eye Research:

While the Fannie/Freddie CDS will be cash settled, there could be some rather nasty P/L surprises for heretofore successful traders of these products. From poster “cds trader” yesterday:

I buy FRE sub CDS, 5y, at 50bps in $100mm, a while back. Nice trade, since it then widens to 250bps, where I sell it in $100mm. What’s my profit? Well, its 200bps a year for the next 5 years, discounted at the risky rate. 200bps = 2%, and lets say 5 years worth of that is worth 8% (not 10%, as we’re discounting those future cashflows).

SO…my P+L is showing up 8% of $100mm = $8mm. Great, nice trade. EXCEPT…along comes todays event, CDS triggers, but bonds are all above par. So the PAR – RECOVERY payout (ie. getting paid 100 in exchange for “defaulted” bonds) is zero, BUT all the CDS contracts stop paying the premiums.

So now I have received no payments, but my CDS trade where I was paying 50bps has gone away, AND the CDS trade where I was receiving 250bps has also gone away, so now my P+L is zero. Unfortunately, I’d already taken my $8mm P+L, so what this means to day is that I’ve just LOST $8mm, and that was from trading well apparently!!

Quite a few people will get surprised by the effects of this today I think.