Bloomberg points out what some observers have already mentioned: putting Freddie and Fannie into conservatorship is a credit event as defined in credit default swaps (note defintions are sui generis, but this one was evidently close to universal in these agreements). Due to the Federal assurance that positive net worth will be maintained, this ought to be moot from a payout standpoint (ie, there would not be loses on the bonde). Even so, an unwind of this magnitude has never occurred, and if contract holders decide to close out their swaps, that would lkely also lead to the settlement of swaps entered into as hedges (most agreements written by dealers were allegedly hedged by offsetting positions), leading if nothing else to a major back office event.
This may not be as trivial as it sounds. Back office procedures for CDS are surprisingly primitive (confirms are sent via fax rather than elecronically, or so I’ve been told; transactions on offer are similarly sent in non-electronic list form). Plus language in contracts has not been tested and some have claimed it is often poorly drafted and subject to challenge.
Now with (in theory) little or no cash changing hands, contracts would presumably be honored, since there would be no economic motivation to block settlement. But there are enough untested moving parts that the mechanics could be problematic.
Investors may be forced to settle contracts protecting more than $1.4 trillion of Fannie Mae and Freddie Mac bonds against default after the U.S. 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.
“This is a big deal,” said Sarah Percy-Dove, head of credit research at Colonial First State Global Asset Management in Sydney. “The market is not experienced at settling a credit event for a name of this size, so it is a bit of an unknown.”…
Both companies also are among 125 companies in the benchmark Markit CDX North America Investment Grade Index, the most actively traded contract in credit markets…
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….
Today’s conference call will determine whether enough dealers agree the Treasury’s action constitutes a credit event, Louise Marshall, spokeswoman for ISDA, said in a phone interview from New York today.