$1.4 Trillion of GSE Credit Default Swaps Triggered by Bailout

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.

From Bloomberg:

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.

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  1. Anonymous

    And at Lemon, some of the most senior back-office staff involved in processing credit derivatives were laid off…in March… and there is now a true B-team doing most of the heavy lifting. Priceless!

  2. Anonymous

    What are FNM and FRE bonds trading at now? Par? Discount?

    The way I read the agreement, payments are guaranteed through 2009. In the interim congress has to make a decision. So, they’re not risk free to potential owners. IN any event, protection buyers have a quick exit now.

    The quotes should tell all.

  3. Anonymous

    One other thought,

    It’s kind of brilliant to declare a credit event at par. This basically allows $1.5T of swaps to be “costlessly” unwound now. No bank goes under and the government doesn’t get the blame for blowing up the system.

  4. doc holiday

    It finally hit me about what I realy dislike about this style of wallstreet bailout. In past recessions, in history, when economic calamities unwind and impact America, you often see The President involved in debate as to where things are headed.

    In this case in this era, we see Bush on vacation, as with Katrina, as with Iran and his on-going flip attitude — while the good ol’ boys and bagmen from Goldman are plugg’n the latest casino leaks. This Treasury engineered bailout was directed at gaming the markets in Asia — before “they” open’d, this was a strategy to manipulate the stock markets and thus attempt to ease the pressures related to on-going accounting fraud, and to not address the core of the problems, or to pinpoint which crooks on wall street should be in prison.

    We have a game in place here to fire up the construction business, so that more homes can be added to the housing inventory glut, which can be linked to the next Countrywide, Citi, WM, LEH, BAC-mortgage fraud banking industry, which relies on synthetic debt and credit to fuel fraudulent illusions. We obviously need to get back to a time when home prices and mobile home prices can triple within months, and become the lotto ticket they have always been. We need to get this fraud back on a sustainable unregulated path, where in this Ownership Society, we allow fraud to continue to have the fullest potential to be able to spread like a mutating toxic cancer — maybe, even to an unimaginable point, where even a few wealthy people start to question if they need to buy second homes for $10 million, or whatever the cost.

    Paulson is working for someone other than American tax payers, and his clear effort to game the Asian stock market on Sunday afternoon game show-like events, is an act of Treason, because he is helping to undermine security in America by not using the powers of his office to pursue justice in the form of instigating investigations into the fraud his wall street friends are currently involved in. Paulson is not working for taxpayers, when he plans to use The Treasury to bail out foreign entities! He is a traitor!

    Meanwhile, we have a President in denial, who lacks any ability to recognize that this is an American problem rooted in wall street fraud, which is evolving into an era of chaos. Why is our president not being accountable and demanding enforcement of law? Why is wall street allowed to get await with this destruction of America?????

    WE need help either from NATO or some foreign leadership to treat Bush and this coup as criminals and speak out against this corruption and isolate America as a threat to the world — we need help !!!!!

  5. Anonymous

    I read this on bloomberg. Any news?

    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

  6. Anonymous

    Sry first time i posted, i forgot a bit. It’s says below 11:00am… Any news?

    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.

  7. dh

    FYI: Re: . Liquidation Rights.
    (a) Upon any voluntary or involuntary dissolution, liquidation or winding up of Fannie Mae, after payment or provision for the liabilities of Fannie Mae and the expenses of such dissolution, liquidation or winding up, the Holders of outstanding shares of the Series M Preferred Stock will be entitled to receive out of the assets of Fannie Mae or proceeds thereof available for distribution to stockholders, before any payment or distribution of assets is made to holders of Fannie Mae’s common stock (or any other stock of Fannie Mae ranking, as to the distribution of assets upon dissolution, liquidation or winding up of Fannie Mae, junior to the Series M Preferred Stock), the amount of $50 per share plus an amount equal to the dividend (whether or not declared) for the then-current quarterly dividend period accrued to but excluding the date of such liquidation payment, but without accumulation of unpaid dividends on the Series M Preferred Stock for prior dividend periods.

    http://google.brand.edgar- online…WlOoWSPZzEhlc47

  8. Abbot_Of_Iona

    The Republic of the United States of America: Government of the People by Goldman Sachs for Goldman Sachs

  9. Anonymous

    The two biggest financial institutions fail and the taxpayer is on the hook – yet no one – none in the media – no one in Congress is calling for an investigation to determine how this took place and who was responsible?

    We have reached banana republic status. A financial and political system for the crooks and by the crooks.

  10. S

    gross on tv saying he is a buyer of mortgages and sell them to the treasury at a higher price. If paulsonhad an iota of a brain left after all that stuttering he should get on the phone and tell this asshole to stay off cnbc lest yhe insight a mob. Seriously you would think the guy would have the good sense to go quietly instead of getting on tv and thumping his chest about how he is fleecing taxpayers. Only in America. End of empire.

  11. Anonymous

    Money Exchange

    Dealers today were quoting the CDX index contracts both with and without Fannie and Freddie. Contracts with the companies dropped 7 basis points to 138 basis points as of 12:55 p.m. in New York, according to broker Phoenix Partners Group. Contracts without the companies were trading 1.5 basis points to 2 basis points tighter, according to Credit Derivatives Research LLC.

    That would imply the market has priced in a recovery rate, as a percentage of total value, “in the mid-to-high 90s,” said Tim Backshall, chief strategist at Credit Derivatives Research in Walnut Creek, California, meaning investors who bought protection would get five cents on the dollar or less to settle.

  12. Anonymous

    A credit event this close to par does at least offer the possibility of an unwind that is costless, at least from a systemic risk perspective. Depending on the leverage exogenous to the swaps the high 90s could still do some damage to some positions. But at least the possibility exists of dodging a bullet on this one.
    And from the way the preferred was handled, I get the sense that some thought is being given to the follow-on consequences of yesterday’s actions.

  13. doc holiday

    Oops, meant to add this text as a convenience:

    In the latest salvo, the SEC yesterday urged a federal court in Alabama to disregard a friend-of-the-court-brief filed by the Securities Industry and Financial Market Association, claiming it is a “flawed piece of advocacy” for SIFMA’s member-firms and those connected with the Jefferson County deals that seeks to negate the authority that Congress has given the commission.

    The SEC made its plea in a 30-page document filed with the U.S. District Court for the Northern District of Alabama in Birmingham after SIFMA claimed the SEC does not have jurisdiction over interest rate swaps based on its municipal swap index because it is an index of interest rates, not securities.

  14. Anonymous

    What would happen if some of the CDS Seller’s at the time of settlement for an event of default did NOT have sufficient CASH?

  15. S

    FF cuts: $450 billion expended for 300 bps

    GSE $300 billion expended for 50 bps in mortgage rates

    $ value of basuis point going up. Kind of like more debt for every dollar of GDP. Good thing we are improving productivity.

  16. RC

    “1) The American people and our elected reps are the responsible parties. We could end this quickly with a few well attended protest marches.”

    I marched with tens of thousands of Americans against the war in Vietnam. I faced prison for refusing to be drafted to fight a war purely for corporate profits.

    “The two biggest financial institutions fail and the taxpayer is on the hook – yet no one – none in the media – no one in Congress is calling for an investigation to determine how this took place and who was responsible?”

    Most of us know that a secret government within our federal government murdered Jack and Bobby Kennedy. Most of us know that same “secret government” participated in bringing down the Twin Towers and building #7. Most of us know that the Bush Family Wars in the middle east are corporate wars fought for profit.

    A government “for goldman sachs” is just another of many outrages. What do we do about it?? We march, we write letters? I say that we are at a point where violence is the only rational response to tyranny.

    I read this blog every day – before I read anything else on the Web. I will continue to read every day so please don’t think that I am “flaming” anyone.

    It is just that I am convinced and saddened that Americans will go very quietly “into that night”.

  17. Matt Dubuque

    If anonymous is correct with his statement that the CDS spread with vs. without GSE is only 8 bp, that’s pretty good news. There is EASILY 5 bp of noise in the system.

    In other words a substantial portion of that spread could be due to chance alone.

    Matt Dubuque

  18. Matt Dubuque

    Although the back office clearing for these swaps has a LONG way to go, it is still FAR better than it was 9 months ago, thanks to the heroic efforts of Gerald Corrigan (former head of NY Fed) and the international Financial Stability Forum (FSF).

    This of course was one of their first priorities in the middle of last year to bring the backlog down to a far more manageable level. I don’t have the stats in front of me at this moment, but the backlog was OFTEN 6 months and now the median is around 2 weeks as I recall; much, much better.

    The Fed was really on top of this key issue back before the chattering mainstream financial press even KNEW this was an issue.
    They worked closely with Corrigan and various regulatory authorities and market participants to make this happen.

    Will they get any credit for this?

    Of course not. Fed bashing is politically correct in the extreme. If you don’t know what to say, bash the Fed.

    Matt Dubuque

  19. Anonymous

    Sorry Yves,

    I posted this comm in NYT, but I want to be shure that Krugman reads it:

    You are mixing depravation with deprivatization, weren’t you?

    It’s quite different!

    Don’t mislead, please!

    Be a perfect well-paid economist, but stop advertisement campaigns, Mr. Krugman.

    The smell is already in this side of the Atlantic ocean!


  20. dh

    Yves, ol boy,

    Have you seen this (smut): TRANSCRIPT & VIDEO: Warren Buffett Tells CNBC Treasury "Did Exactly the Right Thing" on Fannie/Freddie

    I always thought that made a lot of sense. But the portfolio operations enabled both of those entities to use, in effect, government-related borrowing costs and sort of unlimited credit, to set up the biggest hedge fund in the world. And as they started responding more and more to the desires of Wall Street for steady and increasing earnings, they first expanded the portfolios to run an enormous carry trade and then they started playing games with the derivatives involved to report figures that weren't really accurate. So the portfolios are poison. They aren't really needed to carry out the function of Freddie and Fannie. The government guarantee of mortgages turns them, into effect, government bond-type instruments, and those guarantees insure an enormous market world-wide, weren't made explicit as they have now, so I don't see that the portfolio activities are necessary. In fact, I think they can be quite mischievous.

    Buffett: Well, I suppose you could say that, although Joe, I would say that if there is chaos in the market, if would probably net as good for us over a long period of time. But you're quite correct that, if Bear Stearns was an 8.5 on the Richter, the financial Richter scale, this was about a 9.9 or something of the sort. It would, the government really had no choice but to do something, and the question is, is what they did the most sensible thing, and they did do that.

  21. Matt Dubuque

    A legitimate case can be made that this entire GSE debacle was yet another example of BOTCHED privatization.

    Recall if you can that Fannie Mae was doing just fine since its creation in 1938 until LBJ privatized it in 1968 to help pay for his little extermination campaign in Viet Nam. The Texas firm of Brown & Root you see, forerunner of Halliburton, needed the oil.

    After this privatization, the invisible hand of the market began to operate and Fannie Mae engaged in massive hyperleveraging and massive accounting fraud, as revealed in Sunday's NYT.

    Then to promote an illusion of "competition" Freddie Mac was created in 1970, which operataed with the same lust for hyperleverage at the expense of rationality.

    You won't find this factual history in the corporate media that we are told is "free".

    Perhaps the Banana Republicans wouldn't let it be published?

    Erase the memory, erase the culture, take over the nation….

    Matt Dubuque

  22. Anonymous

    Some more on these triggered CDS’

    While the 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 today’s 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.

    While it seems unlikely that this impact will make or break many institutions, on an individual trader basis there could be a lot of unhappiness as this gets resolved. Moreover, the potential for back office error and out-trades would appear to be relatively high, if some of the anecdotals about back office technology and practice are correct.


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