Monday, September 8, 2008

Fannie, Freddie Seizure Triggers Credit-Default Swaps (Update1)

By Shannon D. Harrington and Oliver Biggadike

Sept. 8 (Bloomberg) -- The government seizure of Fannie Mae and Freddie Mac triggered what may be the biggest settlement of credit-default swaps in the market's decade-long history.

The International Swaps and Derivatives Association will set rules by which parties to credit-default swap trades can demand payment on the net amount covered by the contracts, according to a statement today. According to an ISDA memo yesterday obtained by Bloomberg News, 13 Wall Street firms agreed unanimously that the government takeover of the biggest U.S. mortgage-finance companies qualified as a so-called credit event on contracts covering more than $1.4 trillion in Fannie and Freddie debt.

``The market is not experienced at settling a credit event for a name of this size, so it is a bit of an unknown,'' said Sarah Percy-Dove, the head of credit research at Colonial First State Global Asset Management in Sydney.

Because the government stands behind the companies' debt, which rallied on the news, the actual money exchanged between sellers and buyers of protection may be limited, analysts at CreditSights Inc. said. 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,'' CreditSights analysts Richard Hofmann and Adam Steer wrote in a note to clients.

`Potential Significant Losses'

The settlement, however, may wipe out any market-value gains that investors or Wall Street firms were counting on, Bank of America Corp. strategists led by Jeffrey Rosenberg wrote in a note to clients yesterday.

That may spell ``potential significant losses at dealers from this event,'' the strategists wrote, though they said it will be relatively small compared with the more than $500 billion in credit losses and asset writedowns reported by the world's largest banks and securities firms since the start of last year.

Treasury Secretary Henry Paulson and Federal Housing Finance Agency Director James Lockhart yesterday placed Freddie and Fannie in conservatorship, ousting their chief executives and eliminating their dividends. The Treasury may purchase up to $200 billion of preferred stock in the firms to keep them solvent.

Credit-default swaps on Fannie and Freddie debt have been among the most actively traded individual contracts the past few months, according to reports from broker GFI Group Inc. Dealers don't disclose the amount outstanding.

Fannie and Freddie also are among 125 companies in the benchmark Markit CDX North America Investment Grade Index, the most actively traded contract in credit markets.

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 3:45 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.

Five-year contracts on the senior debt of Fannie and Freddie had been trading at about 38 basis points on Sept. 5, according to CMA Datavision. That's down from 81 basis points on July 10. Contracts on Fannie subordinated debt fell from a record high of 364 basis points on Aug. 20 and closed on Sept. 5 at 233 basis points, CMA prices show. The cost is equivalent to $233,000 annually to protect $10 million in notes from default.

A `Unique Situation'

Under the process being created by ISDA, investors will have the option to settle without an actual exchange of the underlying bonds. Wall Street firms including JPMorgan Chase & Co., Goldman Sachs Group Inc. and other market makers will hold an auction to determine a recovery value for the securities. Investors who agree to a cash settlement would exchange the difference between the recovery value set at auction and the face value on a contract.

Because investors have the option to settle contracts using the cheapest qualifying bond, and because bonds with longer maturities can continue to trade at a discount because of interest rate risks, it's too early to assume that the recovery level will be at or almost at par value, said Morgan Stanley strategist Sivan Mahadevan.

``It is a unique situation,'' Mahadevan said on a conference call with clients today.

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