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Fannie, Freddie Credit-Default Swaps May Be Unwound

Fannie, Freddie Credit-Default Swaps May Be Unwound (Update2)

By Oliver Biggadike and Laura Cochrane

Sept. 8 (Bloomberg) -- 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.

``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.''

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.

Dealer Poll

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

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.

``We believe conservatorship is a credit event,'' Barclays Plc analysts Vince Breitenbach and Jeff Meli said in a note to clients yesterday. Barclays is a member of the ISDA.
Contracts on Fannie and Freddie subordinated debt may fall more than 100 basis points as the companies gain Treasury backing and dealers close positions, the analysts said. U.S. default protection costs as measured by the Markit CDX North America Investment Grade Index will also decline, they said. A basis point, or 0.01 percentage point, is worth $1,000 on a swap that protects $10 million of debt.

Default Protection Costs

Five-year contracts on Fannie Mae notes fell from a record high of 364 basis points on Aug. 20 and closed on Sept. 5 at 233, CMA Datavision prices show. The cost is equivalent to $233,000 annually to protect $10 million in notes from default.

The ISDA, which sets standards for the global derivatives market and counts investment banks including Deutsche Bank AG and Lehman Brothers Holdings Inc. as members, will arrange any settlement of the default swaps, spokeswoman Marshall said. She declined to name any participants on today's call.

``Although the settlement effort will be massive, we do not see it as necessarily a negative,'' Gus Medeiros, credit analyst at Deutsche Bank in Sydney, wrote today in a research note. ``Write downs are potentially an issue for holders of preferred equity, but the Treasury said financial institutions exposed to these securities will work with regulators to restore capital positions.''

Treasury Control

Under the U.S. plan, the Treasury will get $1 billion of senior preferred stock in coming days, with warrants representing ownership stakes of 79.9 percent of Fannie Mae and Freddie Mac. The government will receive annual interest of 10 percent on its stake.
While common stockholders of Fannie and Freddie won't be eliminated, they will be last in line for any claims, Paulson said yesterday. Preferred shareholders will be second in absorbing losses, he said. Interest and principal payments will continue to be made on the companies' subordinated debt.

To contact the reporter on this story: Oliver Biggadike in Sydney at obiggadike@bloomberg.net; Laura Cochrane in Melbourne at lcochrane3bloomberg.net

Last Updated: September 8, 2008 06:34 EDT
A bit of follow up...

Fannie, Freddie Derivatives Default May Trigger Dealer Losses

By Shannon D. Harrington

Sept. 9 (Bloomberg) -- The takeover of Fannie Mae and Freddie Mac may cause ``significant'' losses for banks that trade credit-default swaps following a technical default on the contracts, according to Bank of America Corp. analysts.

Banks that make markets in the derivatives contracts on the two mortgage-finance companies may lose profits on the transactions, Bank of America strategists led by Jeffrey Rosenberg in New York wrote in a note to clients yesterday. Attempts to mitigate the losses by buying credit-default swaps on Fannie and Freddie also may backfire because the U.S. government is standing behind the companies' debt and buyers of protection may receive little, if any, in return.

The government's seizure ``has the unintended consequence of potential significant losses at the dealers, though the total size of those losses may be small in comparison to recent writedowns,'' the analysts wrote.

Banks and securities firms worldwide have reported more than $500 billion in asset writedowns and credit-market losses since the beginning of last year as the U.S. subprime mortgage market collapsed and home foreclosures soared.

The settlement of credit-default swaps on Fannie and Freddie is likely to be the biggest yet in the $62 trillion market's decade-long history.

While dealers haven't disclosed the amount of outstanding credit-default swaps on Fannie and Freddie, the individual contracts have been among the most actively traded in the past few months, according to reports from broker GFI Group Inc.

CDX North America

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

Treasury Secretary Henry Paulson and Federal Housing Finance Agency Director James Lockhart two days ago placed Fannie and Freddie into conservatorship, ousting their chief executives and eliminating their dividends. The Treasury may buy as much as $200 billion of preferred stock in the firms to keep them solvent.

Standard definitions used by credit-default swaps investors and dealers list a conservatorship among the events that can trigger a settlement of the contracts. Buyers of the contracts are paid face value in exchange for the underlying securities or the cash equivalent.

The International Swaps and Derivatives Association said yesterday it will set rules by which parties to credit-default swap trades can demand payment on the net amount covered by the contracts.

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.

To contact the reporter on this story: Shannon D. Harrington in New York at sharrington6@bloomberg.net

Last Updated: September 9, 2008 14:28 EDT
I'm sorry, but that's just funny. No matter what the heck you do, there's always SOMEONE getting the short end of the stick. You just can't please everyone, can you?

On a note that I think is even more hilarious than that...

Freddie Mac is still coming to Lehigh University to recruit.

Have they NO SHAME?