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— Analysis —
 The takeover of the Federal Home Loan Mortgage Corp., or Freddie Mac, and the Federal National Mortgage Association, or Fannie Mae, by the federal government is proving to be a test for the way credit default swap traders handle large-scale defaults. And, while it's early yet, the credit derivatives market seems set to handle the issue relatively painlessly, despite its size and scope.
"It will certainly keep people busy," says Kevin Zadourian, a lawyer who focuses on derivatives at Kramer Levin Naftalis & Frankel LLP. "But the process should go pretty smoothly." The credit default swap market has long been pointed to as an area of uncertainty and vulnerability in the financial system. The relatively new CDS instruments -- derivatives that insure buyers against the default of underlying bonds -- have mushroomed over the past few years, and their market remains a self-regulated, over-the-counter operation. One of the fears during the Bear Stearns Cos. run last March was the sheer number of the CDSs the firm was party to. Then when Fannie and Freddie were taken over, many wondered how the system would handle the settlement of the CDSs.
The process in question will manage CDS settlements triggered as soon as Freddie and Fannie were officially declared in default by derivatives dealers on Sept. 8. Given that the CDSs cover a notional $1.6 trillion of debt issued by the mortgage securitizers, the scale of the so-called credit event is unprecedented. However, the International Swaps and Derivatives Association Inc. is working with 13 major CDS dealers and will settle the contracts using a process similar to the one that guided the last several defaults, including Collins & Aikman Corp., Delphi Corp., Calpine Corp., Movie Gallery Inc. and Quebecor World Inc. In those instances, CDS buyers redeemed their insurance based on a single, final price determined by auction as opposed to taking every underlying bond issued by a company individually and correlating them to the individual CDS contract.
In CDS contracts, sellers of protection pay the buyers the face value of the underlying debt after default occurs. Although buyers once had to deliver the actual bonds to the sellers to receive payment, in recent deals cash settlement has been allowed, which removes the onerous need to have bonds in hand. All this has been done to speed up the process and make it more efficient as the CDS market has grown. In an unusual twist, despite the scale of the Fannie and Freddie default, it doesn't appear as though CDS sellers -- that is, those who sold insurance to the buyers -- will have to make large payouts come the first week of October, when the contracts come due. "This is somewhat unique, because it's not a credit-negative event," Zadourian says. Normally, debt tends to trade down after a default, settling at levels that reflect anticipated losses, often a fraction of the debt's face value. Buyers of CDS contracts then are paid the difference between that face value and its market value. However, given that both Fannie and Freddie are effectively being nationalized, few expect the companies to miss their obligations, meaning expected recovery rates on the debt will be high, potentially in the 90% range, a market source says. So, in that case, a buyer of protection will collect the difference between the 100% face value of the debt and the 90% recovery, netting him 10 points, or less. This means buyers of default protection could in some cases lose money, given that they have been paying premiums to the sellers, which could exceed any payment from the defaults. One market participant says some CDS holders may, in light of this meager return, decide to hold on to their contracts, because there's no obligation to trigger them through the auction. "They can just wait for the next credit event," the participant says, adding that hoping for that unlikely event won't cost much, as premiums paid to buy protection will likely fall now, given that Fannie and Freddie debt is now effectively U.S. government debt with a very low risk of cash as opposed to technical default. Not all the settlement details have been worked out, of course. There is some question as to which of the thousands of issues of Fannie and Freddie debt will be used to set cash settlement prices for the CDS contracts and how much ability there will be for buyers of the protection to settle their contracts by physically delivering to the sellers the underlying bonds in question. Those questions, market sources say, will be ironed out in coming weeks. The auction will take place during the first week of October, about 30 days after the default date, as the contracts mandate. There are other wrinkles, too. Because Fannie and Freddie made up such a large percentage of investment-grade debt, they played a big role in the various derivatives indexes created by derivative pricing firm Markit Group Ltd. With the firms now defaulted, Markit has already started to rejigger the relevant indexes to reflect the change. CDS contracts inked against the old indexes, however, will also now have to settle, according to one industry source, and they will also settle in the first week of October. As if this weren't enough, the CDS market suffered another default on Sept. 8, as Canadian forest products company Tembec Inc. filed for bankruptcy protection in the U.S. That default will also need to be settled in the CDS market and will also result in rejiggering of several high-yield indexes, all of which will be taking place in the first week of October. "There is a fair amount coming down the pipe," says one industry source. "But the market is familiar with how to do these things." That's the good news. | |||||||||||||||||||||||||||||||||||||||||||
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