11 Sep 2008, Peter Madigan, Risk magazine
The International Swaps and Derivatives Association (Isda) has confirmed details of the auction protocol will be announced soon and did not rule out that an announcement could be forthcoming as early as today.
No information has been released so far on when the auction, which will be administered jointly by credit derivatives executor Creditex and derivatives data provider Markit, will be conducted. Sources with knowledge of the matter have told Risk, however, that the auction, which will establish a final price for settlement of CDSs referencing the two government-sponsored enterprises (GSEs), will “almost certainly” take place the week beginning September 29.
The US Treasury’s move to place Fannie Mae and Freddie Mac under conservatorship is probably the largest credit event in the history of the CDS market, at least in terms of the number of contracts referencing the mortgage guarantors. No official estimates exists for the volume of CDS paper written against the two GSEs but while some commentators cite a figure as high as $1.5 trillion, analysts at Citi have put a more conservative figure of between $250 billion and $500 billion on the outstanding swap agreements.
“Working off an estimated $75 trillion in CDS outstanding globally, with $25 trillion of that constituted by index CDS and around $12.5 trillion of that in the 125-name CDX investment grade index, we can very roughly say $200 billion of that index CDS is Fannie and Freddie paper and about another $200 billion is written in single-name CDS,” said Michael Hampden-Turner, European head of collateralised debt obligation research at Citi in London.
Despite the masses of CDS written against the GSEs, the impact of the credit event is likely to be muted for counterparties engaged in the agreements. Most senior and subordinated Fannie Mae and Freddie Mac bonds are trading either at or close to par, as the once-implied guarantee that the US government will honour the bonds has been made explicit by the Treasury department.
As a result, the lowest acceptable settlement price that will be established during the auction process looks certain to be in the mid-nineties, meaning extremely high levels of recovery for CDS protection sellers on the contracts. This is not particularly good news for CDS protection buyers, however, who would ideally seek to buy the cheapest possible bond to physically deliver on their obligation while receiving par from the seller and pocket the difference. With bonds trading so close to par, the opportunities to profit on settlement look limited.
“Because the government has indicated it will guarantee the GSE bonds, including even the sub debt, the risk of loss has been mitigated, and that is reflected in the price. Indeed, many traders assume they might trade at par by the time the auction takes place,” said Tess Weil, a partner specialising in CDS and credit derivatives at law firm Purrington Moody Weil in New York.
Observers believe the US Treasury’s clear characterisation of the rescue of Fannie Mae and Freddie Mac as a conservatorship is potentially significant as it virtually ensures that a credit event is triggered. Under the Isda definitions governing credit derivatives, a company is deemed to have entered bankruptcy, and therefore experienced a credit event, if the institution “becomes subject to the appointment of an administrator, provisional liquidator, conservator, receiver, trustee [or] custodian”.
By framing the rescue action as a defined credit event and leaving no room for interpretation, the Treasury effectively ensured the liquidation of CDS contracts written against the GSEs. In contrast, when the UK government nationalised domestic commercial bank Northern Rock in February, the action was executed without triggering CDS obligations. Many analysts believe the US authorities want to be seen to share the financial pain from the GSE rescue with Wall Street, rather than confining it to the taxpayers who will ultimately back the conservatorship.
“From the US Treasury’s perspective, if it simply bought out the shareholders, that would raise the moral hazard argument once again that it is not promoting good market discipline. Perhaps there was an appetite to penalise shareholders and trigger the CDS event so the Treasury was seen to be doing its upmost to discourage moral hazard,” says Citi’s Hampden-Turner.See also: US authorities step in to rescue GSEs
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