Thirteen Wall Street dealers agreed “unanimously” that the government takeover qualifies as a so-called credit event that allows parties to credit-default swap trades to demand face value on the amount of debt covered by the contracts, according to a memo obtained by Bloomberg News today. Investors use the contracts to hedge against losses on their Fannie and Freddie debt holdings or speculate on the companies’ creditworthiness.
“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.
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. The International Swaps and Derivatives Association said in a statement today it will create a process by which investors can settle the agreements.
The actual money exchanged may be limited, 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,” CreditSights analysts Richard Hofmann and Adam Steer wrote in a note to clients.
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.
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.
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.
Under the process being created by ISDA, investors would have the option to settle without an actual exchange of the underlying bonds. Dealers will hold an auction to determine a recovery value for the securities, and the difference between that amount and the face value on the contracts is exchanged.
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.
Under the U.S. plan, the Treasury will be granted $1 billion of senior preferred stock, with warrants representing ownership stakes of 79.9 percent of the companies.
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.