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Nationalization of Fannie, Freddie triggers defaults for derivatives

Section: Daily Dispatches

By Aline van Duyn
Financial Times, London
Monday, September 8, 2008

One of the largest defaults in the history of the $62,000 billion credit derivatives market has been triggered by the US government's seizure of Fannie Mae and Freddie Mac, raising questions about how dealers will unwind billions of dollars worth of contracts.

Although the $1,600 billion of debt issued by the troubled mortgage groups is regarded as safe after the US government's move to take control of the companies, their move into "conservatorship" counts as the equivalent of a bankruptcy in the credit derivatives market.

This triggers a default on credit default swaps -- instruments that provide a form of insurance on fixed-income assets. Dealers in the market are now working to settle these contracts.

The exact amount of CDS on Fannie Mae and Freddie Mac are not known, reflecting the private nature of the market, but they are part of widely traded indices and the amounts are likely to be significant. Analysts at Lehman Brothers said: "There is likely to be a considerable amount of notional protection outstanding."

The industry body, International Swaps and Derivatives Association, said on Monday it would launch a protocol to facilitate settlement of credit derivative trades involving Fannie Mae and Freddie Mac and would publish further details in due course.

The uncertainty surrounding the Fannie Mae and Freddie Mac CDS contacts highlights the need for improved settlement and trading procedures. Already, regulators have put pressure on CDS dealers, including all the large financial institutions, to reduce settlement and trading risks.

The near-collapse of Bear Stearns in March highlighted the extent to which many large financial institutions were linked together through the CDS market, and the Federal Reserve and other regulators want to reduce such systemic financial risks.

The growth of the CDS market over the past decade has outpaced development of settlement systems and trading infrastructure. One worry is the lack of standard procedures in contracts for dealers to agree ways to settle defaulted credit derivatives.

The actual payments on credit default swaps on Fannie Mae and Freddie Mac are expected to be limited because the value of the mortgage agencies' debt remains high after the US government stepped in to back it.

That means that meeting any claims on CDS may not be that costly, although the details are still being worked out and the impact is unknown.

Analysts at Creditsights said regulators could "use the bailout as another lever" to enhance the CDS market's efficiency.

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