Can someone plz explain how the government’s takeover of Freddie Mac and Fannie Mae affects the credit default swap market? thx.
The takeover will result in a conservatorship, which allows parties to trigger both senior and subordinated Fannie Mae and Freddie Mac CDS. Conservatorship is part of the definition of a CDS Bankruptcy Credit Event, even without an actual bankruptcy filing. If you look at where the bonds are trading right now, the final recovery rate will be very close to 100%. However, all MTM gains/losses on the CDS will be wiped out because of the credit event.
In relation to the wipe out of MTM gains/losses… I read an awesome example: I buy FRE sub CDS, 5y, at 50bps in $100mm, a while back. Nice trade, since it then widens to 250bps, where I sell it in $100mm. What’s my profit? Well, its 200bps a year for the next 5 years, discounted at the risky rate. 200bps = 2%, and lets say 5 years worth of that is worth 8% (not 10%, as we’re discounting those future cashflows). SO…my P+L is showing up 8% of $100mm = $8mm. Great, nice trade. EXCEPT…along comes todays event, CDS triggers, but bonds are all above par. So the PAR - RECOVERY payout (ie. getting paid 100 in exchange for “defaulted” bonds) is zero, BUT all the CDS contracts stop paying the premiums. So now I have received no payments, but my CDS trade where I was paying 50bps has gone away, AND the CDS trade where I was receiving 250bps has also gone away, so now my P+L is zero. Unfortunately, I’d already taken my $8mm P+L, so what this means to day is that I’ve just LOST $8mm, and that was from trading well apparently!!
right but most likely if you wanted to monetize your profit when the cds widened to 250 you would have a dealer unwind you as opposed to entering the offsetting trade (this is typical in the market), so the dealer pays you the PV of the risky annuity. So really it is the dealer left holding the jump-to-default risk, which he would probably hedge by buying short-dated FRE protection. BUT, as you point out the dealer would likely size the hedge based on a 40% recovery rate assumption and therefore is significantly under-hedged following the credit event with the auction expected to settle in the high 90s. Only point I guess I’m making is that the bulk of this risk is probably resting with dealers as opposed to investors (although no one really knows stuff like that for sure). The implication is this could affect the ability of investors to unwind CDS trades with dealers in the future as the street, wary following their painful experience here, forces investors to accept payouts below fair value. (they can hedge this recovery rate risk in the recovery lock market, but I don’t think that is current market practice so if it becomes common it’s another cost that will likely be passed to investors). This is fascinating event in the CDS markets no matter how you look at it.