credit derivative swaps (CDS) , fannie freddie, and credit insurers (september 11, 2008)

The conservatorship status of Fannie and Freddie may have implications, as a credit event, on credit default swaps. Banks and insurers typically writes these CDS. We are looking at the implications of this on relevant parts of the banking and insurances sectors with exposure to this CDS. The exercise of these insurances is complicated, and the future will tell whether they would trigger other events, and impacts on stock valuations.

We read some articles on this topic. Some excepts follow on the topic of credit derivative swaps (CDS) , fannie freddie, and credit insurers.

From the Financial Times:

The default of up to $500bn of Fannie Mae and Freddie Mac credit derivatives contracts triggered by the US government’s seizure of the mortgage groups could result in billions of dollars of losses for insurance companies and banks who offered credit insurance in recent months.

The potential losses, as well as uncertainty about exactly how the derivatives contracts will be settled and unwound, is putting strains on the unregulated $62,000bn credit derivatives market, which has been a target of regulators worried about the hidden risks it could hold for the financial system....

The exact number of credit default swaps – a kind of insurance against debt default – outstanding on Fannie Mae and Freddie Mac are not known, reflecting the private nature of the sector. However, according to the latest estimates from dealers and analysts, there could up to $500bn of contracts outstanding.

Michael Hampden-Turner, credit strategist at Citigroup in London, estimates there are $200bn-$500bn of outstanding CDS and other credit derivatives referencing Fannie and Freddie.

This would make their default the biggest the market has encountered. The previous record was held by Delphi, the US carparts maker that went bankrupt in 2005 and which had about $25bn of CDS.

Currently, the recovery value of the Fannie Mae and Freddie Mac CDS is expected to be about 95 cents in the dollar, leading to a potential 5 per cent loss for insurance companies or banks who offered protection against a default. On CDS worth $200bn-$500bn, losses would come to $10bn-$25bn.