The mortgage guarantors' bailout minimizes losses on credit default swaps, but that doesn't mean there won't be any carnage

By Matthew Monks

The credit default swap industry may face its biggest hurdle ever in coming weeks as it settles contracts covering Fannie Mae and Freddie Mac’s $1.4 trillion in outstanding debt. The government takeover of the mortgage giants triggered what will be the largest—and possibly most complicated—CDS settlement in history, industry experts say. And while the losses expected on credit derivatives sold against Fannie and Freddie might seem small—averaging perhaps no more than 2 cents on the dollar—thanks to the Treasury bailout, some experts say that could be enough to wipe out hedge funds and other sellers that have little or no cash on hand.

The credit derivatives market, which has ballooned to $62 trillion in the last ten years or so, only set up a formal procedure to settle swaps in 2005, following the bankruptcy of Delphi, which had fewer bonds outstanding than the number of CDS contracts written on the company. That sent CDS buyers scrambling to purchase the company’s bonds, which they needed to settle their derivatives contracts.

The International Swaps and Derivatives Association, an industry trade group, responded to that chaos by establishing settlement protocols, in which the cash value of a defaulted bond is determined via auction.

There have been just eight protocols for settlements to date, involving other names like Dura Automotive, Delta Airlines and, most recently, Quebecor, a Canadian printer. None have been as large as Fannie Mae and Freddie Mac. That means this settlement could be plagued by technical issues given the scale of the settlement. There could also be unforeseen legal complications, as this is the first settlement to involve government-controlled entities.

Industry experts say unwinding the Fannie Mae and Freddie Mac contracts has the potential to highlight the flaws of settlement protocols at a time when the government is considering tightening its grip on the lightly regulated CDS market. But it could also prove that such protocols work.

To be sure, the stakes are relatively modest given the unique nature of this default. Fannie Mae and Freddie Mac, unlike the other companies that have sparked a settlement protocol, have neither fallen into bankruptcy nor failed to pay on their bonds, which are still trading at or near par because they are now backed by the government.

In comparison, Quebecor, which had about $2 billion in outstanding debt when it filed for bankruptcy earlier this year, had its bonds priced at around 41 cents on the dollar in a protocol. In a cash settlement, CDS sellers pay borrowers the difference between a defaulted bond’s market value and par. In the case of Quebecor, that translated into about 59 cents.

According to a report last week from RBC Capital Markets analyst T.J. Marta, most analysts believe the senior debt of Fannie Mae and Freddie Mac will be settled at between 98 cents and par. Should that be the case, CDS sellers would have to pay 2 cents or less.

“If bonds rally and trade close to par, recovery could be close to 100%, with sellers of protection having little to pay out despite a technical default,” analysts with the research firm CreditSights said in a report last week.

There could be ripples across the financial sector should sellers—particularly hedge funds—be unable to come up with the cash to settle their contracts, according to Christopher Whalen, a managing director with risk management consultant Institutional Risk Analytics.

Mr. Whalen said scores of hedge funds could be wiped out by this settlement, as they tend to have little free cash on hand. That could translate into banks and other institutions that buy CDS coverage writing down sizable losses.

“This is a complicated mess, and it could have rather profound implications,” Mr. Whalen said.