Fannie, Freddie default swaps triggered by bailout

NEW YORK (Reuters) - The U.S. government's takeover of mortgage finance companies Fannie Mae and Freddie Mac may trigger one of the largest ever payments in the credit default swap market, analysts said on Monday.

Losses made by protection sellers, however, are expected to be minimal due to the high trading levels of the $1.6 trillion of outstanding agency debt. Credit default swaps trade in the private market, so the actual amount of protection written on Fannie Mae and Freddie Mac's debt is hard to estimate.

The government on Sunday seized control of the companies, launching what could be its biggest bailout ever to support the U.S. housing market and ward off more global financial market turbulence.

Terms in the credit default swaps contracts specify that the contracts are triggered by the intervention, analysts said, meaning that protection sellers must pay buyers the full amount insured.

It is the first time a company in the benchmark investment-grade credit derivative index has had a credit event, JPMorgan analyst Eric Beinstein said in a report on Monday.

"This will likely be the largest credit default swap credit event in terms of the amount of credit default swap contracts outstanding that has occurred," he said.

Credit default swaps are used to hedge against the risk of a borrower defaulting on their debt, or to speculate on a company's credit quality.

When a credit event occurs, sellers of protection pay the buyer the full amount insured, and the buyer gives the seller debt underlying the contracts or a cash sum based on the debt's value.

The International Swaps and Derivatives Association, the industry's trade association, said on Monday it will create a protocol that includes a process to set the value of the swaps in an auction to simplify trade settlement.

The high trading levels of agency debt, which in most cases are trading at or near their par value, will make settling the contracts different from contracts triggered by defaults, which typically recover little.

"If bonds rally and trade close to par, recovery could be close to 100 percent, with sellers of protection having little to pay out despite a technical default," CreditSights analysts said on Monday.

Risk premiums on agencies and prime agency debt snapped tighter by more than 20 basis points against Treasuries on Monday, after the bailout.

"The cheapest to deliver winds up being the longest-maturity, lowest-coupon bond," but even a lot of those, because rates have rallied so much, are trading above par, said Ira Jersey, analyst at Credit Suisse in New York.

Credit default swaps on Fannie Mae and Freddie Mac's debt are expected to be reintroduced without the terms that were triggered by the government bailout, analysts said.

The most common trigger is when a borrower defaults on its debt though some contracts can be paid out on changes of control, or in this case, a conservatorship.

INVESTMENT GRADE DIFFERENCE

High trading levels of Fannie Mae and Freddie Mac's debt may even result in some of the existing contracts being torn up, said some industry participants.

The derivatives association was host to calls with market players on Monday to discuss the impact the government intervention will have on agency credit default swaps.

The possibility of canceling some contracts was among the topics discussed, as the exchange of cash streams in the event the contracts recover near 100 percent would be futile, market participants said.

To compare, credit default swaps on Quebecor World Inc recovered only 41.25 percent of their value in an auction after the commercial printer filed for bankruptcy in January of this year.

Auctions have been used to settle credit derivative contracts in several cases after companies defaulted on their debt, including the bankruptcies of Quebecor, Movie Gallery Inc, Dura Automotive Systems, Dana Corp and Calpine Corp.

The cost to insure Fannie Mae and Freddie Mac's "AAA"-rated senior debt was around 38 basis points on Friday, or $38,000 per year for five years to insure $10 million in debt, according to Markit Intraday.

Credit default swaps on the mortgage companies' subordinated debt traded at around 219 basis points on Friday, Markit data showed.

(Reporting by Karen Brettell; Editing by Jonathan Oatis)