August 26, 2008 / 5:25 PM / in 9 years

GSEs' subordinated debt unlikely to trigger swaps

By Karen Brettell - Analysis

NEW YORK (Reuters) - Sellers of protection on Fannie Mae FNM.N and Freddie Mac FRE.N subordinated debt are unlikely to be required to pay out on the contracts even if the mortgage finance companies defer interest payments.

Losses from residential mortgages the companies guarantee have created concerns Fannie and Freddie may defer coupons if capital levels fall below minimums required by regulators.

Payments on credit default swaps insuring a company’s debt are typically triggered, requiring protection sellers to pay the buyer the sum insured, when an issuer misses an interest payment, or fails to repay the debt at maturity.

In the case of these government-sponsored entities, however, the companies are able to suspend payments under certain guidelines for as much as five years, or until the bond matures, without triggering payments on the credit default swaps, analysts said.

“There is a grace period for five years,” said Ricardo Kleinbaum, analyst at BNP Paribas in New York. “However, you would have an event of default if a maturing bond were not paid back. It’s also an event of default if the U.S. government takes them over or if there’s a restructuring.”

A restructuring could include extending the maturity of the debt, or reducing the principal amount of a bond and subordinating it to other debt.

However, these seem “unlikely as a first move for the agencies,” Kleinbaum said.

The closest subordinated bond maturity is a $1 billion Fannie Mae bond due on September 2. After that, Fannie Mae has $2.5 billion in debt coming due in February 2011, and Freddie Mac has $1.09 billion due in March 2011, according to Bank of America.

“Provided that Fannie Mae meets its September 2008 subordinated debt maturity, the next earliest date that a CDS investor (buyer or seller) could trigger a Failure to Pay Credit Event would be 2011,” BofA analyst Glen Taksler said in a report sent on Tuesday.

Terms in the contracts also state that if Fannie or Freddie default on a subordinated bond, payments on credit default swaps insuring their senior, “AAA”-rated debt would also be triggered, Taksler said.

“Missing a subordinated bond coupon (after the expiry of the grace period) would allow investors to trigger both senior and subordinated CDS,” he said.


Investors fear that as mortgage defaults rise and erode the companies’ capital, the U.S. Treasury will be forced to intervene, as mandated by Congress in July, by buying stock or debt in the companies, diluting the value of existing stock.

The cost to insure the debt of Fannie and Freddie’s subordinated bonds with credit default swaps has soared to around 249 basis points, or $249,000 per year for five years to insure $10 million in debt, from around 80 basis points at the beginning of the year, according to Markit Intraday.

However, BNP’s Kleinbaum expects Fannie and Freddie to continue to pay interest on their subordinated bonds.

Fannie Mae has $14.4 billion in subordinated debt, which costs $466 million in annual interest payments to service, he said. Freddie Mac has $4.45 billion in subordinated bonds, which costs $244 million in annual interest payments.

“In the whole scheme of things, with $466 million and $244 million, is it worth deferring coupons or restructuring that sub debt? I don’t think so,” Kleinbaum said. “The bigger issue is with the preferreds.”

Fannie Mae has $21.7 billion in preferred shares, costing $1.5 billion annually in dividend payments. Freddie Mac has $7.4 billion in preferred shares, which costs $388 million to service each year.

Moody’s Investors Service also said it views the U.S. Treasury as unlikely to allow a GSE to defer a debt payment, “given potential market ramifications.”

Nonetheless, the rating agency has a negative outlook on their subordinated debt, recognizing that “this is a fluid situation and that, though unlikely, this could change,” Moody’s said in a statement last week.

Editing by James Dalgleish

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