So while much of the news concerning Freddie Mac and Fannie Mae has been concerning the common and preferred shares. A lot of attention hasn't been paid to the credit default swaps and index CDSs that many of the Fannie and Freddie issues are in (CDX IG9 and IG10)
While Fannie and Freddie are still current on their senior and subordinated debt, the credit event will still trigger defaults on those with CDS exposures.
So if one bought $5 million worth of long CDS protection on an issue for 90 cents on the dollar, he/she will earn 500,000 after the CDS position settles while the protection seller loses that amount.
Problem also is that the notional amount of CDSs that exist in the marketplace are also greater than the amount of the underlying contracts they are supposedly insuring. So if there are $5b worth of FNM 5.5%, having $20b worth of CDS on that creates a problem when it comes to CDS settlement.
Seems like there's going to be a big mess for who actually gets to receive physical delivery while the rest of the issues will go cash-settled.
Also for those who were short CDS on those issues (and believe me there are some very sharp players in the market who even predicted this event to happen but didn't forsee the credit event) that are going to get hit from all of this
Thoughts? Comments?
ISDA and major dealers are working on special procedures which will allow counterparties to settle without physical delivery, since there has never been a credit event this large according to Bloomberg.
Settlement will be for the notional less an auction-determined price on the underlying.
The major broker/dealers tend to settle on a general consensus valuation and payment method in a situation like this. It is to the benefit of ALL firms to get this situation dealt with and be able to continue business as usual as soon as possible.
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