Quite an event

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Sep 11th 2008 | LONDON AND NEW YORK
From The Economist print edition

Testing times for the swaps market


THE seizure of Fannie Mae and Freddie Mac is a big moment for the housing market. But it will also be a test for the dauntingly large market for credit-default swaps (CDSs). Placing the mortgage agencies into “conservatorship” counts as bankruptcy, and thus triggers the settling of contracts on these derivatives, which are used to hedge, and speculate on, the risk that a company defaults. The value of swaps linked to the agencies’ $1.5 trillion of bonds is unknown, as CDSs are private. One estimate puts it at $500 billion, which would be the biggest “credit event” yet in a market worth a notional $62 trillion.

It is a strange sort of default. Because of Treasury backing, the bulk of Fannie’s and Freddie’s debt (though not their preferred shares) will settle at par or close to it. That means some buyers of CDSs, who were betting on default, may paradoxically end up worse off. They will have earned mark-to-market gains as spreads on the agencies’ swaps widened (ie, the risk of default grew). Now they will have to give them up.

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Equally, many protection sellers will reap gains. But not all: some have already booked as income premiums from the buyers for the life of the outstanding contracts—usually five years. They will now receive only a part of this.

Auctions to close out the swaps will be held in October by the International Swaps and Derivatives Association, a trade group. Complexity abounds but most dealers think the market can cope. If so, its credibility will receive a boost.

The episode might also be a badly needed catalyst for change. The auctions will involve “cash settlement”, rather than a physical exchange of the underlying bonds, which is needed because the value of swaps far exceeds the face value of those bonds. Regulators have also been urging dealers to tighten up trade processing and to move to centralised clearing, especially since the demise of Bear Stearns, with its vast derivatives exposure, laid bare a huge “counterparty” risk—that it might not be able to honour contracts it had written.

The launch this week of a service to cut the level of capital at risk by batching trades in a process called “compression” is another encouraging sign that the market can heal itself. The quicker it does so, the better. The woes of Lehman Brothers, like Bear a big CDS counterparty, hint at even bigger tests to come.