What would have happened if Fannie and Freddie defaulted?

In The Hidden Bailout of $1.4 Trillion CDS, Daniel Amerman explains what would have happened if the government didn't nationalize Fannie and Freddie:

The financial news of the day was that Fannie Mae and Freddie Mac were both unable to make debt payments and had defaulted on $5 trillion in bonds and mortgage-backed securities. With the US real estate market having fallen $4 trillion in the previous two years (non inflation-adjusted), it should have been no surprise that these two highly leveraged companies were not able to absorb the staggering losses. As this became clear to the markets, Fannie and Freddie lost the ability to borrow - which their survival was based upon - and actual default followed soon after. This default immediately triggered settlements on $1.4 trillion in credit-default swaps (credit derivatives), which had been entered into by major financial firms who had promised - in exchange for lucrative fee income - that if Fannie Mae or Freddie Mac were to default, these guarantor firms would make good on the defaulted bonds.

As the value of Fannie Mae and Freddie Mac debt plunged to 30 cents on the dollar, this meant that there was a 70% loss on the bonds (if one could find a buyer at all). This then triggered a call for settlement on the $1.4 trillion in credit-default swaps outstanding. Because the debt of the two former titans of the financial world was trading at a 70% discount compared to par value, this meant that total credit losses were $1 trillion ($1.4 trillion X 70% = $1 trillion). This meant $1 trillion worth of payments was due from the companies that had guaranteed the value of this debt, through their entering into credit-default swaps.

Settlement was triggered, but as the credit-default swap beneficiaries soon found out, collecting their settlements was an entirely different matter. The financial institutions around the world who had guaranteed Fannie and Freddie in exchange for lucrative corporate fee income (and multi-million dollar individual bonuses) were all highly leveraged themselves (indeed, weaker than the companies they were guaranteeing), and absolutely reliant on the day to day availability of large lines of credit and general borrowing capacity. As the creditors of these financial giants realized that a trillion dollar hit was barreling straight at them, they pulled their financing. Having to repay or replace these loans, without being able to sell massive portfolios of illiquid assets in a market suddenly devoid of buyers, left nearly every major investment bank and commercial bank in the United States and Europe unable to meet their obligations – even before settlement of their trillion dollar credit-default swap losses.

The failure of the major financial firms triggered another massive round of credit-default swap events, with amounts well over $10 trillion by Thursday, and over $20 trillion by Friday. By that time, however, no one was naïve enough to expect actual payment on those swaps, as Wall Street and the rest of the world’s financial hubs had all been insolvent since Wednesday. When the markets eventually opened for business again more than two months later, the official drop in the Dow Jones Industrial Average was over 10,000 points, meaning the index was trading at a level in the 1,000 – 1,500 range.

His conclusion?

In other words, the biggest beneficiaries of the $1.4 trillion Fannie and Freddie bailout were not Fannie or Freddie at all, but the Wall Street firms whose senior officers just happen to be major political contributors to both political parties – with some of those senior officers also running the Treasury Department on a revolving door basis.

It's definitely worth reading the full article.

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