Fannie, Freddie CDS settlement avoids large risks

NEW YORK (Reuters) - Sellers of protection on Fannie Mae and Freddie Mac's debt on Monday were spared the heavy losses some had feared after the $55 trillion credit derivative market underwent its largest test to date in settling the contracts.

Payments on Fannie and Freddie's credit default swaps were triggered last month when the U.S. government placed the mortgage finance companies in conservatorship, even though they continue to repay their $1.6 trillion in outstanding debt.

The auction was much larger than previous efforts to settle the derivatives, with the volume of outstanding swaps on Fannie and Freddie's debt estimated to be hundreds of billions of dollars and involve far more participants than previous defaults.

The largest risk the settlement of Fannie and Freddie's derivatives poses is that a buyer or seller of protection has a large position in the companies' swaps and takes an out-sized loss from how much the contracts recover.

When a default occurs, buyers of protection with credit default swaps are paid the full sum insured. In return, protection sellers receive the defaulted debt, or cash equivalents that are determined by the auction.

Some protection sellers had feared the contracts would recover significantly less than their par value, due to the low trading prices of some of the debt being used to settle the contracts.

JPMorgan analysts last week said some of the swaps may recover as little as 85 cents on the dollar, and noted there were some risks of even lower returns.

This risk was avoided on Monday, with contracts on Fannie Mae's subordinated debt recovering 99.9 percent of the sum insured, and swaps on Freddie Mac's subordinated debt recovering 98 percent, according to results published by auction administrators Creditex and Markit.

In a strange twist, protection sellers on the companies' subordinated debt will be repaid much more than contracts based on their senior debt, as buyers of the subordinated debt in the auction outweighed those of sellers, tilting the result towards a higher recovery.