Swapping Credit by Default

A credit default swap is a financial instrument that allows lenders (or buyers of bonds) to swap their rates of return in the event of default (or another event of similar magnitude, but different direction, e.g., a credit upgrade). They are, essentially, insurance for lenders in case the company that has borrowed their money goes broke.

In yesterday’s ‘Market Mover’ blog, Felix Salmon pointed out that:

Fannie Mae’s credit default swaps are trading over 200bp, despite their implicit government guarantee. Writing protection at these levels seems like a no-brainer to me: even if there is an event of default, recovery is going to be very close to par, and you get all the insurance premiums in the mean time. [link]

What he’s saying is that, since the government has guaranteed FNMA loans, taking out insurance on them is a win-win situation. If FNMA defaults, the government steps in and saves the day, so lenders essentially get most of their money back. People who sell insurance on these bonds will make their money from the premiums, and get most (if not all) their loan amounts back. [200bp means the premium for taking out a CDS on FNMA is 2% of the loan amount].

Brad Delong retorts:

Unless, of course, the default happens very quickly–and you don’t get many insurance premiums first. And that isn’t going to happen–unless it is, and unless somebody knows something and wants to be your counterparty.

Me? I think it is time to make FNMA’s government guarantee explicit, and use it to start buying up mortgages… [link]

Hear, hear. From yesterday’s WSJ:

Investing in GSE [government-sponsored enterprises] loans has traditionally been viewed as a conservative play, but the value of such securities has declined in recent days and risk premiums have widened.

Fannie shares fell 10.7% and Freddie slid 6.9% after the Treasury Department denied rumors that the government would provide an explicit guarantee of the lenders’ debt. Fannie shares have now fallen more than 22% over the last five trading days and have dropped 46% since the start of the year. Freddie shares have fallen 20% in four days and are down 41% for the year to date. [link]

And certainly this news isn’t helping the situation:

The total wealth of American households slipped about $533 billion to $57.7 trillion in the fourth quarter, the first drop since 2002, the Fed said. Central to the decline: The value of housing-related assets — including those that are mortgaged — fell by $170 billion to $20.2 trillion while the value of other financial assets, such as stocks, dropped by $254 billion to $45.3 trillion.

[…]

According to the Mortgage Bankers Association, more than 2% of the nation’s about 46 million mortgage loans were in the foreclosure process in the fourth quarter, and 0.83% of loans entered the process. Both figures are the highest since the industry group started keeping track in 1972. [link]

Unemployment up, foreclosures up, housing prices down, oil prices up. In short: Things are not looking rosy. The question now is: When do we see an upturn? And have we hit the trough yet?

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