That’s when credit default swaps (CDSs) with a notional value somewhere between $500 billion and $1.4 trillion will have to be settled as a result of the (re)nationalization of Freddie Mac and Fannie Mae, which has been deemed to constitute a default event on their bonds. Paradoxically though because the government guarantee of the bonds is now explicit, they are actually safer than before which means that the net payments required in settlement will be very small, and sometimes go to the party who offered protection against default. Don’t worry too much if none of this makes sense, the main point doesn’t depend on it, but you can read a bit more from The Economist.
As The Economist notes, most participants are expecting all this to go smoothly. But one thing about the longrunning credit squeeze is that unexpected (bad) things tend to happen. So what could go wrong?
It would probably take several things happening at once to bring about a lockup of the settlement of the auction – I’ll add some hints in parentheses)
(1) A major participant in the market runs into serious difficulty close to auction day with the result that its counterparties demand immediate cash or physical settlement, but are slow to pay themselves (Lehman)
(2) A second counterparty unexpectedly turns out to have severe difficulties making it impossible to net out offsetting liabiities (??)
(3) The authorities are distracted by a large-scale failure in the mortgage sector, making it difficult to organise a rescue (WaMu)
(4) There’s a sudden rush out of Treasury bonds, constraining the government from issuing unlimited credit (China)
I don’t know what would happen if this chain of events took place. My guess is that there would be some sort of imposed settlement that would solve the immediate problem but would lead to a rapid loss of confidence in the whole CDS market as we have already seen with collateralized deposit obligations (CDOs) and many other marvels of recent financial innovation. Since the CDS market involves notional claims of $60 trillion and gross obligations of around $2 trillion, that could be quite unpleasant.
Of course, the par bet is still that things go smoothly. Even in a period of crisis like the present, predictions of disaster rarely come true. It’s the unpredicted disasters you have to worry about.