F&F Mix Results: Narrowing F&F Spreads But Defaults from F&F Credit Default Swaps

``In traditional finance, borrowers borrow and lenders lend. The only firms exposed to, say, home mortgages, are the banks that issue them. Thanks to derivatives, a firm with exposure can pass it off, and a firm with no exposure can assume it. Markets thus have less information about where risk lies. This results in periodic market shocks. Put differently, derivatives, which allow individual firms to manage risk, may accentuate risk for the group. Markets were stunned to discover that Long-Term Capital owned outsized portions of obscure derivatives. They dealt with that shock in typical fashion: they panicked.” - Roger Lowenstein, Long-Term Capital: It’s a Short-Term Memory

 

With the US government’s recent action to preserve the global monetary system, we find that aside from the undefined cost to taxpayers, the US treasury has now assumed the responsibility for the $5.3 trillion of mortgage securities aside from its outstanding $5.3 trillion of treasury securities as of March 2008.

 

So far, the US Treasury’s action has partially eased the yield spread of the F&F papers from its risk-free counterparts as shown in Figure 4.

Figure 4: Danske Bank: Before and After Spread of F&F vis-à-vis Fed Rate and 10 year Treasury

 

 

Even as the Federal rates had been lowered rates by 325 basis points as shown in the left panel in figure 4, the F&F rates have not equally responded. However, after the action taken by the US Treasury, the F&F rates dropped steeply as displayed in the right panel.

 

By lowering of the mortgage rates, the US government hopes to ease the burdens of homeowners smacked by a perfect storm of lack of access to credit, falling asset prices (real estate and stocks), rising unemployment, slowing economy and still high but fast declining energy/ fuel prices. 

 

And by narrowing the spreads from US treasuries, the US government hopes to provide cushion to the fast deteriorating financial and economic conditions by allowing investors access to cheap money which could feed into the mortgage market and buy F&F papers and thus restoring liquidity and confidence, aside from the credit ratings of the F&F papers.

 

But this doesn’t take away the fundamental problem of having too many houses for sale at prices buyers can’t seem to afford.

 

Moreover, the spreading of the mortgage woes to the level above the subprime market seems to be the next wave of credit concerns. The Alt-A mortgages covering about 3 million US household borrowers totaling some $1 trillion in mortgage papers with about $400 billion issued during the height of the boom in 2006 where an estimated 70% of borrowers were said to have exaggerated income (Bloomberg).

 

Aside the recent actions by the US government appear to have triggered a “credit event” in the CDS market of the F&F papers. A Credit Default Swap (CDS) is a credit derivative functioning as an insurance contract that pays if a company or “counterparty” defaults on its liabilities.

 

However unlike an insurance contract, the CDS market is many times more than size of the actual bonds referenced. The unregulated CDS market is estimated to be at around $62 trillion. The problem of which is if an outsized default occurs a contagion of non-collection from losses may lead to a systemic loss.

 

The recent “conservatorship” of F&F by the US Treasury has triggered defaults on some CDS contracts referencing to the F&F securities. The contracts affected were estimated at $250-$500 billion which should to result to some $10 to $25 billion in additional losses (Financial Times).

 

And perhaps some of these losses had been accounted for the recent volatility in the global markets.