Systemic Risk – the fall-out from Fannie and Freddie

Bill Gross

The F&F take-over is interpreted as a contractual equivalent of bankruptcy in the standard credit derivatives market and some $500 billion of derivatives (insurance instruments mainly offered by insurance companies and banks) will have to be unwound. Although the recovery rate on F&F Credit Default Swaps (CDS) is expected to be 95% (or is this too hopeful?) this would still result in $25 billion being written off immediately. The International Swaps and Derivatives Association (ISDA) is expected to decide the protocol for the settlement of CDS.

Investors, many of them banks and insurance companies as well, will take a huge hit as they write off the F&F share value. The estimate for this is $30 billion, little of which has been written down by institutions, still holding these shares on their books at 2007 prices. These must now be written off according to accounting rules.

Add the $25 billion from settling CDS on top of this and there are a lot of new write-offs coming in this quarter – this on top of write-offs from already stretched property-linked deals. There are many other fragile large financial institutions out there – Lehman and Washington Mutual are examples. If any of these were to fail, that would mean additional write-offs from other financial institutional investors.

Can the markets take another failure – and another big one has been forecast? Global regulators will be examining the books of their major banks over the next few weeks and working out how much it will cost their governments to avoid a series of failures – the domino effect.

Systemic risk and liquidity risk are still inexact sciences. Macro modeling has yet to prove itself. Will the conclusion be that these risks can be anticipated and mitigated, once we learn the lessons – or are we looking at Chaos Theory and will have to admit that some things just cannot be modeled or managed?

(A lot of news got hidden this week – the FSA’s systems crashed flat on their face, the PCAOB took a shot at plans for IFRS, smaller US companies have been reporting pretty bad self-audited Sarbox Section 404 compliance and ill Gross of Pimco (see above) is reported as having made $1.7 billion profit on the F&F takeover!)