The Sinister Story Behind the Freddie and Fannie Bailout
 The stock market here in the U.S. sure liked the news about Fannie and Freddie!I guess stock traders didn’t get the memo that another government-sponsored bailout will put billions of dollars of tax burden on taxpayers. It will also most likely cause a major disruption in the Credit Default Swaps (CDS) that are still on banking books.
Oh, well, we have to learn to deal with mental giants all our lives. This is just another example! So, first, I want to tell you how this epic bailout affected currencies. Then I’d like to take you for a ride on the CDS liquidation wagon. Let me warn you upfront: It’s not a particularly pretty or scenic ride, but it’s definitely worth taking. First off, the Fannie and Freddie news caused the dollar bulls to shake the euro to its foundation yesterday and the euro sank even further. In fact, at one point the euro looked liked it might fall below US$1.40. For the euro (and other currencies), selling came swift and harsh, right after the stock market opening bell. However, the good news is the euro has rebounded in the overnight markets of Asia and Europe to 1.4175… Traders didn’t have any data or news from overseas yesterday morning to warrant the stock market rally. No sir – it was just plain and simple stock market euphoria here in the U.S. Plus, foreigners wanted in on the “action,” so they also started scooping up U.S. stocks. When foreigners buy U.S. stocks, they have to exchange their currency for the dollar, and that pushes the dollar higher. But, as I said, the currencies have rallied back overnight, so, as long as yesterday’s selling is water under the bridge, I’ll be okay with that! A Ride on the CDS WagonLet’s get to this credit default swaps (CDS) stuff, because this is important. There will be a meeting today to discuss how this will all play out. But here’s some perspective on the situation… First and foremost, there’s a question as to whether the government’s recent bailout constitutes a “CDS event.” If it is a “CDS event,” it could force financial institutions to settle outstanding CDS contracts. Fannie and Freddie have roughly US$1.5 Trillion in outstanding debt. But that’s chickenfeed compared to what institutions have in CDS contracts. In fact, we could see multiples of that US$1.5 Trillion worth of unsettled debt! If Uncle Sam’s Freddie and Fannie bailout does constitute a “CDS event” there won’t be enough debt to settle the contracts. This will lead to a need for cash. And that could lead to major problems. The least of these problems will be holders who need the cash might have to sell other assets to raise the capital they need. I know this can be confusing. Honestly, it took me a while to fully understand these credit default swaps. But in essence CDS are simply insurance policies. Debt holders can use them to hedge, or insure against a default under the debt instrument. In case you’re wondering, yes, CDS’s fall under the heading of “derivatives” that you’ve heard all about. |
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Revealed at a “Mystery Theatre” Near You:
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What Happens When a CDS FailsWhen the “credit event” or “default” occurs, then debt holders must unwind these. When CDS’s unwind, then Peter pays Paul, and Paul pays Robert, and so on… It’s a vicious debt cycle – but it’s even worse when they have to pay each other back. In other words, it could get very ugly out there! The association that governs the credit default swaps, the ISDA, will meet today to discuss how this will all come down or fall out. So, more on this tomorrow… In other news, I saw that Google celebrated their 10th anniversary yesterday. Wow! In 10 short years they have conquered the world! Or so it seems, right? Who hasn’t said: “Hey just Google it?” Happy anniversary Google. Meanwhile, Hurricane Ike is headed toward the Gulf of Mexico. Again, let’s hope it fizzles out before it hits land. Have a Terrific Tuesday! P.S. I’m about to hit the road again for our FX University! I’ll join five of my colleagues to give you all the currency tricks of the trades we’ve learned over the past XXX years (probably more than we care to reveal honestly). We’ll be in Seattle on September 15th, then we’re traveling all over the United States! Hope to see you there! Chuck Butler, President of EverBank World Markets and Editor of Currency Capitalist Taking the Long View of the Currency Markets Chuck Butler focuses on the factors that affect a currency’s value over the long run – from trade and fiscal balances to interest-rate policy and credit expansion. Because of his concentration on the fundamentals, he has correctly called the dollar’s demise and the euro’s rise since 2001, as well as many other important long-term moves. |
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