Big news - Derivative market downgrades Fannie, Freddie debt

In my opinion, this is REALLY big news.

July 9 (Bloomberg) - Fannie, Freddie Downgraded by Derivatives Traders

Although you and I know that Fannie and Freddie bonds have very high credit risk, these bonds are top rated and used by everyone, in many ways, as collateral. The debt is an essential part of the world financial system as it is the main paper "stuffing" used wherever paper stuffing is needed (including pension funds, money markets, mutual fund asset LENDING COLLATERAL, foreign central bank reserves...)

And there is trillions upon trillions of this stuff. We're talking on the order of $5 trillion of debt directly, and then many more trillions in derivatives linked to that debt.

The derivatives market (CDS market) is now valuing the Fannie/Freddie debt as far riskier, far more likely to default. The CDS market had similar insights about Citigroup and the investment banks now failing.

OK so it's not news that Fannie and Freddie are broke, but here is why this really is big news:

  1. Now financial markets KNOW that Fannie/Freddie bond risk is high, and that the headline bond ratings are worthless

  2. This means all the places Fannie/Freddie debt is used as collateral and stuffing are going to be re-priced. Not immediately though, many places will be very sluggish and probably hold out as long as possible. After all, the bonds themselves have not dropped in price – probably a manipulation. The CDS market is a traded by institutions, and it's the derivatives on the bonds, not the bond prices themselves, which are calling the solvency problem.

  3. If markets keep pricing agency (Fannie/Freddie) debt this way, the implications are just mind boggling. The agency debt is one of the major backbones of the world financial system, probably only second in importance to US treasuries. This is almost as bad as US treasuries suddenly all getting slashed in credit quality.

Speaking of which, my gut tells me this could also lead to US treasuries getting effectively "downgraded" in the minds of banks.

- Perpetual Bull

UPDATE 1: Yeah, this was really big news in hindsight. The collapse of Fannie Mae and Freddie Mac happened soon after this news, and turned out to be one of the big ingredients in the system meltdown if not the single major catalyst. Myself and my colleagues have believed for a long time that the Fannie Mae problem was going to blow up into America's biggest financial disaster, and it looks like we were right.

UPDATE 2: As predicted in this article, US Treasuries credit quality has suffered. The collapse of Fannie, Freddie, AIG, etc. has resulted in trillions of dollars in new liabilities for the US Government. As a result, CDS on US Treasuries point to elevated risk of Treasury default, as the credit risk transfers from the private institutions to the public. There are also slight hints of liquidity problems in US Treasuries, as older issue treasury bonds now exhibit elevated spreads compared to fresher debt.