On September 7, 2008, the U.S. Treasury announced several steps to support Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac) and the U.S. mortgage market generally, including the placing of the two government-sponsored entities into conservatorship. The Federal Housing Finance Agency has been appointed as the conservator.

Following the announcement by the U.S. Treasury of its plans to support Fannie Mae and Freddie Mac, the major derivatives dealers determined that the appointment of a conservator to Fannie Mae and Freddie Mac by the U.S. Treasury did in fact constitute a Credit Event under the “Bankruptcy” Credit Event of the 2003 ISDA Credit Derivatives Definitions, specifically Section 4.2(f ) thereof, thereby triggering the need to settle CDS contracts referencing Fannie Mae or Freddie Mac.

Because the outstanding notional value of the CDS referencing Fannie Mae and Freddie Mac far exceeds the aggregate amount of cash obligations available in the market for the physical settlement of affected CDS, the International Swaps and Derivatives Association, Inc. (ISDA) will work with the major derivatives dealers and CDS end-users to develop a cash-settlement auction protocol. Adherents to the protocol effectively will be agreeing to amend their existing CDS documentation referencing Fannie Mae and Freddie Mac to allow cash settlement of such CDS at a single final price determined through the auction process. There will also remain a limited ability to physically deliver obligations of Fannie Mae or Freddie Mac through the auction process.

Further details of the protocol, including which obligations of Fannie Mae and Freddie Mac will be utilized for determining the final price to be applied for cash settling the CDS, will be determined in the coming weeks by ISDA based upon input from the major derivatives dealers and the buy-side community. The auctions may be the largest cash-settlement auction protocols, by notional amount of outstanding CDS, to date.

Similar cash-settlement auction protocols have been created in recent years for settling CDS referencing other highly traded credits that have been the subject of a Credit Event. Such credits include Collins & Aikman, Delphi, Delta, Northwest, Calpine, Dana, Dura, Movie Gallery, Inc. (loan-only CDS) and Quebecor World, Inc. Following on the historical success of such auction protocols in facilitating an orderly close out of large numbers of CDS, the Federal Reserve has been encouraging major derivatives dealers tasked with improving CDS trading infrastructure to incorporate standard procedures for such auction protocols into standard CDS contracts. ISDA has been working with market participants to develop amendments to the 2003 Credit Derivatives Definitions to hard-wire and further standardize, to the extent possible, cash-settlement auction mechanics into CDS contracts. We expect the auction protocols for Fannie and Freddie to be similar to the protocols previously established for other credits.