Market watchers are warning of forced selling and diminished liquidity as credit default swaps (CDS) on Fannie Mae and Freddie Mac are unwound following the government bailout of the companies.

It appears an estimated $1.47 trillion in contracts protecting against the default of Fannie and Freddie will need to be settled because the government action constitutes an "event."

According to a memo acquired by Bloomberg News, 13 "major" dealers of credit-default swaps unanimously agreed the Treasury rescue is an event that triggers the payment or delivery of the companies' bonds. The International Swaps and Derivatives Association will hold a conference call to render a decision on the over-the-counter traded products.

"We are currently reaching out to the industry and we will make a statement on the outcome of the industry's decision as to whether this will be treated as a credit event," said Cesaltine Gregorio, communications director at the International Swaps and Derivatives Association.

The resolution of the contracts could unsettle markets because of their enormous size, said T.J. Marta, fixed income strategist at RBC Capital Markets.

"Given that CDS agreements likely outnumber actual bonds by an order of magnitude, parties are likely to be forced to settle a significant amount in cash. Such a development could lead to distressed selling of other assets," wrote Marta in a research note.

By Adam Button and edited by Sarah Sussman
©CEP News Ltd. 2008