US Treasury credit default swaps increase to record following Fannie takeover.

Sept. 9 (Bloomberg) — The cost of hedging against losses on Treasuries rose to a record on concern the U.S. government faces higher liabilities because of its rescue of mortgage companies Fannie Mae and Freddie Mac, credit-default swaps show.

Contracts on U.S. government debt increased 3.5 basis points to a record 18, up from 6 basis points in April, according to CMA Datavision prices for five-year credit-default swaps at 5 p.m. in London. Credit-default swaps on German government bonds cost 8 basis points and Japanese bonds 16.5 basis points.

The Treasury committed to invest as much as $200 billion to prevent a collapse of Fannie and Freddie, protecting investors owning more than $5 trillion of their debt and mortgage-backed securities. The U.S. budget deficit will grow next year to $438 billion, the Congressional Budget Office said today, making it harder for President George W. Bush’s successor to either cut taxes or increase spending.

“The bailout of Freddie Mac and Fannie Mae is weakening the balance sheet of the U.S. and that is causing a deterioration of creditworthiness,” said Mehernosh Engineer, a credit strategist at BNP Paribas SA in London. “The market is anticipating there might be more bailouts.”

The government’s top Aaa credit rating is not at risk following the takeovers, according to Moody’s Investors Service. The amount pledged by the Treasury doesn’t reflect the government’s assessment of potential losses, Moody’s said yesterday.

Debt Agreements

Credit-default swaps, contracts conceived to protect bondholders against default, pay the buyer face value in exchange for the underlying securities or the cash equivalent should a country or company fail to adhere to its debt agreements. A rise indicates deterioration in the perception of credit quality; a decline, the opposite.

Contracts on Treasuries are quoted in euros and a basis point on a credit-default swap contract protecting 10 million euros ($14.2 million) of debt from default for five years is equivalent to 1,000 euros a year.

Most of Fannie and Freddie’s $1.7 trillion in unsecured debt and $3.5 trillion in mortgage guarantees will be recognized as federal obligations by the Congressional Budget Office, the Director Peter Orszag said today

The total amount of $5.2 billion of unsecured bonds and mortgage-backed securities may not all translate into new federal debt, Orszag said, since Fannie and Freddie have loans and other assets backing those liabilities. The nonpartisan CBO provides Congress with independent assessments and recommendations on U.S. economic and budgetary decisions; it does not set budget policy.

Budget Assessments

The exact amount of new federal debt will be fully calculated and integrated into U.S. budget assessments by January, Orszag said.

“The U.S. government is now effectively underwriting $1.5 trillion in debt,” said Michael Hampden-Turner, a credit strategist at Citigroup Inc. in London. “It has undertaken a big commitment and increased the amount of outstanding debt.”

The cost of protecting corporate bonds from default rose today on investor concern the rescue of Fannie and Freddie won’t ease the global credit crisis. Credit-default swaps on the Markit CDX North America Investment Grade index of 125 companies in the U.S. and Canada increased 6.25 basis points to 144.25, according to broker Phoenix Partners Group.

In Europe, the benchmark Markit iTraxx Europe index of 125 companies with investment-grade ratings increased 2.5 basis points to 101, according to JPMorgan Chase & Co. The index may double in the next six to nine months as default rates and inflation rise, according to Barclays Capital’s Puneet Sharma.

“The real problems don’t stem from the issues Fannie and Freddie had,” said Sharma, the head of investment-grade credit strategy at Barclays Capital in London. “The real issues are the housing markets on both sides of the Atlantic are deteriorating, there is a real overhang of potential downgrades and defaults in Europe and the U.S. and inflation in emerging markets is accelerating.”

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