Here’s a scary thought: The government’s bailout of Fannie Mae (NYSE:FNM) and Freddie Mac (NYSE:FRE) could be the catalyst for the much-anticipated meltdown in credit default swap (CDSs). Dave Gonigam in Desidooru Saloon says this could happen…

CDSs are, in essence, an insurance policy you take out on a debt instrument you hold, just in case that debt goes bad.  As you might imagine, the sellers of CDSs practically printed money as long as the credit markets stayed juiced up through August of last year and debts weren’t going bad in any great numbers.

Ever since, the threat has loomed that the sellers might actually have to pay out massive “claims” on those insurance policies.

Today, an organization called the International Swaps and Derivatives Association meets to hash out whether the Fannie and Freddie takeover would trigger such “claims” on Fannie and Freddie paper.

As Chuck Butler explains…

There’s a question as to whether the Gov’t’s conservatorship constitutes a “CDS event”, which would force the settlement of the CDS contracts that are outstanding… Fannie and Freddie have roughly $1.5 Trillion in debt outstanding… But that’s chickenfeed compared to the notional amounts of CDS contracts that could be multiples of that $1.5 Trillion!

But wait… there’s more.

If the Gov’t’s conservatorship does constitute a “CDS event” there won’t be enough debt to settle the contracts, which will lead to a need for cash… And that could lead to major problems, with the least of them being the holders needing cash, might have to sell other assets to raise the cash needed… 

“Other assets?”

Say this does actually play out. Institutions laden with CDSs that are dumping commodity plays and resource stocks for no other reason than they’re actually sellable and can generate cash would suddenly move into overdrive.

But that probably still wouldn’t be anywhere near enough cash to prevent a major deflationary episode, so the Fed suddenly monetizes all these bad debts and triggers a hyperinflation.  A malarial economy – chills, then fever.

This is not a prediction, merely a hypothetical.

Source: Look out below