Aug. 26 (Bloomberg) -- Buyers of credit-default swap contracts that protect against losses on Fannie Mae or Freddie Mac subordinated debt may not get paid immediately if the mortgage-finance companies were to defer interest payments as part of a government bailout, according to Bank of America Corp.

While a failure to make the coupon payments permits credit- default swap buyers to cash in on their protection, Freddie and Fannie subordinated bond indentures allow interest to be deferred for as long as five years, or until maturity, if capital cushions breach certain thresholds, Bank of America strategist Glen Taksler in New York wrote in a note to clients yesterday.

That means it would be 2011 before deferred interest payments on subordinated notes from the government-chartered companies could trigger the derivatives contracts, assuming Fannie meets obligations on a maturity of $1 billion in subordinated notes next week, Taksler wrote.

Credit-default swaps, used to speculate on corporate creditworthiness or to hedge against losses, pay the buyer face value in exchange for the underlying securities or the cash equivalent should a borrower fail to adhere to its debt agreements.

Subordinated debt sold by Fannie or Freddie allows for interest to be deferred if capital cushions fall below minimum levels required by regulators and the Treasury buys the debt at the company's request, according to bond indentures. Payments also could be deferred by one of the companies if it fell below 125 percent of so-called critical capital, defined as half of minimum capital.

Paulson Plan

U.S. Treasury Secretary Henry Paulson last month won approval to pump unlimited amounts of capital into Washington- based Fannie and Freddie of McLean, Virginia, which guarantee or own about $5 trillion of the $12 trillion in U.S. home loans. The companies would have to agree to capital injections.

Fannie had $47 billion of capital as of June 30, according to company filings. Its minimum requirement was $32.6 billion, rising to $37.5 billion with a surcharge required by its regulator, the company said. Freddie's capital stood at $37.1 billion, compared with a minimum requirement of $28.7 billion, rising to $34.5 billion with the surcharge, according to filings.

A failure to pay interest beyond what's allowed in the indentures could trigger credit-default swaps on both subordinated and senior debt, Taksler wrote. The companies combined had $15.6 billion in subordinated debt at the end of June and $1.6 trillion in senior debt.

S&P Downgrades

Standard & Poor's today lowered its rankings for subordinated debt from Fannie and Freddie one grade to BBB+ from A-, citing higher ``uncertainty'' over whether any government support would extend to the securities. Moody's Investors Service last week affirmed its Aa2 rating on the subordinated debt, which is the equivalent of five grades above the S&P ranking. Moody's changed its outlook on the debt to negative from stable.

A capital injection by the government, on its own, isn't likely to trigger credit-default swaps, he wrote.

``Such an injection would effectively make the government an owner of the agencies, without taking control of day-to-day operations,'' Taksler wrote. ``But, to be clear, an actual opinion would depend on all the information available at the time of a potential event.''

Such situations are a ``gray area,'' he said, ``and it may be possible to obtain different -- or even opposite -- interpretations from different sources.''

Credit-default swaps could be triggered under other scenarios, such as coming under the control of a conservator, the Bank of America report noted, citing the International Swaps and Derivatives Association's 2003 definitions for the contracts. The government could put the companies into conservatorship if the companies fell below critical capital levels.

To contact the reporter on this story: Shannon D. Harrington in New York at sharrington6@bloomberg.net

Last Updated: August 26, 2008 16:41 EDT