The credit markets have reacted to the takeover of Fannie Mae and Freddie Mac; they're viewing "conservatorship" as the equivalent of bankruptcy.  It's not, but in the credit default swap markets, that's how it's viewed.  The move by the government is viewed as a 'credit event,' the topic I discussed yesterday in the context of WaMu.

These credit default swaps, CDS, and synthetic collateralized debt obligations, CDOs, are areas where people have fears of serious problems.  (The synthetic CDO is similar to a regular CDO except rather than actual mortgage bundles in each tranche, there are credit default swaps.  The payment flows for the CDS are then ranked based on risk of default and "tranched" just like a regular CDO).  You can learn about CDOs, both cash and synthetic, by clicking here.  If you want to know more about credit default swaps, then follow this link.

The problem is that the CDS beast is huge; the Financial Times puts it at $62 trillion.  It has the power to become toxic as markets in different parts of the world are linked--as are companies.  Things could turn sour fast.  However, for the case of Fannie and Freddie, there shouldn't be a problem, because the risk of default is seen as zero.

I expect we'll all hear a lot more about CDS and synthetic CDOs in the coming months.  They're hard to explain, but once the notion hits, the things are quite scary.  It could be the reason that the government is treading lightly.  As I mentioned previously, I want to buy banks, but I want to see how this credit default business will conclude first.

Warren Buffett has referred to the whole CDS business as "financial weapons of mass destruction."  It's ironic to me that enemies of the US tried to damage or even destroy the financial system; meanwhile, people working in that self same system were unwittingly working towards that same goal.