Fannie, Freddie default swaps triggered by bailout

NEW YORK (Reuters) - The U.S. government's takeover of mortgage finance companies Fannie Mae and Freddie Mac may trigger one of the largest ever payments in the credit default swap market, analysts said on Monday.

Losses made by protection sellers, however, are expected to be minimal due to the high trading levels of the $1.6 trillion of outstanding agency debt. Credit default swaps trade in the private market, so the actual amount of protection written on Fannie Mae and Freddie Mac's debt is hard to estimate.

The government on Sunday seized control of the companies, launching what could be its biggest bailout ever to support the U.S. housing market and ward off more global financial market turbulence.

Terms in the credit default swaps contracts specify that the contracts are triggered by the intervention, analysts said, meaning that protection sellers must pay buyers the full amount insured.

It is the first time a company in the benchmark investment-grade credit derivative index has had a credit event, JPMorgan analyst Eric Beinstein said in a report on Monday.

"This will likely be the largest credit default swap credit event in terms of the amount of credit default swap contracts outstanding that has occurred," he said.

Credit default swaps are used to hedge against the risk of a borrower defaulting on their debt, or to speculate on a company's credit quality.

When a credit event occurs, sellers of protection pay the buyer the full amount insured, and the buyer gives the seller debt underlying the contracts or a cash sum based on the debt's value.

The International Swaps and Derivatives Association, the industry's trade association, said on Monday it will create a protocol that includes a process to set the value of the swaps in an auction to simplify trade settlement.