Fannie, Freddie CDS sellers may be repaid only 85 pct

NEW YORK, Oct 2 (Reuters) - Sellers of protection on Fannie Mae (FNM.N) and Freddie Mac's (FRE.N) debt may be repaid as little as 85 cents on the dollar when the value of the credit default swaps on is settled by auction on Monday, JPMorgan said in a report on Thursday.

The government takeover of the mortgage giants last month triggered payouts on their credit derivatives, even though they continue to repay their $1.6 trillion in debt.

Credit default swaps outstanding on Fannie Mae and Freddie Mac are estimated to be in the hundreds of billions of dollars and settling the contracts will be one of the largest tests the $55 trillion market has faced.

Although much of Fannie Mae and Freddie Mac's debt is trading near full par value, some of the debt that backs the credit default swaps is trading as low as 87 cents on the dollar, JPMorgan analysts said.

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

When a default occurs, sellers of protection pay the full amount insured and receive from the buyer the defaulted debt or cash equivalents. The cash value is determined at an auction, and is based on the prices of the underlying bonds.

Owners of protection typically use the cheapest debt they can find to settle the derivative contracts, and the cheapest to deliver bonds underlying Fannie Mae's swaps are around 87 cents on the dollar, while Freddie Mac's are around 88 cents on the dollar, JPMorgan said.

That means Fannie Mae's credit default swaps could be settled at between 85 and 90 cents on the dollar, and Freddie Mac's at around 87 to 92 cents on the dollar, the analysts said.

Trade association the International Swaps and Derivative Association, in conjunction with major market participants, formed a list of Fannie Mae and Freddie Mac debt that can be used to settle the credit derivatives. (Reporting by Karen Brettell; editing by Gary Crosse)