ISDA settles dispute on Fannie, Freddie default swaps

NEW YORK, Sept 16 (Reuters) - Some investors who had been hoping to profit using very cheap bonds of Fannie Mae and Freddie Mac to settle their credit derivatives were thwarted on Tuesday after an industry association declared them to be invalid.

The government takeover of the mortgage giants 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 $62 trillion market has faced.

Market participants held conference calls last week aimed at settling disagreements over what debt could be used to set the value of the credit default swaps.

Some credit protection buyers were looking to deliver "principal only" obligations for their Freddie and Fannie securities, which can be worth around 30 cents on the dollar, compared with regular bonds from the two companies, which are worth closer to 100 cents on the dollar.

The International Swaps and Derivatives Association, the industry trade body, said on Tuesday that after consulting for legal opinion, the "principal only" debt may not be used.

"The result reflects the optimal outcome for the legal integrity of the contract and is the right outcome for the reasonable economic expectations of market participants," Robert Pickel, chief executive officer of ISDA, said in a statement.

Credit default swaps are used to hedge against the risk of a borrower defaulting on debt, or to speculate on a company's 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. An auction to settle the value of the credit derivative contracts is expected next month. (Reporting by Karen Brettell; Editing by Dan Grebler)