Nov. 3 (Bloomberg) -- The collapse of Iceland's three biggest banks may force sellers of credit-default swaps on the lenders to settle contracts at as much as 97 cents on the euro, causing losses of about 5.5 billion euros ($7 billion).

The size of the payout will be determined at auctions this week, with contracts on Landsbanki Islands hf, the nation's second-biggest bank, the first on the block tomorrow. Icelandic bank bonds are trading at 3 to 5 cents on the euro, according to Bill Blain, a broker at KNG Securities in London.

Iceland's financial regulator took control of Landsbanki, Kaupthing Bank hf and Glitnir Banki hf after they couldn't raise short-term funding last month. The seizures triggered credit- default swaps on the banks' combined 43 billion euros ($55 billion) of debt and prompted the auctions by the International Swaps and Derivatives Association, the first of their kind in Europe.

``Given where bonds are trading, we should expect recoveries to be close to nothing,'' said Tim Brunne, a Munich-based credit strategist at UniCredit SpA. ``As we have seen in previous auctions, recoveries have been below bond prices.''

Dealers set values for Lehman Brothers Holdings Inc. bonds at 8.625 cents on the dollar last month, meaning sellers who signed up for the auction after the bank's September bankruptcy paid 91.375 cents on the dollar to settle the contracts. Lehman's $128 billion of bonds were trading at an average of 13 cents on the dollar before the auction.

Fannie, Freddie

Protection sellers on defaulted bonds of Washington-based Fannie Mae and Freddie Mac of McLean, Virginia paid just 8.5 cents on the dollar because the U.S. government is backing the debt of the two largest mortgage-finance companies.

More than 160 banks and investors signed up to settle credit-default swaps tied to the Icelandic banks, according to the International Swaps & Derivatives Association website.

The net funds transferred may be about $7.6 billion, according to the Depository Trust & Clearing Corp., which operates a central registry for the $55 trillion credit-default swap market. Of the $71 billion gross notional value of credit- default swaps on the three banks, contracts on Kaupthing have a net value of about $3.8 billion, Glitnir has a net value of $2 billion and Landsbanki of $1.8 billion, DTCC said in a statement last week. New York-based DTCC will announce the final funds transfer when the contracts are settled Nov. 20, it said.

Hedge funds, insurance companies and banks typically buy and sell credit protection, which is used to insure a bond against default or as a bet against the company's ability to pay its debt.

A unit of Primus Guaranty Ltd., a Bermuda-based company that has sold more than $24 billion in credit-default swaps, said last month it guaranteed $68.2 million on Kaupthing. The firm also sold protection on $80 million of Lehman debt and $215 million of Fannie and Freddie debt. Primus said last month it had $820 million in cash and liquid investments to meet claims on the contracts.

To contact the reporter on this story: Abigail Moses in London Amoses5@bloomberg.net

Last Updated: November 3, 2008 11:44 EST