Oct. 6 (Bloomberg) -- Credit-default swap investors who sold protection on Fannie Mae and Freddie Mac senior notes will have to pay as much as 8.5 cents on the dollar to settle contracts after the biggest technical default ever, results of dealer auctions show.

Those who sold protection on the senior notes, considered among the safest in the companies' capital structures, would lose more than those who sold protection on the subordinated bonds because of an imbalance of demand for the subordinated debt. Contracts on subordinated debt will be settled with as little as 0.1 cents on the dollar changing hands.

``People are going to look at this and see CDS as not wholly representative of the economic interest of holding the bonds themselves,'' said Brian Yelvington, a strategist at independent fixed-income research firm CreditSights Inc. in New York.

The auctions by 13 credit swap dealers including JPMorgan Chase & Co. and Deutsche Bank AG placed a value on Fannie Mae senior unsecured notes at 91.51 percent of face value and the company's subordinated debt at 99.9 percent, according to Creditfixings.com, a Web site maintained by auction administrators Creditex Group Inc. and Markit Group Ltd. Freddie Mac senior notes were valued at 94 cents on the dollar and subordinated notes at 98 cents.

More than 650 investors and dealers had signed up to abide by the results of the auction.

Transparent Results

``The methodology is very well known,'' said Mazy Dar, Chief Strategy Officer at New York-based Creditex. ``The results could not be more transparent. Every last order that goes into this auction is published on a Web site. The final result for each auction reflects the natural supply and demand for the associated bonds.''

The auction comes as the decade-old market faces its biggest test after outstanding contracts grew more than 100-fold the past seven years as investors used the derivatives to speculate on the creditworthiness of companies, governments and consumers.

While the two companies didn't default on the actual bonds, the credit-default swap contracts were triggered after the government's seizure of the two companies last month. The contracts allowed buyers to demand to be paid if the companies were placed into a conservatorship.

The auctions are used to set a price by which investors can settle the contracts with cash rather than having to physically deliver a bond to their counterparties. Sellers of protection pay the face value of the contracts minus the recovery value set on the bonds.

Investors, CDOs

The settlement affects the biggest group ever of investors and so-called synthetic collateralized debt obligations that sold guarantees on the debt of the two mortgage finance companies, Morgan Stanley strategists led by Sivan Mahadevan wrote in a note to clients last week.

The International Swaps and Derivatives Association, which set the ground rules for the auctions, said the industry proved it could successfully handle such a large credit event.

``The very high participation rate in this protocol and its success in settling a significant number of credit derivative trades on the two GSEs constitute a major achievement for ISDA and for the industry,'' Robert Pickel, ISDA's chief executive officer, said in a statement.

Banks and investors are still dealing with the bankruptcy last month of Lehman Brothers Holdings Inc., among the top 10 counterparties to credit swap trades. Dealers will hold an auction Oct. 10 to determine the value of Lehman bonds. They're scheduled to hold one Oct. 23 to set the value for Washington Mutual Inc. contracts. One was held last week for Tembec Industries Inc., a unit of Montreal-based Tembec Inc., which filed for protection from U.S. creditors, to implement a debt restructuring plan.

To contact the reporter for this story: Shannon D. Harrington in New York at sharrington6@bloomberg.net;

Last Updated: October 6, 2008 18:39 EDT