Hedge funds count the cost of trading losses

Hedge funds and banks are expected to bear the brunt of derivative losses estimated at $15bn (£9.4bn) linked to the collapse of Iceland's three major banks - Landsbanki, Glitnir and Kaupthing - which failed in rapid succession last month.

The complex unwinding of trades linked to debt issued by the banks began yesterday with a settlement auction to determine the payout price on credit default swap (CDS) contracts - insurance taken out against the risk of debts going bad - for Landsbanki.

Payouts on all three banks are expected to be some of the largest ever seen in the $54.6tn CDS market - greater than those relating to Lehman Brothers, whose collapse triggered the meltdown of the global financial system.

The high settlement prices for Icelandic bank CDSs will be a blow to hedge funds, banks and other derivative traders who insured the debt.

The payout price for those firms that sold insurance on Landsbanki debt was set at 98.75 cents in the dollar - higher than market expectations. According to the Depository Trust & Clearing Corporation, net outstanding Landsbanki CDSs amount to $1.8bn, implying losses of $1.78bn.

"I didn't expect [the payout price] to be quite that high," said Michael Hampden-Turner, credit strategist at Citigroup. "I think this result implies the settlements will be pretty high for Glitnir and Kaupthing as well."

Among those having indicated an interest in Icelandic bank CDS settlements are Royal Bank of Scotland, Barclays, HSBC, Standard Chartered and hedge funds Citadel, RAB Capital and Tudor. It is not clear which firms have incurred CDS losses and which have received payouts.

In addition to £1.78bn losses on Landsbanki, analysts estimate losses of a similar scale are likely to be incurred on hybrid credit derivatives known as synthetic collateralised debt obligations (CDOs).

The payout price on Glitnir CDS contracts will be set today and on Kaupthing tomorrow. If prices are set at similar levels to Landsbanki, combined losses would reach $7.5bn - more than the $5.2bn payouts on Lehman CDSs. Add in estimates for related CDOs and losses could reach $15bn.