At 2pm New York time,the settlement auction for $400 billion of credit default swaps connected to bonds issued by Lehman Bros (NYSE:LEH) is due. This opaque derivatives market is a mystery to most investors. Dave Gonigam says the revelation of major losses is the last thing the market needs right now.

This from The Daily Reckoning:

I don’t particularly buy into the talk gurgling across the Internets that the whole worldwide banking system is going to freeze up this month, rendering your ATM card inoperable.  But if it were to go down, tomorrow’s as good a day as any.

Tomorrow is the settlement auction for $400 billion of credit default swaps connected to bonds issued by Lehman Bros (NYSE:LEH).

Actually, this whole month is a minefield of settlement days for toxic derivatives — Fannie (NYSE:FNM) and Freddie (NYSE:FRE) last Monday, Lehman tomorrow, Washington Mutual two weeks from today.

The Fannie and Freddie auction passed without incident, perhaps because the Treasury explicitly stands behind Fannie and Freddie’s debt.  Too, the Fannie and Freddie default claims totaled “only” about $50 billion.  But $400 billion of Lehman paper with no government guarantee?

There’s no telling what will happen, considering what the Financial Times reported last week in a story previewing these auctions:

Because of the opacity of this market, it is still not clear how many contracts have to be settled and whether payouts on the defaulted contracts, which could reach billions of dollars, are concentrated with any particular institutions.

According to dealers, insurance companies and investors such as sovereign wealth funds, which are widely believed to have written large amounts of credit protection through credit default swaps on financial institutions, could have to pay out huge amounts.

But the Lehman cards will be laid on the table tomorrow.  At least one reporter suspects the primary reason the credit markets have come to a near-standstill is that institutions are cashing up for tomorrow.  (Taken to its logical conclusion, you could even say it’s the reason gold is down today.)  If that’s the case, and the various and sundry counterparies have adequately cashed up, we’ll come out unscathed.

At least until the Washington Mutual auction in two weeks.  Whatever the outcome, it might be time to consider a “paddle strategy.”

PS. Last month Money Morning’s Shah Gilani called the $62 trillion CDS market a “ticking time bomb.” This is what he had to say:

“There are credit default swaps written on subprime mortgage securities. It’s bad enough that these subprime mortgage pools that banks, investment banks, insurance companies, hedge funds and others bought were over-rated and ended up falling precipitously in value as foreclosures mounted on the underlying mortgages in the pools.

What’s even worse, however, is that speculators sold and bought trillions of dollars of insurance that these pools would, or wouldn’t, default! The sellers of this insurance (AIG is one example) are getting killed as defaults continue to rise with no end in sight.”

Source: The $400 Billion Trigger?