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By Aline van Duyn, US markets editorThu Sep 11, 2:20 PM ET

The experiences of those frazzled executives in charge of reducing risks in the credit derivatives market are starting to resemble Alice's adventures in Wonderland. Alice shrank after drinking a potion, but was then too small to reach the key to open the door. The cake she ate did make her grow, but far too much.

It was not until she found a mushroom that allowed her to both grow and shrink that she was able to adjust to the right size, and enter the beautiful garden. It took an awfully long time, with quite a number of unpleasant experiences, to get there.

Just as attempts by Alice to achieve the right fit have a seemingly endless number of unexpected consequences, every time it seems the unregulated $62,000bn credit derivatives beast is a step closer to being tamed, an unexpected horror crops up.

The urgency behind doing this is real. The Federal Reserve realised the systemic risks that lurk in the credit derivatives market when it bailed out Bear Stearns in March. It has made clear it wants these threats reduced.

Yet completely out of the blue, the market was this week hit by its biggest-ever default. The credit derivatives market is now "scrambling", as one of its biggest participants said to me, to cope with it.

The default has a particularly surreal air to it because the debt of the defaulted entities is actually in great shape. Indeed, it is arguably the safest debt on the planet. The defaulters are Fannie Mae (NYSE:FNM) and Freddie Mac, the US mortgage giants that on Sunday were embraced by the US government. They have a top-notch triple A credit rating, as they are now explicitly backed by Uncle Sam.

Yet, as part of their effective nationalisation - supported, incidentally, by the same regulators who worry about the market - Fannie Mae and Freddie Mac were taken over by a "conservator". This triggers bankruptcy clauses in credit derivatives contracts.

Although it is the biggest default, just how big is far from clear.

Best estimates are that anywhere between $200bn and $500bn of credit default swaps on Fannie Mae and Freddie Mac exist. I have also heard one dealer to speak of $1,000bn. That is a worryingly large range.

Even in the case of this very safe debt, the losses on credit insurance will probably be about 5 per cent. On $500bn, that amounts to a not insignificant $25bn. It could be more. Who wrote this insurance? Are these losses concentrated in the hands of a few insurance companies, or spread across the globe? Again, there are no definitive answers.

In any case, the 5 per cent estimate for losses is based on the current assumption that Fannie and Freddie recovery values will be 95 cents on the dollar. That could change depending on how the settlement of the defaulted CDS contracts goes.

A few further complications also exist. Fannie Mae and Freddie Mac are part of most synthetic collateralised debt obligations. Fitch Ratings estimates Fannie Mae or Freddie Mac are referenced in about 30 per cent of the synthetic CDOs it rates. Fitch analysts expect the defaults to have a "muted" effect, because the recovery rates are likely to be high. Again, though, such an outcome is not guaranteed.

Probably, the market can cope with the Fannie Mae and Freddie Mac debacle. Whether the settlement process goes smoothly or not will become clear in the next few weeks.

But what if something else happens? One executive put it to me like this, when I asked if there were preparations being made for a possible bankruptcy of a financial giant, such as Lehman Brothers. "We're too busy," was the answer, and it was not said as a joke.

"Down the Rabbit-Hole", the title of the first chapter of Lewis Carroll's book about Alice, is now widely used to describe an adventure into the unknown. Exciting as such a journey may be for individuals, this is a very worrying place for financial markets to be. The lack of hard numbers to measure the Fannie Mae and Freddie Mac impact is very troubling indeed.

Alice woke up from her dream, got up and walked away. We have to hope that there will be enough time for the credit derivatives market to do the same.

Aline van Duyn is the FT's US markets editor. aline.vanduyn@ft.com.

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