I don't think the mortgage holder is likely to lose the full amount of the mortgage if it goes into default. Therefore, if $260 billion goes into default, the actual loss to the mortgage holder would be, I think, substantially less than $260 billion.
You need to check your math. Obviously the assets (houses) have some value to them. A more reasonable estimate would be as follows: 1.3 trillion in mortgages If 20% default, that means that 260 billion worth of mortgages are in default, not necessarily a total loss. Lets assume that the average mortgage is written down 30%. That brings up a total loss of 76 billion.
Okay, for those unfunded transactions, yes, you watch out for floating bodies as you say. Although generally in this case IBs will sign a CSA with the seller so that the seller is supposed to post collateral in an amount equal to the mark-to-market loss (in sort, this is a litle bit simplified). The riskiest swap would be one that is not done under CSA, since generally in this case the protection buyer will only be collateralized by - at best - an upfront amount. Meaning that the buyer faces huge recovery risk. For funded transactions, the whole transaction is obviously fully collateralized on day one so its essentially riskless for the protection buyer. In my opinion, the biggest risks right now for IBs lies with the monolines, who typically do not sign CSA and do no post collateral (their AAA/Aaa rating is all they have to offer as guarantee), but even so, the big monolines, with the exception of AMBAC, have almost all their exposure to super senior tranches, eg those least risky, so IBs do not take very high risk. If however these super senior tranches start defaulting, then the whole street goes burst.
good answer...we now await what mark-to-market really means....akin the Clinton's definition of what "is" is