California says big banks downplay concerns about ‘default swap’ bets against state’s bonds

This article was originally on a blog post platform and may be missing photos, graphics or links. See About archive blog posts.

A lot of big numbers -- but no smoking gun.

That’s what California Treasurer Bill Lockyer says he has found, so far, in probing major Wall Street banks’ trading in so-called credit default swaps on the state’s municipal bonds.

Lockyer last month sent letters to six banking giants, including Goldman Sachs and JPMorgan Chase, questioning whether their activities in the swaps market could drive up the state’s cost of borrowing -- even as the banks earn lucrative fees from underwriting new state bond offerings.

Credit default swaps are a way for investors and traders to buy insurance against a default by a bond issuer. The cost of that insurance on California’s general obligation bonds had surged early this year, which indicated one of two things, or both: Some owners of the state’s debt were growing more fearful of a default, or speculators were pushing up swap insurance prices to foment worries about the state -- which, in turn, could make the insurance more valuable.

Higher swap insurance costs also could have the effect of forcing the cash-strapped state to pay higher interest rates to borrow than it otherwise would. That concern has aggravated Lockyer, who has insisted throughout the state’s budget travails that California would never default on its bond debt.

In a report Thursday, Lockyer said the six banks -- all of which are major underwriters of the state’s bond offerings -- have traded more than $27.5 billion of credit default swaps on the state’s debt since 2007. That figure covers buying and selling the banks did for themselves and their investor and trader clients, including hedge funds. The swaps could have been written against any of the state’s outstanding general obligation bonds, which now total $69 billion.

But beyond the big headline number, Lockyer said the data and answers the banks supplied to his inquiry about their swaps activity “suggest the banks themselves, during the period covered, did not bet against the credit quality of California general obligation bonds.”

As for the question of the swaps market’s effect on the state’s interest costs, Lockyer’s report said it found that any effect “is not significant enough to cause concern at this time,” although the report underlined the last three words.

In what could be a landmark legal case, the Securities and Exchange Commission last week charged Goldman Sachs with fraud in connection with a subprime-mortgage-related investment the bank sold in 2007. The SEC alleges that Goldman failed to disclose that it allowed hedge fund manager John Paulson to help pick securities for the investment, knowing that Paulson also planned to bet against the securities via credit default swaps.

Lockyer on Thursday didn’t resist the urge to take a shot at the banks. Besides Goldman and JPMorgan, his inquiry covered Bank of America Merrill Lynch, Barclays, Citigroup and Morgan Stanley.

“These banks told us that the credit default swaps market can bring some benefit to California because it increases liquidity and makes our bonds more attractive to investors” by allowing them to hedge against risk, the treasurer said in a statement. “That may, or may not, be true. . . . Taxpayers’ primary operating principle should be this: Look out when Wall Street says it’s looking out for you.”

Lockyer also said he wanted more data on the role of speculators who may use credit default swaps to bet against California’s debt even though they don’t own any of the bonds.

“More information is needed to determine the extent to which the banks’ clients who have no California credit exposure have placed speculative bets with California credit default swaps, and the extent to which the banks have facilitated those bets,” the treasurer’s report said. It said the state would ask the banks for that information -- and would require all 86 banks that regularly underwrite the state’s bond sales to report to Lockyer quarterly on their swaps activities.
-- Tom Petruno