Oct. 20 (Bloomberg) -- The U.S. government and New York Attorney General Andrew Cuomo opened a joint investigation into the $34.8 trillion credit-default swap market, the top federal prosecutor in New York said.

The probe seeks to ``determine whether any federal laws have been violated'' in the market for the swaps, which function as a kind of insurance contract for bond losses, and will complement an earlier inquiry by Cuomo's office, U.S. Attorney Michael Garcia in Manhattan said today in a statement.

Cuomo has been probing credit-default swap manipulation by short sellers allegedly spreading false rumors about financial firms. Prosecutors are looking at whether they attempted to drive down stocks, including bankrupt Lehman Brothers Holdings Inc., according to a person in Cuomo's office who declined to be identified. The U.S. is also probing Lehman's failure.

``They're going to look at those individual traders who are responsible for these products and to find out whether or not they were deliberately manipulated,'' said Ralph Fatigate, former director of investigations at the New York State Banking Department and now a consultant at BDO Seidman LLP. ``It's an unregulated area.''

Credit-default swaps, conceived by bondholders, allow investors to buy protection against a possible default by a company. As the market expanded, speculators started using them to bet on a company's credit worthiness. The contracts pay the holder face value for the underlying securities or the cash equivalent should a company fail to repay its debt.

100-Fold

While growing 100-fold during the past seven years, total outstanding contracts in credit-default swaps remain dwarfed by other derivatives markets, including those that make bets on interest rates. Those markets had contracts linked to about $465 trillion as of June 30, according to the International Swaps and Derivatives Association.

The joint probe announced today will also examine allegations of insider trading, market manipulation and other forms of fraud, according to a second person familiar with the inquiry who declined to be identified. Garcia, 47, and Cuomo, 50, took the unusual step of working together in part because there is no central clearinghouse for swap data, the person said.

Cuomo has sought trading data from the New York Stock Exchange and the Financial Industry Regulatory Authority, according to the person.

Richard Adamonis, a spokesman for the NYSE, and Herb Perone, a spokesman for FINRA, declined to immediately comment.

Over-The-Counter

The absence of regulation in over-the-counter markets such as credit-default swaps was the ``principal cause'' of the meltdown on Wall Street last month, New York Governor David Paterson has said. There were at least $34.8 trillion of credit- default swap trades outstanding as of Oct. 9, the Depository Trust and Clearing Corporation, which operates a central registry for the derivatives, said in a statement last week.

``By combining the resources, expertise, and legal authorities of the two offices, we are taking a comprehensive approach to this important issue,'' Garcia said today of the joint probe.

Separately, New York State's insurance regulators began overseeing part of the credit-default swaps market Sept. 22. Manhattan District Attorney Robert Morgenthau has opened an investigation of the swaps market as well, his office said.

Three Companies

Cuomo on Sept. 25 subpoenaed three companies that provide price and trading data on the credit-default swaps market: Markit Group Ltd., Depository Trust & Clearing Corp. and Bloomberg LP, the parent of Bloomberg News, according to the person in his office. Cuomo has also subpoenaed hedge funds in New York, Texas and London as part of the probe, that person said.

The office is seeking information on transactions since July 1 involving Lehman, Goldman Sachs Group Inc. and Morgan Stanley, the person said.

``The probe will bring together top prosecutors from both offices while simultaneously avoiding multiple competing investigations,'' Cuomo's spokesman, Alex Detrick, said in an e- mailed statement.

``This is going to be a very arduous investigation for both the U.S. Attorney and for the attorney general because these are complex transactions,'' said Fatigate. ``If this is part and parcel to the demise in the system, somebody needs to fix this.''

Cuomo and Garcia decided to collaborate about 3 weeks ago, according to the person familiar with the case. Members of Cuomo's investor protection bureau are working with Garcia's securities fraud task force and in the process of cross- designating attorneys so state prosecutors can become special federal prosecutors with access to grand jury material, the person said.

To contact the reporters on this story: David Glovin in U.S. District Court, Southern District of New York, Manhattan, at dglovin@bloomberg.net.

Last Updated: October 20, 2008 16:09 EDT