Sept. 27 (Bloomberg) -- New York Attorney General Andrew Cuomo's investigation of short selling has been expanded to include trading in the $54.6 trillion credit-default swaps market, according to a person in his office.

Cuomo is probing whether credit-default swaps were manipulated by short sellers to spread false rumors about financial companies such as bankrupt securities firm Lehman Brothers Holdings Inc. to drive down stock prices, the person said, asking not to be identified by name.

Cuomo likely wants to know if the credit-default swaps are fueling the failures of financial institutions including Lehman Brothers and mortgage companies Fannie Mae and Freddie Mac, said Anthony J. Carfang, a partner at Treasury Strategies Inc., a Chicago-based consulting firm.

``You have a set of people doing this trade and they're targeting one company at a time,'' Carfang said yesterday in a phone interview. ``When Fannie Mae goes under, they move on to the next target, which was Lehman Brothers, and now you see them in Wachovia and Morgan Stanley.''

Credit-default swaps on both Wachovia Corp., the fourth- largest U.S. bank, and Morgan Stanley reached record highs yesterday, suggesting investors are betting on a failure or hedging against losses.

Regulating Swaps

Several regulators are focusing on credit-default swaps to see if the bets are fueling the global financial crisis. U.S. Securities and Exchange Commission Chairman Christopher Cox said Sept. 23 that Congress should immediately grant authority to regulate the swaps, which investors use as insurance against a drop in the value of investments, such as bonds.

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

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 also has subpoenaed hedge funds in New York, Texas and London as part of the probe, the person said.

Information Sought

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

Cuomo may not find much evidence of collusion because of volatile swings in credit-default swap costs that would have made shorting the companies expensive, said Tim Backshall, chief strategist at Credit Derivatives Research LLC in Walnut Creek, California.

``I really don't think this was widespread, even if it was happening at all,'' Backshall said in a phone interview. ``Claiming CDS were the cause is just ridiculous.''

Lehman filed for bankruptcy protection Sept. 15. Goldman Sachs and Morgan Stanley said this week they are converting to bank holding companies.

Cuomo said last week he was also looking at short sales involving Merrill Lynch & Co., which agreed to sell itself to Bank of America; American International Group Inc., which averted collapse last week by agreeing to a federal takeover, and Washington Mutual Inc., whose assets were sold to JPMorgan after U.S. regulators seized it Sept. 25.

William Leone, former U.S. Attorney for Colorado, now a partner at Faegre & Benson LLP in Denver, doesn't think a probe of credit-default swaps is suited to a state regulator.

`National Approach'

``This doesn't strike me as something a state attorney general's office is very well equipped to investigate,'' Leone said in a phone interview. ``What's needed is a national approach.''

Cuomo announced Sept. 18 he was also investigating short sales of Morgan Stanley, Goldman Sachs and other financial firms to see if the sellers spread false information to push down stock prices. He said his probe also would examine trades of Lehman and AIG. The probe would focus on financial companies whose shares suffered ``precipitous'' drops in mid-September as a result of predatory practices, Cuomo said.

The expansion of the probe to include credit-default swaps was first reported yesterday in the Wall Street Journal.

Morgenthau's Probe

Morgenthau's probe includes a focus on credit-default swaps as well as representations short sellers may have made to drive stocks down, according to Daniel Castleman, chief assistant Manhattan district attorney, who would not identify the companies involved.

``It's very preliminary,'' Castleman said.

Judith Czelusniak, a spokeswoman for Bloomberg LP in New York, said the company received a subpoena from Cuomo. She declined to comment further.

Caroline Lumley, a spokeswoman at Markit Group Ltd. in London and Depository Trust spokeswoman Judy Inosanto declined to comment.

Short sellers try to profit by betting stock prices will fall. In a short sale, traders borrow shares that they then sell. If the price drops, the brokers pocket the difference when they buy back the stock and return it.

In a practice called naked short selling, traders never borrow the shares, raising the risk that flooding the markets with sell orders will drive down prices.

Investors may buy credit-default swaps to bet that a company's financial condition will worsen. The contracts pay the holder face value for the underlying securities or the cash equivalent should a company fail to repay its debt. The instruments' value increases as investor perception of the company's stability deteriorates.

To contact the reporters on this story: Karen Freifeld in New York at kfreifeld@bloomberg.net; Shannon D. Harrington in New York at sharrington6@bloomberg.net

Last Updated: September 27, 2008 00:01 EDT