California’s Lockyer Seeks Curbs on ‘Naked’ Swaps

California Treasurer Bill Lockyer said U.S. and international financial regulators should limit trading of municipal credit-default swaps to help prevent speculative, or “naked,” trading of the derivatives.

Lockyer, a Democrat, said lacking an outright ban on speculative use of credit default swaps -- the trading of debt- insurance contracts by investors who don’t own the securities -- regulators should adopt capital-margin requirements to reduce leverage and prevent abuses.

“The municipal CDS market, when used by bondholders to hedge risk, can benefit issuers by increasing demand for bonds,” Lockyer, who earlier sought a ban on speculative trading of municipal credit default swaps, said today in a statement. “But naked trading of CDS by investors who don’t own California bonds poses a potential danger to taxpayers.”

The growth of credit default swaps has raised questions among officials including Lockyer about whether Wall Street banks that are paid to underwrite their bonds also profit by arranging or promoting bets against them. Credit-default swaps tied to subprime home loans amplified the financial crisis that struck more than two years ago.

There were $31 trillion of credit-default swaps outstanding in the first half of 2009, more than double the level four years earlier, according to the International Swaps and Derivatives Association.

Request to Banks

Lockyer in April asked six banks -- Bank of America Merrill Lynch, Barclays Plc, Citigroup Inc., Goldman Sachs Group Inc., JPMorgan Chase & Co. and Morgan Stanley -- to describe the extent to which they market the default contracts and asked them to explain how trading in the instruments affects interest costs on the state’s bonds. California is the largest issuer of U.S. municipal debt and has the lowest credit rating of the 50 states.

In May, Lockyer asked the banks to say whether they bet against the state with credit default swaps and how much swaps are sold to investors who don’t own the debt. Lockyer said he was concerned that speculative trading could boost borrowing costs if the transactions create an unjustifiably negative perception of California’s risk of default.

‘Unchecked Speculation’

“Unchecked speculation opens the door to market manipulation that could artificially inflate perceived credit risk and increase taxpayers’ borrowing costs on bonds,” Lockyer said today. “Reducing leverage opportunities will make it harder for speculators to game the system and hurt taxpayers.”

Moody’s Investors Service grades California debt at A1, its fifth-highest rating. Standard & Poor’s gives it an A-, its seventh-highest.

Lockyer said the responses he got from the banks show they traded $27.5 billion of credit default swaps on California state bonds since 2007 and that the trading’s effect on bond prices wasn’t significant enough to cause concern at this time. The six banks earned a combined $215 million in fees for underwriting state debt since 2007, Lockyer said.

The price of credit-default swap contracts on California bonds maturing in 10 years has fallen to about $275,000 to protect $10 million of bonds, from $350,000 in February, according to data compiled by Bloomberg.

German Chancellor Angela Merkel’s Cabinet on June 2 backed a ban on naked short-selling of credit-default swaps on euro- area government bonds and shares of German companies.

The U.S. Congress is considering additional regulations for the finance industry, including capital-margin requirements for swap dealers.

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