California Treasurer Bill Lockyer said he wants regulators to prohibit municipal credit-default swaps because of concern that investors may use the instruments to manipulate the market and cost state taxpayers.
Lockyer, 69, said he would ban credit-default swaps, a type of derivative used to protect debt-holders against default, if he had the authority. He’s called on regulators to adopt capital-margin requirements to reduce leverage and to prohibit the speculative use of credit-default swaps -- the trading of debt-insurance contracts by investors who don’t own the securities.
“I’d just ban them if I could,” Lockyer said in an interview at Bloomberg’s headquarters in New York today.
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. California is the largest issuer of U.S. municipal debt, with more than $30 billion of sales in 2009.
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.
Lockyer is a Democrat who faces re-election in November. He started a probe in March into whether speculative trading of credit-default swaps on state bonds had raised California’s debt costs by creating an unjustifiably negative perception of the issuer’s default risk.
California’s constitution gives debt service the second priority after education in drawing from the $88 billion general fund. The state has never missed a bond payment.
“I’m partially perplexed and partially worried about some future potential for some market mischief,” Lockyer said. “I’m perplexed because I don’t know why anyone would buy CDS. I understand why people hedge, but if you are hedging against default risk, every serious analyst says that the likelihood of California debt default is zero.”
The insurance contracts pay off if a borrower fails to meet its debt agreements.
The price of credit-default swap contracts on California bonds maturing in 10 years has fallen to about $270,000 to protect $10 million of bonds, from above $350,000 in June, according to data compiled by Bloomberg.
“CDS spreads suggest the potential for default currently is 50 percent,” Lockyer said. “That’s crazy. The only reason I can imagine that someone would want to buy that is to sell it to a bigger fool next. Otherwise it doesn’t make any sense to me at all.”