California has asked large banks that underwrite the state’s bond sales to detail their trading in credit default swaps on its debt, raising fresh questions about whether derivatives play a disruptive role in financial markets.
Bill Lockyer, the state’s treasurer, wrote to the heads of Bank of America Merrill Lynch, Barclays , Citigroup, Goldman Sachs, JPMorgan and Morgan Stanley to question their activity in credit default swaps (CDS) and whether it has an impact on state borrowing costs.
“I have no preconceived notions about the effect of CDS trading on California GO [general obligation] bond prices, or about your firm’s activities in the California CDS market,” Mr Lockyer said in the letters.
“I do, however, worry about firms selling our bonds, on one hand, and trading CDS on our bonds, or otherwise participating in that market, on the other.”
Mr Lockyer is also concerned that California CDS levels overstate the risk of default and that they could drive up the interest rates the state pays on its debt.
CDS are an insurance policy on debt that pays out in a default. Although this market began as a way for banks and investors to hedge their risk to any one debt issuer, CDS also allows investors to speculate on the future prospects of a debt issuer.
This market dynamic has been blamed for exacerbating the financial trouble of debt issuers ranging from Lehman Brothers to Greece.
California, which has the lowest credit rating of any US state, is also the biggest issuer of state debt.
Municipal issuers, led by California, have increasingly sold taxable debt since the financial crisis. The $2,800 billion “muni” bond market is exempt from US taxes, making this investment attractive mostly to wealthy US individuals.
To reduce borrowing costs from crisis levels, the Obama administration has subsidized taxable municipal bonds, known as Build America Bonds, outside the traditional muni bond market. This has attracted large institutional investors who had not played in this market before.
In his letter, Mr Lockyer asks for a view on how the development of Build America Bonds could increase the use of municipal CDS, which is small relative to the rest of the market.
Matt Fabian, managing director at Municipal Market Advisors, a research group, said: “The prospect is that [Build America bonds] will build a better link between muni bonds and CDS prices.”
Mr Lockyer wants a response by April 12. The banks declined to comment.