Thursday, April 22, 2010

California heightens scrutiny on CDS

Original posted in the FT by Nicole Bullock:

California, the largest issuer of state debt in the US, said on Thursday it would require the 86 firms that underwrite its bond sales to report quarterly with details on their activity in credit default swaps, potentially lifting the veil on a largely unregulated market.

The salvo comes as the derivatives industry has come under scrutiny for fuelling not just the financial crisis of 2008, but recent bouts of distress such as the Greek debt crisis. Last week, the Securities and Exchange Commission charged Goldman Sachs with fraud related to a complex transaction involving CDS.

Preliminary conclusions of an initial query into the CDS trading at its largest underwriters, which have earned fees and commissions of $215m from the state since 2007, showed the effect of CDS trading on bond prices was not “significant enough to cause concern at this time”, and that the banks themselves were not betting against California bonds.

But these findings did not allay the concerns of Bill Lockyer, the state treasurer, who intends closely to monitor bond underwriter’s CDS trading activity.

“We’re not going away . . . The potential for harm exists, and the danger will only grow in the evolving municipal bond market,” he said.

Mr Lockyer is concerned at banks simultaneously selling California’s bonds and betting or facilitating bets against them. CDSs pay out when the issuer defaults.

He is also worried California CDSs overstate the state’s credit risk, which could lead to higher borrowing costs.

Last month, California called on banks to detail their trading in the market for municipal CDSs, which is small relative to credit protection traded for corporations and sovereigns. The recent popularity of taxable municipal bonds is expected to increase CDS activity.

Most of the $2,800bn (€2,100bn, £1,820bn) market for “munis”, where state governments and municipalities raise money for public projects, is tax-exempt. That makes the bonds largely attractive to wealthy US individuals and not the money managers who typically trade CDSs.

Since 2007, the top six fee-earners among the investment banks that sell California’s debt – Bank of America Merrill Lynch, Barclays, Citigroup, Goldman, JPMorgan and Morgan Stanley – completed more than $27.5bn of CDS trades. This equals 63.2 per cent of the $43.5bn of general obligations bonds the state issued. The volume includes trades for the banks and clients, such as hedge funds, broker-dealers, insurance companies and banks.

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