U.S. seen probing if derivatives walloped banks

NEW YORK, Sept 25 (Reuters) - U.S. regulators are looking into credit derivatives as they investigate market manipulation, and some lawyers believe the government is looking at whether traders have used the products to help push banks closer to insolvency.

The Securities and Exchange Commission has said it wants to crack down on investors spreading rumors against financial companies. Lawyers said some traders could be using credit derivatives to harm financial firms more fundamentally than just rumors can.

For example, market participants can buy credit derivatives linked to a bank, boosting the cost of protecting the company's debt against default. That price action could lift a company's borrowing costs dramatically, particularly if combined with rumors of trouble at the company.

For financial companies, which typically borrow billions daily, any pressure on borrowing costs can sap their resources, further pushing them toward the brink.

Boosting a company's borrowing costs through credit derivatives is in some ways similar to short selling, which can also push a bank's shares lower, raising questions about the company's ability to raise equity capital. Those doubts can, in turn, bring ratings downgrades and higher borrowing costs.

"You can affect investors' perception of the company, and affect the company's credit-worthiness," said Andrea Kramer, head of the derivatives practice at law firm McDermott Will & Emery in Chicago.

The SEC declined to comment directly on its theory in this matter, but Scott Friestad, the SEC's deputy director of enforcement, told Reuters "There are a variety of ways that traders can profit from illegal activities and investing in credit default swaps is one of them." The SEC is looking at a number of issues in this area, he added.

Proving anybody behaved illegally will be difficult, lawyers said. The credit default swap market is big enough that any manipulation would have to come from multiple parties conspiring to lift prices and possibly spread rumors. Even more parties would be necessary to manipulate stock prices.

"If you're going to engage in manipulation, you do it when you don't think you'll get caught. To do it in this kind of market environment would be insane," said Bob Bernstein, a lawyer at Vandenberg & Feliu in New York.

WIDER AUTHORITY

But the SEC is determined to do something about market rumors in the credit derivatives markets. In a speech on Tuesday, Chairman Christopher Cox said there are "significant opportunities ... for manipulation" in the market, which he sees as "completely lacking in transparency and completely unregulated."

Cox urged Congress to provide the SEC with the authority to regulate credit derivatives. New York regulators on Monday argued that a segment of the credit derivatives market should be regulated as insurance contracts.

The SEC said late last week it was expanding its probe into market manipulation of financial institutions' shares to include credit derivatives. On Thursday, a source said more than two dozen hedge funds, broker-dealers, and institutional investors has been ordered to turn over information about their trades.

As part of its probe, it said it wanted hedge fund managers, broker dealers, and institutional investors that have taken positions in financial companies' credit to disclose their positions under oath to the SEC.

Regulators have been under heavy political pressure to crack down on the spreading of rumors about broker-dealers for months. That pressure intensified after Morgan Stanley (MS.N) and Goldman Sachs (GS.N), the remaining two U.S. investment banks, saw their share prices plummet last week.

In a memo to employees last week, Morgan Stanley CEO John Mack said that short sellers were pushing the company's shares down, and that he had spoke to U.S. Treasury Secretary Hank Paulson and the SEC's Cox about the matter.

Soon after that, the SEC announced a temporary ban in shorting financial stocks, and said it was expanding its probe into market manipulation. That probe had previously focused on traders spreading rumors to manipulate share prices, but is now widening to derivatives as well.

To Cox, credit derivatives are just another mechanism for shorting.

"Economically, a credit default swap buyer is tantamount to a short seller of the bond underlying the credit default swap," Cox said on Tuesday. (Additional reporting by Rachelle Younglai; Editing by Phil Berlowitz)