April 22, 2010 / 5:01 PM / 10 years ago

UPDATE 2-Underwriters traded $27.5 bln CDS of Calif. debt

(Adds details, comments on Build America Bonds)

SAN FRANCISCO, April 22 (Reuters) - Six top underwriters of California debt have since 2007 completed over $27.5 billion of credit default swap trades on the state’s general obligation bonds, the California Treasurer’s office said on Thursday.

The disclosure marked the latest step in Treasurer Bill Lockyer’s inquiry into whether it is appropriate for the six banks that underwrite the state’s debt to also sell credit default swaps on it.

Lockyer is concerned the twin functions puts the banks in a position whereby they may bet against the state’s low credit rating and inflate the cost for California to issue debt.

The finding results from a letter sent last month by Lockyer to Bank of America Merrill Lynch (BAC.N), Barclays (BARC.L), Citigroup (C.N), Goldman Sachs (GS.N), JP Morgan (JPM.N) and Morgan Stanley (MS.N) expressing concern spreads on California CDS are mispricing the state’s credit risk and inflating interest costs.

Lockyer says the state’s low credit rating a poor gauge of California’s credit-worthiness since it has never defaulted on a debt service payment and is very unlikely to do so despite the state’s budget problems.

California paid the six banks a combined $215 million bond underwriting fees and commission, a statement by Lockyer’s office said.

CDS are used to hedge against default risk or to speculate on credit quality. The contracts were widely blamed for adding to fears about financial firms such as Lehman Brothers before it failed in 2008.

Lockyer’s office in its statement said the treasurer believes the CDS trading’s effect on bond prices is “not significant enough to cause concern at this time.” The statement underscored “at this time.”

“The data suggest the banks themselves, during the period covered, did not bet against the credit quality of California GO bonds,” the statement said.

“The low net face value of the banks CDS positions, on the surface, indicates the absence of any conscious decision to ‘short’ California GOs via the CDS market,” the statement added.

The statement said Lockyer will seek more information to clarify any “proprietary” trading by the six banks of California CDS and on any CDS plays on the state’s debt by bank clients that do not have California credit exposure.

Lockyer will also require the 86 firms in California’s bond underwriter pool to file quarterly reports providing detailed information on their CDS market activity.

Oversight of California CDS trading will be crucial if Build America Bonds (BABs) become a “permanent part of the municipal landscape,” the statement by Lockyer’s office said.

Created in the U.S. economic stimulus plan last year, BABs offer issuers a federal rebate equal to 35 percent of interest costs. The BABs program has proven popular with investors and President Barack Obama recently signed a law extending it past its ending date in December.

“BABs are taxable, and they are more akin to corporate bonds than traditional tax-exempt municipal bonds. CDS play a much more prominent role in the corporate bond market. The six banks agreed CDS likely will gain significance in the municipal bond market if the BABs program lives beyond its current 2010 sunset date,” the statement said. (Reporting by Jim Christie; Editing by Andrew Hay)

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