California Treasurer Bill Lockyer has sent a letter to six big banks that underwrite the state's municipal bond sales, asking what the banks' role may be in also selling credit default swaps on Californian debt.
The letter to Bank of America Merrill Lynch
I have no preconceived notions about the effect of CDS trading on California (general obligation) bond prices, or about your firm's activities in the California CDS market, said the letter.
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.
Taxpayers have a right to know, Lockyer added.
JPMorgan Chase, Barclays, Goldman Sachs and Citigroup declined to comment. Morgan Stanley said it is reviewing the letter and has no comment.
A Bank of America representative was not immediately available.
Credit default swaps are used to insure against potential default or to speculate on the creditworthiness of an issuer. The contracts were widely blamed for adding to fears about financial firms such as Lehman Brothers before it failed in 2008.
California's CDS have been trading wider than spreads on countries including Kazakhstan and Croatia, said Lockyer.
California's five-year credit default swaps were trading at about 200 basis points early Tuesday, according to Markit Intraday. That means it costs $200,000 a year to insure $10 million of debt for five years.
Swaps on Kazakh debt were trading at 170 basis points, while CDS on Croatian debt was trading at 188 basis points, according to Markit.
Swaps on Californian debt have been widening for the past year as it struggled with a fiscal crisis, peaking above 340 basis points last June as the state issued IOUs to suppliers.
Yet, California has never defaulted on a debt service payment in its history and is very unlikely to do so in the future, said Lockyer.
California's general obligation debt is backed by the full faith and credit and taxing power of the world's eighth-biggest economy, he wrote.
What's more, the state's constitution places debt service in second place after payments to schools, providing another cushion of safety to bondholders.
Lockyer said that despite the security-plus backing of California GOs, and our spotless record of paying our debt on time and in full, market participants actively buy and sell credit default swaps on our bonds.
Still, California's persistent fiscal problems have led the major ratings agencies to assign it the lowest ratings of any U.S. state. Moody's Investors Service rates it at Baa1, or three notches above junk status. Standard & Poor's rates it at A-minus, or four notches above junk, while Fitch Ratings rates it at BBB, placing it two notches above junk.
(Reporting by Ciara Linnane; Additional reporting by Dan Wilchins, Steve Eder, Joe Rauch and Maria Aspan; Editing by Padraic Cassidy)