The treasurer of California, the largest municipal bond issuer in the nation, is urging federal lawmakers to amend the pending financial regulatory reform bill to require buyers of municipal credit default swaps to have actual exposure to the issuer’s underlying securities.
Bill Lockyer made the request in a
Lockyer also asked lawmakers to amend the legislation, which is currently under consideration in the Senate, to require that credit ratings be based on the risk of default and to eliminate a provision that would allow the rating agencies to use “distinct sets of symbols to denote ratings for different types of securities.”
The letter came after the California treasurer gathered information from the six largest bank underwriters of state debt and their trading of municipal credit default swaps. CDS pay a buyer in the event of a default on debt, providing investors or traders a way to buy insurance against such a default.
The banks collected a total of $215 million in underwriting fees from California since 2007 and traded state CDS with a notional value of $27.5 billion from 2007 to March 31. Lockyer’s concern was that the banks might be using the CDS to bet against the state, ultimately driving up its borrowing costs.
A report he issued on April 22 found CDS trading had not had a significant impact on the state’s bond prices.
“But one thing seems clear,” he said in the letter sent Friday to federal lawmakers. “Speculative trading of municipal bonds creates the potential for distorting the true credit risk of those bonds and, as a result, can increase taxpayers’ borrowing costs without cause. The potential harm is real. And the danger will only grow if the Build America Bonds program becomes permanent, as we hope it will, and the municipal bond market takes on more of the attributes of its corporate bond counterpart.”
Lockyer added: “The potential harm outweighs any perceived benefits produced by speculative municipal CDS trading.”
However, if buyers of CDS have actual exposure to the underlying issues’ credit, then municipal CDS trading “can serve legitimate hedging purposes,” he said.
“It is not the intent of this suggested amendment to eliminate such hedging trades,” the treasurer stressed. Speculative trading is another matter, he added.
“Taxpayers and working families have borne the brunt of the economic meltdown. They shelled out billions of dollars to bail out investment banks. They deserve the assurance that their financial interests are not subject to casino-like betting on their bonds,” he told the lawmakers.
In an effort to ensure municipal bonds are not unfairly rated lower than comparable corporate debt with higher default rates, financial regulatory reform legislation would require agencies to apply their symbols consistently across all types of securities, Lockyer said. It also would require the Securities and Exchange Commission to write rules ensuring the rating agencies “assess the probability” that issuers will default on their debt. However, it would not explicitly require that ratings be based on the risk of default.
While Moody’s Investors Service and Fitch Ratings have recalibrated their municipal ratings to more closely reflect default risk, “substantial discrepancies remain between the defaults of municipal issuers and corporate issuers with the same or higher ratings,” Lockyer said. “And nothing prevents these agencies from reversing course, or prevents any new agencies that may enter the market from adopting discriminatory ratings practices.”
As a result, it is important that Congress adopt a more explicit requirement that ratings be based on the risk of default, he said.
