SAN FRANCISCO — California’s big underwriters make markets in credit default swaps on the biggest municipal issuer’s general obligation bonds, but they don’t seem to be betting against the state.

That’s the conclusion an investigation by California Treasurer Bill Lockyer into the emerging municipal CDS market. Lockyer last month demanded that six big banks — which collected a total of $215 million in underwriting fees from the state since 2007 — explain their participation in the market for California CDS and its impact on the state’s borrowing costs.

The six banks — Bank of America Merrill Lynch, Barclays Capital, Citigroup, Goldman, Sachs & Co., JPMorgan, and Morgan Stanley — told the state they traded California CDS with a notional value of $27.5 billion from 2007 to March 31, 2010.

That’s enough to insure 63.2% of the $43.5 billion of bonds the state issued during the period, or 39% of the state’s $70.4 billion of outstanding GOs at the end of fiscal 2009.

The investigation did little to explain the impact of the CDS on the state’s borrowing costs, but it offers a glimpse into an emerging market that some worry could lead to speculation and short-selling.

“We will remain vigilant in protecting taxpayers’ interests,” Lockyer said in a statement. “The potential for harm exists, and the danger will only grow in the evolving municipal bond market.”

A credit default swap is an insurance policy against default by a bond issuer. They’re common in the taxable bond market but a relatively new phenomenon in the municipal marketplace, where bond insurers traditionally played the role of guarantor of muni credits.

The seller of a CDS contract agrees to pay the buyer the par value of a bond in the case of default.

Theoretically, the CDS market helps investors reduce the risk in their bond portfolios and could reduce their anxiety about buying the bonds issued by California — the lowest-rated U.S. state.

“We believe that the existence of a CDS market with respect to California GO bonds may have encouraged participation in the GO bond market,” John Lawlor, chairman of municipal markets at B of A Merrill, said in a letter to Lockyer.

While Lockyer’s investigation found that trading in CDS hasn’t yet had a “significant” impact on the state’s bond prices, he remains skeptical.

“These banks told us the CDS market can bring some benefit to California because it increases liquidity and makes our bonds more attractive to investors,” he said. “What we know is Wall Street has a bad habit of turning even good things into catastrophe.”

While CDS allow bond investors to hedge credit risk, they also allow investors to short the state’s credit by buying CDS without buying the underlying bonds. Their investments rise in value as the state’s creditworthiness falls.

As in most CDS markets — where the supply of credit protection often far outstrips the actual amount of bonds outstanding — portfolio hedging doesn’t seem to be the only driver of trading in California CDS, which remains a small market by CDS standards.

“Most CDS trading is not motivated by an expectation of default but rather by a view on credit spreads,” Jack DiMaio and Stratford Shields, managing directors at Morgan Stanley, said in a letter to Lockyer. Morgan Stanley was the most active CDS trader in California’s underwriting pool with $9.4 billion of trades.

The banks listed commercial banks, broker-dealers, hedge funds and insurers, including monoline bond insurers, as participants in the California CDS market.

Goldman Sachs chief executive officer Lloyd Blankfein said 63% of his firm’s California CDS trade volume came from banks or broker-dealers and 31% from hedge funds. Money managers and insurers together accounted for just 5% of the volume.

The muni CDS market is likely to continue to grow, according to the banks, spurred in part by the popularity of the taxable Build America Bond market and by the declining use of bond insurance.

BABs make CDS more popular because taxable investors are more accustomed to using them.

“With the advent and potential extension of taxable BABs, it is possible that the trading volume of state of California CDS will increase substantially,” Howard Marsh, head of Citigroup’s muni securities division, said in his letter to Lockyer. “Because municipal bond insurance remains limited and/or cost-prohibitive, taxable bond investors also may have fewer alternative means to manage their portfolio risk.”

Lockyer will require all 86 municipal bond underwriters that do business with the state to file quarterly reports on their credit default swap activities as part of the price of entry into California’s underwriting pool.

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