Goldman Sachs, Morgan Stanley, Barclays Capital, JPMorgan impact a state's borrowing costs by actively trading credit default swaps on the state bonds they underwrite. 

That's what California Treasurer Bill Lockyer is investigating, according to the WSJournal.  He asked all 86 of the state's bond underwriters to detail the volume of CDS's they traded on the state's $80 billion of G.O. bonds (general obligation) for the 3 months ended 1/31/11. 

        Municipality Concerns.   Since the muni CDS market is relatively illiquid, buying default protection can send the cost of that protection higher, sometimes pushing up borrowing costs for the relevant issuer - although there isn't always a direct correlation between the two.  And, so far Mr. Lockyer hasn't decided whether he will change the criteria for selecting underwriters based on their reported CDS activity.  Of course, California could penalize firms for facilitating bets against the state's credit.

California's Office of the Treasurer has found that financial firms have been facilitating bets on a California default even as they reaped fees for helping to manage state debt offerings.  Six firms said they had traded CDS's on California, whereas the other 80 reported no relevant bets. 

Bank of America and Morgan Stanley both said they had sold more protection on California debt than they had bought;  J.P. Morgan said it had bought more CDS protection than it sold. 

They claim that having a market for default protection on municipal debt helps attract potential investors in municipal-bond deals - because it gives investors the ability to hedge.  However, a spokesperson for Mr. Lockyer said that claim is "wholly unsubstantiated."

        What The Big Banks Reported.  Representatives of the banks declined to comment on the following trading statistics:

• Goldman reported $139 million of trades from 1/1 - 2/16, and a gross notional volume - accounting for all CDS bought and sold in the aggregate on California - of $4.3 billion through 1/31.  Goldman was the only one to say it was "not feasible to assess whether [it] is long or short exposure to State of California credit" solely on the basis of its CDS.

• Morgan Stanley reported $159 million of relevant trades from 11/25 - 2/25, and a gross notional outstanding of $2.53  billion.  As of 2/25, the firm was a net seller of $89.1 million of CDS protection.

• Barclays reported $10 million of trades from December to February, and a gross notional outstanding of $2.467 billion. That netted out to zero once all the contracts were offset.

• Citigroup reported $30 million of trades from 11/1 - 2/28, a gross notional outstanding of $1.92 billion as of 2/28, and a net notional $26.1 million outstanding to that point.  It didn't specify whether this net position left it long or short exposure to California credit.

• J.P. Morgan said it made a gross $18 million of trades in January and had a gross notional of $1.475 billion outstanding as of 1/31.  The firm bought a net $90.4 million of CDS protection on California, leaving it net short the state's debt.

• Bank of America Merrill Lynch said for the 3 months ended 1/31 it had entered $145 million of relevant trades for a gross notional outstanding of $1.87 billion.  It finished with a net long exposure to California credit of $65.5 million.

[WSJournal Credit Markets, 4/28]