WASHINGTON — As the Senate moves toward finishing consideration of financial regulatory reform legislation this week, state treasurers are making last-minute efforts to change some of the bill’s muni-related derivatives and rating provisions, though it’s unclear if they were making any headway with lawmakers.
In a letter sent Sunday to Senate Banking Committee chairman Christopher Dodd, D-Conn., the National Association of State Treasurers warned about provisions that would restrict the ability of states to enter into interest-rate swaps.
Specifically, they said it would be “inappropriate” to impose a fiduciary duty on swap dealers that serve as counterparties to public entities, as is proposed in legislation to regulate over-the-counter derivatives that cleared the Senate Agriculture Committee last month and is to be merged with Banking Committee legislation.
“While swap counterparties and brokers must have a responsibility to determine the sophistication of the government entity and to determine the suitability of a swap transaction for that entity, it would be inappropriate to impose a fiduciary responsibility on swap counterparties and brokers,” NAST wrote in its letter, which was signed by James Lewis, NAST’s president and treasurer of New Mexico.
The group also insisted that the legislation standardize and impose adequate collateral and transparency requirements for credit default swaps, which, under pending legislation, would be regulated at the federal level like other derivatives contracts for the first time. Credit default swaps pay a buyer in the event of a default on debt, providing investors or traders a way to buy insurance against such a default, though there are no requirements that the CDS holders have any exposure to the underlying securities.
Industry officials contend such requirements would curtail market liquidity.
But in a brief interview, Utah Treasurer Richard Ellis, who stressed he was speaking for himself and not for NAST, warned that the credit default swap market is a “breeding ground for speculation and problems” because as the cost increases to bet that a particular issuer will default, the widening spread suggests the issuer may be more risky.
“Whether it is more risky or not, we create a frenzy in the market by [allowing investors to hold] positions without any skin in the game,” Ellis said. “It becomes a self-fulfilling prophecy.”
Issuer concerns about CDS come as state and federal regulators are questioning large investment banks about their involvement in municipal CDS, in an attempt to understand the extend to which the banks themselves use the derivatives to bet against the issuers whose securities they underwrite.
Late Friday, Massachusetts Secretary of the Commonwealth William Galvin sent letters to 12 top firms, including Goldman, Sachs & Co., Citigroup, and JPMorgan, asking for information that could help determine if they had undisclosed conflicts of interest by underwriting muni transactions while also trading muni CDS.
The Securities and Exchange Commission also is conducting an informal investigation of its own, the Wall Street Journal reported Friday. SEC officials declined to comment.
In addition, California Treasurer Bill Lockyer has written to banks asking for more information about the extent to which they help their clients use CDS to bet against the state’s credit, thereby raising the state’s borrowing costs.
Lockyer also has rating concerns. In a letter sent to Dodd Friday , he argued that financial regulatory reform legislation does not go far enough in requiring rating agencies to rate municipal and other bonds on the likelihood of default.
Lockyer’s letter comes in response to Standard & Poor’s proposal last week to separate and update its methodology for rating state credits, a move aimed at providing greater detail to clients that would be based on five broad categories: government framework; economy; budgetary performance; debt and liability profile; and financial management.
Panning the proposal, Lockyer wrote: “What the proposal brings into sharp focus, however, is that S&P’s methodology for rating state GO bonds is divorced from any accurate measurement of actual default risk. As a result, for investors who want to know the likelihood they will be repaid on time and in full, S&P’s ratings do nothing but mislead.”
A Standard & Poor’s spokesman noted that the likelihood of default is a “primary factor” in its ratings, citing the firm’s rating definitions document .
Lockyer’s letter to Dodd follows another one he sent April 30 calling for the financial regulatory reform bill 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.”
In that earlier letter, Lockyer also called for the bill to require buyers of municipal credit default swaps to have actual exposure to the issuer’s underlying securities.
Spokesmen for Dodd did not respond to requests for comment on the NAST and Lockyer letters yesterday.
Market participants said yesterday that they are concerned lawmakers have spurned the lobbying efforts of states and localities, warning that their attempts to influence the legislation come too late.
Peter Shapiro, managing director at Swap Financial Group, noted the derivatives legislation was not unveiled until the middle of April, and it has taken this long for state and local groups to analyze the proposal and formulate formal responses.
“The notion that they’ve given anyone adequate time to consider and comment was really absurd,” Shapiro said.
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