U.S., New York Officials Probe Credit Default Swap Market

By and | October 21, 2008

Federal and New York state prosecutors have launched an investigation of the credit default swap market, inquiring whether speculators had manipulated CDS transaction data to put more pressure on the shares of banks weakened by the credit crisis.

On Monday the offices of Michael Garcia, the federal prosecutor for Manhattan, and New York Attorney General Andrew Cuomo told Reuters they have joined forces to investigate CDS, a $55 trillion market that is virtually unregulated.

Representatives of the state and U.S. prosecutors declined to comment on companies or individuals being scrutinized.

Initially, prosecutors want to see whether investors drove up prices of CDS transactions that were reported to data providers but never actually completed. Widening CDS spreads, indicating a higher risk of default, hammered the stocks of banks during the past year and spooked their clients.

Over time, the investigation will expand to also include the role of interdealer brokers as well as other potential areas of fraud, a person familiar with the investigation said.

“What started out as a useful and important market to allow individuals to hedge and spread risk has over the years become a shadow market, where traders could engage in certain conduct they could not have engaged in in regulated markets,” the person said.

Bank stockholders and executives have complained this year that short-sellers — investors who profit when a company’s stock falls — were using CDS markets to achieve their goals.

About a month ago, after receiving numerous complaints, Cuomo and Garcia agreed to join forces.

“The efforts of the U.S. Attorney’s Office, whose primary role will be to determine whether any federal laws have been violated, will serve to complement the broader mandate of the Attorney General’s Office,” Garcia’s office said.

Cuomo’s office said it has issued subpoenas seeking data from a range of financial market firms, including stock exchanges, hedge funds and three companies that process swap trades: clearing agent Depository Trust Clearing Corp, CDS data provider Markit, and market data company Bloomberg LP.

CDS function as insurance that bond buyers purchase to protect themselves against a default. As more investors relied on CDS data to judge a company’s financial health, rising CDS prices sent bank stocks plunging and disrupted trading and prime brokerage businesses.

The CDS inquiry began several weeks ago but is still in its preliminary stages, prosecutors said.

There is no guarantee the probe will culminate in prosecution. Government authorities have long found it difficult to prove a trader intended to break the rules or manipulate markets.

“I think the government will face an uphill battle here because this market has been unregulated, and therefore not the subject of scrutiny,” said Marc Mukasey, a former federal prosecutor who heads the white-collar criminal defense practice at Bracewell & Giuliani in New York.

If the government pursued criminal cases, it would likely focus on areas where it could build fraud charges involving things like misrepresentations to customers, Mukasey said.

“While there could be securities fraud charges and market manipulation charges, those could always could be recast as much simpler crimes such as mail fraud, wire fraud or conspiracy,” he said.

(Additional reporting by Martha Graybow in New York; Shradhha Sharma in Bangalore; editing by John Wallace and Gerald E. McCormick)

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