Betting against California

State Treasurer Bill Lockyer has been grumbling all year about Wall Street sharpies betting billions that California will default on its bonds. His concern is that the burgeoning market for credit default swaps tied to California’s debt will make investors less bullish on California’s future, forcing the state to offer its bonds at higher interest rates. Higher rates mean higher cost, which the state can scarcely afford.

Wall Street is an easy target. A harder truth, though, is that the demand for credit default swaps is just a symptom of the state’s sorry finances. The main reason California pays higher interest rates than other states has been its sub-optimal credit rating, which sank to the lowest in the nation in February. The downgrade reflects the widespread concern about Sacramento’s annual game of budgetary chicken, as well as lawmakers’ inability to solve long-term budget problems.

Credit default swaps are like insurance: An investor who worries about a security defaulting can pay a premium to the swap seller, who agrees to cover any loss. The availability of that insurance, in fact, helps states sell bonds by enabling investors to reduce their risk. And investors don’t have to own the securities covered by the swaps; they can buy them as a way of betting that something will fail. So far, betting against California has been a losing proposition — the state has yet to default on a bond.

In many markets, investors can glean valuable information about an asset from the price of its swaps. But in the case of California’s bonds, the price of swaps has bounced wildly even as the demand for bonds themselves has increased. That volatility renders the swaps all but useless as barometers of the state’s health.

Lockyer’s office has been scrutinizing the swaps market for signs that it’s hurting bond sales, but it reported in April and June that it had found no cause for alarm. It doesn’t hurt to keep an eye on bond underwriters — as Goldman Sachs has shown, Wall Street banks have no compunctions about betting against the products they sell — but Lockyer shouldn’t pretend that speculators are exacerbating the state’s fiscal misery. The blame for that falls entirely in Sacramento, on the Legislature and the governor.