Cuomo and U.S. probe credit-default swaps

The U.S. government and New York Atty. Gen. Andrew Cuomo have opened a joint investigation into the $34.8-trillion credit-default swap market, the top federal prosecutor in New York said Monday.

The probe seeks to “determine whether any federal laws have been violated” in the market for the swaps, which function as a kind of insurance contract for bond losses. The action will complement an earlier inquiry by Cuomo’s office, U.S. Atty. Michael Garcia in Manhattan said.

Cuomo has been probing alleged manipulation of credit-default swaps by short sellers spreading false rumors about financial firms. Prosecutors are looking at whether they tried to drive down stocks, including bankrupt Lehman Bros. Holdings Inc., according to a person in Cuomo’s office who declined to be identified. The U.S. is also probing Lehman’s failure.

“They’re going to look at those individual traders who are responsible for these products and to find out whether or not they were deliberately manipulated,” said Ralph Fatigate, former director of investigations at the New York State Banking Department. “It’s an unregulated area.”

Credit-default swaps, conceived by bondholders, allow investors to buy protection against a company defaulting. As the market expanded, speculators started using them to bet on a company’s creditworthiness. The contracts pay the holder face value for the underlying securities or the cash equivalent should a company fail to repay its debt.

Though it grew a hundredfold in the last seven years, total outstanding contracts in credit-default swaps are dwarfed by other derivative markets, including those that bet on interest rates. Those markets had contracts linked to about $465 trillion as of June 30, the International Swaps and Derivatives Assn. said.

The joint probe announced Monday will also examine allegations of insider trading, market manipulation and other forms of fraud, according to a second person.