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The civil and criminal investigations of Evil Financial Products Which Destroyed The World have now officially reached the stage of farce, with “federal regulators and state officials” reportedly investigating the fact that banks traded municipal CDS at the same time as underwriting municipal bonds.

The case here is so weak that I can only imagine that the ultimate goal lies in the shadow of the law, in the realm of a global settlement caused by the sheer weight of investigations. The banks can’t afford to laugh this kind of thing off, no matter how ridiculous it is on its face:

The probe is exploring potential conflicts of interest by banks that sell municipal bonds and then poise themselves to profit if those bonds fail, these people said.

A main thrust of their investigation is whether firms use their own money to bet against the bonds they sell and, if so, whether that activity is properly disclosed to bond buyers…

“It seems that when they are trying to sell CDS’s, they have to talk about the riskiness of the bonds, and that has some psychological impact on the investor’s view,” Mr. Lockyer said in an interview. “We might then pay a higher price to sell the bond. This isn’t right.”

That’s Bill Lockyer, of course, California’s treasurer, who started the ball rolling back in November 2008 when he was the prime source for a very silly ProPublica investigation along similar lines. But now he’s moved on from non-profit journalism shops to federal prosecutors, which means that his conspiracy theories are growing real teeth.

The crazy thing here, of course, is that the banks are damned if they do and damned if they don’t. The investigators are apparently trying to nail the banks for not disclosing that they had a short CDS position — but if they did disclose that, then the “psychological impact on the investor’s view” would be even greater, and California might need to pay even more to sell the bond.

What’s more, the WSJ seems happy to jump on the bandwagon, with editorial interjections like this:

Municipal credit-default swaps are still thinly traded, but their existence has the potential to spook investors in the same way investors have feared Greece defaulting on its bonds.

I’m not sure what this is supposed to mean. Is Ianthe Dugan implying that the mere existence of CDS on a certain bond can spook investors into thinking that the underlying credit is the next Greece? Is she saying that the CDS market was somehow responsible for Greece’s fiscal woes? Whatever she’s saying, she’s not making a lot of sense.

Blanche Lincoln would like to force banks to sell their swap desks, in a move which is opposed by a lot of regulators within Treasury, the Fed, and elsewhere. If that piece of legislation gets signed into law, then yes this kind of activity — trading in municipal CDS — would become illegal. But right now it’s perfectly legal, and investigating it is pure politics.

The important thing to remember here is that the effect of the CDS market on municipal borrowing costs, even if it’s non-zero, is exactly the same no matter who is doing the trading in CDS. If Goldman (GS) and BofA (BAC) and JPM (JPM) and the other banks caught up in this probe stopped making markets in municipal CDS, someone else would step in and take over from them. And if the trading moved onto an exchange, as it should, then that would only serve to make the CDS prices even more public, thereby spooking potential investors in municipal bonds even more.

But this investigation is political, it’s not based on coherent jurisprudence or financial logic. And as such, the banks’ responses are going to have to be political too. That global settlement is getting closer by the week.

Source: The Silliest Derivatives Probe Yet