Offered by banks like JP Morgan, Bank of America, and Citigroup, the so-called municipal credit default swaps can be used by investors to bet that insurance contracts protecting holders of municipal bonds will default.
Some states say the derivatives not only scare away potential buyers of municipal bonds by creating a perception of risk, but ultimately drive up states' borrowing costs. Others contend that the instruments are traded too thinly to affect municipal bond markets or a state's credit rating.
The California treasurer is just one of a number of state treasurers that have launched a probe into the sale of these derivatives and the sale of municipal bonds by big Wall Street firms that might reveal "speculative abuse of CDS in the muni market," says one regulator.
Of course, if states or cities go bust, Uncle Sugar will need to bail them out.
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