As the controversy over Goldman Sachs' (NYSE: GS)  proprietary investment and trading operations heated up, there were many who thought that the firm was inappropriately dealing with the state of California and other municipal and state issuers. Indeed, it was big news when ProPublica broke the news that Goldman Sachs had recommended clients bet against California bonds. Because Goldman Sachs was a big underwriter of the bonds, there was plenty of anger in the Golden State. 

In its response, state officials took a fairly measured approach. Treasurer Bill Lockyer launched a probe, seeking a better understanding of why yields on the state general obligation bonds rose. Was it because of speculators in the swaps market creating worry about the state's fiscal position, which was starting to deteriorate? He also wanted a clearer picture of whether the Wall Street banks that underwrite California's bonds were also shorting those bonds. He ended up sending questions to the Bank of America Merrill Lynch, Barclays, Citigroup, Goldman Sachs, JPMorgan Chase and Morgan Stanley. 

The results of his probe are now in, and they seem to be largely favorable to Goldman Sachs and other banks. In a news release, Lockyer said, "One, the effect of CDS trading on California bond prices is not significant enough to cause concern at this time. And two, the banks themselves have not bet against the credit quality of California GO (general obligation) bonds to any meaningful extent." 

This is a welcome bit of news for the banks. They can certainly portray it as reasoned conclusions at a time when anger and bitter rhetoric dominates the media. Lockyer's conclusions will certainly not end the controversy about whether Wall Street banks have abused their municipal clients. There are real questions as to whether these banks have inappropriately sold hedges to cities and towns that ended up blowing up.  Matt Taibi--who coined the term "a giant Vampire squid sucking on the face of humanity" to describe Goldman Sachs--has an article about Jefferson County, Alabama, that broaches some newsworthy issues. 

However, Lockyer would like a rule that would require entities that trade CDSs on municipal or state debt to also own the reference bonds. That would make such trading a legitimate hedge. Not owning the bonds and betting on the CDSs amounts to mere speculation, which he said "opens the door to market manipulation that could artificially inflate perceived credit risk and increase taxpayers' borrowing costs on bonds. Reducing leverage opportunities will make it harder for speculators to game the system and hurt taxpayers." He's also in favor of the tougher capital and margins requirements put forth by proposed financial rules overhaul now working through Congress. - Jim