California's Treasurer has sent a letter to six big banks that underwrite the state's municipal bond sales, asking what the banks' role may be in also selling credit default swaps on California debt.

The letter to Bank of America Merrill Lynch , Barclays Plc , Citigroup Inc , Goldman Sachs Group

, JPMorgan Chase & Co and Morgan Stanley , released late Monday, expresses concern spreads on California CDS are mispricing the state's credit risk and inflating interest costs.

I have no preconceived notions about the effect of CDS trading on California (general obligation) bond prices, or about your firm's activities in the California CDS market, Treasurer Bill Lockyer said in the letter.

I do, however, worry about firms selling our bonds, on one hand, and trading CDS on our bonds, or otherwise participating in that market, on the other.

Taxpayers have a right to know, Lockyer added -- and others in the municipal debt market agreed.

If anybody has the right to ask the question it's probably the state of California, said Michael Pietronico, chief executive officer of Miller Tabak Asset Management in New York, which oversees $250 million in assets,

The state pays out substantial underwriting fees because it's one of the top issuers in the country and it has a right to know if they're working on its behalf, Pietronico said.

JPMorgan Chase, Barclays, Goldman Sachs and Citigroup declined to comment. Morgan Stanley said it is reviewing the letter and has no comment. A Bank of America representative was not immediately available.

Credit default swaps are used to insure against potential default or to speculate on the creditworthiness of an issuer. The contracts were widely blamed for adding to fears about financial firms such as Lehman Brothers before it failed in 2008.

When CDS prices are higher, then it suggests the issuer is less credit worthy and more at risk of default. That can increase the premium investors demand to take on extra risk of owning that issuer's debt.

California's CDS have been trading wider than spreads on countries including Kazakhstan and Croatia, said Lockyer.

California's five-year credit default swaps were trading at about 200 basis points early Tuesday, according to Markit Intraday. That means it costs $200,000 a year to insure $10 million of debt for five years.

Swaps on Kazakh debt were trading at 170 basis points, while CDS on Croatian debt was trading at 188 basis points, according to Markit.

Swaps on Californian debt have been widening for the past year as it struggled with a fiscal crisis, peaking above 340 basis points last June as the state issued IOUs to suppliers.

Yet, California has never defaulted on a debt service payment in its history and is very unlikely to do so in the future, said Lockyer.

California's general obligation debt is backed by the full faith and credit and taxing power of the world's eighth-biggest economy, and the state's constitution places debt service in second place after payments to schools, providing another cushion of safety to bondholders.

Investors have recognized that fact. This month alone they snapped up nearly $6 billion of tax-exempt and taxable general obligation debt offered by Lockyer, and there are no signs demand for the state's bonds will cool soon.

I don't think that's necessarily going to be abating, said Howard Cure, director of municipal research at Evercore Wealth Management in New York, which oversees $1.7 billion in assets, of which two-thirds are in fixed income. I don't think the state is going to default on its debt.

Nevertheless, Lockyer noted that despite the security-plus backing of California GOs, and our spotless record of paying our debt on time and in full, market participants actively buy and sell credit default swaps on our bonds.

Still, California's persistent fiscal problems have led the major ratings agencies to assign it the lowest ratings of any U.S. state. Moody's Investors Service rates it at Baa1, or three notches above junk status. Standard & Poor's rates it at A-minus, or four notches above junk, while Fitch Ratings rates it at BBB, placing it two notches above junk.

(Reporting by Ciara Linnane; Additional reporting by Jim Christie, Dan Wilchins, Steve Eder, Joe Rauch and Maria Aspan; Editing by Andrew Hay)

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