Firm urged hedge against state bonds it helped sell

In that way, the swaps could be beneficial to the market, encouraging risk-averse investors to buy more municipal bonds. But like derivative securities in general, they can be dangerous to hold. That's because they are often highly leveraged. A small investment can buy coverage on bonds worth much more. If defaults rise to unexpected levels, the swap sellers could be hard-pressed to make good on their promises.

The perils of the credit default swap market were brought home this year, when they were instrumental in the collapse of Lehman Bros. Holdings, American International Group and Bear Stearns. Lehman and AIG were rumored to owe far more than they could pay on swaps they had sold. Meanwhile, the prices of default swaps on the three firms soared, signaling to investors that the firms might be in trouble. Investigations continue into whether those swaps may have been manipulated to undermine confidence in the firms and drive them out of business.

"By encouraging people to buy swaps, you're pushing up the price of those and making it more expensive to insure against the default on the bond that you're buying," Heal said. "The fact that such coverage has gone up in price will signal to the investor that the riskiness of the bond has increased, even if that's not true. Even if the underlying financial situation of the state has not, in fact, changed."

Indeed, what some traders found perplexing about the push for a market in municipal credit default swaps was that muni defaults almost never happen.

Goldman was a leader in the effort to build up the market for the muni swaps. In May, when the financial information firm Markit introduced a municipal CDS index to give swap traders a benchmark to set prices, Goldman was listed as one of the seven dealers participating in the rollout.

For some time before that, Lockyer told The Times, Goldman had "regularly urged" California to trade in the municipal swaps itself, ostensibly to hedge the state's risks as a bond issuer. Lockyer refused.

The trading strategy that Goldman pitched to institutional investors was apparently crafted in the spring and summer. The company may have hoped to parlay the swaps market into more activity in municipal bond trading, which is traditionally light because muni investors tend to hold the bonds to maturity.

Theoretically, the swaps index could lure speculators into the muni market, a development that would create much more fluctuation in daily prices, which in turn would generate revenue for trading desks at Goldman and other investment firms.