Should Underwriters Sell CDSs on Their Client's Bonds?

Dealbook reports that:

California’s state treasurer, Bill Lockyer, has sent a letter to six big banks that underwrite the state’s municipal bond sales, asking about the banks’ involvement in selling credit-default swaps on California debt, Reuters reports.

The letter to Bank of America-Merrill Lynch, Barclays, Citigroup, Goldman Sachs, JPMorgan Chase and Morgan Stanley expresses concern that the spreads on the California credit-default swaps are mispricing the state’s credit risk and inflating interest costs.

More from Reuters:

“I have no preconceived notions about the effect of C.D.S. trading on California (general obligation) bond prices, or about your firm’s activities in the California C.D.S. market,” Mr. Lockyer said in his letter, released late Monday.

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

Taxpayers have a right to know, Mr. 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 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,” Mr. Pietronico said.

I certainly think California's entitled to disclosure here. Sunshine being the best disinfectant, and all that. By analogy to agency law, underwriters ought not earn secret profits on their dealings on behalf of the principal. But I'm not sure I see a serious conflict of interest here. As long as the underwriters are charging California market rate commissions and using their best efforts to sell all the bonds offered, how does selling CDSs on those bonds conflict with California's interests?

I suppose under some circumstances the CDS market could affect the market for California bonds, but why should that per se disqualify these underwriters? So long as they disclose, California's no worse off than it would otherwise be. After all, somebody's going to sell those CDSs. So why shouldn't California's underwriters get to wet their beaks?