The federal investigation that prompted Gov. Bill Richardson of New Mexico to withdraw his nomination as commerce secretary offers a rare glimpse into a long-simmering investigation of possible bid-rigging, tax evasion and other wrongdoing throughout the municipal bond business.
Three federal agencies and a loose consortium of state attorneys general have for several years been gathering evidence of what appears to be collusion among the banks and other companies that have helped state and local governments take approximately $400 billion worth of municipal notes and bonds to market each year.
E-mail messages, taped phone conversations and other court documents suggest that companies did not engage in open competition for this lucrative business, but secretly divided it among themselves, imposing layers of excess cost on local governments, violating the federal rules for tax-exempt bonds and making questionable payments and campaign contributions to local officials who could steer them business. In some cases, they created exotic financial structures that blew up.
People with knowledge of the evidence say investigators are not just looking at a few bad apples, but also at the way an entire market has operated for years.
"It's rare to sell a Senate seat, but it's not rare to sell a bond deal," said Charles Anderson, who retired as manager of tax-exempt bond field operations for the Internal Revenue Service in 2007. "Pay-to-play in the municipal bond market is epidemic."
Michael D. Hausfeld, an antitrust lawyer in Washington, who is representing some of the cities, counties and states entangled in the federal dragnet, called it "one of the longest-running, most economically pervasive antitrust conspiracies ever to be uncovered in the U.S." Many of these municipalities say they did nothing wrong and were duped by financial firms, which they are suing.
The possibility of a vast web of collusion would be sobering in any case, but the issue is of particular concern now, as Congress and the incoming Obama administration prepare a big fiscal stimulus package that may spawn infrastructure projects carried out and financed at the state and local level. States and cities issue bonds to raise money to pay for things like schools and road construction, and are supposed to follow strict rules on how the proceeds are handled for investors to receive a tax exemption on the interest.
Mr. Anderson estimated that as much as $4 billion a year was vanishing into the system, based on the volume of problems he saw before retirement.
Christopher Cox, the chairman of the Securities and Exchange Commission, has said oversight of the municipal bond markets is inadequate, and has urged Congress to take steps to protect both investors and taxpayers. Congress has not taken up the initiative.
The S.E.C. and the Justice Department declined to discuss the details or status of their investigations, including in New Mexico, where work on municipal bonds is part of a federal grand jury investigation. Officials at the I.R.S. said they were giving the matter high priority and had challenged the tax-exempt status of municipal bonds in a number of places but declined to describe individual cases.
Christopher Taylor, who retired in 2007 as executive director of the Municipal Securities Rulemaking Board, said the evidence amassed so far included tape-recorded phone calls, in which the independent specialists who are supposed to help local governments pick their bankers could be heard telling bankers: "We want you to bid on this deal, but you're not going to get it - you're going to get the next one. We want you to submit a sloppy bid."
Unsuspecting governments then accepted the recommended bids, and paid too much, he said. Mr. Taylor also cited evidence of banks being paid in cities where they did no work at all, apparently to reward them for throwing the business to their rivals.
The business is lightly regulated, with rules governing the conduct of companies set by the municipal securities board. Municipal bond underwriters are prohibited from making campaign contributions to "buy" the business of bringing bonds to market. But no such rules govern the conduct of a type of professional who appeared in the industry about a decade ago - specialists who work with financial derivatives, like swaps and options.
In the last few years, the use of such derivatives in combination with municipal bonds has grown rapidly, market participants say. And so, it appears, has the interest of federal agents.
The federal inquiry appears to have started at the I.R.S., which was concerned that the rules for tax-exempt bonds were being trampled.
"We saw this coming and went to the Department of Justice and said, 'Hey look! It looks as if there's been price-fixing and bid-rigging on a major scale here,' " said Mr. Anderson, the retired I.R.S. manager.
The efforts have broadened into what investigators and lawyers described as a coordinated effort among the federal agencies broken down by jurisdiction.
The S.E.C. polices fraud in the municipal bond markets and is looking into whether municipal bonds are routinely certified for tax-exempt treatment, by people who perhaps know or should know they do not qualify.
The Justice Department's criminal antitrust division has authority over bid-rigging, and that part of the investigation is being led by federal prosecutors in Manhattan. At the same time, various regional U.S. attorneys' offices around the country are looking at whether campaign contributions and other gifts to state and local politicians were used improperly to "buy" bond-related business.
More than 30 financial services companies have been subpoenaed, including JPMorgan Chase, Merrill Lynch and the American International Group, which have recently received government assistance and in the case of A.I.G., an outright federal bailout. Several have disclosed in corporate filings that their employees have been called to testify before grand juries or have received "Wells notices" from the S.E.C. warning that an enforcement action is looming.
The disclosures follow raids by the F.B.I., in 2006, of the offices of three specialized firms that bring together local officials and the banks and other companies that seek business working on municipal bond sales.
One of the three, CDR Financial Products, of Beverly Hills, Calif., is at the heart of the federal investigation in New Mexico. Investigators there are looking at how CDR Financial came to be selected as the "swap adviser" for a $1.5 billion program - called Governor Richardson's Investment Program, or GRIP - to raise money for road and rail construction in New Mexico.
CDR Financial and its founder, David Rubin, gave $100,000 to two of Governor Richardson's political action committees in 2003 and 2004, and the company earned $1.5 million for advising GRIP in 2004. A Colorado political consultant, Michael Stratton, lobbied on behalf of CDR Financial, and was paid $269,000 by JPMorgan Chase during the same period, according to regulatory filings. JPMorgan was the lead underwriter on about $1.1 billion of bond sales for GRIP.
Mr. Stratton did not respond to messages requesting comment, and a JPMorgan spokesman said the bank would have no comment.
Allan Ripp, a spokesman for CDR Financial, said that Mr. Rubin had made the contributions because he supported Governor Richardson's efforts to register people likely to vote Democratic in the presidential election. He said CDR Financial had competed fairly for the bond business and won its assignment on the merits.
Governor Richardson has said that he and his aides acted correctly at all times, and that he withdrew his nomination as commerce secretary only out of concern that the investigation might cause a long and distracting confirmation battle.
CDR Financial and the other two firms raided by the F.B.I. - Investment Management Advisory Group, known as Image, of Pottstown., Pa., and Sound Capital Management of Eden Prairie, Minn. - had attracted unfavorable attention even before the F.B.I. raids, in some cases because of campaign contributions.
In Philadelphia, Image and CDR Financial were described as "Company No. 1" and "Company No. 2" in the indictments of the former city treasurer, Corey Kemp, and other officials in 2004. CDR Financial had made political contributions and earned $415,000 for helping Philadelphia link a type of derivative called a "swaption" to its bonds. Image squired the city treasurer around by limo, and was in the running to participate in a school bond sale, but the deal fell apart when a local newspaper, The Daily News, questioned Image's involvement.
Mr. Kemp is serving a 10-year prison sentence for accepting illegal payments in exchange for steering city bond business and other contracts to selected companies. Neither CDR Financial nor Image was formally accused of wrongdoing.
The use of derivatives in connection with municipal bonds has grown rapidly in the last five years. The packages are presented as money-savers to the municipalities, which may want to protect themselves against interest rate changes. But over the last year, as turmoil spread through the credit markets, some of the derivatives have blown up, leaving local governments stuck with unexpected costs.
That happened in Alabama, where Jefferson County linked an extraordinary number of derivatives, called interest-rate swaps, to its bonds, in some cases with the help of CDR Financial. Despite publicized concerns about whether improper payments to certain officials were behind the swaps, the county insisted the swaps were saving money. Last year, the derivatives failed, leaving the county with vast bills. Jefferson County is now at risk of declaring what would be the biggest governmental bankruptcy in United States history.
Even in places where the bonds and derivatives are performing as expected, irate government officials are finding they may have overpaid for various services and have inadvertently broken federal tax rules. Again and again, proceeds from tax-exempt bonds appear to have improperly generated investment income for banks and insurers.
Among the governments that have sued these financial firms are the cities of Chicago and Baltimore; Oakland and Fresno, Calif.; the state of Mississippi; and a number of counties, school districts and at least one water and sewer district. The lawsuits were consolidated in November, in Federal District Court for the Southern District of New York. Chicago has since abandoned that litigation.