(FORTUNE Magazine) – Every year, the U.S. government gives up some $20 billion in tax revenues to subsidize the $1.2 trillion municipal bond market. It's a rare gift-American munis are the only major tax-exempt bazaar on the planet. But as with many taxpayer-subsidized projects, what all this easy money breeds is a thick layer of sleaze atop many municipal financings, with corruption tracing from white-shoe Wall Street firms all the way--at least in one instance--to a state governor's spouse.

Today's municipal bond market presents a sordid tale of fast dealing, price manipulation, even bribery. Indeed, barely does the dust settle from one municipal bond scandal than another breaks. Though there have been many transgressions in recent years, some stand out as especially egregious:

In March of last year, a dentist, one Dr. Billy Collins, began serving a 5 1/4-year prison term for extortion and tax fraud. Collins, who was married to Martha Layne Collins, governor of Kentucky at the time her spouse committed his crimes, regularly demanded that Wall Street firms pay him if they wished to do municipal bond business in the state. In one spectacular bit of chutzpah, he asked for and got $35,000 from Donaldson Lufkin & Jenrette to buy a grand piano, which he then gave to his wife as a gift. Collins's appeal is pending.

Earlier this year, Joseph C. Salema, best known as a former chief of staff to ex-New Jersey governor Jim Florio, pleaded guilty to securities fraud. Before Salema joined the state government, he concealed kickbacks that his consulting firm collected from First Fidelity, a large New Jersey bank, in exchange for steering municipal underwriting business its way. At the time, Salema's consulting firm was under contract as a financial adviser to New Jersey's Camden County.

And they keep coming, some sensational, others more routine, and some reported here for the first time. Just a few weeks ago, in mid-July, Los Angeles County officials accused Lazard Freres, a Wall Street investment bank, of overcharging the county by a total of $3.6 million on some 1993 bond refundings. Separately, the county officials also accused Lazard Freres and Goldman Sachs of padding the price of certain securities sold to the county in several municipal financing deals by $4.3 million dollars. Both Goldman and Lazard say they are innocent. The Securities and Exchange Commission is investigating.

Many other investigations have been launched in the past few years, ranging from a federal probe into a muni deal by the Oklahoma Turnpike Authority to one involving construction financing for some Pennsylvania prisons. Yet despite the rising tide of abuse and alleged misdeeds, the public outcry over muni corruption remains muted. After all, with the exception of the earthshaking Orange County default, municipal bonds remain reliable sources of income in many individual investor portfolios. Investment bankers dine on munis too, structuring deals and underwriting new issues in return for handsome fees. This year underwriters should gross about $1 billion in revenues from the municipal bond business. But what troubles regulators, and should concern citizens, is that many millions more were pocketed illegally, at taxpayer expense.

What has grabbed the most headlines so far are the "pay-to-play" deals, in which political contributions or gifts are paid to municipal officials in return for underwriting business. The Municipal Securities Rulemaking Board, or MSRB, the self-regulatory body that makes rules governing muni dealers, recently imposed strictures designed to eliminate pay-to-play, but they are riddled with holes. Example: Under these regulations, which took effect in April 1994, municipal finance professionals who make contributions to a candidate may not do price-sensitive municipal bond business with that official for two years. But the restriction doesn't apply if the campaign contributions are made by members of a Wall Street firm who work outside the muni bond department. And except in some cases, a firm's municipal finance bankers can still contribute to a candidate's political party, if not to a particular candidate. Privately, Wall Streeters say the restrictions are laughably ineffective.

Arthur Levitt, chairman of the Securities and Exchange Commission, is under no illusions that recent laws have brought an end to muck in the muni market. As he put it last June in a speech to municipal finance officials, "Certain practices in the industry remain closer to the backroom deals and 'honest graft' of George Washington Plunkitt and his ward captains in 1905 than to the full disclosure and unimpeachable integrity demanded by our markets in 1995."

Even where laws have no loopholes, they seem to lack teeth. Florida law, for example, requires all investment banks to identify any advisers they employ to win a municipality's business and to report how much they pay them. Willful failure to do so is classified as a felony. But Smith Barney did not disclose that it signed a contract with local lobbyist Eli Feinberg in 1993, promising him $5,000 a month to help it get business in Dade County. While Feinberg was under contract, Smith Barney was hired by the county to co-manage a $432 million bond issue.

Smith Barney counters that Feinberg was not paid specifically to land that bond issue, so it did not need to register him. To others, including Feinberg himself presumably--he registered with Dade County as a lobbyist for Smith Barney--that sounds like outrageous hairsplitting.

As of mid-July, at least two weeks after being tipped off to this possible felony by an attorney for Michael Lissack, a former managing director of Smith Barney and a self-described whistle blower for the muni market, nothing had happened. The Florida agencies that FORTUNE contacted could not even decide which of them might investigate such an allegation.

One reason so many problems pop up with munis is that the chief watchdog for other securities, the SEC, has very limited policing power in this market. The biggest clout lies with the Internal Revenue Service, which has the power to deny the tax exemption on muni issues that it finds are in violation of the tax laws. Says Marcus Owens, the IRS's muni maven: "We have a range of investigations under way, some criminal." Maybe so, but they're burning the midnight oil just to keep up with the headlines. Monitoring the $1.2 trillion muni market has been a staff of 30 to 40 people.

The key area that those IRS auditors are focusing on is a practice known in the trade as "yield burning," a more subtle transgression than pay-to-play but far more costly to taxpayers. Yield burning is a method by which an investment bank pads the bill for Treasury securities it buys on behalf of a municipal client. It sounds mysterious, but at bottom, burning yield is no different from a dishonest butcher's putting his thumb on the scale. The only distinction is that in yield burning, the taxpayer, not the shopper, ends up taking the hit.

Yield burning happens most often when municipalities are doing something called an advance refunding, which is akin to refinancing a mortgage. When interest rates drop, municipalities like to refinance their debt to take advantage of the lower rates. But while individuals can refinance their mortgage whenever they wish, municipalities typically cannot pay off their bonds at will, due to restrictions in their bond covenants. Thus, to get the same benefit as a refinancing, the municipality first issues new bonds at the lower interest rate. It then takes these proceeds and buys a portfolio of Treasury securities--called the escrow portfolio--that is carefully structured to produce sufficient cash flow to service the debt on the old muni bonds. Because Treasuries normally yield more than munis, this mix and match of bonds can result in a savings to the municipality.

One way to build the escrow portfolio is to buy Treasuries in the open market, matching cash flows with the old high-coupon municipal bonds. But there's a wrinkle here: According to the tax code, the yield on the escrow portfolio cannot be greater than the yield on the new municipal bonds. In effect, the rule means that municipalities can only raise enough low-cost money to pay down their old high-cost debt. If that rule didn't exist, municipalities would probably issue much more debt than they needed. Think about it: If you could raise municipal money at 5% and then invest that money in 6% Treasuries, the profit potential would be unlimited.

So the rule makes sense. But there's also an unintended side effect, in that the restriction creates an irresistible profit opportunity for the Wall Street crowd. Put yourself in their shoes: You're an investment banker, and you have to buy Treasuries that will provide enough cash flow in interest and principal to make the expected payments on the old muni bonds. The municipality does not reward you for getting the Treasuries at good prices, because any benefit from hard bargaining at this stage of the deal must go back to Uncle Sam (that's the restriction we just mentioned). So you, the banker, see an opportunity to make an extra profit for your firm by marking up the prices of the Treasuries that you'll sell to the municipality well beyond the going market price. The only problem is that you will have just broken the law, denying U.S. taxpayers savings that should have been theirs. That last point, unfortunately, does not seem to be much of an impediment to investment bankers.

One especially interesting transaction is an $899 million bond refunding done for the Commonwealth of Massachusetts in 1993. It appears to offer a classic example of how yield burning takes millions of dollars from the pockets of taxpayers and puts it in Wall Street's billfold.

The deal in question was senior-managed by First Boston (now called CS First Boston), but Goldman Sachs provided the securities for the escrow. A comparison of the prices Goldman charged, taken from the bond documents, with those printed in the newspaper for the appropriate day, shows that the investment bank charged the municipality $8 a bond more than the going market rate, producing for itself an excess profit of at least $7 million. Is an $8 markup per bond a fair deal? Says Stewart Brown, a finance professor at Florida State University and an expert witness for the SEC: "A markup of that size is unconscionable." New York City, for example, simply refuses to pay a markup of more than $1 a bond.

In the bond filings, Goldman asserts that the prices it charged reflect "the cost and risk involved" in holding the escrow securities during the two weeks or so it took for the deal to close. But Goldman purchased the Treasuries over three days, February 23, 24, and March 5, for the deal, which closed March 9. If what it says is true, then you would expect the firm to exact more of a markup for securities it knew it had to hold longer. But Goldman charged virtually no markup on the first two days of purchases. Nearly all of the markup occurred on the third day, March 5, which should have had the smallest because closing was then only four days away.

When presented with these findings, Goldman Sachs insists that it has done no wrong. "We don't overcharge our clients," says Michael McCarthy, head of the municipal bond department. "We are confident that the securities we sold to the Commonwealth were fairly priced. In addition, the Commonwealth obtained independent verification of the fairness of the prices from First Boston, which acted as financial adviser in the escrow transaction," he says. First Boston has since exited the muni business but stands by its fairness opinion.

As for the Commonwealth of Massachusetts, the man overseeing the deal, deputy treasurer Kenneth Olshansky, says he too relied on First Boston's opinion that the prices were fair. First Boston, however, also supplied a small amount of Treasuries for the escrow, and those securities seem pricey too, though not nearly as much so as Goldman's. Olshansky also told Fortune that the period in which the transactions took place "happened to be a week I was not in the office."

Certainly, Goldman is not the only player that gets premium prices for the escrow portfolios it provides. When officials for the state of Kentucky checked the prices that their escrow provider, Lazard Freres, was charging in a 1992 refunding deal, they discovered that Lazard was trying to charge as much as $6 a bond more than the current market price. A single piece of the deal was overpriced by a cool $1 million. The Kentucky team resisted and talked the price down. The National Association of Securities Dealers (NASD) looked into Lazard's pricing in this case, though it chose not to take any action.

How much money has been lost to yield burning? Nobody knows because nobody has systematically studied all the refunding deals that have been done. But now making the rounds in Washington in a letter to several members of Congress is an estimate of the damage. The figure, reckoned by ex-Smith Barney banker Michael Lissack, puts the price between $500 million and $1 billion just for the 1991 through 1993 period. Says an unusually frank investment banker: "Yield burning? That's been going on for years. And, hey, I'm one of the thieves."

Municipal issuers--cities, states, and local authorities--aren't mere bystanders in all the muni market's questionable dealings. Sometimes they are the prime participants. Take escrow trading. Using some slick legal maneuvering, municipalities effectively trade the Treasuries in escrow, hoping to make a speculative profit. Here's how it works: During the three weeks or more from the date of sale of the munis to mom and pop investors to the final closing of the transaction, the escrow portfolio is sitting on the books accruing interest. Municipalities see this layover as an opportunity to use the bonds for trading purposes and, with luck, to make a fast buck.

According to IRS regulations, muni issuers doing a refunding may not use the bond proceeds for any purpose other than to fund the escrow account. The reasoning is simply that the tax advantages of municipal bonds are a form of federal subsidy to state and local governments, and the restriction helps ensure that the municipality confines its use of the subsidy to legitimate governmental purposes.

But that logic didn't stop the North Carolina Eastern Municipal Power Authority from executing over 1,200 trades while it was waiting for its bond deal to close, turning over a $1.5 billion portfolio of Treasuries six times in three weeks during 1993 and walking off with a trading profit of $21.5 million.

On the face of it, this trading seems like a violation of the logic and spirit of the tax code. But according to the issuer's bond counsel, the New York City law firm Hawkins Delafield & Wood, the strategy is within the law. The lawyers reason that the trades in question took place during the settlement period for the bonds, before the deal officially closed, so the bond proceeds didn't yet officially exist. So where did the city get the money to speculate in the bond market? They traded on margin, say the attorneys, as if speculative margin transactions were a normal, acceptable part of municipal finance. At the very least, that's the the kind of thinking that gives lawyers a bad name.

In the real world, of course, the margin money to finance speculative trading would not have been offered if there were no bond proceeds to back it up. Indeed, when pressed by this writer, one bond lawyer who helped negotiate one of these escrow-trading transactions admitted as much. Yet many bond attorneys have put their names to bond opinions supporting the municipalities' right to speculate in this manner. Massachusetts followed a similar strategy in that $899 million Goldman Sachs deal done in 1993, producing a $2.7 million profit for the Bay State's general fund. Also, deals like North Carolina's have been done for the Los Angeles County MTA, the City of Rochester, and the Austin Independent School District in Texas, among others. Smith Barney happened to orchestrate the North Carolina deal. But Morgan Stanley has claimed credit for doing several of these transactions too. Illegal? No. Questionable? You bet.

So why doesn't the IRS do something about this iffy use of taxpayer subsidized bonds? With a lean staff, the IRS hasn't gone looking for big, complicated problems. Indeed, so long as the bond issuer files a tax return, and the underwriter files a tax return, and the bond holders file tax returns, the IRS has basically been satisfied.

In other words the only tax experts who look closely at these deals are the bond attorneys employed by the issuer. "In fact," says Mark Schwartz, a lawyer and bond expert in Bryn Mawr, Pennsylvania, "everyone at the negotiating table during a bond deal has a strong financial incentive to say yes. The one party not at the table is the one providing the subsidy that makes the deal work, the federal taxpayer."

Now, at long last, that may be changing. The IRS is ramping up to begin an audit program that, for the first time in the history of the municipal market, will systematically scrutinize bond deals for violations of the tax laws. Already over a hundred bond deals are under the magnifying glass. Meanwhile, the SEC has reportedly launched at least a dozen investigations of its own.

Another ray of hope for taxpayers is that a mechanism already exists that at least would make speculating with escrow portfolios, or overpricing them, virtually impossible. The solution, according to William Wood, a former public finance banker with Merrill Lynch and a technical expert on the muni market, would simply be to require all escrow investments to be made in State and Local Government Series securities, or SLGS, called "slugs." These are special Treasuries, with yields custom-cut to match those of tax exempts, designed for use in escrow portfolios. Wall Streeters don't like them because they squelch the possibility for more profits. But mandatory use of SLGS would put a quick end to yield burning, and stop speculation with escrows, which might just save taxpayers from big losses down the road. At present, SLGS are still a bit awkward to use in many complicated refundings. "but the problem is slight," says Wood, "and it can be fixed with just a little tweaking."

The SEC's Levitt has a greater appreciation of the difficulties. The challenge, he says, is "to bring the industry's practices into the 20th century before we arrive at the 21st." No doubt there will be resistance even to that. But given the current climate in Washington and the whirlwind of tax reform churning up discussions inside the Beltway, players in the market would do well to remember that a business perceived as corrupt can all too easily become the turkey for the budget cutter's ax.