NEW YORK (Bloomberg) — The Federal Bureau of Investigation visited the municipal bond market last week.FBI agents last week raided the offices of CDR Financial Products of Beverly Hills, California. Federal agents also carted papers away from Investment Management Advisory Group Inc., of Pottstown, Pennsylvania. The Department of Justice handed out a whole batch of subpoenas to banks and other financial firms, Bank of America Corp. and JPMorgan Chase & Co. and Bermuda-based surety guaranty reinsurers among them.

What’s this all about? Nothing good. The Justice Department said it is conducting an “investigation of anti-competitive practices in the municipal bond industry”.

What this is really all about is an inquiry, replete with federal grand jury, into the world of what happens after states and localities sell bond issues and have to reinvest the proceeds before they spend it on specific projects.

Think of the whole process like two separate card games. After the issuer collects his money at one table, he goes to a second where various firms play for the right to get that big pot of money and invest it.

There is a whole lot of money to be made in that part of the business, and some people will do almost anything to get it.

What’s taken the Feds so long?

For well over a decade, some bankers have been hooting and hollering about how much money there is to be made in the reinvestment-of-proceeds business. Haven’t the Feds heard the rumours, the stories, the whispered tales of greed triumphant in that part of public finance?

Now there’s nothing wrong with making money, but it seemed like the amounts being reaped on that side of the business were a bit too fabulous to be believed. I kept thinking of the advice a banker once gave a roomful of issuers concerning the swaps market: “Eventually, money leads to abuse,” he told them.

Nobody seemed willing to do anything about it, though. We don’t regulate swaps and derivatives and guaranteed investment contracts, the regulators said. They’re not securities.

It was almost as though the murky band of specialists in this area of municipal finance were being set up as untouchables. They were, apparently, beyond anyone’s jurisdiction, and could engage in behaviour — making extensive campaign contributions, among other things — that had been shut down in the regulated part of the municipal market.

The Internal Revenue Service may be the municipal bond market’s regulator of last resort. It is the IRS that waded into the reinvestment-of-proceeds business. Perhaps in the end it will be the IRS that “cleans up” this part of the market.

Where did all of the money come from? Perhaps the easiest way to think about it is to say that people were playing games with prices, and squeezing too much money from transactions.

The IRS over the past few years has uncovered a variety of what it calls “abusive arbitrage devices.” Municipalities, you see, aren’t allowed to earn money, “arbitrage,” on tax-exempt investments. They can’t sell bonds at four percent and invest at six percent, for example. That’s not the purpose for public finance, according to the government.

Nor can they “divert” such arbitrage earnings. I can’t sell them a six percent investment and charge them a fat price to bring down the yield to the four percent they are allowed to earn. This investigation all comes down to the professionals involved in a transaction manipulating prices and market values for their own benefit.

The IRS has found that dozens of bond issues contained abusive arbitrage devices put together after the bonds were sold and the proceeds reinvested. Over the past few years the agency has told the issuers their bonds are now taxable. The issuers reach a “closing agreement” with the IRS, pay the agency some money, and the bonds remain tax-exempt.

More often than not, the issuers say they were clueless about what happened, and why their bonds have been declared taxable. This municipal bond stuff is pretty complicated, they say; they relied on the hired help to get it right.

Besides discovering the illicit arbitrage, the IRS says it came across instances of what it says are price-fixing and bid-rigging and kickbacks.

Nobody much cares about abusive arbitrage devices except for the IRS, which goes in and gets the money back for Uncle Sam. But price-fixing, bid-rigging and kickbacks — “anticompetitive practices” — well, that got the attention of the Securities and Exchange Commission and everyone else.Joe Mysak is a Bloomberg News columnist. The opinions expressed are his own.