(Bloomberg) — The first-ever antitrust probe of the municipal bond market is roiling an industry that states and cities depend on to finance everything from garbage trucks to schools.US Justice Department prosecutors subpoenaed more than a dozen banks and insurers three weeks ago, seizing documents from three brokers in a search for evidence of bid rigging. Lawyers say it’s the biggest criminal investigation of the almost 200-year-old market, where municipalities have more than $2 trillion of debt outstanding.

“You don’t want to have something like this going on,” said Robert Doty, a Sacramento, California-based adviser with American Governmental Financial Services Co., who is the vice chairman of the National Association of Independent Public Finance Advisors. “It’s just bad for the reputation of the market.”

JPMorgan Chase & Co., the third-largest bank in the US, American International Group Inc., the world’s largest insurance company, and Financial Security Assurance Holdings Ltd., a unit of Brussels-based financial services company Dexia SA, are among the companies that received subpoenas. JPMorgan declined to comment. AIG and Financial Security spokespeople said the companies are cooperating with the probe.

The investigation stems from an Internal Revenue Service review that found scores of municipal bond deals robbed federal taxpayers of more than $100 million. Banks and other financial firms arranged to sell guaranteed investment contracts in a way that increased their fees at the expense of the US government, said Charlie Anderson, manager of field operations for the IRS’s tax-exempt bond division.

The IRS in 2005 told Atlanta officials that the city may have overpaid for a $453 million guaranteed investment contract from Bank of America Corp. The IRS asked whether banks arranged to submit “courtesy losing bids” at an auction held to win the city’s investment business, according to a February 5, 2005 letter obtained by Bloomberg News. The contract was for money raised by a 1999 water and sewer bond.

Bank of America spokeswoman Shirley Norton declined to comment.

Amelia Bond, who ended her one-year term in October as chairman of the Municipal Securities Rulemaking Board, a self- regulatory body based in Alexandria, Virginia, said in a speech to the Bond Market Association in May that the IRS probe has left the industry “vulnerable.”

“Any time the IRS is involved you worry about the integrity of the marketplace,” Bond said. “It sounds like they’re finding something.” The Justice Department opened its criminal investigation six months later. The Securities and Exchange Commission also joined the probe.

C. Willis Ritter, a Washington-based bond attorney for Ungaretti & Harris who has worked in the industry for 35 years, said in a Nov. 16 interview that the probe marked “the first time I have ever seen the antitrust division of the DOJ get involved in public finance.”

State and local governments in 2005 sold a record $408 billion of long-term debt in more than 13,000 separate offerings, according to Thomson Financial. The bonds raise money for roads, hospitals and sewage plants, attracting investors by providing income exempt from taxes.

Prosecutors are trying to determine whether banks and brokers conspired to fix prices on so-called GICs, which municipalities buy with bond proceeds that aren’t spent immediately.

The Justice Department asked for information from as far back as 1992, including files on guaranteed investment contracts and other financial products, such as derivatives. A derivative is a financial contract whose value is derived from tradable securities or linked to events such as interest-rate changes.

Investigators also subpoenaed three firms that advise local governments on derivatives and evaluate bids for guaranteed investment contracts: Beverly Hills, California- based CDR Financial Products Inc., Pottstown, Pennsylvania- based Investment Management Advisory Group Inc. and Sound Capital Management of Eden Prairie, Minnesota.

All three said in statements that they are cooperating with the investigation and defended their work.

The municipal finance industry was rocked by scandals in the 1990s, including a probe of influence peddling concerning so-called pay to play, in which banks gave public officials campaign contributions to win no-bid contracts. There was also the controversy over yield burning, in which banks and brokers overcharged local governments for Treasury bond investments.

Local governments are required to solicit bids for guaranteed investment contracts. They rely on brokers such as CDR, which deal with the banks and provide documents certifying that the bidding is fair. States and cities only use competitive bidding for bond sales 20 percent of the time, down from 74 percent three decades ago.

“The way that these folks have operated, largely by telephone and largely out of public view, are not as transparent as they might be,” said Patrick Born, chief financial officer of Minneapolis and the head of the debt committee of the Chicago-based Government Finance Officers Association. “And it’s certainly possible that when you don’t have transparency you can have abuses.”

Anderson of the IRS says regulators “think we have evidence of bid rigging.” Local governments are required to pay as taxes any profits they get by borrowing at low tax- exempt rates and investing in higher-yielding securities.

The IRS probe shows that investment contracts were sold at below market rates, Anderson said. That meant lower returns for municipalities and less tax revenue for the IRS, he said.

“People were winning GICs at below fair market values and there were obviously deliberate losing bids by the losing bidders, thereby allowing the winner to win a sweetheart deal,” said the IRS’s Anderson.

The IRS is concerned that unfair bidding deprived the Treasury of money, much like the so-called yield burning scandals of the 1990s, when Wall Street banks raised the price on Treasury bonds sold to local governments, driving down the yield, to get around restrictions on how much they could earn. Wall Street banks paid more than $170 million to end the Securities and Exchange Commission’s investigation of that practice.

Carol Lew, the president of the National Association of Bond Lawyers in Chicago, said the investigation of GICs will place the firms that work on those transactions under heightened scrutiny by their government clients, who may choose to avoid the contracts.

“The allegations may cause issuers to examine and question whether a guaranteed investment contract is the best investment for them,” Lew said.

Roger Davis, a partner in the San Francisco office of Orrick, Herrington & Sutcliffe’s public finance office, said the probe may end wrongdoing. He said his firm represents more than one client in the investigation, declining to provide names.

“I think this could be good for the industry,” Davis said. “It’s pretty clear the IRS has found some questionable behavior. Sometimes you have to flush it out, get rid of it and move on.”