Muni mess hammers California

Another obscure corner of the debt market is causing pain for taxpayers. States and cities selling municipal bonds are finding they have to pay more to issue so-called variable-rate demand notes, The Wall Street Journal reports. As with the collapse earlier this month of the now infamous auction-rate securities market, the problem is that Wall Street dealers such as Bear Stearns (BSC) and Morgan Stanley (MS) have stopped buying the debt, which allows municipalities to borrow for the long term at lower short-term rates. The dealer pullback has caused demand to dry up and interest rates to spike. The rate California paid on a recent $300 million issue quadrupled to more than 8%, the Journal reports.

Meanwhile, in a novel twist, the failure of the notes to sell at auction could leave them piling up on the balance sheets of so-called backstop banks such as Bank of America (BAC) and Citi (C), which are already stuck with billions of dollars of loans and other assets they can’t sell. That’s not even the worst news in the municipal bond market, though: Bloomberg reports that the California city of Vallejo is near a bankruptcy filing brought on by the collapse of the housing market, which has resulted in lower tax revenue, and rising pension costs. “Bankruptcy is a last resort,” councilwoman Joanne Schivley said, Bloomberg reports. “But guess what folks, that’s where we are now at.”