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.”

The auction rate bond market is under fresh scrutiny after the $330 billion market’s recent breakdown cost issuers thousands of dollars in extra interest costs. California and the Port Authority of New York and New Jersey are among the entities pulling out of the market, Bloomberg reports, while the Wall Street Journal reports that lawyers and regulators are looking at possible actions on behalf of aggrieved issuers and investors.

The auction rate market allowed cities, school districts and the like to issue long-term debt at lower short-term rates by regularly allowing holders to sell their bonds at auction. But it now seems that Wall Street dealers such as Citi (C) and Merrill Lynch (MER) were among the biggest buyers of the bonds - and now that they have pulled back, in a bid to protect their strained balance sheets, there’s little demand for the bonds. That’s why auctions have failed in recent weeks, briefly saddling highly rated issuers such as the Port Authority with rates as high as 20 percent. Bloomberg reports that the Port Authority now plans to get out of the auction rate market within six to eight weeks while redeeming some $200 million worth of debt that ended up carrying higher rates. Also refinancing are schools in Florida and a medical center in Washington state. As for individuals, investment adviser Michael Shedlock at Sitka Pacific suggests holders of muni bond funds that own auction-rate securities should get out while the getting’s good.