The former head of JPMorgan Chase’s (JPM) municipal derivatives sales is the target of a federal criminal investigation of possible anticompetitive actions in the municipal bond market, Bloomberg reports. Douglas MacFaddin was fired last month, Financial Industry Regulatory Authority records show, after he revealed he was a target of a Justice Department probe into Wall Street’s sales of derivatives and investment contracts to state and local governments, Bloomberg reports. MacFaddin is one of 10 current and former traders at JPMorgan and other banks who are being investigated.

The report doesn’t cite any specific deals as having drawn the scrutiny of prosecutors. But a number of cases have come to light recently in which small-town financial officials seem to have gotten in over their heads with exotic Wall Street financing methods. Back in February, Bloomberg reported that the Erie school board had to pay JPMorgan $2.9 million to get out of an interest-rate swap that went sour earlier this decade. And just this month, officials from Jefferson County, Ala., met with federal officials in a bid to stave off a bankruptcy filing, after the county ran into trouble tied to its own bad bets on interest-rate swaps. The good news, such as it is, is that so far the county - home to the state’s biggest city, Birmingham - hasn’t had to resort to a bankruptcy filing.

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 mess in an obscure corner of the municipal bond market is turning into another black eye for the banking industry. Bloomberg reports that the collapse of the $342 billion market for so-called auction rate bonds “demonstrates that regulators are no match for Wall Street.” Dealers such as Goldman Sachs (GS), Citi (C) and Merrill Lynch (MER) previously propped the market up by bidding for bonds that otherwise would have gone unsold, but they are now walking away from this once-lucrative niche in a bid to preserve their own strained balance sheets. Auctions failed on between $80 billion and $85 billion of auction-rate debt last week alone, The Wall Street Journal reports. As a result, even high-quality bond issuers such as the Port Authority of New York and New Jersey and the University of Pittsburgh Medical Center have ended up paying interest rates as high as 20 percent after the auctions for their bonds failed to draw any bidders.

The government hasn’t been totally blind to the possible conflicts of interest in the auction rate market: An earlier SEC probe of possible bid-rigging ended with 15 banks agreeing in 2006 to a $13 million settlement. Now, however, taxpayers are left footing the bill as Wall Street seeks to save its own hide. Meanwhile, understatement remains the order of the day in Washington. Referring to the possibility of bid-rigging in the auction rate market, an SEC official tells Bloomberg that the recent collapse of demand at auction “appears to indicate those concerns were well founded.”