Jan. 23 (Bloomberg) -- California is investigating whether Wall Street banks and financial advisers conspired to overcharge local governments for derivative contracts tied to municipal bonds, a state official said.

The antitrust investigation, with Connecticut and Florida launching similar efforts, follows inquiries by the U.S. Justice Department and class action lawsuits by cities from Oakland to Baltimore. They claim banks and advisers cost taxpayers money by rigging bids or fixing prices on financial contracts.

The investigations center on the investments that schools, states and cities buy with the proceeds of some of the $400 billion of municipal bonds they sell annually and on the interest-rate swaps designed to guard against swings in borrowing costs, authorities have said. Financial advisers are hired to solicit bids for the investments and to determine if their government clients pay fair rates in swaps, which are unregulated instruments not traded on exchanges.

States “almost have no choice but to join in because it involves their towns and cities and maybe even the states themselves,” said Christopher “Kit” Taylor, the former executive director of the Municipal Securities Rulemaking Board, the municipal bond industry regulator. “They’re sitting there saying this is a situation where we may have been taken.”

Continuing Probes

Christine Gasparac, a spokeswoman for California Attorney General Jerry Brown, confirmed California’s participation. She declined to comment further. The probe comes as the most- populous U.S. state and the biggest issuer of municipal debt struggles to close a record $42 billion deficit through next year and faces credit rating cuts on $67 billion of debt.

Connecticut has had a continuing probe. “Our investigation is active and ongoing,” Connecticut Attorney General Richard Blumenthal said in a statement.

Florida Attorney General Bill McCollum has sent out 38 subpoenas asking firms for information on sales of derivatives, including guaranteed investment contracts, where governments place money raised from bond sales until it is needed for projects, said Sandi Copes, a spokeswoman for McCollum.

Among the documents Florida requested were bids and communications between the firms and financial advisers related to the purchase or sale of municipal derivatives, according to the subpoena.

Copes declined to comment further, citing the pending investigation.

U.S. prosecutors and the Securities and Exchange Commission have searched for more than two years for evidence of collusion between banks and brokers to overcharge cities, states and local government agencies.

Winning Leniency

In February 2007, Charlotte, North Carolina-based Bank of America Corp. was granted leniency by the Justice Department for its cooperation in a national investigation of bid-rigging and price fixing involving municipal derivatives.

In exchange for voluntarily providing information and offering continuing cooperation, the Justice Department agreed not to bring criminal antitrust charges against the bank.

Derivatives are contracts whose value is derived from assets including stocks, bonds, currencies and commodities, or from events such as changes in interest rates or the weather.

“This is a trillion-dollar market, and this goes back to the 1980s,” said Michael D. Hausfeld, an antitrust lawyer representing municipalities, including Fairfax County, Virginia, in a class-action case against 30 banks.

Rigged Bids

Investigators are looking into whether bidding for guaranteed investment contracts was rigged. U.S. Internal Revenue Service rules require that the agreements be awarded by competitive bidding from at least three banks.

Eight California municipalities, including Los Angeles, Fresno and San Diego County, filed civil class-action, or group lawsuits. The suits, most of which were consolidated with others in U.S. District Court in New York City, allege that banks colluded by deliberately losing bids in exchange for winning one in the future, providing so-called courtesy bids, secretly compensating losing bidders and allowing banks to see other bids.

Brokers participated in the collusion by facilitating communication among banks and sharing in illegal profits, the civil class-action suits allege.

Three advisers to local governments, CDR Financial Products Inc., Sound Capital Management Inc. and Investment Management Advisory Group Inc., were searched by the FBI in November 2006. More than a dozen banks and insurers were subpoenaed and former bankers at New York-based JPMorgan Chase & Co., Bear Stearns & Cos. and UBS AG of Zurich were advised over the past year that they may face criminal charges.

New Mexico

Now, federal prosecutors are investigating whether New Mexico Governor Bill Richardson’s administration steered about $1.5 million in bond advisory work to CDR, which donated $100,000 to Richardson’s political committees.

CDR also advised Jefferson County, Alabama, on more than $5 billion of municipal bond and derivative deals. A combination of soaring rates on the bonds and interest-rate swaps is threatening the county with a bankruptcy that would exceed Orange County, California’s default in 1994. Jefferson County paid JPMorgan and a group of banks $120.2 million in fees for derivatives that were supposed to protect it from the risk of rising interest rates.

Those fees were about $100 million more than they should have been based on prevailing rates, according to James White, an adviser the county hired in 2007, after the SEC said it was investigating the deals.

CDR spokesman Allan Ripp has said the company stands by the pricing of the swaps and said White’s estimates were incorrect because they didn’t take into account the county’s credit profile, collateral provisions between the county and the banks and the precise time of the derivative trades.

To contact the reporters on this story: Martin Z. Braun in New York at mbraun6@bloomberg.net;

Last Updated: January 23, 2009 09:34 EST