TURMOIL CONTINUES IN

the municipal bond market. This week tax-free municipals have been yielding more than taxable Treasurys, a rare anomaly. Auctions of variable rate municipals have been faltering. The market for tax-free auction rate preferred securities (ARPS), the subject of my column

, remains frozen. Is this a historic buying opportunity for municipal bonds and variable rate securities or a warning of more trouble to come?

Since my column last week, I've received a wave of comments from outraged investors who were sold tax-free auction rate preferred shares as a cash alternative: small-business owners who now can't make a payroll; prospective home buyers who can't complete a purchase; taxpayers who can't access the money they'll need on April 15; stock investors who'd like to take advantage of the market's downturn but can't all because their supposedly liquid assets are frozen.

Last week the market for variable rate municipal bonds also seized up. These are long-term municipal bonds sold at rates that are set at auction, usually weekly. These trade as individual bonds, rather than as shares in a closed-end fund like ARPS. As such, they have remained somewhat more liquid than the funds, but now that liquidity, too, seems to be drying up.

Last week hedge funds exacerbated the situation when they had to dump portfolios of municipal bonds on the market, depressing prices. Apparently many were short long-term U.S. Treasurys and were long short-term municipals. With warning signs of higher inflation showing up everywhere, something likely to drive up longer-term Treasury rates, and short-term rates being cut by the Federal Reserve, this strategy seemed logical. But in the current market environment, logic seems to have lost its predictive value. These markets moved in the opposite direction, forcing the hedge funds to meet margin calls on their short positions in Treasurys by dumping municipal bonds.

The ARPS I wrote about last week constitute an estimated $330 billion market. Variable rate municipals are an estimated $500 billion market. In other words, we're getting close to a $1 trillion crisis. Yet I don't hear anyone in Congress, the Treasury or the Federal Reserve offering any explanations or proposed solutions. The silence from Wall Street firms, which created these vehicles and vigorously promoted them to issuers and investors alike while earning enormous profits on them, remains deafening. Fortunately many state and municipal officials are starting to speak out and demand some relief from exorbitant interest rates that will eventually come out of taxpayers' pockets.

So far no one from any of the big Wall Street firms that sold these vehicles as cash alternatives has been willing speak candidly to me for quotation about this mess, but one executive, who requested anonymity, did offer these thoughts: "This is a 100-year flood. We had 20 years of liquidity in these auction markets. Now there's a panic. The banks have been beaten up. We can't let anything illiquid get on our balance sheets or we'll face another write-down. Nobody is happy. Eventually there will be a solution, but it will take time. Somebody needs to step up."

Yes, somebody does need to step up. If I were Treasury Secretary Henry Paulson, I'd be summoning those bankers responsible and knocking their heads together, starting with my former colleagues at

Goldman Sachs

Citigroup

None of this strikes me as a rational reason to abandon the municipal bond market or the auctions. Many ARPS still carry a triple-A rating as do many variable rate bonds and municipal bonds. State and city governments have weathered many downturns and recessions without defaulting. Comparing municipal bonds to mortgage-backed securities seems absurd. There was no comparable credit binge and no comparable asset bubble. Still, after all the false reassurances surrounding mortgages, everyone is skittish.

For now, there is still a functioning market in municipal bonds, although sellers have to accept a lower price than even a few weeks ago (long-term municipal bond funds are down nearly 4% so far this year). For the millions of Americans who own municipal bonds and have considered them virtually as safe as U.S. Treasurys, this drop in principal is surely cause for concern.

Many brokers are now touting the municipal bond market disruptions as a historic buying opportunity. I've heard from several investors crowing over the 8%-to-10% tax-exempt yields they say they've recently scored in the variable rate municipal market. In my view they may be right, but only if you don't care about liquidity and are prepared to hold these bonds indefinitely or until maturity.

My concern is this: If these high-yielding municipal securities are such a great deal, why aren't the big Wall Street firms buying them or willing to hold them on their balance sheets? They're happy to sell them to you now, but where will they be if liquidity dries up and you need the money? If my ARPS experience is any guide, you'll be stuck.