I would have thought that, given its history, question one in the job interview for a prospective treasurer of Orange County, CA, would be: "Are you going to invest lots of our money in very complex and risky financial products that you don't fully understand?"
Apparently not.

Twenty percent, or $460 million, of the county's $2.3 billion Extended Fund is invested in so-called SIVs that may face credit-rating cuts...

New York state prosecutors have sent subpoenas to Wall Street firms seeking information related to the packaging and selling of debt tied to high-risk mortgages...
The subpoenas, sent by the New York attorney general Andrew Cuomo's office, request information from Merrill Lynch, Bear Stearns and Deutsche Bank...

Eleven-figure writedowns at UBS (that is, $10,000,000,000; I think just writing $10bn underestimates the gravity of the situation), and more SIV damage at SG...

Doubt's also growing over the Superfund, announced with such fanfare back in October - the NYT writes "The new superfund, announced with much fanfare in mid-October, now looks increasingly irrelevant. Originally it was thought that the entity, called a Master Liquidity Enhancement Conduit, or M-LEC, might raise as much as $80 billion that could prevent a sharp sell-off in securities owned by structured investment vehicles, or SIVs. Now, the M-LEC, known on Wall Street as the Super SIV, may raise just $60 billion, in part because many of the banks are working out their own rescue plans, and the Superfund will have little left to do by the time it gets going in (apparently) mid January.

The FT today quotes unnamed "people familiar with the business" saying that Citigroup has been quietly selling off vertical slices of its SIVs - and has cut them from $83 billion to $66 billion over the last couple of months. Now, lots of other banks have been doing this too - Standard Chartered and Dresdner come to mind - but Citigroup's different; not only is it the bank with the largest SIV exposure, but it's also one of the big three pushing the Superfund scheme. If even Citigroup is choosing to solve its own problems, is there really still a case for the MLEC?

Attention is turning to the extent of fraud in the subprime mortgage business, as we wrote last month. The FT is long on generalities and short on hard numbers:

Karen Gelernt, a partner at law firm Cadwalader, Wickersham & Taft, says: “The difficulty is getting a handle on the size of the problem, because there is no real mechanism for reporting fraud for most originators in this market. In fact, they had every incentive not to report.”

Don Ledford, spokesman for the U.S. Attorney's Office in Kansas City, said the type of mortgage fraud now high on the radar are schemes involving teams of conspirators.

"You have one person who is the deal maker, but they also have to have an appraiser who will artificially inflate the price of a home and you've also got to have someone at the title company," Ledford said. "We have had several appraisers convicted because of this."

Two commentators make the link between possible lawsuits and the subprime rescue plan (which seems to be called either Hope Now, or New Hope, which I think is also a Star Wars film, or even, as Mr Bush described it initially, the Freedom Christian Academy of Ponder, TX).

Here's the first: Tim Reason at CFO.com...

But while a rash of foreclosures would cost investors dearly, the plan allows the financial institutions that wrote it to declare large swaths of mortgages in danger of default, and to rewrite those loans without sign-off from homeowners or the investors who own the loans. That may help investors "in the aggregate," as the plan says, but it also may limit the ability of individual investors to sue, and represents a further blow to investor confidence in the practice of securitization...

And the second, the rather less measured Sean Olender:

The sole goal of the freeze is to prevent owners of mortgage-backed securities, many of them foreigners, from suing U.S. banks and forcing them to buy back worthless mortgage securities at face value - right now almost 10 times their market worth.

The ticking time bomb in the U.S. banking system is not resetting subprime mortgage rates. The real problem is the contractual ability of investors in mortgage bonds to require banks to buy back the loans at face value if there was fraud in the origination process.

A couple of points occur - 1) as Karen Gelernt notes (in the FT article), it's going to be very difficult for MBS investors to bring these fraud cases, which is possibly why none of them have done it yet; 2) that's making the assumption that the originators deliberately refused to tell MBS buyers about the problems with the underlying loans, when it's just as possible that the buyers simply couldn't be bothered to look. As one insider points out:

Having been both in the third-party due diligence business as well as employed by mortgage originators on the sell side and mortgage conduits on the buy side, I'll confirm that yes, there's tons of information that falls under the general heading of "due diligence" that nobody paid any attention to... I'd flip open the file to see, right on top, page after page of worksheets, printouts, and memos from everyone else who had handled the thing so far indicating some serious problems with it. Discovering what's wrong with these loans involved using the reading skills Miss Buttkicker taught me in the third grade. But the loans were still in the deal, even though three or four people before me had noticed something wrong.
This is the "repurchase" meltdown, folks. Having ignored their own people, the originators sold these things to Wall Street. Wall Street, having ignored the due diligence firms they hired to look at the stuff, went ahead and securitized it. When it started performing just like all the little potted plants said it would, more due diligence firms were hired--or rehired--to go through and find enough "misrepresentations" so that the loans could be shoved back to the originators.

Somehow, I suspect that no one in the chain is going to come out of this looking particularly good.

Describing the multi-bank liquidity injection, Paul Krugman writes:

...the Fed can come to the rescue. If the rumor is false, the bank has enough assets to cover its debts; all it lacks is liquidity — the ability to raise cash on short notice. And the Fed can solve that problem by giving the bank a temporary loan, tiding it over until things calm down.
Matters are very different, however, if the rumor is true: the bank really did make a big bad loan. Then the problem isn’t how to restore confidence; it’s how to deal with the fact that the bank is really, truly insolvent, that is, busted...What’s going on in the markets isn’t an irrational panic. It’s a wholly rational panic, because there’s a lot of bad debt out there, and you don’t know how much of that bad debt is held by the guy who wants to borrow your money...

Are central banks preparing to suspend Basel capital adequacy rules? The Telegraph, leaping to conclusions, says yes:

More intriguing, however, was how [Bank of England markets director Paul Tucker] then explained that the Bank would avoid this situation. It provides a clue about the dramatic steps the Bank may have to take to end the credit crunch.
There are three options open to it, the first two of which it has already made a start on: cutting interest rates and, together with its international counterparts, pumping extra cash into the markets. The third is more intriguing: "Regulatory authorities around the world are monitoring banks' liquidity and capital positions, including in the context of Basel II."
It may seem like an bland piece of bank-speak, but Mr Tucker's comments are in fact one of the first indications that the financial authorities in the UK are now considering the nuclear option of taking a knife to the regulations that underpin the entire Western banking system...

It's quite a stretch to go from that sentence - which appears on page 13 of a 22-page speech - to the assumption that Basel (I and II) are going to be done away with completely, even though they then find an economist (Peter Spencer at Ernst & Young) willing to back them up.

He warned that, if London's money markets remained frozen and the authorities retain the strict Basel regulations, the full scale of the eventual credit crunch and economic slump could be "disastrous".
Dismissing the assumption that banks are not lending to each other on the money markets because they lack confidence in each others' potential solvency, he argued that they were, in practice, prevented from lending the cash at all because it could leave their balance sheets falling foul of the Basel regulations.
"If these funding routes are not reopened it will have massive consequences for the economy as a whole," he said. "It will make 1929 look like a walk in the park."

...the creation of the off balance sheet vehicles at the centre of he recent market turbulence may be seen in part as a response to the crude regime for capital charges established under the original Basel Accord, under which liquidity facilities
under a year in maturity were exempt. That is being remedied under Basel II. But it is a reminder that we need to be very careful to watch for these distortions in the regulation and
oversight of payment systems and other infrastructures...

Bair said large U.S. banks hold stronger capital positions than they might have otherwise because of the lengthy time it took American banking regulators to agree on a final set of rules for the Basel II accord.
"I think we are very fortunate that we went slow with Basel II, that we kept the capital levels very high, that we will be transitioning over a very long period with a lot of safeguards," she said.

The WSJ has the story (earlier report in Business Week)...

Federal criminal prosecutors investigating the collapse of two internal hedge funds at Wall Street firm Bear Stearns Cos. are examining whether a Bear executive improperly withdrew money he had invested in one of the funds while making optimistic forecasts about the portfolio's prospects, people familiar with the matter say...

The FT joins in:

. Do the leading rating agencies meet the credibility, independence, objectivity and transparency criteria demanded by Basel II? Can banks’ internal ratings be trusted? Does anyone know how good or bad they are compared with those of the rating agencies?

Remember that the IRB approach was thought to be more appropriate for large banks because they were more sophisticated in terms of risk management. Do recent loss figures support or contradict that assumption?

We should also ask what models are going to be used to estimate credit risk parameters such as: probability of default, loss given default, unexpected loss and the other host of variables suggested by Basel II. Will the same models be used to rate these securities – the models that were unable to estimate their fair value?

Whatever the answer to these questions one thing is for sure: the first pillar already looks weak. Let us all hope that the two factors (bad ratings and flawed models) that have temporarily brought the alternative banking system to its knees are not going to do the same to the conventional banking system. That would be really scary! Welcome to 2008.

...with a couple of continuing stories - Ralph Cioffi, the Bear Stearns hedge fund manager under investigation for insider dealing, has "ceased to be an employee".

And in the Refco case - remember Refco? - the brokerage's derivatives lawyer, Joseph Collins of Mayer Brown, has been charged with involvement in the fraud allegedly committed by CEO Phillip Bennett.

Everyone's presumably seen the Morgan Stanley results by now, but here's a little snippet from CBS MarketWatch: "Morgan Stanley lost $5.8 billion, or $3.61 a share, vs. earnings of $2.65 billion, or $2.08 a share, in the same period a year earlier. Analysts polled by Thomson Financial had forecast a loss of 39 cents a share..."
Not exactly a stellar prediction, that.

With only a few days left of 2007, the bad news keeps on coming. Monoline insurers are in trouble. (MBIA says there's nothing new in its announcement, and its CDO squared exposure was already common knowledge - which comes as news to all the startled banks and investors...) Banks are reporting massive writedowns. The ABX and the SIV may now be dead and gone.
But if you're worrying about the winter, take heart - it could be worse. You could be Ralph Cioffi, who, Felix Salmon suggests, may be "singlehandedly responsible for everything that went wrong of late". Or you could be a Citi credit salesman, trying to pitch a new sort of CDO backed by loans to struggling Tajik bicycle repairmen.

And, of course, there's always the hope that you may end up with a late Christmas present in the shape of a Risk Award. The winners will be announced in the next issue of Risk, published in the new year.

Until then, happy holidays to all our readers.