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.

The latest earnings report from Swiss banking giant UBS (UBS) shows the pain of the U.S. housing bust is far from over. UBS said Wednesday morning its fourth-quarter financial report will include a $14 billion writedown tied to the plunging value of the firm’s holdings of mortgage-related securities. UBS said $12 billion of the writedown comes “on positions related to the U.S. sub-prime mortgage market,” and the rest on other positions related to U.S. residential mortgages. Last month, UBS projected its fourth-quarter writedown would be $10 billion. In adding to its losses on U.S. housing bets, UBS joins Citi (C) and Merrill Lynch (MER), both of which posted bigger-than-expected fourth-quarter losses earlier this month.

Adding to the gloom over the banking sector, Oppenheimer analyst Meredith Whitney says UBS, Citi and Merrill could be in for billions of dollars of additional writedowns this year tied to problems at the bond insurers Ambac (ABK) and MBIA (MBI). Whitney says she doesn’t believe a bailout of the insurers is likely to come to pass, which could lead to some $40 billion in 2008 writedowns at big banks - the majority of which would be taken at Citi, Merrill and UBS.

 ”While we had previously believed the monoline insurers MBI and ABK were too important to fail due to the threat of systemic risk and thus would likely be bailed out,” she writes in a report Wednesday, “we no longer think systemic risk is even realistic or a bailout of the monolines even viable.” Additional writedowns could bring the big banks back to the trough for more capital, even after a two-month span that has seen the Merrill-Citi-UBS trio dilute shareholders by raising tens of billions of dollars. No wonder financial stocks were selling off Wednesday morning - even as rate-cut relief looms this afternoon.

The mortgage mess keeps wreaking havoc on Wall Street. Fixed-income bonuses at Merrill Lynch (MER) will drop 40 percent from a year ago on average, Bloomberg reported Monday, as new CEO John Thain seeks to steer the firm past this fall’s bond market meltdown. The bonus cuts will be steepest for traders in mortgage bonds and collateralized debt obligations, the risky debt whose collapse led to an $8 billion writedown at Merrill last quarter and cost former chief Stan O’Neal his job. Corporate bond and interest rate traders will see their bonuses cut as well, the report indicates.

The move comes as Goldman Sachs (GS), which has been the one firm on Wall Street to clean up on the mortgage mess, prepares to report fourth-quarter numbers Tuesday. It’s widely expected that the firm will report another slate of eye-popping profits, even as rivals such as Morgan Stanley (MS) and Bear Stearns (BSC) — whose fourth-quarter numbers are due out Wednesday and Thursday — struggle to contain the damage. It’s a good bet that Merrill’s bad news on the bonus front won’t be the last for the once-highflying CDO crowd.