US stocks tumbled in late trading on Tuesday as investors responded to more bad news about the subprime mortgage market, bringing an end to the worst month for US equities in three years.

Stocks gave back earlier gains as two mortgage insurers warned of a possible $1bn subprime loss and shares in American Home Mortgage Investment, a leading lender, plunged 90 per cent after it said it could no longer fund home loans.

Several hedge funds were hit by subprime mortgage losses and – in a demonstration of the extent of the turmoil – the German state bank, KfW, said it would bail out IKB, a German lender with US subprime losses.

The S&P 500 index fell 1.3 per cent to 1,455.19, bringing its loss for July to 3.2 per cent, its worst month since July 2004. It also marked the first time that the benchmark had fallen in consecutive months since March-April 2004. The yield on the 10-year Treasury bond fell six basis points to 4.74 per cent, its lowest level since May as investors sought the safety of government debt.

Larry Kantor, of Barclays Capital, said: “Problems in the structured credit markets are still unfolding, and it is hard for anyone to know when it will end or how much damage will ultimately result.”

American Home, which boasted a book value of nearly $20.6bn at the end of the first quarter, warned last week that it had to pledge more cash to its lenders after suffering losses. Its shares plunged as they resumed trading yesterday after a halt that lasted a day and a half.

American Home’s problems were particularly worrying because it specialises in “Alt-A” borrowers, consumers with credit ratings one step above the subprime designation assigned to people with particularly tarnished credit histories.

It emerged on Tuesday night that Bear Stearns, which has seen two of its credit hedge funds implode in recent weeks due to their exposure to the subprime market, has suspended investor withdrawals from a third hedge fund.

The problems at the Bear Stearns Asset-Backed Securities fund, which has about $850m of prime and Alt-A securities, was first reported by the Wall Street Journal. Bear Stearns said the fund had no leverage and that it did not believe it was “prudent” to sell assets to meet redemptions in the current market environment.

Moody’s said on Tuesday it was “refining” its rating methods for Alt-A mortgage loans in response to rising delinquencies. It said weaker Alt-A loans were performing like stronger subprime loans, “signalling that underwriting standards were likely closer to subprime guidelines”.

Mortgage Guaranty Investment Corp and Radian Group, two mortgage insurers, slid after they said their combined investment of more than $1bn in a subprime mortgage company may be worthless.

MGIC and Radian said they could be forced to write down their entire investments, valued at $516m and $518m, respectively, in Credit-Based Asset Servicing and Securitization (C-Bass), an issuer, servicer and investor in credit sensitive mortgage assets. C-Bass said the state of credit markets meant it had been subject to an “unprecedented amount of margin calls from our lenders”.

MGIC shares fell 15 per cent to $38.63 while Radian’s sank 9.9 per cent to $36.21. Fitch Ratings downgraded the insurer financial strength rating of MGIC to AA from AA+ and said it had placed Radian’s debt ratings on rating watch negative.

Hedge funds also suffered. Braddock Financial of the US said it was closing its $300m Galena fund after subprime losses. Another fund said to have suffered is HFH Group’s special opportunities fund, which was down 17.5 per cent in June.

Australia’s Macquarie Bank said investors in one of its mutual funds could lose up to 25 per cent of their money. Separately, Axa insurance group has also warned that two of its funds have been badly dented.

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