NEW YORK: U.S. stocks fell Monday for a second consecutive session, led by banks and brokerages, after auditors said that American International Group inflated the value of financial assets.

AIG, the worlds largest insurer, tumbled the most since 1987 as said it must update its accounting for credit-default swaps in its 2007 financial statements. Citigroup, Merrill Lynch and JPMorgan Chase dropped after Goldman Sachs said they face rising losses on loans used to finance buyouts. Altria Group and Honeywell International declined after being removed from the Dow Jones Industrial Average.

The Standard Poors 500 Index lost 0.69, or 0.1 percent, to 1,330.6 in New York. The Dow Jones Industrial Average decreased 38.2, or 0.3 percent, to 12,143.93. The Nasdaq Composite added 5.18, or 0.2 percent, to 2,310.03. About three stocks fell for every two that rose on the New York Stock Exchange.

“Its still way too early for financials,” said Tim Hartzell, chief investment officer at Legacy Asset Management in Houston.

Most European stocks fell, led by banks and insurers. Asian shares retreated, led by Kookmin Bank and Commonwealth Bank of Australia.

The SP 500 Financials Index has lost 28 percent over the past year as the collapse of the subprime mortgage market caused banks and brokerages including Citigroup and Merrill to report record losses. Eighty-eight of the 92 companies in the index dropped Monday.

Citigroup may need to write down $2.2 billion of its $43 billion of unsold leveraged loans, more than any other firm, causing a 5 percent reduction in 2008 earnings per share, Goldman said in a report. Merrill may lower earnings by 6 percent as it writes off $800 million, and JPMorgan faces a 2 percent cut in income from a $900 million mark down, Goldman analysts said.

Citigroup, the largest U.S. bank by assets, dropped 27 cents to $25.76. Merrill, the securities firm, fell 41 cents to $51.78. JPMorgan, the U.S. bank, decreased 59 cents to $43.23.

AIG lost $5.72, or 11 percent, to $44.96 in New York trading after saying in a regulatory filing it “is still accumulating market data in order to update its valuation” of the credit-default swap portfolio. The company, which has units that originate, insure and invest in subprime loans, has declined about 30 percent in the past year.

Washington Mutual slid 77 cents to $17.31. The Bank of America analyst Robert Lacoursiere said Washington Mutual shares have been propped by speculation that it may be taken over. The analyst said he factored in only a 25 percent probability of the savings and loan being bought because of an “uncertain credit outlook.”

Altria and Honeywell will be replaced by Bank of America and Chevron in the Dow average. The revisions to the 30-member gauge were prompted by Altrias spinoff of Kraft Foods last March and the planned divestiture of its overseas tobacco unit next month, according to a statement from Dow Jones Indexes, a unit of News Corp.

Altria, the worlds largest tobacco company, lost 62 cents to $72.47. Honeywell, the biggest maker of aircraft controls, decreased 85 cents to $56.98.

Chevron, the oil company, slid 25 cents to $79.01. Bank of America, the largest U.S. bank by assets, retreated 19 cents to $41.97.

Technology companies in the SP 500 posted the steepest advance among 10 industries after Yahoo rejected Microsofts $44.6 billion takeover bid, saying it “substantially undervalues” the company.

Yahoo added 48 cents, or 1.7 percent, to $29.68. Microsoft lost 47 cents to $28.09.

Motorola added 24 cents to $11.50 after The Wall Street Journal said the biggest U.S. mobile phone maker and Nortel Networks may combine their wireless infrastructure units in the latest response to sluggish growth in the telecom-equipment industry. A Nortel spokesman, Jay Barta, declined to comment. An e-mailed message to Motorola was not immediately returned. Nortel rose 23 cents to $11.30.

The Bank of England considered hitting homeowners and borrowers with a 0.5 percentage point interest rate rise for the first time in 10 years of independence, it was disclosed today.

At the monetary policy committee (MPC) meeting two weeks ago, all nine members voted for a smaller 0.25 percentage point rise to 5.5% - the fourth increase in 10 months.

But the committee considered lifting rates by 0.5 percentage points as some members were concerned over “upside risks” to inflation and a “buoyant outlook for growth and demand”.

The MPC eventually agreed on the smaller rise because of uncertainties over the impact of previous rate hikes.

The minutes said: “Those members who had considered voting for 50 basis points preferred to wait for more data to assess the impact of past increases.

“Other members were concerned that any excess movements in rates could create downsize risks to growth.”

The MPC is charged with keeping consumer prices index (CPI) inflation within a 1% range of the bank’s 2% target.

In April the CPI dropped to 2.8% from March’s 3.1% spike, although the bank warned last week that a further rise in rates to 5.75% would be necessary to bring inflation back to the 2% target by 2009.

The committee’s agreement on this month’s quarter-point rise was widely expected by the market and the more cautious approach came as volatile movements in oil and metal prices made it more difficult for the MPC to assess medium-term inflation pressures.

The MPC agreed that, despite signs of producer price inflation and strong reports from agents on business confidence, there was little evidence of pay growth and a “degree of slack” in the labour market despite the temporary rise in CPI inflation in March.

But in voting for the rise, the committee admitted that “there had possibly been more underlying inflationary pressure than expected”.

The MPC said the main risks to inflation included strong demand growth raising company prices, prospects for energy and import prices, and the degree of spare capacity in the economy.

But the bank expects CPI to fall back towards its 2% target later this year as falling energy prices filter through to customer bills.

Over the last decade or so, the business that made Silicon Valley famous — semiconductor manufacturing — has quietly evolved into a highly specialized industry whose division of labor has scattered vital skills across the globe.

On one side of the world, Silicon Valley companies still lead in the design of complex chips. But the manufacturing of those chips is increasingly being done in factories, known as fabs (for fabrication plants), owned and operated abroad.

A plant that doesn’t do design, but simply makes the chips, is called a foundry. And the percentage of manufacturing capacity represented by such foundries has grown from the low single digits in the mid-1990s to nearly a quarter of all chip production in 2006.

“The reason the foundries have represented such a large percentage of capacity is cost,” said George Burns, a longtime industry analyst with Strategic Marketing Associates in San Luis Obispo. The industry has found it more efficient to design in micro and produce in macro.

Insiders say this industrial ecosystem helps meet the relentless demand for faster, cheaper and smarter electronics by allowing research-and-design firms located in the valley to outsource production to fabs in Taiwan, Singapore, China and perhaps India in the near future.

Though this global division of labor has so far allowed Silicon Valley to maintain its predominance in chip design, industry leaders say the overseas migration of manufacturing raises long-term questions about U.S. competitiveness in the field.

Meanwhile, it is increasingly common for Silicon Valley semiconductor firms to operate like magazine publishers, creating chip “content” here and sending designs out to be manufactured abroad — often filtering designs through systems created by other specialty vendors to catch design errors before a chip goes into production.

Consider Nvidia, a Santa Clara chipmaker known for creating state-of-the art graphics processors. Nvidia engineers design the electronic pathways that they think will deliver better visual performance. But before team leader Brian Kelleher sends this chip-to-be off to the fab, he puts the blueprint through a final test — a computer array that emulates each interaction among what will be roughly 1 billion transistors.

“Getting a billion of anything to contribute with each other and interact with each other is quite a feat,'’ said Kelleher, adding that the design-here, build-there model is more efficient.

“It’s quite simply economics and expertise,'’ he said. “Our core expertise is not outfitting buildings with complicated equipment and chemical processes to fabricate the silicon. We have the world’s leading experts in 3-D graphics architecture. That’s our core expertise.”

Overseas plants

At the same time, specialty manufacturers, typically located in Taiwan, Singapore and China, have built fabs costing billions of dollars to mass-produce semiconductors for firms like Nvidia.

Silicon Valley insiders call companies like Nvidia fabless chipmakers. Jodi Shelton, executive director of the Fabless Semiconductor Association, likened these chip-design firms to magazine publishers.

“As long as there are great printing presses out there, there’s no reason to own one,” said Shelton, who founded the association in 1994. Today it includes hundreds of firms, most of them as invisible as the chips they design for cell phones, computers and cars.

Burns, the market researcher, has spent more than 15 years learning everything there is to know about fabless chip making. He said this global division of labor between chip design and manufacturing began in the 1990s and gathered force as the cost of building semiconductor factories rose into the billions of dollars.

“Only the most successful companies can raise that kind of cash,” said Burns. He cited Intel Corp., which recently announced plans to build a $2.5 billion chip-making factory in China, as the premier example of a company that both designs and builds chips.

But few companies have Intel’s financial clout and, over time, Silicon Valley has evolved to concentrate research and design in the United States while manufacturing is migrating abroad.

A key local company in this specialization game is San Jose’s Cadence Design Systems, which sells the equivalent of desktop publishing software to help map out the millions of transistors that must interoperate on chips the size of a thumbnail.

At Cadence’s headquarters, corporate Vice President Craig Johnson and Chief Technology Officer Ted Vucurevich estimated the costs of designing a new chip and its embedded software. To create a moderately complex chip with 200 million transistors to run a handheld gizmo might take 18 months, involve 75 to 100 people, typically working in teams across the country or the world, and cost $75 million to $100 million. And that’s before the design is sent to the fab.

“You also have the risk of surprises,” said Johnson, referring to the possibility that chips might not end up working as designed.

Proofreading chips

Nvidia’s Kelleher said just such a failure in the 1990s cost an extra year — an eternity in computing — to get a crucial chip into volume production. “That taught us a lesson,” said Kelleher, who now proofreads designs using emulation computers developed by Cadence before he sends chips to the fab.

At the other end of the production pipeline, offshore fabs are developing an increased manufacturing expertise. Taiwanese entrepreneur Morris Chang pioneered the concept of a stand-alone factory to offer pay-per-chip production when he founded Taiwan Semiconductor Manufacturing Co. in 1987.

“In all candor, not everybody thought this model would work,'’ said Chuck Byers, the company’s worldwide brand manager. Skeptics thought Taiwan Semiconductor would be unable to recoup the capital costs of building the fab if all it did was wait for fabless firms to bring in their chip designs.

Skeptics were wrong. Burns, the market researcher, said that during the mid 1990s, the output of stand-alone fabs represented just 3 percent of total semiconductor industry manufacturing capacity. “As of the end of 2006, it is 23 percent,” he said.

Since Chang pioneered the concept, such fabs have spread to Singapore, China, Germany and Ireland. India recently threw its hat into the chip-making ring, offering tax incentives to lure any type of semiconductor manufacturing investment to a newly named Fab City.

“We are trying to catch up and have our piece of the pie,” said C.S. Rao, a technology adviser to Andhra Pradesh, the Indian state that would be home to Fab City.

Shelton, director of the Fabless Semiconductor Association, said outsourcing chip manufacturing strengthens Silicon Valley’s position as a center for semiconductor design because it encourages venture capital and private-equity firms to make million-dollar investments in fabless design firms — knowing that manufacturing capacity exists.

When her association tracked worldwide investments in fabless design in 2006, it found that 56 percent went to California companies.

But if the United States concedes chip manufacturing, it could hollow out the industry over time, warned Semiconductor Industry Association President George Scalise in a 2005 comment to an advisory panel on federal tax reform.

Warning on outsourcing

In that letter, the association estimated that while U.S. chipmakers sell about three-quarters of their products abroad, they employ 55 percent of their workers and spend 75 of their labor costs inside the United States .

“To date we are maintaining a rather vigorous capability in the United States,” Scalise said recently.

But in his 2005 letter, Scalise warned that “if manufacturing moves overseas, then over time R&D will be pulled overseas as well,” arguing that the United States needed to get competitive on tax incentives to encourage fabs at home and protect the industry.

While this global jockeying continues, the semiconductor ecosystem struggles to keep up with trends like the growing consumer demand for cell phones and digital music players — a big change for chipmakers whose bread used to be buttered by corporate buyers.

“I never thought I would be in an industry that depends on the whims and wishes of a 14-year-old,” said Byers. “But here we are.”

E-mail Tom Abate at tabate@sfchronicle.com.