Financial stocks resumed their swoon Wednesday, led by a 5% drop in Citi (C) after Oppenheimer analyst Meredith Whitney cut her earnings estimates on the banking sector. The selloff shows that even after stocks staged a rally in the wake of Monday’s Bear Stearns (BSC) buyout sweetener, investors remain worried about the health of the economy and the ramifications of the credit crunch. While many observers are still puzzling over how we got into this mess, Steve Waldman at Interfluidity offers up a strikingly simple explanation in his Credit Crunch for Kindergarteners.

More bad news for the banks. Oppenheimer analyst Meredith Whitney cut her earnings estimates on big financial firms including Citi (C), citing rising write-offs of collateralized debt obligations and other mortgage-related debt. Whitney now expects Citi to post a 2008 loss after a first-quarter writedown of $13 billion. That’s not the biggest number out there - analysts at Merrill Lynch projected earlier this month that Citi could take first-quarter writedowns of as much as $18 billion - but coming from perhaps the most closely followed analyst on the banks, it’s a number worth noting.  

Citi isn’t the only outfit feeling Whitney’s wrath. She cut her estimates on JPMorgan Chase (JPM), Bank of America (BAC) and Wachovia (WB) as well. Whitney has been warning for almost six months now of serious pain in the banking system, starting with last October’s prediction that Citi would have to cut its dividend and raise capital. Those events came to pass two months later, but these companies still aren’t out of the woods, she writes Wednesday. “Despite cutting estimates for financials over 30 times since November, we are confident that this will not be our last reduction in 2008,” Whitney warned. ”We anticipate further downside to both estimates and stock prices.”

The cost-cutting never stops at Citi (C). The bank said it will cut back its U.S. mortgage business in a bid to save $200 million annually. Citi said it will reduce residential mortgage assets by $45 billion over the next 12 months, marking a 20% decrease from December 2007 levels, and will cut the amount of new loans to be held in portfolio by more than 50% in the next year. Citi also intends to boost the number of mortgages it underwrites that are eligible to be sold to Fannie Mae (FNM) and Freddie Mac (FRE) to 90% of originations from 65% last year - just as the market is worrying about the government-sponsored lenders’ capacity to shoulder a heavier burden. All of these changes will come under a newly combined consumer lending operation called CitiMortgage. “This end-to-end realignment will create a simplified and streamlined organization that is more sharply focused on clients and able to direct resources to the business lines and customer segments with the highest growth potential,” said Bill Beckmann, president of CitiMortgage. “At the same time, these changes will enable us to manage the business unit’s capital for enhanced returns.”

Maybe every day doesn’t bring more bad news about Citi (C) after all. Citi shares dropped 4% on Tuesday after Sameer al-Ansari, the head of Dubai’s sovereign wealth fund, said at a private equity conference that the struggling New York-based bank will need more than the $30 billion it has already raised to muddle through the mortgage mess. “It will take a lot more than that to rescue Citi and other financial institutions,” Bloomberg had him saying. It will “take a lot more money” to pull Citi through the mortgage mess, he told Reuters.

That all seems clear enough, but DealBook at The New York Times notes that Dubai is now backing away from the statements. “Dubai International Capital has never expressed an opinion on the investment merits or financial condition of Citi,” the sovereign wealth firm said in a press release issued Wednesday. “Further, we have not been privy to any non-public information about the company, neither has Citi approached Dubai International Capital for a capital raise.”

As nice as the sentiment is, it isn’t doing Citi any good just yet. Shares fell 4% in a marketwide selloff Thursday to within a penny of Tuesday’s nine-year low.  Even so, Dubai’s statement indicates it has the big picture in view. ”Dubai International Capital maintains an ongoing relationship with Citi and has substantial respect for the company,” Wednesday’s press release reads. Not to mention a desire to steer clear of protectionist-minded sovereign wealth bashers in Congress.

Citi (C) sank 6% to a nine-year low amid rising worries about the banking giant’s financial health. Analyst Guy Moszkowski at Merrill Lynch cut his 2008 earnings estimate to 24 cents a share from $2.74, citing billions of dollars in subprime-related writedowns and other problems, starting with the U.S. consumer. “We remain concerned about loss provision potential, the direction of long-term strategy, and weak markets for the Capital Markets businesses,” Moszkowski writes.

Concerns about Citi are widespread. CNBC reports the bank could be forced to cut more than 30,000 jobs - up from a previously announced plan to cut 24,000 positions - in a bid to bring expenses back in line with revenue. The CEO of Dubai’s sovereign wealth fund believes the $22 billion Citi has raised recently won’t be enough to keep the bank from going back to the markets for more capital soon.

The good news, such as it is, is that with the stock trading around $22 - down from $55 last summer - Citi is trading roughly on par with book value on a pro forma basis, Mozkowski writes, adjusted for an expected first-quarter loss and recent capital-raising activity. While there’s no telling how much further Citi shares might fall, a bank stock trading at book value can expect to start attracting at least some attention from value-minded investors.

Citi (C) is in dire straits indeed. The $22 billion that the financial titan raised in recent months from investors including funds in Abu Dhabi, Kuwait and Singapore won’t be enough to see Citi through the credit crisis, the head of Dubai’s sovereign wealth fund predicted Tuesday. “It will take a lot more than that to rescue Citi and other financial institutions,” Sameer al-Ansari,  Dubai International’s chief executive, said at a private-equity conference in Dubai, Bloomberg reports. Al-Ansari, whose fund has invested in HSBC (HBC) but not in Citi, told Reuters it will “take a lot more money” to pull Citi through the mortgage mess.

The bank has taken $18 billion in writedowns tied to the collapse of mortgage-backed securities, but Merrill Lynch analysts expect Citi to take an added $15 billion in mortgage-related writedowns in the first quarter and to post a loss of $1.66 a share. No wonder the stock, down more than 1% in premarket trading Tuesday, is trading within a dollar of its 52-week low.

Another obscure corner of the debt market is causing pain for taxpayers. States and cities selling municipal bonds are finding they have to pay more to issue so-called variable-rate demand notes, The Wall Street Journal reports. As with the collapse earlier this month of the now infamous auction-rate securities market, the problem is that Wall Street dealers such as Bear Stearns (BSC) and Morgan Stanley (MS) have stopped buying the debt, which allows municipalities to borrow for the long term at lower short-term rates. The dealer pullback has caused demand to dry up and interest rates to spike. The rate California paid on a recent $300 million issue quadrupled to more than 8%, the Journal reports.

Meanwhile, in a novel twist, the failure of the notes to sell at auction could leave them piling up on the balance sheets of so-called backstop banks such as Bank of America (BAC) and Citi (C), which are already stuck with billions of dollars of loans and other assets they can’t sell. That’s not even the worst news in the municipal bond market, though: Bloomberg reports that the California city of Vallejo is near a bankruptcy filing brought on by the collapse of the housing market, which has resulted in lower tax revenue, and rising pension costs. “Bankruptcy is a last resort,” councilwoman Joanne Schivley said, Bloomberg reports. “But guess what folks, that’s where we are now at.”

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.

Hedge fund manager Ed Lampert is cutting his losses on Citi (C). Lampert is best known for providing his investors with 20 percent-plus annualized returns since 1988, and for his efforts to turn around retailer Sears (SHLD) through a 2005 merger with Kmart. But 2007 wasn’t a good year for him - as shown by the action in Citi, where Lampert appears to have spent the year buying high and selling low.

Lampert cut his stake in Citi by 31 percent in the fourth quarter ended Dec. 31, according to a Securities and Exchange Commission filing. He held 19.1 million shares in the financial giant at year-end, down from 27.8 million shares in September. What’s more, Lampert made his sales during a quarter in which Citi’s shares were falling sharply, spending most of the period below the prices at which Lampert made his earlier purchases.

Before the latest quarter’s stock sales, Lampert had spent more than a year accumulating shares of Citi. He began buying the stock back in 2006, when Citi shares traded between $44 and $57, and continued his purchases through the first three quarters of last year, when Citi ranged between $44 and $56. During the summer of 2007, before the subprime mortgage crisis hammered stocks across the financial sector, Lampert’s stake was worth as much as $1.3 billion. Given Lampert’s track record, it’s no surprise that his foray into Citi had some observers applauding his prescience.

But Citi shares lost more than a third of their value during the fourth quarter alone, as CEO Chuck Prince departed after Citi admitted it would have to take a multibillion-dollar writedown of mortgage-related securities. The shares fell to just over $29 in December from $45 earlier in the quarter. By year-end, Lampert’s Citi scaled-down holdings were worth just $561 million, filings show - a fraction of their peak worth.

It’s impossible to know whether Lampert has been buying or selling Citi shares this year, but so far 2008 is shaping up as another rough one. Five of his fund’s six holdings at Dec. 31 are down for the year, with Citi down 12 percent, AutoZone (AZO) down 6 percent, AutoNation (AN) down 4 percent, Sears off 3 percent and Home Depot (HD) down 1 percent. Only marketing services firm Acxiom (ACXM), Lampert’s smallest holding at Dec. 31, is up, with a 9 percent gain. Lampert’s showing is in line with the broad stock market declines so far this year, but that surely can’t make his investors any less antsy.

More trouble for Citi (C). The bank stopped investors from pulling their money out of a hedge fund that specialized in corporate debt after the fund, CSO Partners, posted an 11 percent loss for 2007, The Wall Street Journal reports. The Journal reports Citi injected $100 million to stabilize the fund, which has about $500 million in assets but faced an attempt by investors to withdraw 30 percent of the fund’s money.

Citi isn’t the only financial titan with hedge fund problems, though. The Journal reports that investigators are probing whether former Bear Stearns (BSC) fund manager Ralph Cioffi misled investors on an April conference call that was held just  months before the firm admitted that two in-house hedge funds had collapsed. On the April call, the Journal reports, Cioffi said he was “cautiously optimistic” about the funds, which made leveraged bet on subprime mortgage-backed securities - despite the fact that he had just pulled $2 million of his own money from the funds. Cioffi’s lawyer is considering making him available to prosecutors for informational interviews, the Journal adds. Perhaps he’ll tell investigators that he really needed to diversify his portfolio.