More problems ahead for Citigroup

NEW YORK (Fortune) -- If only it were just a matter of quickly replacing one CEO with another.

Citigroup's chief executive, Charles Prince, stepped down Sunday - a move that could set the stage for the company's recovery. But Citi also delivered grim financial news: It said it may have to suffer as much as $11 billion in writedowns because of the still-unfolding subprime mortgage crisis.

Prince may resign this weekend.

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Citigroup (Charts, Fortune 500) is also expected to post a regular filing with the Securities and Exchange Commission that gives more details about its performance in the third quarter. This filing could contain new information about stricken assets that could further unnerve investors.

Citigroup's stock, which has underperformed for years, has lost nearly a third of its value this year.

And, amid the heightened balance sheet fears, Citigroup's board has to start a search for a CEO who would be capable of both managing through more upsets and drawing up a far-reaching restructuring plan that could win over discontented employees and investors.

Since there are currently no obvious strong replacements for Prince - in or outside the bank - optimism stemming from his departure could give way to fears that the bank could remain headless too long or that the board may move too quickly and pick an underqualified candidate.

Clearly, the next few weeks are critical for Citigroup. So, what could go right for Citigroup - and what could go wrong?

One extremely bad scenario - which could unfold soon with the SEC filing - would be if Citigroup gives any indication that its already-reported third quarter results understated losses and now have to be revised higher.

This is not an outlandish possibility, since the SEC is reportedly looking into Citigroup's accounting.

And recall that certain losses in Citigroup's official third quarter results were noticeably higher than estimates the bank made just under four weeks earlier.

In its third quarter earnings on Oct. 26, Citigroup reported losses on complex debt securities called collateralized debt obligations that were $250 million higher than estimates made on Oct. 1.

And the addition Citigroup ended up making to its bad loan reserve in the consumer business was $250 million bigger than the bank said it would be on Oct. 1. (Additions to this reserve are counted as a hit to the income statement.)

While Citigroup may not go back and restate third quarter results, it's almost certain now that its fourth quarter could be a lot worse than Prince said it would be on a conference call on Oct. 26.

It seems incredible - even foolhardy - now, but on Oct. 26 Prince held out the possibility of an earnings recovery for Citigroup in the fourth quarter: "While we cannot predict market conditions or other unforeseeable events that may affect our businesses, we expect to return to a normal earnings environment in the fourth quarter," he said.

Citigroup is now expected to take further large losses in its fourth quarter. Deutsche Bank analyst Mike Mayo estimates Citigroup could write down assets by another $4 billion in the fourth quarter, for example.

Fourth quarter losses were expected to be one of the main talking points at Sunday's board meeting. Board members like Robert Rubin, Citigroup's 'chairman of the executive committee' and former Treasury secretary, and Time Warner CEO Richard Parsons both expressed support for Prince recently. But boards dislike surprises and Citigroup's may have lost patience if it recently learned from managers that there are a lot more losses to come.

But strong action by the board on losses would be a good thing for Citigroup and is a key part of its recovery.

If, for example, the board says this coming week that managers are taking a more conservative and careful look at Cititgroup's balance sheet - regardless of whether it means higher-than-expected losses - investors could actually feel more confident about the bank because they'd end up having a better handle on what it's actually worth.

The other huge headache for the board is finding a new chief exec who can rise to the twin challenges of steering Citigroup through rough waters at the same time as charting out a new long-term course for the bank. (The irony, of course, is that Merrill Lynch (Charts, Fortune 500), since Stanley O'Neal departed the CEO post last week amid large losses, is looking for someone with exactly the same combination of abilities.)

Many people think Rubin is capable of doing the CEO job at Citigroup, but he has reportedly long been reluctant to be considered for that post. Internally, Vikram Pandit, head of Citigroup's investment bank, is considered capable, but he has only been at Citigroup since the spring. Externally, the most-mentioned candidate is John Thain, CEO of the New York Stock Exchange and a former top executive at Goldman Sachs (Charts, Fortune 500).

The big wild card in the Citigroup saga is what happens now with its large, shadowy bond funds that the credit crunch has hurt. Citigroup's so-called structured investment vehicles (SIVs) - which have approximately $80 billion in assets - are kept off the balance sheet and are having trouble because investors stopped buying the notes they issued to fund their investments.

Other banks, along with the Treasury, are trying to set up a new, bigger SIV that would effectively stop the other SIVs from going into liquidation. The Wall Street Journal reported Friday that the Securities and Exchange Commission, the stock market regulator, is looking into whether Citigroup has been accounting correctly for transactions it has done with its SIVs. A Citigroup spokeswoman is quoted in the Journal saying the bank is confident that it has accounted for its SIVs correctly.

If the SEC review does find irregularities, there's a chance Citigroup would have to reflect at least some of its SIV exposure on its balance sheet. Some analysts think Citigroup doesn't have sufficient capital - the cushion left after subtracting liabilities from assets - so any move to reflect the SIVs on the balance sheet could deepen worries over the bank's financial strength. However, other analysts believe Citigroup has adequate capital to deal with an SIV shock and more losses from mortgage-related assets and bad loans.

Prince has vacated his throne but left the kingdom in horrible disarray for his successor.