After Prince, more problems for Citi

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 gave up his throne this weekend.

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Citigroup (Charts, Fortune 500) is also expected to post a regular filing with the Securities and Exchange Commission as soon as this week that would give more details about its performance in the third quarter. This document could further unnerve investors with new information about stricken assets. Citigroup's stock, which has underperformed for years, has lost nearly a third of its value this year.

Shares of Citigroup stock fell nearly 5 percent in Monday trading.

And, as it deals with the enormous new losses, Citigroup's board has to find a CEO who would be capable of both managing through more pain and drawing up a far-reaching restructuring plan that could win over discontented employees and investors.

Since there are 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 days and weeks are critical for Citigroup.

In some ways, Citigroup did the right thing Sunday by coming out with a new projection for mortgage-related losses and clearing away some of the uncertainty hanging over the bank.

The problem is that few analysts expected the writedowns - which are on subprime mortgages, and securities backed with such mortgages - to be so high. Citigroup estimated that the value of these assets has fallen since Sept. 30 by between $8 billion and $11 billion. The bank said these losses could hit net income by between $5 billion and $8 billion. That $8 billion would be equivalent to nearly 60% of Citigroup's net income in the first nine months of this year, and it could weaken Citigroup's capital ratios, which some analysts think are already weak.

And while the projected losses give some clarity, Citigroup talks about them with language that is far from comforting. For example, it says that the final loss range in reported results "could differ materially" from the $8 billion to $11 billion range. Factors such as house prices and credit ratings could influence this range, but Citigroup alluded to one factor that could be a real source of unease: The market prices of the distressed securities, which have barely traded since demand evaporated in the summer.

Citigroup noted that its $43 billion exposure to collateralized debt obligations (CDOs) - the complex debt securities that also caused large losses at Merrill Lynch - has been valued chiefly according to in-house estimates. When and if the CDOs start to trade, the market may ascribe an even lower value than Citigroup's own guesses.

And the guessing about the ultimate size of the losses could go on for a long time. Citigroup said Sunday that it won't publicly update its loss estimates until it reports fourth quarter earnings in January.

The bank did put a good face on one point on Sunday. It said that it has no plans to cut its dividend, a strong retort to a Wall Street analyst who argued in a report last week that the bank may have to reduce its dividend to shore up capital levels.

By committing to the dividend, Citigroup is implicitly saying that it does not believe its credit rating - AA, which is one notch below the highest rating possible, AAA - is in danger of a downgrade. Like other banks, Citigroup needs high credit ratings to borrow cheaply and would almost always opt to protect its rating over paying out capital to shareholders in the form of a dividend.

While all eyes will be on the fourth quarter, the third quarter will also come under scrutiny if, as expected, Citigroup submits its SEC filing for the third quarter. These filings often contain data that never make it into earnings press releases. Investors will be looking for any signs that the bank now has doubts about the accuracy of the third quarter numbers it released on Oct. 26.

As the guessing game over numbers continues, the other big issue hanging over Citigroup is finding a fitting successor for Prince.

The board has to find a new chief executive 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. (One irony, of course, is that they are now looking for a new CEO while Merrill Lynch (Charts, Fortune 500) - whose chief, Stanley O'Neal, departed last week amid large losses - is looking for someone with exactly the same combination of abilities.)

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 Department, 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 is looking into whether Citigroup has been accounting correctly for transactions it has done with its SIVs. A Citigroup spokeswoman was quoted in the Journal saying the bank is confident that it has accounted for its SIVs correctly. But, conspicuously, Citigroup didn't mention its SIVs, at least explicitly, in the Sunday press release on losses.

If the SEC review does find irregularities with the SIV trading, there's a chance Citigroup would have to reflect at least some of its SIV exposure on its balance sheet. Because of the doubts about Citigroup's capital strength, any move to reflect the SIVs on the balance sheet could deepen worries over the bank's financial footing. 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 he left the kingdom in horrible disarray for his successor.