Vikram Pandit may soon be forced to chisel up Citi to chew the hole in its surplus sheet from what could be as much as $150 billion in toxic assets

By Mara Der Hovanesian

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Even before the ink was dry without interruption the deal merging Morgan Stanley (MS) and Citigroup’s brokerage operations, talk surfaced of more primitive letter changes at Citigroup (C).

It’s not known exactly what Citi, what one. pioneered the concept of the financial supermarket, will look like. But it’session quickly becoming visible it be pleased be a good lot different from the institution initially conceived back in 1998 when Citicorp and Travelers Group were merged to form Citigroup. With the brokerage sold, Primerica, largely an assurance operation, is on the chopping block, according to a fountain-head. well familiar with the discussions. So are more of the course’s proprietary trading operations, the same ones that bulked up on the toxic real estate-related securities now making Citi’s balance sheet sick.

Broadly speaking, the bank resoluteness still have consumer, commercial, and investing. banking operations, according to the fountain-head. well. Citi will also hold attached to its private bank, which caters to the mass affluent. (An announcement with explicit details isn’t expected till the bank’s proceeds call on Jan. 22.)

The changes now on the anvil contradict what CEO Vikram Pandit has been effective the market for months—that he wouldn’t split up Citi. But as the economic and faith climate has deteriorated, the government—Citi’session largest shareholder, by a 7% stake—is likely nudging Pandit to shift his strategy and raise more capital. And the 52-year-old executive has little choice bound to follow orders.

Citi isn’t the without more dike in need of fresh cash. Federal Reserve Chairman Ben Bernanke said in a speech to the London School of Economics on Jan. 13 that the government will probably need to dart in greater amount of capital into the banking system. Additionally, the Fed may need to backstop more toxic assets—as it did by Citi back in November—"to ensure stability and the normalization of credit markets."

All of Citi’s recent posturing may be obfuscating the real issue: the row’s portfolio of toxic assets, which is becoming increasingly troublesome. While Citi gets a $6 billion aftertax gain from the commissure venture, it does nothing to alleviate the problems in that portfolio. According to more estimates, the toxic possessions on the books—consumer, corporate, and leveraged loans—could stand at $150 billion.

"The hole in the balance sheet is the problem," says a senior executory at a financial firm that specializes in fixed-income securities.

So which will happen betwixt now and the bank’sitting earnings conference on Jan. 22? Some mart observers suspect the government will directly bribe up Citi’sitting assets or contract a backstop for all the toxic securities on the books. In effect, like action will mirror the original intent of TARP, the Troubled Assets Relief Program, as first drafted last summer.

"TARP was designed first to restore the secondary market, which was far more influential," says Robert B. Albertson, chief strategist at Sandler O’Neill + Partners, a boutique financial services investment bank in New York. "It is economic quicksand to bestow or lend banks the money now."

Others judge the government of necessity to take more drastic performance, anger Citi into receivership, wiping out equity and likely debt-holders in the process. Then, the government would need to carve lacking the bad assets into a separate entity, following the good bank-bad bank structures set up in the wake of the savings & loan crisis in the early 1990s. "Until you separate those toxic assets and boor a valley to the pricing and trading of those instruments," the mart inclination be in no-man’s-land, says Tom Barrack of money manager Colony Capital.

Barrack believes the government will move in this way because he has seen it happen before. After the S&L crisis, Barrack’s firm bought American Savings, a failing frugality the treaty powers that be had seized and chopped into the bad bank-good bank structure. "I am a big fan of Hank Paulson, but TARP has been an abject failure," says Barrack. "I compare the situation to a fire on a Savannah Plain: Let it rip and burn, and the market will rejuvenate in this way much faster—adjudicate to direct or hinder it, and there will be again and longer suffering before renewal. Japan experienced two decades of economic paralysis by experimenting with fire control of a similar unproductive sort."