NEW YORK (Dow Jones)--Citigroup Inc. (C), stung by a very public setback in its recovery when regulators vetoed its share buyback, is preparing investors for the worst when it comes to a downgrade of its debt rating.

The nation's third largest bank by assets disclosed in a regulatory filing Friday that the doomsday scenario, a two-notch downgrade of its bonds by rating firms, could require about $4.7 billion in additional collateral for its holding company and its banking subsidiary--although that is actually $700 million less than had been predicted three months earlier.

Citi said such a downgrade could have a $2.1 billion impact on funding costs. It didn't hint in its quarterly earnings filing with the Securities and Exchange Commission how likely it is that it would actually be downgraded by two notches, rather than one, and Citi no longer discloses the impact of a one-notch downgrade.

Meanwhile, the value of Citi's Smith Barney brokerage joint venture with Morgan Stanley (MS), which is valued at $10 billion, is no longer identified as "impaired" as it was three months ago, the filing said.

That could mean that, based on equity-method accounting, the value of the venture has increased from the previous quarter, when Citi had disclosed the value might be impaired. "The midpoint of Citi's current range of estimated fair values for this investment was above its carrying value as of March 31," the bank said.

Morgan Stanley said last month first-quarter revenue from the firm's wealth-management business, the majority of which is the joint-venture with Citi, rose 6% from the fourth, and that pretax profit margins increased.

Moody's Investors Service said in February that it is reviewing the ratings of 17 banks around the world that have global capital markets operations, including Citi, because the rating firm said "these firms face challenges that are not fully captured in their current ratings."

A decision from Moody's is expected by the end of June.

So far, Citi and its competitors have provided details about funding losses and collateral requirements in case rating agencies downgrade banks one or two notches. Bank of America Corp. (BAC) said in its quarterly filing Thursday "Moody's offered guidance that downgrades to our ratings, if any, would likely be limited to one notch." Moody's had previously downgraded Bank of America's long-term senior debt rating two notches to Baa1 from A2 in September.

A downgrade might make it more expensive for banks to fund loans and investments because the banks would have to pay higher interest rates, and counterparties would likely require more collateral. Banks have been preparing investors quarterly about the increased costs if they were to be downgraded.

Citi, however, erred on the side of caution in Friday's filing; it stripped out the impact of a one-notch downgrade and provided only information about a two-notch downgrade.

For banking subsidiary Citibank, additional collateral for a one-notch downgrade could be $2.6 billion, compared to $3.2 billion three months ago.

Moody's had placed Citi's A3 long-term rating on review for possible downgrade last year. Fitch Ratings recently downgraded Citi's long-term issuer credit rating one notch, to A from A-plus; Standard & Poor's lowered Citi's issuer credit rating to A-minus/A-2 from A/A-1.

If just Moody's were to downgrade Citi, the bank's cash obligations and collateral requirements could increase by only about $1.1 billion, the filing said.

In a huge surprise to management and shareholders, Citi's efforts to buy back stock were rebuffed in March by the Federal Reserve, which determined in its annual "stress test" that Citi doesn't have enough capital to do so. Shareholders, meanwhile, refused to ratify the bank's executive compensation at Citi's annual meeting last month.

-By Matthias Rieker, Dow Jones Newswires; 212-416-2471; matthias.rieker@dowjones.com

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