Citigroup Inc. (C) could be compelled to sell its profitable and highly rated Mexican subsidiary Banamex due to a probe expected this week by Mexico’s Supreme Court.

A group of senators has objected that Citigroup’s Mexican subsidiary is in breach of national law since the US government bail-out of the company. National law of Mexico bans foreign governments from owning a stake in domestic banks.

Banamex, or Banco Nacional de Mexico, is one of Citigroup’s brightest jewels, and accounts for over $20 billion, or 15% of its global profits.

A number of other foreign-dominated banks operating in Mexico also remain exposed to the same risk, as many foreign governments own stake in them following the global financial crisis. These banks include American International Group, Inc. (AIG), Bank of America Corporation (BAC) and Bank of New York Mellon Corporation (BK), as well as European giant Royal Bank of Scotland (RBS).

However, Banamex has gathered much higher attention and risk, as it is the country’s second-largest bank and is symbolic of Mexican nationalism. Therefore, the politicians have targeted Banamex in an increasingly vociferous campaign to clarify the law and scrutinize the Mexican finance ministry’s dealing in the case.

In March 2009, the ministry passed a ruling stating that Banamex’s status was acceptable because the US government’s stake in the financial institution was circumstantial and impermanent.

However, the senators have contested the ruling by the Supreme Court. In case the decision goes against the ministry, the court has 30 days to decide whether it will examine the case. Consequentially, it might coerce Citi to sell a stake in Banamex or perhaps sell it off entirely.

Though Citi is eager to repay its TARP loans as soon as possible, which would nullify the case altogether, how soon it would be able to do that is quite uncertain.

Furthermore, Mexico’s central bank chief recently joined the escalating debate, arguing that foreign-owned banks, including Banamex, should list on the domestic stock market. This is likely to aggravate an already hot debate over Banamex at a time when the government is coming under increasing pressure to do something about the bank’s legal status.

Citigroup, once the largest U.S. bank by assets, fell behind last year after a series of acquisitions by rivals. The bank has been severely hurt by billions in losses and write-downs of problem loans and toxic assets.

Citigroup’s third quarter 2009 loss from continuing operations of 23 cents per share was in line with the Zacks Consensus Estimate. This compares favorably with a net loss of 72 cents in the prior-year quarter. Results for the quarter included $8 billion in net credit losses and an $802 million in net loan loss reserve build.

The U.S. government injected $45 billion in bailout funds into the bank, $25 billion of which was recently converted to a 34% equity ownership stake. Top-level management at the company is conceiving plans to downsize the government’s stake in the company through a multibillion-dollar stock offering.

We expect Citigroup to incur higher credit losses in the upcoming quarters as its restructuring process continues. Moreover, the obscurity around the valuation of Citi Holdings will remain a drag on the shares in the near term. As such, we are maintaining our Neutral recommendation on the shares of Citigroup.
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