Citigroup Inc on Friday said loan losses surged again in the second quarter, yet gains from selling most of its Smith Barney brokerage helped the company report the highest profit among big U.S. banks.

Citigroup, twice deemed too big to fail by the U.S. government during the past year, recorded an $11.1 billion pretax gain from selling Smith Barney into a joint venture with Morgan Stanley's brokerage unit. Citi received a 49 percent stake in the venture and cash.

The deal boosted Citi's net income to $4.28 billion, or 49 cents a share, compared with a year-earlier loss of $2.50 billion, or 55 cents. That surpassed the $2.7 billion profits reported this week by both Goldman Sachs Group Inc and JPMorgan Chase & Co .

Yet strip out the gain and Citigroup had an operating loss. Analysts pegged the loss at 62 cents a share, compared with the average forecast for a 31 cent per share loss.

Shares of Citi, little changed late in the session after rising 5 percent earlier, illustrated how investors are not quite sure how to grade the bank's ongoing efforts to rebound from two years of woe.

It's a mixed quarter. You weren't looking for a Goldman Sachs or JPMorgan-type of quarter, but we expected Citi to be a lot better than it was, said Michael Mullaney, who helps manage $9 billion for Fiduciary Trust Co in Boston.

Analysts and investors said the credit costs at Citi, which has banking operations in more than 100 countries and a pile of toxic assets, were a bigger drag than they had expected.

They seem to be suffering more than the others as far as losses go from credit cards, mortgages and consumer loans, in general, Mullaney said.

Citigroup stock is down 94 percent since peaking in May 2007 and has fallen by half this year, though it has tripled in price since financial services stocks began rallying in March. Shares were off 3 cents at $3.00 in New York Stock Exchange trade.

LESS BAD

The New York bank, once one of the most powerful in the world, has been among the biggest losers in the three-year financial crisis. The U.S. government has twice stepped in to bail out a bank slammed by credit losses, injecting $45 billion through preferred stock after Citi exhausted private sources.

Under pressure to revive the fallen giant, Chief Executive Vikram Pandit in January split the company in two: Citicorp, the company's global commercial and investment banking business; and Citi Holdings, an assortment of unwanted units and assets to be sold off.

In presenting second quarter results to investors, Citigroup officials emphasized that the pace of the increase in credit losses has slowed.

Chief Financial Officer John Gerspach told Reuters he sees improvement in Citi's consumer loan portfolio and expects the bank to fare better than rivals as commercial real estate -- where it has less exposure -- starts to suffer rising losses.

You can think of the credit cycle in three pieces: the wholesale securities piece, the consumer piece and the commercial real estate piece. As a relative matter, we have less exposure in the third area, Gerspach said.

Quarterly revenue jumped by $12.4 billion, or 71 percent, to $30 billion from last year, but nearly all the increase stemmed from Smith Barney as well as the rebounding value of its assets.

The bad news is that credit costs also surged, up 81 percent to $12.4 billion. That includes $8.4 billion of net loan and securities losses and the addition of $3.9 billion to loan loss reserves.

All in all, our quarter comes down to mortgage and credit card losses, Chief Executive Vikram Pandit told analysts.

GOOD BANK, BAD BANK

Pandit wants investors to focus on the virtues and brighter outlook of Citicorp, the ongoing banking business. Income from continuing operations there fell 11 percent to $3.06 billion, largely as credit losses slammed consumer banking profits.

Citi's investment banking and trading division enjoyed a strong quarter, boosting its income 16 percent to $2.84 billion.

Citi Holdings posted operating income of $1.36 billion, compared with a loss of $5.23 billion a year earlier, though again the results reflected Smith Barney. Consumer finance losses surged to $4.2 billion while a special asset pool of toxic loans and securities generated losses of $1.3 billion.

Over time, Pandit said, assets will be sold off or allowed to mature.

For now, though, investors have to sort out whether the bank is resolving its balance sheet problems quickly enough.

It is hard to say whether they've completely turned the corner, but they are heading in that direction, said Walter Todd, portfolio manager at Greenwood Capital Associates. Part of that is the economy bottoming out and part of that is actions they have taken internally.

Pandit also noted the bank is taking steps to end the government's 10-month relationship as an investor. Common shareholder earnings were reduced by $1.28 billion of preferred stock dividends paid to the U.S. government and other investors, compared with $361 million a year ago.

The Financial Times this week reported that Citigroup Inc. is close to a secret agreement with one of its main regulators that would increase scrutiny of the U.S. bank and force it to fix financial and management shortcomings. Citi officials declined to comment.

In any case, the bank next week expects to swap preferred shares sold under the Troubled Asset Protection Program into a 34 percent equity stake. Pandit assured analysts the bank's improving capital ratios and performance since the Federal Reserve scrutinized the biggest U.S. banks will help it repay the government.

As we continue to sustain this outperformance, as we plan, we create capacity to repay TARP, he said.

(Reporting by Joseph Giannone; Additional reporting by Steve Eder; editing by John Wallace and Gerald E. McCormick)

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