Sept. 14 (Bloomberg) -- A few months ago, the Bank for International Settlements, which acts as a bank for the world’s central banks, warned in its annual report that “the financial sector needs to recognize losses” and “adjust balance sheets to accurately reflect the value of assets.” We are starting to get a taste of what that means, and it’s not all bad.

This week, Citigroup Inc. said it would record a $4.7 billion pretax charge to earnings after agreeing to sell its stake in its brokerage joint venture with Morgan Stanley. In hindsight, Citigroup had been overvaluing the business on its balance sheet for months, and maybe years. Yet investors took the news well. Citigroup’s stock price rose. Shareholders seemed glad to get the matter over with, even though the loss wipes out about a quarter’s worth of earnings.

Let that be a lesson to other financial institutions. Now is as good a time as ever to fess up to long-overdue red ink. The stock market is surging, and the Federal Reserve and European Central Bank are doing all they can to prop up the industry. Booking pent-up losses gets bad news into the past and helps banks build credibility, which they will need in abundance the next time they go to raise fresh capital. As Citigroup’s chief executive, Vikram Pandit, put it this week, “the more we put the past behind us, the more we can focus on our future.”

Reality Deficit

There has been plenty of news lately that backs up the assertions by the Basel, Switzerland-based Bank for International Settlements about hidden losses. At Hudson City Bancorp Inc., one of New Jersey’s largest lenders, the balance sheet was so detached from reality that the company agreed last month to sell itself to M&T Bank Corp. at a 20 percent discount to book value, or assets minus liabilities. Even so, the $3.7 billion sale price was 12 percent more than Hudson City’s stock-market value at the time. So its shareholders benefited.

Last week, Atlanta-based SunTrust Banks Inc. said it would record $725 million of pretax charges to write down bad loans, buy back soured mortgages and sell losing investments. At the same time, it also said it would book a $1.9 billion gain from selling shares of Coca-Cola Co., which SunTrust had held since 1919 when it helped take the soft-drink maker public. With the losses amply sugarcoated, SunTrust’s stock rose on the news.

This week, the Treasury Department sold most of its majority stake in American International Group Inc. While the sale drew widespread praise, it also showed the government may not have much faith in AIG’s financial statements, four years after bailing out the insurance giant. The Treasury sold at $32.50 a share, or a little more than half of AIG’s book value.

One reason financial institutions can bury losses for years on end is that the accounting standards make it easy for them. Many types of financial instruments, including loans, don’t have to be carried at their fair-market values. And the rules for writing them down tend to be flexible.

Often the same kind of asset or liability can be treated many different ways for accounting purposes, depending on what its owner supposedly intends to do with it. For instance, SunTrust had been classifying its Coca-Cola shares as “available for sale.” That meant the company’s paper gains didn’t hit net income and could be saved to offset unpleasant blemishes later.

Citigroup’s 49 percent interest in Morgan Stanley Smith Barney, which Morgan Stanley agreed to buy for about $6.6 billion, is another classic example. In its 2011 annual report, Citigroup said the investment had a “temporary impairment” as of Dec. 31, but that management didn’t plan to sell “prior to recovery of value” and didn’t believe the bank would be required to. Citigroup also said its potential loss “was not material.”

Stressed Out

A Citigroup spokeswoman, Shannon Bell, said in an e-mail this week that, based on the information available to Citigroup at the time, “it was unclear whether MS would be in a position to exercise its option to purchase an additional stake in the JV,” or joint venture. She pointed out that, back then, the Fed hadn’t yet released the results of its latest stress tests and capital reviews at the largest U.S. banks.

In other words, there was a chance Morgan Stanley might fail the Fed’s stress test. (It didn’t, although Citigroup did.) That made for an odd accounting result: The less likely it was that a buyer existed for Citigroup’s investment, the more money the investment was worth. Citigroup’s loss, of course, proved to be quite material in the end.

Morgan Stanley later did decide to buy Citigroup’s piece of the business. When the two sides couldn’t agree on a value, they put the question to a third-party appraiser, which came up with a number closer to Morgan Stanley’s much-lower estimate. Morgan Stanley, which trades for just 58 percent of book value, hasn’t disclosed the amount it has been using on its own balance sheet for the three-year-old joint venture.

Citigroup first warned in July that a big charge to earnings was possible. A critical question is how many more losses of this magnitude may loom. At $34.45 a share, the stock is trading for 55 percent of the company’s June 30 book value. So the market believes there’s about an $83 billion hole in Citigroup’s balance sheet.

The more Citigroup clears the decks, the more trust its leaders will build with the public, assuming they don’t go crazy and write off so much dreck that they spark another crisis. All investors want is a reason to believe them.

(Jonathan Weil is a Bloomberg View columnist. The opinions expressed are his own.)

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To contact the writer of this article: Jonathan Weil in New York at jweil6@bloomberg.net

To contact the editor responsible for this article: James Greiff at jgreiff@bloomberg.net