Citigroup (NYSE: C) is in talks with federal and New York State authorities to settle charges that it misrepresented the liquidity of the auction-rate securities that it sold to clients. The financial instruments were presented as being nearly as liquid as cash, but when the market in the paper locked up a year ago, owners of the securities could not sell them.

According toThe Wall Street Journal, Citi conversations with regulators "to resolve allegations of wrongdoing in the auction-rate-securities market could result in its buying back several billion dollars of the illiquid securities from investors and paying a sizable fine."

Leaving Citi aside, banks and brokerage houses could face another substantial series of write-offs if the industry decides to come clean on the auction rate mess. The market totaled about $360 billion. While the paper is not worthless, it may bring only 60% of its face value. The leaves a hole of nearly $100 billion.

Financial companies may not have a choice beyond settling. It appears that both personal investors and corporations were told that they could get the money out of auction rate securities with ease. When banks decided to no longer take on the risk of trading the paper, most of the bonds could not be sold at all.

Investors at banks and brokerage houses should get ready for a new round of write-offs large enough to take their shares back to their recent lows.

Douglas A. McIntyre is an editor at 247wallst.com.

The latest balance sheet of the Federal Reserve makes me wonder whether it's solvent. That's because its balance sheet has clearly deteriorated in the last year. And with $40 billion in capital, that deterioration could take a big bite out of the Fed's capital.

Unfortunately, I do not know enough about how the Fed gets its capital or how it accounts for the value of its assets and liabilities to be able to do more than raise questions. But here are three things that concern me:

• Declining asset quality. The total value of the U.S. Treasury securities on the Fed's balance sheet declined by $312 billion between July 2007 and this July -- a 43% drop in this highest quality asset.
• Increase in shakier assets. During this same period, the balance in Term Auction Facilities -- the credit line that investment banks are using to get their shakier assets -- such as Collateralized Debt Obligations (CDOs) off their balance sheets --increased from $0 to $150 billion. Another $29 billion in assets come from Maiden Lane, LLC -- the entity created for the Fed to take on the toxic waste that sank Bear Stearns.
• High leverage. While the Fed has more capital backing up its assets than the typical investment bank -- which holds $1 of capital for every $32 in assets -- the Fed is still highly leveraged -- with only $1 of capital for every $23 of assets -- it borrows the rest. Put another way, if the Fed was forced to account for its balance sheet on a mark-to-market basis, a mere 4.5% decline in the value of the Fed's assets would wipe out its capital.

These observations raise questions in my mind:

Public companies with auction-rate securities on their balance sheets were, in many cases, forced to write-down the value of those assets because they have become illiquid. Firms took on the investments because they were considered as easy to buy and sell as cash, but offered better interest rates. Then the market for the securities stopped trading.

Under GAAP, the companies holding the auction-rate paper had to take a P&L charge.

According to The Wall Street Journal, "According to a study of earnings reports conducted by securities-valuation firm Pluris Valuation Advisors LLC, 402 public companies disclosed that they held variations of auction-rate securities. Half had written down the value of their holdings. Of those that did, the average markdown was 13.2%, the study shows."

What investors should watch for is the companies which have not acted, because they could face a significant hit in future quarters. That, in turn, could mean a sell-off in their shares. Some companies which do not have huge amounts of cash, could actually face a credit squeeze.

Several fairly big and, one would think smart, companies that took a haircut in Q1 include Google (NASDAQ: GOOG) and Starbucks (NASDAQ: SBUX).

Douglas A. McIntyre is an editor at 247wallst.com. He is also the author of the Ten Stocks Under $10 letter.