The surprisingly low valuation made by Morgan Stanley ( MS - Analyst Report ) for its brokerage joint venture – Morgan Stanley Smith Barney – with Citigroup Inc. ( C - Analyst Report ) may result in Citi incurring a substantial charge in the third quarter of 2012. The news became public as a result of a filing made by Citi with the Securities and Exchange Commission.

Morgan Stanley which currently holds 51% in the brokerage joint venture (JV) is making efforts to buy an additional 14% stake from Citi. While making such deals, Citi has valued its 49% stake in the JV at about $11 billion. However, quite astonishingly, Morgan Stanley has valued the full brokerage firm at around 40% of Citi’s valuation for the JV.

This wide variation in the valuation of the brokerage firm by Citi and Morgan Stanley has called in for a third party appraisal process. At the end of August, this third party appraisal process is to be accomplished and by September 7, the 14% stake sale by Citi is scheduled to be completed.

It was way back in 2009 when Citi sold off its 51% stake in Smith Barney brokerage unit to Morgan Stanley after suffering significant losses during the financial crisis. Citi termed several businesses as non-core and is continuously winding down these units so as to streamline its business and generate adequate capital to run and expand its core franchisee and satisfy regulatory norms. Notably, Morgan Stanley, which currently holds a 51% stake in the JV, has the right to acquire the full brokerage unit.

We believe that the stake sale is a strategic fit for Citi. Though this wider gap in the valuation of the JV by Citi and Morgan Stanley has led to the involvement of the third party appraisal process and could result in Citi shelling out non-cash charges in the third quarter, the sale would ultimately help Citi in roping payments which would boost its Tier 1 Common regulatory capital ratio for Basel III purposes.

However, as Citi’s stake in the brokerage joint venture is not included for Basel III regulatory capital purposes, its impairment related to that asset would not impact its estimated Basel III capital position. As a matter of fact, the capital rules proposed under the Basel III norms are aimed at helping the financial industry at large and the banks in particular to overcome any stress situation by holding adequate buffer capital.

Currently, Citi shares retain a Zacks #3 Rank, which translates into a short-term Hold recommendation. Considering the fundamentals, we have a long-term Neutral recommendation on the stock.