In a letter sent to employees Monday, Citigroup Inc. (C) Chief Executive Officer Vikram Pandit said the bank has been operating at a profit through the first two months of the year for the first time since the third quarter of 2007 – the last time it recorded a profit.

But even as the news was hitting Wall Street, a report revealed that regulators are “contingency planning” ways to further stabilize Citigroup if needed.  And yet another report said major banks could face “catastrophic” losses on derivatives if the economy worsens.

“I am most encouraged with the strength of our business so far in 2009,” Pandit wrote in an internal memorandum obtained by Bloomberg. “In fact, we are profitable through the first two months of 2009 and are having our best quarter-to-date performance since the third quarter of 2007.”

Pandit said the first-quarter performance so far is based on historical revenue and expense rates. Citi’s projected earnings before taxes and one-time charges would be about $8.3 billion for the full quarter.

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Citigroup’s shares rose 38.1% on the news in trading yesterday (Tuesday) to close at $1.45 a share.

However, the report was tempered by an article in the Wall Street Journal that outlined how the bank is still in the sights of federal regulators who are guarding against further losses.  Even though Federal officials aren’t expecting a sudden turn for the worse, they are examining what fresh steps they might need to take to stabilize the bank if its problems mount, the Journal reported, citing anonymous sources.

Further clouding the outlook for the financial sector, a report by McClatchy Newspapers contends that America’s five largest banks, which already have received $145 billion in taxpayer bailout dollars, still “face potentially catastrophic losses from exotic investments if economic conditions substantially worsen.”

Based on an in-depth review of end-of-year regulatory filings, the report says that “current” net loss risks from derivatives held by Citibank, a unit of Citigroup, Bank of America Corp. (BAC), HSBC Bank USA (HBA-Z, ADR: HBC), Wells Fargo & Co. (WFC) and J.P. Morgan Chase & Co. (JPM) surged to $587 billion as of Dec. 31, a jump of 49% in just 90 days.

Fueling the concerns are the banks’ holdings of credit-default swaps – insurance-like bets tied to a loan or other underlying assets – which can provide protection against defaults on subprime mortgages or guarantee payments for borrowers who walk away from their debts.

Money Morning Contributing Editor Martin Hutchinson said last week that trading in credit-default swaps is tantamount to “casino capitalism,” because they are bought and sold in a murky, private market that is largely beyond the control of federal regulators. Except for those actually trading the instruments, no one knows who owes what to whom.

“I don’t trust any numbers on them,” said David Wyss, the chief economist for New York credit-rating agency Standard & Poor’s.

The risks of these off-the-balance-sheet holdings became crystal clear when investment banker Lehman Brothers Holdings Inc. (OTC: LEHMQ) and insurer American International Group (AIG) – both major swap dealers – collapsed last September. Their failures led to a massive pullback from risk, spawning the current credit crisis.

Christopher Whalen, a managing director of Institutional Risk Analytics, a company that grades banks on potential for loss risk, calls the big banks’ credit-default swap holdings “a ticking time bomb,” noting the derivatives hold face values in the trillions of dollars.  He notes that future losses will be determined by the fate of the overall economy.

Citibank now reports 60% of its $301 billion in potential losses from derivatives are in the highest-risk category, up from 40% in early 2007.

Citigroup has racked up five straight quarters of losses totaling more than $37.5 billion since 2007.  The company’s shares fell below $1 in New York trading last week as shares of banks fell to their lowest levels in decades amid broad stock and bond market declines.

At the same time, the cost of insuring against defaults by financial institutions wheeling and dealing in the credit-default-swap market is soaring. The action reflects a lack of investor confidence on the heels of repeated bailouts of financial companies.

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