Morgan Stanley is likely to pay Citigroup between $2 billion to $3 billion for a 51 percent stake in the brokerage Smith Barney, a person close to the negotiations said.
Morgan Stanley would then have the option to buy Smith Barney over the next three to five years, the person said. The person spoke on condition of anonymity because he was not authorized to speak about the ongoing talks.
If negotiations proceed through the weekend as they have been, an announcement could come as early as Monday, the person said.
Word of the negotiations came as investors digested news Friday that Robert Rubin, a senior adviser to Citi who has drawn heavy criticism, would resign and would not seek another term on the board.
A combination of the brokerage units would help Citigroup get more much-needed cash and cut costs, said Aite Group analyst Alois Pirker. The benefit for Morgan Stanley, Pirker said, would be a bigger staff to compete with other growing brokerages - particularly Merrill Lynch, which recently was acquired by Bank of America Corp..
The deal may also lead to a full-fledged merger between the two banks, he speculated.
"The ultimate goal could be to merge the two entities fully," Pirker said. "Morgan Stanley needs deposits, there's no doubt about that. They won't get that by telling brokers to get deposits from their clients."
Morgan Stanley applied to become a bank holding company last fall to get loans from the government and collect deposits - one of the few reliable sources of funding these days with the credit markets still squeezed.
The government is not driving the negotiations between Citigroup and Morgan Stanley, people with knowledge of the situation said. They also spoke on condition of anonymity because they were not authorized to speak about the matter.
There were no talks scheduled for this weekend between the Treasury Department and Citigroup officials.
The potential deal is another sign of the U.S. banking industry's consolidation into a few huge power players - ones that are still heavily reliant on the government for backing as the economy deteriorates.
"It's a bit of a worrying sign, I think," Pirker said. "It seems like the firms are too big as they are, from the brokerage perspective. They are racing to get bigger than the next one. One wonders if they'll have to shrink back again."
Citigroup's CEO Vikram Pandit spent decades working at Morgan Stanley before starting his own hedge fund, and has appointed many former colleagues to top-level management positions at Citigroup.
Private analysts said Citi's interest in raising revenue with a Smith Barney deal was likely aimed at demonstrating to the government and Wall Street investors that it was working to bolster Citi's finances.
The company has reported four straight quarters of losses totaling $20.2 billion through September 2008 and is expected to post yet another loss when it releases fourth-quarter results on Jan. 22. Thomson Reuters said analysts it surveyed expect Citi to report a loss, on average, of $1.14 a share for the October-December period.
Citigroup has received $45 billion in support from the government's $700 billion financial rescue fund, an amount that is almost double what has been provided to any other major bank.
Some analysts said that they expected Citi to make further efforts beyond Smith Barney to sell assets to raise cash including selling some of their foreign operations.
"The bottom line is that Citigroup has to shrink its size and sell off assets to bring in cash to shore up their capital base and be in a better position to eventually pay back the government," said Sung Won Sohn, an economist at the Smith School of Business at California State University.
"Even during the boom times, Citi was in too many businesses," Sohn said. "I think Citigroup is going back to what it used to be, a much smaller organization with significantly reduced costs."
Citigroup was hit particularly hard by the housing market downturn because the bank was heavily invested in mortgages and other loans. The company has reported four straight quarters of losses, and is expected to post yet another loss when it releases fourth-quarter results later this month.
If Morgan Stanley ends up buying Smith Barney, it "sounds like the beginning of a liquidation," said Christopher Whalen, managing director of Institutional Risk Analytics.
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