Citi-Morgan talks seen leading to wave of deals

updated 10:53 a.m. ET Jan. 12, 2009

NEW YORK - Talks between Citigroup and Morgan Stanley about a deal to combine their brokerage operations continued on Monday, a move analysts say could trigger a fresh wave of consolidation in the troubled and thinning banking industry.

An announcement could arrive Wednesday at the earliest, a person close to the negotiations said Monday. The person spoke on condition of anonymity because he was not authorized to speak about the ongoing talks.

Citigroup shares fell 60 cents, or 9 percent, to $6.15 in early Monday trading, while Morgan Stanley shares rose $1.10, or 5.8 percent, to $20.16.

The potential deal between Citi and Morgan Stanley underscores the problems still facing the industry after a year in which several well-known financial firms toppled under the weight of rising losses tied to bad mortgages.

"This really shows the continued vulnerability of the banking system," said Keith Springer, president of Capital Financial Advisory Services.

Morgan Stanley is likely to pay Citigroup between $2 billion and $3 billion in cash for a 51 percent stake in the brokerage Smith Barney, the person close to the talks said. In total, after accounting for the revaluation of Smith Barney, Citigroup would get a pre-tax gain of $10 billion, or $5 billion to $6 billion after taxes, the person said.

Morgan Stanley would then have the option to buy the rest of Smith Barney over the next three to five years, the person said.

During the past several months of financial turmoil, many banks have had to overhaul their business models. Morgan Stanley and Goldman Sachs Group Inc. became bank holding companies shortly after rival Lehman Brothers Holdings Inc. filed for bankruptcy protection and Merrill Lynch & Co. was sold to Bank of America Corp. in an emergency sale initially valued at $50 billion. Investors had grown concerned that stand-alone investment banks would no longer be viable amid continued weakness in the credit markets.

A deal to combine the brokerages of Citigroup and Morgan Stanley would not only give Citi much-needed cash, it would also give Morgan Stanley more manpower, analysts said.

"If Morgan and Citi get together, they would be able to put together a retail brokerage unit that is larger than Merrill's thundering herd, which could position them well in the marketplace," said Chris Probyn, chief economist at State Street Global Advisors. "This may be a way of staying competitive."

The move would also be beneficial to Morgan Stanley as it looks to build its less-risky, lower leveraged businesses after becoming a bank holding company. The move would also provide Morgan Stanley a greater sales force to build its growing retail deposit based, which has been among the bank's top priorities in recent months, Lauren Smith, an analyst with Keefe, Bruyette & Woods Inc. wrote in a research note Monday.

Morgan Stanley has been able to hold up relatively better than other financial firms amid the ongoing credit market turmoil, though it did post a $2.37 billion loss during its fiscal fourth quarter, which ended Nov. 30. Still, Morgan Stanley's woes have not been of the same magnitude as Citi's.

Citigroup has been hit particularly hard by the housing and credit crises. Though the bank has received $45 billion in support from the government's $700 billion financial rescue fund, its financial footing remains shaky.

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