Despite a $45 billion capital injection from the government in 2008, Citi is in dire enough need of capital that it is planning to spin off its retail brokerage operation, Smith Barney, according to reports, in a joint venture with cross-town rival Morgan Stanley. At least one analyst says Citi also hopes the deal will save Smith Barney, where disgruntled advisors and clients are said to be exiting.

According to news reports, Morgan Stanley would pay Citi between $2.5 billion and $3 billion for 51 percent ownership of the combined brokerage units. Morgan would likely have the option to acquire the rest of the newly formed company over three to five years, according to a Bloomberg report. Further details on the deal are expected to be made public this week. In the meantime, a spokesperson for Citigroup says, “We don’t comment on rumors” and Morgan Stanley says the firm is “not commenting right now.”

Questions remain about why Citi would dismantle a model it has long said it believed in. “This is one of the first significant steps away from the universal banking model. After many years of being among the elite in that model, Citigroup is moving away from it by getting rid of its brokerage business. It’s really an indication that they’re running out of options,” says Bob Ellis, senior vice president of wealth management at Celent.

But in fact, Ellis says he thinks a deal may be the only thing that can save Smith Barney. “The less discussed component of this deal, which you don’t hear much about, is the fear that Smith Barney was losing advisors and unable to attract new ones,” says Optique’s Fitzpatrick. “It was also losing client assets. So there was the fear that Smith Barney is a sinking ship. A new name on the door could go long way towards stabilizing the conditions at Smith Barney.”

But there are plenty of other reasons for Citi to sell. Bill Fitzpatrick, an analyst at Optique Capital Management in Milwaukee, which does not own Citigroup shares, says that at this point, the mortgage risk on Citi’s balance sheet has been taken care of, but potential trouble lurks in the bank’s commercial loan and credit card portfolios. “They have big credit card portfolio that’s done well in the past but is in danger of delinquency due to higher unemployment,” he says. “If we get to 10 percent unemployment, that could mean a 10 percent delinquency increase.”

The Deal

A merger between the two operations would face plenty of obstacles, but the resulting combination would create the biggest brokerage in the U.S. “We expect that it will take three years to successfully merge these operations together and in the meantime the retail business will face a severe downturn. If properly integrated and tightly run, the capital [Morgan Stanley] is potentially committing to a somewhat larger retail brokerage business is a good investment,” says Brad Hintz of Sanford Bernstein. If the deal were finalized today, the combined unit would hold about $1.5 trillion in retail client assets and 20,000 brokers.

Would a deal do enough to resolve Citi’s liquidity problems? A Smith Barney sale could have brought in $20 billion 2 years ago and perhaps even $10 billion last year, according to Ellis, but it’s unclear exactly how much cash this deal will give Citi today. “While we believe this deal will provide some near-term capital relief, more likely will be needed,” Meredith Whitney, a financial analyst at Oppenheimer & Co., wrote in a report. Citigroup stock fell 11 percent at midday Monday to $6. Citi has reported four straight quarters of losses totaling $20.2 billion through September 2008. It’s expected to report another loss on January 22 when it posts fourth quarter results.

The good news is, Smith Barney advisors may embrace the idea of a deal with Morgan Stanley—as opposed to other firms on the Street. “They’re relieved because they’re no longer wondering what’s going to happen to them,” says Bob Ellis, senior vice president of wealth management at Celent. Some Smith Barney advisors knew they’d be sold off even as Citi CEO, Vikram Pandit, publicly stated otherwise, he says. “Smith Barney is among the largest severable arms at Citigroup. They were looking to make substantial capital from selling off retail brokerage,” Ellis says.

Morgan’s Future

For Morgan Stanley, the deal could represent something of a coup—as long as it plays the deal right. “Morgan Stanley could grow a lower risk revenue stream as it continues to deemphasize higher-risk, leveraged businesses. In addition, greater scale in retail would also serve as a strong foundation to grow MS's retail deposit base; it is a priority at the firm as a bank holding company to grow this source of funding,” KBW analyst Lauren Smith wrote in a note today.

Chip Roame, principal of Tiburon Strategic Advisors, an industry research and consulting firm, says Morgan’s co-president James Gorman is betting on retail. “Gorman has converted the firm into a bank holding company, started a traditional bank deposits business by hiring CeCe Sutton from Wachovia, strengthened its retail leadership with Ellyn McColgan from Fidelity and now is likely the one spearheading the move to acquire Smith Barney. This says to me broadly that Morgan Stanley is headed down the retail path rather than the investment banking path—not exclusively, but the bets are aligning in one direction,” he says.

But there may be some potential risks in store down that route. Hintz says Morgan’s strategy to significantly increase its exposure on the retail side comes at the expense of its institutional business. “Retail is a high operating leverage business with very long performance cycles that lags market declines and lags economic recoveries. In a recovering economic environment a large retail firm will substantially underperform an institutional firm because institutional businesses recover either before or with the economy while retail lags the economic recovery,” Hintz says.