Jan. 13 (Bloomberg) -- Morgan Stanley bought control of the Smith Barney broker unit of Citigroup Inc. for $2.7 billion, two weeks after Bank of America Corp. purchased securities firm Merrill Lynch & Co., widening the shakeout on Wall Street from the worst credit panic in seven decades.

Morgan Stanley, led by Chief Executive Officer John Mack, will own 51 percent of a newly formed brokerage joint venture named Morgan Stanley Smith Barney and receives an option to acquire the rest after five years, the companies said in a statement today. Morgan Stanley Co-President James Gorman, 50, will oversee the venture as chairman.

Citigroup, which received $45 billion of U.S. government aid last year after recording $20 billion of losses, also may sell its CitiFinancial consumer-lending unit and cut back on trading with the firm’s capital, people familiar with the plan said. The bank will get cash as well as a $5.8 billion after-tax accounting gain from writing up the value of Smith Barney. The venture will employ 20,390 advisers, surpassing the number at Bank of America after its purchase of Merrill Lynch, and will have $1.7 trillion in client assets.

“Morgan Stanley has experience in the business, and I think it’s a positive for them and a negative for Citi,” said Matt McCormick, a money manager at Cincinnati-based Bahl & Gaynor Inc., which oversees $2.5 billion for clients and doesn’t hold either company’s stock. “Citigroup needed the funds, and clearly the government is exerting its power and wants them to raise some capital.”

U.S. Investments

The financial crisis has recast banking industry rivals as merger partners and transformed the U.S. government into one of the biggest investors in Wall Street firms, including Morgan Stanley and Citigroup. Both firms are based in New York.

Citigroup was formed in 1998 by the $37.4 billion merger of Travelers Group Inc., led by Sanford “Sandy” Weill, and John Reed’s Citicorp. Travelers, which owned brokerage Smith Barney Holdings Inc., had a year earlier paid about $9 billion for Salomon Inc., the parent of Salomon Brothers Inc., to form Salomon Smith Barney Inc.

The joint venture may generate about $1.1 billion of cost savings, or 15 percent of the combined firms’ estimated expense base, by eliminating overlapping technology, operations, marketing, sales support and product development costs, the firms said in the statement. The firms hope to achieve the cost reductions over 18 months, Gorman told analysts and investors on a conference call today.

Pandit

Citigroup will gain $6.5 billion of equity capital from the joint venture, according to the statement.

“Citi and its clients will maintain access to the industry’s leading wealth management platform,” Citigroup CEO Vikram Pandit, who turns 52 tomorrow, said in the statement. “In addition, we will generate equity capital that we can deploy to other core businesses.”

Smith Barney is the third business from Travelers to be jettisoned in the past decade, following the sales of the insurance underwriting unit and the asset-management division. On Jan. 9, Citigroup said Robert Rubin, the former U.S. Treasury Secretary who joined Citigroup in 1999, would leave the company.

“Both actions suggest an end to the dream that John Reed and Sandy Weill had when they merged legacy Citicorp with legacy Travelers in an attempt to build a monolithic global financial company,” Richard Bove, an analyst at Ladenburg Thalmann & Co. in Lutz, Florida, wrote in a Jan. 10 note to investors.

Loss Guarantee

As Lehman Brothers Holdings Inc. sank into bankruptcy in September, crippled by the frozen credit markets, Merrill agreed to be taken over by Charlotte, North Carolina-based Bank of America. Morgan Stanley and Goldman Sachs Group Inc. converted from securities firms to bank holding companies. Citigroup, led by Pandit, received the government funds and loss guarantees on $306 billion of assets.

Morgan Stanley, which had been the second-biggest U.S. securities firm, has been trying to attract retail deposits from brokerage customers to reduce its reliance on debt markets for funding. The firm, which lost 70 percent of its market value last year, received $10 billion from the U.S. Treasury in October.

“Morgan Stanley would likely benefit from a larger footprint in the more stable wealth-management business,” Roger Freeman, an analyst at Barclays Capital in New York, wrote in a Jan. 9 note. “The largest benefit to Morgan Stanley shareholders might be in acquiring an attractive property from a motivated seller in a dislocated market.”

Fifth Loss Seen

The two companies expect the transaction to be completed in the third quarter, following regulatory approvals. Neither company will have to pay a penalty if they decide to back out of the venture.

Citigroup, which is expected by analysts to post a fifth consecutive quarterly loss when it reports fourth-quarter results later this month, suffered a 77 percent decline in its stock price last year. The shares have dropped 12 percent in New York Stock Exchange composite trading this year, while Morgan Stanley has gained 18 percent.

“Capital remains at the focus of Citigroup’s challenges,” Meredith Whitney, an analyst at Oppenheimer & Co. in New York, wrote in a note to investors. “While we believe this deal will provide some near-term capital relief, more likely will be needed.”

Krawcheck Replaced

Pandit, Citigroup’s CEO for more than a year, told employees on a conference call in November that he didn’t plan to dismantle the company and didn’t want to sell Smith Barney.

Pandit in September replaced Sallie Krawcheck, the head of the wealth-management division, which includes Smith Barney. Taking her place was Michael Corbat, a 25-year veteran of the bank. At Morgan Stanley, Ellyn McColgan was named president of the wealth-management business in December 2007, reporting to Gorman.

“Smith Barney doesn’t use much of Citi’s balance sheet, and it doesn’t represent a particular problem area,” said Robert Willumstad, a former Citigroup CEO. “Because it’s not problematic and it’s the easiest transaction to uncouple, they’re selling it.”

Citigroup will contribute Smith Barney, Smith Barney Australia and the U.K.’s Quilter Holdings Ltd. unit, which it bought from Morgan Stanley two years ago, to the venture. About 11,960 Citigroup financial advisers will join the business and those working in bank branches will not become part of the new joint venture.

Similar Cultures

The venture will offer its brokers retention packages that will be “in line with industry practice,” Gorman said, without specifying the terms. He said that while it’s possible some brokers will choose to leave, the firm doesn’t anticipate “excessive” defections.

“The culture of the organizations is very similar,” Gorman said. “The fit is going to be fantastic.”

Morgan Stanley will have an option to raise its stake in the venture by 14 percent after the third year of operation and by 15 percent after the fourth year, Citigroup banking head Edward “Ned” Kelly told analysts on a conference call today. The purchases will be made at fair-market value. Once Morgan Stanley attains 80 percent ownership, Citigroup will have the power to force Morgan Stanley to buy the rest within a year.

The units that Citigroup is contributing were carried on the company’s books at a value of $3 billion to $4 billion, Kelly told analysts, enabling the bank to take the accounting gain.

Morgan Stanley gained its retail brokerage in the 1997 combination with Dean Witter, Discover & Co. The business had 8,426 financial advisers at the end of November, $546 billion in total client assets, and generated $6.3 billion in revenue during 2008 when the gain from an asset sale was excluded, according to a company report last month.

Gorman said that the joint venture could result in a gain to Morgan Stanley’s book value, although it will reduce the firm’s Tier 1 capital by about 1 percent. The company said Dec. 17 that its Tier 1 ratio was about 18.3 percent.

To contact the reporters on this story: Christine Harper in New York at charper@bloomberg.net; Bradley Keoun in New York at bkeoun@bloomberg.net.

Last Updated: January 13, 2009 20:50 EST