Financial world, say hello to Morgan Stanley Smith Barney -- and likely, before the economy turns around, hello to a much-downsized Citigroup (C).

Morgan Stanley (MS) and Citigroup announced on Tuesday afternoon that they are going to combine their wealth-management businesses into MSSB, as Citigroup works to restructure amid the financial crisis.

Citi will exchange 100% of its Smith Barney, Smith Barney Australia and Quilter units for a 49% stake in the joint venture and an upfront cash payment of $2.7 billion. Morgan Stanley will exchange 100% of its Global Wealth Management business for a 51% stake in the joint venture, according to a press release issued jointly by the companies.

The deal is a sign that Citi is still struggling. Citi’s top management had been trying to avoid selling Smith Barney, which is regarded as one of the company’s crown jewels, despite the company’s increasingly dire financial situation. Brokerages are particularly valuable now because they can still make money, while other divisions are more hamstrung by the credit crisis.

“You never sell a brokerage at the bottom of the stock market. That’s Rule #1 in investment banking,” said Tobin Smith, chairman of Changewave Research and a FOX Business contributor. “That’s the price these guys are paying for their past sins and overleverage.”

Sources have told FOX Business that Citi’s fourth-quarter results will be the worst in the company’s history. Some have said the operating loss could be $10 billion or more.

That comes on top of billions of dollars in losses over the past year, as well as tens of billions of dollars infused by the U.S. government. The company lost $308 billion in total assets from the third quarter of 2007 to the third quarter of 2008.

The combined Morgan Stanley Smith Barney entity will have more than 20,000 financial advisers and will manage $1.7 trillion in client assets for around 6.8 million households. Its headquarters will remain in the New York area.

After three years, MS will have the option to acquire another 14% of the entity, after four years another 15%, and after five years 20%. Citi can put its entire interest to Morgan Stanley on certain conditions, including on a change of control at MS. If there’s a change of control at Citi, MS can call 100% of Citi’s interest in MSSB.

Either party can seek an initial-public offering after year six.

Any tranche sales would be done at fair market value, executives said on a conference call announcing the deal.

Each of the organizations will retain its deposits as of the close of the transaction, which is expected to occur in the second half of 2009. From then on, they will go into the joint venture.

At the close of the transaction, Citi will recognize a pretax gain of around $9.5 billion, or about $5.8 billion on an after-tax basis, the press release said, adding that the transaction will create around $6.5 billion of tangible common equity.

The companies expect to see cost savings of around $1.1 billion, which they said was around 15% of the combined firm’s estimated expense base, excluding financial advisors’ compensation. Executives said they expected to see most of the synergies in the first 18 months of the joint venture.

James Gorman, Morgan Stanley’s co-president, will serve as chairman of the new company while continuing in his present position. Charles Johnston, who was most recently president of Citi’s Global Wealth Management business, will be president of the combined entity.

Executives of the companies said on the conference call that they feel the culture of the two firms is very similar, as are the business operations.

Smith disagreed of Changewave disagreed, saying there’s “an extreme culture clash” and “major bad blood” between the brokers at Smith Barney and Morgan Stanley, which could make the deal look less optimal once it’s done.

“The only people this is good for are brokerage head-hunters, who get paid a bounty for the best reps,” Smith said, as well as Bank of America’s (BAC) Merrill Lynch, UBS (UBS) and Wells Fargo’s (WFC) Wachovia, which could cherry-pick brokers.

The board of MSSB will have four Morgan Stanley and two Citigroup representatives.

The press release said the joint venture will offer “a superior platform with unmatched resources, intellectual capital and research,” and will offer clients an “unmatched selection of financial products.”

No other bidders were involved, according to executives on the conference call. They also said there are no major restrictions other than “technical issues” on the sale of stakes in MSSB, and there are no breakup restrictions or penalties on the deal.

The companies said the systems and integration would be done based on “best of breed,” rather than having the entire joint venture work on the systems of one or other of the parent firms.

Morgan Stanley was advised by its Institutional Securities Group and Wachtell Lipton Rosen & Katz. Citi was advised by its Institutional Clients Group and Davis Polk & Wardwell.

Even with this deal, however, Citigroup might be a long way from solving its financial troubles.

Meredith Whitney, a banking analyst at Oppenheimer & Co., said that the sale of a stake in Smith Barney, even combined with the government’s bailout money, wouldn’t be enough to stabilize Citi.

“Clearly, they have gotten the come-to-Jesus meeting” with government officials, Smith said. He said Citi was likely told, “you’re a commercial bank, not a brokerage. The only chance you have to raise more capital is as a commercial spread-lending bank. You match your assets with your liabilities, you do spread management. That’s what you are, so get rid of the stuff that ain’t that.”

The willingness to sell a prime asset also showed that Citi is taking steps to downsize, a step that FOX Business has said for months would happen.

Corresponding with that view, The Wall Street Journal reported on Tuesday that Citi was going to unveil a major reorganization on Jan. 22, along with its fourth-quarter earnings report. The WSJ said Citi will concentrate on two areas: wholesale banking for large customers, and retail banking for customers in select markets worldwide.

The Journal said that in addition to the Smith Barney deal, Citi would likely get rid of its consumer-finance operation, private-label credit cards and some consumer-related businesses in Japan. It also said Citi would reduce its proprietary-trading activity.

FOX Business has been reporting since the government’s rescue of Citigroup last November that insiders were saying what was once the world’s biggest bank would have to break itself up. Here are the links:

http://emac.blogs.foxbusiness.com/2008/11/21/the-next-steps-at-citi/

http://emac.blogs.foxbusiness.com/2009/01/12/whitney-weighs-in/

Morgan Stanley and Citi Press Release