Citigroup (C) appears likely to emerge from this economic downturn a much-changed, and likely much smaller, company.

Citi confirmed on Tuesday that it is in talks with Morgan Stanley (MS) about possibly combining its Smith Barney retail brokerage business and Morgan Stanley’s wealth-management business, but questions remain about how effective the deal would be, both for Citi and for the new merged entity.

In addition, reports have emerged that Citi plans to announce a major reorganization in coming days, which FOX Business has been reporting as likely for months and has addressed recently as well.

Sources told FOX Business that a deal announcement for Smith Barney could come as early as Tuesday afternoon after the markets close.

Citi said no agreement has yet been reached, and said it would not comment beyond the press release. Reports suggest that Citi would sell 51% of Smith Barney to Morgan Stanley for $2 billion to $3 billion.

The talks are 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.

Some thought the prospective deal could be favorable for the company.

"While ambiguity abounds, with unconfirmed transaction details and lacking Smith Barney disclosures, we estimate that C could record a pretax gain of nearly $10 billion," Sander O’Neill analyst Jeff Harte said in a research note, according to Dow Jones Newswires. He said the gain might “give a much needed boost to [Citi's] common equity levels."

Even if the deal turns out to be a good one, 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.

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

“There will be 19,000 reps for about a nanosecond,” Smith said, predicting that many representatives would be fired or quit almost immediately if a deal is done. “The only people this is good for are brokerage head-hunters, who get paid a bounty for the best reps,” as well as Bank of America’s (BAC) Merrill Lynch, UBS (UBS) and Wells Fargo’s (WFC) Wachovia, which could cherry-pick brokers.

Reports of the possible deal had emerged on Friday, the same day it was announced that senior adviser Robert Rubin would be leaving the company.

Morgan Stanley did not respond to a request for comment.

The willingness to sell a prime asset also showed that Citi is taking steps to downsize.

“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.”

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.