(Recasts, adds details)
By Mark Felsenthal and Michael Erman
WASHINGTON/NEW YORK, Oct 5 (Reuters) - The U.S. Federal Reserve is brokering discussions between Wells Fargo & Co (WFC.N) and Citigroup Inc (C.N) over which of the banks will buy Wachovia Corp's WB.N assets, people familiar with the matter said on Sunday.
The Fed is pushing the two banks to compromise by potentially carving up Wachovia between them, the Wall Street Journal reported. Wachovia, the sixth-largest U.S. bank, has been hobbled by the credit crisis but has an attractive branch network.
Charlotte, North Carolina-based Wachovia is the latest casualty of a crisis that has led to shotgun sales of Bear Stearns and Merrill Lynch & Co Inc MER.N, the near collapse of American International Group Inc (AIG.N), and the bankruptcies of Lehman Brothers Holdings Inc LEHMQ.PK and Washington Mutual Inc WAMUQ.PK.
Wells Fargo and Citigroup spent much of the weekend fighting in state and federal court -- as well as a judge's home in Connecticut -- over which party was entitled to move ahead with a deal to buy Wachovia assets.
The Federal Reserve views resolving the dispute as important, having already decided that Wachovia must be sold for the sake of the stability of the financial system, a person familiar with the matter said. Discussions were continuing late on Sunday, the person added.
Citigroup reached a preliminary agreement to buy Wachovia's banking assets for $2.2 billion in a deal backed by the U.S. government on Sept 29. Wachovia did not sign an official merger agreement with Citi, although it did sign an agreement to negotiate exclusively with Citigroup through Oct 6.
But on Friday, Wells Fargo, the seventh-largest U.S. bank by assets, said it signed an agreement with Wachovia to buy the entire company without the government's help, apparently topping the Citigroup offer.
Citigroup won a New York state court order late on Saturday that would have extended an agreement it had to negotiate exclusively with Wachovia. Citigroup lawyers met New York State Supreme Court Justice Charles Ramos in his home in Cornwall, Connecticut, with lawyers for the other two banks phoning in.
An appeals court on Sunday overturned that order, in part because the decision was not made in New York. Citigroup plans to appeal that decision.
Also on Sunday, Wachovia asked a federal judge for a temporary restraining order that would have prevented Citigroup from interfering with the Wells Fargo deal.
U.S. District Court Judge John Koeltl denied the request, but said the court will hear on Tuesday whether or not the exclusivity agreement that Citigroup says prevented Wells Fargo from making the bid for Wachovia is enforceable.
Koeltl said Wells Fargo's argument appears to be valid. It is not likely he will preside over the hearing.
Wachovia said on Sunday that its agreement with Wells Fargo is valid and proper, and is best for shareholders, employees and U.S. taxpayers. Wells Fargo said in a statement it has a binding merger agreement with Wachovia, and its deal, which keeps Wachovia intact, is better for all of Wachovia's stakeholders.
"We are confident that we will complete our announced merger with Wachovia," Wells Fargo said.
Wachovia spokeswoman Christy Phillips-Brown said early Sunday: "Citigroup is always free to make a superior offer to Wachovia."
One of the earliest effects of the $700 billion bailout legislation signed by U.S. President George W. Bush last week could come in Wachovia's federal court case, which argues that a clause in the bill invalidates the exclusivity agreement signed with Citigroup.
The Federal Reserve is pushing Wells Fargo to consider options including taking Wachovia branches in the Southeast and California, the Wall Street Journal reported, citing people familiar with the talks. Wells Fargo would also take over Wachovia's asset management and retail brokerage businesses, the newspaper reported. Citigroup, meanwhile, would take Wachovia's branches in the Northeast and mid-Atlantic regions.
The plans being discussed now do not include any help from the U.S. government, the Wall Street Journal reported.
Citigroup last week offered to significantly boost the price it was paying for Wachovia, the Wall Street Journal reported on Sunday, citing people familiar with the matter.
The proposal remains on the table, although the exact terms and structure of the sweetened deal are unclear, the newspaper said. A spokeswoman for Citigroup declined to comment on the report.
Citigroup, which has sustained about $60 billion of write-downs and losses during the credit crunch, is eager to buy Wachovia's banking assets, which include more than 3,000 bank branches. Banks are eager to boost their branch networks, which can be a stable source of funding as bond markets prove to be an increasingly expensive and unreliable place to secure financing.
Citigroup is seeking $60 billion in punitive and compensatory damages against Wells Fargo for interfering with the deal, according to a person familiar with the matter. (Writing by Dan Wilchins, additional reporting by Elinor Comlay, Nicole Maestri and Jonathan Stempel; Editing by Edward Tobin and Ian Geoghegan)