(Recasts lead, adds deal details; paragraphs 10 to end)
By Megan Davies and Dan Wilchins
NEW YORK, Jan 11 (Reuters) - Citigroup Inc (C.N) was closer to a deal on Sunday to join its Smith Barney business with Morgan Stanley's brokerage operation (MS.N) in a move that would create the world's largest retail brokerage.
The creation of the joint venture deal would lead to Morgan Stanley making a cash payment to Citi of about $2.5-$3 billion, a source familiar with the situation said.
The deal will also lead to Citi revaluing the unit as part of the bigger venture rather than a stand-alone business, leading to a gain of $5-$6 billion post-tax in tangible common equity, said the source, who asked not to be identified because the talks aren't public.
The cash would be a big boon for Citi, which is under tremendous pressure from the U.S. government to shore up its balance sheet after taking $45 billion of government capital in October and November.
Capital is crucial for the bank, which has posted more than $20.3 billion of net losses for the four quarters ended Sept 30.
Under the deal being discussed, Morgan Stanley would take a 51 percent stake in the venture and would also have options to increase that amount at a period of 3-6 years in the future, the source said.
The cash payment would allow Morgan Stanley -- which has a smaller brokerage business than Citi -- to take a controlling rather than a minority stake in the venture.
A deal could be announced this week but is unlikely to come as soon as Monday, the source said. A second source said an announcement was expected this week.
The new business would have a combined estimated value of $16 billion to $20 billion, the first source said.
For Citi, securing a joint venture deal is an easier move than selling the asset at a bad time in the market. Indeed, few buyers have the cash available to buy Smith Barney outright.
The deal also allows Citi to enjoy a share of the venture's earnings. The new joint venture could extract cost savings from consolidating real estate and trade processing platforms.
The combined business would likely have Morgan Stanley Co-President James Gorman as chairman, and Citigroup Global Wealth Management President Charles Johnston as its chief executive, a source previously told Reuters. That could strengthen Gorman's position in any future discussions over a possible successor to Morgan Stanley CEO John Mack.
A source previously told Reuters that Citi had also discussed internally the possibility of selling its Banamex Mexican banking unit. However, a source on Sunday said that unit wasn't on the block.
Shedding Smith Barney would be the latest, and perhaps the boldest step in dismantling Sanford "Sandy" Weill's original conception for Citigroup when his Travelers Group Inc bought Citicorp to create the world's largest financial services conglomerate.
Citi CEO Vikram Pandit is trying to shed hundreds of billions of dollars of assets and reduce risk. The bank has taken $45 billion from the government's Troubled Asset Relief Program, $20 billion of which came from a federal bailout in November that will also limit potential losses on some assets.
Separately, former U.S. Treasury Secretary Robert Rubin resigned as a senior counselor to Citigroup on Friday, following months of criticism of his performance. The 70-year-old Rubin will remain a director until the bank's annual meeting later this year.
The future of chairman Sir Win Bischoff is unclear. The New York Times previously reported that Citigroup's directors are considering replacing him with lead director and former Time Warner Chairman Richard Parsons as soon as next week.
Parsons told the Wall Street Journal Sunday that the banking giant's board isn't losing faith in Pandit.
"We have confidence in the current management and leadership of Vikram," he said. "There's no truth" to rumors that Pandit's job is in jeopardy barely a year after he took the reins, Parsons told the paper.
Rubin had been a key supporter of Pandit. (Additional reporting by Joseph Giannone; Editing by Bernard Orr and Lincoln Feast)