The seismic restructuring of the US financial services industry continued yesterday as Citigroup agreed to buy the banking operations of Wachovia for $2.16 billion (£1.17 billion) after the US Government promised to cap billions of dollars of potential losses.

The takeover will significantly change the face of Citigroup in the United States, increasing the number of its retail branches in America from 1,075 to 4,416 and allowing it to regain its title as the country’s biggest bank by assets; it was briefly eclipsed by JPMorgan Chase last week after its takeover of Washington Mutual.

Citigroup, which has already taken a hit of more than $40 billion from the credit crunch, conceded that it would announce a further writedown of about $15 billion when it reports third-quarter results next month.

The announcement of the deal capped a weekend of frantic discussions by the Federal Reserve, US Treasury and banking regulators. Although Wells Fargo appeared to be close to clinching a deal on Sunday night, eventually a transaction was agreed with Citigroup. Banco Santander, of Spain, was also in talks about a tie-up.

Sheila Bair, chairman of the Federal Deposit and Insurance Corporation, the regulator, said that the deal was struck under extraordinary circumstances, with significant consultation between regulators and the Treasury. She was at pains to emphasise that Wachovia had not failed in the way that other groups, such as Lehman Brothers and Washington Mutual, had.

Ben Bernanke, Chairman of the Federal Reserve, sought to reassure the markets, adding that the deal demonstrated the Government’s unwavering commitment to financial and economic stability.

Yet investors still panicked, amid fears that further banking failures, fire sales, government bailouts or dilutive capital-raising would depress the value of their battered stock portfolios. National City, a regional bank, was hit the worst, its shares falling by 46 per cent to $1.99 in midday trading. The Ohio-based bank was forced to issue a statement saying that it had no need or plan to raise additional capital.

Citigroup said that it would issue about $10 billion in new shares to boost its capital reserves in the face of significant writedowns on the Wachovia loan portfolio. It will also cut its quarterly dividend by more than half to 16 cents a share to help to pay for the deal, which will leave the group with combined deposits of $600 billion in the US, or 9 per cent of the market, and $1,300 billion globally.

Citigroup, which will pay the $2.16 billion price tag using its shares, will assume about $53 billion of debt issued by the group and absorb up to $42 billion of losses from the $312 billion of mortgage-related assets that it is taking on in the deal. The Government will take on losses beyond that.

It is not clear how big the eventual write-off on Wachovia’s loan book will be, but Citigroup expected to record $30 billion of losses as soon as the transaction is completed, around the end of the year. After the deal, Wachovia will continue as a public company, operating AG Edwards, America’s third-largest retail brokerage with 14,600 financial advisers and about $1,000 billion under management, and the Evergreen mutual fund business.

The hunt for a buyer of Wachovia’s banking business intensified last week after JPMorgan bought Washington Mutual (WaMu) and said that it would need to write down the value of its $176 billion mortgage portfolio by $31 billion. Much of that writedown related to so-called option-ARM mortgages, an extremely high-risk home loan in which WaMu is a big player – but Wachovia is the largest of all. Wachovia, America’s sixth-largest bank, reported $9.7 billion of losses in the first half of 2008, as writedowns on its mortgage book dragged the group into the red. The bank’s troubles largely stem from the $26 billion acquisition of Golden West Financial in 2006, at the height of the property boom.

The group specialised in the toxic option-ARM mortgages. These are prone to default because they allow borrowers to skip interest payments and add them to the principal. As house prices fell, many borrowers were left with mortgages that far exceeded the value of their homes just as the economic downturn reduced their ability to meet repayments.

Wachovia holds $122 billion of option-ARMs; Fitch Ratings predicts that default rates on securities backed by these loans could reach 45 per cent.

Wachovia’s shares ended the day $8.16 down at $1.84, a fall of more than 80 per cent. Citigroup’s shares closed down $2.40 at $17.75.

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