You can find more stories like this in our On the Brink series.

Updated from 11:07 a.m. EDT.

Citigroup

(C) - Get Report

on Monday said it would acquire

Wachovia's

(WB) - Get Report

banking operations for $2.16 billion and warned that the continued deterioration in consumer credit has had a "significant" negative impact on profits this quarter.

Citi said it will assume all of Wachovia's senior and subordinated debt, totaling approximately $53 billion, in the all-stock deal brokered by the Federal Deposit Insurance Corp. Wachovia's banking operations includes its retail bank, corporate and investment bank and wealth management business. Wachovia will retain is retail brokerage and asset management business.

The FDIC in a press release stressed that Wachovia did not fail. Citi will take the hit for up to $42 billion of losses on $312 billion of Wachovia loans identified as potentially troubling exposure, while the FDIC will take responsibilities for additional losses. Citi granted the FDIC $12 billion in preferred stock and warrants for assuming the risk.

Additionally, Citi said that it would raise $10 billion in common stock and cut its quarterly dividend in half to 16 cents a share. Citi's Tier-1 capital ratio is expected to be 8.8% upon completion of the deal, it said.

"This is a historic day and this is a historic transaction," Citi CEO Vikram Pandit said on a conference call. The combination "is good for both Citigroup and Wachovia. It's great for our clients and customers and I believe it's great for the U.S. financial system.

"This combination creates a dominant U.S. franchise," Pandit said. "We have contained the risk in this transaction so not only is this a high-opportunity deal for us, it's also a low-risk transaction. ... The transaction supports our goal to build a franchise with a high-annuity like earnings stream with controlled risk."

Pandit went on to say that he has known Wachovia's CEO Robert Steel for nearly 20 years.

"By the time Bob

Steel and I started to talk, we at Citi had the opportunity to look at a number of deals," Pandit said. "We passed on these because they were not compelling. This one is compelling."

Pandit added that the deal "will augment our access to stable funding and liquidity and will accelerate our efforts to establish Citi as the world's leading global financial institution."

At the same time, Citi said that as a result of the extreme volatility and continued deterioration in consumer credit, third-quarter net income is expected to decline vs. the second quarter, but improve from the first quarter, according to earnings guidance issued by CFO Gary Crittenden on the conference call.

Citi, which will report quarterly results on Oct. 16, expects to take writedowns on its subprime, leveraged loan, monoline and structured investment vehicle exposure totaling $4.2 billion. It also expects to see securitization losses in its cards business of $2 billion, Crittenden said.

Citi had previously announced a charge of $500 million related to a settlement on auction-rate securities and its exposure to

Fannie Mae

( FNM) and

Freddie Mac

( FRE) preferred and convertible shares of $450 million.

The company's total credit costs for the quarter are expected to be in the range of $9 billion to $10 billion, up from roughly $7 billion last quarter. Crittenden said approximately half of the increase is due to loan loss reserve building, primarily in relation to its credit card and mortgage businesses, while the remaining half is due to higher net charge offs than the company expected.

"I said in the past that high losses in our cards portfolio should be expected for the remainder of this year and well into 2009 as unemployment and housing trends both continue to deteriorate," he said.

Citi is acquiring more than $700 billion in assets. It will be responsible for the first $30 billion of losses on Wachovia's loan portfolio and will record them under purchase accounting when the deal closes, expected to be completed by the end of the year. The company will then be responsible for the next $12 billion of losses up to a maximum of $4 billion a year over the next three years.

Additionally, through the acquisition of Wachovia's deposits, Citi will have more than $600 billion deposits in the U.S. -- a 9.8% market share -- and more than $1.3 trillion globally. After the deal is completed, Citi will own about 7,600 branches, 4,300 of which will be in the U.S.

Citi plans to fold its U.S. retail bank -- about one-third of the size -- into the Wachovia platform, Pandit said.

"During recent weeks, the financial landscape has changed significantly and presented us with unprecedented challenges," Steel said in separate release. "Today's announcement is the best alternative for the company, enabling a resolution on the Golden West portfolio."

Wachovia will continue to own its parts of its wealth management business, retail brokerage subsidiary AG Edwards and asset manager Evergreen Investments. Citi will headquarter the retail bank in Charlotte, N.C. and the investment bank in New York.

FDIC Chairwoman Shelia Bair said the government's participation in the deal will not come at a cost to the Deposit Insurance Fund.

"On the whole, the commercial banking system in the United States remains well capitalized," she said in a statement. "This morning's decision was made under extraordinary circumstances with significant consultation among the regulators and Treasury. This action was necessary to maintain confidence in the banking industry given current financial market conditions."

Treasury Secretary Henry Paulson said a failure of Wachovia "would have posed a systemic risk."

"As a result of this transaction, all Wachovia depositors will be protected and Wachovia's senior and subordinated debt will be assumed by Citigroup," Paulson said. "The FDIC's actions help to mitigate potential systemic risk to our financial system. As I have said before, in this period of market stress, we are committed to taking all actions necessary to protect our financial system and our economy."

Last week, reports had surfaced that Wachovia had been in talks with Citi as well as

Banco Santander

( STD) and

Wells Fargo

(WFC) - Get Report

.

That came a week after the bank had been in talks with

Morgan Stanley

(MS) - Get Report

about a possible merger. Those negotiations ended after Morgan Stanley changed its status to a bank holding company and said that

Mitsubishi UFJ

(MTU)

agreed to take a 21% stake in the firm.

Amid worries about its financial health, Wachovia saw its shares plunge nearly 40% Friday, the day after the failure of

Washington Mutual

(WM) - Get Report

and the subsequent sale of its banking operations to

JPMorgan Chase

(JPM) - Get Report

.

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For months, Wachovia has been dealing with a host of mortgage problems that followed its 2006 acquisition of California residential real estate lender Golden West.

Citi has taken its own massive losses as a result of the housing and credit crisis. The New York based bank was reportedly among the list of suitors considering an acquisition of WaMu.

Standard and Poor's said Monday that it placed Citi's counterparty credit ratings on negative credit watch following the news of the further writedowns. S&P and Moody's Investor Services also placed Wachovia's debt ratings on review.

"The action reflects continued pressures on Citigroup's own performance from writedowns on market-disrupted assets and the loan portfolios," said S&P credit analyst Tanya Azarchs.

Citi's "own market-disrupted assets and mortgage loan exposures pose significant risk," S&P said.

"While there have been questions about the

Citi model, I hope over the events of the last many weeks and months it's absolutely clear why we continue to think this is the right model and today's transaction, if nothing, strengthens that model significantly for us as a company," Pandit said.

"I want to assure you that while we are working on this transaction ... nothing is going to take our eye off the ball in getting fit," he said. "We're committed to the same things we talked about" in terms of expense reduction, business repositioning and asset reduction.

"That plan continues in full force," he said.

Both stocks fell amid a market-wide selloff following the House's rejection of the $700 billion financial

bailout

plan. Wachovia shares were plummeting 81% to $1.90 in recent trading. Citi shares were up 5.3% to $19.08.