Is the government betting that Citi and Chase are too big to fail?

Forget for a moment the $700 billion bailout bill bandied about Capitol Hill, the multibillion-dollar lifeline cast by the government to Fannie Mae and Freddie Mac, and the $85 billion it shelled out for an 80% stake in AIG to keep the company afloat. Those interventions aside, Uncle Sam is still on the hook for billions more.

With the failure of Washington Mutual (WaMu), once the largest savings and loan in the US and now infamous for being the largest financial institution in the history of the country to fail, the FDIC has now guaranteed more than $200 billion in deposits in the 13 banks that have gone under so far this year.

The government is also giving concessions to two of the nation’s largest banks — Citigroup and JPMorgan Chase — as they help pick up some of the slack. For instance, Citi, which is dealing with billions of mortgage-related losses of its own, is picking up the banking operations of Wachovia. The proposed $2.1 billion deal calls for Citi to assume liability for some $40 billion of Wachovia’s debt and losses, with the FDIC covering any remaining losses from Wachovia’s $300 billion-plus loan portfolio. Citi could also potentially sell troubled Wachovia assets to the government at a profit.

The government also was the catalyst in JPMorgan Chase’s acquisitions of WaMu and the failed investment bank Bear Stearns. It approached the company about a takeover in both cases, brokered the deals, and offered financial assistance. JPMorgan, too, might be able to sell some of WaMu’s most toxic assets to the government at a profit.

These deals, coupled with the demise of the erstwhile fourth-largest bank, Wachovia, creates a massive gap between the Big Three (Citi, Chase, and Bank of America) and everyone else. Combined, the three banks will control nearly a third of all domestic deposits. On the sidelines is Wells Fargo (now #4). It is probably the most well-capitalized of them all and has been rumored to be an acquirer of WaMu, Wachovia, and almost every other down-on-its-luck financial services company. Thus far, the company has remained above the fray. Perhaps until the government needs its help, too.