NEW YORK (Reuters) - Wachovia Corp (WB.N) is in talks with rivals to be taken over, sources familiar with the situation said on Sunday, after the U.S. bank's shares fell 27 percent on Friday due to concerns about its portfolio of illiquid mortgage assets.

The sources said Citigroup Inc (C.N) and Wells Fargo & Co (WFC.N) are among the parties in talks with Wachovia, the sixth-largest U.S. bank by assets.

The New York Times said the two companies were locked in a bidding war for a possible takeover of Wachovia, citing people involved in the talks. The U.S. government, led by the Federal Reserve and the Treasury Department, is also involved in the talks, the newspaper said.

A treasury department official declined to comment on any specifics of Wachovia discussions, but said "we are in regular contact with market participants."

Citigroup and Wells Fargo are unlikely to bid more than a few dollars a share for Wachovia, whose shares closed Friday at $10, the newspaper said. It is unclear whether Wachovia would be sold as a whole or be broken up, or how much Wachovia bondholders might lose in any transaction, it said.

The government is resisting guaranteeing some of Wachovia's assets, as it did for Bear Stearns when it engineered that company's sale to JPMorgan Chase & Co (JPM.N), and is also opposed to taking over Wachovia unless its financial position deteriorates more rapidly.

Talks could go past Sunday night, the Times said.

By late Sunday evening Wells Fargo appeared to be the preferred bidder, the Wall Street Journal said, citing people familiar with the situation. Details of the proposed transaction were not immediately clear, the paper added.

A Wachovia spokeswoman declined to comment. Citigroup and Wells Fargo could not be immediately reached for comment.

The talks come as U.S. lawmakers gear up to vote on Monday on creating a $700 billion government fund to buy bad debt and alleviate the financial crisis. The bank would be a prime candidate for help, depending on the types and amounts of securities the government would accept.

Investor concern about Wachovia mounted Friday after JPMorgan said it would take a $31 billion write-down on loans it acquired when it took over Washington Mutual Inc's (WM.N) banking unit on Thursday.

The write-down raised worry that Wachovia might have to take much larger write-downs on a $122 billion portfolio of option adjustable-rate mortgages it largely inherited when it bought California lender Golden West Financial Corp in 2006.

The bank suffered a record $9.11 billion loss in the second quarter and some analysts have said it may need more capital after raising $8.05 billion in April.

The market value of Wachovia was about $21.6 billion as of Friday's market close, Reuters data shows. Citigroup's was $109.7 billion and Wells Fargo's was $123.4 billion, the data show.

For Citigroup, combining the two companies would create by far the largest U.S. retail brokerage, with close to 30,000 brokers before attrition. Citigroup would also get the major U.S. retail banking presence it has long lacked, and make it a strong rival to Bank of America Corp (BAC.N), JPMorgan and Wells Fargo.

(Additional reporting by Jonathan Stempel and Savio D'Souza; Writing by Michael Erman; Editing by Ian Geoghegan)

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