Feds step deeper into Citi bailout

Shift of preferred shares to common stock increases embattled bank's capital base. Stock down by nearly a third in volatile trading.

NEW YORK (CNNMoney.com) -- The U.S. government waded deeper into the bailout of one of the nation's largest banks Friday when it announced a deal that will give it control over as much as 36% of Citigroup's common stock.

Citigroup shares plunged about a third in midday trading on the news.

The deal will convert preferred shares that the Treasury Department already holds in Citigroup for common shares, a shift that is designed to improve the embattled bank's capital base, which in turn will hopefully allow it to increase its lending.

The U.S. government has already given Citigroup $45 billion, for which it received preferred shares and warrants in the company.

The new deal Friday did not give the bank any additional taxpayer dollars. But the government is taking on a greater risk by assuming more volatile common shares. The market price is well below the $3.25 per-share conversion price the government is paying.

Taxpayers will also lose roughly $2 billion in dividends, because the preferred shares they are giving up paid 8% dividends. Citi suspended its common stock dividend as part of the agreement.

The Treasury is trying to prop-up one of the nation's largest banks as a key part of its efforts of fixing the battered banking system.

For Citigroup, the conversion is important because it increases the bank's tangible common equity, making an improvement in the bank's troubled balance sheet.

In the deal, Treasury will convert up to $25 billion of preferred shares, matching dollars that Citigroup is able to bring in from other investors, such as sovereign wealth funds.

It will virtually force those other preferred share investors to convert to common shares by eliminating most preferred dividends as well, although the government will continue to get an 8% dividend on the $20 billion in preferred shares it is not converting.

Friday's move could very well be the first of similar actions taken by the federal government going forward. The Treasury Department said in its rescue plan, unveiled this week, that any major bank that comes up short in the so-called "stress tests" now being conducted will be required to raise more capital, and that may be accomplished by converting the preferred shares that Treasury now holds in each of the institutions.

The $20 billion of preferred shares Treasury will have left in Citi could also be converted if Treasury determines more assistance is needed, although company officials argued Friday this move puts it in the strongest capital and tangible common equity position among major banks.

But the move will reduce the stake that existing shareholders hold in the bank to as little as 26%. New common share investors, including other current preferred shareholders now expected to convert their shares to common, will own the remaining stake -- which could be as much as 38%.

Shares of Citigroup, a component of the Dow Jones industrial average, have plunged about 90% in the past year even before Friday's slide. Still, the bank hopes that the move will eventually help rebuild its battered share price.

In a call with investors, Citi Chief Executive Vikram Pandit said the decision was difficult because of what it would do to current investors, but that the bank had little choice.

"In the end, our business is about confidence," he said. "We wanted to take definitive steps to put all capital issues aside."

Analysts questioned Pandit as to who would be calling shots at the bank going forward.

"Will Citigroup be run for the shareholders, or is Citigroup going to be run for public policy goals or some other purpose?" asked Michael Mayo of Deutsche Bank.

Pandit insisted that Citi management would continue to be in charge -- not the government or regulators -- and that decisions would be made to maximize profits and shareholder return, rather than public policy agenda.

"For those people who have a concern about nationalization, this should put those concerns to rest," Pandit said. "We're going to run Citi for the shareholders."

Many industry observers have argued that a 36% government stake is the equivalent of nationalizing Citigroup.

"This begs the question of nationalization," said Sen. Richard Shelby, the ranking Republican on the Senate Banking Committee, at a hearing this week, as discussions of this kind of government stock swap swirled around both Wall Street and Washington. "If you had 40% working control, you wouldn't own it, but you'd own working control."

Ned Kelly, head of global banking for Citigroup, disputed that view in an interview Friday after the announcement.

"The term of nationalization covers a multitude of sins," he said. "But the common equity has not been wiped out. There is no change in management. There are no operational restrictions."

Under the deal, a majority of Citigroup's independent directors will be replaced. Pandit and Chairman Richard Parsons will retain their positions.

Pandit tried to ensure investors that the deal is being structured in a way that allows it to retain its current stakes in foreign banks, such as Grupo Financiero Banamex, the No. 2 bank in Mexico. Some countries, such as Mexico, prohibit ownership of banks by companies controlled by foreign governments.

The Federal Deposit Insurance Corp. considers a bank to be critically undercapitalized if the tangible equity-to-asset ratio is 2% or less. Citi's ratio hovers around 1.5% now. Citigroup said it believed that ratio will rise to more than 4% as as result of Friday's moves.

Citi said in its statement that the agreement could increase the tangible common equity of the company from the fourth-quarter level of $29.7 billion to as much as $81 billion.

At the same time, Citigroup ( C, Fortune 500) announced a pretax $9.6 billion charge in the recently completed fourth quarter, resulting in a roughly 50% increase in its 2008 loss.

The charge was to write down the value of the goodwill carried on its balance sheet for some key business units. It came to $8.7 billion on an after-tax basis. The company said that will result in a full-year loss of $27.7 billion, up from the previously reported $18.7 billion.

Corporate goodwill is the value of a company operation carried on balance sheet beyond what can be attributed to its strict financial operations, placing a value on such intangible items as the company's name, reputation and its customer relations.

The charge will not result in any cash drain for the company or reduce its tangible common equity. It is an accounting procedure that wipes out the goodwill of Citigroup's consumer banking operations in North America, Latin America and other key overseas markets.

When Citi announced its fourth-quarter results last month, it said it was continuing to review its goodwill to determine whether an impairment had occurred.

Citi's Kelly said the charge announced Friday is simply an accounting procedure required by the sharp loss in market value of the company's stock, not by damage to its brand caused by the drumbeat of bad news over the last year.

"We do not think it's been permanently damaged. We still have a very strong brand globally," he said. "Clearly when you're in the spotlight, there's going to be some negative impact. But it's had no economic impact."