Citi deal inspires no confidence

The government's latest attempt to prop up Citi fails to ease worries that a full-scale takeover is on the way for it and other banks.

NEW YORK (Fortune) -- If investors have regained confidence in the big U.S. banks, they have a funny way of showing it.

Shares of most big banks tumbled Friday morning after the government agreed to convert part of its preferred-stock investment in Citigroup ( C, Fortune 500) to common stock.

By swapping $25 billion of its preferred shares for new common shares, the Treasury Department is giving Citi a boost to a key measure of its capital cushion against future losses -- tangible common equity.

But the move, the government's latest bid to quell fears about the New York-based bank's health, also dilutes existing shareholders.

That is one reason why Citi's shares tumbled more than 30% to an 18-year low Friday. And some warn it could still leave Citi undercapitalized compared with other banks.

Analysts at Goldman Sachs said in a report Friday that the conversion would raise Citi's tangible common equity to 4.3% of total capital -- but noted that this figure is bloated by a deferred tax asset.

Excluding that asset, Goldman said, the ratio would be just 2% - compared with 3% at the average large bank.

Wall Street was not only concerned about Citi's future though. Investors were also worried about the possibility of future federal intervention in the banking sector beyond Citi.

Shares Bank of America ( BAC, Fortune 500), which like Citi has received more than $100 billion in federal aid in recent months, tumbled 12%. Wells Fargo ( WFC, Fortune 500) fell 7%.

The use of taxpayer funds to support troubled financial institutions has become unpopular in Congress, particularly in light of recent reports of the perks lavished on some banks receiving federal aid.

Treasury Secretary Tim Geithner and Federal Reserve chief Ben Bernanke have said repeatedly over the past month that they want to keep the financial system in private hands.

But with the U.S. economy in its worst recession in at least 26 years, there is growing concern among investors that the half-measures taken so far by the government won't be enough to prevent a wholesale takeover of the most troubled firms.

With unemployment rising, problems are increasingly spreading to the credit card and auto loan portfolios at many banks.

Earlier this week, JPMorgan Chase ( JPM, Fortune 500) - one of the healthiest big banks - slashed its quarterly dividend by 87% in a bid to conserve cash and add to its capital base.

Wall Street had high hopes earlier this month that Geithner would unveil a comprehensive plan to support banks. But the proposals he outlined were short on details. Treasury said this week it began conducting so-called stress tests of banks, but results aren't expected for weeks.

In the meantime, investors -- burned in the plunge of financial stocks since the credit markets started seizing up in August 2007 -- are staying away from the banks, frustrating the administration's efforts to bring in private capital to help solve the crisis.