Even if the government takes a large common equity stake in Citigroup Inc, worries are likely to persist about the bank's ability to absorb soaring losses in a deepening recession.

The third-largest U.S. bank by assets is in talks with federal regulators on plans for the government to increase its stake, a person familiar with the matter said. Converting $45 billion of preferred stock that the government obtained last fall to common stock is one of many options, the source said.

Shares of Citigroup, which fell below $2 on Friday, rose as much as 23.1 percent after the talks surfaced, and after U.S. bank regulators said they stood ready to provide more capital to the sector and preserve the viability of systemically important financial institutions.

Even if shareholders get diluted, as long as the bank isn't nationalized there could be tremendous upside, said Ralph Cole, a portfolio manager at Ferguson Wellman Capital Management in Portland, Oregon.

But investors remained worried that losses from credit cards, emerging markets, trading and toxic assets could overwhelm Chief Executive Vikram Pandit's efforts to restore the bank's fiscal footing. Analysts do not expect Citigroup to be profitable in 2009 or 2010.

It helps their capital ratios but it doesn't help their problem assets, said Walter Todd, portfolio manager at Greenwood Capital Associates LLC in Greenwood, South Carolina. If Citi were out of the woods, the stock would not be at $2.

I'm not sure funding and keeping alive companies that are potentially insolvent helps out the broad economy and the broad market over time, said Ben Halliburton, chief investment officer at Tradition Capital Management in Summit, New Jersey.

The government plans on Wednesday to begin stress tests to evaluate large banks' potential capital needs.


Citing people familiar with the situation, The Wall Street Journal said New York-based Citigroup was in talks for the government to convert much of its preferred shares to as much as a 40 percent common equity stake, though bank executives hope to limit the stake to about 25 percent.

It can be taken as a commitment that some banks are too big to fail and the economic consequences too bad to contemplate, said Tony Morriss, senior markets strategist at ANZ Investment Bank, in Sydney.

Washington acquired the Citigroup preferred shares, which equate to a 7.8 percent stake, when it bailed out the bank last fall and agreed to share in losses on $301 billion of toxic assets.

The government doesn't want to do this, said Art Hogan, chief market analyst at Jefferies & Co in Boston. This is government looking into Citigroup, saying what is the best way to keep the banks alive, not the stocks alive. That's the important part.

The White House has said President Barack Obama favors a privately-held banking system. Moreover, Treasury Secretary Timothy Geithner's bank stabilization plan allows lenders to apply to convert preferred shares into convertible preferred shares and later into common equity, a spokesman said.


In the coming weeks, the Treasury Department is expected to subject banks with more than $100 billion of assets to stress tests to decide which need capital. Citigroup ended 2008 with $1.95 trillion of assets.

Governments worldwide are moving to prop up ailing financial companies. Britain, for example, has taken a majority stake in Royal Bank of Scotland Group Plc, while the United States in September took a nearly 80 percent stake in the insurer American International Group Inc.

New government assistance to Citigroup could fuel speculation that Bank of America Corp and other lenders might need similar help. If that happened, shares of other lenders could fall, including relatively healthy ones.

Nationalization is a trap that the U.S. government should avoid, Fox-Pitt Kelton analyst David Trone wrote. If Citi is nationalized, all bank stocks are likely to get crushed in fear.

In afternoon trading, Citigroup shares were up 19 cents, or 9.7 percent, at $2.14, after earlier rising to $2.40.

Bank of America rose 5.3 percent to $3.99, JPMorgan Chase & Co rose 0.5 percent to $20.00, and Wells Fargo & Co rose 2.6 percent to $11.19. The Standard & Poor's 500 was down 1.7 percent.


Citigroup declined to comment on talks with the government, but in an email said its capital base is very strong, despite $28.5 billion of losses in the 15 months that ended December 31, 2008.

Pandit has tried to add stability by dividing the bank in two, creating Citicorp for businesses the bank wants to keep, and Citi Holdings for businesses and assets it hopes to shed.

Nevertheless, Citigroup and many large rivals come up short in their ratios of tangible common equity to tangible assets.

Tangible common equity measures how much common equity a bank has to cushion itself in tough times, when intangible assets like goodwill may have to be written down.

If the government converted $45 billion of preferred shares into common stock, Citigroup's ratio would rise to about 3.9 percent from 1.5 percent. There is no consensus on what ratios banks need, but many analysts prefer 5 percent or more.

Citigroup began raising capital aggressively in late 2007, including from Abu Dhabi Investment Authority, Kuwait Investment Authority and Singapore Investment Corp.

Saudi Prince Alwaleed bin Talal, the bank's largest individual shareholder, also boosted his stake.

Singapore declined to comment. The others were not immediately available for comment.

Converting Citigroup preferred shares would add pressure on Bank of America, which also received $45 billion from the government and a loss-sharing pact on $118 billion of assets. About three-fourths of those assets came from the former Merrill Lynch & Co, which Bank of America bought on January 1.

Bank of America spokesman Robert Stickler said the largest U.S. bank is not in, and does not expect to enter, talks about new capital or converting preferred stock to common stock.

We are in very healthy shape, we have strong capital, we have the strongest liquidity in the industry, we are profitable and we are lending across business lines, he said.

(Additional reporting by Rodrigo Campos, Elinor Comlay, Ellis Mnyandu and Dan Wilchins in New York and Tony Munroe in Hong Kong; Editing by John Wallace)