The deal announced Friday by the company and the Treasury Department represents the third rescue attempt for Citigroup in the past five months. It's contingent on private investors agreeing to a similar swap.
The administration decided to restructure the bailout package for Citigroup again in the hopes that converting $25 billion of preferred shares into common stock would give investors more confidence the bank has sufficient capital reserves to withstand mounting losses on its holdings of mortgages and other loans. While the conversion to common stock will dilute current shareholders' investments, a wider equity base could calm investors since there would be more reserves in place to guard against further losses as the economy sours.
Besides a stronger capital base, the company is getting a critical boost to its cash flow as it forgoes its 4 cent annual dividend on its common shares. That is giving Citi an additional $2.18 billion a year. The bank will also no longer pay the 5 percent dividend it owed on the government's preferred shares that have converted to common stock.
But the deal doesn't affect one of Citi's greatest problems, the billions of dollars in failed mortgage-backed securities that still sit on its books. As those investments have fallen in value, they have exacerbated Citi's losses.
The plan comes one day after the Obama administration laid the groundwork in its first budget request for greatly increasing the size of the $700 billion bailout program that Congress passed in October. Administration officials said no decisions had been made yet but suggested the size of the effort could be expanded by as much as another $750 billion.
But the administration is mindful about growing unhappiness among voters and lawmakers in the huge sums that have been provided to the nation's banks, money that so far seems to have done little to stabilize the situation.
The aim of the government's rescue effort is to keep the New York bank holding company alive and bolster its capital as it faces growing losses amid the intensifying global recession. Existing Citi shareholders would see their ownership stake shrink to as little as 26 percent.
Investors appeared disappointed in the deal and expected dilution of their stake, sending shares plummeting 94 cents, or 38.2 percent, to $1.52 in afternoon trading. Stocks tumbled early but pulled off their lows as the Dow Jones industrial average came within 34 points of breaching the 7,000 mark for the first time in more than 11 years.
Underscoring its precarious nature, the company also disclosed that it recorded a goodwill impairment charge of about $9.6 billion due to deterioration in the financial markets.
While customers may not notice much of a difference, banking industry analyst Bert Ely told CBS Radio News that Citigroup could be a much different company before long.
"The key impact is going to be Citi moving at a faster pace in downsizing itself and selling off some of its business and restoring itself to profitability," he said.
The Treasury Department said the transaction requires no new federal funds, though it left the door open for Citigroup to seek additional government funding. For now, the remaining $20 billion of the government's investment will be converted into a new class of preferred shares that will pay an 8 percent annual dividend.
The conversion will make the government the largest shareholder in Citigroup, but company officials said they still expect to call the shots.
"We ... remain in charge of the day-to-day operations of the company and none of that changes," chief executive Vikram Pandit said in a conference call with reporters.
Investors have punished the shares of Citigroup and other banks in recent weeks out of concern the government could nationalize troubled banks, which would involve replacing management and wiping out shareholders.
Treasury officials and Federal Reserve Chairman Ben Bernanke have said there are no plans to take such steps.
Dean Baker, co-director for the Center for Economic Policy and Research, a liberal think tank, said the government's efforts to avoid a takeover amount to "a further handout to Citigroup."
"We really should own it outright," he said, given that taxpayers have provided the company $45 billion in assistance, several times its market value.
Citi will offer to exchange up to $27.5 billion of its existing preferred stock held by private investors at a conversion price of $3.25 per share. That's a 32 percent premium over Thursday's closing price of $2.46.
The Government of Singapore Investment Corp., Saudi Arabian Prince Alwaleed Bin Talal, Capital Research Global Investors and Capital World Investors are among the private investors that said they would participate in the exchange.
The conversion will provide Citi a better mix of capital to withstand further weakening in the economy. The conversion to common stock was laid out by the administration earlier this week as an option for providing relief to banks.
The transaction also is an acknowledgment by the administration that the government's ownership of preferred shares didn't boost investors' confidence in the banks.
The preferred shares are similar to debt and the banks were under pressure to essentially pay back the government in five years. Preferred shares also get paid back before common shareholders in the event of a bankruptcy.
Neither of those conditions accompany common shares. Still, owning such shares means taxpayers will share in future gains or losses from any drops or increases in the company's share price.
One of the hardest hit banks by the ongoing credit crisis, Citi has also received guarantees from the government protecting it from the bulk of losses on $300 billion of risky investments.
The deal comes as Citi is in the process of shedding assets and cutting staff as it looks to reduce costs and streamline operations ahead of splitting its traditional banking businesses from its riskier operations. Citi last month reached a deal to sell a majority stake in its Smith Barney brokerage unit to Morgan Stanley.
Citi also will reshape its board of directors, Richard Parsons, the bank's chairman, said in a statement Friday. The board, which currently has 15 members, will have a majority of new independent directors as soon as possible, he said.
Three board members in recent weeks have said they would not seek re-election as the company's annual shareholders meeting in April. Two others will reach the mandatory retirement age by the time of the meeting.
Roberto Hernandez Ramirez earlier this month said he would not stay on beyond his current term. Last month, Robert Rubin, a former Treasury secretary who was a longtime Citigroup board member, and Win Bischoff, most recently chairman at Citigroup, announced their retirements from the company.
The goodwill charge announced Friday was added to Citi's 2008 results along with a $374 million impairment charge tied to its Nikko Asset Management unit. The charges resulted in Citi revising its 2008 loss to $27.7 billion, or $5.59 per share.