Federal officials are discussing the possibility of converting the U.S. government’s preferred shares of Citigroup Inc. (C) to common stock in a move that would boost taxpayers’ stake in the company to 40%, The Wall Street Journal reported.

The government currently owns $45 billion in preferred Citi shares, or a 7.8% stake of the company. By converting those shares into common stock, the government would increase its stake to 40% at the expense of current shareholders, whose stock would be diluted. The move would be at no additional cost to taxpayers.

Citigroup officials would prefer the government stake be closer to 25% according to The Journal.

By converting the preferred shares into common stock, Citi would bolster its “tangible common equity,” or TCE.  The TCE is a measure of what shareholders would receive if an institution were liquidated. It is expected to be one of the key components of the new financial stress tests being administered by federal regulators.

Those stress tests are scheduled to begin this week and will determine how much – if any – additional money that large financial institutions receive from the government. This additional step is being taken to address a gap in how the U.S. government – under the original Troubled Assets Relief Program (TARP) – was previously analyzing the health of big banks and other financial institutions, before injecting taxpayer-provided capital. With the stress tests, the Obama administration is aiming to have a better handle on the health of these institutions, and to lessen the odds that additional rounds of rescue money would have to be brought to bear.

Indeed, under this new plan, if the current financial situation deteriorates, the government may resort to take a majority stake in the most troubled lenders. This has raised the specter of bank nationalization, something that has been hotly debated among the country’s leading financial analysts.

The government has already taken controlling interests in insurance giant American International Group Inc. (AIG), and mortgage giants Fannie Mae (FNM) and Freddie Mac (FRE), and now analysts are starting to believe that many financial institutions – Citigroup in particular – are technically insolvent and will ultimately have to be taken over by the government no matter what happens.

“History has shown that those shareholders will likely be wiped out anyway,” Michael Parness, chief executive officer of TrendFund.com, told Cherry Creek News. “Look at Bear Sterns, AIG, Freddie and Fannie Mac. The Fed is trying to be all things to all people and support the system while propping up the stock market.”

Meanwhile, critics have said that nationalization will undermine the entire private financial sector and could cause investors to panic and abandon shares of healthy institutions.

For now, the federal government has given every indication that it will continue to balk at outright nationalization, choosing instead to provide a “temporary” buffer for firms against increased losses during the crisis.

“There’s a very strong commitment on the part of the administration to try to return banks or keep banks private or return them to private hands as quickly as possible,” U.S. Federal Reserve Chairman Ben S. Bernanke said last week.

White House spokesman Robert Gibbs echoed that sentiment at recent press conference.

“This administration continues to strongly believe that a privately held banking system is the correct way to go, ensuring they are regulated sufficiently by this government,” Gibbs said. “That’s been our belief for quite some time and we continue to have that.”

Source:  With Government Talking to Citi About a Larger Stake, Bank Nationalization Still Off the Table