Citigroup's road to nationalization

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NEW YORK (CNNMoney.com) -- Citigroup may be on the verge of nationalization. But what exactly that means remains to be seen.

Those concerns flared up again over the weekend amid reports that the government was thinking of taking a much bigger stake in the beleaguered banking giant.

According to the reports, the government could convert a large portion of its preferred shares into common stock, a move that would give taxpayers as much as a 40% stake in the bank.

Wall Street seemed to embrace the notion that the government would not let Citigroup fail. Shares rose 10% on Monday. The stock is still down more than 68% so far this year though.

But assuming the government does take a bigger stake in Citi, what would be done next to try and restore the bank to health?

The Obama administration has already indicated that they have no interest in running Citigroup (C, Fortune 500) or its embattled peer Bank of America (BAC, Fortune 500). Some argue that Citi and BofA, which have each received $45 billion in funding from the bank bailout as well as hundreds of billions of dollars in loan guarantees, have essentially been nationalized already.

Experts say there are a number of options.

The most drastic measure would be to effectively place the bank into a conservatorship situation where regulators take over the company, kick out the management and maybe even sell off parts of the business.

That's what the government has already done with mortgage financing giants Fannie Mae and Freddie Mac.

Banking regulators undertook similar action when they seized the troubled California mortgage lender IndyMac last summer and later sold it to private investors.

This approach worked for Sweden and Finland in the early 1990s and Japan more than a decade ago. All the banks that were nationalized returned to profitability within five years, according to a recent report published by the financial services consultancy Oliver Wyman. The governments each maintained a minority interest in some of these banks afterwards, however.

But Gerard Comizio, senior partner in the financial services practice group at the law firm Paul Hastings, warned that this scenario is typically complicated and expensive, noting that the government would probably need to continue pumping taxpayer funds into the bank.

That's not to mention the backlash from owners of common stock and the company's debt holders, whose stakes would be effectively wiped out.

"The question of nationalization really boils down to what does the government want to do?" said Comizio.

Others suggest that the case of insurance giant American International Group could wind up being a model for what happens to Citigroup.

Last September, the government took a nearly 80% stake in AIG (AIG, Fortune 500) in order to keep it from bankruptcy. So far, the government has lent the insurance giant about $150 billion and there were reports Monday that it is in talks for even more aid.

But unlike what has happened with banks, regulators have played an active role in shaping the future of AIG. The government installed its own chief executive officer after rescuing the firm and ordered that the company begin to sell off much of its massive portfolio of assets which, at the time, included everything from an aircraft leasing unit to life insurance operations.

The government declined to take board seats at AIG. But experts note a similar move would raise eyebrows since there would be calls to have some individuals on Citigroup's board that represent taxpayers' interests.

"Typically in private transactions where you take a large stake, you want representation," said Joe Scott, a senior director at Fitch Ratings who tracks Citigroup.

Of course, there is also the argument for doing nothing. Both top executives and industry groups have endorsed such an approach in recent days.

In a statement issued late last week, Edward Yingling, president and CEO of the American Bankers Association, stressed that talk of nationalization is keeping many willing investors on the sidelines.

Still, even if the government did nothing, regulators would still need to keep a close eye on Citi and other troubled institutions to make sure that management is not taking part in risky activities.

"The government has to make sure the institution isn't being run imprudently and management isn't gambling for resurrection," said James Barth, a professor at Auburn University who also serves as a senior finance fellow at the Milken Institute, a nonpartisan economic think tank.