Citi shareholders: who gets wiped out?

NEW YORK (Fortune) -- When news broke this week that talks were in motion for the U.S. government to gain a larger stake in Citigroup, somewhere between 25% and 40%, it immediately raised the question: What happens to current stockholders? In efforts to keep itself afloat, Citigroup has proposed a partial nationalization that would give the government far greater control. In one scenario, some of the $45 billion in preferred shares held by the government would convert to common stock, diluting the shares of current stockholders.

Yet the stock market responded to news of the prospective new bailout by boosting Citi share prices, as investors seemed to view partial government control as a better prospect than a full nationalization. Opinions ran the gamut, with some analysts hailing such a move as the quickest fix for the beleaguered bank and other banking experts cautioning against the government raising an expectation of many more such bailouts. "We're already in a nationalization phase," analyst Paul Miller said on Bloomberg TV. "We already own a chunk of Citigroup and Bank of America. The problem is that the government is dancing around this nationalization issue." While the details of the proposed government deal are hammered out, several scenarios could bring different outcomes for Citi shareholders. Here's a look at what might happen to investors.

Nationalization: Though the Obama administration insists that it doesn't want to nationalize Citi or any other banks, the debate over what nationalization actually means could just be coming down to semantics. In any case, if Citi were to be fully nationalized ? meaning the government completely owns the bank ? it would mean common shareholders would be wiped out.

Preferred to Common: The current talks center on the government converting its preferred stocks into common stocks. The logic behind the move, says James Barth, a finance professor at Auburn University, is to raise the ratio of tangible common equity, which is a criterion used to determine a bank's strength. The Federal Deposit Insurance Corp. considers a bank to be critically undercapitalized if the tangible equity-to-asset ratio is 2% or less. Citi's ratio hovers around 1.5% now.

While there's no magic ratio number, most experts agree that if Citi's ratio were boosted to at least 3%, the market could begin to embrace its stock. "It would reassure the marketplace that the government doesn't intend to wipe out shares," Barth says. Though investors wouldn't lose their shares in a preferred to common share scenario, their stocks would be diluted. But that may be perceived as the price of avoiding a full wipeout.

Conservatorship: In September, when the government seized control of mortgage behemoths Fannie Mae and Freddie Mac, investors' shares fell into an ambiguous position called conservatorship, which is essentially makes the government Fannie and Freddie's guardian. While holders didn't lose their shares, they aren't exactly worth much these days--Fannie's around $0.40 and Freddie hovers around $0.50. However, the rationale for holding on to these stocks could well pay off someday: if Frannie and Freddie regain their financial footing, the government will take a back seat and the market will bounce back.

In the Citigroup case, however, conservatorship may have more troublesome implications because there are more than two banking giants. Barth says if the government places Citi shareholders in conservator status, it raises expectations that the government would have to do the same with Bank of America's investors or many of the other 8,000 or so banking institutions.

So which Citigroup investors are left to possibly lose, at least in the short term? Most notable is Saudi Arabia's Prince Alwaleed bin Talal, the bank's largest individual shareholder, and such large mutual funds as Growth Fund of America and the Dodge & Cox Stock Fund. And those mutual funds are continuously re-evaluating their holdings. "Some might sell and take losses," Barth says, "whereas others might buy thinking the price will go no lower." One thing's for sure: there's no way to know what shareholders will ? or should ? do until it's clear exactly what the government will do with Citigroup.