June 10 (Bloomberg) -- Citigroup Inc. began swapping $58 billion of preferred stock into common, a deal that will make the U.S. government the bank’s largest shareholder and close a shortfall in common equity found in stress tests last month.

A portion of the Treasury’s $25 billion of preferred stock will be converted to common, the company said today in a statement, giving the government a 34 percent stake in the New York-based bank. Citigroup will also exchange as much as $33 billion of preferred securities not held by the government.

Citigroup is counting on the transaction to replenish an equity base eroded by $27.7 billion of losses last year. The bank said in April it would delay the swap until government stress tests were completed. Those results came last month. It was also held up as Federal Deposit Insurance Corp. Chairman Sheila Bair questioned the company’s leadership, people familiar with the matter said.

“I don’t think it means by any means they are out of the woods,” said Marshall Front, who oversees about $500 million as chairman of Front Barnet Associates LLC. “There are a number of things they have to do and this was one of the first. They are going to have to demonstrate an ability to improve their capital position through earnings. Longer term, they have to get out of the clutches of the government.”

More than 17 billion shares may be issued to the government and other preferred holders, diluting existing stockholders by about 76 percent. The deal is set to expire July 24, and distribution would be made on July 30.

‘Confidence’ in Management

“Citi’s management team, led by CEO Vikram Pandit, has clarified the company’s strategy,” Chairman Richard Parsons said in the statement. The bank “has taken the tough decisions to downsize the company and cut expenses significantly. We have confidence in our management and the future of our institution.”

Bair’s objections centered on whether the bank’s management has enough commercial-banking experience, people close to Citigroup said. Treasury Secretary Timothy Geithner has indicated he thinks replacing top executives now might be destabilizing, people familiar with his views said.

“The FDIC has absolutely not delayed efforts of Citigroup to bring an exchange offer to market,” Andrew Gray, an FDIC spokesman, said June 8. “The FDIC strongly supports efforts of all banks to raise additional capital where possible, and improve the quality of their capital structures.”

Citigroup said in a statement this week that it “appreciates the cooperation and support it has received from federal banking regulations,” and said reports that regulators had delayed the offer were “entirely incorrect.”

Talking to Board

Bair addressed Citigroup’s board yesterday to ease tensions between her agency and the bank, the Financial Times reported today, citing people close to the situation. Citigroup spokesman Jon Diat declined to comment on the report, as did FDIC spokesman David Barr.

After completion of the exchange offering, Citigroup’s tangible common equity could increase by as much as $61 billion and its Tier 1 common may increase by as much as $64 billion, Chief Financial Officer Ned Kelly said in the statement.

The company also said its board adopted a “tax benefits preservation plan” that would protect assets that could be lost with a switch in ownership by major shareholders. The plan doesn’t apply to the government’s acquisitions of Citigroup common stock.

Hovnanian, Stamps.com

The plan, in place for three years, “is designed to reduce the likelihood that Citi experiences such an ownership change by discouraging any person or group from becoming a 5 percent shareholder and dissuading current 5 percent shareholders from acquiring more than a minimal number of additional shares of Citi’s stock,” the company said.

Companies including homebuilder Hovnanian Enterprises Inc. and Stamps.com have taken similar steps in the past year to limit the size of individual stakes. Otherwise, the firms would be in danger of losing the tax gains they expect from deferred losses, said Robert Willens, president of New York-based tax and accounting advisory firm Robert Willens LLC. Citigroup has $43.5 billion of these so-called deferred tax assets.

“They are coming close to having an ownership change so they don’t want a small acquisition to tip the scales,” Willens said. “That would be nothing short of a disaster.”

FDIC Backing

The FDIC guarantees $34.6 billion of the bank’s long-term debt and $30 billion of short-term debt, filings show. The FDIC also was one of several agencies, including Treasury and the Federal Reserve, to participate in an insurance policy on $301 billion of Citigroup’s distressed assets.

The delays have frustrated investors who bought preferred stock in anticipation of profiting when the exchange closes, CRT Capital LLC analyst Kevin Starke said. Many such investors have sold borrowed shares in anticipation of paying them back after the conversion. Delays increase the cost of financing trades.

Citigroup shares rose 7 cents, or 2.1 percent, to $3.48 in New York Stock Exchange composite trading at 4 p.m. The stock is hovering near levels in mid-February, just before it began a two-week slump that forced Pandit to seek a rescue from the Treasury.

To contact the reporter on this story: Josh Fineman in New York at jfineman@bloomberg.net.

Last Updated: June 10, 2009 16:10 EDT