Feb. 27 (Bloomberg) -- The U.S. government ratcheted up its effort to save Citigroup Inc., agreeing to a third rescue attempt that will cut existing shareholders’ stake in the company by 74 percent. The stock fell 39 percent.

The Treasury Department said it would convert as much as $25 billion of preferred shares into common stock provided private holders agree to the same terms, the government said in a statement today. The conversion would give the U.S. a 36 percent stake in the New York-based company.

“We’re in these dire conditions, and this is a restructuring of a troubled company,” CreditSights Inc. analyst David Hendler said. “Common shareholders are severely diluted.”

Increased government involvement complicates Chief Executive Officer Vikram Pandit’s attempt to restore confidence in the company after the stock sank to the lowest in 18 years. The government is supporting Citigroup because of concern its failure might roil weak global markets. The U.S. doesn’t immediately intend to inject additional money after channeling $45 billion to Citigroup last year.

The bank, which last year slashed its quarterly dividend to 1 cent a share, said today the payout will be eliminated. It also took an accounting charge related to the plummeting value of some businesses, swelling its record 2008 loss to $27.7 billion, or 48 percent larger than reported a month ago.

Moody’s Cuts

Moody’s today reduced its rating on Citigroup’s senior debt to A3 from A2. Moody’s said that even after government support, the bank will emerge from the economic crisis on a smaller scale, “which could diminish its relative importance to the U.S. banking system.” Standard & Poor’s affirmed its A/A1 rating and changed its outlook to “negative” from “stable,” citing the possibility the government may have to provide more support.

Assuming the maximum amount of preferred shares eligible for conversion, existing stockholders would be left with a 26 percent stake. The stock fell 96 cents to $1.50 in composite trading on the New York Stock Exchange at 4 p.m. as a record 2 billion shares changed hands. It plummeted 90 percent during the past 12 months and is down 78 percent so far this year. Only Cincinnati- based Fifth Third Bancorp fell more out of 24 companies on the KBW Bank Index.

‘Creeping Nationalization’

“This is another step toward creeping nationalization,” Arthur Levitt, former chairman of the U.S. Securities and Exchange Commission, said in an interview on Bloomberg Radio. “This country is going through no less than an economic revolution,” said Levitt, a board member of Bloomberg LP, the parent company of Bloomberg News.

Federal Reserve Chairman Ben S. Bernanke said Feb. 25 he wants to avoid nationalizing Citigroup and other large banks in a way that would wipe out shareholders and leave the U.S. in full control. Bernanke said the government might end up owning a “substantial minority” of the bank.

The Government of Singapore Investment Corp. said its stake in Citigroup will increase to 11.1 percent after it converts its preferred shares into common stock. Prince Alwaleed Bin Talal, Capital Research Global Investors and Capital World Investors are among other preferred stockholders that have agreed to participate in the exchange, Citigroup said.

Under the terms of the deal, Citi will exchange common stock for as much as $27.5 billion of its preferred securities at a conversion price of $3.25 a share.

New Bailout Funds

The Treasury Department is injecting a fresh round of bailout funds into the nation’s banks to help them weather the recession. Regulators on Feb. 25 announced details of “stress tests” to determine how much capital banks will need should unemployment climb to 10.3 percent in 2010.

“It’s just unbelievable,” said David Rovelli, managing director of U.S. equity trading at Canaccord Adams Inc. in New York, in a Bloomberg Television interview. “The government is making up the rules as they go. A continued breakup is probably in the cards.”

Pandit, 52, has been selling units to free up capital. He said last month he planned to sell the bank’s CitiFinancial consumer-finance and Primerica life-insurance subsidiaries as soon as the market permits. He also struck a deal to sell majority control of the bank’s Smith Barney brokerage to Morgan Stanley.

Board Shakeup

As part of today’s deal with the government, Citigroup also agreed to reconstitute its board so that a majority of the directors are new and independent.

The change was intended to be a statement to Wall Street and the public that there are some consequences when the government needs to take extraordinary steps to stabilize a company, an administration official said on condition of anonymity.

Even with that agreement, the government isn’t dictating who will be named to the board, nor will it set the bank’s business strategy, Chief Financial Officer Gary Crittenden said in a Bloomberg Television interview.

Pandit has said he wants to refashion the financial-services behemoth, built in the 1980s and 1990s through a chain of acquisitions, into a global bank focused on retail branches, securities trading, investment banking and payment processing. Citigroup refers to the businesses it wants to keep as Citicorp, harking back to the pre-1998 entity that preceded its landmark merger with Travelers Group Inc.

Banamex Future

On a conference call today, Pandit said the U.S. government’s bigger stake won’t preclude ownership of banking units in other countries, such as Banamex in Mexico.

“We have structured these investments and are in the process of structuring them so that all our franchise in the form of Citicorp remains intact,” Pandit said.

Pandit said the transaction should put to rest any concerns that the bank will be nationalized.

“Our business is about confidence,” Pandit said. “This capital should take the confidence issues off the table, even in a stressed environment.”

The government’s increasing control over the bank’s affairs grew apparent after the bank got $25 billion of bailout funds in October and another $20 billion in November. The bank also paid $7 billion of preferred stock for $301 billion of guarantees on mortgages, junk-grade loans and subprime-tainted securities.

Citigroup has already accepted restrictions on executive pay and limited luxury perks such as office renovations and unnecessary private-jet travel. Citigroup said in a separate statement today it will suspend dividends on preferred stock.

Political Scrutiny

The bank also was pressed to participate in a foreclosure- prevention program favored by Federal Deposit Insurance Corp. Chairman Sheila Bair. The company consented to lawmakers’ demands that it support a bill, opposed by the banking industry, that gave bankruptcy judges the authority to write down mortgage principal.

Citigroup still faces scrutiny of whether it’s appropriately using the bailout funds. Some lawmakers have criticized its $20- million-a-year sponsorship of the New York Mets’ new baseball stadium in the New York City borough of Queens. Corporate- governance advocates say the bank is paying for millions of dollars of perks, including offices, secretaries and cars and drivers, for retired executives.

The bank said last week director Roberto Hernandez Ramirez will keep getting reimbursed for his use of private aircraft and other perks after he steps down from the board in April because of his continuing role as non-executive chairman of Banamex. The benefits, which also include an office, secretary and personal security, cost $2.61 million in 2007, according to a March regulatory filing.

To contact the reporters on this story: Bradley Keoun in New York at bkeoun@bloomberg.net; Rebecca Christie in Washington at Rchristie4@bloomberg.net

Last Updated: February 27, 2009 18:11 EST