Feb. 23 (Bloomberg) -- U.S. financial regulators pledged to inject additional funds into the nation’s major banks to prevent their collapse and will this week begin examinations to determine whether they have enough capital.

Banks that cannot privately raise the additional capital they need after the so-called stress tests will get taxpayer money, regulators said in a statement in Washington. Government funds would be in the form of “mandatory convertible preferred shares” that would be exchanged into common equity “only as needed over time.” Stakes the Treasury has already bought will be eligible to be changed to convertible preferred shares.

While the new injections could leave the government with majority ownership of several lenders, Citigroup Inc., Bank of America Corp. and other banks rallied on speculation shareholders won’t be wiped out. Officials said that the move would be a temporary effort to ensure firms stay in business and keep providing credit to households and businesses.

“The goal here is to incrementally provide as much support as necessary,” up to what could be called “temporary nationalization,” said Kevin Petrasic, a former official at the Office of Thrift Supervision, who is now a lawyer at the Paul, Hastings, Janofsky & Walker law firm in Washington.

Stocks Gain

The Standard & Poor’s 500 Banks Index advanced 2.1 percent to 59.41 at the close in New York, still leaving it down 57 percent since the start of the year. Citigroup gained 10 percent to $2.14 after plunging 44 percent last week on concern it can’t keep going without some form of nationalization that hurts shareholders. Bank of America rose 3.2 percent to $3.91.

“The market is voting and saying ‘this is a good thing, it looks like they’re not going to do anything stupid,’” said Michael Holland, who oversees assets worth $4 billion, including JPMorgan Chase & Co. shares, as chairman and founder of Holland & Co. in New York.

“I need a lot more beef before I think they’re getting it right,” Holland added. The Treasury already has bought more than $280 billion worth of stakes in U.S. financial companies since Congress approved a $700 billion financial-rescue fund in October. That’s failed to stem an exodus of investors from banks on concern credit losses will surge further this year.

‘Temporary’ Buffers

The new government funds are designed to provide a “temporary” buffer for firms against increased losses during the crisis, the Treasury, Federal Reserve, Federal Deposit Insurance Corp., Office of the Comptroller of the Currency and Office of Thrift Supervision said.

The mandatory convertible preferred shares will be exchangeable to common equity on a one-to-one basis, a government official said on condition of anonymity.

Officials are open to considering requests to exchange existing government stakes into common equity shares if the bank and its regulator believes it would help it survive, Treasury spokesman Isaac Baker said late yesterday.

“The U.S. government stands firmly behind the banking system during this period of financial strain,” the Treasury and bank regulators said in today’s statement. “The government will ensure that banks have the capital and liquidity they need to provide the credit necessary to restore economic growth.”

Supervisors will start the stress tests on Feb. 25 to assess whether banks have enough capital to withstand “a more challenging economic environment.” The statement didn’t specify the tests that bank examiners will run or say when the results will be known.

FDIC Report

Regulators will announce further details about the tests in two days, an official said. FDIC officials will release a quarterly report Feb. 26 with an updated tally of the number of “problem banks,” put at 171 in the third quarter.

“They don’t want to announce to the world that a third of the banks are undercapitalized and have to be nationalized,” said Sean Egan, managing director of Egan-Jones Ratings Co. in Haverford, Pennsylvania. “So they’re trying to finesse it.”

U.S. business economists in a survey today projected that the country’s recession will be the worst in more than three decades as job losses mount and consumers and companies retrench.

The world’s largest economy will shrink by 1.9 percent this year and a total of 2.8 percent in the current downturn, the most since the 1973-75 slump, according to the median estimate in a poll taken by the National Association for Business Economics. Another 3.2 million Americans will be cut from payrolls in 2009, pushing unemployment to 9 percent by year-end, NABE said.

Nationalization Idea

Sliding bank shares have given momentum to the idea of nationalizing banks in recent weeks. Nouriel Roubini, the economist and professor at New York University’s Stern School of Business, Republican Senator Lindsey Graham of South Carolina and former Federal Reserve Chairman Alan Greenspan have all suggested it as a solution to banks’ woes.

Fed Chairman Ben S. Bernanke said last week “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.” Senate Banking Committee Chairman Christopher Dodd said in a Feb. 20 Bloomberg Television interview that “short-term” government takeovers may be unavoidable.

By converting its preferred shares to common, the government could pad too-thin tangible common equity, or TCE, ratios. TCE strips out intangible assets, goodwill -- the premium above net assets paid for acquisitions -- and preferred stock, including shares issued to the U.S. Treasury. The ratio measures TCE against tangible assets.

Citigroup Stake

The government holds $52 billion of preferred shares in Citigroup, five times the bank’s market value as of Feb. 20. If the U.S. were to convert all of its holdings into common shares, it would own more than 80 percent of the company.

Charlotte, North Carolina-based Bank of America, which has received $45 billion in TARP funds in exchange for preferred shares and warrants, would be 66 percent owned by the government if its entire stake were converted to common equity, according to data compiled by KBW Inc., a New York-based investment bank.

The figure would be 69 percent at Regions Financial Corp. in Birmingham, Alabama, which has received $3.5 billion from the U.S. It would be 83 percent at Fifth Third Bancorp, the largest Ohio-based lender, which got $3.4 billion.

KBW calculated the government stakes based on a conversion price of 80 percent of the stock’s value as of Feb. 5.

Bank of America, Citigroup and Wells Fargo & Co. in San Francisco are among more than 400 financial institutions that have received cash in exchange for preferred shares under the program.

Current Capital

The regulators today said major U.S. banks are currently meeting their existing capital requirements.

“Major U.S. banking institutions have capital in excess of the amounts required to be considered well capitalized,” the regulators said.

Still, analysts and investors anticipate that writedowns will climb. President Barack Obama has also said that some lenders haven’t fully recognized likely losses. The International Monetary Fund estimates that writedowns and credit losses on U.S. mortgage-related assets will reach $2.2 trillion, after a total of about $1.1 trillion so far.

Officials are still “attacking the symptoms of the problem as opposed to the underlying cause,” Egan said. “The base problem in the financial markets right now that has yet to be addressed is the valuation and pricing of structured finance assets.”

Treasury Secretary Timothy Geithner outlined earlier this month a Public-Private Investment Fund designed to address the toxic assets. Officials have yet to specify how the program, which may reach $1 trillion, will work.

To contact the reporter on this story: Rebecca Christie in Washington at Rchristie4@bloomberg.net

Last Updated: February 23, 2009 16:14 EST