The U.S. government will commit to holding a common equity stake of up to 30-40 percent in Citigroup in a deal that will see most of the group's board replaced, a person familiar with the transaction said on Friday.

The cornerstone of the agreement to bolster the fallen financial giant's capital base, expected to be announced later on Friday, is the conversion of up to $25 billion in government-held preferred shares in the bank to common equity, the source said.

But Citigroup will first have to raise funds from private investors willing to convert their preferred stock to common shares.

The U.S. Treasury would then match the private conversions dollar-for-dollar up to $25 billion, the source said. The state currently holds about $45 billion of Citi's preferred stock purchased through two separate capital injections last year.

By 3:41 a.m. EST, Citigroup's Frankfurt-listed shares were down 0.5 percent at 1.97 euros in thin trade. Citigroup closed at $2.46 on Wall Street on Thursday, missing out on a rally in other major U.S. bank shares as some investors feared it was facing outright nationalization.

Europe's banking sector was also lower, falling 2.9 percent after Lloyds Banking Group unveiled a massive loss for 2008 and said it had not finalized details of a plan to put billions of pounds of assets into a UK government-backed insurance scheme.

The source said the government was likely to wind up with around 30-40 percent of Citi's common stock, though the size of its stake would ultimately depend on the amount of privately-held preferred stock that was converted.

President Barack Obama's administration signaled broad support for the nation's banks this week, with a fiscal 2010 budget plan that includes a 'placeholder' provision for the Treasury to purchase $750 billion more in securities from the banking sector.

Under the deal with Citi, a majority of the bank's directors will be replaced, though Chief Executive Vikram Pandit will keep his job, the source said.

The action, which marks the third major Treasury intervention to aid Citigroup since mid-October, follows more than a week of negotiations between the Treasury and the firm, once the world's largest financial services group.

The increase in Citigroup's common equity is expected to greatly boost its capital ratios, making it better able to withstand losses.

The government is expected to receive a slight discount on its conversion price compared to private investors, the person familiar with the deal said. But taxpayers will be giving up dividends of up to 8 percent on preferred shares that are converted.

NEXT MOVE: INVESTMENT FUNDS

It was unclear to what extent Citigroup's major private preferred stock investors were willing to do the same.

Government Investment Corp of Singapore (GIC) spokeswoman Jennifer Lewis declined comment on the arrangement. In January 2008 the Singapore fund bought about $6.88 billion worth of perpetual, convertible notes in Citi that pay a 7 percent annual dividend.

A banking source in Singapore said the U.S. government deal would put pressure on GIC to convert those securities.

Abu Dhabi Investment Authority (ADIA), the world's largest sovereign wealth fund, bought $7.5 billion worth of Citi notes in November 2007, convertible into not more than 4.9 percent of Citi shares at that time.

On Wednesday, the U.S. Treasury pledged to provide sufficient capital to about 20 of the largest U.S. banks that undergo a stress test program to assess their ability to cope with the possibility of a worse-than-expected recession.

Citigroup will still be subjected to the stress test despite the conversion transaction, the source said.

Banks judged to need more capital will have six months to raise funds from private investors or accept the Treasury's offer of buying preferred shares that are convertible into common equity.

The Treasury also will allow other banks that previously receive capital injections under the $700 billion bailout program to convert those preferred stock investments to convertible preferred shares and later to common equity to help boost capital ratios.

For a graphic on Citi's decline, click on: https://customers.reuters.com/d/graphics/MKT_CITI0209.gif

(Additional reporting by Saeed Azhar and Kevin Lim in Singapore and Rafael Nam in Hong Kong; editing by John Stonestreet and Jon Loades-Carter)

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