Updated from 12:20 a.m. EST

Citigroup's ( C) investors may be relieved that the banking institution is not being fully nationalized, but that doesn't mean the company won't suffer from being under tighter government control.

The Wall Street Journal reported late Sunday that the company is in talks with federal officials that could result in the U.S. government substantially expanding its ownership of the bank to as much as 40%, citing people familiar with the situation.

In its proposed plan to regulators, Citi executives hope the stake will be closer to 25%, these people said, the Journal reports. But there is the possibility the talks could fall apart, the Journal adds.

Shares of Citi jumped as high as 27% on Monday, before closing up 9.7% to $2.14. Investors seemed calmed by the fact that a larger government equity stake "could be a better outcome than a full nationalization as some have feared," Jason Goldberg, an analyst at Barclays Capital, wrote in a note.

Still at it current stock price, Citi has just two choices -- nationalization or additional government intervention, says Morningstar analyst Jaime Peters. " There seems to be zero way that the company can make it on its own with its current stock price," she says.

"The positive is going to be a firmer capital base, which should in turn induce more customer confidence" in the company, she says. "That seems to be the only major reason to do this."

Still, "there is a difference between a 40% stake and actual nationalization," Peters says. "This is not nationalization." Rather, the government is taking baby steps toward nationalization in hopes that the economy will stabilize before it is forced to do so, she says.

Under the scenario being considered, according to the Journal, a substantial chunk of the $45 billion in preferred shares held by the government would convert into common stock, people familiar with the matter said. The government obtained those shares, equivalent to a stake of 7.8%, in return for pumping capital into Citi.

The Journal says the move wouldn't cost taxpayers additional money, but other Citi shareholders would see their stock diluted. A larger ownership stake by the government could fuel speculation that other troubled banks will line up for similar agreements.

The government has gone to great lengths to stress it is not planning to nationalize the banking system. Concerns over customer attrition -- caused by fears prompted by the declining stock price - and reports the government will begin its so-called stress testing on the banks this week, probably accelerated Citi's acknowledgement that it needs more help, Peters says.

Citi declined to comment on the Journal article, but reiterated on Monday that its capital base is "very strong" and that it continues to focus on reducing assets on its balance sheet, expense control and streamlining businesses for "future profitable growth."

In an internal memo distributed late Friday, Citi's CEO Vikram Pandit addressed the speculation of the nationalization of the bank. He attempted to reassure employees by saying that he remained "very confident in Citi's prospects and business position around the world."

Pandit highlighted statements made by the White House on Friday that it prefers a privately held banking system.

While Citi's tier-1 capital ratio was close to 12% at the end of the fourth quarter -- far above the 6% well-capitalized threshold, Citi's tangible common equity ratio -- another measure of a bank's financial strength that gives weight to common shares -- was far more miniscule, at 1.5%. In comparison, JPMorgan Chase's ( JPM) tangible common equity ratio was 3.8%, while Wells Fargo ( WFC) had a tangible common equity at 3.5%, according to Peters.

On Friday, shares of Citi fell 22% to close below $2, and Bank of America ( BAC) shares also sank, as talk of the banks' nationalization spooked investors. Both banks already have received significant help from taxpayers as the government has rushed in to try to save the financial sector. The White House, however, has insisted it's not trying to take over the two ailing financial institutions.

BofA said Sunday that it isn't discussing the sale of a larger ownership stake to the government.

Fox-Pitt Kelton Cochran Caronia Waller analyst David Trone worries that the government could "harmfully meddle" in Citi's operations and strategy and that customers will "avoid" Citi as a result.

"It's possible that Citi could end up unprofitable even in normal times," he writes in a note. "If we're right, the government will have a hard time ... selling its stake back to the public markets."

He refers to nationalization as "a trap that the U.S. government should avoid" and "completely unnecessary" as long as depositors are calm, he writes.

"In our view, the U.S. government should not set a precedent of catering to the stock market's fears and the associated pressure from the press, particularly since, if Citi is nationalized all bank stocks are likely to get crushed in fear," the note says. Joseph Woelfel contributed to this report

Copyright 2009 TheStreet.com Inc. All rights reserved. This material may not be published, broadcast, rewritten, or redistributed. AP contributed to this report.

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