PANICKED CITIGROUP shareholders fled the ailing banking group in droves last night as the US government stepped in with plans to take a 36 per cent stake in the company and remove a slough of directors.

Minutes after the government released plans to take what is effectively a controlling shareholding in the world’s biggest banking group, Citi shares plunged more than 48 per cent to little more than $1.

The US government move, made after days of speculation that Citi was to be nationalised, is the third attempt by the US Treasury to stabilise the troubled banking group and arrest the rapid decline in its share price.

Previous government efforts to restore the bank’s fortunes – including a $45 billion capital injection in exchange for a raft of preferred shares and a guarantee on more than $316 billion worth of dodgy loans – did nothing to restore the market’s confidence in the one-time banking behemoth.

In the face of this continued failure, the US Treasury made its boldest move yet to save Citigroup an hour before Wall Street opened for trading yesterday. It proposed converting to common equity some $25 billion worth of the preferred shares it had received in exchange for the earlier capital injections. The exchange will be made at $3.25 a share – a 32 per cent premium to Thursday’s closing share price – and only if and when a group of private preferred stock holders agree to do the same.

Those private investors, who hold some $27.5 billion of preferred Citi stock between them, include long-time Citi backer Saudi prince al Waleed bin Talal and the government of Singapore Investment Corporation.

If the plan is fully executed the US government’s stake in Citi would equal more than 36 per cent while existing shareholders would see their holding slump to just 26 per cent.

“This securities exchange has one goal – to increase our tangible common equity,” Citi chief executive Vikram Pandit said.

Critics of the government intervention say the new plan is effectively a nationalisation of Citigroup but Treasury and White House officials maintain that they want to avoid direct government ownership of private banking companies.

Government intervention in the day-to-day affairs of running Citi is already apparent, however. Dick Parsons, the Citi chairman, announced plans to get rid of five of the board’s 15 current directors at the same time as the government deal. It is understood that hiring a majority of so-called “independent” directors was a condition of the renewed government bailout.

Mr Parsons said the new directors would be brought on board as “soon as feasible” but it is understood that several prospective directors have turned down offers in recent weeks. “It is not exactly a job many people would want to take on in the current environment,” said one Citi insider.

Citi also suspended its one cent a share dividend last night as it increased already record losses for 2008 by a further $10 billion to $27.7 billion.

In the coming weeks Citi, along with all other major US banks participating in the US government bailout schemes, will be forced to endure a so-called “stress test” to see if it can survive further pressure.

Anticipation of the test results is serving only to spook investors further, however. The market’s reaction to the latest Citi bailout plan was a clear indicator that investors feel betrayed by Citi and the US government.

“Investors pretty much lose everything they had in Citi through this deal,” said David Wyss, the chief economist at Standard Poor’s in New York who owns a small number of Citi shares in a personal account.

Shares in Citigroup were down by more than 35 per cent in midday trading on Wall Street at just $1.59 a piece.

“This deal is clearly good for the long-term survival of the bank and for its bondholders,” Mr Wyss added. “The equity holders can complain but you have to say to a certain extent that this is what they are there for. They take a risk and invest, if it doesn’t go well they lose.”

The cost of insuring Citigroup bonds over five years – a key measure of how creditworthy the company is – dropped dramatically as soon as the government deal was announced, showing bondholders are much more pleased with the deal that equity holders. “Bondholders now have, almost, the full faith and credit of the US Treasury behind them,” Mr Wyss said.