The US government rode to the rescue of Citigroup, entering an agreement to guarantee up to $306bn in problematic assets and inject $20bn in capital to restore confidence in a bank that defines the term “too big to fail”.

The 11th hour transaction, announced just before midnight on Sunday in the US, calls for Citi to absorb the first $29bn in losses it sustains from its portfolio of risky assets – from residential mortgages to commercial real estate and leveraged loans, collateralised debt obligations and auction rate securities. Federal government entities will stand behind 90 per cent of the remaining losses, which could amount to $249bn.

The cost of insuring Citi’s debt almost halved on Monday as the rescue package was seen to lessen the risk of default. Its five-year credit default swap tightened from close to 500 basis points on Friday to 255bp, or $255,000 a year to protect $10m of debt.

President George W. Bush spoke about the rescue when he appeared alongside Treasury secretary Hank Paulson on Monday: ”This is a tough situation for America, but we’ll recover from it,” he said. ”The first step for recovery is to safeguard our financial system.”

The news also sent Citi’s shares up 58 per cent to $5.97 in early trading in New York on Monday.

Under the terms of the arrangement, the US Treasury will invest $20bn in Citi preferred stock under the federal government’s troubled asset relief programme (Tarp) and receive dividends at a rate of 8 per cent annually. On top of that amount, Citi is receiving an additional $7bn in return for preferred shares issued to both the Treasury and the Federal Deposit Insurance Corporation for their roles in guaranteeing the risky assets.

In addition to the $27bn capital infusion, the reconstruction of Citi’s balance sheet in effect frees up an additional $13bn, so the total capital benefit to Citi will be $40bn.

Following the agreement Citi promised to cut its dividend to 1 cent a share and to abide by restrictions on certain types of executive compensation.

Gary Crittenden, Citi’s chief financial officer, said that last week’s plunge in the bank’s share price, from $9.36 last Monday to $3.77 at Friday’s close, was “very concerning.” At Friday’s share price, the bank’s market capitalisation stood at a mere $20.5bn, according to Bloomberg.

Mr Crittenden added that the arrangement with the government, hammered out after more than two days of non-stop deliberations, should effectively remove any doubt among Citi’s investors that the bank can withstand the current market downturn.

Responding to criticism that Citi was getting special treatment that would not be available to another institution, Mr Crittenden insisted that the arrangement was deliberately packaged in “a plain vanilla flavour” so it could be applied to other lending institutions.

Citi and the US government made it clear that the Citi arrangement would be extended to other banks that pose risk to financial system stability, if need be. That is why the arrangement included broad swathes of Citi’s assets but was not tailor-made to suit Citi alone. As a result, Citi’s credit card loan portfolio, which analysts expect could see much higher losses as the recession deepens, was not included in the loss-sharing agreement.

The deal is likely to raise questions on whether the terms were onerous enough. For example, there were “enhanced restrictions on executive compensation” but no demand that management step down. The 8 per cent dividend on the preference shares is still lower than what some private shareholders have been offered.

The deal “was not about punitive, it was about financial stability,” said Mr Crittenden.

He said the $306bn in assets that would be backstopped did not amount to the sum total of problematic assets on Citi’s books, and included good assets that had not dropped in value.

Citi’s loss-sharing arrangement with the government, its new issuance of $27bn in preferred stock and its dramatic reduction in dividend payments will leave the bank with substantial excess capital.

Officials and market participants hope that excess capital can be put to work buying securities in the secondary market. The secondary market has almost totally frozen up since the Treasury’s announcement that it would not buy distressed mortgage securities through Tarp.

If banks begin to use such excess capital to buy these troubled assets in size in the secondary market – at levels that many believe are artificially depressed – and create a floor for prices, that in turn could break the logjam and kick-start lending in the primary market.

Government officials involved in the deal described it as a strong statement of support for large financial institutions.

They said the government saw no reason to seek a change of management at Citi, in contrast to the purge of executives at AIG, the insurer, after its bail-out in September. The officials declined to explain their differing approaches to the two cases.

Officials said Hank Paulson, Treasury secretary, and Ben Bernanke, chairman of the Federal Reserve, both helped broker the deal, which was approved by a unanimous vote of the Fed board on Sunday.

Tim Geithner, president of the New York Fed, was in the thick of the drama, hours before he was expected to be unveiled as President-elect Barack Obama’s pick for Treasury secretary.

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