NEW YORK/WASHINGTON (Reuters) - A small Midwestern bank has negotiated with the U.S. Treasury for taxpayers to essentially buy the bank’s shares at an above-market-value price, in an unusual transaction reflecting how the government’s bank investments are entering a new phase.

A protester holds a sign reading "Give Us Our $$$$ Back" as US Treasury Secretary Timothy Geithner (L) addresses a hearing of the Congressional Oversight Panel of the Troubled Asset Relief Program on Capitol Hill in Washington, April 21, 2009 file photo. REUTERS/Jonathan Ernst

Midwest Banc Holdings Inc MBHI.O agreed to swap $84.8 million of preferred shares it sold to the U.S. government in 2008 for securities that will convert into about $15.5 million of common shares -- roughly an 80 percent loss to taxpayers.

To some analysts, the transaction is an outrageous giveaway to an ailing bank, and its investors.

“There’s a lot of funny stuff going on here,” said James Ellman, president at hedge fund Seacliff Capital in San Francisco.

Others say it is a sign of the tough choices the Treasury faces dealing with banks that remain weak despite receiving government capital. In some cases, taxpayers must choose whether to lose 80 percent of their money, or all of it.

A Treasury official told Reuters that the deal is designed to help Midwest Banc Holdings raise private capital, which is the main goal of this phase of the Troubled Asset Relief Program (TARP).

The biggest banks repaid the money they owed the U.S. Treasury last year and earlier this year, and with a few exceptions, they did so easily.

But more than 600 smaller banks are still left in the program, and owe roughly $130 billion to taxpayers.

In the latest stage of TARP negotiations, many banks will struggle to repay that money. The government will be forced to negotiate separate deals with banks that could result in losses for taxpayers.

The Chicago area, where Midwest Banc Holdings is based, could have a large number of problem lenders.

A recent presentation by rival Chicago bank MB Financial Inc MBFI.O said there are 157 banks in the metro area with more than $100 million of assets, and 70 of them are by one measure experiencing real credit stress.

When banks applied for the Treasury capital, they had to be deemed “healthy” by their regulators to receive taxpayer funds. So far, the only outright loss the government has taken so far on the TARP Capital Purchase Program is a $2.3 billion loss on its investment in CIT Group, which went through a bankruptcy reorganization last year.

The Treasury has said it expects its bank capital injection program overall to earn a profit, helped by preferred stock dividends and warrant sales. But the overall TARP program is expected to lose about $117 billion, from companies like insurer American International Group Inc AIG.N.

Chris Robling, a spokesman for Midwest Banc, declined to comment.

SHARING THE GAINS

What irks some analysts is that the government may be giving up some potential gains on Midwest Banc’s stock. The Treasury could have traded its $85 million of preferreds for common stock now worth about $85 million.

That move would have given Midwest the same amount of capital, but the bank would have issued more shares to taxpayers at a lower price, giving taxpayer’s more profit if the company’s shares rise.

“Taxpayers should be allowed to share in the upside,” Seacliff’s Ellman said.

An analyst in New York said, “The government is giving away money here.”

But others argue that issuing fewer shares to the government may be necessary if the bank is looking to sell more common shares to private investors.

The government’s mistake was investing in the bank in the first place, and its best option is now to choose the outcome that minimizes losses, said Linus Wilson, a longtime critic of TARP at University of Louisiana at Lafayette.

“We weren’t in that good a bargaining position,” Wilson said, adding that the current market value of the government’s TARP preferred shares is about $8 million.

Midwest is not alone in having renegotiated its TARP obligations. Citigroup Inc C.N exchanged about $25 billion of the United State's TARP preferred shares into common stock, and another $20 billion of TARP securities into trust preferreds.

Superior Bancorp SUPR.O and Popular Inc BPOP.O last year also exchanged trust preferreds for the government's preferreds.

And GMAC Financial Services in December swapped some of the government’s TARP preferreds for mandatory convertibles.

Midwest Banc is giving securities known as mandatory convertibles to the U.S. government, in exchange for the preferreds it sold in December 2008 plus $4.5 million in unpaid dividends on that stock.

Those securities will automatically convert into about 47.1 million common shares in seven years. The bank can convert them sooner if it sells at least $125 million of new equity for cash, and meets a few other conditions.