WASHINGTON (MarketWatch) - U.S. banks that fail a looming government stress test of their financial viability could be forced to accept government investment, pushed into shotgun marriages or simply nationalized if the institution's situation is bad enough, regulatory observers said.

Those are some of the likely options facing troubled banks that fail the tests, which are expected to begin shortly. Details of the plan are expected to be released Wednesday.

"Depending on the level of failure discovered through the stress test, the government may take convertible preferred shares, or if a bank is clearly insolvent, I expect bank regulators to nationalize by taking over common stock and putting in a board of trustees made up of bank managers," said Columbia Law School Professor John Coffee.

Separate stress tests are expected to be conducted by different bank regulators; however, the Office of the Comptroller of the Currency, which oversees roughly 1,600 nationally chartered large and small banks, is likely to complete the majority of the reviews. The Federal Deposit Insurance Corp., Office of Thrift Supervision and the Federal Reserve also will examine financial institutions under their purview.

The new details about the stress test come after reports Monday about the possibility that the government could take as much as 40% of Citigroup Inc.'s C, -2.12% common stock, in part, by converting a significant portion of the $45 billion in preferred shares already controlled by the Treasury.

After rising in early trading, the Dow Jones Industrial Average DJIA, -0.47% dropped sharply in response to the possibility of bank nationalization, the new details about Citigroup and speculation about further trouble for American International Group Inc. AIG, -1.23% . Treasury said it had "no comment" on whether it is in talks with Citigroup and AIG.

Facing increased concerns about financial institutions, the White House on Monday repeated its support for a private banking system. "The president believes, the economic team believe, and I would simply reiterate what I said here on Friday, that the president believes that a privately held banking system regulated by the federal government is -- is the best way to go about this," said White House spokesman Robert Gibbs.

“ 'They are going to replace the one-size-fits-all approach with one that provides widely ranging capital injections depending on the stress-test results.' ” — David Brown, Alston & Bird

As part of the stress test, bank regulators will consider how much capital a bank has left if it were to register its losses immediately, according to Fred Cannon, managing director at investment bank Keefe, Bruyette & Woods in San Francisco. The test is expected to also examine a bank's capital position over the next two or three years by taking into consideration its losses over that period. Each bank's tax position and what credits they have available will be examined as well.

On Monday, Treasury provided some details about how it expects to proceed with its infusion program, known as the Capital Assistance Program, or CAP. According to a statement, Treasury will provide government capital in the form of "mandatory convertible preferred shares."

David Brown, partner at Alston & Bird LLP in Washington, said he believes that by "mandatory," Treasury means it will put out a deadline, perhaps within five or seven years, by when banks must convert the preferred shares into common equity.

Banks that fail the stress test are expected to be required to take capital injections from bank regulators; however, they can buy out the government stake prior to the deadline "as needed."

Pricing questions

Questions remain about how much funding will be made available, as well as the price that banks can buy out government stakes early if they wish. "Will banks that want to buy out the government preferred stake need to do so at common equity prices at the time, or at the price at the time the government bought the stake?" Brown asked.

Cannon at Keefe, Bruyette pointed out that the Treasury statement on Monday did not reiterate a statement it made on Feb. 10, when it said banks will use the Feb. 9 stock price, with a modest discount, to determine the conversion price for the preferred convertible shares. "The stock price of many financial institutions has fallen since then," he said. "Will they stick with a conversion price at that level?"

The CAP program adds to an existing Treasury Capital Purchase Program that already has invested $196 billion in a $250 billion cash-infusion program, as of Feb. 23.

Unlike, CPP, CAP is expected to provide widely differing capital infusions to financial institutions based on the stress test. The CPP program provided standardized infusions based on a bank's risk-weighted assets.

"They are going to replace the one-size-fits-all approach with one that provides widely ranging capital injections depending on the stress-test results," said Brown.

Coffee at Columbia Law School said that the stress test is in response to pressure from a Congressional Oversight Panel for the bank-bailout program. The COP reported earlier February that Treasury overpaid for its capital infusions by putting in about $254 billion for warrants and other securities worth about $176 billion, a shortfall of $78 billion as of the date of the transactions. "Treasury is responding to the Congressional Oversight Panel," he added.

Some large form of nationalization will take place, Coffee expects, if government regulators believe that a particular large financial institution is insolvent and its collapse would have a systemic impact on the markets.

One possible approach is for Treasury to take over all or most of a bank's common shares and insert a board of trustees made up of banking executives, following an approach used by Sweden during its own banking crisis in 1992. This approach, employing a board of trustees, is being utilized as part of Treasury's recent bailout of AIG.