Citigroup [C 3.70 -0.25 (-6.33%) ] and wells fargo [WFC 25.49 0.08 (+0.31%) ] said they were paying back funds to the U.S. government, in transactions that will end taxpayers’ capital support of the biggest U.S. banks much sooner than had been expected.

Uncle Sam and money

With regulators signing off on the plans, the U.S. government is signaling that it is comfortable removing some of the support it has provided to banks since the failure of Lehman Brothers created pandemonium in financial markets in the fall of 2008.

The banks are hoping to escape some of the added regulatory scrutiny that came with U.S. support. The obama administration’s pay czar, Kenneth Feinberg, had to sign off on pay for Citigroup’s top 100 employees after the bank received more than $45 billion of capital over three bailouts.

Wells Fargo received only one government capital injection of $25 billion and was subject to fewer restrictions.

Both banks faced pressure to repay the United States after Bank of America[BAC 15.63 --- unch (0) ] announced plans to sell more than $18 billion of equity to help repay the $45 billion it received from the government under the Troubled Asset Relief Program, analysts said.

Citi and wells fargo became the last big banks to leave tarp.

But the government and the banks that have left tarp are taking a risk. If the economy weakens considerably next year, more bailouts could be necesssary.

Citigroup Chief Executive vikram pandit is giving up a government guarantee the bank had against excessive losses on $250 billion of assets. The bank has yet to consistently post real profits from its banking operations.

Banks are evidently concerned about the economy, and have been reducing their loan books and boosting their investments in risk-free securities.

President barack obama told top U.S. bankers on Monday that they had to open up the credit spigot for small businesses and start lending again.

Still, many investors now believe the worst is behind the U.S. economy, in part because of extreme efforts by the government and the Federal Reserve to rescue the financial system.

The United States is more optimistic about the outlook for the banking sector as well. The obama administration’s projected cost to taxpayers for tarp was cut by about $200 billion last week.

Citigroup said it plans to issue $17 billion of common shares and $3.5 billion of securities that convert into shares in three years to help repay $20 billion of capital it received late last year from tarp.

Citigroup’s share offering is expected to be sold on Wednesday.

The government, which owns about 7.7 billion of the bank’s shares worth about $28.5 billion, plans to sell up to $5 billion of citi shares alongside the bank’s offering.

Wells Fargo plans to sell $10.4 billion of shares, and also raise up to $1.5 billion of equity through asset sales.

Both Citigroup and wells fargo are offloading stock to their employees, with Wells selling $1.35 billion to benefit plans instead of contributing cash to them, and Citigroup selling $1.7 billion of common stock to staff pending shareholder approval.

Beyond Wells Fargo’s share sales and asset sales, the bank did not specify how it would fund the rest of its payment to the government.

PAYING THE PRICE TO EXIT

Both banks will enjoy some benefits from exiting tarp. Citigroup will save about $2 billion of interest expense annually by exiting tarp, while wells fargo will reduce annual dividend expense by $1.25 billion.

Citigroup will also reduce the government’s say over the bank’s compensation packages beginning in 2010, although the bank cannot pay employees more for 2010 to make up for 2009 pay cuts mandated by Feinberg, a Treasury official said.

But both deals are also bruising for the banks. Citigroup is taking an $8 billion pre-tax loss on the trust preferred purchase, because the securities were recorded on the bank’s books at less than their face amount.

Canceling securities linked to the government’s asset guarantee will result in another $2.1 billion of pre-tax losses for Citigroup. Those losses eat into the benefit of raising capital.

Wells Fargo’s hit to common shareholders will be $2 billion in the fourth quarter.

Both banks are also diluting shareholders, something wells fargo executives had said they wished to minimize or avoid.

To avoid extra dilution, wells fargo said it was buying out Prudential Financial Inc’s [PRU 49.45 0.56 (+1.15%) ] stake in a brokerage joint venture for cash instead of its prior plans to use cash and stock. Prudential said last week that deal, which closes in January, will boost its investable funds by about $4 billion.

For Citigroup, the dilution to shareholders from its deal is about 15 percent. That is much higher than the dilution to Bank of America Corp’s shareholders when the bank repaid the government earlier this month.

Citigroup received $45 billion last year under tarp. This year, the government agreed to convert $25 billion of those funds into Citigroup common stock, leaving the United States with a stake of roughly 34 percent in the bank.