The U.S. Treasury is facing a dwindling number of options for strengthening the nation's banks without owning many of them outright.

When Treasury Secretary Timothy Geithner announces on Tuesday the U.S. government's latest effort to shore up the financial system, investors will be listening closely to hear how federal banking regulators plan to address banks' razor-thin levels of common equity.

Initial reports of the government's deliberations include plans to make new preferred investments in banks that would convert to common shares after a number of years - possibly seven - which means the government may try to gradually boost banks' common equity levels over years, rather than weeks. If regulators can wait to convert the government's stakes to common shares until banks' share prices recover, they can likely avoid scaring off private investors by heavily diluting shareholders.

"Under the new proposal, it appears that the government may selectively convert the preferred TARP shares into common equity over a seven-year period thus minimizing the dilutive impact," said Anthony Polini, an analyst at Raymond James Financial Inc. (RJF), in a note to investors on Monday.

"The key factor," Polini says, "will ultimately be where these stocks are trading when they finally do raise common equity" - whether from the government or by issuing shares on the open market. The higher the share price, the less dilutive those equity raises will be.

Investors largely agree that most banks are in dire need of common equity. Since a bank's common shareholders take losses on the balance sheet before preferred shareholders and debt holders, the last 18 months of heavy losses have left common shareholders with shriveled stakes, even though many banks issued new shares before investors' appetites dried up.

What's more, since the government first began investing in banks last October, it has done so by purchasing preferred shares rather than common shares, through the Treasury's Troubled Assets Relief Program. Holding preferred shares, instead of common shares, allowed the Treasury to avoid holding voting rights in banks, and also to cushion taxpayers against future losses.

But over that same time, the largest U.S. banks have racked up billions in additional losses and seen their share prices sink fast. Their tangible common equity ratios - or a measure of shareholder's equity as a percentage of a bank's total hard assets - have fallen with them.

Of the largest U.S. banks, Citigroup Inc. (C) has the lowest tangible equity ratio, about 1.2%, according to a report on Monday from analysts at Keefe Bruyette & Woods. Wells Fargo & Co. (WFC) has the second lowest, at 2.6%. Bank of America Corp. (BAC) and JPMorgan Chase & Co. (JPM) have ratios of 2.7% and 3.7%, respectively.

Those ratios are all far short of the historical norm of about 6%.

Low tangible common equity ratios can be a sign to investors that a firm may soon need to raise more common equity, which at low stock prices dilutes existing shareholders to a great extent. This concern has been a factor in the decline of bank stocks in the last three months.

The simplest way for the government to boost banks' common equity would be to convert its current TARP preferred shares into common shares. But doing so would open a whole new can of worms, since the government would then own many banks outright.

According to the same Keefe Bruyette & Woods report, the government would own 66% of Bank of America if it converted its current preferred shares in the firm into common shares. Under the same scenario, it would own 37% of Wells Fargo and 27% of JPMorgan. The report did not provide an estimated government stake for Citigroup.

Under that same scenario, the report said the government would also own majority stakes in a number of other banks, including Fifth Third Bancorp. (FITB), CIT Group Inc. (CIT), Marshall & Ilsley Corp. (MI) and KeyCorp (KEY).

In recent days, as the Treasury has worked to design its next rescue package for the financial sector, fears quickly spread that the government might soon nationalize one or more banks. Those fears were largely responsible last week for sending Bank of America's shares to lows not seen since 1984.

Amid those fears, Secretary Geithner is likely to avoid any suggestion that the government is thinking of nationalizing a bank, and could duck altogether the question of converting its preferred shares into common shares.

"It is possible, and we think probable, that the government [will] not announce whether it intends to convert the current preferred shares it holds in banks into common," wrote Brian Gardner, the author of the Keefe Bruyette report.

But there is "one thing we are confident about," wrote Gardner. "The word 'nationalization' will not pass Secretary Geithner's lips on Tuesday."

-By Marshall Eckblad, Dow Jones Newswires; 201-938-4306; marshall.eckblad@dowjones.com