Why Citi Common Crashed And Why The Common-Preferred Arb Could Be The Next Volkswagen

(Please read update 4 for very important additional information)

The Volkswagen bandwagon idea de jour was a capital structure arbitrage in Citi preferred paired with shorting Citi common. As the government's term sheet proposed the conversion of Citi preferred stock into common at a price of $3.25, a huge number of accounts thought there was a significant arbitrage to be held here.

The math is roughly as follows: the face value of Citi preferred stock (C AA on Bloomberg) is $25, implying 7.69 shares of common to be received per preferred share (at $3.25). As C common traded at an average price of $1.60/share during the day, a preferred share holder would effectively arb into an implied value of $12.30 of common stock per preferred share. Citi preferreds traded down to a low price of $4.5 early in the day, after closing at $5.50 yesterday, however they quickly inverted and hit a high of $9.25 as people realized the potential arbitrage, before closing for the day at $8.05 on volume of 46.5 million shares. The trade could be boxed by shorting 7.69 shares of common for every share of preferred purchased, thereby "securing" a roughly 50% return. This (probably among other things) explains the persistent drop in Citi common over the day as hedge funds were locking in what they thought was a certain premium.

The problem that most however may have overlooked is a little footnote in the Citi illustrative example of how preferred to common conversion would take place, where Citi noted that the government will provide separate treatment for private and public preferred shareholders: "Ownership assumes conversion of publicly issued preferred stock is done at a significant premium to market, while the U.S. Government's and privately placed preferred are done at par."

Investors are now hoping that the premium for their publicly purchased preferred shares will be lower than the "guaranteed" 50% return they would pocket if they executed the trade at the end of the day, as otherwise they face massive losses on the conversion. As the Volkswagen example has taught us, and as the government has shown in its "white glove" treatment of private investors of all kinds, and couple that with some forced repo pulls by Citi common longs who may eventually realize their stock will skyrocket if they cause a forced squeeze, we wait with baited breath to see the carnage as the "Citi Arb Trade" blows up at some point over the next several weeks.

For people who want to dig through the most recent prospectus supplement to the Citi Series AA Preferred stock, you can do so here.

CreditSights has done an invaluable comparison of the 3 different classes of exchanging securities as part of the transaction, listing out the key terms for each tranche of securities. One of the relevant findings is that the gov't will exchange the balance of its existing preferreds (not exchanging to common) into 8% Trust Preferreds. The implication is current TruPS and eTruPS holders will be pari with the government, which is good from a security protection point, but risky in case the government decides to waive the dividend on the TruPS as all current TruPS holders will also lose dividend payments. The last is unlikely as it is the last form of dividend-paying security that taxpayers have remaining in Citi.



But what about all those toxic, toxic assets on the left side of the balance sheetreaders ask? Won't they drag the company down anyway regardless of what the government does on the liabilities side? What good is a technical play if the company is an AIG in the making?

The same people at CS put together a good analysis of what the key Stress Test metric of Tangible Common Equity/Risk Weighted Assets will look like in a severe scenario. And by severe Zero Hedge would use the term realistic. This analysis also presumes that all the potential converters in the preferred to common exchange go along for the ride as demonstrated in Citi's presentation:

The "severe" world is one in which:

• unemployment is 10-12%
• GDP is negative for more than 18 months
• credit card receivable portfolios losses reach 15%
• leverage loan marked down by -45%
• losses on mortgage portfolios are:

1. subprime: -40%
2. optionARM: -50%
3. second liens: -30%
4. Alt-A: -20%
5. first liens: -7%
6. commercial real estate: -15%
7. residential and commercial construction: -40%

Presuming things really hit the skids, the incremental equity generated by the exchange may just be sufficient to not let Citi fail, which itself has stated that based on its own internal stress tests the newly generated TCE "will be enough to let the company pass through this period." TCE/RWA will go from a precariously low 3.0% to 4.9% even in the Draconian scenario. Of course, whether it is pessimistic enough is anyone's call and the government may very well may be left with another AIG, however due to the lack of exponentially devaluing assets such as CDS contracts which become worth less and less with time, Citi's toxic assets may really only go down in value so far.

Disclaimer: ZH purchased Citi common at the end of trading Friday.

Update 1: Story is starting to spread... Picked up by Dow Jones at 10:18 PM...

Update 2: More interesting preferred tranches emerge. The spike in Series AA Preferred occurred with Series T 6.5% preferred as well. The stock, whose liquidation preference is $50 and should trade at double the price of AA by implication, closed at $15.75, a slight arbitrage most likely driven by liquidity.

The higher rated Series XV/XVI and other Trust Preferreds (BB-/BB vs CC+), which traded up to a 10% premium over AA/T comparable $25 liquidation parity closing around $8.80 (we are looking at the structural subordination issues regarding regular preferreds vs TruPS).

Update 3: Some legal perspectives on the deal.

Update 4: Some more math on the current equilibrium price for the preferred based on the very crude information provided by Citi in the conversion example slide:

• As the lower right number indicates there would be 21 billion shares of common outstanding pro forma for all participants converting;
• Current common shares out are about 5.5 billion;
• The government's conversion of its total $25 billion worth of preferred shares would add another 7.7 billion shares of common (at $3.25)
• As the slide shows, combined public and private ownership would be 38% of 21 billion or 7.98 billion. As the private preferreds hold 12.5 billion shares, this implies 3.85 billion of common, leaving 4.13 billion shares of common for public preferreds.
• This allows to calculate what an implicit price for the public preferreds would be: taking 14.9 billion public preferreds translating into the 4.13 billion share of common gives a 3.6 conversion ratio, which is 47% of the unadjusted conversion of 7.69 shares pref/common. Assuming the Friday common closing price of $1.50 is used, we get a value of 3.6 x $1.50 Citi common giving a value of $5.40 for the $25 par value of public preferreds.
• The Pref's closed at $8.05 on Friday. They are said to convert to significant premium to market. If one takes Thursday's closing price of $2.50 for Citi common, 3.6 share is equal to $9/share, which is a 9/5.5 = 64% premium to market to the Thursday preferred closing price of $5.50
• The question is: Is 64% considered a significant premium to the government? The end number could be much lower (or higher). There is no definitive information yet. A "mere" 20% premium to Thursday's close is a $6.6 implied preferred price, a 20% discount to the Friday closing price, and an explicit 20% incremental value to the common as the arb has to be repriced.

P.S. We will not respond to individual emails requesting additional mathematical elaboration. All you need to come to the presumed conclusion is here.

Update 5: Next Bank Of America picks up on this theme and in a research note focusing on the Citi exchange cautions that the Public Preferred could be in trouble:

An important difference in exchange terms wording

We note that in the term sheet of Citi’s exchange offer, privately placed and government held preferreds are to be exchanged into common stock at “$3.25/share at par”. However, publicly issued preferreds (including the Series T 6.5% convertible preferred) are to be exchanged into common equity at “$3.25/share at premium to market”. We think this is an important difference for investors of those targeted publicly issued preferreds. In our view, “$3.25/shareat premium to market” opens up the possibility that those publicly issued preferreds are likely to be exchanged into common equity not based on their original par value, but based on their recently-depressed trading prices.

Implication for the Citi 6.5% convertible preferred

We are looking for Citi to provide additional details on the exact definition of the term “at premium to market” regarding the exchange of those publicly issued preferreds. In our view, “at premium to market” could be interpreted as an “adjusted par value” that is based on past trading price of the preferreds plus a certain premium. Here, we offer our scenario analysis based on certain assumptions. The current trading range of the Citi 6.5% convertible preferred of $15 - $17/share (versus $1.50 C common price) implies an “adjusted par value” of about $33-37/share, which is about 65-74% of the original par value of $50/share and is a premium of 145-178% over the 30-trading price of the series T preferred. Assumptions and detailed scenario analysis are on the second page.

Importantly, investors should note that this is only one of the multiple possible interpretations of the exchange terms, and it could be very different from the more precise exchange terms that Citi may announce later. Investors are strongly recommended to look for Citi’s further clarification regarding this exchange announcement.

Additionally BofA present the following hypothetical conversion analysis on the Citi 6.5% Cvt Pfd (which has a liquidation preferrence of $50, so divide all output numbers by 2 to get comparable values for the Straight Preferred AA, E, and F $25 liquidation pref public preferreds). The question is whether the 45-78% implied premium conversion over recent pref trading prices is what the govt has in mind with its cryptic statement.

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