Wednesday, March 18, 2009

A Graphic Representation Of The Citi Arb Carnage, Over $5 Billion In Losses

It took all of 2 weeks for the Citi Common-Preferred arb to become Volkswagen Jr. And if the administration feels abnormally nasty, this could become a fast money hedge fund neutron bomb that would make the Volkswagen megasqueeze seem like dress rehearsal for the Mormon tabernacle choir. But don't take my word for it: here is just how it looks graphically. The screen below is a Bloomberg CIX screen based on the formula: (C Common)*7.31 (pro forma for the 0.95 price adjustment) - (C AA Preferred). Now in an ideal world for there to be no Common-Preferred arbitrage, this would have to be equal or close to zero. Indeed this was the case for a while, when the $1 delta was embedded in the arb due to the risk of regulatory change in the final outcome of the deal (i.e. preferred getting converted into less than 7.31 shares of common). Then over the past three days something went horribly wrong and the arbitrage exploded. As ZH wrote earlier, the increasing borrow pulls by both retail and institutional holders of underlying stock, as well as some potential Orwellian not so invisible hand here and there, and all the funds who had shorted 7.69 shares of common for every preferred share they bought started to get a nauseous case of Volkswagen deja vu. It will be very poetic justice if the funds who barely survived VOW GR, end up imploding as a result of the Citi arb.



As the chart above shows, funds that have put this trade on over the past 2 weeks are now facing a loss of about $7.5 per unit (assuming it was put on when the delta was $1 which was the predominant value of the past 14 business days). If one assumes that a half of the trades in Citi common stock since the government's announcement of the exchange on February 27 were predicated on the arbitrage, then of the roughly 11 billion shares of common changing hands, there are around 700 million arb units in existence and at a $7.5 loss today, this would mean there could be over $5 billion in unrealized losses among hedge funds at market close today! (the assumptions are broad - I welcome any adjustments to this calculation). And let's not forget the funding cost: one year term borrow on Citi shares from broker dealers that still can find a few repoable shares, can be as high as 200%! This means the longer funds wait for this situation to normalize the more they have to pay. If they hold this arb for longer than 6 months, the arb has to return over 100% for the trade to be profitable, and even at today's closing levels, the best possible return is about 70%.

And the short squeeze is not the bulk of funds' worries... If the government really does feel like obliterating the bulk of the fast money HFs (read: most of them), all it has to do is adjust the terms of the Common-Preferred conversion ratio lower. And seeing how pretty soon C common will be trading above the conversion price for the preferred of $3.25, the likelihood of the ratio getting whacked grows by the day... If on top of a short squeeze, the 7.31 ratio is adjusted to say 3, the ridiculous levels reached by VOW stock will be like a walk in the park compared to the destruction that would follow as everyone runs for the Citi arb exits... Can't say Zero Hedge didn't warn them.

Tangentially, for all value investor club readers, isn't it an amusing coincidence how all your highest rated ideas end up being nuclear ICBMs - first VOW GR now Citi arb? Guess the too good to be true maxim applies not only to ponzi schemes...

6 sigma.

Disclaimer: ZH has been long Citi common since Feb 27. Sphere: Related Content
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24 comments:

Anonymous said...

Dude, reading your posts is like fun.

Administrator said...

Something tells me you are about to take off too.

Anonymous said...

yeah, this blog is the best part of my day. keep it up.

iifacts said...

great analysis! thanks!

Anonymous said...

Mr. Tyler D.

Are you still long C stock? no profit taking?

Tyler Durden said...

small position was taken off and reestablished early today. net long common

Matthew said...

Well done again Tyler. I'm out half the position today with a nice friggin gain. I went long after reading your 2/27 post on this citi/vw kinda squeeze thinggeee.

Thanks for sharing your work.

Anonymous said...

Nice trade. Is that what happened to AIG this week?

Anonymous said...

Re "Tyler Durden said...
small position was taken off and reestablished early today. net long common"

I too have been trading around and making small profits but still hold a big core long position. Also setup a Good-til-cancel sell order at $25, to try to prevent brokers borrowing my shares for short positions by others.

The perfect storm you detailed has already formed off the coast. If it is a direct hit, how high can C go short term fundamentally? Reason i ask is we have already tripled.

thanks in advance.

Anonymous said...

What about the news that Citi has no shares to issue for employee compensation, and that they are trying to authorize more shares to do this. Wont this cause dilution?

here is the wsj article preview
http://tinyurl.com/chzt4a

Excerpts:
Citigroup Inc. and Morgan Stanley are facing a problem as they try to pay their employees: The companies are running out of shares.

In the next few weeks, the two New York companies will announce plans to authorize or repurpose shares so they can have enough stock to compensate employees, people familiar with the matter said. The need to add or free up stock has been exacerbated by plunging share prices.

Citigroup will ask holders to boost its authorized share count far beyond what it needs to meet a capital restructuring announced last month. Morgan Stanley may need to use more of its currently authorized shares for bonus payments, which will require shareholder approval.

The dilemma the companies face reflects the devastation that the bear market has inflicted on their share prices. Lower prices mean they must pay out a larger number of shares to meet a given compensation sum.

Citigroup is finalizing plans to seek shareholder approval to boost its share authorization to 40 billion shares or more from the current 15 billion shares, according to two people familiar with the matter. Citigroup is requesting the overhang in large part to pay out equity-based compensation, said people familiar with the matter.

Sam said...

Love your posts. Great work!

Roy Zimmerhansl said...

Another great article Tyler. Linked to it in my blog. http://tinyurl.com/d4fbwf

cshiti short sucka said...

the thing i love most about this blog, even more than the brilliant analysis, is that when tyler talks his book, he's honest about it.

that is a rare and treasured trait in mine eyes.

cheers to you papa.

with that said, i heard much similar to anon @ 12:23 AM. worth investigating if one is long Cshiti.

might be a desperate attempt at disinfo from some dying rats, but if there is any validity, this ride's not over by any stretch.

...best to be nimble no?...

full disclaimer: caught a lowball offer on FAZ for a handful of shares at the end of the day today...too little to care if i lose, too low not to think i won't at least break even on them again sometime soon.

the Cshiti's never sleep...for now.

Anonymous said...

Nice analysis. Love the VIC reference! Classic.

Anonymous said...

now they are executing reverse stock split!

Anonymous said...

6 Sigma SPC. Yea.

Anonymous said...

why would they need to pay out 40 billion in bonuses? 40 million is more likely.

of course i realize that people these days can't tell a million from a billion (see AIG bonus scandal).

Anonymous said...

OMG $5B in losses at hedge funds?

Jay Otto said...
This comment has been removed by the author.
Anonymous said...

Best financial blog out there

Anonymous said...

Looks like the exchange factor is most likely to be 95%, except for series T (C PRI) at 85%.

CreditTrader said...

Been doing some math on this and looking at VWAP. The Pfds have a $9.40 VWAP since 02/27 (currently at $15.9). The common has a VWAP of $1.8583 (compared to $2.9 current). So, on average we sold 7.31 C common at $1.8583 at a cost of $13.58 and bought 1 Pfd at a cost of $9.40. The common is now worth $21.20 (meaning we lost $7.62 on our Common leg). Pfds have made $6.5. Net-Net on average using VWAP since the Treasury announcement investors lost $1.12 per common stock traded PLUS the cost of borrow - OUCH! Total volume in C common has been 12.4bn (if we go with ZH's assumption of say 50% in the arb then we end up with 6.2bn x $1.12 or around $7bn losses total on the arb! and growing) OUCH!

Anonymous said...

I came here from ClusterStock. Nice blog. Here is my Q. What is your opinion the C will go up to? I am new to trading and I have a tiny position (really tiny) in C Calls for Jan 10 at $10. I am wondering if this will become an "in the money" call soon?

VW was bizarre. I am hoping for it unless of course Timmy bails the funds out here too.

JD said...

Do you this happens tomorrow? What is your timeframe thoughts?