Friday, February 27, 2009

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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Anonymous said...

$3.25 per C share IS the premium to market. No?

Tyler Durden said...

$3.25 is the conversion price into common based on a $25 book value per preferred share. i.e. you 25/3.25 common shores post conversion. however you have to be a pvt investor or the government to be assured of this. if you just bought public you may get much less shares than that, hence the "premium" warning in the citi example

Anonymous said...

Are the public prefs convertible at all?

Anonymous said...

The private (read: foreign) investors got cut down by 50% and gave up their divvies in exchange for common. They must realize that ultimately C is FUBAR no matter what, and converting to common is the only way to get some of their investment back. So perhaps there will be continuing selling pressure from them, unless they continue to hold out with faulty hopes that C is worth more. Hint to them: it's worth 0!

Anonymous said...

Nicely done Tyler. If I understand your post correctly....a small fry like myself can engage in a little "stick it to the man" trade by going long this turd's common for a quick squeeze to the upside. No?

Love the blog. You do good work here.

Tyler Durden said...

that's the read... also, little downside, and massive upside in case of squeeze... but also lots of risk. caveat emptor and all that

Anonymous said...

Yes indeed. Mucho risk. Caveat emptor always.

Good weekend.

Anonymous said...

Your analysis is flawed. VW vs C is comparing apples and oranges. Citi is insolvent. Only a fool will cover a short position at this point. VW was a viable company. C common is going to be a penny stock in months.

Anonymous said...

I got several questions.

Question #1 is are publiclly traded preferreds even convertable? I think they are trust prefereds, and just continue pay the divvy (I could be wrong here)

Question #2 is I think "shorts" are not bona fide equity shorts. I think that was what killed LEH, is they poured money into equity trying to "squeeze" logal shorts, while the real "shorting" was done with equity swaps and CDS.

Today I found out that there is a way the hedge funds can create a synthetic short without borrowing shares, or going to an open market to sell through equity swaps. I guess investment banks offer those services to them, and "hedge" by selling equity in the open market legally. CDS turned out to be no winners in a lot of cases, but I've not heard about equity swaps before I've read SKF prospectus. If C wants to fight bear raid old school way, they may lose just like LEH did. I would think they can win if somebody pulls equity swaps from the market in an organized way. I have an odd feeling GS, JPM & MS did that already, because shares are not under attack even from SKF, but C & BAC are shorted with what seems like more shares that exists in circulation.

Granted, your converts arb blow up is what C had in mind, I start to wonder who those constant shorts are. C is perpetually a hard to borrow stock, so who has the borrow even now??? Look at SKF, it's every day on treshold securities list, yet I have no doubt it's heavily shorted.

Tyler Durden said...

would have to disagree that C and VW are not comparable. the VOW thesis was short common long preferred, in fact identical. it was merely a cap structure play. the common was trading at 30x PE when stock was at 200 euro, which was much richer than citi is trading now. botom line is neither of these is a fundamentally driven trade but merely a convergence, and in this case the investing public rushed in on false premises.

Anonymous said...

In theory the math makes sense, but the firm is insolvent. Weak hands might get shaken out Monday because they think the govt bailout will help C survive. But it won't.

Max Leverage said...
This comment has been removed by the author.
Anonymous said...

I have traded preferreds for a long time and was thrown for a loop by the "at premium to market,"
thinking it was an additional amount , not a lesser amount than the private shareholders. If the conversion is 3.25, the number of shares would be XX.XX regardless of that additional "at premium to market." Right? So, then what really does "at premium to market" mean?

Anonymous said...

BTW, the I, M, and O are straight preferreds. I believe the rest are trust preferreds, backed by junior subordinated debentures.

For a long time I have speculated whther these would be treated differently than straight preferreds, and now we know.

Perhaps a reason for continuing to pay on the sub debentures (which generally allow interest payments to be deferred for 5-10 year or in ING's case indefinitely) is that as long as the institution isn't in default, not only does it have to continue to accrue the interest on it's books, but also the holder has to PAY TAX ON THE PHANTOM INCOME.
That's right, if they defer interest on the TRUPS , yuo would still owe tax on the interest as a cash basis taxpayer, even if you did not receive the interest income. This continues unitl the amount due is deemed uncollectible. That could be 5 or 10 years. Then you get to deduct the interest you reported, all in the year it becomes uncollectible.

Anonymous said...

Does the pure volume of shares become an issue? My understanding was VW was a great squeeze thanks to its small number of shares. C is a core holding of almost every mutual fund, money manager, etc.. it seems there would be tons of shares out there. I claim no great knowledge.. just curious. The idea is intriguing though.

Tyler Durden said...

You would need a perfect storm of events to incite a substantial squeeze: arbs who over the weekend look and realize they may have rushed, a very crowded trade which will take stops out on the way out, disclosure by the government on the "premium to market" clause (effective dilution to public prefs which is undefined as of yet), float pulling by repo desks, etc.

We have no additional insight, but the fact that the arb still exists (parity price for preferreds is about $10 as common and preferred converge to breakeven) should be cause for concern as it indicates there are many traders who are taking the opposite trade already.

Anonymous said...

Great aalysis Tyler, but I have to wonder - is any of this even relevant as nothing has really changed at Citi due to this deal? The problems remain on the asset side of the ledger. As long as Citi keeps these toxic assets and market remains weak they'll suffer the same fate as AIG and perpetual write-downs until they market these assets properly.

I see your point that the stock could pop on the arb induced squeeze, but as someone else said those would be the weak hands who think that Citi's financial strength has actually changed here when in fact, it hasn't.

Anonymous said...

"until they mark these assets properly". It's still early here on the best coast.....

Tyler Durden said...

Wrt C viability: it is tied to that of the US. If C goes, so does the US. Period. it is an unfortunate coupling but that's where the gov't bad decisions have led us. The gov't will keep printing cash and pumping... and diluting... but common will always have option value until the US defaults. In the meantime, I dont believe the stock is a short here due to limited upside and substantial downside based on constantly changing cap markets rules and cover potential. Yesterday's price action is a lot of outright shorting, as longs would not sell at $1.5: they would keep the stock for option value: how much of the 1.9 billion shares traded was new shorting i do not know, but it was a substantial amount.

Anonymous said...

What is going to happen to shareholders of common stock? Will the price go back up or will it dwindle down to nothing?

Anonymous said...

I am not saying that C will go under. Of course you're right - the US can't let C fail. They truly are "too big to fail", but that doesn't mean they won't go the way of AIG, FMM & FRE and become bloated tax taxpayer blackholes.

This deal looks like they're rearranging deck chairs on the Titanic. They are not confronting the problems on the asset side of the ledger. Until they do that I think it's hard to make an argument that there is any shareholder equity left at this company.

I hope the trade works out for you though. We've often seen these huge short induced pops after government intervention (reference just about any of the other bailouts) even without the fuel from the arbs.

Good luck.

Tyler Durden said...

Also keep in mind the only reason arbs shorted roughly 8 shares of common is because they bought 1 share of preferred. If accounts now estimate that a preffered would be worth less than that per the "premium to market" language, they will have to buy back 1 to 3 shares for each prefered they own (if the premium is up to 50% to market.

Anonymous said...

Very good post. However, keep in mind that Citigroup and the government very, very much want as many preferred holders to convert as possible. Without the pfds converting, the TCE/Total Asset ratio is only about 2.5% (close to 4% with full conversion). The premium to mkt is likely to be set reasonably high to get pretty much full conversion, but probably not par. My guess, 85-90% of par, leaving 15-20% incentive to tender.

Anonymous said...

More great insights from Tyler Durden....

While this trade has high risk, you get the potential squeeze from those with seller's remorse as well as a potential bump if the market decides to rally here before the next big drop....

Basically a call option....

Outstanding....Keep up these "best" level insights....


Anonymous said...


In simple terms, you bought citi Friday because:

A) you felt common holders of citi preferred misinterpreted the conversion terms
B) most of the selling was short and panic
C) Both A and B may cause a short squeeze in citi common stock, which closed at 1.50

Is this about right?

Anonymous said...

It is no so simple,because the pari passu clause, read an extract of another poster in yahoo message board @ c-pp:

"...The good news is that CITI and GOVT lawyers have not done their homework very well. What I am bout to say in PART II will reveal that:

1) CITI requires 2/3ds votee of all pari passu equal ranking PREF shareholders to pass the deal (we would lose that vote since PUBLIC shareholders only account for 28% of the pari passu PREF stock outstanding!!) . However, the documents essentially say that if any shareholder is materially worse off (that is US!!!) after the new terms and conditions, then they dont get to vote to pass this deal!!!!! YES I believe this is true!!! I have read the docs a hundred times and am convinced we have a case and a very good case!!! . Furthermore, even if they were allowed to take a shareholder vote, the only shareholders that can vote are US guys - the guys getting screwed – WOW! How can that be you ask. Here is why?. The concept is easy to understand. If they guys getting screwed by CITI are OK with being screwed then no one gets hurt so the deal can be done. Makes total sense and that is whay this is in the prospectus..."

Anonymous said...

You did the numbers incorrectly. You are correct, based upon the presentation, the $14.9BB of public preferred is assumed to convert into 4.13 BB Citigroup shares. But at $1.50, that is a value of $6.2 BB, or 41.6% of par. For a $25 par preferred, that works out to be $10.39 per share. Don't kid yourself, the govt and Citigroup are desperate for all the public preferred to convert. They will make the terms generous enough to ensure conversion.

Tyler Durden said...

To anonymous, my math is right. you mix apples and orange using the premium to market to calculate the conversion ratio based on notional. that is incorrect. also, the preferred will convert regardless as they will be stuck with a security that will have no clear terms and could be even more worthless than common post conversion thus prompting the exchange. theoretically even a 1% premium to Thursday closing price would be a kiss from the govt.

Anonymous said...

Tyler, thanks for the info. So basically if the 3.25 is increased to 3.75-4 we should see a short squeeze, correct? I guess the other possibility is that the par value is decreased and the 3.25 stays.

Unknown said...

Tyler, your math is incorrect in Update 4. The units are completely messed up. You are comparing units of DOLLARS/SHARE to SHARE/SHARE.

The 3.6 "conversion ratio" you calculated is just the $3.25/common share.

You basically calculated a bunch of numbers that are already implied in the table with numbers from the SAME table. The only difference is you did not take into account the rounding errors hence the discrepancy.

I'm guessing the $14.9B is the face value of the public preferred shares. If so, then the ~21B shares calculated is assuming the 'HIGH' and probably unrealistic case where the shares are traded at face value.

Anonymous said...

4.16 X1.5=6.24 billion
Face value of preferreds is 14.9 billion
% of preferred face represented by total value
if you pay less than .4118 X 25 for the preferreds you make money
you are confusing the $ value of the prefferds with the the # of Shares

Anonymous said...

It is 8:30 am.The shorts in C are being crucified.Oh no it's the longs.While Tyler runs an outstanding website,follow your own analysis before trading.Remember almost everyone has an agenda

Tyler Durden said...

last time i checked citi was up 5% with market getting destroyed. but yes, everyone likely does have an agenda

Anonymous said...

There are significant terminology mistakes in the fourth and fifth bullet point below "Update 4:" that need correction.

Given your math, which is correct, you are confusing the conversion PRICE with the conversion RATIO ($14.9b/4.13b shares = $3.60, NOT 3.60 shares).

This then implies ~6.94 shares (the correct conversion ratio) on a $25 face ($25/$3.60) or $10.41/preferred.

Take note and please make the correction.

Anonymous said...

Sorry, $10.41/preferred at $1.50/Citi share (6.94 * $1.50 = $10.41).

Anonymous said...

c-m is up 15 cents@8.20

c is down 11 cents@1.39

We are having a LONG SQUEEZE

Unknown said...

Gorilla, think about it some more, if you do the same calculations as Tyler, without rounding, you will get $3.25.

This is because the 21~ billion shares for the "high case" is $52.5B/$3.25 per share. That assumes $14.9B is what they are exchanging it for.

Like I said, I'm not sure whether that's the face value or the market value -- I haven't bothered checking.

IF it is the face value of those shares, AND Citi is using market price, the ratio of ownership will CHANGE.

Anonymous said...

Make a correction now that you are wrong and conersion is at 95% of Face. You are confusing retail investors selling trust preferreds with great yields and retail and others that do not know it is 7.307 shares per....

Anonymous said...

C becoming impossible to borrow. As more people realize this the stock will rally taking preferreds with it. The trust preferreds C.PRZ C.PRS C.PRM for example, yield in the 20's and are clearly more valuable then the regular. They are screaming buys into this confusion.