Why Citi’s shares are trading higher
Lucky Tan over at Diary of a Singaporean Mind has an interesting blog post on why Citi’s shares have been appreciating recently:
In Feb 2009, GIC was given a deal to convert its preferred to common stock at US$3.25 per share – given that the stock was trading at US$2.42 at that point in time it meant that GIC has to take an immediate loss on paper of about 30% which sounds okay because if they didn’t convert the preferred wasn’t worth much[Link]. Citigroup offered the deal to convert because it will improve their equity base and somehow that help to improve its balance sheet[Link]. So GIC converted 1 preferred to roughly 8 common shares ($26.35 divided by $3.25)…1 to 8 – this ratio will become very important later on in the story.
However, once GIC converted to common, Citigroup shares started to plunge like a rock all the way to US$1. GIC lost 70% of its investment when that happened. Citigroup plunged for 2 reasons – fears of further dilution, fear that it will be overwhelmed by losses as the economy weakened…but the last reason is the most important but not well known until now.
When GIC converted its preferred to common at a ratio of 1 to 8, many arbitragers (people who profit from price difference before and after a conversion) assumed that all preferred can be converted at this ratio. This assumption led them to do this arbitrage trade, that goes something like this:
1. Buy preferred at $14.
2. Short sell the 8 times the amount of Citigroup common at $2. …collecting $16.
In the process, they made $2. Once they convert their preferred at a ratio of 1 to 8, they can cover the all the common stock they shorted. They did this repeatedly causing Citigroup stock to plunge all the way to $1. Citigroup became the most shorted stock on the NYSE[Link]. It was shorted until there were no stocks left to short. …then it started to rise on the news that banks were operationally profitable in Jan/Feb 2009. Also, the +ve results from Well Fargo caused it to surge some more in recent days.
The problem for the arbitragers now is the 1 to 8 ratio was never a “black and white” thing – Citigroup never promised that all preferred shareholders that they get to convert at this generous ratio[Link]. If they can’t and Citigroup stock keep rising, these arbitragers stand to lose hundreds of millions. So they started to reduce their exposure to this arbitrage trade by reversing it – selling the preferred and buying back the common they shorted. As they buy, the stock goes up…and they panic and buy some more. It is this panic that is driving up Citigroup stock[Link]. Video link on this : [CNBC Citigroup Arb Carnage].
However, since the GIC is unlikely to sell its Citi stake any time soon (there’s been no news reports on that) the gains on Citi stock are nothing more than paper gains (as opposed to paper losses). Meanwhile nothing has changed from the point of view of the bank’s balance sheets. All the above shows is that the Dow or any other market indices isn’t reflective of the general state of the economy or even the company which is supposedly tracks. Share prices, as can be seen from above, are powerfully affected by the actions of strategic traders, even if nothing has fundamentally changed at the company itself.
Note to satire-impaired readers: Lucky Tan was likely being sarcastic in his last sentence.