EVEN AFTER THE FORMAL start today of Citigroup's (ticker: C) massive $58 billion exchange offer involving its preferred stock, Citi's preferred issues are trading at a sizable discount to their exchange values.
This makes the $15 billion of publicly issued preferred an attractive way to play a revival in beleaguered Citi.
Citi's 8.125% AA preferred stock, which is listed on the New York Stock Exchange as C preferred P, is trading at $21.58, up 58 cents. The spread, however, between the preferred and the exchange value of the Citi common shares actually has widened about 50 cents to $4.55 a share from Tuesday. Citi shares are up 17 cents at $3.58.
Each share of the series AA preferred will be swapped for roughly 7.3 Citi common shares, or roughly $26.13 based on today's Citi common-share price. The three other publicly traded preferreds targeted for conversion into common stock trade at similar spreads to their exchange value.
Many traders figured that the formal start of the exchange offer might result in a tightening in what has been a volatile spread since Citi initially announced the exchange offer in February. Why has the spread actually widened today? Because it's still very difficult to short Citi shares and when it is possible, the borrowing costs are very high. The exchange offer is due to expire on July 24, which is past the expiration of July options on Citi.
Many arbitragers have used Citi options to hedge the risk of owning the Citi preferreds because of the difficulty in shorting the common. With the exchange offer expiring on July 24, arbs need to use more expensive September options as a hedge now. This raises the cost of hedging and results in a wider spread of the preferred to the common exchange value. Many arbs have lost money in the Citi trade. They had bought the preferred and shorted the common to capture the spread and then saw the spread widen as Citi became increasingly tough to short.
With the Citi AA preferred at $21.58, investors effectively are creating the stock at about $2.95 a share, considerably below the current Citi share price. To arrive at the $2.95 price, take the preferred price and divide by the exchange ratio of 7.3.
This means the preferred offers an appealing alternative to the common stock.
In a note today, Jefferies analysts wrote that the raw spread of the preferred to the exchange, which stood at 19% yesterday, "has been volatile and remains wide." The spread is tighter at 5% if investors seek to create an arbitrage using expensive options or other derivatives.
The spread could close if the New York Stock Exchange allows when-issued trading in the Citi shares that will be issued in the exchange offer. The NYSE apparently is weighing such a move. There was no immediate comment from the exchange.
A when-issued market probably would result in a tightening spread of the preferred to the common because it would facilitate hedging because it's generally easier to short when-issued stock than regular stock, Jefferies noted today.
The $58 billion preferred exchange offer includes some $25 billion of preferred held by the government, $12.5 billion of privately placed preferred, $15 billion of public preferred and $5.5 billion of Citi trust preferred securities. The exchange offer, if fully subscribed, will result in a huge increase in Citi shares outstanding to about 23 billion from five billion. Assuming a full conversion, Citi's tangible book value is expected to fall to about $4 a share and its ratio of tangible common equity to assets will rise to about 5% from the current 2%.
In a statement today, Citi CEO Vikram Pandit said that following completion of the exchange offer, "Citi will be among the best capitalized banks in the world."
$3.5 (06/11/09)
