Citi Is Scrambling To Survive

The near bank nationalisation of Citgroup sent its shares spiraling downwards. Didn't Roubini advocate bank nationalisation? Was the move bad? The government's term sheet proposed the conversion of Citi preferred stock into common at a price of $3.25. The face value of Citi preferred stock is $25, implying 7.69 shares of common to be received per preferred share (at $3.25). If all the preferreds convert, the common shareholders will see a 75% dilution. What that means is that assuming earnings go back to what it was 5 years ago, the EPS would have to see a similar 75% dilution in real EPS just by the sheer amount of new common shares. So, if you think Citi was going back to $40 like in the old days - similar earnings 5 years ago would only make the current Citi share to reach $10, and that is a wildly optimistic view now. Citi should be locked under $5 for the next few years.

Following the announcement, Citigroup traded at around $1.60 on Friday, a preferred share holder would effectively had an 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 Friday, 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. This was an excellent arb opportunity whereby you can short 7.69 shares of common for every share of preferred purchased. This arb is worth nearly 50% return. I do believe that the government's move was "positive" for Citi. However there are some unknowns still in the conversion amount, and added to that the arb opportunity caused persistent selling in the second half of the day.

The uncertainty also affect the arb in addition to shaking down the share price. There was a 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." Which is to say the rest of the preferred stock's conversion rate is still unconfirmed.

The arbs 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. If not, the whole arb trade will collapse and you will see massive short covering in Citgroup shares.

The government's move is good as it will give effective control to the government, hence the bank would be more than likely to be biting the bullet on some of the niggling issues which many troubled banks have been neglecting to do - sell down the toxic assets; work closer with private equity and hedge funds to take some of the toxic assets off the books. The other good from the move is that Citi will save from having to pay dividends/interest on the preferred stocks that have been converted. Don't laugh, that is worth some $10bn over the next few years, which is as good as receiving a capital injection of $10bn to Citi.

The other reason for the sell down is the amount new to be converted stock that is coming onto the market for Citi by the preferreds. The key to raising confidence in Citi was to massively increase its tangible common equity, a measure of capital that shows the value attributable to common shareholders. TCE doesn't include securities such as preferred shares. Citi's TCE prior to the new move was at a shaky 1.5%, now it should go above 4.3%. Citi still has to convince Singapore's GIC and Abu Dhabi I.A. to convert their preferreds - a move not palatable to them but in the end they will have little choice really. Expect Citi shares to swing wildly over the next few days but I expect reality to sink back in and go back above $2, some short covering to come in as well.

p/s photo: Marion Caunter