BEIJING, PEOPLE’S REPUBLIC OF CHINA - From my vantage point here in Beijing this week, I find my mind drifting this Tuesday morning closer to home and specifically back to Citigroup Inc. (NYSE:C).
Shares are under pressure for reasons that most investors, particularly those who were looking for a repeat of Goldman Sachs (NYSE:GS) - don’t understand - especially after a “favorable” conference call and results that were widely interpreted as positive. Others are taking it a step further and suggesting there’s a massive capitalist “conspiracy” at play in the financial sector - especially now that the government is so heavily involved.
While I’m not ruling out the fact that there’s some backroom-government maneuvering at work, my experience as a veteran trader suggests there’s a much more logical explanation - not unlike the infamous “Bin Laden Trade” rumor that I dispelled in the past, or the “Dark Pools” that I brought to light. Unfortunately - as was true of the Bin Laden and Dark Pools examples - the Citigroup case is shaping up as yet another example of a situation in which the proverbial “little guy” could get caught short once again as the Big Money crowd has its way and runs roughshod all over Wall Street.
It all comes down to Economics 101 - basic supply and demand. Here’s why.
When Simple Supply and Demand Isn’t so Simple After All
Most retail investors purchase shares in a company such as Citi on the assumption that it’s going to rise in price over time. And that’s good for stock prices. Supply and demand tells us so.
Back in early March, for instance, when Citigroup Chief Executive Officer Vikram S. Pandit’s “we’ve made money” memo leaked into the mainstream press, the good news stoked investor demand for Citi’s shares - causing them to shoot up 38% in one day.
But as we all learned in Econ 101, there’s another part of this formula - supply. Even as investor demand was increasing, there’s also an incredible incentive to short the stock - in no small part due to Citi’s Feb. 27 announcement that it would exchange as much as $52.5 billion in preferred stock for common stock, beginning in April, at an approximate price of $3.25 per share. This all has to do with a type of trading known as “stock arbitrage,” meaning that sophisticated investors can play one value off another and profit from the difference.
In this case, the difference was between the value of Citi’s preferred shares - those that were part of the deal announced in February - and Citi’s common shares. Because there is enough money at work, the pressure from the arbitrageurs actually creates something of a reverse incentive for the banking giant’s common shares, to the effect that the lower the price of the common shares when the conversion happens, the greater the profit traders who are in on the deal can make.
The bottom line: No matter how much the investing masses would like to see Citi’s share price increase, big money has been wagered that the bank’s stock price would fall first.
One Short Sale That’s in Short Supply
An investor who wanted to participate would have to buy Citigroup’s convertible preferred stock Series T, which closed Friday at $34.25. [Note: We prepared this piece and ran through these calculations using Friday's closing prices; however, Citi's shares fell a steep 19.45%Monday due to rising concerns that the bank's credit losses are continuing to mount.]
Under the terms of the deal announced in February, each $34.25 preferred share would convert to approximately 13.08 shares of common stock, which, at Friday’s price, was worth $47.73. This meant you could buy $47.73 worth of stock for $34.25 and lock in a 39.35% gain - again if the deal is not shelved or modified in any way, and assuming the $3.25 per share specified in February’s announcement remains set.
The risk is that the deal could be delayed or go away entirely, depending on what the government’s so-called “stress tests” reveal, or if Citi simply decides it doesn’t want to play ball. Traders in on the deal are already dancing in the aisles. Those still on the outside are understandably drooling because the spread between Citi’s preferred shares and the common stock continues to widen. Adding fuel to the fire is the fact that repo desks all over Wall Street are calling in Citi’s shares, inducing bursts of forced short covering - which is making it even more difficult to put on new shorts.
To that end, when asked on a recent conference call whether the terms will change or the deal could go away, Citigroup Chief Financial Officer Edward J. “Ned” Kelly III said that he doesn’t think that will happen, but still assigned a “5% chance the sun doesn’t come up,” Reuters said last week.
Conspiracy vs. Capitalism
If you’re a “glass-is-half-full” kind of investor (in short, an optimist), Kelly’s statement could be construed as a 95% confidence factor. Given that, I’m not surprised to have seen a huge jump in Citi options transactions. You may have noticed it, too. This means that there’s a huge contingent of traders who still want to participate in this potential arbitrage. But they are using derivatives to set up the same transaction - probably at a fraction of the cost and capital commitment.
Because Citi’s exchange offering pegs the $50 face value of Citi’s preferred shares against a market value of $34.25, the exchange terms include a 15% discount. Because regular Citi shares were trading at $3.65 on Friday, each preferred share was worth approximately 13.08 common shares, or $47.73. [At Monday's close, Citigroup's preferred stock was trading at $29, and the common at $2.94].
Meanwhile - hang with me here - the difference between the price of Citi shares and the price set in the exchange offering is about 10%, which is nearly double the 5% difference of a week ago - a shift that reflects a change in the arbitrage value between the two.
Therefore, at a time when traders would normally have shorted the stock as part of the trade, they’re instead bypassing the rising cost of doing so by assembling what are called “synthetic shorts.” In case you’re not familiar with that term, synthetic shorts are a specialized type of options trade that involves buying puts and selling calls at the same strike prices to achieve the same risk/reward profile as an outright short in Citi stock. The advantage of a synthetic short is that you don’t have to go through the hassle of actually shorting the stock, or trying to borrow it in a hard-to-borrow market.
Not only does this make the trade infinitely more flexible, but potentially more profitable, too. As reported by Reuters, one hedge fund trader who is participating in the trade suggested that it could yield a “200% annualized profit, even after including the rising costs linked to shorting shares” - and that’s presumably true synthetically or otherwise.
At the end of the day, there’s no doubt there could be a massive conspiracy at work here. I’ve simply seen too much in my career and, in particular, in recent months to believe that many of the machinations we’re seeing are anything but deliberate monkey business.
Yet, I’ve also seen glimmers of pure capitalism at work and that’s what I think is really at play here - an aggressive and highly creative pursuit of profits.
As long as the spreads between preferred shares and common shares continue to widen, there’s uncertainty ahead. And as we know, uncertainty breeds opportunity.
At the end of the day it comes down to whether the investor wants to play it.