Go back a couple of weeks ago to Citi’s (C) last government bailout. Remember that Citi’s preferred shares rallied, as investors believed that the publicly traded preferred shares were being converted to common equity at a favourable price (an inducement for guys like Prince Alwalid to play along).
Many hedge funds simultaneously went long the preferred while shorting the hell out of the common stock, causing shares to collapse. Shorting the common stock essentially inoculated the arbitrageurs from future share declines that might mess up the profitable conversion.
But there was a catch.
The government never promised that the average Joe would be able to convert their preferred to common at the same ratio as everyone else. And there was an immediate concern that when investors realised this, Citi’s shares would rally amid a massive short squeeze.
It didn’t happen right away, but that appears to be what’s gone on over the past couple of weeks, as the stock has rallied over 300%. WSJ kind of loosely brings it up today, just mentioning the short squeeze amid fears that the conversion price might change.
Tyler of Zero Hedge picks through the carnage and explains:
If one assumes that a half of the trades in Citi common stock since the government’s announcement of the exchange on February 27 were predicated on the arbitrage, then of the roughly 11 billion shares of common changing hands, there are around 700 million arb units in existence and at a $7.5 loss today, this would mean there could be over $5 billion in unrealized losses among hedge funds at market close today! (the assumptions are broad – I welcome any adjustments to this calculation). And let’s not forget the funding cost: one year term borrow on Citi shares from broker dealers that still can find a few repoable shares, can be as high as 200%! This means the longer funds wait for this situation to normalize the more they have to pay. If they hold this arb for longer than 6 months, the arb has to return over 100% for the trade to be profitable, and even at today’s closing levels, the best possible return is about 70%.
Read the full post for the technical explanation.