A lot of people were a bit mystified when the preferred shares of Citi soared after news broke on the government’s latest rescue. After all, these things stand to get converted to Citi’s common, which sunk to a new all time low. Shouldn’t the preferred shares getting converted have sunk right down with the common?
It’s a perfectly reasonable question. The reason Citi’s preferred rallied is that the shares were so cheap already that conversion to common at dirt cheap levels actually makes sense. On Wall Street they call this an “arbitrage play,” which is a fancy term for trying to make money when two prices that should move together have moved apart.
Here’s how the Citi arbitrage play worked today.
- Citi said it would offer to exchange all preferred shares to common stock at $3.25 per share, giving the preferred around 7.7 share of common stock. The common, however, was trading far below $3.25–all the way down to $1.50. Basically, Citi was asking preferred holders to pay $3.25 for shares that you could buy in the open market for just $1.50. Who would do that?
- Smart guys at hedge funds, that’s who.
- Let’s take the Citi preferred shares called “Class M.” There are something like 81 million shares of these things and they originally sold for $25. But Citi’s troubles led investors to sell those off so steeply that they were recently trading between $5 and $7. 50.
- Now the maths is simple. If you get 7.7 shares of common worth $1.50 a share, each share of preferred is worth $11.55.
- To put it differently, if you bought a share of preferred for $7.50, you could flip them for common worth $11.55. When investors—especially hedge funds—got their mind around this, they started buying up the preferred shares like crazy, sending the price higher.
- Want to make this even better? Short the common while you buy the preferred. That way even if the common keeps dropping, you won’t have to worry about losing your money. This is exactly what hedge funds were doing today.