On Friday, John Carney explained why Citi preferred shares rallied at the same time as Citi common stock sank miserably. Basically, hedge funds recognised that the official preferred-to-common exchange ratio provided compelling value, so they piled into the preferred, while shorting the common. But the trade may have been a mistake.
As Zero Hedge explains, many of the arb players may have jumped in too soon:
The problem that most however may have overlooked is a little 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.”
Investors 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. As the Volkswagen example has taught us, and as the government has shown in its “white glove” treatment of private investors of all kinds, and couple that with some forced repo pulls by Citi common longs who may eventually realise their stock will skyrocket if they cause a forced squeeze, we wait with baited breath to see the carnage as the “Citi Arb Trade” blows up at some point over the next several weeks.
The bottom line is that we don’t yet know how normal owners of the preferred shares will be treated. That will be announced at a later date, and it may not be nearly as favourable as the treatment offered to special private investors, like Prince Alwaleed.
If investors freak out and rush out of their common shorts, the stock could stage a vicious rally.