Further Adventures in the Citi Capital Structure

March 19, 2009

There’s a lot of noise this morning on the Citi preferred/common arbitrage, with the WSJ giving an overview and Tyler Durden going into the gory details. And just in case you’re not completely confused yet, Citi has now announced a reverse stock split to go along with its preferred-common exchange.

Given the tendency of bank stocks to go towards zero on a nominal basis, I’m not sure this is a good idea, but at least it should get Citi out of the embarrassing situation of risking its stock trading at less than a buck a share. When stocks trade that low, weird things happen: Bill Ackman, for instance, is buying up large chunks of General Growth stock in the expectation that it will declare bankruptcy.

One of the weird things which happens when nominal stock prices are very low is that volatility goes through the roof, and percentage changes in the stock price can be enormous. Ultimately, that’s what’s happening at Citi, I think: it has been trading at zero for the past couple of months now, and it’s silly to (a) try to infer anything meaningful from stock fluctuations around zero; or (b) think that trading Citi common is anything other than a pure gamble. This is a penny stock now, let’s not obsess about its price too much.

As far as policymakers are concerned, the important price is not that of the common stock, but rather that of the senior and junior debt. Yields on senior debt, remember, are the rate at which banks fund themselves wholesale — at least in normal times. If healthy banks are in the national interest — and they are — then it’s in the national interest for the yields on that debt to come down substantially.

But then you get into the senior/junior arb. There’s an obstacle to senior bank debt yields coming down, and that’s the fact that junior bank debt yields — the yields on preferred stock — are stratospheric:

A Merrill Lynch & Co. index of European banks’ lowest-rated debt has collapsed this year, with its market value sliding 50 percent to 19.7 billion euros, on concern lenders may be nationalized and junior bondholders wiped out. In the U.S., a similar index has declined 42 percent by value in the period.

Deutsche Bank’s Jim Reid thinks that the way of solving this problem is for governments to wade in to the market and start buying up preferred stock (junior debt). The idea has something to be said for it: Treasury, for one, is sitting on hundreds of billions of dollars of freshly-issued preferred stock already, so it’s clearly comfortable taking that kind of risk.

Buying up preferred stock would be a clear indication from any government that nationalization is not an option, or at least that it’s willing to lose quite a lot of money up front if it does end up deciding to nationalize. (Any sensible nationalization plan involves recapitalizing the banks, which in turn involves wiping out the common equity holders and most of the preferred stockholders as well.)

But there might be other ways of making investors more comfortable with senior bank debt. I got an email this morning from a reader saying that "the existence of governments liable to nationalize banks for systemic reasons has itself created a major hazard for investors"; I’m not sure that’s true. It might be a hazard for investors in common equity, but there’s no way that banks are going to be able to raise new equity in this market anyway. And it might be a hazard for investors in junior debt, but investors in junior debt have historically been a very small and select group. As far as investors in senior debt is concerned, the possibility of nationalization, at the margin, makes the debt safer, not riskier: the government is essentially the last resort now, as opposed to liquidation — which would hit senior debt hard.

So maybe the government might start making public the nationalization schemes which we know they’re thinking about in private. Naming no names, it could make it clear that none of the schemes involve imposing a haircut on senior debt holders. And it could also make it clear that it will always nationalize a big bank rather than allow it to fail. Maybe that alone could help support the very important wholesale funding cost for banks.

Reprinted from Portfolio.com

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