Sunday, April 19, 2009

"Long in the Tooth"

Just some thoughts for those who think this rally is getting a little long in the tooth.

Last week I had about six people( regionally) call me up asking about going long Citi and BofA. Over the previous 6 months I had exactly zero calls regarding this type of trade.

The most popular stock is of course the one that has fallen the most. By early last week, it felt like everyone I knew was long citi... My neighbor, a cousin in Dubai, a cousin in the states, a couple of non-financial services friends, a colleagues good friend and his brother. Everywhere I looked there were citi longs popping up left and right. So, I was not surprised by the fact that I also ended up answering a few professional enquiries going into the earnings release. The icing on the cake though was an email I received on Wednesday from an uncle in Beirut who also wanted to know whether citi could beat expectations and whether or not the stock could pop. This was the most surprising inquiry as based on my knowledge this relative never trades US equities.

Considering that the average Joe in the financial services industry probably did not understand what was going on with citi stock and its arbitrage driven short squeeze, explaining this to your average retail investor was next to impossible.

Here is what a typical citi exchange went like....

X (family member, friend, client, colleague): What do you think of Citi stock into earnings?

Me: It is going up because of an arb trade gone awfully wrong, it should be really trading much lower.

X: So, if they beat earnings this week it will go up won't it.

Me: No, not necessarily, earnings don't really matter here, what matters is whether or not they complete the equity offering.

X: So, it’s going go down then.

Me: Umm, again not necessarily, it could go up a lot more because of this squeeze if they delay the offering on Friday.

X: Are they going to delay the offering?

Me: I don't know, but if had to guess, probably yes, as it’s been a good thing for financial stocks.

X: So, it going up.

Me: Again, not necessarily, because many people have gone long the stock based on this squeeze already, and they might sell into this news irrespective.

X: So, it's going down.

Me: Again, I can't say for certain because they could change the terms of the conversion and raise the price, and then the stock would potentially be justified in rising somewhat further.

X: Do you think they will do that?

Me: No, there is a clear agreement in place, and thus I doubt they would change the terms, as any modification would only hurt the preferred holders.

X: If there is an agreement in place then it must eventually go down, why would you even suggest this.

Me: Good point. I don't know, but it seems other people are speculating on this potential outcome.

X: So, basically you have no idea what is going to happen. What is it exactly that you actually do again?

Me: Exactly. As for your second question, I'll have to get back to you on that one.

Here is an excerpt from the Citi CC courtesy of Seeking Alpha. I found it interesting considering the conversations I had last week.

Sam Saba] – JP Morgan
Regarding the press, you have the three buckets, the government, the private, and the public. If you did consider the idea of raising the stock price so its say 450 you’ve cut the dilution on your equity by about 6% and it would affect the probability of getting your TC up to $81 billion. Considering that I don’t really understand why you wouldn’t do that.

Ned Kelly
We have certainly considered that dynamic. As you know, we have agreements with the privates and we have an agreement with the government at 3.25%. The fact is that leaves the $15 billion of public. Having considered pros and cons as you suggest I stand by the earlier statement which is at this stage we can’t envision changing either the stock price or the conversion ratio, understanding your point.

[Sam Saba] – JP Morgan
What’s the downside for doing that, for not increasing the stock price?

Ned Kelly
As I said, we have an agreement with the privates, we have an agreement with the government and we’ve thought about precisely what you’re thinking about and we’ve concluded that we can envision circumstances in which we wouldn’t leave the stock price and the exchange ratio where they are. You’re not going to draw me out any farther so we might as well just.

What's interesting about this exchange is that the JP Morgan analyst doesn't seem to 'understand why citi' wouldn't break an existing agreement with preferred stock holders for the benefit of current common equity holders. This is a reflection of the times we are in. Everybody seems to think that nothing is set in stone. Now that citi's stock is rising instead of falling, you have analysts encouraging mgmt to do something that would benefit common stock holders at the expense of the taxpayers and preferred stock holders that have kept Citi afloat. It’s really quite amusing when you think about it. Citi common holders would have nothing left if the taxpayer and these sovereigns had not come and provided capital to absorb losses over the last 18 months at a time during which every common stock holder was running for the hills. Now, the common stock rises 350% off of its lows, and everybody who’s recently gone long the common wants a free ride on the backs of the investors who are further up the capital structure ladder. Call me crazy, but isn't it supposed to be the other way around.

I now truly sympathize with the arbs who put on the long pref/short common trade. They have been blown up by day traders and momentum chasers who literally do not understand that Citigroup's common stock has been diluted by over 70%. All of them are seeing the dollar signs associated with a stock that could rise a 1000% in a few months turning citi back into one of the most valuable companies on earth again. Moreover, the longs that do understand this are hoping that the recent rally in financials will allow Citi mgmt to take advantage of those investors who saved the company when it seemed to be on the verge of collapse. A do over so to speak for all citi common holders. At the $4.6 share price citi hit last week the company was hypothetically worth over $90 billion again if all the preferred shares are converted as expected at the agreed upon price. That means that for a brief moment Citi was the second most valuable publicly traded US Bank. I'd call that pretty shocking development or a really bad print if I had a short memory that didn't extend beyond the Volkswagen debacle.

Citi longs are playing a dangerous game as their bank is clearly worth less than the non-diluted BofA or WFC. Personally, I don't see how it trades anywhere over three dollars. If I believed in riskless trades anymore, I’d be long the other big money center US banks and short citi. That way I benefit from the fact that citi needs to find its rightful place on the mkt cap ladder sometime in the immediate future.

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