A Graphic Representation Of The Citi Arb Carnage, Over $5 Billion In Losses

It took all of 2 weeks for the Citi Common-Preferred arb to become Volkswagen Jr. And if the administration feels abnormally nasty, this could become a fast money hedge fund neutron bomb that would make the Volkswagen megasqueeze seem like dress rehearsal for the Mormon tabernacle choir. But don't take my word for it: here is just how it looks graphically. The screen below is a Bloomberg CIX screen based on the formula: (C Common)*7.31 (pro forma for the 0.95 price adjustment) - (C AA Preferred). Now in an ideal world for there to be no Common-Preferred arbitrage, this would have to be equal or close to zero. Indeed this was the case for a while, when the $1 delta was embedded in the arb due to the risk of regulatory change in the final outcome of the deal (i.e. preferred getting converted into less than 7.31 shares of common). Then over the past three days something went horribly wrong and the arbitrage exploded. As ZH wrote earlier, the increasing borrow pulls by both retail and institutional holders of underlying stock, as well as some potential Orwellian not so invisible hand here and there, and all the funds who had shorted 7.69 shares of common for every preferred share they bought started to get a nauseous case of Volkswagen deja vu. It will be very poetic justice if the funds who barely survived VOW GR, end up imploding as a result of the Citi arb.

As the chart above shows, funds that have put this trade on over the past 2 weeks are now facing a loss of about $7.5 per unit (assuming it was put on when the delta was $1 which was the predominant value of the past 14 business days). 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%.

And the short squeeze is not the bulk of funds' worries... If the government really does feel like obliterating the bulk of the fast money HFs (read: most of them), all it has to do is adjust the terms of the Common-Preferred conversion ratio lower. And seeing how pretty soon C common will be trading above the conversion price for the preferred of $3.25, the likelihood of the ratio getting whacked grows by the day... If on top of a short squeeze, the 7.31 ratio is adjusted to say 3, the ridiculous levels reached by VOW stock will be like a walk in the park compared to the destruction that would follow as everyone runs for the Citi arb exits... Can't say Zero Hedge didn't warn them.

Tangentially, for all value investor club readers, isn't it an amusing coincidence how all your highest rated ideas end up being nuclear ICBMs - first VOW GR now Citi arb? Guess the too good to be true maxim applies not only to ponzi schemes...

6 sigma.

Disclaimer: ZH has been long Citi common since Feb 27.