From the desk of Jeroen Bakker,
In the third episode on (In)Famous Securities Lending Transactions we focus on a ‘preferred to common’ securities exchange. After previous posts of in-depth analyses on a directional short play and a massive short squeeze now the focus is on one of the biggest revenue generators in securities lending for a long time if not ever: Citigroup.
The year is 2009, the effects and fall out of the Great Financial Crisis are slowly becoming clear, most countries are in a recession and many banks required governmental support, Citigroup was one of them. Citigroup received $45bn in loans from the US government as well as protection against losses on $300bn in risky investments.
In order to increase Citigroup’s tangible common equity (TCE) Citigroup offers to exchange preferred stock in exchange for common stock. This transaction is intended to rebuild and restore investor confidence. TCE is a measure of a company's physical capital, which is used to evaluate a financial institution's ability to deal with potential losses. Tangible common equity is calculated by subtracting intangible assets and preferred equity from the company's book value. It is considered next to TIER 1 capital ratio as one of the major indicators to measure a bank’s financial health, especially when there is a large portion of preferred stock outstanding. The formula shows that converting preferred stock into common stock will leave the total size of equity the same but increase the TCE.
TCE = total equity – intangible assets – goodwill – preferred stock
On 27 February 2009 Citi announces it will offer to exchange common stock for up to $27.5 billion of its existing preferred securities and trust preferred securities at a conversion price of $3.25 a share. The U.S. government agrees to match this exchange up to a maximum of $25 billion face value of its preferred stock at the same conversion price.
In order to investigate if this is a financially interesting proposal, we need to look at the share price of Citigroup at the time:
To highlight this even further below are the closing prices of Citigroup in the days following the announcement of the equity conversion:
On paper the offer would be a $1.75 premium per share, so how would this impact the securities lending market?
Let’s do a quick recap on what happens in a preferred for common equity exchange. Often the preferred stock will trade at a premium compared to the common stock so if you sell the pref with the premium (and borrow these in the SBL market) you simultaneously buy the other stock to create a perfect hedge. On conversion date, your prefs will be converted into commons and you can return these to the lender. You can read more on event-driven arbitrage in this blog.
In the Citigroup case, the situation was a bit different; this time there is a guaranteed offer on the table to convert preference shares at a set price of $3.25 per share while the stock price is actually lower than the conversion price. This means there is a premium on the table, however in order to create a delta hedge you will need to sell common shares of Citigroup and borrow those in the SBL market, so as long as the share price of the preference shares are below $3.25 and there are sufficient common shares of Citigroup to short (i.e. to borrow) the arbitrage is alive, or is it?
With the data provided by FIS’ Astec Analytics, we can provide a deep analysis of how Citigroup became uber-special and how this became the biggest securities lending revenue generator in a long time.
Securities Lending Fees
The year 2009 started off relatively slow for Citigroup taking into consideration the stock price of Citigroup tumbled from around $300 in early 2008 to around the $20 mark in February 2009. (prices adjusted for the 2011 fee split). Fees are around the “GC” mark at the start of 2009 and if we index that at 100 the rest of the year looks as follows:
You are indeed reading this correct, round mid-March the fees are 30,000% of the fee at the beginning of the year with a peak of 700,000% in June. During the months of April and May fees were in the 70-80% brackets with fees increasing to the 80-90% bracket in June and July. There was even one day that fees skyrocketed to >1000%. Early August fees returned to the normal “GC” levels.
If you calculate the total SBL revenue for these four months across the market the graph looks as followed:
Total SBL revenue in 2009 for Citibank shares across all participants has been calculated well over $1bn, which is a record by all accounts. So why was this such a massive revenue generator compared to other securities lending transactions that are conducted on a daily basis?
Three reasons 1. Revenue – the premium on the conversion was more than 100% of the stock price of Citigroup and as a result, a lot of parties piled into the trade 2. Availability of Citigroup in the SBL markets 3. Duration of the “specialness”
Revenue
The premium on the conversion was more than 100% of the stock price of Citigroup, as a result, a lot of parties piled into the trade. This was a rather straight forward conversion deal with a depth of $81bn, with that much of premium available there is plenty to share as well.
Availability
The availability in the SBL market of Citigroup is very high as most securities lending participants hold the stock despite a lot of people exiting the stock during the dramatic price fall, therefore many lenders were able to benefit from the inflated rates.
Duration
The duration of the specialness of Citigroup was 4 to 5 months, from the moment the news broke at the end of February till the beginning of August when the Citigroup share price broke the $3.25 mark and the arbitrage was no longer there.
Conclusion
In general, specials are securities that are hard to find and are special for a specific reason and timeframe, it doesn’t happen often that a mainstream blue-chip turns special for a longer period of time at such inflated fees.
The revenue securities lending participants made in Citigroup saved their year 2009 from an economic point of view.
This concludes the third episode of this series, please get in contact with us if you have any particular securities lending transaction that you would like to know more of or have any other question on securities finance.