The Citigroup Repo

As I’ve noted in a series of posts (here’s the most recent), there’s an anomaly in the pricing of Citigroup securities. Several issues of Citi’s preferred stock are scheduled to convert into common by the end of the month. Yet the common stock has been trading at a significant premium to the preferred in recent months. As I type this, for example, the common is trading at roughly a 14% premium to the preferred common, even though the conversion is just a few weeks away.

As best I can tell, the only explanation for this pricing anomaly is that Citigroup common stock is very difficult to sell short. So arbitrageurs can’t bid the spread down to levels that would be normal for such a deal.

This anomaly intrigues me for two reasons. First, it appears to be a blatant rejection of strong versions of the efficient markets hypothesis. However, as I will discuss in a later post, the market for Citigroup securities is actually ruthlessly efficient in many ways. As a result, it’s extremely difficult to profit from the anomaly. Sharp financial types have already bid other prices — most notably those for Citi options — to a level where obvious profit opportunities don’t exist.

Second, the anomaly is a big dangling carrot for big-money types to get creative. Markets always try to find ways around imperfections like the limits on short-selling. So I’ve been wondering what creativity would come out of the woodwork. Well, today I got an answer.

To date, one response to the anomaly has been natural: financial types have been willing to pay up in order to borrow Citigroup common shares that they could sell. It’s unclear to me how much of this money has made it back to retail customers, although I have heard stories that they’ve been able to make some money by lending their shares.

But clearly that hasn’t been enough to narrow the pricing gap.

So today a friend (who wishes to remain anonymous) told me of the latest innovation: a major financial firm if offering to buy your Citigroup shares today and then return them after a fixed period (e.g., one month) plus a generous interest payment. In other words, the firm wants you to do a term repurchase agreement with them.

The beauty of the repo is that the financial firm gets common shares that it can turn around and sell while, presumably, buying the preferred. The firm can then unwind the trade, and return the shares to the original owner after the deal closes. The investor, meanwhile, gets a nice interest payment in addition to what ever the returns on Citigroup common are. And all of this would take place outside the usual system for borrowing and lending stock, which hasn’t proved up to the task of closing the pricing gap.

Not the usual way for retail investors to manage their investments, but big anomalies inspire creativity.

P.S. I’d be fascinated to hear if any readers actually do this transaction.

Disclosure: As research, I am currently long a small amount of Citigroup preferred and short some call options on the common.

6 thoughts on “The Citigroup Repo”

  1. You mentioned in an earlier post that part of the problem was that the options are American-style call options. Do you think this potential term repurchase is just a way to mimic a European-style option? Do you think the pricing discrepency would disappear if we just used European call options?

    1. I don’t think having European call options would eliminate the problem which is ultimately a flaw in the market for common stock. But European options would be free of the threat of early exercise and, as a result, their prices could convey more more information about what the market really expects the common share price to do.

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