The Citigroup Anomaly Lives

Summary: Citigroup securities are still violating the law of one price.

Later this week, Citigroup will finally launch its offer to convert some preferred stock into common stock.  That exchange has big implications for the government, which purchased preferred shares through the TARP program; after the exchange, the government will become Citi’s largest shareholder.

The exchange also has big implications for investors.

As I noted two weeks ago, there have been some anomalies in the pricing of Citigroup securities. Those anomalies have gotten smaller, but they are still with us. Citigroup is still violating the law of one price.

The crux of the pricing anomaly is that there are three different ways to invest in Citigroup’s common stock:

Continue reading “The Citigroup Anomaly Lives”

Venture Capital: Follow-Up

Last week, an article in the Wall Street Journal prompted me to post a short piece on the decline in venture capital.  Economist Susan Woodward sent me a helpful note outlining what she sees as the key reasons for this contraction:

The 2000 vintage year is going to be the worst year for venture capital ever.  I believe it will be the first year when venture fails, overall, to return capital to investors. Vast sums of money poured in ($95 billion was invested in portfolio companies that year, versus an average of $25-30 billion per year 2002 and later), and the prices paid were high, and a lot of the stuff funded was dumb.  In a fund’s 10 year life, nearly all of the good stuff has happened by year 6 or 7.  Any company that has not become obviously valuable in that time is very unlikely to do anything good for investors.  Investors know this too. Thus, pretty much all of the year 2000 funds look terrible by now.  Their general partners see that investors are not going to fund another fund for them, so they are making other plans.

(Susan has had a ring-side seat for the rise and decline of venture capital.  Based in Silicon Valley, she’s a Principal at Sand Hill Econometrics, where, among many other things, she has tracked the returns on venture investments.)

A fun parlor game is to try to remember — without using Google, Bing, or Cuil — some of the “dumb” venture deals from that era.  My first two guesses were Pets.com (“Because pets can’t drive”) and Webvan, but both were already public by 2000.

Venture Capital Declining

An article in this morning’s Wall Street Journal documents a decline in venture capitalists.  Both the number of VC firms and their capital under management have declined sharply:

A large number of individual VCs are also departing their firms.  And, the Journal notes:

The actual number of exits might be even higher than the trade group’s figures indicate. Venture-capital funds are typically 10-year investment vehicles. That means even if a venture capitalist no longer actively invests, he or she can remain on a firm’s masthead because they have to wind up their investments in older funds.

The article is worth reading in full for its discussion of the factors — weak economy, reduced investment capital, natural turnover, etc. — that are contributing to the decline in venture activity and the departure of individual VCs.

I don’t know how much this generalizes (readers please chime in) but one VC friend of mine reports two other factors that may be driving him and some other successful VCs from the business:

Continue reading “Venture Capital Declining”

The Berkshire Anomaly

Readers seemed to enjoy my post about anomalies in the pricing of Citigroup securities, so I thought it would be fun to look at another anomaly, this time in the shares of Berkshire Hathaway, Warren Buffett’s famous company.

This pricing anomaly is small compared to the Citigroup one.  But it does raises some interesting questions about how well the markets are functioning (and, who knows, maybe someone can profit from it).

The root of the anomaly is that Berkshire Hathaway has two classes of shares: A and B.

Continue reading “The Berkshire Anomaly”

What a Strange Round Trip It Has Been

In the months after Lehman’s fall, yields on regular Treasuries plummeted in a massive flight to liquidity, while yields on less-liquid inflation-indexed bonds rose sharply. Those moves have reversed in recent months bringing both 10-year Treasury yields back to where they started.

Treasury yields have been surging.  The yield on 10-year Treasuries, for example, closed at 3.71 percent on Wednesday, up more than 60 basis points over the past two weeks.  That’s a big move.

Economic commentators are grappling to understand the causes and implications of this increase.  Is it the return of bond vigilantes worrying about the grim U.S. fiscal situation?  Concern that aggressive policy actions will ignite inflationary pressures?  Or, perhaps, just a sign of healing in the financial markets?

I don’t have an answer for you today.  But I did find one tidbit that suggests that there’s something to the healing hypothesis.  Treasury yields – on both regular 10-year bonds and their inflation-indexed equivalents – are almost exactly where they were before the fall of Lehman:

                                    9/12/2008                           5/27/2009

     Regular                      3.74%                                      3.71%                                   

     Inflation-Indexed       1.79%                                      1.83%

In the months after Lehman’s fall, yields on regular Treasuries plummeted in a massive flight to liquidity, while yields on less-liquid inflation-indexed bonds rose sharply.

Those moves have reversed in recent months bringing both 10-year Treasury yields back to where they started.

Source: Federal Reserve Board, Release H.15

Auction the TARP Warrants

Treasury should give up on negotiated sales and simply auction the bank warrants it received through its TARP investments. Auctioning the warrants will enhance the transparency of the process, ensure that taxpayers get a fair return on their investment, free banks from the nuisance of government involvement, and allow banks, if they choose, to preserve needed capital.

Summary: Treasury should give up on negotiated sales and simply auction the bank warrants it received through its TARP investments.  Auctioning the warrants will enhance the transparency of the process, ensure that taxpayers get a fair return on their investment, free banks from the nuisance of government involvement, and allow banks, if they choose, to preserve needed capital.

Healthy banks are anxious to escape from the government’s Troubled Asset Relief Program.  TARP capital seemed cheap at first since the government offered more generous financial terms than were available from private investors.  But now the hidden costs of government investments – compensation limits, tighter regulatory scrutiny, and a public backlash against financial bailouts – have become apparent.  As a result, many banks want to pay off Uncle Sam and free themselves from the TARP.

Repayment sounds simple.  Subject to regulatory approval, banks can simply write a check to Treasury that covers the amount of money they received (by selling preferred stock) plus any outstanding dividends.  But there’s a complication.  When Treasury purchased the preferred shares, it also received warrants to purchase common stock in the future.  To fully escape the burden and stigma of TARP, the banks thus need a way to get Treasury to relinquish those warrants.

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The Citigroup Anomaly

Something is amiss in the market for Citigroup securities: prices are out-of-whack with standard arbitrage relationships. This suggests that (a) recent financial turmoil — or, perhaps, the policy responses to it — have undermined market efficiency and (b) some investors are over-paying.

Summary: Something is amiss in the market for Citigroup securities: prices are out-of-whack with standard arbitrage relationships.  This suggests that (a) recent financial turmoil — or, perhaps, the policy responses to it — have undermined market efficiency and (b) some investors are over-paying.   

Recent weeks have witnessed yet another case of law-breaking in the financial sector: Citigroup is violating the law of one price.

When the market closed last Friday, there were at least three different ways you could invest in Citigroup’s common stock:

Simple: You could buy common shares of Citigroup, just as you would with any publicly-traded company.

Preferred: You could buy shares of preferred stock that will convert into common shares. Citi has announced, for example, that it intends to convert each share of Series F preferred into about 7.3 shares of common stock.

Synthetic: You could buy and sell options in a way that replicates the financial returns from owning Citi stock.  For example, you could buy a call option with a strike price of $4, sell a put option with the same strike price, and set aside $4 in a bank account.  Taken together, those investments will give you the same financial returns as owning a share of Citigroup common stock. (I am gliding over some small details here.)

In normal times, the law of one price would imply that you should pay nearly identical prices under any of these approaches.  Transaction costs might allow prices to stray a bit from one another, and the preferred might trade at a small discount if the conversion isn’t completely certain.  But any price differences should be small as arbitrageurs buy stock the inexpensive way and sell it the expensive way.

That isn’t the case today. Continue reading “The Citigroup Anomaly”