Citi Stock's Wild Ride Explained in Arb Trade

When The Wall Street Journal first reported that Citi and the government were in talks about the preferred-common stock swap, Citi shares surged as much as 27% -- despite the fact that such a move would massively dilute common shareholders. Shares closed up 19 cents, or 10%, at $2.14.

The stock rose more than 26% over the next four trading days, to $2.46, before plummeting 44.7% to $1.50 the day the deal was announced.

While seemingly illogical on its surface, the stock's move can be explained by the arbitrage opportunity presented in Citi's plan to swap preferred stock for common shares.

In the food chain of debtors and investors, senior debt comes first, followed by junior debt, preferred equity, and then common stock at the bottom of the pile. Though Citi cut dividends on common and preferred shares, it is still paying out dividends on trust preferred and enhanced trust preferred stock, making those assets more attractive. In addition, the conversion price on the preferred securities being exchanged is $3.25 per share, more than three times Citi's closing price of $1.02 on Thursday. The stock closed up a cent to $1.03 Friday.

As major private investors -- including The Government of Singapore Investment Corp., Saudi Arabian Prince Alwaleed Bin Talal, Capital Research Global Investors and Capital World Investors -- started exchanging massive holdings of preferred shares for common equity, a feeding frenzy has ensued. At the same time, short interest started to climb up from 0.6% of outstanding shares at the end of January to nearly 1% by mid-February, according to Bloomberg data.

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