FTAlphavilleFT Alphaville is a 2008 Webby Award Winner

• News
• Markets Live

Ok, so we’re going to side with Mr Peter Principle*, who’s posted a comment on Andrew Clavell’s Financial Crookery blog regarding this vexed Citi capital raising:

What’s driving me nuts is that I think I’ve almost got it.

The financial blogoshere has gone nuts (in a technical sense), on this Abu Dhabi mandatory reverse convertible, with its staged cap/collar option attributes, implicit collateral yield, tax efficient smocking and attractive skew.

Witness Clavell himself, linking to this blog:

The FT and the Wall Street Journal are guilty of sensationalist journalism and have totally missed the point in their quest to find the worst possible slant on any investment bank’s activities. I suppose this is in vogue at the moment. Perhaps if they had wanted to batter ADIA instead of Citi, the headline might have been:

“Unsophisticated Arab financiers write massive put option on US investment bank”

And Information Arbitrage (Roger Ehrenberg, applauding Clavell):Jesus, Andrew, thanks for the lucid post! All the other crap being written is beyond comprehension (because the deal is beyond the writers’ comprehension). You know the business and are obviously spot-on. Congratulations and thanks.

To be sure, Citi has raised money at a headline rate of 11 per cent - two and half times Fed rates and about 200bps above typical junk. But the mandatory convertible nature has enabled Citi and others to argue that it is raising money at a similar cost to its regular equity.

True to our tabloidesque instincts, FT Alphaville jumped on that word ‘junk,’ because it helps illustrate the story.

But we’ve been slow to recognise that one aspect of the ongoing credit malarky, is that amongst both market participants and market observers, many are increasingly ready to read “down” as “up,” “red” as “black”, and “bad” as “good.” Witness Monday’s 215 spike on the Dow. Witness, even, Portfolio’s Felix Salmon:

…while Citi’s shareholders are by no means guaranteed their dividend. On the other hand, any cut in the dividend might conceivably result in a rise in Citi’s share price, if shareholders are convinced it would put the bank on a much more sustainable footing going forwards.

Yes, cut the divi and the stock’s a ‘buy,’ apparently.

There’s an irony here. The argument over the effective cost of Citi’s newly acquired capital can roll on ad nauseam, but it remains the case the Citi felt that while it needed to bolster its core equity, it wanted to do so without immediately issuing fresh stock. Otherwise it would have had to scrap its dividend, because you can’t raise fresh money from shareholders and then send it straight back to them.

Indeed, even the Abu Dhabi convertible wotsit has a clause allowing the coupon to be suspended in the event Citi can’t make its payout to ordinary shareholders.

At the end of the day, the cheapest and most direct way for a bank or any other company to improve its capital position is to cut the distribution of profits to the owners. Citi has avoided that, for now.

But what do we know?  Here’s the view of FT Alphaville’s friendly (professional) convertible arb specialist:

Firstly, this is a mandatory convertible. It’s NOT DEBT (obviously as it qualifies as tier 1 capital). An 11% coupon may sound high but if one considers what this structure actually is then it should become apparent that this is not high.

This deal is best thought of as a forward issue of equity with a minimum maturity of just over 2yrs and a max of just under 4yrs. Citi is effectively guaranteed that it will be issuing the holder(ADIA) common stock at a premium to last night’s closing of between 4% and 21%. Taking this into account and given that the current div yield of the stock is over 7%, this no longer looks such a bad deal.

I have valued the structure:

(i) what we know:
- $7.5bn face
- 11% coupon
- mandatory conversion (”purchase contract settlement dates”) of Mar 15 2010, Sep 15 2010, Mar 15 2011 and Sep 15 2011.
- “Strikes”: stock closed last night @ $30.7 but let’s assume to start with that this deal is priced off $31.83 as this is the “lower strike”. With the stock price < = $31.83, Citi will issue 235,627,500 shs (ie at most $7.5bn of stock). stock price >= $37.24 Citi will issue 201,390,000 shares. The number of shares issued varies between these two “strikes” such that ADIA receives $7.5bn worth of stock ie par. This is otherwise known as a 100/117 mandatory.

(ii) assumptions:
- Citi div’s are flat for the life of the structure @ $2.16.
- credit spread for Citi is 0 (5yrs is actually L+90 but this has a minimal impact on the theoretical value (TV) so we’ll give Citi the benefit of the not inconsiderable doubt).
- “skew” is 10vol’s; ie we will price the put at 51 vol and the call @ 41 vol (this looks to me to be in line with where options are currently quoted).
- that the mandatory, rather than having a variety of different strikes from £31.83 up to $37.24 over the 4 “settlement dates” is in fact just one strike of $37.24 with a March 2010 expiry.

(iii) valuation:
On the basis of these assumptions above, Citi have issued a structure for $7.5bn that is worth $7.18bn (ie 95.75% of par). If I value the Sep 2011 mando’ using the same criteria as above then the TV is 99.60 (ie are issuing something worth almost $7.5bn).

(iv) conclusions:

This is NOT necessarily expensive financing for Citi. I get TV for the longest dated mandatory to be 100. If the strikes are staggered over time the TV climbs. For example the TV of the mar 2010 structure above using 7 skew and a 10% premium rather than 17% (ie $35.00 upper strike rather than $37.24), is effectively par. Also, if Citi cut the dividend by 5% each year during the life of the structure the TV of the Mar 2010 structure goes up by 1pt.

* Peter Principle
n.  The theory that employees within an organization will advance to their highest level of competence and then be promoted to and remain at a level at which they are incompetent.