Citigroup Arithmetic Explained

Since I’ve been writing about preferred and common stock so much this week, I thought I would just try to explain the arithmetic of the Citigroup deal announced today. (By the way, it isn’t a done deal: all it says is that Citi is offering a preferred-for-common conversion to its outside investors, and the government will match them dollar-for-dollar, although the WSJ says that several investors have agreed to participate.)

Right now, according to Google Finance, Citi has 5.45 billion common shares outstanding. It is offering to convert up to $27.5 billion of preferred shares held by “private” investors other than the U.S. government (like the government of Singapore and Prince Alwaleed) into common shares, at a conversion price of $3.25. That would create another 8.46 billion shares. For every dollar that is converted, the U.S. government will also convert one dollar of its preferred stock, up to $25 billion; that is the $25 billion from the first round of recapitalization back in October, which is paying a 5% dividend. (Fortunately someone realized we should convert that before converting the second chunk, which pays 8%.) That would create another 7.69 billion shares. So if everyone converts as much as possible, there will be 21.60 billion shares outstanding, of which the U.S. government will own 7.69, for an ownership stake of 36%, the number you read in the papers. (Actually, if the private investors convert exactly $25 billion and not $27.5 billion, the government would own 37%, but that’s a detail.) The other private investors would own 39%, and current shareholders would own 25%.

The government got some warrants on common shares in connection with the earlier recapitalizations. I assume the warrants it got for the first investment will no longer exist (because that first investment is being “paid back”), but the warrants on the second investment, if exercised, would presumably push the government up a couple percentage points.

Where did the $3.25 price come from? Who knows. Yesterday’s closing price was $2.46. If that price had been used, the government’s target ownership percentage would have been 38% instead of 36%, which seems immaterial. Presumably it was the product of a negotiation, since it’s hard to see how the investors involved – especially the ones that are not the U.S. government – would have wanted to pay more than the current stock price for a company that is clearly in trouble. At least they didn’t use $3.46, which is the price that any future Citigroup convertible preferred stock can be converted at.

And why did the stock plummet (now $1.57), despite the fact that the preferred shareholders are “paying” $3.25 per share? Probably because the common shareholders realize this is largely an accounting game, and the preferred stock wasn’t worth its face value to begin with. The current shareholders’ ownership stake could fall from 100% to 25%, but the stock is only down 36%. This implies that the market thinks that the total common shareholders’ stake will more than double in value, but won’t quadruple in value (the amount required to offset the dilution). Their stake increased in value because (a) Citigroup can avoid paying dividends on all the preferred stock that gets converted and (b) that much less money will have to get paid back to preferred shareholders in case of liquidation. But there’s still a large cloud hanging over Citi, and it’s on the asset side of the balance sheet.

Originally published at the Baseline Scenario and reproduced here with the author’s permission.