Citi trade profitable but now tough to execute

NEW YORK (Reuters) - A popular trade involving Citigroup shares could yield fat profits after the bank said on Friday it is not changing terms of a preferred share exchange, but new investors could struggle to get a piece of the action.

The trade involves buying Citi preferred stock and simultaneously selling borrowed shares of common stock (C.N), known as short-selling.

The preferred shares can be converted into common stock in a few weeks, meaning they can effectively be used to buy Citigroup shares at a much lower price than the level at which they can be sold now, potentially yielding a 200 percent profit.

Getting into the trade now is difficult, because borrowing Citigroup shares to sell them short is so expensive.

The cost of borrowing Citi shares until mid-June, as implied by the options market, went from roughly 5 percent in early March to about 25 percent now because of the increase in demand, analysts said.

Citigroup said in February it would begin exchanging up to $52.5 billon of preferred shares for common shares in the beginning of April. As early April turned into mid-April, many investors feared the terms of the deal would be changed, or the transaction would be delayed for a long period of time, or even canceled altogether.

But Chief Financial Officer Ned Kelly said on Friday the exchange is going to go through on previously described terms, after the government finishes its stress test of the bank.

When asked on a conference call if there was any chance of the offer being canceled, Kelly said, "I think there's a 5 percent chance the sun doesn't come up but the short answer is no."

To many experts, that signals the trade is still alive.

Analysts Venu Krishna and Maneesh Deshpande at Barclays Capital on Friday said value investors could simply buy Citi convertible preferred stock series T, which traded for about $34.25 on Friday. When the exchange offer goes through, a $34.25 preferred share will convert into roughly 13.08 Citi shares now worth about $47.73. In other words, $34.25 of preferreds can buy $47.73 worth of common stock.

Under the exchange offer terms announced in February, preferreds will buy Citigroup shares at $3.25 each. Some analysts and investors had speculated earlier this week that Citigroup might lift that price closer to $4, a step that would allow Citigroup to issue fewer new shares and dilute existing shareholders less.

"We are more comfortable that the deal will go through without any changes after today's announcement," said Krishna.

MOVING TO DERIVATIVES

Here's how the trade works: On Friday, Citi's convertible preferred shares series T (C_pi.N) traded at around $34.25, with a face value of $50. Under the terms of Citi's exchange offering, the $50 face value is discounted by 15 percent, and can then buy shares at $3.25 apiece, which translates to about 13.08 shares. Those shares now trade at $3.65 a piece, so 13.08 shares are worth about $47.73.

The difference between the price of Citi shares and the exchange price is now about 10 pct, while a week ago it was about 5 percent.

One hedge fund trader in New York who is betting on the trade working said that even including costs linked to shorting shares, it could yield a 200 percent annualized profit.

"There would have been a lot of disappointed people if Citigroup had changed the terms," said Marshall Front, chairman of Front Barnett Associates LLC in Chicago, who has not tried the trade.

Because shorting the shares is so expensive now, many investors have been using derivatives instead.

Options on Citi's shares have seen high volumes of trading recently, in part linked to the arbitrage between the preferred stock and the common shares.

Investors have been constructing what is known as a synthetic short, by buying a put and selling call with the same strike, said Lars Kestner, managing director in equity derivatives at Deutsche Bank. Earlier on Friday, the 15 most active options in the country were all on Citigroup, he said.

"The options have been incredibly, incredibly active," Kestner said.

(Reporting by Elinor Comlay and Dan Wilchins; Editing Bernard Orr)