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March 19, 2009

Reverse stock split

Citigroup has announced that it will be doing a reverse stock split. The aim of such a reverse stock split is to raise the perceived value of the company: it dosn't really do anything much other than that.

Citi first announced the plan in late February, and said it hopes it will convert about $52.5 billion of preferred shares into common shares. The bank said it hopes to launch the exchange offer in early April, subject to regulatory approval. Citi also said it is asking for approval to execute a reverse stock split of its common stock.


I'm not going to try and explain the conversion of the preferreds to common stock but just to stick to the reverse stock split.

Citigroup Inc (C.N) on Thursday said it may conduct a reverse stock split as part of an exchange offer that could give U.S. taxpayers a 36 percent stake in the bank.

Citigroup, which took $45 billion from the government's Troubled Asset Relief Program, also defended spending $10 million to renovate executive offices at its Park Avenue headquarters, saying the project will save more than it costs.

Chief Executive Vikram Pandit is trying to restore the third-largest U.S. bank to health after $37.5 billion of losses over five quarters, largely from exposure to housing-related and complex debt.

Citigroup shares slid below $1 two weeks ago, despite three U.S. attempts to prop up the bank since October, and the bank has eliminated its common stock dividend.

The important thing explaining the reverse stock split is that fall in the stock price to below $1.

Citigroup said Thursday it plans to propose a reverse stock split for its common shares, as well as an increase in its authorized shares outstanding, as the embattled bank moves ahead with a previously announced plan to convert preferred shares to common equity.

Citi also said it filed a registration with the Securities and Exchange Commission outlining the public exchange offer for preferred stock not held by the United States government, which is part of the financial aid package it announced with federal officials in February. The bank said it had already reached definitive agreements with holders of $12.5 billion in convertible preferred securities.


So why should a fall to under $1 mean a reverse stock split, whatever a reverse stock split might be?

A reverse stock split reduces the number of a company's shares outstanding, but increases the value of its earnings per share. The market value of the shares remains the same. Companies often elect to do a reverse stock split in an effort to make their stock look more valuable if the share price is significantly low. Citigroup's shares dropped below $1 a share earlier this month on the fear that the government's efforts wouldn't be enough to save it from failing.


That's sort of right. Imagine a company with 100 shares of stock. Each is worth $10. The company is thus worth $1,000.

We could also have exactly the same company with 1,000 shares, each worth $1. Or 10 shares each worth $100. Nothing has really changed there.

However, the idea behind stock splits is that something has indeed changed. There's this idea (very similar in concept to what economists call the money illusion) that we the potential buyers of stocks look at the dollar value of the stock and make at least some of our decisions on whether it is the "right" price based on what range of prices it is in.

For example, it's generally thought to be true that when a price goes over $100 per share that people will view this as "expensive". Although there is no difference between one share at $100 and ten at $10, they will still be the same percentage of the overall company, the general opinion is that if you have a stock split then this will make the shares rise in price. Instead of having ten shares each at $10, they will be worth $11 each.

Weird, I know, but pretty much everyone believes that this is true. That by making a stock split you can make the original one $100 stock worth $110 by making it 10 $10 stocks which then will rise to $11 each.

Basically, they're saying that we're not rational in outr investments and that we've got some idea of the "right" sort of price a stock should trade in.

OK, well, a reverse stock split is just the opposite. It's taking those 10 stocks at $11 each and combining them into one stock that will be valued at $100....well, of course, we don't do that because that would be losing value. What we do think is that when stocks go over about $100 or so each then a stock split will increase the value. When they go below $10, and especially if they go below $1 (and on NASDAQ there are other reasons too, your stock must stay about $1 to remain on that market) then by combining stocks, by having that reverse stock split, you'll be adding value.

Essentially, we all believe that stocks should be in the $10 to $100 range, so splitting when they go above this and having a reverse stock split when they fall below this range adds value.

Weird, I know.

But what's even weirder is that in London, on the stock market in England, the "correct" range is £1 to £10. No, I don't know why it's different in London from New York and nor does anyone else. But then no one really knows why stock splits and reverse stock splits work either. They shouldn't do, unless we're all stupid. And the fact that reverse stock splits do work thus has to be taken as evidence that we are indeed all stupid I guess.

March 19, 2009 in Finance | Permalink

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