Description

The WB pref trades at an 8.7% yield to maturity while the WFC pref trades at a 7.1% YTM. The terms of the two securities are substantially similar and they will rank pari passu following the close of the deal. To be clear, the holding companies of WFC and WB will be merged and the WB security will become an obligation of WFC, so it will not be structurally subordinated to the WFC pref. The opportunity exists because there is widespread dislocation in the market for bank preferred stocks following the failures of Lehman, the GSEs and AIG, which wiped out $10’s of billions of preferred. Similar arb opportunities exist between the preferred shares of other bank targets and acquirers. For example, I posted the CFC pref arb in October, although the arb spread has largely collapsed since then. I don’t think the arb spread will close tomorrow when the deal closes, rather it should close over time as people realize that the WB pref is the same as the WFC pref.

As the exhibit shows, if you assume the WB pref trades to the same yield as the WFC pref over one year, you make 31% on the long side. If you are long and short, so that you are 100% hedged, you make 20% in a year on an un-levered basis. I think it is safe to just take the long side of the trade because the WB pref is almost as safe as a government obligation. This is a very strong statement. My rationale is:

1.    The WB pref is senior to the $25 bn of preferred that the government just invested in WFC. The government preferred is straight preferred, while the WB pref is technically junior sub debt. Therefore it is senior to the government; if the WB pref is not getting paid its coupon, the government cannot get paid its dividend. I think there is very little chance that the government will let the largest bank in the country defer dividends on the government’s investment given the negative political and economic fall-out that would occur. Instead, the government will fund WFC as much as possible to keep it solvent just as the government did by injecting a second $20 bn round of preferred into Citigroup last month and agreeing to insure $300bn of its assets. 

Catalyst