By Elinor Comlay and Doris Frankel
NEW YORK, April 24 (Reuters) - Some traders are betting that Bank of America will fail its stress test, spurring it to boost its capital levels by converting the government's preferred shares into common stock.
The move, which would follow a similar planned conversion by Citigroup Inc, would be the easiest way for Bank of America to raise capital, aside from selling assets at a time when valuations are depressed, or trying to sell equity to investors leery of bank stocks.
To profit from the exchange, investors are buying Bank of America preferred shares and simultaneously selling borrowed shares of its common stock, known as short-selling.
Bank of America shares had fallen 17 percent through Thursday, although the bank reported a better-than-expected profit on Monday helped by $4.1 billion in one-time gains.
The bank's preferred stock rose sharply on Friday. The Class D preferred shares, which have a face value of $25, jumped more than 13 percent in trading to $12.75, from $11.26 on Thursday.
'These are big ifs, but if Bank of America comes out of the stress test and needs to raise more capital, a pretty good way for them to do it would be to do an exchange of the preferred,' said Andy Baker, analyst at Jefferies & Co in New York.
Bank of America, the largest U.S. bank has by one measure the lowest capital levels of all major banks apart from Citi. Regulators are increasingly focusing on this measure, known as tangible common equity, because it strips out assets that may not have real value in difficult times.
Citigroup said in February it would exchange up to $52.5 billion of preferred shares for common shares. The bank recently said the conversion will happen after the government finishes its stress test.
Buying Citi's preferred stock and selling its common shares short became such a popular trade that the cost of borrowing the shares to short soared from about 5 percent in early march to about 25 percent, as of last week, analysts said.
'Once Citi was announced, people thought, who's next?' said Baker, who explained that investors are using Citi's exchange offer as a road map showing how such an offer from Bank of America might work.
A Bank of America spokesman declined comment.
OPTIONS TRADING
Bank of America options trading has also picked up. Some investors have been buying a put option and selling a call option with the same strike price and maturity and also buying the underlying stock in a strategy often used to replace a short stock position.
'The stock has become hard to borrow due to the speculated perferred/common conversion,' said Joe Kinahan, chief derivatives strategist at online brokerage thinkorswim Group in Chicago.
This option play, known as a 'conversion' also has the benefit of locking in the borrowing rate, whereas investors that borrow stock on an overnight basis from a broker will pay fluctuating rates, said Sveinn Palsson, equity derivatives strategist at Credit Suisse.
'Trading (in Bank of America options) is on a smaller scale to Citigroup, to be sure, but the volumes continue to get larger and larger specifically with respect to the options strategy,' said Lars Kestner, managing director in equity derivatives at Deutsche Bank.
'My guess is that arbitraguers and dealers are positioning themselves ahead of something that might be announced on the back of stress test results,' Kestner added.
(Editing by Andre Grenon) Keywords: BANKOFAMERICA/TRADE (elinor.comlay@thomsonreuters.com +1 646 223 6116) COPYRIGHT Copyright Thomson Reuters 2009. All rights reserved. The copying, republication or redistribution of Reuters News Content, including by framing or similar means, is expressly prohibited without the prior written consent of Thomson Reuters.
NEW YORK, April 24 (Reuters) - Some traders are betting that Bank of America will fail its stress test, spurring it to boost its capital levels by converting the government's preferred shares into common stock.
The move, which would follow a similar planned conversion by Citigroup Inc, would be the easiest way for Bank of America to raise capital, aside from selling assets at a time when valuations are depressed, or trying to sell equity to investors leery of bank stocks.
To profit from the exchange, investors are buying Bank of America preferred shares and simultaneously selling borrowed shares of its common stock, known as short-selling.
Bank of America shares had fallen 17 percent through Thursday, although the bank reported a better-than-expected profit on Monday helped by $4.1 billion in one-time gains.
The bank's preferred stock rose sharply on Friday. The Class D preferred shares, which have a face value of $25, jumped more than 13 percent in trading to $12.75, from $11.26 on Thursday.
'These are big ifs, but if Bank of America comes out of the stress test and needs to raise more capital, a pretty good way for them to do it would be to do an exchange of the preferred,' said Andy Baker, analyst at Jefferies & Co in New York.
Bank of America, the largest U.S. bank has by one measure the lowest capital levels of all major banks apart from Citi. Regulators are increasingly focusing on this measure, known as tangible common equity, because it strips out assets that may not have real value in difficult times.
Citigroup said in February it would exchange up to $52.5 billion of preferred shares for common shares. The bank recently said the conversion will happen after the government finishes its stress test.
Buying Citi's preferred stock and selling its common shares short became such a popular trade that the cost of borrowing the shares to short soared from about 5 percent in early march to about 25 percent, as of last week, analysts said.
'Once Citi was announced, people thought, who's next?' said Baker, who explained that investors are using Citi's exchange offer as a road map showing how such an offer from Bank of America might work.
A Bank of America spokesman declined comment.
OPTIONS TRADING
Bank of America options trading has also picked up. Some investors have been buying a put option and selling a call option with the same strike price and maturity and also buying the underlying stock in a strategy often used to replace a short stock position.
'The stock has become hard to borrow due to the speculated perferred/common conversion,' said Joe Kinahan, chief derivatives strategist at online brokerage thinkorswim Group in Chicago.
This option play, known as a 'conversion' also has the benefit of locking in the borrowing rate, whereas investors that borrow stock on an overnight basis from a broker will pay fluctuating rates, said Sveinn Palsson, equity derivatives strategist at Credit Suisse.
'Trading (in Bank of America options) is on a smaller scale to Citigroup, to be sure, but the volumes continue to get larger and larger specifically with respect to the options strategy,' said Lars Kestner, managing director in equity derivatives at Deutsche Bank.
'My guess is that arbitraguers and dealers are positioning themselves ahead of something that might be announced on the back of stress test results,' Kestner added.
(Editing by Andre Grenon) Keywords: BANKOFAMERICA/TRADE (elinor.comlay@thomsonreuters.com +1 646 223 6116) COPYRIGHT Copyright Thomson Reuters 2009. All rights reserved. The copying, republication or redistribution of Reuters News Content, including by framing or similar means, is expressly prohibited without the prior written consent of Thomson Reuters.