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Citi Stock's Wild Ride Explained in Arb Trade

Stocks in this article: C AIG GM

The debt markets are still haywire, with preferred shares are now trading at a "significant discount," according to Igor Lotsvin, managing director of the hedge fund Soma Asset Management.

"Preferreds of Citigroup or Bank of America (BAC) are trading at a significant discount to par -- 20 cents on the dollar," says Lotsvin. "At the same time, people senior to equity holders are seeing they aren't even getting paid, so equity should be zero."

Lotsvin, who is short Wells Fargo (WFC) and JPMorgan Chase (JPM), but not Citi, uses General Motors (GM) as another example. The automaker indicated on Thursday that auditors had "substantial doubt" about its viability, raising the specter of potential bankruptcy once again.

"If GM is slated to go bankrupt, it might have enough money to pay senior bond holders, but not junior bond holders or equity holders," Lotsvin notes.

Perhaps unsurprisingly, short interest in GM has also climbed, and its stock plunged as much as 18% on Thursday, closing down 34 cents at $1.86. Lotsvin says a similar capital-structure arbitrage strategy would be just as lucrative -- and just as risky -- for the troubled automaker as the troubled financial-services industry.

But this strategy of going long preferred and short common is risky -- not only for opportunistic hedge-fund managers engaging in it, but for the average investor whose common holdings are at their mercy.

Short bets can be very profitable, but the upside is limited to shares falling to zero, while the downside is infinite. A short investor borrowing shares and sells them in the open market, betting that they will fall in price. If that does occur, he earns the net difference between the two prices. If it doesn't occur, and the shares rise, he is forced to cover his bet by buying the shares back at a higher price.

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