Updated from Thursday, March 5

Citigroup ( C) shares finally broke the buck on Thursday, but the fallen giant's rollercoaster ride toward penny stock-dom may have more to do with a popular trade for hedge funds than the company's fundamentals.

Citi and the Treasury Department last month revamped a federal bailout plan, in which the bank would exchange common shares for trust and preferred securities held by both the government and private investors.

The complicated deal drastically changed the ownership structure of the firm, and offered Uncle Sam a 36% stake in Citi. Although most of the news was widely anticipated, Citi shares plunged over 40% in trading that day, and closed down 96 cents at $1.50.

A big portion of the movement is coming not from a drastic change in the market's thesis on Citigroup -- there's little doubt the firm may not have survived without government aid -- but from hedge funds and institutional investors taking long positions in preferred shares or senior debt, while shorting common equity to capture massive differentials in pricing.

"It's a high-risk trade, but when Citi converts those preferred shares , people will have to unwind a massive short position in Citi common," says one hedge fund manager, who is playing the other side of the bet -- going long Citi in the hope that short covering will drive the stock's price up.

Citi shares faced record volatility last month, according to Bloomberg data. But to the average investor, some of the dips and peaks made little sense.

When The Wall Street Journal first reported that Citi and the government were in talks about the preferred-common stock swap, Citi shares surged as much as 27% -- despite the fact that such a move would massively dilute common shareholders. Shares closed up 19 cents, or 10%, at $2.14.

The stock rose more than 26% over the next four trading days, to $2.46, before plummeting 44.7% to $1.50 the day the deal was announced.

While seemingly illogical on its surface, the stock's move can be explained by the arbitrage opportunity presented in Citi's plan to swap preferred stock for common shares.

In the food chain of debtors and investors, senior debt comes first, followed by junior debt, preferred equity, and then common stock at the bottom of the pile. Though Citi cut dividends on common and preferred shares, it is still paying out dividends on trust preferred and enhanced trust preferred stock, making those assets more attractive. In addition, the conversion price on the preferred securities being exchanged is $3.25 per share, more than three times Citi's closing price of $1.02 on Thursday. The stock closed up a cent to $1.03 Friday.

As major private investors -- including The Government of Singapore Investment Corp., Saudi Arabian Prince Alwaleed Bin Talal, Capital Research Global Investors and Capital World Investors -- started exchanging massive holdings of preferred shares for common equity, a feeding frenzy has ensued. At the same time, short interest started to climb up from 0.6% of outstanding shares at the end of January to nearly 1% by mid-February, according to Bloomberg data.

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.

Similarly, the debt markets seem to be aware that there are no guarantees that those bets will pay off. The price of credit default swaps on Citi -- protection against the company reneging on its debt -- hit new records on Thursday, according to Bloomberg, with investors paying $525,000 a year to protect $10 million of debt against default.

The scramble to cover short positions and get ahead of other equity holders has fueled huge swings in penny stocks like Citi and AIG ( AIG) as well as those of other high-profile firms where investors smell trouble ahead, like GM, Bank of America and Wells Fargo. For instance, a volatility measure for Citi stock was almost twice as high in mid-February as the average daily reading over the past year.

A catalyst for upticks in shares of troubled companies can be something as simple as an overall market bounce, or the passage of a government initiative that benefits financial institutions, like a change in accounting rules. Both of those factors are incredibly unpredictable, as are the debt markets.

But if hedge fund managers are lucky, it can be a lucrative bet -- reaping rewards of 11% to 20% on the difference between common and preferred shares, according to the hedge fund manager who discussed the trade.

"The institutions have been eating this trade up," the hedge fund manager says.

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