Hedge funds shorting bank stocks again as Euro stress tests perceived as too weak

News - Funds

Written by Ray Clancy

Monday, 16 August 2010 10:30

Hedge funds have started shorting bank stocks again amid concerns that last month’s stress tests were too weak and failed to reveal underlying problems, it is claimed.

Although many are cautious of taking big bets in such choppy markets a wave of what some commentators have seen as good news, including a bumper earnings season, an easing of capital reforms and relatively few failures of the high profile stress tests, have lifted banks’ shares, creating an opportunity for short sellers betting prices will fall.

‘Some funds have started to put on shorts again after the strong rally. Managers believe that until they (the banks) come clean they’ll be hugely volatile and remain sick for years to come. They’re still sitting with a lot of loans that are not performing,’ said Ken Kinsey-Quick, who runs funds of hedge funds at Thames River Capital.

Hedge fund Noster Capital has begun shorting five European banks, Barclays, UBS, Intesa SanPaolo, UBI and BBVA. Manager Pedro de Noronha criticised the recent stress tests for ignoring sovereign debt that banks hold to maturity.

‘The widely anticipated PR exercise (also referred to as stress tests) on European banks produced results that were considerably better than most investors expected. Last time we checked, to stress test anything meant to stress something until the point it breaks. That’s not even close to what was done to European banks,’ he said.

Last month Reuters reported that Onslow Capital was shorting some European banks’ debt, saying they were sceptical about the stress tests, which they described as ‘very weak’.

Shares were also boosted after looming Basel III capital reforms were scaled back and banks were given longer to implement changes. Banks also reported higher than expected profits last week, boosted by a sharp fall in bad debts, which outweighed a slump in investment banking income after Greece’s economic crisis.

‘It’s a very active area. A lot of managers are playing it. On average people are more bearish than bullish. Most people feel the stress tests were not robust enough and areas of weakness may emerge,’ said another manager who added that some funds are betting on spreads between senior and unsecured bonds, while others are using credit default swaps or simply shorting the equity.

However, hedge funds are wary of taking big bets when sentiment is changing so much, what fund managers call the ‘risk on, risk off’ trade. ‘The problem is that volatility just kills you. You might short banks, they go successfully through a weak stress test and all of a sudden there’s a rally,’ said Kinsey-Quick.

‘You’ve got to take more of a trading approach. If you are going to play it, you probably wait for big rallies and then go short,’ he added.

Meanwhile hedge fund firm Eddington Capital is to shut down and return capital to clients after failing to attract cash inflows, as nervous investors continue to shun all but the best-performing managers.

The firm, set up in 2003 as a joint venture between management and Caledonia Investments, will wind down its funds after seeing assets fall to $115 million from a peak of $265 million in 2008, chief executive Glenn Baggley said.

Eddington’s demise illustrates the problems facing smaller hedge fund firms, which have struggled to attract assets in recent years as investors have opted for the perceived safety of larger firms.