As Bank Stocks Rebound, The Feshbachs Get Routed

PALO ALTO, Calif. - The Feshbach brothers have a sign pinned up on a bulletin board that could serve as their credo: "Having fun at the expense of others."

Last year, the three brothers had lots of fun at the expense of the banking industry.

Just before the bottom was about to drop out of bank stocks, the short-sellers bet millions that institutions like Bank of New England and MNC Financial were poised for a nosedive. The brothers and their firm reaped a fortune.

And they earned the hatred of bankers - not only because they profited from the industry's problems, but also because they brashly trumpeted their views, such as calling Wells Fargo a "dead duck" and C&S/Sovran "a joke."

Not as Much Fun

But these days, the Feshbachs are having a lot less fun. They dismissed the bank stock rebound last fall as a fleeting rally and continued to bet heavily that equities - notably shares of Well Fargo - would decline. That has cost them dearly. The rising market and customer defections have cut their firm's capital in half, to about $500 million.

"We just went through our version of the crash," says Joe Feshbach.

For the brothers - Joe, 37, his identical twin, Matt, and Kurt, 39 - it has been a humbling experience both financially and emotionally. Over eight years, the trio built their firm into the most nation's successful short-sellers, raising their capital each year by an average of 40%. Last year was truly exceptional - bringing a 57% increase, thanks in large part to their gambles on 60 to 70 bank stocks.

Now the firm is trying to weather its first major crisis. A 38% drop in its capital this year has stolen a lot of the luster from the firm's impressive track record.

Too Much Risk?

The brothers and their partner, Tom Barton, find themselves for the first time examining whether the firm takes on too much risk.

Like other short-sellers, the Feshbachs sell stock they have borrowed through a broker. Their profit or loss is determined by prices at the time they buy shares to replace the borrowed stock.

If the shares plunge in value, as they did for most of last year, the short investor makes a killing. But shorting into a bull market - which the Feshbachs ended up doing this year - can be devastating.

A Move Toward Hedging

The brothers are now considering the use of futures and options to hedge their bets. "We hope they can cushion or cap losses without giving up too much profit potential," Mr. Feshbach said in a recent interview.

Meanwhile, some of the firm's nearly 100 investors have withdrawn their capital.

The partners are also toning down their public image. Joe is the only one who talks to the press these days.

And, in perhaps the most visible blow to their pride, the corporate jet bought last year at the height of the firm's success is now on the block. It's clearly a touchy subject. Says Joe Feshbach: "We bought a jet. It's now for sale. That's really all we have to say."

When the Feshbachs' capital was at a peak of about $1 billion last year, 20% was riding on bank stocks - the single largest concentration. Now that has dropped, but Mr. Feshbach won't say by how much. Bio-technology and health-care companies are now sharing the center of attention. And, of course, their depleted capital means that bets are now much smaller.

"We scaled everything back," says Mr. Feshbach. "When you lose as much money as we did, you have to."

Still, they remain convinced that their fundamental theory is correct: Loan problems at a number of large banks are so deep that the institutions are in for some very tough times.

The firm, formally known as Feshbach Brothers, is still shorting 30 to 40 banks, including C&S/Sovran, First City Bancorp, Midlantic, and Southeast Banking.

One of their biggest remaining positions in on Citicorp. They started shorting it last year when shares were at $24. The price is now around $14.50. (See accompanying article.)

As the brothers see it, their biggest mistake was timing. They admit to guessing wrong on interest rates, which kept falling - an event particularly beneficial to banks. And they were surprised that investor sentiment turned bullish when the Persian Gulf War started.

But they're as bearish as ever on bank stocks. "Our view of the specific financial issues we're currently short hasn't changed much," says Joe Feshbach.

"Our view of the timing has changed somewhat. But the notion that what we saw (in 1990) was just a passing little nightmare and that everyone will wake up in the morning, get a cup of coffee, and feel fine is very optimistic."

Fall and Rise of Wells Fargo

The bitter irony for the Feshbachs may be that they were right after all about Wells Fargo, which proved to be their Waterloo.

Last summer, when the San Francisco-based company's shares were plummeting from a peak of $80, the short-sellers bet the stock was headed for the teens.

They believed that Wells' huge pool of loans to real estate developers and leveraged companies would sour and drive the stock through the floor.

The shares did fall to near $40, dragged down by the bear market, but the raft of bad loans failed to materialize. Then, in October, prominent investor Warren Buffett gave management an impressive endorsement by buying five million shares. The company's stock rebounded sharply.

Firmly convinced they were right, the Feshbachs held on until April, before finally bailing out at a big loss when the shares were back up to around $80. This month, the shares peaked at $97.75.

"We got out of the way of Wells because it was obviously not worth the fight," says Joe Feshbach.

"I mean, it's one thing to be intellectually right and another to preserve your capital to make sure you're around to play for another day."

A few days after the interview, Wells announced that its problem assets would increase by 28% in the second quarter. The disclosure shocked the market, sending Wells' shares plunging to $69. But Wells' problems surfaced too late for the Feshbachs.

From Tennis to High Finance

The brothers seem an unlikely trio to be running such a highstakes business.

Before starting the company, they had no formal financial experience whatsoever.

Joe, the co-director of research, briefly attended Utah State University. Matt, the managing general partner, never attended college; he ran a tennis school and store in Menlo Park, Calif. Kurt, who didn't finish high school, was a diamond broker. (The eldest brother, Dan, 43, runs a data base firm in San Francisco.)

In 1981 they stumbled upon their first short target - and the idea for the business - while working for their father, Bernard. He owned a business that did public relations for small energy companies. The target, Universal Energy, was an oil and gas company with a market value of $45 million but low sales and capital. They made about $5,000 each when the stock fell to $2 from $8 a share in a month.

The brothers soon earned a reputation for being able to spot impending trouble, and investors started handing over their money. At their peak last year, the Feshbachs were overseeing $1 billion.

Ten to 15% of their capital comes from pension funds, the rest from wealthy individuals and money management funds. The business soon made them rich. The four partners reap a 1% management fee and 20% off the top of profits.

The brothers' demeanor does not conjure up the image of high-powered financiers. Cocky and irreverent, they dress casually and poke fun at those who don't. Kurt, with shoulder-length blond hair, looks more like a surfer than the company's portfolio manager. Joe is balding and carries a paunch.

The firm's three-story headquarters, in the shadow of Stanford University, looks like an insurance claims office rather than a sophisticated trading operation. It's furnished with cheap, stained pine and particle-board funiture.

A few years ago, the partners sent all their investors jackets with the words "Stock Busters" printed on the back. Since then they have sent watches and T-shirts with the same logo.

"They're very unconventional," says Jeffrey Friedman, an analyst at Dreyfus Inc., a client since 1986. Another customer dubs them "the bad boys picking the bad stocks."

The Feshbachs, who are of Jewish background, are members of the Church of Scientology, an affiliation that some of their investors privately say bothers them.

They run the firm according to management principles devised by the church. They are also generous contributors; as of late last year the brothers had given the church a total of at least $600,000.

Founded by science fiction writer L. Ron Hubbard in 1950, Scientology professes to help followers control their emotions in times of crisis. However, it was accused recently in a Time magazine article of being a mafia-like racket with evil intentions.

Mr. Feshbach says that during their recent setbacks, the brothers would have "thrown in the towel and and given up on the business entirely" without the strength provided by the church's teachings. "We're still able to remain analytical," he says, adding wryly: "And we're not out shooting our employees."

Sleazy or Necessary?

Of course, few in corporate America are shedding any tears over the Feshbachs' difficulties. In fact, most executives are celebrating.

Short-sellers are feared and hated in board rooms across the country because they drive down stock prices. For the same reason, stockholders also dread them. And none is despised as much as the Feshbachs, the largest and most vocal of the lot.

In part because they profit from the failures of others, short-sellers are often regarded as sleazy and even un-American.

"People view it as being against baseball and apple pie," says Theresa Hamacher, managing director of Prudential Equity Management.

She said a lot of people think short-sellers don't research the stocks they short, but just spread false rumors. Some accuse them of planting seeds of doubt in the financial press.

(In April, it was reported that federal investigators are looking into whether Feshbach received confidential information on drug approvals from the Federal Drug Administration employees. Mr. Feshbach denies any wrongdoing.)

The brothers shrug off the fact that they make enemies. "If we're doing a good job, there ought to be a small group of people who really hate us," says Joe Feshbach. "Most people don't get a big kick out of having mismanagement exposed or poor lending practices highlighted."

Mr. Feshbach argues that short-sellers make stock pricing more efficient and improve liquidity.

And he dismisses criticism that the practice unfairly hurts the targets. "We haven't written any of these loans, and we haven't failed to collect on them," he says. "Our crime, if there has been any, is that perhaps we have been too outspoken about various banks."

How Companies Are Targeted

Whatever criticisms might be leveled, the Feshbachs can't be accused of not researching their targets. They view their business as a financial detective agency and devote one floor of their headquarters to 15 analysts, who comb the country in search of overvalued companies.

Like Wall Street researchers, the analysts study cash flow, product lines, management skill, and competition.

But the Feshbachs have also been known to use more unorthodox techniques, such as calling a company's suppliers to see if it is paying its bills, or sending detectives to examine a company's inventory.

"They look outside the information flow from analyst to company," says James McDermott, president of Keefe, Bruyette & Woods, a bank research firm. "And they seem to be well plugged in."

Most potential targets wouldn't give them the time of day. So to get information directly from a company, Mr. Feshbach says, "We just have someone else call them," often a broker.

Before a target will be considered, analysts have to fill out a six-page checklist of the qualities of a good short. One question: Are the company's problems worthy of a "Heard on the Street" column in The Wall Street Journal?

While outwardly a jovial bunch, the Feshbachs are demanding bosses. As part of the Scientology philosophy, each employee is given a statistical performance goal and must chart it weekly. The graphs hang by employee desks like doctors' charts at the foot of hospital beds.

For an analyst, the goal might be the number of phone calls made about a particular company. For a secretary, it might be the number of letters typed.

"If the number doesn't keep going up, you get called in to Matt's office to discuss why," says Meridee Moore, the firm's director of marketing. "It's known to be a harsh environment," she admits, but adds that the approach makes everyone feel like they are part of the firm's success.

Loan Problems a Magnet

The Feshbachs turned to financial stocks in the mid-1980s when they saw a number of thrifts heading toward disaster. They hit it big on Sunrise Savings and Commonwealth Savings - two spectacular Texas failures - and on Charles Keating's American Continental. (Mr. Feshbach declines to discuss the firm's gains or losses on specific stocks.)

Banks got their attention in 1989 when they spotted sharp deteriorations in asset quality. "We usually focus on banks that have a huge proportion of highrisk loans to equity," Mr. Feshbach says.

The firm dedicated such a large amount of its capital to banks last year because there was a lot of stock available to borrow.

Usually the most attractive candidates for shorting are relatively small and therefore don't have a lot of stock outstanding. But last year, it was the largest banks that seemed to be the best candidates, providing a large pool of shares.

When bank stocks rebounded sharply early this year, the Feshbachs were convinced that their targets wouldn't be swept along.

"Over the last several years, we've made a lot of money shorting into rallies instead of covering," says Mr. Feshbach. "But this one was one of those blowout rallies that took everyone out."

The firm's losses prompted rumors of a liquidity crisis - which Mr. Feshbach denies - and a number of clients pulled their money out.

But most have remained loyal.

"The question you have to ask is, How are they doing against their peers?" says money manager Kelley Price, general partner of Price Meadows & Co. in Bellevue, Wash. "All short-sellers lost money this year."

Mr. Price uses the Feshbachs to hedge his long positions. "You never like to have a manager who loses money, but without them I couldn't be long," he says.

Mr. Friedman of Dreyfus says, "You had a bull market where there was no discrimination between high- and poor-quality stocks. Some of the things they shorted had terrific bounces without significant changes in the fundamentals."

But the money manager adds: "It may have been a mistake to put so much money in banks that did not look like they were going out of business. The banks had gotten so hammered last year that they were poised for a rally."

The firm earlier this year gave up its positions in Security Pacific, First Interstate, and PNC Financial. It also cut back on C&S/Sovran But Mr. Feshbach expects that going forward, the firm will short more banks, rather than fewer. "We're very skeptical about the so-called bottom in the commercial real estate market," he says.

Waiting for the Verdict

What will the rest of the year hold?

The firm's capital, down 42% in the first quarter, is up a bit since then, Mr. Feshbach says. Some investors say they will be more than happy if the firm breaks even this year.

Mr. Feshbach is more optimistic, although he won't specify what the firm is shooting for.

"We just have to stick to the discipline we have," he says. "It's worked for eight years. We obviously made one of the worst market calls, but from here on we simply want to manage our risk as best we can and see if some of these stories actually play out."

And to those gloating at the firm's misstep, he warns: "We'll be around for a long time irritating people."

PHOTO : NO HONEY FOR BEARS: Bull market for banks has slashed capital of short-sellers Kurt, Matt, and Joe Feshbach and Tom Barton.

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