With energy stocks enjoying the biggest rebound since the beginning of the oil rout, short sellers have shifted their sights to regional banks that do business with the industry.
Bearish bets have shot up 35% on average this year among the 10 most-shorted stocks in the KBW Regional Banking Index, data compiled by Bloomberg and Markit show. Cullen/Frost Bankers and Prosperity Bancshares. in Texas have seen short interest surge about 60%. The banking gauge fell 0.8% at 9:30 a.m. New York time.
As oil prices plunged, concern over energy companies' ability to pay back loans drove investors to unload or bet against financial stocks judged to have the most at stake in the sector. So far, the rebound that pushed oil to around $40 a barrel has done little to dilute that speculation. Stubbornly low interest rates are also squeezing profits in a group that trades at a premium of almost 40% to their larger brethren.
"It's generally a very tough environment," said Stephen Moss, a New York-based analyst at Evercore ISI. "Beyond oil and the yield curve, we have seen signs of credit softening overall. So going forward, it feels like you are going to have incrementally higher credit costs, which obviously will pressure earnings."
Energy loans account for 15% of Cullen/Frost's portfolio, while they make up 4% of Prosperity's, according to Moss. Of the 10 most shorted regional banks, the majority do business in states like Texas, Oklahoma and Arkansas, centers of the drilling industry. Banks that have exposure higher than 4% to energy in their loan portfolios have slumped 22% since late 2014, Morgan Stanley's Ken Zerbe wrote in a report earlier this month.
Bigger banks have also increasingly lured bears this year. Short interest makes up 6.2% of Zions Bancorp.'s shares outstanding and 4.5% of Comerica.
Regional banks are also more sensitive to the trajectory of interest rates, as a bigger proportion of their revenue stems from deposits and lending compared with larger investment banks like JPMorgan Chase. The Federal Reserve scaled back its forecast for tighter policy on March 16, citing weaker global growth. That translates to lower-for-longer short-term rates, which crimp what local banks can charge on loans.
Westamerica Bancorp. has the highest short interest in the gauge — 18% of shares outstanding — without any exposure to the energy industry, said Aaron Deer, a San Francisco-based analyst of Sandler O'Neill & Partners. Short sellers may be targeting the San Rafael, Calif.-based company because of its high valuation and concern about its balance sheet, Deer said. The company trades at 2.3 times book value.
Evercore ISI's Moss said even if the Fed speeds up interest rates increases, a stronger dollar would hurt manufacturers, which in turns affects lenders. "You've seen hints from banks signaling that things are getting tough on that front," he said.
While shorts are boosting bearish bets, other investors are taking the opposite view and loading up on shares. Gary Bradshaw, a Dallas-based fund manager for Hodges Capital Management, said his firm recently increased its position in Cullen/Frost.
"I am looking at low price-to-book, good earnings and what I think will be a higher energy price," said Bradshaw. "I don't think interest rates are going to go up dramatically, and that will be the headwind for banks. But at the same time, some of the regional players will benefit more from higher energy prices."
Financial stocks in the Russell 2000 Index trade at 1.4 times their book value, the second cheapest sector after energy out of 10 groups, data compiled by Bloomberg show. Cullen/Frost trades at 1.2 times book. Hancock Holding and Prosperity have the lowest valuations out of the top 10 most shorted lenders in the KBW Regional Banking gauge.
"There is some uncertainty on how significant these oil credits are going to mean to the credit costs for these banks going forward," said Daniel Werner, an analyst at Chicago-based Morningstar. "Investors are right to be cautious with names in the Texas and Oklahoma area. That's a fair assessment by investors until we figure out what's going on with oil.