Short sellers betting heavily against banks. Is their read right?

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Wednesday’s rally aside, it has been a rough year for the stock market — especially among bank stocks.

The KBW Nasdaq Bank Index has fallen nearly 23% this year, and some market participants appear to be betting on things to get worse for bank shares before they get better.

A growing number of investors placed bets that the stocks of companies like New York Community Bancorp in Westbury, N.Y., and Prosperity Bancshares in Houston will keep dropping, according to a recent assessment by FIG Partners of short-selling positions as of Nov. 30.

Broker-dealers are required to report data on short-selling positions to the Financial Industry Regulatory Authority. A short seller seeks to turn a profit by borrowing a security, selling it, and then buying it back at a cheaper price once the stock falls; the short seller keeps the difference before returning the security to its owner (minus any interest payments to the share owner).

While investors may be shorting a bank’s stock for a reason specific to that company, any investor who keeps a close eye on the banking sector should expect a wild ride once 2019 begins, said Brian Martin, an analyst at FIG. There are so many hard-to-predict variables present in this market that more investors may decide that it is time to short banking stocks, he said.

“The short interest in banks will be interesting to watch over the next couple of months, because there has been so much volatility,” Martin said. “The way the stock market has fallen apart the last couple of weeks, you’re going to see some changes” in how investors value bank stocks.

At New York Community, 13.9% of outstanding shares were in short interests at Nov. 30 — the highest among publicly traded banks with a market capitalization of at least $100 million, FIG said. That was up from 7.6% at the same point a year earlier.

Investors are likely shorting the $51.2 billion-asset New York Community because of its high concentration of commercial real estate loans, Martin said. New York Community’s ratio of CRE to total risk-based capital was 757% at Sept. 30.

However, New York Community recently got news that may alleviate some of those concerns. Regulators lifted a restriction on the bank that had capped the bank’s CRE exposure at 850%, though they generally advise banks to keep CRE concentrations below 300%.

“Our CRE exposure is predominantly focused on rent-regulated apartment buildings in New York City. It’s a business we’ve been doing for about 50 years, and we’ve never needed to charge off loans to capital,” said Salvatore DiMartino, New York Community’s director of investor relations. “It’s been an excellent asset class for us. We have a very robust credit risk management practice in place.”

DiMartino declined to comment on short positions in the company’s stock.

Investors may be shorting Prosperity’s stock for different reasons. About 6.6% of Prosperity’s outstanding shares were in a short position at Nov. 30, according to FIG. That was up from 5.1% at Oct. 31, one of the highest one-month increases of all banks that FIG surveyed.

The $22.6 billion-asset company has a relatively large exposure to the cyclical energy sector, as about 3.5% of its loan book is tied to energy, Martin said. Last week oil dropped below $50 per barrel for the first time this year, according to Bloomberg. West Texas Intermediate crude oil was at $46.63 a barrel in late trading on Wednesday.

Prosperity also maintains a larger securities portfolio than other banks of its size, which may lead to slower loan growth and more pressure on its profit margins, since securities tend to have lower yields than loans. About 42% of Prosperity’s total assets were in securities at Sept. 30, higher than the 17% average rate of its peer banks, according to its most recent call report.

Though the short interest in Prosperity increased so much in a month, it is still near the company's historical average, Cullen Zalman, a vice president at the bank, said late last week. Prosperity's short interest is also close to that of its peer banks in Texas, he said.

Zalman also dismissed Martin's suggestion that Prosperity's exposure to the energy sector is the cause of the increase in shorts.

"With all the market volatility, it is hard to speculate what the recent pickup in the ratio is due to, but I wouldn’t think it would be due to exposure to the energy sector," he said. "Energy makes up a very small percentage of our overall portfolio, and some of our peers have much higher energy exposure."

Several other banks have seen sharp upticks in their short positions.

Short positions in the outstanding stock of the $31.2 billion-asset Sterling Bancorp in Montebello, N.Y., rose to 9.4% on Nov. 30 versus 4.3% a year earlier. At the $4.2 billion-asset Franklin Financial Network in Franklin, Tenn., the short position rose to 9.1% from 3.4% in the same period last year.

While short interests increased at those banks, there may be a silver lining to the most recent volatility, Martin said. In some cases, investors may have succeeded with their shorts and taken some profits off the table, he said. In other words, they may be gone.

“Probably some people have made money, and they’ll decide it’s time to cover their short,” Martin said.

A regional bank chief last week defended bank stocks, arguing that strong consumer and commercial credit quality and other strengths were being overlooked.

It is unfair that bank shares are being shunned “like they have leprosy,” Bruce Van Saun, the chairman and CEO Citizens Financial Group in Providence, R.I., said in an interview Thursday. He did not address short sales but generally disputed the bearishness created by interest rates, trade issues and other broad concerns.

“The way banks are being valued is completely disconnected from the fundamentals that the banks see,” Van Saun said. “Banks are putting up great numbers this year, [and] I think we all have good outlooks for next year. We don’t see a recession in ‘19 and probably not in ‘20 either. Somebody’s right and somebody’s wrong, so we’ll see how that plays out.“

Laura Alix contributed to this article.

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