By Chris Gillick
No other hedge fund strategy depends more on Uncle Sam right now than financials. The federal government not only controls monetary policy. Through its Troubled Asset Relief Plan, the government now manages the largest long-only financials fund out there. With TARP nearly fully invested—it has plowed nearly $700 billion into more than 600 financial institutions— hedge funds are looking to catch a ride on the reflation trade. The opportunity could be short-lived, as bank stocks may be oversold and many financial companies still have troubled assets on their books. For now, though, shares of big banks—Bank of America and Goldman Sachs on the long side and Wells Fargo on the short side—are taking center stage.
Who better to lead the way than $27.2 billion Paulson & Co.? Paulson successfully shorted the subprime housing market in 2007 and a handful of British finance companies, including Barclays and Lloyds, in 2008. (He since has covered his Barclays short.) Last October, when Congress passed TARP, John Paulson’s firm launched the aptly named Recovery Fund to take advantage of an expected comeback in beaten down financials and real estate securities. After a flat start in 2008, returning 0.12% for the shortened year, Paulson Recovery Fund gained 9% in this year’s first half and is managing about $1.3 billion.
At the end of June, more than two-thirds of the Recovery Fund’s assets were invested in bullish bets, with more than 40% of the net asset value devoted to restructuring banks, according to marketing materials. One position featuring prominently in the portfolio is BofA. As of June 30, Paulson’s funds owned 168 million shares, making the firm the fourth largest shareholder in the Charlotte, N.C., bank. Paulson’s cost basis in the common stock was about $9 to $10; the firm is forecasting the price will rise to $30 by the end of 2011. As of press time in late August, shares were trading slightly above $17.
Other long holdings in Paulson’s Recovery Fund include Capital One Financial, CB Richard Ellis Group, Fifth Third Bancorp, IndyMac (now OneWest BankGroup), Regions Financial, State Street and SunTrust Banks. Paulson’s event funds have recently had long exposure to Goldman Sachs. A spokesman for Paulson declined to comment.
Concurring with Paulson’s thesis on
BofA are Dan Loeb of the $1.8 billion Third Point and Andreas Halvorsen of $10.6 billion Viking Global Investors. In a letter to investors dated July 31, Loeb wrote that Third Point has continued to hold BofA equity “and [we] believe it is significantly undervalued.” Third Point’s research indicates a normalized earnings power of about $3 per share, which implies the stock is trading at about 4.3 times earnings. “With tangible book value of $11.66 (as of June 30), if BAC simply traded at the 1.5x tangible book value afforded most of its peers, it would imply nearly 50% upside from today’s levels.”
Of Viking Global’s top 10 long holdings, five are financial stocks, according to a July 8 letter to investors. These financials are Invesco, JPMorgan Chase, Mastercard Worldwide, Visa, and of course, BofA.
Hedge funds have been bullish on BofA, but the same cannot be said for Wells Fargo in San Francisco. Despite raising $8.6 billion in equity capital following the government’s bank stress tests in May (a process that Wells Fargo chairman Richard Kovacevich called “asinine”), Wells Fargo has not convinced every investor that it is well capitalized. “The Wachovia acquisition left them saddled with resetting option ARM mortgages, and their commercial lending portfolio is a complete disaster,” says a long/short financials manager in Greenwich, Conn. The manager says his fund’s portfolio is net long, but short WFC common stock, adding, “Wells Fargo was also one of the slowest growing banks in the second quarter and has a substantially lower Tier 1 common equity ratio (4.5%) than JPMorgan (7.7%). That alone says a lot about where it stands.” For most traders, however, a short stance has not proved profitable: The stock has rallied to about $27.50 as of press time off a March 5 low of $7.80. Wells Fargo declined to comment.
Most managers view these transactions as independent, but they can also be treated as a pair trade. In an August 5 memo, a sell-side financial strategist wrote that long BofA and short Wells Fargo was his “favorite large-cap pair trade,” adding that he expected another $5 in near-term spread convergence.
Karen Finerman, cofounder of Metropolitan Capital Advisors in New York City, has also been short Wells Fargo common stock, but only to hedge her long position in the bank’s preferred shares. “Back in February and March, the market was pricing in nationalization, as Wells Fargo preferred stock was trading at yields that were indicative of severe distress,” says Finerman. “Our bet was that the banks would not be nationalized, and we were right. But in the case that they were nationalized, we had to hedge by shorting the common.” Metropolitan has since sold most of its positions in Wells Fargo but maintains a long bias as a yield play should the bank “earn its way out” of its debt to the government. Metropolitan, which manages a couple of hundred million dollars, has also bought preferred shares of BofA.
Performance for long/short financial funds has been mixed. “Given the mix of strategies these managers use, with so many who were short last year along with those caught in long ‘value traps,’ I would expect to see a wide dispersion of return numbers,” says one New York City fund manager who runs a proprietary long/short financial book for a large bank. The data confirm this hunch. Funds following a long/short financials strategy in 2008 lost a median 6.9%, according to HedgeFund Intelligence. As the sector rebounded in 2009, the strategy returned a median 11% through July. Because the financial crisis took down many hedge funds last fall, and because returns are self-reported, this data might be skewed to the upside.
Funds performing well this year through July include Steve Eisman’s FrontPoint Financial Horizons Fund, up 25.46%; William de Winton’s Lansdowne Global Financials (USD), up 33.44%, and Martin Hughes’ Toscafund, up 31.12% following disastrous 2008 in which the fund got burned on a stake in Washington Mutual. Crispin Odey’s Odey European fund has gained 37.79% this year.
The bank prop trader, like Halvorsen, Loeb and Paulson, is long BofA common stock and in fact has positioned his portfolio’s largest long exposure. He has no exposure to Wells Fargo but does confess to being short American International Group. AIG “is still worth zero, despite the recent 1-for-20 split,” the trader says, adding that the group’s portfolio has been short on the bailed-out insurer from a split-adjusted cost basis of roughly $600. This spring, Citi was a popular short, but fund managers have steered clear of the stock since a massive short squeeze in May.
In another signal that hedge funds believe in a bank rebound, a special-purpose acquisition vehicle controlled by Warren Lichtenstein’s Steel Partners announced on July 31 that the SPAC would merge with Frontier Financial in Everett, Wash. While the SPAC was not set up to buy a bank, clearly Steel saw value. “This opportunity is attractive when considered amidst the backdrop of today’s historically low bank valuations and the opportunity for improved valuation in the future,” Lichtenstein said in a press release announcing the $24.4 million deal, which has yet to close. The transaction also revives some hope in the SPAC market, which has been hard hit by redemptions and lack of deal flow resulting from the lack of available credit.
Asset flows do not paint a rosy picture. Long/short finance sector hedge funds have seen net outflows since the third quarter of 2007, according to data from Hedgefund.net. In that month alone, the sector shrank by 6.9% even as the S&P 500 Financials index nearly doubled through the end of June from its March lows.
Despite net outflows, profitable opportunities are plentiful. Regarding the popularity of the long BofA trade, one manager says that his peers like the operating leverage that the company can exert into a recovery. “Bank of America has fewer competitors in every segment of their business than when the financial crisis began,” says David Sackler, managing partner of the $150 million Moab Partners in New York City, which does not own anything in the BofA capital structure. “If the economy stays on an upward track, BAC should be able to outperform current consensus earnings estimates for the next 18 months.”
Unfortunately the financial sector’s biggest investor—the American taxpayer—didn’t get to be as lucky.
