Hedge funds increased their stakes in financial stocks during the second quarter according to the Goldman Sachs Hedge Fund Trend Monitor (WSJ). Specifically, ownership in financials increased 55% from Q1 to Q2, growing to $70 billion - representing 3.7% of the sector's market capitalization. Bank of America (BAC) and JPMorgan (JPM) were some of the more popular financial holdings within hedge funds, with Regions Financial (RF) and Citigroup (C) also becoming new long positions for some funds. While the net short position of financials also rose slightly, 8% to $63 billion, the large increase in long exposure has resulted in hedge funds being net long the financials by the end of Q2 (WSJ). Although hedge fund redemption request have decreased, reducing the need for forced selling, it is unclear if hedge funds on average will maintain their net long positions in financials after the nice run these stocks have made since the March market lows.

Meredith Whitney was recently on CNBC (the video is provided below) discussing the banks and financials. Some observations from the interview include:

• This will be a tactical quarter for the banks.
• She has a bullish call on Goldman Sachs, but a bearish call on financial stocks in general.
• A huge refinance wave will create the "Mother-of-all" mortgage quarters, boosting earnings for the quarter for many banks, even though business in general is not getting better.
• Core earnings numbers may not be very good, but below the line numbers will be good due to all the mortgage activity. This will result in huge moves in tangible book value for the banks, even with unimpressive earnings numbers. These stocks trade on multiples of tangible book.
• A move from $18 billion in incentives to $75 billion in incentives to modify mortgages, with less modification liability, could cause some banks move 15% short-term.
• Mortgage modification numbers will increase logarithmically, causing past dues to become current, and allowing the banks to receive fees for the modifications.
• As a result of the fees and less litigation due to the current legislation, banks may even seek to modify mortgages which have not yet defaulted, or are not yet past due.
• Bank of America (BAC) is the cheapest of the banks, based on tangible book value (excluding Citi).
• Bank solvency has been off the table for a few quarters now, but main street has not been helped by the financial bailouts as much. A lot of refinancing is occurring, but not a lot of new lending. The new legislation and increased risk aversion is actually providing less access to credit.
• The next couple of years will be debt market-focused due to the tsunami of debt issuance needed to pay-off current spending.
• She also mentioned in the discussion (not included in the CNBC online video) that unemployment could reach toward 13%.
  
  
  Source: CNBC Video
  

For the first time since 1993, credit card companies were unable to sell bonds backed by customer payments (see Bloomberg article). Top-rated credit card-backed securities maturing in three years are selling at spreads of 475 basis points over Libor, compared to a spread of only 50 basis points less than a year ago. Given higher unemployment, leading to potentially higher credit card use and an inability to pay, lenders are expecting higher default rates for 2009. American Express is already accessing the Fed commercial facility program, as well as cutting 10 percent of its work force. Bank of America, JPMorgan, and Citigroup all rely on the debt market to fund their credit card portfolios, and could also subsequently be impacted by higher spreads and lower liquidity.

The WSJ has a nice article summarizing the auction-rate security mess, along with a short primer on what auction rate securities are, as well as how they are bought and sold through auction. Definitely worth the read for those interested in what has recently become a larger Wall Street focus. Auction-rate securities are essentially a form of debt issued by municipalities, student-loan organizations, and others interested in borrowing for the long-term, but doing so at short-term interest rates. How is this achieved? By auction, of course. Every 7, 28, or 35 days, depending on the product, banks will hold auctions in what amounts to a resetting of the interest rates as the securities are passed on to the new security holders (or reset for existing holders that want to stay long).

As reported, UBS, Merrill Lynch, and Citigroup alone have committed to buying back more than $36 billion of the securities. The problem that each of these companies find themselves in, among others, is that at times the auction-rate securities may have been promoted as being similar to short-term CDs, but with higher returns. Unfortunately, as credit problems increased, the auction-rate security market also began to freeze up, making it difficult for these securities to be re-priced. Many investors were left with bank statements that simply listed a "null" placeholder where their security prices were once quoted, implying that liquidity was poor enough that a reliable price could not be provided. To complicate matters, apparently the liquidity issue has persisted for a while, even as more securities were being marketed and sold, causing many banks to prop-up the market by issuing their own bids. The WSJ reports that UBS alone may have submitted bids in just under 70% of its auctions between January 2006 to February 2008. Allegations against Merrill Lynch imply that they gave the false impression that demand was high, driven in part by dark pools of liquidity in the auction market (see previous posts here, here, here, and here on dark pools of liquidity).

As recourse, and a way for UBS to hopefully reduced the intensity of this recent black eye (how many eyes does UBS even have?), the company has agreed to buy back from investors nearly $19 billion of auction-rate securities, starting with individuals and charities this October, all the way to institutional clients in mid-2010. It is worth noting that while UBS plans to start buying back securities in October, the actual purchase could take longer. As reported in a Barron's article back in May, and discussed in a previous post, how much money investors get back from auction-rate securities depends on who originally issued the securities. The investors of auction-rate securities sold by a municipality or a closed-end taxable mutual fund have already received their money or will be receiving it soon. Investors in closed-end tax-free municipal-bond funds will probably have to wait a little longer. If you or one of you investment funds purchased auction-rate securities sold by a CDO or student-loan trust, well, you may be waiting a while to get your money back, possibly many years.

The auction-rate security issues once again highlight the need for better due diligence and a better understanding of risk. As we often forget, higher reward is almost always accompanied by higher risk - I dare say 100% of the time, but someone will always find exceptions in an inefficient market. If you look for more return, you need to understand the risk. Auction-rate securities based on CDOs should have raised red flags for some. Deception is one thing, but offering a blind-eye is another. Furthermore, the way we talk about risk also probably needs to change. For instance, have you ever noticed that we seem to be having "100 year floods" every other year, or how the metaphorical "perfect storm", whether in finance, insurance, or other fields seems to occur with more regularity? Anecdotal? Sure. But eventually simply stating that the recent event was the prefect storm or a once-in-a-lifetime event will not cut it. There are only so many times that you can cry wolf before no one cares about the real danger lurking in the woods. Maybe auction-rate securities and their current issues provide another one of those warning calls we need to listen to, regardless of its eventual magnitude and implications in the current market.

As discussed in a recent Bloomberg article, the spread between the 3-month Libor and the overnight index swap (OIS) rate, traded forward 3 months, is greater than similar expiring spreads. This recent movement in the spread is signaling that traders are concerned that banks will have difficulties obtaining cash to fund existing assets, as well as putting into question their ability to shore-up their balance sheets. In general, an increasing spread signals that funds are becoming less available. The recent activity appears to be driven more by traders leaving the short-term, closer to expire positions early over worries about Libor and its reliability.

The spread has averaged about 11 basis points over the last 10 years, but has ranged between 24 bps to 90 bps this year, and has gotten as high as 106 bps last December. The activity in the swaps market is worrisome, indicating that derivative traders do not feel that the sell-off of financial companies in March was the low, and that the worst is not behind us. Recent problems/concerns with Lehman Brothers, Wachovia, and UBS, as well as the recent sell-offs in Goldman Sachs, Merrill Lynch, JP Morgan, and Citigroup are also highlighting concerns with the financial companies. As usual, this is not good news for the economy and the market as a whole as it needs a strong financial system to keep greasing the gears of expansion. It may be a long summer until the credit markets start showing a little more confidence.

It looks like Citigroup is going to compensate clients that incurred losses at its Falcon and ASTA/MAT hedge funds. Both were fixed-income funds that were hit by the recent credit crunch, with Falcon falling 75% in value and ASTA/MAT falling more than 90% in value. Before credit problems, each fund generated significant returns, with the help of leverage, of course.

Under the compromise, the wealth-management unit will absorb $250 million to allow investors in the Falcon fund to exit without incurring total loss if they agree to forfeit all legal claims against the funds and Citigroup. It is expected that some ASTA/MAT investors will get a similar offer. Of interest is how the story mentions that "some" will get a similar offer. Given that all investments are risky, and that even in a "conservative" fixed income fund there are going to be losses, Citigroup certainly sees this as an opportunity to retain some clients. Others don't agree and feel that Citigroup is worried about getting sued. If Citigroup did push the fund as a "safe" fixed-income investment, like investing in CDs, then some investors may have a case. This may also influence how they determine who gets compensation and how much. As reported in the WSJ, some feel the bank did in fact set the compensation at a level that was "just enough so they don't sue us." Nonetheless, given that there was a debate inside Citigroup about whether to even compensate these investors, I suspect is was less about getting sued, and more about keeping large clients.

Update: To add insult to injury, Citi just reported that it will sell at least $3 billion in common stock to strengthen its capital base. This comes after it recently sold $6 billion in preferred stock just a few weeks ago. The company has already raised over $36 billion in new capital through preferred stock and sovereign wealth fund investments, in part to cover $35 billions in write-downs on CMOs and bad LBO debt, among others. Maybe the hedge fund losses and disgruntled investors are still the least of their problems.

Ticker: C

Citigroup is close to selling $12 billion in loans to a group of private equity firms that include Apollo Group, the Blackstone Group, and TPG. The average price is just below 90 cents on the dollar. The loan sale is an attempt to help sure up their books after incurring exposure to $43 billion in leveraged loans last year. Another good call my Meredith Whitney a few weeks back.

Tickers: C, BX