Before the Bell: Short Selling Bank Stocks, the SEC, and What Is Banking, Anyway?

Premarket action on Friday had the three major U.S. indexes trading higher. The Dow Jones industrials were up 0.46%, the S&P 500 up 0.63% and the Nasdaq 0.64% higher.

Thursday was something of a disaster for regional banks. Ten regional bank stocks dropped by at least 10% for the day, and shares of PacWest Bancorp (NASDAQ: PACW) dropped more than 50%. The stock is down 90% since early March. Western Alliance Bancorp. (NYSE: WAL) tumbled by 38.5% on Thursday and has dumped nearly 75% of its value over the same period.

Also on Thursday, Odeon Capital Group’s Dick Bove commented that hedge funds and traders who were shorting regional bank stocks “are doing the American public a meaningful service. They are winnowing the banking industry and forcing these companies to stabilize their financial statements.”

Bove said that federal regulators could and should have been doing this, if they had only issued rules against shorting bank stocks. An SEC spokesperson told Bloomberg that the agency was not considering a ban on short sales like the one imposed in 2008 when bank stocks plunged. That time, the SEC imposed a 15-day ban on shorting bank stocks that affected nearly 800 financial companies.

The American Bankers Association (ABA) agrees that the SEC should act. In a letter published Thursday to SEC chair Gary Gensler, the group’s CEO and president, Rob Nichols, wrote:

Since the two bank failures in March, some of our members have experienced significant short sales of their publicly traded equity securities that do not appear to reflect the issuers’ financial status or general industry conditions – indeed, short sales have followed relatively favorable earnings reports from some of the banks in question and from peer institutions. We have also observed extensive social media engagement about the health of various banks and the sector generally that appears disconnected from the underlying financial realities. We urge the SEC to investigate this behavior.

As for “winnowing” the banks, the ABA likely does not agree with Bove. The fundamental difference could boil down to how a financier like Bove looks at banking and how a banker looks at banking. In the financial view, banks take deposits (borrow short) and make loans or buy bonds (lend long) with the money. The value of the bank’s assets matters. When interest rates rise, asset values typically fall, and bad things happen. The virtually instant death of Silicon Valley Bank (SVB) is a textbook example.

From a banker’s point of view, banks take deposits which they believe will sit in their vaults for a long time (borrow long) and use those deposits to make loans or buy bonds (lend long). This viewpoint is based on the relationship (which is long term) that a bank has with its customers. In this case, rising interest rates cause the mark-to-market value of a bank’s assets to fall, but the bank’s net interest income rises. This is good for banks because they do not care much about assets and equity, as long as they have customers who believe their bank will still be in business next week and are willing to leave their deposits with the bank. Bloomberg’s Matt Levine has a more detailed and sophisticated analysis and cites Byrne Hobart, who shorted SVB in February:

[O]ne reason banks aren’t required to mark assets to market is that they can hold them indefinitely as long as they have deposits … it would take an absolutely titanic bank run to actually impair the company’s liquidity, so a run is unlikely.

In a tweet, Hobart makes the point more directly:

Here is a look at how the markets fared on Thursday.

Nine of 11 market sectors closed lower Thursday. Financials (−1.29%) and communications services (−1.26%) posted the day’s biggest losses. Real estate (0.92%) and utilities (0.73%) had the day’s only gains. The Dow closed down 0.86%, the S&P 500 down 0.72% and the Nasdaq down 0.49% on Thursday.

Two-year Treasuries dropped 14 basis points to end Thursday at 3.75%, and 10-year notes lost one basis point to close at 3.37%. In Friday’s premarket, two-year notes were trading at around 3.83% and 10-year notes at about 3.41%.

Wednesday’s trading volume was above the five-day average. New York Stock Exchange losers outpaced winners by 2,108 to 868, while Nasdaq decliners led advancers by about 3 to 2.

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