Hedge funds are net short financials compared to a net long position in the last quarter of 2007. Wachovia Corp, a US bank, is the latest casualty having seen its shares drop to a 13-year low. Earlier this month, S&P lowered ratings on Lehman Brothers, Morgan Stanley and Merrill Lynch, reflecting ongoing worries over further write-downs. JP Morgan and Bank of America may be next, warned S&P.

David Einhorn, who heads Greenlight Capital, the $6bn hedge fund, started to bet against Lehman last July and so far he has been right. The stock has dropped 59% in the past year into early June.

The ranks betting against financials has been growing in recent months. Based on short interest filings as of March 31, hedge funds were short $116bn of financial stocks, estimates Goldman Sachs. Hedge funds filed $106bn of long positions on the same day, suggesting they had a 9% net short position, compared to a 14% net long at year end and 26% net long at the end of Q3 2007. Short-interest is filed bi-weekly with the exchanges and released with a 10-day delay.

When considering the value of short interest filings from April 30, hedge funds are estimated to hold $125bn in short financial positions, an increase of 8% from March 31. “The rally in financials in April was not caused by hedge fund covering,” says David Kostin, chief US investment strategist at Goldman.

One hedge fund, the $800m Hovde Capital, which has been short financials for two years, does not intend to cover any time soon. “Short interest is on the rise. What the banks are experiencing is a massive deterioration of credit, shrinking profit margins and strained loan-loss reserves, all of which are forcing the financial sector to re-capitalise,” says CEO Eric Hovde. “A number of them will go bankrupt. Lower rates will clearly help, however, only at the margin. It will not alter the situation in a significant way.”

Compared to other sectors, financials account for 21% of short positions, followed by consumer staples (16.6%), information technology (14.8%) and industrials (11%). The results are based on 755 hedge fund filings with $833bn in assets.

VB