EJF Capital’s Emanuel Friedman at a 2017 conference in Las Vegas. His Debt Opportunities fund is down 19.8% for the year through July.
Photo: richard brian/ReutersHedge fund M3 Partners of Salt Lake City notched its best returns during the financial crisis, gaining more than 32% in 2008 and 2009. This year has been a different story.
Bets it made on a swath of highly-capitalized community banks have backfired as banks have sold off broadly. The sector has been crushed by the pandemic, as lower rates dent lending margins for the industry and concerns about possible loan losses have proliferated. Fund liquidations and forced selling have added further downward pressure on bank stocks.
The $265 million hedge fund has lost 12.8% for the year through July, its worst year so far—and that is one of the stronger returns for a financials fund this year.
Hedge funds that invest in banks are getting bloodied this year, leading to double-digit losses and shutdowns for some funds.
The KBW Nasdaq Bank Index has fallen 33.1% this year; the S&P 500 is up 6.2%, including dividends. Regulatory filings Friday showed Warren Buffett’s Berkshire Hathaway Inc. sold out of billions of dollars of bank stocks in the second quarter, though it added to its Bank of America Corp. stake.
Funds including Castine Capital Management in Boston have told clients they are shutting down. Emanuel “Manny” Friedman’s EJF Capital was down 19.8% for the year through July in his $2.1 billion Debt Opportunities fund from credit positions tied to banks and insurers, and more in a smaller financials fund.
FJ Capital Management, founded by Mr. Friedman’s nephew, Martin Friedman, was down 26.3% for the period in its flagship fund, according to an investor document. London-based Toscafund Asset Management was down 17.4% for the period in its financials fund, hurt partly by European banks suspending their dividends.
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The ranks of financial funds have thinned due to fund closures during the financial crisis and waning investor appetite tied to low rates and sometimes-volatile returns. The recent issues with banks are putting more pressure on those investors that remain.
“Looking at financials funds and other sector funds, there’s so much more going on in biotech and in technology and there’s so little going on in financials at the moment that looks exciting, that more capital is moving away from financials,” said Kieran Cavanna of Old Farm Partners, a New York firm that invests and advises on roughly $275 million of client money in hedge funds.
The funds’ pain this year largely reflects tumbling profits for banks and uncertainty about many banks’ outstanding loans in the pandemic.
Even bets against banks have backfired on some funds. Managers said banks they have been short have rallied at times as other investors who are under pressure have bought the stock to cover their own short wagers.
Banks themselves are facing myriad issues. The Federal Reserve slashed interest rates to near zero in March and said it expects to keep them there for the next two years. The move is expected to hurt banks’ lending margins, typically their biggest revenue driver.
At the same time, businesses and consumers are stressed, meaning outstanding loans look riskier. The largest banks have set aside tens of billions of dollars to account for potential loan losses.
Some hedge-fund managers say stimulus programs and the granting of deferrals make loan data and banks’ financial statements—fundamental data they have historically used to ground their wagers—unreliable.
“Ordinarily we look at delinquency numbers and make a judgment about the impact on a bank’s earnings and capital. Today, we feel unable to make a judgment about whether a loan whose payments are being deferred will become a performing loan again or whether it will lead to a large loss,” wrote Castine executives in a July 23 letter to clients telling them they were shutting down after more than 17 years because they felt uncomfortable putting money to work.
Castine executives also wrote that another large wave of businesses shutting down because of the coronavirus would be disastrous. Bankers’ lack of conviction in their own guidance, coupled with “a complete lack of any Covid-19 strategy at the federal level,” led them to conclude: “Bank stocks will be un-investable for at least the intermediate future.”
Banks still have believers. Several investors said the financial crisis had strengthened the ability of banks to survive an economic collapse—indeed, some view banks’ navigation of the pandemic as a success—and that deep discounts were available.
EJF believes loan losses won’t be as large as expected and that they will be manageable for U.S. banks given their high capital levels entering the year, according to a person familiar with the fund. As some regional and larger community banks have gained ground the first two weeks of August, its under-$100 million financials fund trimmed its losses for the year to about 16.7%, the person said.
M3, founded by Jason Stock and William Waller, told clients it remained watchful for credit losses at banks and that it expected loans tied to restaurants, hotels and retail to have more problems than loans tied to other industries.
Still, M3 said some community banks should benefit in coming quarters from their role in delivering emergency loans to smaller borrowers through the Paycheck Protection Program. Several banks are reporting fees that rival one to two quarters of earnings. The fund also said it expected deals activity, which it said had slowed to a standstill amid the pandemic as management teams proved “reluctant to risk acquiring another bank’s problems,” to surge when the environment stabilized.
The fund has taken in additional money this year to take advantage of the selloff, said a person familiar with the fund. M3’s average annualized returns are 10.1% since its January 2008 start, compared with a 1% return for its benchmark, the SNL Bank & Thrift, according to a client letter.
Write to Juliet Chung at juliet.chung@wsj.com
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