It was a familiar sight on Thursday morning: Shares of Germany’s two largest banks, Deutsche Bank and Commerzbank, were the worst-performing stocks in Germany’s blue-chip DAX. Perhaps that explains why they’ve become the target of massive short sales by US hedge funds, which are betting that share prices of the troubled institutions have even further to fall.
Deutsche Bank, once Germany’s flagship financial institution, has four investment funds betting €979 billion ($1.1 billion) that its shares, already below €10, will decline even further. AQR Capital Management, one of Deutsche’s short sellers, also has a €172 million short position in Commerzbank.
Adding insult to injury, hedge fund speculators seem to be putting these German banks in the same category as Italy’s. Short positions on some big Italian banks expect that their large holdings of government bonds and the country’s shaky finances will push down share prices.
Short selling weighs on shares
Short selling is a standard practice for active investors. An investor borrows the shares from a stockholder for a fee and sells them in the open market in anticipation the price will decline. When the price goes down, the short seller buys back the shares and returns them to the owner, pocketing the profit on the sale.
The risk is that if the price instead goes up, the seller must pay more to buy them back and suffers a loss. The practice has its critics and is subject to abuse, but it adds liquidity to the market, helps investors in price discovery, and is a useful tool for hedging long positions in the same sector.
Short selling can become a self-fulfilling prophecy if enough investors jump on the bandwagon. At the very least, it can help depress the share price.
The short position on Deutsche, equivalent to nearly 5 percent of outstanding shares, helps explain its sharp decline in recent weeks. The bank’s shares have been flirting with new record lows since the end of May.
AQR, a fast-growing fund backed by US billionaire Cliff Asness, has a short position equal to 2.4 percent of Deutsche Bank’s shares, as well as the Commerzbank position, equal to 1.6 percent. Other hedge funds betting against Deutsche are Marshall Wallace (1.34 percent), Capital Fund (0.6 percent), and World Quant (0.51 percent). Investors are required to report only short positions exceeding 0.5 percent, so these big positions may not tell the whole story.
The problems of the two banks are well-chronicled. Deutsche has suffered years of losses from scandals, egregious missteps, and a cost-heavy structure. Swapping out chief executives in April has done little to slow its decline as it seems incapable of trimming costs as fast as it is losing business. Commerzbank suffers from years of troubles being an also-ran that has never had particularly good management. It remains part-owned by the German government after a bailout in 2008-2009.
Silver lining is possible rebound
The silver lining in this cloud is that shares can rebound when short sellers close out their positions and buy shares back. A crash in the blue-chip DAX index earlier this year is attributed in large part to short sellers. The subsequent recovery reflected them closing out their positions.
Bridgewater Associates, backed by US investor Ray Dalio, was particularly active shorting German blue chips. This backfired in the case of Bayer, which continued to rise despite the turmoil over its acquisition of Monsanto. But it succeeded spectacularly in the case of Deutsche Bank, which fell 25 percent from the end of January to mid-April without ever getting back to its starting point.
It was mid-April when Bridgewater’s short positions fell below the 0.5 percent reporting threshold. The DAX closed above 12,500 that day, after reaching its low for the year, 11,787, just three weeks earlier.
Short sellers may magnify gains and losses in share prices, but they ultimately reflect the underlying trend. The two German banks have shown little success in overcoming their difficulties and may well face darker days ahead.
Deutsche Bank was the only one of 35 big banks operating in the United States to fail the US Federal Reserve’s recent round of stress tests. Commerzbank, a component of the DAX since its inception, may well be forced out of the index in the upcoming review as its market capitalization continues to decline relative to other blue chips.
It’s hard to know where all this will end, but the short sellers seem confident it won’t end well for shareholders.
Jürgen Röder covers investing and finance for Handelsblatt. Darrell Delamaide adapted this article into English for Handelsblatt Global. To contact the author: firstname.lastname@example.org