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* Some funds put on short positions
* Wary stress tests, earnings disguise deeper problems
* Funds wary of being caught out by market volatility
LONDON, Aug 13 (Reuters) - Hedge funds have started shorting bank stocks again on concerns last month's stress tests were too weak and failed to reveal underlying problems, although many are cautious of taking big bets in such choppy markets.
A wave of what some commentators have seen as good news, including a bumper earnings season, an easing of capital reforms and relatively few failures of the high-profile stress tests, have lifted banks' shares, creating an opportunity for short-sellers betting prices will fall. "Some funds have started to put on shorts again after the strong rally," said Ken Kinsey-Quick, who runs funds of hedge funds at Thames River Capital.
"(Managers believe that) until they (the banks) come clean they'll be hugely volatile and remain sick for years to come. They're still sitting with a lot of loans that are not performing."
Hedge fund Noster Capital has begun shorting five European banks -- Barclays (BARC.L), UBS UBSN.VX, Intesa SanPaolo (ISP.MI), UBI (UBI.MI) and BBVA (BBVA.MC). Manager Pedro de Noronha criticised the tests for ignoring sovereign debt that banks hold to maturity. [ID:nLDE66T1RQ]
"The widely anticipated PR exercise (also referred to as stress tests) on European banks produced results that were considerably better than most investors expected," manager Pedro Noronha wrote in an investor letter this week.
"Last time we checked, to stress test anything meant to stress something until the point it breaks. That's not even close to what was done to European banks."
Meanwhile, last month Reuters reported that Onslow Capital was shorting some European banks' debt, saying they were "sceptical" about the stress tests, which they described as "very weak". [ID:nLDE66Q1DC]
The STOXX Europe 600 Banks index .SX7P rallied as much as 9 percent in the fortnight after Europe's test of 91 banks in 20 countries, which showed seven had failed, and is still up around 2 percent, outperforming the STOXX Europe 600 index .STOXX. [ID:nNN2516007]
Shares were also boosted after looming Basel III capital reforms were scaled back and banks were given longer to implement changes. [ID:nLDE66Q0KU] [ID:nLDE66Q11A]
Banks also reported higher-than-expected profits last week, boosted by a sharp fall in bad debts, which outweighed a slump in investment banking income after Greece's economic crisis. [ID:nLDE6721I5] [ID:nLDE67317O]
"It's a very active area... A lot of managers are playing it," said one fund of funds manager, who spoke on condition of anonymity.
"On average people are more bearish than bullish... Most people feel the stress tests were not robust enough and areas of weakness may emerge."
The manager said some funds are betting on spreads between senior and unsecured bonds, while others are using credit default swaps or simply shorting the equity.
While stock lending data -- a good indicator of short interest -- varies from one company to another, stock out on loan for HSBC rose from 1.04 percent, the day the stress test results were released, to 1.46 percent on Wednesday, according to figures from Data Explorers.
Stock out on loan for Santander also rose sharply in the fortnight after the stress tests, although has since fallen back, while UBS UBSN.VX, Credit Suisse (CSGN.VX) and BNP Paribas (BNPP.PA) all saw small rises in stock out on loan.
However, hedge funds are wary of taking big bets when sentiment is changing so much -- what fund managers call the "risk on, risk off" trade.
"The problem is that volatility just kills you. You might short banks, they go (successfully) through a weak stress test and all of a sudden there's a rally," said Thames River's Kinsey-Quick.
"You've got to take more of a trading approach... If you are going to play it, you probably wait for big rallies and then go short." (To read the Reuters Funds Blog click on blogs.reuters.com/fundshub; for the Global Investing Blog click here)