It's Not Too Late To Short Financials

Includes: FAZ, SEF-OLD, SKF, XLF
by: Nicholas Pardini

Of all sectors, Financials have been hit the hardest this year. However, with the Euro crisis unraveling to the point of a possible collapse of Italy and Spain, there is plenty of downside to come. I remain bearish on the financial sector due to its exposure in sovereign debt, the slowing global economy, and fading confidence in the banking system by both the financial community and on the individual level.

The primary downside anchor that will continue to plague the financials is the European debt crisis. Throwing out the prime minister of Greece and spreading false rumors about the stability of Italy and Spain may temporarily support the markets, but bond yields tell a different story. Italian yields have shot up 100 basis points since October 1st and Spanish bonds have risen 60 basis points over the same time period. This reflects a clear lack of confidence of creditors' expectations of these governments' ability to raise money to pay off their debt, with or without a bailout. The ESEF is struggling to raise funds with its first bond issue, and unless the ECB commits to printing money to finance the remainder of the debt, this leveraged bailout will have a dearth of buyers.

In addition banks such as Barclays (NYSE:BCS), Jefferies (NYSE:JEF), BlackRock (NYSE:BLK) (who is still the biggest private buyer of Italian) and Citibank (NYSE:C) have significant exposure in Spain, Porutgal, and Italy through sovereign bond holdings and/or commercial bank exposure. In conclusion, out of all of the sectors, financials clearly have the most to lose as they were the financiers of this debt, and have an average of a 11:1 leverage ratio that compounds losses. Since the banking system is global, American banks are not safe because they are the counterparties for derivatives transactions of many highly at risk European banks, such as Societe Generale (SCGLF.PK) , UniCredit (OTCPK:UNCFF), Barclays, and BNP Paribas (OTCQX:BNPQY).

10 year bonds Italian bonds 6.66%

10 year Spanish bond yields on the rise as well

The instability in Europe has also caused a loss of confidence in the global financial system as a whole. ECB overnight holdings are at record highs and the LIBOR-OIS spread has tripled in a little over two months. This shows a clear lack of confidence that banks even have amongst themselves. The public in Europe and the U.S. feel strong animosity towards the financial system. Fee hikes, political anger, and the risk of PIIGs pulling out of the Euro make the risk of a European bank run a real possibility. A second wave of foreclosures occurring since last August also has a negative undertow on future earnings.

The best way to short the sector as a whole is by buying inverse ETFs. Since financial companies do not have to mark to market, it makes it difficult to identify the weakest of the banks before they become the next MF Global (OTC:MFGLQ). As a result, I think it's better to short the sector as a whole. The SEF-OLD is a direct inverse of financials, and probably the safest option to short the sector. Buying the FAZ offers more returns as it is a three times levered short of financials, but carries equally higher risk. I recommend buying both due to weak fundamentals of the banking system and both are near technical support levels with positive MAC-D buy signals. Your concentration of FAZ versus SEF is based on your risk horizon.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in FAZ, SEF-OLD over the next 72 hours.