Short sellers are back

Hedge funds have resumed the practice of short-selling UK financial stocks with a vengeance in recent weeks, raking in billions of pounds by betting on share price falls at banks and insurers since an FSA-imposed ban expired in mid-January.

While the strategy faces a crackdown worldwide as countries try to stabilise their financial systems, funds such as Odey and Lansdowne are piling into trades in UK financial companies. Both banks and insurers face additional strain on their finances and the possible need for more share issues in coming months.

The FSA imposed a ban on short-selling 34 financial stocks in September. But the regulator allowed the ban to expire last month, though short-sellers of financial stocks in the UK are still required to disclose positions exceeding 0.25 per cent of a company's shares.

Some maintain that the ban should have been extended at least until the crisis subsides in the interest of stability. "We are not against the short selling of banks' shares as a matter of principle; we have however called for the temporary suspension of short selling as it was clear that systematic short selling was destabilising the market and putting already weak banks at greater risks than they already faced," said a spokesman for the Liberal Democrats, whose Treasury spokesman, Vince Cable, has in the past spoken out in favour of the ban. "Given the current volatility it would seem sensible to have a temporary suspension."

The ban is, however, unlikely to return in reality, with the FSA, the Government and even the industry body representing banks advocating the current relatively liberal regulatory approach to the issue.

"The banking industry feels the UK regulators struck a sensible balance on short selling; it was right to allow short selling to resume in January and gave the industry time to prepare for its return," said a spokesman for the British Banking Association. "Continuing the ban might have given rise to speculation that short selling could ultimately be forbidden altogether and legitimate short selling can be useful."

British banks, whose share falls in September helped to force a government bailout and were partly blamed on short-selling, are suffering from the weakening economy.

They are raising additional capital through share issues, and in some cases return cap-in-hand to the Government for additional help.

"Banks have had serious problems – the downleg is not about people being able to short again, it's about how bad the toxic assets are on the banks' balance sheets," said Kevin Burrows, a senior analyst at Nedgroup Investments, a so-called fund-of-funds that invests money – largely in its case from South African retail investors – in both hedge funds and traditional asset managers.

Insurers, meanwhile, are also coming under pressure to raise cash as the worsening economic picture erodes the value of their investments and the falling pound increases the amount of cash they need to allocate for US claims. Hedge funds have piled into such companies in recent weeks, as cash call speculation has surrounded the likes of Legal & General and Aviva, leading to major share falls in recent weeks.

Not all countries are taking the UK's laissez-faire approach. As well as Italy and Australia, which have both extended their bans on the practice, the US is considering bringing back the recently repealed "uptick law", which limits shorting by stipulating that a stock needs to have risen before a short-seller closes out its position.

While some politicians have blamed short-selling for exacerbating banks' problems, many in the fund industry argue this is wrong. Among arguments to support the view, they point out both that banks' shares continued to fall during the shorting ban, and that far from making a guaranteed profit, hedge funds can lose money as well on such trades.

"Short-selling (in financial stocks) is not the one-way street to the rich gang it has seemed to be of late," said Mr Burrows. "It is only because it has become so obvious these companies are in trouble and that there have been gains to make on the downside."

Mr Burrows also pointed out that some hedge fund managers had flagged potential troubles at banks as early as 2007, and the market took a while to catch up, meaning any short positions at that time initially lost money.

The risks associated with shorting have also been shown by the Porsche case last year, where hedge funds with short positions on the German car maker Volkswagen lost billions of pounds when Porsche announced a takeover offer, forcing a spike in the price of the shares.

With the UK is unlikely to follow rivals in insulating financial shares from shorting, hedge fund investors should be warned that anything that falls may also bounce back up and they could lose out spectacularly.

Making a killing: The hedge fund bosses selling Britain short

Philip Falcone

Harbinger Capital was first to declare a short position in HSBC following the bank's record rights issue, after making more than £300m from a similar tactic with HBOS last year. Harbinger had on Monday taken a short position in HSBC shares, worth about £110m. Any gains so far from this trade are likely to be modest, but its head, Philip Falcone, has won big at the races before on such flutters. Harbinger has also taken short positions in Spanish banks, including one for 0.4 per cent of Santander, the owner of Abbey National. Mr Falcone, was one of five hedge fund managers quizzed by US lawmakers last November.

Paul Ruddock

Lansdowne Partners could have made almost £13m from a short position in Aviva as of Monday, although some of this paper gain has been cancelled out by a subsequent rise in the insurer's shares. It is still, however, sitting on a hefty profit from the trade. Lansdowne had already last month made a possible profit of almost £2.7m from short positions in Old Mutual and Legal & General, and also has trades in Aviva and Prudential. The fund is reported to have last year made a £100m profit from the fall of Northern Rock. Its founder, Paul Ruddock, is a major donor to the Convervative Party and also chairman of London's prestigious Victoria & Albert Museum.

Crispin Odey

Odey Asset Management raked in on paper more than £1m – possibly actually as much as £3.8m – in the space of 10 days in February when it took a 0.35 per cent short position on the insurer Legal & General on 13 February, which it reduced to "less than" 0.25 per cent on 23 February. Its founder, Crispin Odey, was formerly a portfolio manager at Barings before leaving to set up Odey Asset Management in 1991. He is one of the best-known figures in the London hedge fund industry, and is married to Nichola Pease, deputy chairman of the fund manager JO Hambro. Mr Odey reportedly paid himself £28m for 2007, as his fund remained profitable heading into the credit crunch.

John Paulson

The fund founded in 1994 by John Paulson has made more than £300m shorting Lloyds. The former US Federal Reserve supremo Alan Greenspan is on its advisory board. It has since September held positions in Lloyds TSB and HBOS, which were converted into a 0.79 per cent stake in Lloyds Banking Group after the banks merged earlier this year, according to regulatory filings. The hedge fund reduced its short position to below 0.25 per cent on Monday. Paulson also made billions anticipating the US subprime mortgage crisis. Formerly an M&A banker at now-defunct Bear Stearns, John Paulson is among the 100 richest Americans listed by Forbes magazine.

Richard Gilder

Gilder, Gagnon, Howe, which will have made thousands of pounds already from a short position in the insurer Legal & General, on Tuesday tripled the size of that position to 0.00782 per cent. The firm is one of the oldest hedge funds out there, founded in 1968. The fund's mission statement is "to seek, to find, to own, and to sell with great reluctance". Its founder, Richard Gilder, is a US-based philanthropist who is on the boards and committees of New York cultural landmarks including the New York Historical Society, of which he is chairman of the executive committee. He is married to the former Bond-girl Lois Chiles, who played Holly Goodhead in 1979's Moonraker.