Remember the heyday of this crisis, when shorts were blamed for singlehandedly bringing down investment banks, including Bear Stearns (now part of JPMorgan Chase (NYSE:JPM)) and Lehman Brothers? For a while, the government even banned the short-selling of 799 financial stocks -- the shorts were repelled. That's no longer the case.

They're back!
The shorts are back and, according to Bloomberg, aggregate short sales in the shares of the 18 publicly traded financials subject to the government's stress tests "were twice as high on April 15 as they were at their peak last year in July, two months before Lehman Brothers Holdings Inc. collapsed."

The following table shows the five most heavily shorted stocks among the banks being stress-tested:

Bank

Short interest as a % of shares outstanding (Latest)

Days to cover (Latest)

BB&T (NYSE:BBT)

11.1%

7.2

Fifth Third Bancorp (NYSE:FITB)

9.8%

3.9

Key Corp (NYSE:KEY)

7.9%

3.3

Capital One Financial (NYSE:COF)

7.1%

4.8

SunTrust Banks (NYSE:STI)

5.8%

2.7

Source: Capital IQ and author's calculations.

Is a trend at work here? Four of these five firms are regional banks (the next two stocks on the list are also regional banks: Regions Financial and PNC).

Note that the short interest doesn't necessarily represent only outright bets that these bank stocks will decline. They could be one leg of an arbitrage trade based on the assumption that the banks will convert preferred shares into common shares. The conversion is one of the ways in which a bank can shore up its common equity base if the government instructs it to do so.

Oblivious and foolhardy
Yesterday, I wrote that I was bewildered that bank stocks were being heavily bid up this week, ahead of the release of the stress test results. Today, the market continues to confound me -- in the face of the report that Bank of America (NYSE:BAC) has a $34 billion capital shortfall, the bank's shares are up over 10% as I write this -- for a gain of nearly 40% on the week! All the banks in the above table are also up sharply today (all over 10%).

While I find these gains puzzling, the idea of being short these banks outright going into the announcement of stress test results tomorrow afternoon seems foolhardy. If the results are better than expected, we could witness a short squeeze. Perhaps today's gains are simply the product of shorts beginning to pare their bets.

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