How to profit from Hot Money

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For those with some extra cash, here's a nice way to trade on Hot Money. As I posted over the weekend, Hot Money -- also known as brokered deposits -- are deposits that pay an interest rate that is 20 percent higher than the industry average. And banks that depend heavily on Hot Money take on much greater lending risk so they can make enough money to pay those higher deposit rates.

You can profit from this by shorting the stock of the most vulnerable hot money banks, while depositing your money in them.

How so? The FDIC insures those Hot Money deposits, which means that if the bank goes belly up, you can profit by covering your short position and by getting your deposits back from the FDIC. Why?

According to Foresight Analytics, the 79 banks that failed in the last two years had four times more brokered deposits as a share of total deposits than the average bank. The biggest risk with this trade is that the banks that depend the most heavily on brokered deposits might survive -- in which case you might lose money on your short position.

Want some specific names? I looked for banks with more than $1 billion in assets that are publicly traded and depend heavily on brokered deposits -- I found that many operate out of Puerto Rico. But not all such banks that take brokered deposits are necessarily in trouble -- the ones that are losing money and have a high level of bad loans would be the best short sale candidates. But do your own research before taking any of these short bets.

Here are two candidates to consider:

  • W Holding Company (WHI) owns Westernbank and 77 percent of its deposits are brokered. This bank has $15 billion in assets -- a whopping 9.9 percent of which are non-performing. Westernbank is more than a year behind in its financial reports. The most recent, in March, was for the year ended December 31, 2007, and it showed $1.79 billion in soured assets, a six-fold increase from the prior year. Its stock trades at $11 and has lost 75 percent of its value in the last year.
  • Fifty-five percent of Doral Financial (DRL) deposits are brokered. This bank has $9 billion in assets -- 8.5 percent of which are non-performing. Doral lost $318 million in 2008 and $46 million in the first quarter of 2009. And earlier this week, the SEC announced that it would pay $123 million to investors for its fraudulent accounting earlier in the decade. Its stock trades at $1.94 and has lost 86 percent of its value in the last year.

While there are other banks with higher levels of brokered deposits, these two have the benefit -- for short sellers -- of having high levels of bad loans which one would expect for a bank taking big risks to finance those higher deposit rates. The big unknown for investors considering shorting these stocks is whether there is more bad news to come that would further depress the stocks.

There's just one thing -- it is an outrageous failure of bank regulation that the FDIC would reward this kind of risky bank management by letting the banks pay low insurance premiums and thus shift the risk of failure onto the taxpayer.

You can profit from this moral hazard by depositing your money in these banks -- to earn the higher deposit rates -- even as you short their common stock on the assumption that they'll eventually sink into oblivion.

Peter Cohan is president ofPeter S. Cohan & Associates. He also teaches management at Babson College. His eighth book isYou Can't Order Change: Lessons from Jim McNerney's Turnaround at Boeing. He has no financial interest in the securities mentioned.

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