Short interest in the big banks have doubled but guess which is the most shorted bank?

Growing concerns about the quality of the mortgage book of Westpac Banking Corp (ASX: WBC) and its peers are likely to fuel increase interest from short-sellers looking to profit from further drops in the share prices of our big four banks.

Even before yesterday’s fiasco that saw Westpac’s share price tumble 3.6% to a two-year low of $28.13 on the belief that Westpac has the most lax lending standards among big bank lenders (click here for details, short interest in the sector had already doubled in the March quarter.

Short interest is the amount of shares that short-sellers have borrowed. Short-sellers are traders who borrow stock to sell on-market in the hope of buying it back later at a lower price to profit from the difference.

The analysts at Macquarie Group Ltd (ASX: MQG) noted that short interest in the sector had increased to 1.4% of total shares on issue that is worth $6 billion in the March quarter from 0.7% in the previous quarter (or $3.8 billion).

What is interesting is that Westpac is the most shorted stock among the big banks with around 1.8% of its stock short-sold and that is before news of its more relaxed approach to lending came to light!

Westpac can also lay claim to a second dubious title. Short interest in the embattled bank increased by around $700 million or 0.9% – the most among the big four that includes Commonwealth Bank of Australia (ASX: CBA), National Australia Bank Ltd. (ASX: NAB) and Australia and New Zealand Banking Group (ASX: ANZ).

It also appears that only local investors are keen to buy big bank stocks on the dip with the sector underperforming the S&P/ASX 200 (Index:^AXJO) (ASX:XJO) due to concerns raised at the Banking Royal Commission, slowing credit markets and rising cost of funding for the banks.

“Our analysis suggests that after two quarters of building their positions in banks offshore investors were marginal net sellers in 1Q18,” said the broker.

“Domestic institutional investors were net sellers of ANZ/CBA and net buyers of NAB/WBC. Retail investors continued their trend of buying into weakness across all of the majors.”

The good news is that Macquarie thinks that all the bad news is in the price and is recommending investors go overweight on the sector.

On the other hand, the broker did acknowledge that there is a lack of obvious catalysts that could trigger a re-rating in the sector. This means share prices of the big banks could stay depressed for a while yet.

I hope Macquarie is right as I hold shares in three of the big four banks. But I am not holding my breath as I think more water will need to pass under this bridge before I will start crossing again.

UBS’s downgrade of Westpac to “sell” yesterday is a good start though. I want to see more analysts take a razor to their estimates before I start thinking about whether I should add to my underweight position in the big banks.

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Motley Fool contributor Brendon Lau owns shares of Australia & New Zealand Banking Group Limited, Macquarie Group Limited, National Australia Bank Limited, and Westpac Banking. The Motley Fool Australia owns shares of National Australia Bank Limited. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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