Credit Concerns Dog Financial Funds

Now that many of the subprime lenders have already gone bankrupt, the Federal Reserve announced that it will begin to increase scrutiny of subprime lenders later this year. Better late than never.

The Dow Jones Industrial Average and the significantly broader S&P 500 both set new record highs this week. But the funds holding financial stocks fell an average of 1.47%, held back by credit concerns.

TheStreet.com Ratings senior bank analyst Philip van Doorn explains that "despite strong earnings, bank stocks have lagged in this bull market, mainly because of credit quality concerns." And that "mortgage backed securities could be a ticking time bomb for banks." No wonder investors are shying away from the sector.

The financial services fund that took the hardest hit was the (FGB Quote)First Trust/Gallatin Specialty Finance and Financial Opportunities Fund (FGB), which fell 5.06%.

The holdings of this fund are not disclosed on the company's Web site. But a footnote explaining the very high 7.15% expense ratio discloses that this fund may invest in "acquired funds" that "may pay performance based or incentive fees ... typically up to 20% of returns above a pre-determined hurdle rate." Or, in simple English, this closed-end fund may invest in hedge funds.

The (FF Quote)First Financial Fund is a closed-end fund that has been sliding lower since last November. It gave up 3.69% this week. Just under 80% of the fund's assets are exposed to the problems in the U.S. financial services sector. This is partially balanced by 5.1% in Switzerland, 3.7% in Bermuda, 3.5% in the U.K. and 2.1% in Canada.

Down 3.35% over the past five trading days, the (FBRSX Quote)FBR Small Cap Financial Fund (FBRSX) is heavily invested in savings and loans that make up 65.2% of the portfolio, with banks accounting for another 24.0%.

The fund's largest holding, Washington Federal (WFSL Quote)which comprises 10.33% of total investments, fell 3.68% this week. Another losing position, PFF Bancorp (PFB Quote), announced credit-related charges of between 48 cents and 51 cents per diluted share that likely contributed to the stock's 11.4% decline.

Worst-Performing Financial Funds Returns for the week ended July 19
Fund	Ticker	Rating	Fund Type	1 Week Total Return
First Trust/Gallatin Spec Fin and Finl Opportunities Fund	FGB	U	Closed-End	-5.06%
First Financial Fund Inc	FF	E+	Closed-End	-3.69%
FBR Small Cap Financial Fund	FBRSX	E-	Open-End	-3.35%
Ultra Financials ProShares	UYG	U	ETF	-3.23%
Burnham Financial Services Fund	BURKX	E-	Open-End	-3.05%
Alpine Dynamic Financial Services Fund	ADFSX	U	Open-End	-3.03%
John Hancock Bank and Thrift Opportunity Fund	BTO	D+	Closed-End	-2.96%
ProFunds Banks UltraSector ProFund	BKPIX	E	Open-End	-2.83%
First Trust Financial AlphaDEX Fund	FXO	U	ETF	-2.65%
iShares Dow Jones US Broker Dealers Index Fund	IAI	B-	ETF	-2.43%
Source: Bloomberg

The best-performing financial sector fund this week is the UltraShort Financials ProShares(SKF Quote), which, as its name suggests, bets against the sector. It is designed to increase by twice the daily percentage decline of the Dow Jones U.S. Financials Index. The strategy returned 3.24% over the period.

The WisdomTree International Financial Sector Fund (DRF Quote) squeezed out a gain of 1.10% by completely avoiding U.S. stocks. It allocates 23.5% of assets to the U.K., 11.8% to France, 11.8% to Australia, 9.8% to Italy and 8.1% Spain. At 6.4% of assets, HSBC Holdings PLC is the fund's largest holding, followed by Banco Santander Centra at 3.9%.

Best-Performing Financial Funds Returns for the week ended July 19.
Fund	Ticker	Rating	Fund Type	1 Week Total Return
UltraShort Financials ProShares	SKF	U	ETF	3.24%
WisdomTree International Financial Sector Fund	DRF	U	ETF	1.10%
Hartford Global Financial Services HLS Fund	HFIAX	U	Open-End	0.46%
Hartford Global Financial Services Fund/The	HGFAX	C	Open-End	0.35%
PowerShares Financial Preferred Portfolio	PGF	U	ETF	0.10%
Century Shares Trust	CENSX	E-	Open-End	-0.17%
Saratoga Advantage Trust/The - Financial Services Portfolio	SFPAX	E+	Open-End	-0.31%
iShares S&P Global Financials Sector Index Fund	IXG	B	ETF	-0.31%
Claymore/Clear Gbl Exch Brokers & Asset Mgrs Index ETF	EXB	U	ETF	-0.62%
Senbanc Fund	SENBX	E	Open-End	-0.63%
Source: Bloomberg

Defaults on large construction loans to builders may be in the next wave of financial sector woe. Last week at an Orlando homebuilders' conference, Florida Governor Charlie Crist joked that "it's like we have a new state bird: the building crane." New Miami condos are increasingly getting harder and harder to sell. There is a glut of them available competing with existing homes for sale.

Banks have stopped approving loans for new building projects. But more condos are still being built, since the construction financing was already in place before the real estate recession began. Would-be buyers are finding that it is cheaper to walk away from their deposit and buy elsewhere than to close on the property at the pre-construction price.