Don’t Jump Into This Red Hot Sub-Sector

| March 12, 2010 | 0 Comments

On the third Tuesday of every month, I’ve got to put my money where my mouth is.  That’s when I send out my new ETF recommendations to subscribers of my Sector ETF Trader service.

As my deadline closes in, I’m feeling pretty good.  You see, as I pour through the economic data and look at all of the charts, I think I’ve found two ETFs set to soar over the next few months.

But there’s one ETF I’m staying away from.  And you should too.

It’s a tough call because this sub-sector’s been red hot lately.  But I just don’t see its run continuing.

The sector I’m talking about is regional banks.  And the ETF that tracks them is the SPDR KBW Regional Banking ETF (KRE).

KRE invests equally into 52 mid-size banks.  These banks are smaller than the big money center banks like Bank of America (BAC) or JP Morgan Chase (JPM), but larger than a community bank.

Regional banks bread and butter is very simple.  They take deposits and make loans.

For the most part, they’re not international banks, they don’t run trading desks, and they don’t have huge portfolios of derivatives.  They leave that funny business to the larger money center banks.

KRE’s shot up over 15% since February 5th…

But there’s a problem.  Regional banks are facing serious headwinds.

The number of FDIC insured “problem banks” is growing.  As of December 31st 2009, 702 banks are considered problem banks.  In just the first two and half months of 2010, we’ve already had 26 bank failures!  And the FDIC expects the problems to get worse before they get better.

Here’s why their problems are going to get worse.

Massive write downs are coming in commercial real estate.  Regional banks have the biggest exposure to commercial real estate commitments.

Regional banks fell in love with risk valuation, credit quality, and stress testing models.  For too long, overconfidence in the models lulled them into a false sense of security.  As a result, regional banks started adding too many commercial loans to their balance sheets.

When the bottom fell out of the economy, the models of risk management proved to be worthless.  Good and bad companies alike went down in flames.  And loans started to go bad quickly.

Bankers sprung into action to save collapsing loan portfolios.  They’ve been playing games the last two years to prevent their own demise.

The game’s called “extend and pretend”.

Loans close to default are being modified to prevent them from defaulting.  I’ve heard some pretty crazy stories about payments being cut to less than an interest only payment or deferred altogether.  The key is extending the term of the loan without re-qualifying the borrower.

This is just kicking the can down the road.  Eventually the write offs will have to be taken.

At the same time though, business and property values are falling.  The collateral for many commercial loans is now worth less than the loans made against them.  In other words, they’re underwater.  And those losses get bigger everyday as the collateral continues falling in value.

Foreclosure or forcing bankruptcy will result in the write downs bankers don’t want to take.  So they continue to extend and pretend.  Even if they’re facing bigger potential write downs in the future!

The regional banks’ (temporary) saving grace is extremely low short term interest rates.  The large net interest rate spread has boosted profits and earnings.

Here’s the problem with earnings generated from low interest rates…

Once the economy improves, interest rates are going to rise.  The net interest rate spread is going to shrink and the profitability of these banks is going to disappear.  And, they’re still going to be sitting on a mountain of unrealized loan losses.

Now, don’t expect income from new loans to recover anytime soon either.  Most commercial loans are originated with front loaded fees.  This fee income is a big driver of regional banks’ profitability.

Despite rhetoric from Washington DC about increasing loans to businesses, new loans aren’t being made.  That’s because banks are being forced by the FDIC to tighten their underwriting standards.

There’s an odd dynamic at play.

Politicians are campaigning for the banks to lend more money.  But the government’s regulatory body is preventing loans from being made.  In other words, politicians want money lent to borrowers who are deemed too risky by the FDIC.

It all adds up to a potential disaster for the regional banks.

So despite their impressive 15% run over the last month, don’t buy the hype.  Regional banks have a huge hill to climb before than can return to profitability (at least without 0% interest rates and accounting gimmicks).

Between now and then, some of these banks are going to fail.  And when they do, it will spook investors and send the entire sector plummeting.

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Category: ETFs

About the Author ()

Corey Williams is the editor of Sector ETF Trader, an investment advisory service focused on profiting from ETFs and the economic cycle. Under Corey’s leadership, the Sector ETF Trader has become one of the most popular and successful ETF advisories around. In addition to his groundbreaking service, Corey is the lead contributor to ETF Trading Research, where he shares his insights about ETFs and financial markets on a daily basis. He’s also a regular contributor to the Dynamic Wealth Report and the editor of one the hottest option trading services around – Elite Option Trader.

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