Using the Regional Banking ETF to Play Bank Mergers

Among the mess that was the global financial markets on Friday morning there was some very positive and indicative news. PNC Financial Services (NYSE:PNC) agreed to purchase National City Corp (NYSE:NCC) in a stock deal. Along with the merger announcement PNC revealed that it will issue $7.7 billion in preferred stock to the US Treasury under the TARP.

This deal makes PNC one of the first banks to choose to participate in the TARP and could provide a model for how banks intend to use the program. Instead of making loans with the money, PNC has elected to purchase a weaker rival and increase its capital base. This is a first step in repairing the global financial markets and will likely be followed by other deals.

In fact, the government may actually encourage more mergers. A Wall Street Journal report on October 21, 2008 (“US Rescue Fund is Likely to Foster Bank Takeovers,” WSJ 10/21/08) quoted a government official saying, “If a healthy institution is making an acquisition, we would look very favorably on that.”

This government encouragement and available capital has not been lost on healthy bank CEOs. On BB&T Corp’s (NYSE:BBT) Q3 earnings conference call, in reference to the TARP, CEO John Allison said,

We think there are going to be some acquisition opportunities, either now or in the future, and this is a relatively inexpensive way to raise capital.

The market rewarded PNC for this move, as it was one of the only financials that was up on the day. Again, this is a very interesting occurrence as acquirers usually fall on the deal announcement and the acquiree rises. The PNC bid for NCC was 7% below Thursday's close, which explains the sell off in NCC. However, the rise in PNC is a canary in the coal mine that may signal that in this wave of bank mergers the acquirer will be rewarded.

There are two ways to play this theme of bank consolidation. First, one can sift through every regional bank and determine weak and strong. Typically the value player would look to buy the potential acquiree, however, based on the pricing of this deal and on how the market reacted it makes sense to purchase the stronger banks.

The second and more efficient way to play the theme is to purchase the Regional Bank HOLDRS ETF (AMEX:RKH). This ETF holds both the strong and the weak banks and provides an opportunity to participate in any deal among these players. 

Regional Bank HOLDRs Composition

Company	Symbol	Current Weighting
Bank of America	BAC	7.17%
BB&T Corporation	BBT	3.59%
Bank of New York	BK	4.72%
Comerica	CMA	1.46%
Fifth Third Bancorp	FITB	1.61%
JPMorgan Chase	JPM	18.98%
KeyCorp	KEY	1.52%
Marshall & Ilsley	MI	1.13%
National City	NCC	0.46%
Northern Trust	NTRS	4.02%
PiperJaffray	PJC	0.21%
PNC Financial	PNC	6.18%
Regions Financial	RF	1.08%
Synovus Financial	SNV	0.81%
SunTrust Banks	STI	3.66%
State Street Corp	STT	4.36%
US Bancorp	USB	19.00%
Wachovia	WB	2.76%
Wells Fargo	WFC	17.27%

Source: www.holdrs.com

Since the components are market weighted the stronger banks will have a higher weighting as market players sift through the rubble and bid up the stronger companies.

The price action of the ETF suggests that market participants have similar thoughts. Earlier this month, during the equity market sell-off, RKH did not make a new low. This is significant given the fact it is loaded with financials and several of the companies reported substantial losses. Even though futures limit were down on Friday morning, the ETF still held above the October 10 low. 

The market weakness is providing one of those rare low risk entry points into RKH. As the weeks progress, we will most likely see more mergers and more uses of the TARP in this manner.

Disclosure: I have a long position in RKH.

Comments

[fatcat:]

KRE may be a better play for the authors scenario...

2008 Oct 26 11:57 AM

[fatcat:]

On second thought,KRE might be the short end of a pairs trade,if you use the author's thinking...

2008 Oct 26 11:59 AM

[MichaelZZ:]

Paraphrasing Isaac: Objects in motion tend to remain in motion, objects at rest tend to remain at rest, and to change either condition, requires energy.
In this case the energy factor should be effected by Congress by legislating the appropriate fiscal adjustments, i.e., immediately (do not wait until 2010) repeal those portions of the Bush tax legislations for those with taxable incomes in excess of $200,000 (arbitrary, i.e., could be $225M, $230M) and legislate permanent tax reductions for those with taxable incomes under $80,000.
This will be the energy factor, which will prime the engine of our economy. The longer it takes to do this, the more problematic will be the results.
A one-shot stimulus package will not work, as the recipients will pay down debt or add to savings due to insecurities, whereas a permanent tax reduction will mean that they will see their net paychecks increase and will have greater confidence. Unless consumers increase their collective confidence and spend, the situation will become much graver.
The parameters of the first traunch of $125 billion should be changed:
1) Only those institutions who want the funds should receive, i.e., none should be coerced into taking
2) The dividend rate should be changed to, at least 11%, for the purpose to stimulate the institutions to attempt to raise capital from private sources. They would know that they have the backstop of the 11% preferreds.
3) The conversion factor should be significant
4) As in the case of the Buffett purchase of GS preferreds, there should be substantial long-term warrants
5) The "fund" should be given seats on the Boards.
6) All dividends, other than any preferred stock dividends should be deferred for one year and will be re-assessed at the end of the year
7) There should be a moratorium for any bonuses and this will be reevaluated at the end of the first year
8) Those institutions which do not accept the "fund's" requirements and eventually fail, and which have exacted bonuses will place in civil and criminal jeopardy those recipients of the bonuses. The punishments will include imprisonments and the return of the bonuses plus substantial monetary penalties.
The common shareholders will be adversely affected (much of which has already been reflected), but that is appropriate.
Capitalism will be alive and well.

Michael Z.
Sherman Oaks
[e-mail]

2008 Oct 27 09:10 AM

[Armagedon:]

This is a silly article. How can you profit in an merger arbitrage by holding an ETF of the sector? Merger abritrage generally requires you to short the acquirer and long the target. This is because merger arbitrage is a ZERO SUM GAME. If you hold the ETF you both hold the target and the buyer = no gain

Maybe what the author intended to say is that if you buy the ETF you will benefit from a strengthening of regional banks through mergers... Unfortunately, this too does not make sense as the same principal applies.

The only way for this trade to work would be if large banks came and purchased the regionals at ABOVE market prices (not the now so popular take-under). Unfortunately, banks have no intention or balance sheet to pay for the regionals.

Conclusion - This trade idea requires an important quality control review.

2008 Oct 27 05:34 PM

[Armagedon:]

This is a silly article. How can you profit in an merger arbitrage by holding an ETF of the sector? Merger abritrage generally requires you to short the acquirer and long the target. This is because merger arbitrage is a ZERO SUM GAME. If you hold the ETF you both hold the target and the buyer = no gain

Maybe what the author intended to say is that if you buy the ETF you will benefit from a strengthening of regional banks through mergers... Unfortunately, this too does not make sense as the same principal applies.

The only way for this trade to work would be if large banks came and purchased the regionals at ABOVE market prices (not the now so popular take-under). Unfortunately, banks have no intention or balance sheet to pay for the regionals.

Conclusion - This trade idea requires an important quality control review.

2008 Oct 27 05:34 PM

[nyka:]

is, was, is, was, is, was. Why so many linking verbs? Upgrade your vocabulary. Employ vivid verbs in your writing. Otherwise, you risk putting your readers to sleep; make that a deep sleep.

2008 Oct 29 08:02 PM