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By Mike McDermott

When considering the health of the U.S. financial industry, most traders immediately think of the large money center banks and blue-chip brokerage operations. After all, these are the institutions that have been primarily responsible for the financial crisis in the U.S. and across the globe.

But from a trading perspective, the smaller regional bank industry may offer better setups and profit potential.

As a general rule, regional banks operate simpler businesses focused on deposits, lending and other traditional banking functions. Proprietary trading, loan securitization, derivative exposure and esoteric profit centers are usually not a major concern when it comes to the regional banks.

With fewer behind the scenes issues to worry about, regional banks trade more in line with the underlying fundamentals of their primary business lines. In other words, the group's trading patterns follow traditional relationships to interest rate shifts, real estate prices, and the health of each institution's client base.

Today, we're going to take a look at the SPDR KBK Regional Bank (KRE) ETF which tracks a diverse basket of regional banks. With rates likely on the rise and sustained real estate weakness, the ETF and the underling group is setting up for an attractive short opportunity in the weeks and months ahead.

KRE – A Diverse and Equal Weighted ETF

The SPDR KBW Regional Banking ETF is considered an "equal weight" basket and is made up of 49 different bank positions. The ETF's largest holding is SVB Finanicla Group (SIVB) which accounts for just 2.92% of the fund assets. Adding the top 10 holdings together makes up must 26% of the entire ETF, so no one particular bank will cause an exceptional movement in the broad vehicle.

This diversification is important for traders seeking to capitalize on the overall trend of regional banks. A diverse equal weight ETF insulates traders from company specific risks (and returns) such as a bad portfolio of loans, weakness in that bank's particular geographic footprint – or on the bullish side, a takeover offer or unexpectedly positive earnings announcement.

So for this reason, KRE is an excellent vehicle for speculating on the regional bank industry, while trading individual stocks within this ETF is more appropriate for traders with a deeper knowledge of company specific metrics.

Macro Headwinds for Regional Banks

The fundamental outlook for U.S. regional banks is closely tied to the real estate market. Across the country, regional banks are sitting on portfolios of both commercial and residential real estate loans that are vulnerable to another round of valuation pressures.

As long as homeowners, property developers and local businesses continue to make principal and interest payments on the loans, the value of these assets can remain stable.

But as foreclosure rates rise, banks are forced to write down the value of these portfolios. As loan valuations are written down, banks' capital ratios are affected (asset values are lowered while liabilities remain stable). Without enough of a capital cushion, these devaluations can send financial metrics below regulatory standards.

This is when the FDIC steps in to take over the assets of the banks and protect depositors. So far this year, there have been 40 banks taken into receivership or forced to merge because of insolvency.

More importantly, the number of banks in danger of failing continues to grow. This from the most recent FDIC Quarterly Banking Profile:

The number of institutions on the FDIC's "Problem List" increased from 860 to 884 in the fourth quarter. Total assets of "problem" institutions increased from $379 billion to $390 billion.

~FDIC Fourth Quarter 2010 Report

For investors in the large money center banks, this figure is not such a big problem. The federal government has shown a willingness to embrace moral hazard and bail out financial institutions that are deemed "too big to fail." In doing so, the Fed has actually increased the risk profile of these banks because of the implicit guarantee at the expense of taxpayers.

But regional banks don't share the same importance – or guarantee from the government.

As interest rates begin to tick higher, regional banks will likely see profit margins constricted. Borrowers using variable rates will face higher financing costs, leading to higher delinquency and charge off rates. The next few quarters could be an extremely challenging period for the regional banks which have survived up to this point.

This week, the National Association of Homebuilders reported its housing market index is still at 16. To put this number in perspective, a level of 50 represents a flat environment, so we are currently in a sharp contraction (and have been for months on end). The last time the index was above 50 was April of 2006.

The Technical Picture

After coming off the lows in the final months of 2010, regional banks have traded in a narrow range this year. Low interest rates have helped to pad profit margins for the group, and a modest economic recovery has masked underlying loan problems.

This week, the index has tested the support area near $25.50 and rebounded from this level. The confirmation of a price floor for the group may very well entice new capital flows into the group.

But watch the action carefully over the next few weeks. If KRE is not able to retake the 50 day average (gold line), it will be a minor loss for the bull camp. If the ETF slides below the 2011 support line, all bets are off. A short position from this level could have a very high reward to risk ratio. A tight risk point could be used (as a rebound back above the support level would be bullish) while a short position could be allowed to run into the low $20′s


(Click to enlarge)

Source: A Look at the SPDR KBK Regional Bank ETF