How to Play the 'DONK' Financial Bill

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U.S. Banks Go Ba-DONK!

You will not see this on the front page of the Wall Street Journal, but last evening, Moody’s warned that the Dodd-Frank Bill (a.k.a. DONK) could have significant negative impact on U.S. bank ratings. The primary goal of DONK is to eliminate”too-big-too-fail” by explicitly stating that the government will not bail out systematically important financial institutions. To our mind, we did not need legislation to end “too-big-to fail”, all the Fed/Treasury has to do is refuse to bail-out troubled institutions… As far as we can tell there was no legislation requiring bail-outs. Perhaps this line of thinking is why our playground is the financial markets and not Washington D.C.

We digress, back to the matter at hand.

The thrust of Moody’s report was that U.S. bank ratings (both commercial and regional) had been boosted by several notches due to implicit government support. Now that DONK aims to explicitly end support of systematically important financial institutions, banks ratings are too high. While Moody’s did not cut ratings, it reserved that pleasure for the next few months as DONK is fully implemented.

In essence this change will likely lead to higher borrowing costs for banks as lower rated credits pay more for financing. In turn, this cost will be borne by the customer, if the cost cannot be passed on to the customer then bank profit margins will get squeezed. At this point in time, demand for credit is waning, even at historically low rates. It is counter-intuitive to think that higher rates will result in more demand!!!

Our preferred play on this theme is a short position in the Regional Bank ETF (NYSEARCA:RKH). The RKH is currently poised at a resistance point and offers a great risk reward entry point.

Click to enlarge:

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Upon the opening of trade we shall be entering a short position and will be using an $81 stop loss.