2023-05-04 09:28:24 ET
Summary
- KRE is an exchange traded fund that holds regional banks equities.
- The fund is down over 40% in the past year, and has been greatly impacted by the current bank failures.
- Things might get much worse for regional banks before they get better.
- The article gives a retail investor an options based strategy that offers a 14% discount to current spot prices.
Thesis
We are in the midst of a banking crisis. There is no doubt about it, and before this is over we are going to have yet another one or two restructurings. With the largest banks 'out of the way' so to speak, the distressed entities at hand might just get significant equity capital infusions rather than go through FDIC take-overs:
Bank Failures (NY Times)
The bank failures this year have been very large. That was part of the problem. Equity infusion deals could not have worked just because of the sheer size of the asset base. Potential suitors wanted to pay a 'mark-to-market' price which was significantly lower than what the equity was worth.
As we are writing this article PacWest Bancorp ( PACW ) is down over -40% in pre-market, after signaling they are exploring a capital infusion . Furthermore legacy deals such as the TD take-over of First Horizon ( FHN ) seem to have gone out the window , with FHN down over -15% in the past 5 days, and sporting a rough $15/share price, much lower than the advertised $25/share takeover price.
Macro Set-Up for Regional Banks
At its core, a commercial bank makes money by borrowing cheap and lending at higher rates. A bank 'borrows' via deposits (when you put your money in a bank you become a lender) and then issues mortgages or commercial loans in order to make money. The difference between what it makes on its loans and what is paid on the deposits is called net interest margin.
Keep in mind we have moved from a zero rates environment to a 5%-5.25% Fed Funds rate in a little bit over a year:
Fed Funds History (Federal Reserve)
The net impact to banks is that the deposit side (i.e. where banks borrow) has become increasingly expensive, while on the lending side they are sitting on many legacy loans and mortgages which are yielding much lower rates than 5%. This will result in a significant net interest margin compression until the Fed starts lowering rates. Also expect larger loan loss provisions. The picture is not pretty. It is going to get worse before it gets better.
Should you invest in regional banks?
If you are thinking about investing in regional banks for the long term, do expect more weakness. Timing is impossible in financial markets, therefore, in our mind, the best way to take a long position in the SPDR S&P Regional Banking ETF ( KRE ) is via options. Our solution involves a cash covered put strategy, where an investor takes advantage of the very high implied volatility in order to take a position at a much lower entry cost, if the price keeps going lower.
Writing cash covered put options at this stage is an ideal way to forgo timing issues, and secondly not be overly stressed out if the market keeps going down due to the embedded buffer in the purchase price. This is a smart way to take a long position in the current environment.
KRE Top Holdings & Pre-Market Action
The ETF's top holdings are as follows:
We can notice these names make up over 30% of the fund currently. Let us have a look at the pre-market action on some of the names:
- NY Community Bancorp ( NYCB ): down -2.55% pre-market
- First Horizon Corporation ( FHN ): down now -42% pre-market, on the back of the now announced cancelled TD take-over
- Western Alliance ( WAL ): down over -16% pre-market as this entity is in the cross-hairs of the depositor flight issues
We can see how the top holdings in this fund are under increased pressure, with no bottoming-out process having formed yet.
What is the trade?
We are putting forward the following trade:
Potential Trade Idea (Author)
A retail investor can sell 3 put contracts for KRE with a December 29, 2023 maturity date. The net potential exposure is $9,885 when accounting for the premium (i.e. you need to have $10,000 in cash in your brokerage account). If the price for KRE is above $37/share on expiration date, the retail investor will not be long the name, but will have realized a 16.5% annualized yield. Conversely, if the price keeps plummeting and investor ends up purchasing the name at $32.95/share, or a price which is lower by 14% when compared to today's price.
Scenario 1 - the KRE price on Dec 29, 2023 is below $37/share
- The put options get assigned
- The investor will be long 300 shares of KRE at an entry price of $32.95/share
- The entry point is lower by 14% when compared to today's level
Scenario 2 - the KRE price on Dec 29, 2023 is above $37/share
- The put options expire worthless
- The investor realizes the premium of $1,215
- The amount gained represents a 16.5% annualized yield when compared to the amount set aside as cash
Conclusion
You might have heard the expression 'don't catch a falling knife'. We are of the strong opinion it currently applies to KRE. From a fundamental standpoint the profitability of the sector is contracting, and it will continue to do so until the Fed starts lowering rates. With challenges, opportunities also arise. None of the market participants know where the bottom is for KRE, but with a -40% drawdown in the past year, the sector is approaching its 2020 levels. In our opinion, a retail investor interested in buying KRE here as a long term hold, is better served by doing it via options.
The article discussed a cash covered put idea that takes advantage of the current high implied volatility in the name. An investor can obtain a 14% discount to current spot prices via this strategy, or obtain a 16.5% annualized yield on the cash set aside for the potential trade.
For further details see:
KRE: Are You Thinking About Buying Regional Banks? Consider Options