When the financial bomb went off in the fall of 2008, it damaged or destroyed nearly everything in its path. Banking stocks (and banking ETFs) were near the epicenter of the blast, and therefore suffered significant damage. But even within the banking sector, there is a huge discrepancy in the returns generated by various types of financial institutions. While some types of banks have begun to prosper, regional bank ETFs have been among the hardest hit in our Financials ETFdb Category, and face a tough road to recovery. Two regional bank ETFs, the iShares Dow Jones U.S. Regional Banks Index Fund (IAT) and the SPDR KBW Regional Banking ETF (KRE) are down roughly 16.4% and 29.7%, respectively, year to date. Meanwhile, XLF, an ETF holding a sizable stake in large banks such as J.P. Morgan, Wells Fargo, and Bank of America, is up over 23% year to date. This large disparity can be traced back to two interrelated issues: TARP repayment problems and the depletion of FDIC reserves.
Stuck Under the TARP
While a majority of the banks comprising the top 5 holdings in each of these ETFs have repaid TARP funds, some look like they will be unable to do so for quite some time, and will have to make the interest payments on their debt to the government. PNC and SunTrust, which make up a significant portion of IAT, owe 41.2% and 45. 5%, respectively, of their market capitalizations to the government on TARP funds. Of KRE’s holdings, First Horizon Bank and WestAmerica Bank owe about 32% and 6%, respectively, of their market capitalization to the government. With such high percentages, it is difficult to see much upside to these banks without first experiencing significant dilution to their common shares.
FDIC: Running On Empty
Another cause for concern for regional bank ETFs is the current status of the FDIC, which currently has $10.3 billion in its reserve fund, the lowest since 1993. While $10.3 billion might seem like a decent backstop to any near term problems, keep in mind that the FDIC insures $13.3 trillion in assets across the country, leaving a razor thin margin of safety of just .22%. While it is extremely unlikely that depositors would lose any money (since the FDIC has a line of credit available from the Treasury of over $100 billion), the need to tap this reserve would undoubtedly shake investor confidence in the banking system and could even lead to a run on the bank. If that happens, an uptick in prices for precious metals such as gold (GLD, IAU) or silver (SLV, SILV) is a likely outcome as people turn to tangible assets as a way to safeguard their wealth (sign up for our Free ETF Newsletter for more information about investing in gold and silver ETFs).
There are, however, some reasons to be optimistic about an investment in regional bank ETFs. These funds do deliver excellent dividend yields: KRE is yielding 6.0%, compared to XLF at 3.7%. If the economy continues its recovery, regional bank ETFs could stand to benefit the most since they have been so thoroughly beaten down over the past year. So these funds may be appropriate for investors with a long time horizon who are willing to reinvest their dividends. These investors could see large gains in the future if the banking sector stabilizes as some are predicting. Also, recent FDIC proposals have called for the authority to breakup large financial institutions. Such actions may make level the playing field, allowing regionals to compete for customers.
Regional bank ETFs look to be in for a rough end of the year as the list of troubled banks grows ever larger and consumers consider jumping to the few banks that are ‘too big to fail.’ While the potential for huge gains in the regional banking sector exists, huge risks are also present. Make sure you have a large appetite for risk, and the desire to ride out any future financial storms on the funds’ decent dividend yields before investing in any of these ETFs.
Disclosure: No positions at time of writing.