Trouble for Regional Banks Ahead

04/22/2010 11:45 am EST

Focus: OPTIONS

Michael Shulman

Editor, Short-Side Trader

Michael Shulman, editor of ChangeWave Shorts, says the financial system isn’t out of the woods yet, and regional banks may be the next to face trouble.

JPMorgan Chase (NYSE: JPM) beat its numbers, and the other big banks will probably do the same. (Goldman Sachs Group, Morgan Stanley, and Citigroup all did—Editor.) Now the question is what happens to the banks in [the second quarter] and beyond.

My expectation at this point is that [the second quarter] will be fine, especially for investment banks with trading desks that generate huge profits from trading Treasuries and other bonds. [The third quarter], on the other hand, may well be a different story.

It will be the first step in the sorting out and sifting of the banks—money center versus investment banks versus regionals. The Street will be looking at the economic outlook for 2011 and will have much higher earnings estimates than it did for 2010, and will be focusing more and more on banks that have trading desks and investment banking operations that can generate profits—and also on those that do not.

[But] JP Morgan’s home equity write-offs rose to 4.59% compared to 3.93% in the first quarter of 2009; subprime charge-offs were 13.43% compared to 9.91% in the first quarter of 2009, and prime mortgage write-offs were 3.10% compared to 1.95% in the first quarter of 2009.

[Meanwhile,] more than one million mortgage holders who have not made a payment in several months (or more) have not been put into default and foreclosure. They are essentially living rent free while they wait for the other shoe to drop; and when that shoe drops, it will land squarely on the banks' balance sheets.

Which banks are most vulnerable to not just a weak third quarter but bad news coming even sooner? They are the regionals, which have huge exposure to commercial mortgages and no investment banking operations to offset losses.

Given JPMorgan's weak report from its commercial and consumer lending operations, it's hard to see the regional banks producing good numbers or forecasts any time soon.

For this reason, I am recommending buying puts on Huntington Bancshares (Nasdaq: HBAN) and KeyCorp (NYSE: KEY).

[Huntington] is a weak bank whose shares have more than doubled during the market rebound during the past year. Get positioned now on the short side for some big profits in the coming few months.

Buy the Huntington October 2010 5.00 Puts (HQB 101016P00005000) under 50 cents. (They traded around 25 cents Tuesday, while the stock closed above $6.50—Editor.)

Also buy the KeyCorp January 2011 7.50 Puts (XBM 110122P00007500) under $1.15. (They traded around 75 cents Tuesday, while the stock closed just below $9.) Please use limit orders only.

(Buying put options to speculate that a stock is going to fall is only for very risk-tolerant investors and traders who can afford to lose the money they’re investing—Editor.)

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