Regional bank stocks are getting clobbered. Ever since the collapse of Silicon Valley Bank two months ago, nobody on Wall Street wants anything to do with the sector.

At the end of February, the SPDR S&P Regional Banking ETF (KRE) closed above $61. On May 2, the day after JPMorgan Chase (NYSE: JPM) announced that it would acquire what’s left of First Republic Bank (NYSE: FRC), it closed below $39.

If you’re doing that math, that’s a decline of 36% in just nine weeks. The last time KRE traded this low was during the depths of the coronavirus pandemic three years ago.

Back then, COVID-19 all but shut down the global economy. And with no vaccine in sight a that time, Wall Street’s aversion to regional banks was justified.

This time, it is a virus of a different sort that is threatening regional banks. Even worse, the cause of the disease was self-inflicted.

By law, a bank must keep 10% of its deposit base in reserves. The rest can be lent out to earn a profit on the interest rate spread between savings and loans.

In an effort to stretch for profits, some regional banks invested their reserves in long-term Treasury securities for the (slightly) higher yield. Normally, there would be nothing wrong with that.

But the past year has been anything but normal. The Fed jacked up interest rates, pushing bond prices considerably lower.

That is a problem when depositors lose confidence in a bank and start pulling out their money. The bank must sell its bonds to come up with cash. When those bonds are sold for a big loss, the bank can quickly run out of money.

The End is Near

I don’t know when the run on regional banks is going to end. But I do know that it will end, and when it does there will be a lot of money to be made.

The regional banks that survive this mess will be stronger as a result. They will also be severely undervalued by the stock market.

The simplest way to participate in a rally by regional banks is to buy shares of KRE. Even if it regains only half of what it has lost this year, that would equate to a gain of 25%.

The potentially more lucrative, and much riskier way to play a bounce in KRE is to buy call options. A call option increases in value when the price of the underlying security goes up.

Last week while KRE was trading near $37, the call option that expires on December 29 at that strike price could be bought for $6.

For this trade to be profitable, KRE must rise above $43 before the end of this year. If it recovers half of what it has lost this year and makes it back to $50, the return on this trade would be 100%.

Believe it or not, the $55 call option that expires on the same date is getting a lot of action. It doesn’t cost much, about 50 cents, but KRE would have to recover nearly everything it has lost for that trade to produce the same turn on investment.

I don’t think that is likely to happen. But I do believe that regional banks will bottom out soon and steadily recover during the second half of this year.

A Game of Musical Chairs

To hear Fed Chair Jerome Powell tell it, the regional banking crisis may be close to over. During a press conference on May 3, Powell said that JPMorgan’s purchase of First Republic’s assets and deposits “is an important step toward drawing a line under that period of severe stress.”

Okay, so that’s not exactly the same thing as saying that the crisis is over. But it does imply that he does not want to see many more banks cross over that line.

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And what Jerome Powell wants, he usually gets. Over the past two months he has engineered shotgun weddings for the regional banks that he considers to be the most vulnerable.

If Powell must arrange another forced marriage or two to keep the regional banking sector from collapsing, he will. The same banks that were criticized for being “too big to fail” fifteen years ago are now being called on to save depositors of the banks that are now too small to survive.

Until recently, the banking sector was about the last place you would look to for a potentially lucrative options trade. Their share prices tend to move slowly. But now, the banking sector has become a game of musical chairs.

I don’t expect this game to last much longer. The next time the music stops may be the last time. Opportunities like this don’t come along often. But when they do, they can deliver outsized gains for investors daring enough to claim their chairs before Wall Street decides to take a seat at the table.

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