One trade I have been extremely bullish on is a long position on the KBW Bank Index [KBE: 18.71, (0.00%)] while  shorting the KBW Regional Bank Index [KRE: 21.09, (0.00%)].  This trade has worked out very well ever since I wrote on RealMoney’s Columnist Conversation with the trade.  The play is betting on the relative out-performance of the large cap banks compared to smaller regional banks.  The trade is unique in the sense that you are hedging your downside risk by shorting the Regional Bank Index, but profit when the spread widens.

In more detail, the KBE is an ETF of the 20 largest banking institutions in the U.S.  Players like Bank of America [BAC: 11.31, (0.00%)], Wells Fargo [WFC: 25.69, (0.00%)], J.P. Morgan, US Bancorp, and Bank of New York Mellon [BK: 28.44, (0.00%)] make up the top five holdings of the security.  The KRE ETF replicates the KBW Regional Banking Index, which is an equal weighted index of over 50 geographically diverse regional banking institutions.  Top players in the KRE include First Niagra Financial Group [FNFG: 12.66, (0.00%)], WestAmerica Bancorp [WABC: 53.49, (0.00%)], TCF Financial [TCB: 14.60, (0.00%)], Hudson City Bancorp [HCBK: 12.63, (0.00%)], and City National [CYN: 39.19, (0.00%)].

After the Fed’s report on the results of the “stress test”, it has become quite apparent who the strong players in the industry are.  The large players such as J.P. Morgan Chase [JPM: 35.54, (0.00%)], Goldman Sachs [GS: 133.60, (0.00%)] and even Citigroup [C: 3.55, (0.00%)] had better than expected results.  Two large banks, Bank of America [BAC: 11.31, (0.00%)] and Wells Fargo [WFC: 25.69, (0.00%)], had surprising results where the government reported they needed additional capital (more than analysts were anticipating).  I would argue that this was expected considering the model inputs which fed officials were using to measure loan losses in these firm’s respective portfolios.  Both BofA and Wells Fargo have made large risky acquisitions with BofA acquiring Countrywide Financial and Merrill Lynch and Wells Fargo acquiring Wachovia.

Some of the smaller large cap banks such as FifthThird [FITB: 7.52, (0.00%)], KeyCorp [KEY: 5.93, (0.00%)], and Suntrust [STI: 15.03, (0.00%)] were all among the smaller players which will be required to raise their capital ratios.  These reports from some of the larger regional banks are a signal of what is likely to come; more consolidation in the industry.

Over the course of the past month, the KBE has returned almost 16%, with the KRE only returning about 2%.  With this play, you would have profited 14% with hedged downside protection.  The play will continue to work as long as the large-cap banks can remain profitable with net interest margins increasing and asset prices continue to rise closer to normal levels.  Capital is flowing much better than the situation we were in only a few short months ago.  This is great news for the large-cap banks and the financial industry.  What is not a good sign for regional banks is the struggling results that many of them have been posting this past quarter.  Many of these regional banks are hurting from large writedowns (in the hundreds of millions) relative to their asset base.  Many regional banks continued to lend frivolously in the later half of 2007 and a majority of 2008 as they raced to increase their revenues.  Many of these banks have and will issue new equity through public offerings, which will dilute current shareholder ownership.

A safer play than either of these two ETFs would be to bet on the spread between the KBE and KRE.  By going long the KBE and shorting the KRE, you can be assured that your money is protected with a downside (short) protection.  This play will likely work for the next couple of weeks as investors and analysts figure out the full damage of the stress test results and how they affect the entire industry.  For now, invest in a play that has been working and will continue to work.