FDIC Red Cards Regional Banks

This column was originally published on RealMoney on April 28 at 3 p.m. EDT. It's being republished as a bonus for TheStreet.com readers.

The red-hot real estate market has fueled tremendous growth for community banks across the country, but this trend appears ready to turn, and they could be left with portfolios riddled with bad real estate loans. With the shares of many trading at or near all-time highs, the prudent investor should book profits now.

Community banks are heavily dependent on fees and interest income from real estate loans. As the housing market slows, fee income will decrease and the risks associated with nonperforming loans will increase.

Furthermore, the Federal Deposit Insurance Corporation is waving warning flags -- many banks' balance sheets have exceeded key capital ratios that measure real estate risks.

Long-term investors should use strength to liquidate holdings in case the real estate market deteriorates more than expected. Why take the risk when you can book profits at or near all-time highs?

Regional banks were buoyed Thursday by Federal Reserve Chairman Ben Bernanke's hints that the FOMC would pause in its rate-hike policy after raising the funds rate to 5% on May 10. This led to a breakout in the Philadelphia Banking Index, or BKX, which tracks the regional bank industry, and the Bank HOLDRs Trust (RKH Quote), an ETF that is a proxy for the industry.

CNBC reported Friday that several brokerage firms raised their ratings on regional banks on the theory that they will benefit six months after the FOMC stops raising rates. I say they are wrong: The FOMC may pause, but that does not mean that the rate hikes are over.

My strategy questions the ability of these indices to sustain their breakout. One reason is that the homebuilders are developing cracks in their foundations. It will be difficult for the banks to sustain earnings growth, given the warnings from the homebuilders. Furthermore, the risk of balance-sheet damage now at the regional banks from their exposure to the real estate market should not be ignored.