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MOST READ: How to Play Crumbling Financials

TheStreet.com Ratings takes a look at investors options, as the parade of bad news for banks continued Monday.

Financial stocks lately are taking a beating as the mortgage crisis persists, tempting many investors to attempt to call a bottom for the real estate market and for banks.

Do so at your own peril.

A brutal week for financial stocks last week continued Monday, as

Goldman Sachs cut its rating

TST Recommends

for the financial services industry to underweight from neutral and said that it was "clearly wrong" in upgrading the sector in May. That came on top of Merrill Lynch's report on Friday, which

lowered earnings estimates and price targets

for the largest regional banks. Merrill lowered price estimates for 12 large banks and predicted dividend cuts for four.

It certainly wasn't comforting when the Federal Deposit Insurance Corp. issued new rules last Tuesday for large banks to follow in maintaining deposit account records and customer information. These rules are designed to make it easier for the agency to determine which deposits are insured in the event of a bank failure.

Eventually there will be a bottom for home prices, followed by a bottom for the banks, but it seems clear we haven't hit either yet. In the meantime, let's take a look at a few troubled bank stocks and explore a few ways to play the banking sector right now -- if they dare.

Here are total returns for the banks covered in the Merrill report, along with the S&P 500 and S&P 500 financial stock indices:

Regional players were hit hard, with

Fifth Third Bancorp

(FITB) - Get Report

suffering the most as shares dropped 23% last week. This followed the company's

$1 billion preferred stock offering

, which was announced on Wednesday and priced on Thursday, with a coupon of 8.5%. Fifth Third's common shares have returned a negative 74.66% over the past year, surpassed only by

National City

(NCC)

, whose diluted common stock investors have lost 84.46% on their shares over the past year.

SunTrust

(STI) - Get Report

also had a terrible week, with shares returning a negative 15.60%. After Goldman Sachs last week predicted U.S. banks would need to raise another $65 billion capital, shares traded as low as $35.92 before recovering a bit later in the week when SunTrust issued a press release standing by its previous estimates of charge-offs for the second quarter and stating that it had no plans to cut its dividend or raise additional capital.

Merrill lowered SunTrust's earnings estimates to $2.40 for 2008 and $3.00 for 2009, from $3.45 and $4.

Regions Financial

(RF) - Get Report

, also mentioned in the Goldman and Merrill reports, dropped 15.51% for the week. Regions posted net income of $337 million for the first quarter of 2008, much improved from $71 million the previous quarter, however, this simply reflected a reduction in the quarterly provision for loan loss reserves, which was $181 million, down from $358 million in the fourth quarter.

Merrill expressed concern over the holding company's $15.5 billion in construction loans, and estimated losses of up to 5%, or $775 million, in 2009. Merrill also stated that it expected the holding company's second quarter 2008 provision for loan losses to be nearly double from the first quarter. If Merrill's projections are accurate, Regions will remain a weak earnings performer through 2009, with earnings per share of $1.40 for 2008 and $1.25 for 2009, down from previous estimates of $1.85 and $1.95.

On Friday,

The Wall Street Journal

reported

Bank of America

(BAC) - Get Report

was planning to complete its acquisition of

Countrywide Financial

(CFC)

on July 1. BofA shares closed down 4.5% on Monday to $25.88, a new 52-week low.

While it's easy to understand that Bank of America's desire to protect the $2 billion preferred stock investment it made in Countrywide last year and to become the leading U.S. mortgage originator, you would be very hard pressed to find anyone outside the company who

doesn't dread the acquisition

, at least over the short term. Merrill predicts cumulative losses of $11.37 billion on loan portfolios acquired from Countrywide.

Another thing to consider over the very short term is headline risk, from the recent reports of the involvement of key members of the Senate Banking Committee in Countrywide's

"friends of Angelo" lending program

, set up by Countrywide CEO Angelo Mozilo to handle VIP loan requests.

A Senate investigation of these relationships could get messy, considering that some of the senators mentioned are also involved in drawing up mortgage bailout legislation.

Close to a Bottom?

Bargain hunters have been probing for a

bottom in the financials

for some time. It's possible we are approaching a bottom for the housing crisis, evidenced by good news in certain regions where large homebuilders have taken drastic action to reduce the inventory of newly-built homes.

But as we are seeing with regional banks, pain caused by construction loan delinquencies, which are trailing home mortgage delinquencies, has yet to fully manifest. Even if we are close to the bottom, total loan delinquency numbers are likely to continue increasing through the end of 2008.

Quarterly provisions for loan losses are the biggest factor driving banking industry earnings down. Banks and thrifts earned a combined $19.6 billion for the first quarter of 2008, compared to an aggregate net loss of $208 million in the fourth quarter of 2007 and net income of $36.2 billion in the first quarter of 2007. The fourth quarter 2007 number was revised downward, as several large institutions revised their earnings numbers to reflect the impairment of goodwill carried over from expensive acquisitions.

Even though first quarter earnings this year were 46% lower than the same period in 2007, industry earnings are likely to suffer further since, by one measure, loan loss reserves remain at historically low levels. Reserves covered 89% of nonperforming loans as of March 31, which is the lowest level of reserve coverage since 1993, according to the FDIC. While 89% coverage is still a decent level, considering that most nonperforming loans are secured by real estate, there is continued pressure for elevated loan loss provisioning.

One Way to Play Banks Down Here

If you are adverse to shorting individual bank stocks, then Kevin Baker, TheStreet.com Ratings' mutual fund analyst, points out that you may want to consider investing in the exchange-traded funds that sell short large portions of the financial sector.

On June 12, ProShares launched the

Short Financials ProShares

(SEF) - Get Report

. This fund seeks returns opposite the daily performance of the Dow Jones U.S. Financial Index.

The new fund is a less aggressive version of the 200% negatively leveraged

UltraShort Financial ProShares

(SKF) - Get Report

targeting the same index that has been trading since February 2007. In the last year, the UltraShort Financials ProShares have nearly doubled in value, up 92.57% including a 34.42% rise year-to-date. This fund topped the

list

of best performing financial funds earlier this month.

Here are the largest positions in the long version of the fund, as of June 20:

To create the leverage, the fund portfolio includes nearly $1.17 billion notional value of swap contracts on the underlying Dow Jones U.S. Financial Index. The inverse fund's bets against the above stocks and against the index amount to a notional value of swap contracts reaching $4.56 billion.

TheStreet.com Ratings' Mutual Fund Analyst Kevin Baker contributed to this report.

Philip W. van Doorn joined TheStreet.com Ratings., Inc., in February 2007. He is the senior analyst responsible for assigning financial strength ratings to banks and savings and loan institutions. He also comments on industry and regulatory trends. Mr. van Doorn has fifteen years experience, having served as a loan operations officer at Riverside National Bank in Fort Pierce, Florida, and as a credit analyst at the Federal Home Loan Bank of New York, where he monitored banks in New York, New Jersey and Puerto Rico. Mr. van Doorn has additional experience in the mutual fund and computer software industries. He holds a Bachelor of Science in business administration from Long Island University.