What is your general outlook for the financial sector at this time?

We are assuming that GDP growth will be slightly negative for the next 3 or 4 quarters, though the credit markets will begin to function again. Not much can be done about the fundamental cause of the crisis -- the steep decline in the housing prices (we may only be halfway through the decline), which will continue to hurt the profitability of all financial institutions that hold mortgages and mortgage-backed securities.

Isn't part of the problem how banks are doing business with each other?

Banks still do not have trust each other, and the moves by the Treasury and Fed to get the banks to start lending to each other have failed so far. The U.K. government took the big step of providing guarantees on interbank loans. The U.S. regulators will also follow suit in guaranteeing the interbank loans as also temporarily insuring all U.S. bank deposits.

We expect that the regulators will allow the weaker companies to fail and support the stronger firms to take over their assets. There will be a lot less competition in the industry.

What signs will you be looking for that a real recovery is taking place?

Once the bailout program is in place, capital infusion will strengthen the balance sheets, bad assets will be removed from balance sheets and credit will begin to again flow. Also, the Fed is expected to lower interest rates further, which will help the banks with a liability-sensitive balance sheet.

On the negative side, forced dilution resulting from the Government's action and continued credit losses will hurt the shareholders.

Assuming you have banks under coverage worthy of investors' dollars, what types of banks would they be?

We prefer those with low exposure to housing/real estate loans and/or which derive a significant portion of their earnings from fee based sources. Those with higher exposure to housing/residential construction loans, such as KeyCorp (KEY), National City (NCC), Zions Bancorp (ZION), Comerica (CMA) and Wilmington Trust (WL) will continue to be under pressure.

With most banks winding up their riskier mortgage loans business (subprime and no documentation loans), the profitability of mortgage business will be significantly lower. Further, as the housing turmoil is affecting the consumers in general, we now see higher losses in other asset classes as well. Tighter lending and underwriting norms will limit the lending activity of the banks and further hurt profitability. Student lenders like Sallie Mae (SLM) face increased higher funding and credit costs, which will continue impacting the profitability of the company.

Neena Mishra is a senior analyst covering the financials industry for Zacks Equity Research.