As we begin a new month and a new quarter financial stocks are flying. After the disastrous first quarter, the market seems to want to put the losses and bad news behind them and move forward. The question is should they?

Sometimes, as long term investors, we need to take a step back and look at what is happening instead fo what we hope is happening. This morning UBS AG (UBS) was out with its earnings report. It was so bad the chairman resigned in its wake. The bank reported a loss of over $12 billion. Total write-down's came to about $19billion. This brings the total losses for UBS to a staggering $40 billion so far in the mortgage and credit crisis. As a result of this Standard and Poors cut their credit rating to AA-. As a result of the downgrade the bank will be looking to raise as much as $15 billion of new capital. This will bring their capita ratios back up to over 10% when completed, well above the minimum of 4 set by the European Union. The bank also announced that it was continuing to cut its exposure to the US mortgage market. Subprime exposure has fallen from 27 billion to $15 billion and the portfolio of Alt-A mortgages shrank from $26 billion to $16 billion.

Also this morning Deutsche Bank said that it expected to announce at least $4 billion in asset write-down's when they release earnings on April 29. The losses are from the banks exposure to leveraged loans, Commercial real estate, and of course residential mortgage backed securities.

Influential banking industry analyst William Tanona of Goldman Sachs was out with reports this morning lowering his estimates on two bellwether financial stocks. He estimated that first quarter losses for Citigroup (c ) would be in 50% higher than his previous estimate. He expects the bank to have over $12 billion of new write downs from asset backed securities in the quarter and report a total loss of $1.55 a share, well above his previous estimate of a loss of just $.50 a share. He also cuts his full year profit estimate by 60% to $.50 a share. For Merrill Lynch (ML), Tanona estimated another $2.5 billion of write-down's and a quarterly loss $2.45. He also cuts his full year estimate to just $.70, down from $3.85, a cut of over 80%.

Major financial stocks are rallying this morning in expectations of better days ahead. The reality seems to be that the situation is still cloudy and best. Asset values continue to fall and earnings are expectations are drastically reduced. This appears to be one of those times where it is best to sit out the early rally to avoid the possibility of a permanent impairment of investment capital, sustaining huge losses that would take years to recover.

Billionaire vulture investor Wilbur Ross has announced that he intends to invest as much as $4 billion in small regional and community banks around the United States. Ross has already made large investments in financial institutions during the current credit and financial market turmoil including mortgage servicing companies and bond insurance companies. He made his fortune exploiting similar market sector collapse including the steel and textile industries. Ross is also planning to fly to Abu Dhabi in the near future to pitch the idea to Arab investors including the giant sovereign wealth funds in the region.
Mr. Ross thinks that there are at least 1000 smaller banks that will need additional capital before the crisis is over. He told reporters recently that most US depository institutions were quite overexposed to real estate and would need outside capital. He has apparently compiled a list of between 100 and 200 smaller banks that are of interest to him as potential investments for his hedge fund.
His thinking is in line with my own. Smaller banks should recover much quicker than their larger counterparts. Although they are exposed to real estate, they do not in most cases have exposure to the complex and volatile mortgage backed securities markets. You will not find the alphabet soup of leveraged securities that are on the books fo industry giants like Citigroup ( C) and Bank of America (BAC). Nor do they make corporate buyout loans for highly leveraged transactions. They will be the prime beneficiaries of the recent Fed rate cuts. As the yield curve steepens they will be able to increase earnings form the yield spread. Recent stock market volatility should also make it easier to attract depositors in local institutions.
It is also likely that there will be substantial consiolidation in the industry. One of the easiest ways for larger institutions to grow earnings and repair their balance sheets is to buy smaller, healthy, profitable institutions.

Wilbur Ross has made billions bottom fishing in various industry groups. His intent to move into smaller banks should awaken investors to the profit potential in small regional and community bank stocks