Financial services stocks, which had badly underperformed the broader stock market last year, were the strongest performers so far this year in a otherwise bleak 2008.

That is, until Monday, when banking analysts downgraded shares of Wells Fargo & Co., Wachovia Corp., U.S. Bancorp and Sun Trust Banks Inc., among others.

That news turned the financial sector's modest year-to-date gains into a 1 percent decline and underscored the persistent uncertainty plaguing credit markets.

"I've been saying 'buy, buy, buy' for [several months], and I looked pretty silly on some companies," said Ganesh Rathnam, a financial services analyst with Morningstar in Chicago. "But I thought the banks were undervalued."

Nobody is suggesting that all the bad news is out about defaulting subprime mortgages, busted residential property developers and unoccupied commercial properties. But Rathnam and others are saying that there may be some bargains out there that were pounded as short sellers waded into the financial sector last year to capitalize on the bad news. (Short sellers make profits when a stock goes down.)

Chairman Ben Bernanke and the Federal Reserve stepped in with two sharp rate cuts in January. And banks tend to prosper when rates go down.

But lenders, burned by the speculative loans they'd made in recent years, now have made it tough for even customers with good credit to get a loan. And some lenders anticipate more delinquencies and losses this year, assuming that "economic activity progresses in line with consensus forecasts," according to an ominous-sounding quarterly survey of senior loan officers released by the Fed on Monday.

According to the Fed, about 80 percent of banks raised standards on commercial-property loans, a record since the Fed began seeking information on the subject in 1990.

Bernanke and his colleagues had that information in hand last week when they lowered their benchmark interest rate by half a percentage point last week, on top of a whopping three-quarters-of-a-point drop on Jan. 22.

"It's definitely a broader-based tightening than we've seen before," Edward McKelvey, senior U.S. economist at Goldman Sachs Group Inc. in New York, told Bloomberg News on Monday. "The economy is weakening in a pretty substantial way."

Ben Crabtree, a veteran bank analyst who works for St. Louis-based Stifel Nicolaus in Minneapolis, found his universe of 23 small to midsize depositories down about 30 percent in value in 2007, even though most of them have little or no exposure to the exotic Wall Street-developed products that have infected the financial system.

At the time, Crabtree suggested that aggressive investors might want to start buying some TCF and Associated Bancorp -- both solid performers that had fewer problems than some big banks.

And Rathnam and other big-bank analysts suggested U.S. Bancorp and Wells Fargo.

What banks need

But there's still no guaranty that the financial sector is out of the woods. Banks need confident, creditworthy commercial borrowers and retail customers who are able to pay back their home equity loans.

"The havoc-maker for small banks are the residential construction loans, and builders are having trouble paying their debts," said Bryce Rowe, analyst at Robert W. Baird in Milwaukee.

Jon Arfstrom, a veteran bank analyst at RBC Dain Rauscher, said the natural inclination is to rush in and buy banks in the wake of a big Fed rate cut.

"We're still skeptical," he said. "The hedge funds that did well last year shorted bank stocks. With the Fed pumping money in, the shorts get nervous when bank stocks start going up and they get squeezed out.

"Our view is to just own the best credit managers," Arfstrom said. "[And] TCF, Wells Fargo and USB have been good credit managers."

Rathnam suggested that prudent, long-term investors might want to put some money into a financial services index fund. He's not sure exactly when the sector is going to recover, but it shouldn't get much worse. Bank stocks as a group are trading at several-year lows and pay attractive annual dividends of around 5 percent.

Neal St. Anthony • 612-673-7144 • nstanthony@startribune.com