Nobody said the recovery would be easy. After staring into the abyss, the financial sector has bounded back in the past year, offering very strong first quarter results, and bringing a measure of confidence back to the weathered sector. Nonetheless, problems and uncertainty continue to come from Washington, Europe and companies' own balance sheets.  After fighting to stay above water on Wednesday, the industry, as measured by the Financial Select Sector SPDR exchange-traded fund, finished the day with down 0.6%. Goldman Sachs Group ( GS - news - people ) fell 0.8%, Morgan Stanley ( MS - news - people ) dropped 0.7%, while Citigroup ( C - news - people ) slid 1.9% and Bank of America ( BAC - news - people ) ticked down 0.2%.  The once-mighty American International Group ( AIG - news - people ) also decreased 1.4%. JPMorgan Chase ( JPM - news - people ) proved to be an exception, managing a gain of 0.5% on Wednesday.  Since the beginning of the year the Financial Select Sector ( XLF - news - people ) has risen 10.6%, while its regional banking counterpart, the SPDR KBW Regional Bank ( KRE - news - people ) ETF, as gained 21.9%.  The downward move came on the same day former Bear Stearns' Jimmy Cayne, Alan Schwartz and other testified before Congress on the events leading up to the former brokerage shop's ultimate demise. (See "Bear Should Have Been Able To Handle It.") The firm collapsed in March of 2008 under a flurry of disruptions in the credit markets, leading the Federal government to swoop in sell it to JPMorgan at fire sale prices. The development shocked the market but proved to be a harbinger of things to come.  Dick Bove, vice president of equity research at Rochdale Securities, is optimistic about the industry, though mindful of the hurdles it faces. "If you look back two or three years, the only issue that investors have cared about was the quality of a firms loan portfolio, so when quality was eroding there was aggressive selling, and when the erosion stopped and there were signs of improvement the prices started to move sharply higher," Bove said.  Now, the question for investors is whether the financial stocks have taken into account the improved earnings. Bove, for his part, doesn't believe so. Nonetheless, the next stage for the industry will come when loan-loss provisions are finally out of the way, but it's difficult to determine when that will be.  "There are still a lot of bad assets on balance sheets," said Len Blum, managing partner of Westwood Securities. "Banks are also making their money from trading fixed-income, but that trend can't last, and loans haven't fully returned, which is unfortunate."  When that new stage is eventually reached, Bove expects a second wave of earnings from better utilization of balance sheets which have been inhibited by have to set money aside.  Regulatory reform in Washington is also weighing on stocks. Aside from what bill President Obama ultimately signs, stocks will be impacted by the weekly developments that will take place while the bill is being shaped. "There are a couple things that could damage profitability," Blum said, "one being limiting banks to engage in risky practices." He also noted that the recent developments surrounding Goldman has placed the industry in a politically unfavorable light. (See "Absurd Theater Starring Goldman Sachs.")  Then there's Greece. (See "Greece Saved For Now But Eurozone Not Safe Yet." and "Greece Needs To Exit The Euro Zone.") The $146 billion joint bailout from the European Union and the International Monetary Fund formalized earlier this week could take care of the country's short-term fiduciary problems, but major questions remain over how the country will look in the long-term, if it will ultimately be able to avoid default, and whether its problems will spread to other countries.  "It's hard to contain sickness in the global economy," Blum said. "It's like when you have a sick kid that goes to class with other kids, and to the extent it spreads through the EU it could weigh heavily on the world as a whole."  Bove said it's more than likely Greece will repudiate on its debt. "It simply can't afford to make its payments," he said, "and if you think Greece is like Argentina, they will repudiate, raising the possibility that another will." Such a move could have a very negative impact on big banks, Bove said, because of their exposure to the region, while regional institutions will be less affected.
The financial sector works to rebound from the brink of disaster and now deals with more risk from Athens and Washington.