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Treasury officials announced on Tuesday that ten of the nation's largest banks have met the necessary requirements to repay part of the highly-controversial bailout funds injected into the financial sector in late 2008.

The announcement paves the way for the banks, including JPMorgan Chase (NYSE:JPM), Goldman Sachs (NYSE:GS), and Morgan Stanley (NYSE:MS), to return up to $68 billion of the government funds and exit the Troubled Asset Relief Program (TARP). Despite what many interpret as good news, equity markets were generally unchanged Tuesday, with bank ETFs rising slightly.

While some of these institutions may continue to tap government funds from other sources, the ability to repay the loaned TARP funds in a relatively short time period indicates that the health of the U.S. banking sector has improved significantly. Many bank ETFs, which exhibited tremendous volatility in the first half of 2009, were up slightly on Tuesday following the Treasury's announcements.

In addition to the obvious benefits associated with debt reduction, exiting TARP means shedding the stigma of accepting government handouts. State Street's Financial Select Sector SPDR (NYSEARCA:XLF) and iShares Dow Jones U.S. Financial Sector (NYSEARCA:IYF) are now nearly even for the year, with XLF up 102% and IYF up 85% from their March lows. On Tuesday, XLF and IYF edged up 0.73% and 0.45%, respectively, on the TARP news.

XLF is Up More than 100% From its March Low

Where Do We Go from Here?

Since the stress test results were announced in May, U.S. banks have set out on a well-marked road to recovery.

While each step (or at least each of the first several steps) of the way has been clearly laid out by the U.S. government, progression down this path is far from a foregone conclusion. But there are signs that the recovery is going (dare I say it?) just as planned.

The deadline for institutions "failing" stress tests to raise capital passed with little fanfare earlier this week, largely because these institutions were able to meet the requirements with surprising ease.

In fact, many banks raised excess funds in recent offerings, placing them back on solid financial footing without relying on government funds, and allowing them to make good on loans from the U.S. taxpayers.

This is of course a positive for current shareholders since it reduces likelihood of the government taking a major ownership stake and diluting equity interests.

So far the banks have seemed up to the monumental task put before them. But there's still a long ways to go, and the tremendous rally that started in March of this year is showing signs of losing steam. Here are a few of the "next steps" I'm looking for to indicate that bank ETFs are continuing on their road to recovery:

  • No News Would Be Good News: Despite significant improvements in the eyes of many, bank closures have continued at an alarming rate in 2009, with nearly 40 institutions closing already in the first five months of the year. A return of consumer confidence in the banking industry must start locally, and until the wave of closures slows, a turnaround will be put on hold.Bank Closures
  • Better-Than-Worst-Case Earnings: Predicting earnings for banks has become a guessing game, with so many factors causing potentially huge swings. Much like the stress test results (which actually weren't all that great), any results that beat the worst case scenario will be cheered by investors who remain thoroughly unconvinced of a sector turnaround.
  • Congressional Testimony: The shakeout from the financial crisis includes a harsh review of many previously unchecked areas, including over-the-counter derivatives trading, a lucrative activity for many banks in recent years. This week Congress will hear testimony regarding a proposed central clearinghouse for derivatives trading, a move that would further erode bank profitability.
  • Commercial Real Estate Markets: As residential home prices show some signs of stabilizing, many analysts fear that the commercial markets will be the next shoe to drop. With some industry sources projecting office vacancy rates soaring above 20%, banks could be hit hard by a new wave of defaults. But again, it seems that there is room on the upside here. Many forecasts for the commercial markets are so abysmal, that even a significant downturn would beat expectations.

When stuck in a downturn as prolonged and severe as the current crisis, investors tend to discount good news, viewing it is an abnormality rather than the potential beginning of a positive trend. Right now, there's a lot of good news coming out of the banking industry, but the wounds of 2008 are still far too fresh for many investors to support a further rally.

Disclosure: No positions.

Source: TARP Repayment News: Where Do We Go from Here?