The quality of those earnings has been an obvious point of contention because of the accounting rule known as debt valuation adjustment (DVA). As a result of that rule, bank earnings actually get a boost when their debt falls in value.

Because of fair value accounting, when debt falls in value, the difference between the fair value and the face value of the debt is basically treated as a gift from the debt holders. Unfortunately, DVA has the potential to create phantom earnings by building an illusion of strength where none actually exists.

Beyond banks’ quality of earnings, the European sovereign debt crisis is weighing heavily on banks.

American banks have little direct exposure to troubled European sovereign debt because they don’t actually hold the troubled bonds. But according to data released by the Bank for International Settlements (BIS), American banks are counterparties to about $518 billion in credit default swaps (CDS) on the debt. CDS contracts act much like an insurance policy, so if a bond defaults, the counterparty must make good on the bond. With the Europeans on course to orchestrate orderly defaults, that CDS exposure could prove problematic if banks are forced to make payouts on those contracts.

But according to data from BIS and the Office of the Comptroller of the Currency, most of that exposure is likely concentrated among the “Big Five” banks: Citigroup (NYSE: C), JPMorgan Chase & Co. (NYSE: JPM), The Goldman Sachs Group (NYSE: GS), Bank of America Corp (NYSE: BAC) and Morgan Stanley (NYSE: MS). And according to their own quarterly reports, these banks have used hedges to reduce their net exposures to European sovereign debt to around $45 billion. On top of that, the International Swaps & Derivatives Association, the ultimate arbiter of whether or not payoffs are required, has thus far maintained that the deal struck to reduce the value of Greek bonds by 50 percent won’t trigger CDS payments.

Still, for most investors, that’s not much comfort.

In addition to the potential financial issues, banks’ poor efforts at public relations are starting to impact sentiment.

Consumers were displeased when several of the large money center banks announced their intent to charge fees for debit card usage. For years, banks have conditioned customers to use their debit cards instead of writing checks.

With each swipe of a debit card, banks collect a fee which essentially falls to their bottom line, particularly since banks don’t offer rewards programs any longer. But checks actually cost the bank money because of the back office processing involved. So even though the Dodd-Frank financial reform bill limits the fees that banks can charge merchants that accept debit cards, banks are still better off when consumers use debit cards instead of writing checks.

Banks failed to anticipate the extent of public anger in response to their proposed fees. National Bank Transfer Day (NBTD)–this past November 5–was part of that backlash. NBTD encouraged consumers to move their accounts from the “greedy megabanks” to smaller, community-based institutions which don’t charge as many fees and are perceived to be more responsive to customer needs.

While no firm data is available yet, there have been estimates that as many as 650,000 accounts have been transferred from the aforementioned Big Five banks to smaller outfits.

However, it’s unlikely that such discontent created much of a real problem for the major money center banks. That’s because it’s rare for consumers to change bank accounts because of all the variables involved in such a decision. And now that banks have backed off their proposed debit card fees, much of the public furor should die down.

Still, it’s yet another reason to be leery of the major banks.

In contrast, smaller regional and community banks are in a position of strength.

Smaller banks are producing earnings growth without the taint of DVA.

For one, loan-loss reserves are being released and flowing back to the bottom line.

Source: FDIC

Loan-loss reserves have been a major drag on bank earnings since the latter part of 2007. As mortgage debt was going bad at a record pace, banks were forced to set aside an ever growing amount of cash to protect against potential losses. While reserve levels are still well above those seen prior to the real estate crash, they’ve fallen from a high of more than $70 billion to around $20 billion today as credit quality on loan portfolios has improved considerably.

Although the release of loan-loss reserves created one-off earnings bumps for most of the major banks, the smaller banks have deployed that capital and will reap the benefit of higher future net income. According to Federal Deposit Insurance Corporation data, larger banks have continued to hoard cash, while smaller banks are increasing their pace of lending and maintaining high standards of credit. In fact, small bank lending is, on average, growing at a 5 percent faster pace than their larger peers, and small bank earnings are growing about 3 percent faster.

Additionally, the smaller banks largely steered clear of European sovereign debt. While there may be the odd bank out there with some form of exposure, small banks, particularly post-credit crisis, tend to restrict their activities to the market they known best–their own.

Smaller banks also have much less to fear on the financial reform front since most banks with less than $10 billion in assets are largely exempt from many of the Dodd-Frank bill’s provisions. So while major banks will struggle with the cost of compliance with Dodd-Frank’s rules, small banks will enjoy a competitive landscape tilted in their favor.

SPDR S&P Regional Banking ETF (NYSE: KRE) continues to be our favorite way to play these trends. When we added the fund to our Portfolio in March 2010, we saw many of these trends developing even then. Unfortunately, we were a bit early with our recommendation and are currently down 6 percent.

Even so, we remain positive on the collection of 69 banks held by the exchange-traded fund (ETF). While there are a handful of larger banks in the mix, such as PNC Financial Services Group (NYSE: PNC), the average market cap of the ETF’s holdings is $1.9 billion. Most of the fund’s constituent banks also have asset levels that fall within the Dodd-Frank exemptions.

A majority of the banks also operate in so-called “fly-over country,” which was insulated from the worst excesses of the US housing bubble and its subsequent bust. As a result, the banks have attractive credit profiles.

Nevertheless, it’s likely to take some time for bank stocks to come back into favor. Given the massive potential dislocations still facing the industry, few are willing to try picking winners and losers.

SPDR S&P Regional Banking ETF has a low annual expense ratio of 0.35 percent, so the passage of time won’t erode returns with hefty advisory fees while we await our thesis to be rewarded. The fund also pays a modest 1.7 percent yield, so it offers some total return in the interim.

Continue buying SPDR S&P Regional Banking ETF under 31.

The Global ETF Profits Way

As a reminder, the Global ETF Profits Model Portfolio is divided into three sections: Growth, Income & Hedges (I&H) and Short-Term Opportunities.

The Model Portfolio provides the full spectrum of strategic approaches to investing by recommending growth, income, and hedging strategies, as well as shorter-term tactical opportunities. Additionally, the use of exchange-traded funds (ETF) can capitalize on trends in specific sectors without incurring the risk of selecting the wrong stocks in those sectors.

The Growth and I&H Portfolios are appropriate starting points for investors seeking to establish positions for the long term. The Short-Term Opportunities Portfolio is best suited for those investors who have a greater tolerance for risk. We’ll adjust the ETFs in the overall Model Portfolio on an ongoing basis to reflect investment objectives. Our recommendations are sorted in descending order of preference, starting with our favorite pick at the top of each section.

It’s important to buy a cross-section of recommendations–taking into account, of course, your objectives and risk tolerance–in order to gain broad exposure to the investment themes we’ve highlighted, as well as to maintain proper diversification.