“Yo, Contra Dudes, aren’tcha gonna buy some of them financial stocks?” It’s a question we’ve been hearing a lot lately. The short answer is “Not yet,” but we’re definitely watching this sector very closely.

In an article last February, we explained why we thought there was plenty more pain to come as the credit squeeze and the economic slowdown made life miserable for banks. Six months on, it’s still hard to know if the midpoint in the breadth of the valley is near, but it’s obviously gotten a lot deeper.

The failure of California-based IndyMac has been a serious dent in the armour of US Treasury Secretary Henry Paulson’s oft-repeated assurances that the US banking system is safe and sound. IndyMac was no pipsqueak regional savings and loan. Its was the second-largest bank failure in the past 75 years, and is expected to vapourize a tenth of the entire assets of the Federal Deposit Insurance Corporation. And, as with all types of insurance, when there is a whopper of a claim, you can be sure that premiums are going to jump, and that hurts the entire financial community.

Also demoralizing were horrible quarterly results by Wachovia, the fourth-largest bank in the US The bottom line was sullied to the tune of $8.9 billion (US), and company management is in full-blown crisis mode. What was once a handsome annual dividend of $1.50 a share has been emasculated to a paltry 20 cents. Many other banks are also slashing or eliminating dividends.

In the midst of these earthquakes, the government is being forced to throw a lifeline to Fannie Mae and Freddie Mac. Allowing this pair to go down would be inconceivable. They are the world’s two largest financial institutions, responsible for nearly half of the $12 trillion mortgage industry. “Too big to fail” goes the mantra, but shareholders would be wise to remember that this umbrella provides little protection to their backsides.

The crux of the problem is that banks need to fix up their balance sheets. Ideally, that would mean selling off some assets, taking a step backwards after many years of steady expansion. But the troubles are so generic that it’s nearly impossible to offload anything at a decent price. That means they will have to raise capital, by hook or crook.

Which brings us to the fascinating case of HBOS, the United Kingdom’s largest mortgage provider. Last April, the bank announced a rights offering to raise 4 billion pounds in new funds. The rights entitled shareholders to buy shares at a deep 45 percent discount to the then prevailing price. But that discount eroded as HBOS’s stock kept slumping lower, until it actually fell below the offering price of 275 pence. As a result, the underwriters, themselves investment banks, got left holding the bag. This precedent will make it even more difficult for other banks to find underwriters to take on the risk of backing new offerings.

It’s a great example of how one financial institution’s travails spread out in concentric rings, so that its problems become transmitted to its neighbours. As with any contagion, the worst isn’t over until the rate of infection starts to decrease. At that point there will be a lot of sick banks, with cheap stock prices, offering huge potential gains as the epidemic passes and the companies slowly return to health.

To be frank, all this dire news has us more excited about deploying our cash hoard than we have been in years. We sense a coming opportunity to get back into financial stocks in a big way. But dude, not yet.