You can still practically smell the wreckage. Stocks of the nation’s largest banks, most of which were overexposed to toxic subprime assets, crashed and burned during the financial crisis.

The KBW Bank Index (an index of the largest American banks) fell from a high of more than 120 in early 2007 the less than 20 in March of 2009, a fall of more than -83%. But, as fear of a depression and bank nationalizations subsided, the index recovered to near 50 by the summer of 2009, near where it is today.

But stocks of the largest banks might be on the cusp of a huge comeback in 2011.

While profits are still far from 2007 levels, most of the nation’s large banks have paid back their TARP money to the government, greatly improved their balance sheets and returned to profitability.

In fact, a bull market may already be underway. After underperforming the S&P 500 for much of the past year, the KBW Index has soared more than +13% in December alone. Analysts in general have warmed up to financials, and Goldman Sachs (NYSE: GS) upgraded financials to “overweight” for the first time since the financial crisis.

What’s going on?
It’s the economy. The new tax deal in Congress seems to have reached critical mass and many strategists have become much more bullish on the economy seemingly overnight. The major catalysts being cited are the extension of the Bush tax cuts and a new one-year tax break on Social Security taxes. Goldman Sachs raised its 2011 forecast for GDP growth to 2.7% from 2.0%, and Pimco raised GDP growth expectations a full percentage point from 3% to 3.5%.
While a rising economy lifts all boats, it particularly helps the banks for several reasons.

Lower loan losses
Credit losses and loan losses in the tough economy have forced banks to set aside money in reserve to cover them, offsetting profits. However, things are already starting to turn around. In the third quarter, the overall banking industry (about 7,700 banks and thrifts) set aside 45% less money for losses than they did a year ago. The number of banks that were unprofitable fell from about 33% in the year ago third quarter to 19% in the last quarter. The lower losses were the main driver of higher profits, which increased more than sevenfold in the third quarter from a year ago.

Loan growth
As businesses undergo more projects and expansions in a stronger economy, banks are there to loan money. The higher loan activity will increase profits under just about any circumstances, but especially in the current interest rate environment.

Steeper yield curve
Banks typically borrow money from the Federal Reserve and loan that money out to clients at higher rates, thus making money on the spread. A steep yield curve, low short-term rates and higher long-term rates primes the profit pump for banks as loans become more profitable. The discount rate (the rate at which banks borrow money from the Fed) remains at just 0.75% while rates on the 10 Year Treasury have soared to more than 3%, up more than 35% since October.

Rising stock prices
An improving economy would likely buoy the stock market. Rising stock prices mean rising commissions and revenue at the wealth management divisions of large banks.

That said, banks still face strong headwinds, including a still-depressed housing market, continued credit and loan losses and new financial reform legislation. Most banks slashed dividends to mere pennies during the financial crisis. But, as profits have returned, banks have still not raised dividends largely because of uncertainty regarding the Frank Dodd Financial Reform Bill. There is still uncertainty regarding how much capital banks need to hold as well as new classifications of asset types that can be used as capital.

Several banks including Wells Fargo (NYSE: WFC), Bank of America (NYSE: BAC) and JP Morgan (NYSE: JPM) have expressed a desire to raise dividends in the near future. An improving economy and more regulatory clarity should be forthcoming in the next several months. Potentially higher dividends, as well as continued preferential dividend tax treatment as a result of a Bush tax cut extension, are an added reason that big banks could perform well in 2011.

Action to Take –> You could buy any of the big banks individually, but a safe and easy way to gain exposure to the big bank group in general is to simply buy the SPDR KBW Bank ETF (NYSE: KBE), an exchange-traded fund (ETF) that tracks the KBW index. KBE is about 13% off its 52-week high and can be purchased at current prices.