UPDATE: Battered Financial Stocks Could Be Ejected From S&P 500: Analyst

By John Spence

BOSTON (Dow Jones) -- As if the credit crisis and the latest brutal sell-off weren't enough for troubled financial-services firms, some stocks could be punished further if they are ejected from widely followed indexes.

Hard-hit financial stocks may be dropped from the S&P 500 Index as the recent wave of selling whittles down their market caps, a Wall Street analyst said Wednesday.

If the index committee at Standard & Poor's decides to remove embattled financial stocks from the blue-chip benchmark, it could push the shares even lower, as index funds sell to reflect the index changes.

"In the S&P 500, four financials rank within the bottom 10 companies in the index," wrote Melissa Roberts at Keefe, Bruyette & Woods in a research note.

She named the financial stocks at the greatest risk of near-term deletion from the S&P 500 if the committee opts to proactively remove the smallest constituents: Developers Diversified Realty Corp. (DDR), E-Trade Financial Corp. (ETFC), Huntington Bancshares Inc. and MBIA Inc. (MBI).

Through Tuesday's close, shares of bond insurer MBIA and online broker E-Trade were both down more than 35% so far this year. Meanwhile, real estate investment trust Developers Diversified was off 60%, and Huntington has plunged nearly 85%.

In late February, S&P cut eight stocks from a trio of indexes it manages: the S&P 500, the S&P MidCap 400 and the S&P SmallCap 600. Roberts at KBW noted that those impacted stocks were the smallest constituents in their respective indexes.

"The S&P index committee does not actively manage the index and seeks to keep turnover to a minimum, but does from time to time remove the smallest-ranking constituents in the index," the analyst said.

"The limited acquisition activity impacting index members leave very few spots opening for replacement in the index," she added. "This may force the index committee to remove such low-ranking capitalization constituents if corporate actions of current index members such as spin-offs necessitate it."

S&P says the committee's goal is to ensure that the S&P 500 is a leading indicator of U.S. stocks, reflecting the risk and return profile of large-cap shares. The committee also considers a stock's liquidity and tries to limit turnover.

Looking at the smaller-cap indexes, Roberts said Colonial BancGroup Inc. (CNB) has the largest risk of falling out of the S&P MidCap 400 if the committee elects to remove the smallest members. Meanwhile, she flagged Independent Bank Corp. (IBCP) in the S&P SmallCap 600.