While congressional leaders hashed out the details of a $700 billion financial rescue package for the nation’s troubled banks, many local financial institutions were wondering if they will be left out in the cold.

The dramatic and sweeping bailout, which would allow banks to sell their distressed assets to the U.S. Treasury, is intended to bring stability to the nation’s financial markets by taking toxic mortgage-backed securities and other assets off the books of many institutions.

But even as political leaders worked to reach a deal late last week, it was unclear if small institutions would be able to participate to any significant degree. That could mean Southern California would miss out on the historic government program.

“I totally disagree with that. I don’t think they should discriminate based on asset size,” said Paul Hudson, chief executive of Broadway Financial Corp., the holding company of Broadway Federal Bank.

While the Los Angeles-based savings and loan maintains it is healthy, Southern California is home to a large number of troubled banks given the area’s status as a driver of the nation’s housing boom. Even premier local institutions, including Beverly Hills-based City National Bank, are taking losses due to investments in mortgage giants Fannie Mae and Freddie Mac, which were recently taken over by the federal government.

The advocacy group Independent Community Bankers of America has waged a campaign to ensure that small institutions are not excluded from the bailout. The group, which represents some 5,000 banks nationwide, is encouraging its members to reach out to political leaders and ask that community banks not be denied access to the bailout.

“We definitely think that community banks should be able to participate in the asset sales to the Treasury on an equal footing” with larger institutions, said Stephen Verdier, senior vice president and director of the group’s congressional relations division.

But with the government’s focus on the largest institutions, small banks may be deemed not worth the trouble of saving. Indeed, a number of local institutions have seen huge mortgage-related losses and could benefit from government assistance.

Downey Financial Corp. of Newport Beach has been battered by losses related to its option adjustable rate mortgage lending. Federal regulators ordered the struggling lender earlier this month to raise capital, but the illiquid market has made it difficult for the struggling company to offload its distressed assets.

PFF Bancorp Inc. of Rancho Cucamonga, one of the state’s oldest banks, suffered major losses as a result of its exposure to the Inland Empire real estate market. It tried to raise capital but was unable to as the markets seized up, forcing the $4.2 billion-asset institution to sell itself to FBOP Corp. in June for just $31 million.

Meanwhile, FirstFed Financial Corp., the Santa Monica-based holding company for First Federal Bank of California, has billions of dollars in risky option adjustable rate mortgages, convincing many investors the institution is on shaky ground.

As of mid-September, FirstFed was the most shorted stock on the New York Stock Exchange, with 71 percent of its outstanding shares being shorted, while Downey was No. 2 on the list. (See story on page 6.)

Douglas Goddard, chief financial officer of FirstFed, said he does not expect his company to be eligible for the program. In any case, he asserted the company is financially sound and does not need to offload any distressed assets.

And even if small banks are allowed to sell their assets to the Treasury, they will want to wait to see what price the government offers. Sung Won Sohn, an economist at California State University Channel Islands and former chief executive of Los Angeles-based Hanmi Financial Corp., said the government likely will not pay enough to justify the sale.

Many loans on banks’ books are being “held to maturity,” meaning the banks plan to hang onto them until the market gets to a point that they are worth as much or more than the institutions originally paid for them, he said.

In the current market conditions, however, the loans are worth relatively little and if a bank chooses to sell them at current market value the institution will take a loss that it might not otherwise have. Many institutions, he noted, could not afford such a hit to their capital levels.

“If you decide to sell that asset, then you are realizing the loss. That could really erode your capital quite a bit,” Sohn said. “If I’m a community banker, I would be reluctant to sell those assets.”