NEW YORK (CNNMoney.com) - You're the largest savings and loan in the country faced with a dreary outlook for mortgages and increasing pressure on profits from higher interest rates. What's the best course of action to take?

If you're Washington Mutual (down $0.85 to $43.56, Research), you keep your fingers crossed that the new Federal Reserve Chairman puts an end to the rate hikes and plow your energy into retail banking and cost cutting.

That's the strategy the company plans to employ in 2006 after it reported disappointing fourth-quarter earnings this week due to weakness in its flagship mortgage business.

In the long term, the strategy may reap benefits for the company, analysts said, as Washington Mutual continues to reinvent itself as a diversified financial player rather than a mortgage-centric thrift.

But it's the short-term outlook that has analysts and investors worried, prompting at least one analyst downgrade and cautious words about the company's prospects for 2006.

Punk & Ziegel analyst Dick Bove downgraded Washington Mutual to "market perform" from "buy," saying that the company's fundamentals are eroding at a faster clip than previously expected, and that he was discouraged by the company's comments related to Federal Reserve's interest rate policies.

"Without alleviation of interest rate pressures from the Federal Reserve, there was little reason to believe that earnings could advance from the current quarterly levels," he said in a research note. "However, management intends to proceed under the assumption that there will be relief."

David Hendler, senior analyst at CreditSights said banks should be cautious about assuming that the Fed is close to ending its rate hikes.

"We're going to have a new Fed chairman, and with economic statistics mixed as usual, that's the big wild card," he said. "It looks like it's going to be hard to count on the Fed as a cure-all."

Analysts said that if the Fed decides to keep raising rates, Washington Mutual would see its mortgage volume continue to fall, sales gains would come under pressure, and prior estimates concerning margins would be adjusted lower – all bad news for earnings growth this year. Bove cut his 2006 earnings estimates to $3.42 a share from $4.01.

Washington Mutual reported fourth-quarter earnings of $865 million, or 85 cents a share, after Wednesday's market close, below Wall Street expectations of 90 cents, according to earnings tracker Thomson First Call.

Revenue from sales and servicing of home mortgage loans -- its flagship business -- tumbled to $264 million in the fourth quarter from $497 million in the third quarter of 2005 and $384 million in the fourth quarter of 2004. But that weakness was offset in part by deposit growth in its retail banking operation and the solid performance of Providian Financial, the credit card company Washington Mutual acquired late last year for $6.5 billion.

During the company's conference call with analysts, chairman and chief executive Kerry Killinger was excited about Washington Mutual's prospects in retail banking. He said the company will continue to invest in its retail banking network by opening between 150 and 200 new outlets in 2006 on top of the 210 new branches it opened last year.

Given the weakness in mortgages and sour interest rate environment, CreditSight's Hendler said the company was looking to drive growth for shareholders by opening new locations and growing deposit accounts.

Not a bad strategy, under normal circumstances, but competition in retail banking is becoming increasingly fierce.

Moshe Orenbuch, research analyst at Credit Suisse, said the consumer is becoming more interested in opening CD accounts rather than money market accounts to take advantage of higher interest rates. To remain competitive, banks are offering sweet deals to lure consumers, an increasingly expensive venture for financial institutions.

Washington Mutual, for its part, is looking to control expenses by moving more of its back office jobs to foreign countries and places such as Texas, where it costs less to do business.

The company already informed 1,000 call-center workers in Chatsworth, Calif., on Wednesday that their jobs are headed to San Antonio and Costa Rica. Washington Mutual also plans to add about 4,400 jobs in foreign countries during the next couple of years, company executives told analysts.

And the company is looking to increasingly cross-sell its products to Providian consumers – an area that could see more growth but ultimately will add only a relatively small benefit to the company, Orenbuch said.

Thomas Monaco, director of research at Moor & Cabot, said the company's diversifying initiatives given the tough mortgage environment will start to pay off in the next 12 to 24 months, which could be a positive motivator for the long-term investor.

This year, however, will continue to see a tough operating environment, and investors are already taking note.

The stock, which recently hit a 52-week high of $45.60, fell as much as 3 percent in Thursday trading, and analysts said that the stock is likely to come under further pressure if earnings growth slows down, as expected. Both Punk Ziegel's Bove and Credit Suisse's Orenbuch have a $45 price target for the stock.

"Killinger is a good salesman and the market, so far, has been buying his pitches well," said CreditSight's Hendler. "But investors now want to see real sustainable results and this will be a good year to judge them."

None of the analysts quoted in this story own shares of Washington Mutual although Credit Suisse has an investment banking relationship with the company.

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For more about Washington Mutual's rebirth, click here.

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