Is Another Market Panic Coming?

With the return of market volatility in just the past few weeks, many are beginning to worry about the possibility of another dizzying financial panic.

Are those fears well founded? What should individual investors do? Read on to find out the answers to those two important questions.

Storm's coming
The trigger for the last storm was the fall of Lehman Brothers. To figure out the likelihood of another panic, let's take a quick peek at banking's current weak link, Bank of America (NYSE: BAC  ) .

With $2.3 trillion in assets, BofA definitely qualifies as "too big to fail." A stumble could spread to other banks and trigger another panic. And every day seems to bring more bad news of lawsuits that some believe threaten the company's existence.

In addition to the euro crisis and weak loan demand, banks -- and BofA in particular -- face three enormous legal problems:

  1. They are accused of selling bad loans to mortgage-backed security investors (think companies like Fannie and Freddie, PIMCO, Chimera (NYSE: CIM  ) , Blackrock, AIG (NYSE: AIG  ) , etc.), while pretending the loans were good.
  2. Banks weren't especially meticulous with their record-keeping. Among the documents that frequently went "missing" or destroyed were the "Mortgage Notes," legal IOUs that are critical to making the $8.3 trillion mortgage-backed-securities market actually backed by mortgages.
  3. Widespread reports of document fabrication to account for the missing documents and "robo-signing" in banks' rush to foreclose, as well as charges of deceiving homeowners who are trying to receive mortgage modifications.

How widespread were these problems? At least a quarter of the loans that due-diligence giant Clayton Holdings examined failed to meet the appropriate standards. Reports so far indicate that the problems could be huge. A Massachusetts official found that in his county at least 75% of mortgage assignments had invalid documentation. He found that at least a quarter were straight-up fraudulent.

Now, BofA isn't alone in these allegations, but because of the prior CEO's horrendous acquisitions of Countrywide and Merrill Lynch, it has the most exposure. It's for that reason that I took a short position in Bank of America from December until Aug. 15 in the real-money Dada Portfolio I co-manage. (We closed the short after a 45% gain and currently have no position in the stock.)

If Bank of America would be the financial system's first domino, it's worth asking what it would take to potentially topple it. Based on recent filings and FDIC rules, a $115 billion loss would leave Bank of America undercapitalized. Before it got to that point, though, things could spiral out of control if creditors behind the bank's lenders or depositors got nervous. (Your FDIC-insured deposits are safe.)

Here are a few of the suits on their plate and my (rough) potential cost estimates:

Lawsuit

Scale of Estimated Losses Under Settlement

BNY Mellon/New York Significantly higher than the expected $4.3 billion in losses from the original settlement -- perhaps $29 billion to $58 billion
AIG $0.9 billion to $1.4 billion
US Bancorp About $0.2 billion
FHFA $5.2 billion to $12.6 billion
Nevada $0.5 billion to $2.5 billion
50-State Investigation $3 billion to $10 billion
Total $38 billion to $85 billion

Source: Author's calculations.

These kinds of losses wouldn't necessarily doom the bank, but they are starting to get a bit too close for comfort. No one truly knows for sure how deep the problems are, how expensive they will ultimately be, and what other allegations could be lurking. A lot hinges on the BNY/New York, FHFA, and 50-state suits, which have the potential to be both costly and revelatory. To protect itself, BofA could continue to sell assets, trim costs, and stretch out settlements to give it more time to earn its way out.

What this means for investors
Bank of America could be in trouble. And we haven't even talked about the exposure of the other banks. Does the possibility of future turmoil mean investors should avoid stocks? No, and here's why.

On March 6, 2009, in the depths of the financial crisis, I wrote a column titled "Is This the Market Bottom?" in which I explained why another plunge was easily possible. But the article concluded that it's very difficult to time market bottoms, and with stocks cheap right now, investors' long-term returns should be excellent.

March 6, in fact, happened to be the market bottom. But the advice would have still been correct had the market fallen further. That's the essence of Buffett's adage "Be fearful when others are greedy and greedy when others are fearful." You buy stocks when they're undervalued. If they get cheaper, you buy more.

So yes, a financial shock like the potentially massive losses facing BofA could trigger a market selloff. On the other hand, a number of companies are already trading below their oh-my-god-the-world-is-ending March 2009 valuations.

Surprised? Me, too. Amazingly, 377 stocks (12% of non-micro caps) are already that cheap. And not all of these companies have been operational duds. In fact, 247 of them have actually grown sales and operating income over the past two years, including high-quality names such as these:

Company

P/E (3/9/2009)

P/E (9/7/2011)

2-Year Annual Operating Income Growth

Apple (Nasdaq: AAPL  ) 15.9 15.0 63%
Berkshire Hathaway (NYSE: BRK-B  ) 22.7* 13.9* 115%*
Teva Pharmaceutical (Nasdaq: TEVA  ) 56.8 10.8 26%
Intel (Nasdaq: INTC  ) 13.5 9.3 51%

Source: Data from Capital IQ, a division of Standard & Poor's.
*Berkshire Hathaway's earnings statistics aren't the best measure of its performance, but it is also cheaper on a price-to-book basis.

So I'm buying the stocks that I think are bargains today, while saving some money in case we do see even better prices.

The recent market selloff has created some serious opportunities for individual investors. It's not quite like March of 2009, when you could make money throwing darts while drunk and blindfolded. But there are a few tremendous bargains today -- you just have to be selective.

If you're looking for more vetted stock ideas to profit in this market, check out "5 Stocks The Motley Fool Owns -- and You Should Too." Among the names in this special free report is a dividend-payer that's making enormous profits because of the downturn. Find out more.

Ilan Moscovitz owns shares of US Bancorp, Apple, and Berkshire. He doesn't have a financial stake – long or short -- in any other company mentioned. The Motley Fool owns shares of Bank of America, American International Group, Berkshire Hathaway, Chimera Investment, Apple, Intel, and Teva Pharmaceutical Industries and has bought calls on Intel. Motley Fool newsletter services have recommended buying shares of Berkshire Hathaway, Intel, BlackRock, Teva Pharmaceutical Industries, and Apple, creating a bull call spread position in Apple, and creating a diagonal call position in Intel. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (11) | Recommend This Article (29)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 14, 2011, at 12:14 AM, Len613 wrote:

    If I recall correctly, the S&P P/E was about 7 at the 1974 low.

  • Report this Comment On September 14, 2011, at 11:31 AM, Tygered wrote:

    So it seems that these crooks might actually get their just deserts and that will cause the market to tumble?

    Better that we get rid of "too big to fail" and start going back to the old fashioned idea of small businesses that actually compete for our money instead of trying to defraud us. We should have thousands of small local banks instead of 4 or 6 giants who rule the country and think that they will never have to pay for their crimes.

    I say to the lawyers going after these guys, "Burn 'em big time and take them all down."

  • Report this Comment On September 14, 2011, at 6:48 PM, DonkeyJunk wrote:

    TEVA and INTC are steals right now, imho.

  • Report this Comment On September 15, 2011, at 12:24 PM, plange01 wrote:

    another market panic has been here for about 6 weeks! a leaderless america's debt problems have spread to europe.its time to remove obama from office and send his $450 billion! save his own job plan with him!

  • Report this Comment On September 15, 2011, at 12:24 PM, SwampBull wrote:

    Ilan,

    I like the message and the thought behind the article. Cautiousness and prudent analysis are essential for sound investing during tumultuous economic and political events.

    Can you provide some explanation as to how you arrived at the potential litigious obligations at Bank of America? I am puzzled as to how you can predict a settlement amount, though with no legal background, I expect you have some method or formula.

    Thanks for the article. Remember to include a significant 'domino effect' in your numbers, where even a modest narrowing of the gap between capitalized and undercapitalized could trigger a run on a major entity, becoming a self-fulfilling prophecy after some bad press. For example, a $20B settlement could be portrayed as 'driving them towards the brink' in the media, and then their fate is sealed.

  • Report this Comment On September 15, 2011, at 1:10 PM, BlazerMania wrote:

    I wish we would stop calling B of A and the rest of these companies "banks." They becamse trading companies years ago.

  • Report this Comment On September 15, 2011, at 1:40 PM, TrojanFan wrote:

    BofA should be the least of your worries right now.

    Take a look at Soc Gen in France and the cross contamination points into the US.

    The European sovereign debt crisis is on the brink of going viral and affecting every major financial institution across the developed world and my confidence in the ability of European fiscal authorities to get out in front of that tidal wave is very, very low.

    At the end of the day, the FED is going to attempt to overcome their collective indecisiveness by rescuing them with swap lines drawn on the FED so we are about to attempt to rescue the entire world from their financial indiscretions.

    If ever there was a time for caution in your investing life, that time is now.

    The real question is whether these institutions deserve to continue to exist in light of their lengthy and unending list of transgretions. Until severe consequences are brought to bear on them, how can you possibly expect them to change their behavior and by virtue of their sheer size it is the honest, hardworking taxpayers of this country who consistently find themselves on the hook for their never-ending stream of mistakes.

    How does any of that make any sense?

  • Report this Comment On September 16, 2011, at 2:07 PM, canadacomments wrote:

    @plange - Its time that you and the Tea Party adopt a realistic view of the world. The only way that the US (and the rest of us) are going to get out of this mess is to 1. Charge the CEO's (and former CEO's) of UBS, BoA, Citibank, Morgan Stanley, etc. with criminal fraud and let them pay the costs out of their own ridiculous salaries and bonuses; 2. the rich of the world, especially the US, are going to have to start paying their way with much higher personal income taxes.

    Canadacomments

  • Report this Comment On September 16, 2011, at 2:37 PM, ApostateIguana wrote:

    One thing I've been wondering... If BoA gets into big trouble, what happens to the securities in my Merrill Edge accounts? Are they obliged to let me transfer those to another broker?

  • Report this Comment On September 16, 2011, at 4:01 PM, TMFDiogenes wrote:

    Can you provide some explanation as to how you arrived at the potential litigious obligations at Bank of America?

    Again, no one knows for sure how this will all play out because it's uncharted territory. But I looked at the exposure they had to each accusation, which (again, I'm not a lawyer, but from the state of the mortgage market, the evidence seems pretty plausible) and took settlement amounts ranging from some 10%-25% depending on how serious the charges were and how much leverage the other side seemed to have. For instance, some litigants have subpoena power. That's a bad sign. (Goldman Sachs used the 20% precedent from a BAC-UBS settlement for judging the FHFA lawsuit losses.) I then used a 45%-55% loss rate, which is BAC's historical loss severity on securities they've had to buy back.

    "Remember to include a significant 'domino effect' in your numbers, "

    Agreed -- I mentioned that before they actually would run out of capital, things could spiral out of control if there's a loss of confidence. Preempting that was almost certainly a big part of the motivation for getting Buffett to invest.

    Ilan

  • Report this Comment On September 24, 2011, at 10:23 PM, DonR215 wrote:

    This up and down buying selling is designed to get the unsuspecting to pull the last bit of money from under their mattress so they don't miss a cent of investor cash. They are following the same playbook that worked so well for the depression era thugs.

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