Which Companies Are Swimming Naked Right Now?

"As house prices fall, a huge amount of financial folly is being exposed. You only learn who has been swimming naked when the tide goes out -- and what we are witnessing at some of our largest financial institutions is an ugly sight."

-- Warren Buffett

That was the Oracle of Omaha's adept summary of the current housing and credit crises in his most recent annual letter to shareholders. When things are humming along smoothly, almost any company can look successful. When the going gets tough, though, the weakest companies reveal their shortcomings.

Cover up, already!
In essence, thanks to the mortgage meltdown, banks are now less than willing to lend money to one another. This is a real problem, because banks need to keep a certain amount of cash on hand as a reserve against any loans they have written. If their cash falls below that level, they need to borrow enough to cover the shortfall.

Under ordinary circumstances, banks will lend short-term money to each other with barely a shrug. But with so many subprime mortgages imploding, that pool of ready cash has largely evaporated. Stronger banks, such as Wells Fargo (NYSE: WFC  ) and US Bancorp (NYSE: USB  ) , are using their cash to cover their own relatively modest mortgage losses and shore up their reserves.

Focusing on preserving their own cash has left them with far less available to loan out to their weaker counterparts. As a result, when those weaker banks were short of cash after bringing their bad loans back on their balance sheets, they found themselves without a safety net. As Buffett said, when the tide went out, we discovered who'd left their suits back on the beach.

Those same companies are now publicly begging for cash from sovereign wealth funds, or getting bought out for a fraction of what their balance sheets said they were worth. (See: Stearns, Bear.)

Who's embarrassed now?
Mortgage giant Countrywide (NYSE: CFC  ) is perhaps the poster child for such unfortunate imagery. The nation's largest mortgage lender is now in such desperate straits that it agreed to be bought out by Bank of America (NYSE: BAC  ) for a sliver of its previously reported book value. As long as there is any validity to Countrywide's balance sheet, that's likely great news for Bank of America shareholders. However, if you happened to have owned Countrywide stock (now off 88% from its pre-meltdown highs), you're painfully aware of the fate that awaits banks caught without sufficient capital.

Countrywide isn't alone. Check out how these other skinny-dipping companies have been forced to cover themselves:

Company

Desperate Capital Raised

Citigroup (NYSE: C  )

$7.5 billion from Abu Dhabi.
Expected to seek more

Merrill Lynch (NYSE: MER  )

$5 billion from Singapore,
Reportedly looking for $4 billion more

Morgan Stanley (NYSE: MS  )

$5 billion from China

These former behemoths have had to raise a lot of cash -- at a significant cost to their shareholders. What's more, Citigroup has since dipped back into the well, and rumors have Merrill Lynch looking for additional cash. Those signs suggest that the problems facing these banks' businesses are likely even larger than what we already know.

The $64,000 question: Is now the time to buy?
With all of the writedowns, capital infusions, and general fear pervading the industry, the stocks caught swimming au naturel trade well below their highs. In fact, many of them are pushing multiyear lows. It may seem like a prudent idea to buy now, since you'd be getting so much more for your money.

There's at least one huge risk to that line of thinking, however. This influx of emergency capital comes with a tremendous price -- dilution. Morgan Stanley's bailout, for instance, hands 10% of the company to China. Unless you account for the impact of that dilution -- and any more that may come later -- you may be buying shares that are worth far less than you originally anticipated.

The bigger problem with buying shares of beleaguered banks is that no one understands exactly what you would be buying. These businesses' derivative liabilities and structured investment vehicles are just too opaque. And if Buffett is right, even the executives at these companies "really didn't have any idea what risks they were involved with."

If you're still tempted to buy
The industrywide riptide has unfairly pulled down some financial companies, but investors in financial stocks should tread carefully. Troubled banks that have fallen far from their peaks may appear tempting, but a recent International Monetary Fund report suggests otherwise. The report shows that subprime loan first-rate resets are about to be replaced with the even more problematic option/ARM loan recasts. In those loans, borrowers didn't even have to cover their interest, much less pay down their principle. For crisis-ridden banks, an end to this lending mess seems nowhere in sight.

Fortunately, though, the current meltdown hasn't caught every financial company with its trunks down. While I won't be putting new money in bank stocks any time soon, some financial stocks look legitimately cheap. One financial-services company looks so fundamentally strong in the face of this disaster that Motley Fool Inside Value recently recommended it for the third time. If you're looking to put money to work in the market, but need you need solid, stable ideas, you can find out what our thrice-picked company is right now with a 30-day free trial.

At the time of publication, Fool contributor and Inside Value team member Chuck Saletta owned shares of Bank of America. Bank of America and US Bancorp are Motley Fool Income Investor recommendations. The Fool's disclosure policy always dresses appropriately for the occasion.


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