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:

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:

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.