The Credit Crisis: Chicken Little or a Game of Chicken?

By Rachel Barnard, Ph.D.

If the sky isn't falling on financial stocks, it certainly looks that way. Every day there are new reports of companies being exposed to losses in mortgages, subprime credit, or CDOs. Banks are taking charges that run into the billions of dollars. There is no doubt that market conditions are deteriorating rapidly and financials are taking it on the chin.

Fear now dominates the marketplace. Financial-services stocks have fallen by 15% over the past three months, as measured by the S&P Financial Services Index. Investors are running for the hills--or at least for safer havens including cash and gold.Yet at Morningstar, our analysts are recommending an unprecedented number of financial-services stocks, even names that have been badly beaten up such as Countrywide Financial (NYSE:CFC - News), PMI Group (NYSE:PMI - News), and Citigroup (NYSE:C - News). What can we be thinking?

To sum things up, we base our recommendations on numbers and not emotion. We also model how much stress a company can bear before cracking.

To date, paper losses and non-cash charges abound, but the actual cash impact of the credit crisis has been fairly minimal. There is a lot of room yet before the financial industry reaches a breaking point. Could a catastrophic financial crisis be looming? It's always a possibility. But the data we've seen so far suggest that it's a remote one--and hence not something we'd want to base our recommendations on. Our approach has been to model in the worst mortgage-related losses in recorded history (a scenario that isn't even close to fruition yet) but stop short of predicting a financial collapse. We feel this represents the most likely scenario. And though we may have some very bearish assumptions built into our valuations, they are bullish compared with what prevails on Wall Street. So we have been advising investors, as Warren Buffett says, to be greedy when others are fearful.

But investing in times like these is not for the faint of heart. The decline in financial stocks could be nothing more than a Chicken Little rumor that the sky is falling when in fact, the financial markets are built to handle the stress of an occasional credit crisis. Or it could be a real game of chicken, with the health of the U.S. financial system riding on the hope that rational investors don't blink first.

We believe the next few months will be a crucial time for the financial markets. And as we watch the news unfold, we will share with you our latest thinking. We will comment on specific news and talk about the implications for the stocks we cover. We will also talk about our favorite--and our least favorite--stocks in financial services, detailing the risks and rewards for investors.

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