Profiting from subprime turmoil

(Money Magazine) -- News this week that major banks are planning a massive fund to prop up the hardest-hit victims of the subprime mortgage crisis got investors worrying again.

Specifically, they're concerned that potential losses from bad subprime bets could be much bigger than previously feared.

In fact, the bailout fund is good news. And you actually have a chance to profit personally over the long term from today's turmoil, as long as you make your investment decisions cautiously.

Shares of banks and financial services companies may not have hit bottom yet - but there will soon be bargains to be had. And some companies with exceptionally strong balance sheets are already good deals.

Understanding the problems

The credit crisis itself is very complicated, but here's pretty much what you need to know. As home prices kept rising over the past few years, more and more people wanted to buy houses. Lenders accommodated them by devising mortgages that required less money down and lower monthly payments.

Often the interest rates on these mortgages could increase sharply from initial low levels. That created the risk that buyers who had stretched to the utmost to buy a house could be forced to default.

The risks were greatly multiplied as the original mortgages were bundled into separate investments and sold off. This kind of packaging has been done for decades by institutions, and the resulting securities have long been part of a stable credit market.

But the new packages, a type of collateralized debt obligation (CDO) known as structured-investment vehicles (SIVs) are far more complicated - too complicated, in fact.

The packagers sliced and diced underlying pools of mortgages, mixing lousy loans with solid ones, until nobody could tell what was what. Even the resulting investments that had great credit ratings could ultimately be backed in part by shaky mortgages.

In addition, long-term assets in the portfolios were financed with short-term borrowed money. That means that rising interest rates or tight credit could force banks to take losses as they scrambled for cash.

The great risk is that the overall credit market freezes because lenders are afraid to lend.

And that's why recent news has been encouraging. The Federal Reserve has made extra short-term credit available to banks and is clearly willing to do more. And the Fed aggressively cut short-term interest rates in September, which greases the wheels for more lending.

In addition, the new fund that the major banks are proposing will ensure that the hardest-hit investors will be able to sell securities when necessary. Equally important, the fund will allow solid securities to be separated from those that are iffy.

Ratings agencies and other experts estimate that there are as much as $400 billion of SIVs outstanding, although it's impossible to know the total amount. But not all of this is at risk - the actual losses should be in the manageable range for major banks that earn tens of billions of dollars a year.

The credit crisis will require more big earnings writeoffs, like the one that slashed Citigroup's (Charts, Fortune 500) profits by 57 percent in the third quarter. Bank of America (Charts, Fortune 500) and Washington Mutual (Charts, Fortune 500) also announced weak results. But once they are completed, such writeoffs won't impair the value of the stocks involved.

Bargains to be had

When things calm down, top-quality financial stocks will likely be great bargains, as I discussed in the October issue of Money Magazine.

Basically, there have been a couple of episodes, starting with the Savings & Loan crisis almost 20 years ago, that were similar to what's been going on recently. In those earlier cases, it took about six months for financial stocks to hit bottom.

So far, the big banks are generally above their August lows. The notable exception is Citigroup, which is having the most trouble, because its exposure is estimated to account for about a fifth of the outstanding SIVs. Other banks should have an easier time.

The good news is that once the past selloffs ended, financial stocks posted gains of more than 50 percent over the following two years.

Still, take your time about adding more financial stocks to your portfolio. There could still be some unpleasant surprises between now and early next year when final 2007 results are known. At that point, however, financial shares will actually be a lot less risky because the extent of their problems will be known and reflected in share prices.

If you're looking for stocks in other sectors that are smart buys now, you'll find bargain-hunting opportunities among companies with plenty of cash or pristine balance sheets. At a time when banks are cautious about making new loans, businesses that have ready money or that are still attractive borrowers will be able to expand, acquire weaker players and take advantage of other opportunities.

Investors haven't yet fully recognized the competitive advantage of creditworthiness. But they will soon enough, and financially strong companies should then be accorded higher price-to-earnings ratios. The greatest bargains are likely to be stocks that are depressed and trade below their typical price/earnings ratios, such as Johnson & Johnson and Microsoft. For more on financially fit stocks, click here.

While stock prices will likely be volatile over the coming year, the odds are still in favor of continuing growth rather than recession. So hold down your risk by adding stocks with relatively low P/Es to your portfolio and diversify as broadly as you can. But don't shy away from equities because of today's market troubles. Remember that after the S&L Crisis ended, stocks enjoyed a six-year bull market.