The system was damaged and what was worse, brokerage firms and major banks could not put a number on the extent of their potential losses. Wall Street can take bad news, as long as it knows and quantifies the news: the value is re-set and the markets figure the ultimate direction of the security. But with subprime paper, the exposure was unclear and incalculable for a quarter or two. Or three.

The first wave of write-offs began in the March quarter. Banks like Citigroup (NYSE: C) and Bank of America (NYSE: BAC) reserved in the neighborhood of $1 billion to $2 billion. Countrywide Financial (NYSE: CFC), the biggest mortgage originator in the U.S., took its hits, but gave the hint of confidence in the system. But it only got worse.

The second- and third-quarter write-offs were stated in mega-billions, with more yet to come. Stanley O'Neal, a one-time hero CEO at Merrill Lynch (NYSE: MER), was fired. Chuck Prince, the CEO of Citigroup was also fired. Both men tried to deliver heroic profits to their respective firms but stretched the risk profiles way too much. Merrill Lynch and Citigroup are not finished yet with multibillion write-offs. These CEOs did not lose their jobs because of one or two bad quarters: structurally, these firms will both look very different for years to come.

It should be noted and explained that the depressed paper held by many of the well-funded institutions are still receiving the monthly cash flow from the supportive mortgages. Remember, 97%+ are still paying their monthly mortgages. So why all the write-offs or write-downs?

Accounting rules specify that a publicly traded entity must acknowledge an asset that has been materially re-priced in value and reflect that new price -- fancy talk for, it's down in value, now recognize it as such. So that raises a question: Is the mortgage-backed paper that is causing billions of dollars in write-downs worthless? No value whatsoever? No, and therein may lie the opportunity for the better-managed and better-funded banks to seize a future earnings upswing. It will not happen tomorrow or even this quarter, but value investors are seeing growth opportunities take shape.

Wells Fargo (NYSE: WFC), Bank of America, JP Morgan Chase (NYSE: JPM) and US Bank (NYSE: USB) are holding some depressed paper, but because of their massive balance sheets, they can ride out the storm and hold onto the paper. Bottom line, unlike smaller, poorly funded players, or leveraged hedge funds that were forced to sell, these financial institutions can almost act like vulture funds: write down the paper, per accounting requirements, but continue to collect the interest payments and wait the crisis out. Once confidence begins to return to the system, the value of the paper will begin to go up. It may not go back up to 100% value again, but 80% or 85% will do just fine.

Also, the aforementioned banks had a higher quality loan portfolio before this mess even started. They maintained stricter mortgage requirements and therefore their collective exposure to subprime is lower than Citigroup or Merrill Lynch. They still encountered pain and write-offs, but the overall quality picture is still in better shape.

Which leads us to the opportunity...

Continue reading The Good, the Bad and the Ugly: The Financial Stocks, Part 5

Georges Yared is the CIO of Yared Investment Research and the author of Stop Losing Money Today.