Hedge funds have reported losses in the billions, subprime mortgage companies have filed for bankruptcy and most subprime debt is valued well below par, and the still the major ratings agencies had not reviewed the credit quality of these securities.

Sense finally came to Moody’s today, and the agency downgraded approximately $12 billion worth of mortgage-backed securities. This did not come as a surprise to investors. Still, investment banking stocks moved lower on this news. As an investor who often looks for cheap, distressed securities with solid fundamentals, I think this is a great opportunity to buy these stocks.

Let’s take a look at Lehman Brothers (NY:LEH), a bank whose performance is heavily tied to several large hedge funds. With stakes in Ospraie Management LP, Marble Bar Asset Management, D.E. Shaw, GLG Partners LP and Spinnaker Capital, it is certain that Lehman has exposure to risky hedge funds who hold these securities. I would stay away from this stock until it reports Q2 earnings.

Bear Stearns (NY:BSC) is in a similar situation, and I would wait for the company to trade near its 52-week low before adding it to a portfolio.

Focus on companies that have a diversified portfolio of services. Goldman Sachs (NY:GS) may have exposure to these securities, however, its brokerage and investment banking operations will mitigate the losses from its subprime investments. The same goes for JP Morgan (NY:JPM), another well diversified investment bank.

Just like any portfolio, the more diversified the better.

Filed under: Fundamental Research, Sector Watch, Stocks