Financial stocks to bank on

(Fortune Magazine) -- Wall Street chieftains long ago stopped marking the progression of the financial crisis with sports analogies. That's because they got it completely wrong when they did so last spring. The game was clearly not in the early fourth quarter, as Goldman Sachs boss Lloyd Blankfein suggested, nor in the "eighth or ninth inning," as John Mack, who runs Morgan Stanley, asserted.

But by now both may have suffered the worst of the rout. Investors looking for safety in the financial industry should consider these survivors of the 2008 Wall Street crash. That may sound heretical at a time when the investment-banking industry has become a pariah for paying out bonuses after taking government handouts. Its reputation has been sullied and its earnings hit, and heightened regulation looks unavoidable.

Still, consider the merits of Goldman (GS, Fortune 500) and Morgan Stanley (MS, Fortune 500), which currently trade below their book values (more on that shortly). Though they are now bank holding companies, they account for most of the assets on their balance sheets slightly differently from banks. Like the securities arms of commercial banks, they must mark their holdings to market. That's what precipitated last year's huge write-downs.

The valuations they've set for those assets reflect market expectations and fears, not necessarily their likely performance. Just as asset prices overinflate on the way up, they tend to overshoot on the way down. But spooked shareholders have had a tough time believing these are worst-case valuations. That's a major reason that, since the Lehman Brothers collapse, both firms have been valued by the market at less than the sum of their assets minus their liabilities, or book value.

Usually book value is a good measure of a company's worth. But it often proved a trap during the crunch. Many who based their investment decisions on it, as Legg Mason's Bill Miller did with homebuilders two years ago, got singed as book values turned out to be wrong. But the metric may soon represent something of a floor for Goldman's and Morgan's stock prices.

That doesn't mean the broader crisis is over - far from it. But the Obama administration's plans for a sort-of bad bank should at least stabilize, if not boost, the prices of dodgier assets. Having written down the worst of their dross to less than 20 cents on the dollar in some cases, Goldman and Morgan Stanley should benefit whether they sell some of the assets to the government or hold on to them.

Indeed, a 10% bounce in the values of their most opaque assets would boost Goldman's book value to around $102 a share and Morgan Stanley's to $33, according to Fox-Pitt Kelton research. Even though their stocks have rallied so far this year, both are still trading at discounts to those potential valuations.

The same could perhaps be said of other financial institutions. Citigroup (C, Fortune 500) has slashed the value of assets on the books of its securities business by $55 billion. But Citi - like Bank of America (BAC, Fortune 500) and J.P. Morgan - still has deep exposure to the consumer, whose shaky financial health is directly correlated to rising unemployment. If that causes them further pain, they may need more capital.

Not Goldman and Morgan Stanley. The woes of the consumer and the broader economy hamper their ability to generate new investment-banking and trading profits. And there's always a chance new regulations may crimp earnings further. But it's a lot easier to slash costs in a downturn than to have to pass the hat around for money again.