Bank plan buys time, but that's all

By Jon Markman

Stocks have zoomed around this month like hornets escaping from a broken hive, generating an exciting buzz and just a hint of danger. And the good news is that they've got a real shot at staying on the loose for as long as 45 to 60 days -- plenty of time to make us some money before they're rounded up and squished.

Here's the situation, and a few ways to play it.

Deteriorating U.S. and European home prices and unpaid mortgages, as you know by now, are the central curse of this entire bear market. These seemingly minor matters have spread like a bad flu through the entire global financial system and caused all manner of aches and fevers, from bankruptcy at big brokerages to galloping unemployment. Yet if the mortgage problem can be solved, then most of the other problems can also be contained.

In six weeks the U.S. government, after much dithering and navel gazing, is going to do something concrete about those bad loans and the securities they've been packaged into. Treasury Secretary Timothy Geithner has announced a plan to join forces with handpicked private funds to buy up to $1 trillion worth of soured loans from struggling banks. The Treasury says it will kick in most of the money -- shagging some from taxpayers, and printing or borrowing the rest -- so long as the fund managers agree to do the dirty work of pricing and reselling the assets.

It sounds like a "win-win-win," as one private-fund manager put it, because if it works in practice like it looks on paper, then banks will finally be able replace yucky old mortgage loans with fresh, green, lendable money; fund managers will have new product to mark up and sell; pension funds will have new high-yield paper to satisfy their long-term obligations; and Geithner will earn some time off to get a tan and put some weight on his skeletal frame.

A cure-all for the banks -- for now

The reason stocks may be buyable for a short while: No bad news will be counted heavily against bank stocks until this program gets under way, which means that the low set on March 6 is likely to endure for a while. For a time, no matter what potentially damaging economic data are in the news, analysts will say that this loan-removal surgery will fix the problems.

This gives bulls two months to lift the Dow Jones Industrial Average ($INDU) 30% toward its 2008 average of around 10,000, which would be a typically strong rally within the context of a bear market, before hitting a wall.

Ah, but there are problems with this rosy scenario, as you may well imagine. First, five times the $1 trillion in bad mortgage-based loans and derivatives remains outstanding. And second, everyone knows win-wins are never available at the Wall Street casino. So the mere fact that this one is advertised as such is a gigantic red flag. Indeed, judging from my discussions with a lot of fixed-income experts you won't see on television, there's a decent chance that the whole deal will blow up in about six weeks.

To understand why, you need to realize that the U.S. financial system is not facing troubles that the world has never seen. Booms and busts of the credit cycle underlay much of Western economic history, as banks have repeatedly borrowed too much in good times and gone splat in bad times. The usual response is for governments to close the banks for a while, extinguish the bad loans, tell equity investors and some bondholders they're out of luck, print new money to make up for the missing credit, suppress peasants outraged about dilution of their cash, then wait a while and pretend it never happened.

That process takes guts and time, and the Obama administration appears short on both. And besides, hey, we're modern and have more brains, tools and hope. Why not try something new?

Watching the BlackRock bids

The new idea is for government to lock arms with supportive bankers and try to browbeat investors into pretending that the "toxic" loans really aren't so bad. To entice them to use rose-colored glasses instead of green eyeshades when examining the details of the deals they're considering, the Treasury is handing them massive amounts of taxpayer money and loans that never need to be paid back.

Now here's where the proposal might run into trouble. The Treasury has drawn up the requirements for participating in the program in such a way that only a handful of large fund managers will apply. They need to have raised at least $500 million in the past, command a large sales force and already own at least $10 billion in distressed loans. There are probably only five to eight companies in this category, including Pimco, Western Asset Management, Wellington, Bridgewater and BlackRock (BLK, news, msgs).

Of those, I'm told that only Bridgewater and BlackRock have had any real expertise in valuing the type of woeful derivative securities -- mostly residential-mortgage-backed securities packaged into collateralized debt obligations, or CDOs -- that banks are expected to make available for sale. And BlackRock is widely believed to have the very best mathematical model for doing so. So if five bids are made for a single pool of distressed residential-mortgage-backed CDOs, and other managers discover that their bids are much higher or much lower than BlackRock's, they are more than likely going to pull them. In this way, some experts are saying that the program is really the BlackRock full employment act.

There are also questions over the quality of loans and securities the banks will put up for sale and the prices they will accept. There is already a very active market for these securities -- the government isn't starting from scratch -- but banks have been unwilling to let them go for what investors are willing to pay. If you assume most of these loans and securities started life being worth the equivalent of $100, most are now being carried on banks books at around $80. The government would be happy to buy them with its funny money at $80 as a sneaky way to recapitalize banks without nationalizing them, but real-money investors in recent months have been willing to pay only $25 to $35.

Continued: Impatience at the elevator

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