How Will Banks Fare in the Bailout?

The details still have to be worked out for the $700 billion fund the U.S. government will create to take distressed mortgage-related assets off banks' hands in hopes of thawing the country's frozen credit system. The most obvious beneficiaries of the plan will be members of the "shadow banking system," including such surviving investment banks as Merrill Lynch (MER)— which has agreed to be acquired by Bank of America (BAC)— and Morgan Stanley (MS), but even more conservative commercial banks that don't have much to purge from their balance sheets are expected to gain as the effects of the program spread through the economy.

A major question that will determine how helpful the bailout is: the price the government is willing to pay, which could turn out to be as low the 22 cents on the dollar that Merrill Lynch got for $30 billion in assets it sold to private equity firm Lone Star in July.

The financial companies that are holding distressed assets don't even necessarily have to sell them to the U.S. Treasury in order to benefit from what many are calling the "mother of all bailouts." A financial company might decide not to sell its distressed assets in the belief that there's more value in holding onto them until the market recovers somewhat and prices for the assets increase, predicts Gerard Cassidy, senior equity analyst at RBC Capital Markets (RY) in Portland, Me.

The Buyer of Last Resort

As Merrill Lynch's transaction with Lone Star showed, the discount on these assets has two components: credit risk, which is based on the likelihood of defaults on the underlying mortgages, and lack of liquidity discount, which stems from a dearth of potential buyers, says Cassidy.

By stepping in as the buyer of last resort, the U.S. government will be pumping liquidity into the banking system, which is expected to boost the value of these securities, he says. As a result, the liquidity discount in the price of the assets should narrow substantially as market participants recognize there's a big buyer providing liquidity, which could help attract more buyers, Cassidy adds.

One group that isn't likely to get any relief from the bailout are hedge funds that hold a large quantity of the distressed debt products, says Jack Ablin, chief investment officer at Harris Private Bank (BMO) in Chicago. "Here's a case where hedge funds, as unregulated entities, have no recourse at the table," unlike the banking lobby and mutual-fund industry group Investment Company Institute, both of which will likely have some influence over the legislation that ultimately materializes, he says. He also believes the hedge funds were directly targeted by the Securities & Exchange Commission's ban on shorting more than 800 financial stocks, which took effect on Sept. 22 and is due to last through Oct. 2.

GM May Be a Loser

Other losers may include companies such as General Motors (GM), whose affiliated financing arm GMAC likely has exposure to toxic securities but may not qualify for the government bailout because it's not strictly a financial firm, says Ablin. "You certainly get into odd territory with GMAC," he says. "It's almost entirely owned by a private equity fund [Cerberus Capital Management]. So do you want to bail out [Cerberus chairman] John Snow?"

Commercial banks, most of which have kept their balance sheets free of toxic assets, will probably benefit indirectly as the increase in market liquidity will help push their borrowing costs lower, says John Jay, senior analyst at the Aite Group, an independent financial services research firm in Boston. "If [its funding costs] go low enough, their senior managers will start to look for businesses to lend money to." In the end, their profit margins are expected to grow as the differential between their borrowing costs and lending rates widens.

The shares of some financial players have had a strong run in spite of the market's attempts to paint them with the same brush as the rest of the industry, says Jocelyn Drake, an equity analyst at Schaeffer's Investment Research in Cleveland. PNC Financial Services (PNC), Wells Fargo (WFC), and Hudson City Bancorp (HCBK) all steered clear of toxic assets and their shares hit one-year highs last week before Treasury Secretary Henry Paulson announced the plan on Sept. 18. The shares posted further gains after the announcement.

Skeletons in the Closet

Schaeffer's tends to base its stock picks on technical performance and the degree of pessimism directed at them. Market pessimism —which is reflected in analysts' ratings, the level of short interest and the ratio of options betting on lower prices for certain stocks vs. bets on higher prices—can give you a sense of how much investing money is sitting on the sidelines waiting for the right signals to come into the market. "There are still some skeletons that could come out of the closet [for the financial industry] and hinder the group," says Drake. But she's betting that as certain stocks continue to buck the trend and outperform their peers, sidelined investors will cave in and start to buy these stocks so as not to miss the boat.

There are also a couple of homebuilder stocks that Drake expects to benefit as liquidity returns to the housing market and inventory begins to move.

She likes Meritage Homes (MTH) and Toll Brothers (TOL), both of which have been in an uptrend since the beginning of this year. She takes the drop in mortgage rates after the government bailout of mortgage giants Fannie Mae (FNM) and Freddie Mac (FRE) was announced two weeks ago as a positive sign, which she believes will help stoke demand for houses.

A Contrarian View

She recommends that investors hedge such bets that go contrary to market sentiment by buying shares of index exchange-traded funds that short the corresponding sectors. For financials, she uses Financial Select Sector SPDR (XLF and UltraShort Financials ProShares (SKF) to hedge her bank picks and SPDR S&P Homebuilders (XHB) to protect against the downside in homebuilders.