"Bad Bank" Plan Gives Market Steam, But Questions Remain

Bank stocks are higher today on reports the Obama administration may be close to announcing a so-called "Bad Bank" plan. Under the expected plan, the bad assets, that have been clogging up bank balance sheets, will be removed by the government. The government would likely pay more than the market value of the assets, arguing that it has the liquidity and fortitude to hold the assets until maturity. The government may get common stock or warrants in the banks as part of the deal.

The FDIC is expected to be a key participant in the plan. Reports surfaced today that FDIC chairwomen Sheila Bair cancelled a trip to Davos to help spearhead the plan.

Shares of Bank of America (NYSE: BAC) are up 15%, Wells Fargo (NYSE: WFC) which reported better-than-expected results this AM are up 25%, Citi (NYSE: C) is up 18%, JPMorgan (NYSE: JPM) is up 10%, Goldman Sachs (NYSE: GS) is up 10% and Morgan Stanley (NYSE: MS) is up 10%.

The "Bad Bank" plan sounds similar to the original TARP plan introduced by former Treasury Secretary Henry Paulson and Fed Chairman Ben Bernanke, before they flipped to the UK model of providing the banks with direct capital injections by buying preferred shares in the banks.

While market participants are reacting positively to the news today, many questions remains about how the plan will be structured and implemented:

1. How will mark downs will be handled? For example, if banks have assets valued on their books at $50 billion that are eligible for the plan, but the government will only pay $30 billion, how is the $20 billion write-down handled?

2. How dilutive to current common shareholders will the plan be? Technically such a plan could wipe out current common shareholders, as it could be easily argued that the banks are currently insolvent. But as the bailouts have progressed, from Fannie/Freddie & AIG (NYSE: AIG) to Citi (NYSE: C), the government has become more lenient on shareholders. Will the new administration continue this trend of leniency or will they reverse it?

3. What will the government do with the assets once they own them? As everyone knows, the U.S. balance sheet and the Federal Reserve balance sheet is already "stretched" to say the least. How long can these toxic assets be held without public outrage? If they run-them-off who will buy them?

Commenting on the plan from Davos today, billionaire George Soros called the plan a bad idea. Soros thinks we should focus on "good" assets, not the "bad" ones.

StreetInsider.com addressed this problem back in November, suggesting the government should create a great big "good bank." Anyone in Washington listening?

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