How Will Banks Fare in the Bailout?

Here are the industry winners and losers that could emerge as the grand plan takes shape

by David Bogoslaw

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.