A few months back my colleague Peter Staas and I co-authored a brief research report focusing primarily on smaller community banks. It was free to the public and very well received (as most everything that is free usually is). Based on the volume of questions and correspondence I’ve had about the report, a lot of folks purchased shares in at least some of the banks we recommended. All of them continue to hold up well despite the problems in the money centers, though of course their share prices have been buffeted depending upon the news flow.

Needless to say, since the report hit the virtual presses, I’ve watched the news flow surrounding banks obsessively. While I’m sure there are those among you who would disagree, I like to think that I’m pretty good at what I do. Partly because I’m terrified of losing someone else’s money. If I make a bad call and lose my own cash, tough luck, I learn not to make that mistake again at my own expense. I don’t care how long you’ve been at this, there’s always more to learn and just like everyone else in the industry, I’ve biffed enough picks to know that. Thankfully though, I’ve had more winners than losers.

I have to say I think the government has biffed a call of its own.

Even as Treasury Secretary Geithner was discussing his now infamously vague plan to save the banking industry, I was sitting in front of a Bloomberg terminal watching all of the major indexes plunge. In the wake of the stunning declines, all of the talking heads kept sermonizing on the fact that it was the lack of details that made the markets plunge.

My thinking is that Mr. Geithner was deliberately vague for reasons that we’ll get to, and that the markets nosedived because our captains of the industry were expecting the announcement of more juicy giveaways.

Since that day there have been media reports that the primary reason for the vagueness was the fact that the plan had taken an abrupt change in course just days before the announcement. So there wouldn’t have been that many details to give since he wouldn’t have even had them all.

But I think his plan is deliberately opaque and that the “stress test” is a back door to nationalization. Like everyone else, I loath to have the government take over banks and then decide who does and doesn’t get credit. Even though, to some extent, they already do that. Then again, the government has been nationalizing banks for years and has been doing it at a pace of two to four banks a week since January 1. In fact, my own copy of FMW is delivered to me around 7:00PM every Friday, and I’d be willing to wager by the time I get it this evening, at least two banks will have already been nationalized. The government already has the power and doesn’t mind using it.

Admittedly, the banks the FDIC has “resolved” thus far have been fairly small so no one’s shed a tear so far. But realistically speaking, the basic process for resolving Citigroup (NYSE: C) wouldn’t be much different, though it’d be much more complex and I think these stress tests are the first step to making that happen if need be.

Stress testing is already done on banks to some extent, with banks being examined on a rolling basis. And while Geithner hasn’t enumerated exactly how these stress tests will be conducted, they’ll be along the same lines, only much more stringent. Whether or not government regulators are actually able to pull it off is open to some debate in my mind, especially since the regulators have been severely neglected from a budgetary perspective over the past few years. So I don’t know that they’ve had the cash to attract and retain the top talent because if you actually understand the nuances to using and pricing all the different sorts of derivatives out there, I have a feeling you’d be working on Wall Street making the real money. But for the sake of argument, let’s assume they have the know-how.

So they do the stress tests and figure out that The American Bank is in fact insolvent. What do they do? They’ve already tried pumping massive amounts of cash into the banks, though I have to admit that they were much more conservative on that front than I thought they would be. A few months back, I actually wrote here that I thought taking some small speculative positions in the big banks might not have been such a bad idea. At the time, I didn’t think the government would just fire up the printing presses for the banks, I figured they’d just give them to them. But so far that hasn’t worked as the banks of mainly hoarded the cash yet keep saying they need more.

At this point, I don’t think it really matters how much money you give or “invest” in the banks, not even pre-bubble lending activity will resume. There are still too many bad assets sitting on the banks books and the prices are still falling with no real bottom in sight. And the banks themselves are mainly to blame for the falling prices of the bad assets. They were more than complicit in the creation of the assets, their demand for and trading in them helped to drive the prices, and their new found reluctance to take risk and buy the things is mainly what’s killed the prices on them. True, hedge funds and pension funds share some of the blame, but there are no innocent parties here.

The vagueness of the Treasury Secretary’s plan leaves the door wide open to nationalization, and again, I think that’s the ultimate intent. Like everyone else, I think the name will be different given the fact that the new political establishment is already being perceived as having socialist tendencies. And when I hear the word nationalization, I think of governments seizing industries with the intention of running them themselves, meaning five-year plans aren’t too far off.

But I don’t think that would be the intent, nor should it be. We already have the mechanisms in place to pull off (the FDIC) and two separate models for how the clean up can be achieved (the Swedish model or our own “bad bank” method from the S&L crisis). Granted, sorting this mess out will probably take longer than either of the two previous experiences given the much larger scale and much different circumstances, but banks only need to be controlled for as long as it takes to clean off the books.

It would have been easier if this had been done a year ago and I think it’s being put off now for the same reasons as it was then; the implications of the term nationalization and the fact that, just as in Sweden and in our own S&L crisis, equity holders will likely be completely wiped out. Debt holders would likely become the new equity holders, essentially left with whatever good assets there were. And there are a lot of both equity and equity holders who both vote and make campaign contributions.

These stress tests hopefully will allow regulators all of the information they need to make a determination on as to whether or not individual banks are salvageable or just need to be taken down, with seizure of the insolvent players allowing the time and resources to orderly dispose of the junk. And since the Fed is the ultimate regulator of banks and such a program isn’t completely unprecedented, I think it’s primarily political considerations that holding them back. Say what you will, but the Fed only has as much freedom as the political powers that be allow it.

So, for whatever reason, I feel confident in saying the government has biffed their response to the banking crisis, though that’s much easier to say with the benefit of hindsight.

At any rate, by continuing to delay nationalization we’re only allowing the pressure in the system to build. We’re not going to wake up tomorrow and find that the prices of CMOs and CDSs have suddenly risen. Regulators have to actively clean these guys out instead of passively handing them cash. Otherwise we may very well find out what a real depression is like.

And I’m tired of seeing my quality small banks getting thrashed because the big boys made some bad decisions.

Gold briefly broke $1,000 today, spurred on by troubled economies, weak earnings and bad banks. This past Tuesday, George Kleinman talked about surging gold prices and how to play them in Commodities Trends:

As I mentioned in our last issue, gold, with a 5 percent gain, was one of the few markets that registered any gains at all in 2008. And thus far in 2009, despite a stronger dollar, gold prices are up an additional 6 percent. Gold has been a safe haven during the financial storm.

However, truth be told, gold hasn’t been an easy market to trade. It’s been volatile, with huge swings in both directions. Dealers are charging huge premiums for buying coins and bullion right now, and the futures have been erratic and riskier than usual. While options offer a limited risk, leveraged way to invest or trade in the gold market, the option premiums are also very high right now, making this an extremely expensive way to play.

I see the gold market moving higher over the coming three to six months and perhaps beyond that time frame as well. I’m not an expert in gold mining stocks and have noted many of these have actually moved lower despite gold itself moving higher. Therefore I want a pure gold play, with some leverage, but without sticking my neck out completely.

With this in mind, over the long weekend I took a look at the gold futures and options and developed a suggested leveraged strategy that has limited risk. While the profit potential has a limit as well, it’s still high.

This strategy involves buying gold futures, buying a put option for protection and selling an out-of-the-money call option to take advantage of the high option premiums currently in the marketplace.

Here’s how it works: First, we buy the June gold futures at the market price. I’m going to use the market prices available as we go to press to illustrate my strategy. These values change with the market and will no doubt be different if you look to execute this strategy. However the relative prices should be similar, at least for the coming week or two.

As we go to press, June gold is trading around $945 an ounce. At approximately the same time we buy our June gold futures, we look to buy a June put option with a strike price about $50 under the market, and simultaneously sell a June call option with a strike price about $50 above the market. For example, if the market is still around the $950 level, buy the $900 put and sell the $1,000 call.

With the market at $945, the $900 put is quoted at $54 and the $1,000 call at $57. Because each option has a size of 100 ounces, at this price the put will cost $5,400 ($54 multiplied by 100 ounces) and by selling the call option we’ll receive $5,700. Note both option premiums (prices) are high right now, with the calls slightly more costly than the puts due to the bullish nature of the current market environment. Note also the call being higher priced than the put essentially has the call paying for the put.

For the rest of the article, click here.