Steve McDonald of Investor’s Daily Edge recommends three profit-potential bank stocks that could play out following the downside of government intervention.

This from Steve:

The complete inability of the banks to offer any solution to their current problems, other than to have the taxpayers pay for their bailout is the best case for some form of government intervention.

Nationalization is a disgusting word to me, but even I have reached the point of believing something needs to be done to pull us out of this mess.

Bankers have always been a strange group to me. They are the first and loudest to scream about welfare and people taking responsibility for their actions, and they are the first and loudest begging for a bailout from a situation they are responsible for creating, at least in part.

These people absorbed the entire first half of the TARP money and made no appreciable change in their lending. They have acted as if the TARP money is theirs and not the taxpayer’s.

They created and bought mortgage-backed securities they knew were garbage and expected the U.S. Government to make good on them. It’s another form of welfare.

It’s hard to believe the best and the brightest didn’t know what they were buying, with other people’s money, of course.

The obvious solution to this problem is to have the banks work openly with mortgage holders and rework these problem loans, sell off the garbage, take the loss and get this show on the road.

They haven’t done this because I believe they have no ability, or lack the willingness, to see beyond the balance sheets and recognize that this is a unique situation. The solution requires imagination, creativity and stepping beyond the normal banking parameters.  Bankers are not known for their creativity.

Bankers cannot solve the banking mess. They have offered no solution other than to wait.

The best proposal, with the greatest probability of success, looks like this: a government group takes over the asset base of the zombie banks.  The group separates the good assets from the bad, values them as accurately as possible, sets up a sale mechanism similar to the Resolution Trust Corporation to get something for the dead wood and then turns the cleaned up operation back to the bankers.

The banks take a loss, but the good assets become available to be used as reserves for lending.  We can finally stop guessing and actually know exactly what we have.

There is money to be made in this nightmare, but you’ll have to do your best imitation of not thinking like a banker to take advantage of it. Here’s my recommendation.

There appears to be no way banks, or their stock, will recover from their current situation unless something radical is done. If the limited intervention concept wins, and I think it will, we will see bank stocks drop to something similar to an AIG scenario, the stocks will be near worthless until there is a resolution of their balance sheets and asset woes.

So the obvious play now is to short or buy puts on individual bank stocks or the S&P Select Financial Spyder ETF (NYSE:XLF). Yes, I know, they are already in the toilet, but take a look at the XLF puts for Sep 09 or Jan 10 and you’ll see some real profit potential.

Also, JPM and WFC have not been immune to the beating the markets have been handing out lately. While these are the two banks with the smallest problems, they are not immune to the coming slaughter. There is lots of room for a downside play here.

If the markets react as they always have, we will have a period of severe bleeding following the government intervention, which is why this strategy will work. This should be followed by the usual waiting period to allow the street to adjust to the change and then I see a big upward move in what I call “resolved banks.” Time frame? 18 to 36 months.

How do you make money now? Look further out than the end of your nose, imagine what we could do to turn this mess around, and don’t sit around waiting for the government to send you this month’s welfare check.

Keep your eye on the horizon.

Source: Short The Banks Again For A Huge Gain