Why the markets hate the bailout.

If one test of a public official is the willingness to make a lot of people on all sides of an issue unhappy, Barack Obama and his treasury secretary are doing well. On Tuesday, the administration rolled out the one-two punch of a giant stimulus that conservatives think will be a giveaway to government, and a new beefed-up bank bailout idea—the bad-bank plan—that liberals think will be a giveaway to big business.

At least in the stimulus bill almost everyone will find something to love. Not so with the bad-bank plan. Critics of the banks (and who isn't these days?) think that it'll cost a fortune. The stock market took a nosedive in a clear sign that investors think it won't work. Unfortunately, there's a good chance that both the critics and the markets will turn out to be right.

No doubt all the talk of a bad bank leaves a lot of folks more confused than they are willing to admit. If you find yourself reading about the Treasury's asset-buying plans and feeling embarrassed that you don't quite get it, don't be. Check out this blog post from Paul Krugman a few weeks ago, in which Krugman says that he just doesn't really understand all the bad-bank talk. By now, no doubt, Krugman's up to speed. But the man has a Nobel Prize in economics.

So, what's a bad bank? Simply put, the bad bank would be a government-sponsored corporation that buys up the mortgage bonds and derivatives that no one else wants. The basic theory behind the bad bank is that some of that toxic waste may be worth something—but banks just can't wait to find out what. As the banking crisis drags on, more and more people and companies default on their loans. Real estate prices fall further. The losses grow bigger. It gets harder to refinance, so there are more defaults and still more losses.

So, yesterday, a banker thought that if a debtor defaulted, he could at least foreclose and sell a mortgaged house for $300,000. Today the house is worth only $200,000. Tomorrow, if things keep going the same way, it will be worth less. So losses beget more losses, and the total bank losses that were estimated at $400 billion early last year go up to $600 billion-plus, and now to well more than $1 trillion—a point at which we need not just a new economic plan but more zeros. Setting up a bad bank is supposed to put an end to this cycle.

That's the theory, anyway. But if you've taken even a passing glance at the markets since the new stimulus plan and bad-bank plan were rolled out, you can see that the stock market hasn't reacted with glee. Even as critics of the bad-bank strategy line up to call it a giveaway for big business, big business isn't very optimistic that it will work.