What really is a 'bad bank'?

There is talk among top U.S. officials about a partial solution to the current financial crisis which involves creating a so-called 'bad bank,' but what exactly is the concept behind it?

In essence, the U.S. government will take ownership and burden of banks' bad investments and put them in a new entity called a 'bad bank.' This will ideally set once troubled banks free to hopefully lend to businesses and consumers once again.

One of the debates about a possible bad bank is how much the U.S. government should pay for the assets. Determining the value of such assets is difficult, given the fact that investors have shied away from them, even labeling them toxic assets.

If the U.S. decides to buy the bad assets at a high price, they can then be sold off at much lower prices, or kept on the chance that they will regain their worth after the current uncertainty passes and investors gain enough confidence to pay higher prices.

The government has not yet created a 'bad bank' but is mulling that option.

The U.S. has chosen to call those bad investments troubled assets. It has already approved $700 billion to help ease the crisis among financial institutions. However a provision in the law about the use of these funds has allowed the government to give some of the money directly to banks, giving them relief from immediate financial pressures. The money has not been used to take the assets off their balance sheets, however.

Figuring out the market prices for investments, many of which are linked to the suffering mortgage market will be a challenge. Since home sales are in a steep downturn, the value of the assets is seen as unstable and risky. To avoid risks, some investors would choose to buy the assets only at very low, or fire-sale prices.

President Barack Obama has said he expects to soon say what additional steps his administration will take to resolve the crisis. His top economic official, the newly appointed Timothy Geithner, spoke two weeks ago about how to determine the value these 'toxic assets' as he testified before Senators at his confirmation hearing.

He indicated that the assets could be priced by looking at similar assets, using computer-models from independent firms, and even seeking the judgment of bank supervisors.

They all have limitations, he said, according to Bloomberg. I think you need to look at a mix of those types of measures.

Some economists at Wall St bank Goldman Sachs made one estimate recently, saying their total cost would be $4 trillion. That amount could increase if the economy worsens more than expected.

Unfortunately, with an unprecedented meltdown in mortgage credit and a deep recession in the broader economy, there is a great deal of uncertainty about the value of almost any asset, the Goldman economists wrote in a note to clients, according to Reuters.