President Obama and his advisors face some tough decisions regarding the banks.

Paul Krugman writes for the New York Times, teaches economics at Princeton, and won a Nobel Prize. He may be too liberal for some but he lies out the problem pretty well in this Op Ed piece on the NY Times.

Lets say we have a bank with assets of $2 trillion and liabilities of $1.9 trillion. So its net worth is $100 billion. However suppose that $400 billion is overprices – mortgage backed securities and other junk They may be only worth $200 billion. So the bank has really gone bust. It may still be open and its stock may have some value, but the value is based on the hope or expectation of a government bail out.

The government needs to bail the bank out because of its importance to the national and global financial system. The government let Lehman collapse, financial markets froze, and the world financial system nearly collapsed. So the government wants to avoid a repeat.

The government could just give the bank money, say $200 billion. However that would be a giant gift and would probably encourage more irresponsible risk taking in the future.

Another idea would be to do now what was done in the 80s with the Savings and Loans. The government took over the S and Ls, moved the bad assets to the newly created Resolution Trust Corporation, made the S and Ls solvent, then sold them.

Doing this with the banks will look like the government is nationalizing the banks. So a third idea is a variation and it appears to be the most likely. The government will move the bad assets from the private banks to a new government bank. The government will pay “fair value” for the bad assets.

While this approach looks good, its not a gift because the government is getting something in return and it not nationalizing the banks. However, how do you price the bad assets. Probably at more than they are worth. The price must be high enough to keep the banks solvent for one thing. For another, if the price was not too high then the banks could probably sell the assets to someone else. So it is really a gift disguised as something else.

I expect this will play out pretty soon. Will be interesting and historical to watch.