Why Use Bad Banks?
Thanks send risky assets over to bad banks so that they look stronger. By getting junk assets off the books, banks can stay in business. Other banks will continue to lend to them, people will keep deposits there (and not make a run on the bank), and investors will feel comfortable with the bank.
Bad Bank Creation
To create a bad bank, you move risky items from the otherwise "good" bank to the bad bank. These risky items might be loans that are unlikely to be repaid, such as subprime mortgages.
Troubled items are replaced with safer assets, which improve the bank's strength.
Bad Bank Pricing
The bad bank purchases these items from the "good" bank. How much does the bad bank pay?
The items being moved to a bad bank are often considered risky, "toxic", or junk. They may be considered worthless, or of very low value. However, if the bad bank pays very little or nothing, the good bank receives almost nothing. In that case, the bad bank has not helped.
Bad banks need to pay enough to keep the good bank in business, but not so much that they reward the good bank for holding junk (see How Moral Hazard Works). In some cases, money for the bad bank may come from a government and its taxpayers, so it's important that the bad bank pays the right price.
Lifetime of Bad Banks
Bad banks are generally temporary measures. Once the troubled assets can be valued, sold, or retired, the bad bank goes away.
