For Geithner's "Bad Bank": A Toxic Financial Mutant

But in Strata's case there is no stack. Instead, BofA imagined it had invested $1 billion in the bonds of 75 different companies, and then pretended that Strata wrote insurance against a $20 billion slice. BofA bankers placed Strata toward the bottom, in order to justify its relatively high yield.

To understand how this works, think of Strata as a car insurance policy with a deductible. And then imagine you just had the worst wreck of your life while driving your diamond-encrusted Rolls Royce. The first $130 million in losses from the accident is your deductible. You are covered for the next $20 million in losses. The next $850 million comes out of your pocket again. (See pictures of expensive things that money can buy.)

That's basically the scenario for Strata. Its investors don't owe a dime on the first $130 million (or 13%) in losses on the $1 billion bond portfolio. That may seem like it gives Strata investors a lot of protection. But if just 15% of BofA's $1 billion imaginary bond portfolio, which are real bonds just not necessarily owned by BofA, goes bad, then 100% of the investment in Strata is toast. Because of that, Moody's rated the bond the equivalent of BBB-, which is the lowest investment grade rating the firm has.

So what is Strata worth today? Certainly not the original $20 million it's investors paid for it. According to research firm Markit, the average CDO tied to mortgage bonds lost half its value last year. CDOs based on corporate bonds have performed better. However, Strata sold insurance against high-yield corporate bonds, and those will be the first corporate debts to go bad if the economy gets worse. Indeed, one of the companies in Strata's bond pool, Hawaii Telcom Communications, recently filed for bankruptcy. In mid-January, Moody's put Strata on its list of bonds it was thinking about downgrading.

Of course, the government hopes the aggregator bank model it is proposing, with private investors actually making the purchases, gets around the difficult job of having the government figuring out just what these bonds are worth. But it is not clear it will. Even if private investors name the prices, the government will still have to certify the values are reasonable before providing insurance or some other type of incentive to get the purchases complete, if it cares about not throwing more taxpayer money down the rat hole.

"There were a lot of shenanigans that went on in the synthetic space," says Janet Tavakoli, who is an expert in structure finance and author of the recent book Dear Mr. Buffett. "These bonds were created by financial meth labs. Now the government is going to have to figure out how to take the hit."

See who's to blame for the financial crisis.

See George W. Bush's biggest economic mistakes.