Treasury Secretary Tim Geithner will announce a plan early next week to relieve failing banks of their toxic assets by attracting back private investors rather than have the government buy up all the risk, according to officials familiar with the plan.

Private investors, including hedge funds, will be able to bid on the assets using a pool of capital from the investors and the government, with taxpayers sharing in profits or losses.

The plan uses up to $100 billion of taxpayer funds to leverage up to $1 trillion in private capital, the officials said.

“We’re creating a market, not bailing out banks,” said an official briefed on the plan. “Because we’re creating a market, we’re letting the private sector set the price, which will likely be below purchase price but above what government would get for them. “

Here is how it would work:

—A Treasury/Federal Reserve /FDIC Purchase Facility will provide funding to purchase real estate-related legacy assets.

—Public-Private Capital will co-invest, initially at up to $500 billion, expanding to $1 trillion over time.

—Private Sector Pricing: Private sector buyers determine price for currently troubled and previously illiquid assets.

The government estimates bank balance sheets that currently have at least $2 trillion in “legacy” (toxic) assets that originated in 2005 and 2006.

“All of this is based on private investment – that’s what is so innovative about it,” the official said. “We are using the private sector to help us stabilize the system, which saves taxpayer dollars. Government has never done this before. Taxpayers are protected because they share in all the profit, and investors share in all the loss. So there is a huge incentive to make good, careful investments.”

Treasury has taken action to deal with three big problems fueling the economic meltdown—falling home prices, frozen credit markets, lack of confidence and capital in the banks—and now is taking on toxic assets.

The officials explained the problem the plan is aimed at correcting: The bursting of the housing bubble caused losses for financial institutions on residential mortgages and related securities. Those losses resulted in the need to reduce risk and leverage. As a result, institutions were forced to sell, causing further price declines. This fueled further deleveraging, creating a bad cycle.

This has reduced banks' ability to lend—because these loans are stuck on bank balances sheets because of a large gap between banks' carrying values and market prices. This makes it difficult for banks to access the private markets to access new capital. And, since there's no secondary market for these assets, they've become frozen.