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...For example, one of Paulson’s proposals for buying up distressed securities is a reverse auction in order to establish prices for these secondary market debt instruments. Once that price is established, the government will presumably buy each debt security backed by a pool of mortgages at the price established by the auction.

But there are tens of thousands of different pools of mortgages against which hundreds of thousands of debt instruments have been issued, all of which have different characteristics. Is Paulson going to undertake a reverse auction for each different type of debt security? Is that even possible? It would take 100 years to do so, and the ultimate result would provide neither stability nor transparency. Paulson will invariably have to undertake an ad-hoc approach in the face of random bidding with no hope of real success, similar to what he has done so far in addressing this financial crisis.

Instead of providing a general government bailout of mortgage-related securities as a means to addressing the liquidity crisis, the government should consider guaranteeing — for a price and under certain conditions — the principal balance of each troubled mortgage held by the servicers who administer mortgage-backed security pools. This would create a “floor” on the value of each troubled mortgage originated in the primary market, thereby creating a floor on the value of the related secondary market mortgage-backed security, thereby helping to eliminate valuation uncertainty, and restoring confidence and liquidity to the market.

So that borrowers also benefit, the government guaranty would only be provided if the servicer of the mortgage loan provided to the non-performing borrower a better set of terms (i.e., reduce the principal balance of the loan to some extent and offered the borrower a better fixed interest rate). In addition, the government would charge a guarantee fee.