Build a better bailout

A crucial component of this plan is that it moves whole loans (and not fractional securities) under government control. Once it holds these loans, the government can take charge of workouts and refinancings. This is the approach that the Home Owners Loan Corporation took in the Great Depression, and the Federal Deposit Insurance Corporation (FDIC) is already operating such workout programs for loans held by failed banks under its control.

If the Treasury bought these toxic pools, it could offer relief for borrowers who were misled or abused, and then deal more harshly with speculators. This strategy would empower the government to aid troubled homeowners, not just Wall Street.

A further benefit is that it could change the incentives now facing loan-pool trustees. One reason the market has struggled to adjust to falling housing prices and increasing foreclosures is that mortgage-backed securities trustees have been reluctant to renegotiate individual loans, out of uncertainty and fear of litigation. Facing the threat of forced sales to the US government and with clear guidance on how much the government is likely to pay for their loans, such trustees will be highly motivated to renegotiate loan terms on their own, further clarifying market values and enhancing price discovery.

We also need to think harder about financing the cost of government intervention. Under the Paulson proposal, the American taxpayer would pick up the bill for whatever the government loses on its $700 billion of asset purchases.

Congressional Democrats are attempting to soften the blow by requiring the government to receive an equity interest from selling firms. While laudable, this approach significantly complicates the transactions, and it doesn't fairly spread the costs of the program to all the financial institutions that will benefit.

A cleaner approach would follow the model that Congress set up in 1991 for the FDIC when it spent extra funds to shore up systemically important commercial banks: Impose an after-the-fact assessment on the entire industry to defray the costs. Congress could do the same thing with the Paulson proposal.

Once the government's losses are clear, the Treasury should assess some share of the costs – for example, one half – on all of the financial institutions eligible to participate in the program, based on some objective formula. This would be a fairer approach to cost sharing than what is being proposed. It would also give the financial-services industry a strong incentive to help the government keep costs down and avoid similar interventions in the future.

The challenges facing the Treasury and Congress are formidable and urgent. But even in the face of such pressures, it's important to consider alternative approaches that may offer a more efficient and more equitable way out of the nation's difficulties.

• Howell E. Jackson is a professor of law at Harvard Law School. A coauthor of "Regulation of Financial Institutions," he has served as a consultant to the US Department of Treasury.

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