The problem with Treasury Secretary Hank Paulson’s $700 billion bailout plan is that it is aimed at the wrong market.

Instead of addressing what Paulson himself calls the root problem — the housing crisis and the failing mortgages originated in the primary market — Paulson’s plan is aimed at the financial instruments of the secondary market, which involve the repackaging of mortgages made in the primary market and the ultimate creation of debt securities backed by those mortgages.

While the secondary market for mortgage-backed securities is nothing short of a mess, the secondary market is failing because of failures in the primary market. Paulson’s congressional testimony reveals that he knows as much, yet his solution is not aimed at dealing with the borrower-level problem in the primary market.

Paulson’s approach would likely inspire more market confidence if it were aimed at the right market. Its misplaced focus on the secondary market also leaves the taxpayer unprotected.

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.

All new mortgages renegotiated with the government guaranty would become fixed rate mortgage loans amortizing over a period of 30 years from the date of renegotiation. This homogeneous mortgage product underlying the guaranty is necessary so that the government can manage this program by creating a “quasi-market.”

In the quasi-market, the government entity that provides the guaranty will establish a host of publicly available parameters each day, and these parameters will indicate the terms upon which the government guaranty will be provided.

For example, this entity could offer on Monday that it is willing to guarantee the entire principal balance of loans written down to 75 percent of balances with a fixed interest rate of 7 percent for a 0.6-percent guarantee fee; 76 percent of balances with a fixed-interest rate of 6.89 percent for a 0.7-percent guarantee fee; 77 percent of balances with a fixed interest rate of 6.79 percent for a 0.8-percent guarantee fee; 78 percent of balances with a fixed interest rate of 6.64 percent for a 0.9 percent guarantee fee; and so on and so forth all the way to, for example, 90 percent of balances with a fixed interest rate of 4.5 percent for a 1.2-percent guarantee fee. These examples are entirely notional, but the inverse relationship between remaining balance and rate should be apparent, as should be the positive correlation between remaining balance and guarantee fee.

On Tuesday, this government entity could change the parameters based upon how appealing its Monday rates were to the servicers. If few servicers accept the rates on Monday, this entity could set more favorable parameters on Tuesday. If too many accept the rates on Monday, this entity can make them less favorable on Tuesday. In essence, the government can assist market stability through this process by slowly teasing out where the market is for guaranties based upon the daily shifting parameters. This will begin to establish value broadly, unclogging the secondary mortgage markets.

From among the daily schedule of rates, servicers could choose which one makes sense for each distressed mortgage. The program would be voluntary, and servicers would remain perfectly free not to participate.

There are details to be worked out, especially involving servicer discretion and liability, but this ultimately leads to a government-driven market-like solution. If servicers see an opportunity, they’ll take it, rate lock and then process the minimal paperwork to rehabilitate the distressed borrower, resulting in secondary market securities that are incrementally more marketable with each rehabilitation. This plan leaves the discretion as to whether to pursue a guaranty in the hands of servicers who, unlike the government, have better information about the value of the underlying property and the credit quality of the borrower.

Under this plan, foreclosures are dramatically reduced and market equilibrium is restored while at the same time avoiding a Depression-era bureaucratic bailout approach. This quasi-market will quickly identify the bottom of the market, and the government will play a comparatively limited role.

But, that role would be complex. The government would need to hire some of the best financial engineering experts in the world to determine the daily parameters, and the processing of the guaranties would be done through some type of ordered exchange through which servicers lock down a particular day’s guaranty based on the prevailing rate schedule.

Once the terms are locked, the servicer has 30 days to work out the new arrangement with the borrower and present the paperwork to the government to secure the guaranty. The paperwork could be as simple as an amendment to the promissory note, upon presentation of which the guaranty is issued.

This market-like approach provides much more flexibility in addressing this problem than assigning total discretion to the Treasury Secretary.

– Kevin Thomas Pigott is an attorney in private practice in Washington, D.C. and a co-founder of The Next Generation for Free Enterprise. Vince Haley servers on the executive team of American Solutions for Winning the Future in Washington, D.C. Each is writing in his personal capacity.