Post WWII, Germany's banks held worthless Third Reich government bonds as practically their sole asset. To get the banking sector going again, the German government allowed the banks to rate these bonds as capital, but the banks were obliged to write them off over time. In the meantime, the bonds were not redeemable and bore no interest.
This is a story I dimly remember from economics lectures. I did not find anything on a quick Google.
Applying this to the situation in the US, Paulson could form a (government-owned) Toxic Waste Bank. Any bank can sell its assets (i.e. MBSs, CDOs, etc.) to the TWB at face value in return for a - say - 10-yeat TWB-Bond. The TWB-Bond is not redeemable and bears no interest, but the Fed will allow the bank to count it as capital. In the first year, at 100%, and 10% less in straight line over 10 years; in other words, the bank must write down the bond out of profits.
This solution does not increase the federal debt and does not oblige the taxpayer to put money on the table.
This is not entirely without cost to the Treasury, as the bank will not be paying taxes on the annual write-down - but on the other hand, the assets bought from the bank are hopefully not all completely worthless, either. And the TWB will be completely free in renegotiating the terms of the MBSs, CDOs etc.
If the real problem is banks' balance sheets, this will fix it.
Views welcome