The chatter that the American taxpayers will pay $700bn to save the banks is nonsense. I have a straightforward plan that should revive the market in mortgage-related securities (MRS), greatly enhance bank capital and earn several tens of billions of dollars for the US Treasury.

The distress in the US credit market reflects that MRS are no longer priced on a rational basis. Rather, a few companies with a desperate need for cash have sold these securities for 25 cents on the dollar; the accounting conventions require that this price is used to value similar securities owned by other banks.

There are 40m mortgages on residential real estate in the US. Ninety seven per cent or 98 per cent of homeowners make their mortgage payments on a timely basis. The median home price in the US is $250,000. Assume 1m homeowners are subject to foreclosure and that the lenders incur a loss of $100,000 each time a borrower defaults. The losses to the lenders then would total $100bn. If 4 per cent of the homeowners with mortgages default, the losses to the lenders would total about $150bn.

The ownership of these MRS is concentrated; 20 US banks have 80 per cent of the mortgage-related securities that are not owned in Europe and Asia.

The face value of MRS owned by US companies might be $5,000bn-$6,000bn or more (there is triple-counting because these securities have been sliced and diced) and the economic losses on these securities are likely to be in the range of $100bn-$200bn. US banks already have reported losses approaching $350bn, or more than twice the estimate of eventual losses of $150bn.

There are two key elements in the plan. One is that each of the troubled US banks would place all of the MRS it owns in a trust and then issue a new security that would be a claim on all of the cash received by the trust each month from its holdings of MRS. The other is that once a week, a new US government agency (Tarp) would offer to buy $10bn-$15bn of these new securities in a reverse auction.

Each bank that wishes to participate in one of the weekly auctions would indicate the minimum price that it would accept for $50m, $100m and $250m of the new securities issued by its trust. Each bank would also indicate the interest income and the debt service payments associated with the MRS that it had placed in the trust.

Tarp would accept those bids that offer the highest rate of return, which would be measured by the relationship between the interest income earned by the trust and the price at which the bank was offering to sell the securities. Tarp would set one buying price at each weekly auction; some banks would get a bonus because their offer price was below the price that would clear the market.

Initially it seems likely that the banks that are most desperate to improve their capital position would place a relatively low price on the securities that they would offer to sell.

Once a weekly auction had been concluded, Tarp would announce the price that it had paid, which would establish a value for the underlying MRS. If Tarp had paid $350 for securities with $1,000 of principal value, each bank could value its holdings of MRS at $350. If a bank previously had carried these securities at $250, the bank could reprice them at $350, which would lead to a corresponding increase in the bank's capital.

Once Tarp had announced the prices that it had paid at the auction, private financial institutions would have three days to buy these securities from Tarp at the prices that Tarp had paid.

The prospect is that the prices that Tarp would pay would increase from one weekly auction to the next. Each bank could revalue the MRS that it owns at the higher auction prices, which would automatically lead to an increase in its capital.

At some stage, liquidity would return to the market in MRS and their market prices would reflect their prospective debt service receipts. Tarp would then sell the securities that it had purchased back to these banks at these prices. The accountants and their confrères that insisted on mark-to-market accounting should be made to stand in the corner for six months. The economic and business journalists that have shrilled about bail-outs should be given a six-month assignment to cover the daily fire and police department activities.

This plan is easy to understand, even by Washington standards. The banks that have some of the tarnished MRS would have no opportunity to "cherry pick" and sell only those securities to Tarp that they believe have an exceptionally large amount of toxic waste. Moreover, the bureaucrats in charge of implementing the plan would have no basis for favouring one seller over another - always a problem when "free money" from Washington is involved. Finally, the price discovery process is transparent and continuous, the data on the winning bids in each weekly auctions would be published in the business press. The success of this reverse auction would restore confidence and trust in the US Treasury and the Federal Reserve, which have been shattered by their myopia and opaqueness.

How much money will the US Treasury earn? No one knows. However, the gains to the global economy from reviving the US credit markets will be worth many hundreds of billions.

The writer is emeritus professor of international economics and finance at the Graduate School of Business, University of Chicago. He is the author of The New International Money Game and brought out the fifth edition of Charles Kindleberger's classic, Manias, Panics, and Crashes