The government could offer to buy first mortgages for 50% of the face amount or 50% of the current appraised value of the underlying property, whichever is lower. The loans sold to the government would mostly be non-performing loans. The government could then write down those loans by 20% or 30% and try to get the delinquent borrowers to start making payments again. Whether they did or didn't, as long as real estate prices didn't fall another 50%, the government would eventual break even or better on the deal.
By putting a floor under the price of mortgages, this deal would, presumably, stabilize the market for mortgage backed securities and CDOs derived from MBS. If not, the same financial engineers who put the complex securities together could figure out how to unwind them and sell the underlying mortgages to the government. Since mortgages would be easier to value than the securities derived from them, the government would be less likely to overpay and more likely to turn a profit on the whole deal.
Entrepreneurs are already taking this sort of approach on a small scale, as I mentioned in a post last month ("Profiting from the Credit Crunch/Real Estate Bust"). I don't see why the Treasury Department couldn't scale up a similar approach.
Update: University of San Diego Law Professor Frank Partnoy proposed something similar in this New York Times op/ed published Saturday, "Buy the Loans".
1Some have speculated that the government intends to deliberately overpay for these assets, in order to infuse more capital into firms participating in the reverse auctions. If this is true, it's a bad idea. A better way to infuse capital directly in key firms, if it is needed, would be to take preferred equity stakes in them (along these lines, some pundits have asked why the government can't get a deal similar to what Buffett got with Goldman Sachs).