Well after spending hours noodling outloud on why I object to the Treasury bailout proposal, Paul Krugman asks the same questions I asked and comes up with the same conclusions, but short and sweet:

What is this bailout supposed to do? [ed. That's the $700 billion question.] Will it actually serve the purpose? [ed. Not bloody likely!] What should we be doing instead? [ed. A real RTC-like effort.]

What's the heart of the problem? The pricing scenario (my Scenario 2) we must assume if the plan is to have any impact at all.

So where in this process does the Temporary Asset Relief Plan offer any, well, relief? The answer is that it possibly offers some respite in stage 4: the Treasury steps in to buy assets that the financial system is trying to sell, thereby hopefully mitigating the downward spiral of asset prices. But the more I think about this, the more skeptical I get about the extent to which it’s a solution. Problems: (a) Although the problem starts with mortgage-backed securities, the range of assets whose prices are being driven down by deleveraging is much broader than MBS. So this only cuts off, at most, part of the vicious circle. (b) Anyway, the vicious circle aspect is only part of the larger problem, and arguably not the most important part. Even without panic asset selling, the financial system would be seriously undercapitalized, causing a credit crunch — and this plan does nothing to address that. Or I should say, the plan does nothing to address the lack of capital unless the Treasury overpays for assets. And if that’s the real plan, Congress has every right to balk.

As they say, read the whole, short thing.
UPDATE: Fester has a good roundup of sensible objections in "talking points" format at Newhoggers.