Last week, Gov. Paterson wrote a letter to Treasury Secretary Tim Geithner asking for a two-pronged federal bailout of the municipal bond market. “The current financial crisis has severely hurt the ability of local governments to borrow,” Paterson wrote. Municipal Market Advisers writes today that Paterson’s proposal — for the feds to put money into failed bond insurers — is “the worst possible policy choice.”

Paterson wrote that many “local governments, school districts, hospitals and water and sewer districts either cannot borrow or must pay high interest rates.”

One problem rippling through the muni market, Paterson correctly notes, is that until last year, many municipal issuers depended not on their investors’ understanding of the individual municipalities’ own underlying credit rating to access the market.

Instead, they paid AAA-rated “bond insurers” like MBIA a fee to use those insurers’ AAA ratings.

Investors in the muni bonds could be assured that they were investing in sterling credit, as the bond insurers were taking on the responsibility of making good on the debt if any default were ever to occur.

Trouble is, the bond insurers, much like AIG, were using their own balance sheets to take huge risks — insuring mortgage bonds and other assets backed by bad loans as well as muni bonds.

That’s why several of the bond insurers, including MBIA, lost their AAA credit ratings last year, making them worthless as muni bond insurers.

Paterson says that New York State, responsible for regulating much of the national insurance market, has taken steps to fix the problem. The state has licensed two new insurers — including Berkshire Hathaway’s — to plug the hole in this market. New York has also approved bond-insurance giant MBIA’s proposal to split itself into two companies, one to hold all of the bad mortgage-related stuff and one to insure muni bonds.

However, the muni bond side still hasn’t regained its AAA rating — no surprise.

First, the institutional capital there, still made up of people who decided to bet the nation’s municipal balance sheet on subprime mortgages, just isn’t AAA quality. MBIA and others had a public trust and destroyed it.

Second, investors rightly worry that all of those mortgage bonds will continue to overwhelm the new, supposedly protected municipal bond arm, possibly through litigation or, in a worse-case scenario, some form of federal liquidation and asset sell-offs.

So Paterson first wants the feds to pump $2 to $3 billion into insurers like MBIA’s split-off muni arm to win them back their AAA rating on that front.

And to deal with the second problem, he also wants the federal government to back the bond insurance that the bond insurers had pledged on the mortgages bonds, as well.

The governor says that federal insurance of private insurers’ now failed insurance would have an ancillary benefit of helping to save New York’s banks and other financial institutions, because the banks had depended on such private bond insurance for the mortgages that the banks themselves had bought.

But Municipal Market Advisers writes that these efforts would be a losing battle.

“No amount of corporate structuring ‘separation’ can insulate market confidence” in the new muni-bond arm of companies like MBIA “from ratings damage at the holding company,” which is still responsible for those mortgages, it writes.

But federal guarantees of the mortgage securities would expose “any federal expenditure … to the very likely worsening credit trauma” there. “Further, choosing favorites will raise hurdles for new entrants …, exacerbating our market’s systemic exposure to just a few companies.”

I agree with all of these points, and would go even further.

Bond insurance has proven itself to be a failed model. It is obviously better for investors to depend on the strength of lots of diverse, small municipal credits in a state, rather than on one lumbering bond-insurance giant.

The muni market simply must adjust to a world in which issuers like states, cities, and school districts pay higher interest rates in return to get investors to put money into their less-than-AAA issues, rather than pay the higher amount in the form of a fee to the giant insurer like MBIA.

The governor certainly can help in this adjustment. One problem here is a lack of information on small towns and school districts.

So the state can help smaller issuers present data and other evidence to potential investors to make the case that they’re not such bad credit risks despite their less-than-AAA ratings.

Moreover, the governor has not made the case that the muni market is broken and in need of extraordinary intervention.

It is true that some speculative revenue-based projects, like hospital and dorm expansions, likely can’t access the market on economic terms. But that is a problem with the individual projects in light of the current economic environment.

Decent credits like New York State, New York City, and the MTA have continued to access the market throughout the crisis, albeit at higher interest rates and by selling small amounts of debt at once, rather than huge chunks.

Credit-rating agencies continue to put out reports on new muni bond issues, including from small-town issuers, from around the country. Perhaps some of these new debt deals are pulled after rating but before sale to investors because of a lack of demand.

But if that were the case industry-wide, the new ratings would have stopped by now.

If anything, the governor should be worried that massive issuance of the federal government’s Treasury debt to pay for all of these bailouts will overwhelm the municipal bond market, crowding out demand for local and state bonds and lots of other stuff, too.