What are the options for replacing Fannie Mae and Freddie Mac, and which approach do you favor?

At one extreme, the government's role would be limited to supporting mortgages to lower income households through the existing programs at the Federal Housing Administration. To a first approximation, that's the right approach, but there are times…like the crisis period we just experienced…when markets benefit from government support. At the other extreme, the government would provide a backstop to private firms that would provide broad-based guarantees of mortgage-backed securities [MBS]. This approach would be most similar to the current system except that the new firms would not be government sponsored and would have to pay for the government backstop.

Our paper argues that this approach is problematic on a few fronts. First of all, if the government charges the right price for bearing the credit risk of its guarantee, the effect on mortgage rates is likely to be small. Second, the government guarantee proposals that involve private financial firms are likely to suffer from the same sorts of governance problems that plagued Fannie and Freddie, which will expose the taxpayer to considerable risk in housing downturns. Given that guarantees have small benefits during normal times, these costs are probably not worth bearing. And finally, when markets are stressed, private financial firms that guarantee mortgages are likely to be financially impaired. This will limit their ability to guarantee new MBS issues even if the government guarantee protects old MBS issues. So, in a crisis the government may have to inject capital into private guarantors to ensure that mortgage credit keeps flowing, just as it has done with Fannie and Freddie.

That's why we have advocated a middle-of-the-road approach where the government is just a "guarantor of last resort" in a time of crisis when private mortgage credit dries up. In that case, a government-owned corporation could guarantee newly issued, high-quality mortgage-backed securities to keep credit flowing. This entity could have a small footprint in normal times to ensure that it could ramp up its activities in the crisis.

In a way, this would return the government to its original role in housing finance, which was to facilitate mortgage credit during the Great Depression, a time when markets were functioning poorly. We were happy to see an approach like this included in the administration's white paper.