In a two-part series, experts will tackle fundamental questions left over from the housing bubble crash: What should we do with Fannie Mae and Freddie Mac? How should we reform the market so that it is fair and risk-free? In the first part, Christopher Papagianis, Managing Director of the New York City office at the think tank e21, argues for full privatization with direct government subsidies to ensure access to credit for all. **Read part two here.

1. What are the GSEs and what went wrong with them?

Fannie and Freddie buy and guarantee mortgages, converting the mortgage payments into guaranteed cash flows for MBS notes and standardizing the notes to enhance investor acceptance and market liquidity. Before they blew up, their investors would capture the guarantee fees on the mortgages and pass through the rest of the mortgage payments to MBS holders. They also used their ability to issue implicitly guaranteed debt to build massive portfolios of the same mortgage-backed securities (MBS) they issued. These portfolios were the source of huge profits during the boom years. The profits came from the gap between the yields on mortgages and the interest rate Fannie and Freddie paid on their own borrowings, which was just slightly greater than Treasury rates thanks to government sponsorship.

The analytical challenge before us is that the most egregious excesses of the previous GSE model are not what precipitated all the taxpayer losses. For example, the first instinct of many reformers would be to ensure that the GSEs (or their successors) are never again able to build big mortgage portfolios. Once a pool of mortgages was converted into GSE-guaranteed MBS notes, there was no need for them to then issue additional debt to repurchase the guaranteed MBS. These big portfolios served "no credible purpose" aside from a profit center for GSE shareholders and management. The second instinct would probably be to strictly limit the mortgages that would qualify for purchase or guarantee.

While both make sense and would have made for sound reform in 2005, focusing on these two issues now more or less ignores the big lessons from the 2006-2010 market meltdown. Of the GSEs' combined $226 billion in losses, over $166 billion (73%) came from the guarantee business. The investment portfolio accounts for just $21 billion (9%) of losses. Had the investment portfolios been eliminated in 2005, the GSEs would have still suffered losses from guaranteed mortgages that would have wiped out their capital base several times over.

For many, the challenge ahead seems to be designing a strategy that maintains a government guarantee for mortgage credit risk while attenuating some of the more egregious elements of the old GSE model. The problem with operating under this framework, however, is that it was the mispricing that arose from the government guarantee itself that really turned out to be the big source of taxpayer losses.

2. Is there a role for the government in the housing market?

Yes. Today, almost all of the new mortgage originations in this country are done with some government involvement. In addition, the government dedicates roughly $300 billion each year to directly subsidize housing, split roughly evenly between tax subsidies and direct government spending. In all, it cuts across several agencies and over 28 different programs to support both homeowners and renters. Given all of the current support that's in place, the real question is how can we comprehensively rationalize the role for government in the housing market.

Unlike the fairly straightforward accounting and (on-budget) treatment of all the different tax provisions related to housing, the subsidies on the spending side are more complex and confusing. On behalf of taxpayers, the federal government issues, guarantees, and insures mortgages. Taxpayers subsidize the redevelopment and sale of vacant properties and foreclosed homes. They subsidize housing vouchers, a public housing program, and at least eight more block grant initiatives for rental housing. The budgetary costs of these programs are measured in three different ways - on a cash flow basis, on a present value basis, and on a present value basis adjusted for market risk. Without an apples-to-apples comparison, it is nearly impossible for policymakers to compare the effectiveness of these programs and to allocate scarce budgetary resources in ways that do the most good.

With regards to Fannie and Freddie, there appears to be a consensus now that the inherent flaw of the "government-sponsored" business was a lack of transparency and accountability in the allocation of the underlying subsidy: profits went to private shareholders and losses were socialized, or ultimately covered by taxpayers. As policymakers review housing subsidies and consider alternatives, they must be careful to make clear the risks and costs of subsidizing housing investment. Government loan guarantees can appear to be low cost since they pay out only if a borrower defaults and official estimates often exclude a premium for market risk. But we have learned that such guarantees are contingent on an accurate assessment of the various risks involved and they can be extremely expensive if those risk assessments are wrong or if the defaults all occur at the same time. Improperly scored loan guarantees also create a moral hazard, as the implementing agencies can assume too much risk by lowering their lending standards over time.

Where possible, it would be more transparent and far more efficient for Congress to deliver housing-related subsidies directly to the homeowner. This is the primary way the government subsidizes food with food stamps or charity through the tax code. Private financial institutions then would no longer have the ability to capture some of that subsidy for their managers and shareholders, as Fannie and Freddie did for so many years. Direct subsidies would also reduce the risk of another economic crisis.

3. What does your plan do to fix the problems?

The government has a terrible track record for pricing guarantees correctly. There are other ways to subsidize housing if that's what Congress and others would like to do. Providing housing-related subsides directly to the individual is probably the only way to avoid the moral hazard that comes with a mortgage guarantee.

Therefore, it appears as though the most promising path for Congress is to commit to a credible strategy that puts the GSEs in receivership and liquidates their operations over a 5 to 7 year period. Taxpayers would cover any shortfalls so no creditor loses anything in a wind-down or is tempted to sell their securities. In the future, Congress would keep Federal Housing Administration (FHA) mortgages available for borrowers under certain income and mortgage loan thresholds and leave the rest of the market to the private sector.

4. Given that there are many plans, what is the strength and weaknesses of your approach?

The strength is little to no moral hazard moving forward. We stop obscuring just how much taxpayers are put at risk by indirectly or implicitly subsidizing housing.

The weakness is that without some other actions by Congress, mortgage costs would presumably go up, as the old guarantees would now be paid for directly by mortgage borrowers.

However, Congress does have some options if it wants to try and offset some of this cost increase. Several scholars have suggested subsidizing interest rates on certain loans or providing a flat housing credit. (See Charles Calomiris and Raj Date for more on how interest rates could be subsidized through swaps. See Josh Rosner for more on how the mortgage interest rate deduction could be reformed to reward building equity over adding more debt and how establishing clear securitization disclosures could help re-start this market.)

5. What will the mortgage market look like if your plan is enacted, for both people who want to lend money and people who want to buy a home?

In the future, prospective homebuyers would still work with banks and brokers to find the best loan for the price. And since nobody is talking about winding down Fannie or Freddie tomorrow, the private market could be folded back into the equation steadily over time. This would give the securitization market time to develop. Obviously, you'd want to make sure reforms were in place as this happened so that the future system would be equipped with the information required to evaluate/measure credit risk over time. Perhaps a covered bonds market could also be started as well. Portfolio lending would also likely increase.

6. Will there be 30-year, fixed loans in the future? What are the consequences of this?

Yes. First, FHA will still offer its 30-year product. Second, I think that 30-year fixed loans will still be available in the private market for borrowers who can extend a meaningful downpayment. The jumbo mortgage market is probably a good analog.

Borrowing in general, however, will probably cost more because there will be no under-priced government guarantee involved to shield investors from losses. This means that some borrowers who qualified for certain loans during the boom would face new and real trade-offs. Put more bluntly, credit would (and should) not be as readily available - compared with the boom years.

Surely, some individuals (or families) will end up renting. Others will save more so they can extend a larger downpayment or purchase a less expensive home.

7. Hasn't TARP taught us that the government will always be some sort of implicit backstop? How can the government ever credibly commit to not jumping in at the last moment?

By this logic, the government should just come out and guarantee most large institutions or even asset classes.

There is a fundamental question that people need to ask when they think about GSE reform and the future of housing finance. Is it in the long-run interests of the economy to provide continued credit support for housing (at least at the current pre-crisis magnitude)? Housing is a form of consumption and its continued subsidization diverts capital from other more productive uses.

This question is also wrapped up in the Too Big To Fail issue. The GSEs proved to be TBTF. Several of the top big banks were also deemed TBTF. In a world without Fannie and Freddie, there is a risk that investors will just assume that the government will step in and protect the banks that are necessary to maintain a liquid mortgage market. I am concerned about this.

Yet, while I do not think Congress solved the TBTF issue with the Dodd-Frank law, I still hold out hope that it will find a solution. I guess I'm not pessimistic enough to concede defeat and just assume that the government will be better off by explicitly taking on all the tail risk in the housing market.

8. If we go with full privatization, we'll see the private securitization market grow as a percentage of total mortgages. But didn't private securitization markets fail in many ways over the past 10 years? Didn't hedge funds and middle-men make a lot of loans that went bad and increased volatility, and won't that happen again?

It is not a foregone conclusion that securitization will be re-born. The alternative to securitization markets - and shadow banking generally - has always been the traditional banking model of funding mortgages through deposits. It may be that the low-cost guarantee written by the GSEs made the traditional banking model uneconomic and that the elimination of this guarantee will make banks more willing to hold loans on balance sheet. We should not be so quick to write off the possibility of greater on-balance sheet lending. The GSEs' portfolios, for example, are a perfect example of its profit potential. The challenge for private lenders had been managing the interest rate risk and attracting funds of sufficiently low-cost to compete with the GSEs.

The future of securitization is likely to be much better than many anticipate. There is little evidence of systematic mis-rating of mortgage-backed security (MBS). The big problems came with CDOs and other re-securitization products. For example, why is it unreasonable for $75 million of a $100 million deal with 400 (high credit quality) mortgages with an average principal balance of $250,000 to receive a AAA rating? For investors in this tranche to suffer losses, half of the mortgages would have to default and suffer loss rates of 50% on average. Subordination of this magnitude is likely to suffice in all but the worst housing environments, as is seen by the surprisingly strong performance of the GSEs' subprime portfolios. Will a CDO market re-start and create new problems? Perhaps, but there does not seem much appetite for mezzanine ABS CDOs at the moment and it seems reasonable to believe the next blow-up will occur elsewhere, given investors' and rating agencies' experience (and new information demands) with regards to these products.

Christopher Papagianis is Managing Director of the New York City office at the think tank e21.