In the ongoing debate on how to reform the housing finance system, the House Financial Services Committee is holding a hearing this morning. Witnesses include the Treasury's Assistant Secretary for Financial Institutions Michael S. Barr and Federal Housing Finance Agency's (FHFA) Acting Director Edward J. DeMarco. The subject is the government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac. DeMarco reveals his concerns about the most popular option for reform: an explicit government guaranteeing for mortgages going forward.

In August the Treasury held a conference on the future of housing finance. At that time, it appeared that a broad consensus of participants favored explicit government guarantees for most mortgages. This would consist of a system where the government promises to cover any mortgage losses as a sort of insurance, where it charges lenders a fee for that protection. The hope would be that those fees would cover any resulting loses that might occur.

But as we have learned through the GSEs, guarantees don't always work as well as anticipated. In fact, the vast majority of Fannie and Freddie's losses have come from their guarantee book, which was noted last month, and DeMarco also points this out in his prepared testimony (.pdf). But Barr's testimony appears to say that the FHFA, which is now in charge of the GSEs, has remedied the guarantee problem when explaining improvements to their origination process:

Guarantee fees have been increased and the GSEs have risk-adjusted their pricing.

Yet, DeMarco's testimony appears to dispute that these new fees -- or future fees that GSEs might collect for guarantees -- will definitely allow the government to escape future losses. He's appears to be worried about knowing how high the fees must be for mortgage guarantees, since the future is hard to predict. He offers three observations, which look a lot like fears, about the proposal that all mortgages should be guaranteed going forward:

First, the presumption behind the need for an explicit federal guarantee is that the market either cannot evaluate and price the tail risk of mortgage default, at least at any price that most would consider "reasonable," or cannot manage that amount of mortgage credit risk on its own. But we might ask whether there is reason to believe that the government will do better? If the government backstop is underpriced, taxpayers eventually may foot the bill again.

Second, if the government provides explicit credit support for the vast majority of mortgages in this country, it would likely want a say with regard to the allocation or pricing of mortgage credit for particular groups or geographic areas. The potential distortion of the pricing of credit risk from such government involvement risks further taxpayer involvement if things do not work out as hoped.

Third, regardless of any particular government allocation or pricing initiatives, explicit credit support for all but a small portion of mortgages, on top of the existing tax deductibility of mortgage interest, would further direct our nation's investment dollars toward housing. A task for lawmakers is to weigh such incentives against the alternative uses of such funds.

These are all important points. They highlight that even the head of the FHFA worries that explicit mortgage guarantees could still result in a world where taxpayers will get stuck with housing-related losses, a system where political whims can still sway housing finance, and a market where residential real estate continues to suck up too much investment when other options might be more desirable from an economic standpoint.

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