By now, we can pretty much all agree that the government-sponsored mortgage companies Fannie Mae and Freddie Mac were a problem. Their bailout will easily stick taxpayers with a bill exceeding $150 billion. Of course, knowing that, doesn't nearly end the housing policy debate. Instead, the question becomes whether to reform them or eliminate them completely. Even if you agree with the latter approach, such a transition will take time. But in a Wall Street Journal op-ed today, American Enterprise Institute financial policy fellow Peter Wallison argues for a quick wind down.

After making some fairly controversial remarks about the extent to which affordable housing was the root of the Fannie and Freddie's problem, Wallison finally begins to consider what should be done with Fannie and Freddie. He argues that a good solution would be to remove the government's influence in the housing market almost completely, probably only leaving a small role for the Federal Housing Authority to play in low income housing, as it traditionally has done.

In the meantime, he wants to begin to dismantle Fannie and Freddie. Here's the approach he would take:

The U.S. housing market is so large that banks alone cannot supply all the necessary mortgage credit. The securitization market, which is a mainstay of the credit-card and auto-loan markets, has a place. The collapse of mortgage securitization in 2007, like the insolvency of the GSEs, was caused by the securitization of subprime mortgages. Securitizations of "jumbo" mortgages--those larger than Fannie and Freddie were allowed to buy--lost value in the recession that followed the financial crisis, but they have been recovering.

Privatization or elimination of Fan and Fred is necessary to revive the securitization market, which cannot compete with the GSEs' subsidized rates. But as long as the GSEs are controlled by the government, the size of the mortgages they are able to buy can gradually be reduced. This can be done in, say, $50,000 increments every six months. As the GSEs are slowly removed from a portion of the market, securitization will take their place. When the GSEs' permitted level of mortgage acquisitions has been sufficiently reduced so that they are no longer important market factors, they can be closed down or privatized.

While Wallison's confidence in the securitization market is admirable, it's also a tad overly optimistic. Mortgage securitization hasn't really come back to life since it died in 2007. Although he's right that there have been a few private deals for jumbo mortgages, the market barely has a heartbeat.

The general idea that the mortgage size limit Fannie and Freddie can guarantee (currently between $417,000 and $729,750, depending on location) should be reduced could be a good approach. But the timeline he suggests -- a $50,000 reduction every six months -- is way too aggressive. So two-and-a-half years from now, the limit would suddenly be between $167,000 and $479,000? Remember, currently, the median existing home price is around $168,000. In other words, by mid-2013, the mortgage-backed securities market would have to be responsible for funding around 50% of the mortgage market in most areas, and a large portion of mortgages in high-cost areas. That's up from funding approximately 0% right now.

If Wallison is right, and the economy would be better off if the government is excluded from the mortgage market, the process for getting it out of the picture must be more gradual. You can't simply assume that the mortgage-backed securities market will return because regulators say so. It suffered a catastrophic failure of confidence. Investors from that market are likely to demand all kinds of additional data and due diligence on mortgages going forward.

Some progress has been made towards creating an infrastructure to provide enhanced information to the market, but even once it's fully in-place, investors have to become comfortable with analyzing the data. They're moving from almost blindly trusting the rating agencies to understanding complex securities themselves. Not to mention they'd have to re-allocate billions of dollars to bonds based on non-guaranteed mortgages, which they now know can decline in value.

What's the harm with trying to force the mortgage market to heal too quickly? It's like putting a football player back into the game before an injury is fully healed -- he could re-injure himself and be even worse-off. If the private market isn't ready to fund mortgages as quickly as regulators demand, then mortgage rates will skyrocket for some borrowers and others will be completely excluded from the market. That would harm what's already expected to be very anemic home buying demand on the part of consumers over the next few years. As housing inventory grows larger than ever, home prices could fall even below the bottom they are destined to hit if government mortgage guarantees are left intact.

Curbing the influence of Fannie and Freddie is a pretty clearly desirable outcome. But doing so too hastily could cause the economy more harm than good. Frankly, the damage caused by these government-sponsored mortgage entities is largely done. Little will be accomplished by trying to do away with them too quickly.

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