Mortgage rates could be one percentage point higher and house prices 10% lower if the U.S. mortgage market were fully privatized, according to a paper to be released Tuesday by Mark Zandi, chief economist at Moody’s Analytics.

The calculations help build Mr. Zandi’s case for replacing Fannie Mae and Freddie Mac with new entities constituting a public-private hybrid system for financing home loans.

The proposal is the latest in a growing list of white papers by economists and academics looking to influence the debate over how to reinvent the nation’s mortgage market. The Obama administration is set to issue its own recommendations as soon as this week.

For the last 40 years, the housing-finance system has been an odd blend of public and private roles. Fannie and Freddie buy mortgages from banks and other originators, repackaging them for sale to investors as securities and making investors whole when borrowers default.

Investors long assumed that the shareholder-owned firms had an “implied” government guarantee, allowing them to borrow at below-market rates. That enabled them to fund low-cost 30-year fixed-rate mortgages. The housing bust forced the government to take over the firms in 2008. Few believe the status quo is desirable or sustainable, but there’s significant disagreement over how to design a system.

Conservative Republicans say government ties should be severed to protect taxpayers, while Democrats and some moderate Republicans say government backing may be needed to keep mortgages available to qualified borrowers, particularly during bad economic times.

Mr. Zandi argues that a purely public market risks putting too much risk on taxpayers because policy makers would be tempted to subsidize homeownership by setting mortgage-insurance fees too low.

A purely private market won’t work either, he says, because investors will assume that the U.S. government will intervene in a crisis. “No matter how much you talk about ‘no government backstop,’ when push comes to shove, the government will step in,” says Mr. Zandi.

Moreover, lenders would be likely to retreat or demand much higher rates during financial shocks, exacerbating downturns. And lenders would be much less likely to offer 30-year fixed-rate loans at attractive rates, leading the majority of homeowners to opt for adjustable-rate mortgages. “I could be wrong, but I’m not sure it’s worth taking the chance,” says Mr. Zandi.

Mr. Zandi proposes a hybrid system that is part private and part public. To replace Fannie and Freddie, Mr. Zandi recommends creating between five and 10 privately owned, but government-chartered “mortgage bond insurance companies” that buy eligible loans from banks and issue mortgage-backed securities explicitly guaranteed by the U.S. government.

Mr. Zandi, who co-authored the paper with Cristian deRitis, also of Moody’s Analytics, built a steady profile as an influential centrist by providing advice on economic matters to both congressional Democrats and Sen. John McCain’s (R., Ariz.) 2008 presidential campaign.

Under the proposed hybrid system, mortgage originators would sell loans to the mortgage bond insurance companies, or MBICs, which would then bundle those mortgages and issue government-backed securities through a “mortgage securitization facility” similar to Ginnie Mae, a federal corporation that backs payments of principal and interest on securities composed of government-guaranteed loans.

The federal facility would require the MBICs to adopt the same form of mortgage security with identical legal structures, terms, and conditions in order to ensure standardization that maximizes liquidity. The MBICs would be required to hold enough capital in reserve to withstand a 25% decline in home prices; by contrast, Fannie and Freddie held just enough capital to withstand a 10% decline in prices.

Mr. Zandi estimates that under such a model, mortgage rates would be around 0.3 percentage points higher than they were before the mortgage meltdown, largely because the industry was undercapitalized before the financial crisis. Meanwhile, mortgage rates would be around 0.9 percentage points lower than under a fully private market, assuming that private investors would meet similar capital levels and require a 30% return on equity.

The difference in rates “is large enough to have meaningful impacts on the housing market and homeownership,” the paper says. Compared with a fully private market, the hybrid model would result in around 375,000 more home sales per year, an 8% gain in median home prices, and an increase of one percentage point in the homeownership rate.

via Moody’s Zandi: Replace Fannie, Freddie With Public-Private Hybrid – WSJ.com.