The U.S. housing market is still deeply troubled. There are a million excess houses on the market and foreclosures are running at record postwar rates. The housing bubble has ended, but prices are still falling rapidly with the risk that housing prices will overshoot on the downside.

While economic difficulties have spread so widely that fixing the housing sector will not fix the economy, we still have to fix the housing sector as part of the broader economic policy response to the current crisis.

The administration's response to the housing crisis has at best been active, but muddled; however, there are still sound public policy steps that can be taken to ease the situation. Increasing housing demand and slowing the growth of excess supply is still critical. A lot of attention has been given to modifying the loans of borrowers at risk of defaulting in order to keep them in their homes and to prevent additional excess supply from hitting the market.

Much less attention has been paid to jump-starting demand. The simplest and most straightforward approach would be a substantial tax credit for home purchases. This could be effective — but costly. An alternative to purchaser tax credits would be a significant reduction in mortgage interest rates. The importance of this has not been ignored; however, a simple and low-cost way of doing this has been overlooked.

Historically, the rate of interest on a 30-year fixed-rate prime conforming mortgage has been about 1.25% to 1.5% above the rate of interest on a 10-year bond issued by the Treasury. This relationship has broken down during the recent financial crisis. While 10-year treasuries are currently yielding less than 2.2%, the 30-year fixed mortgage rate is about 3 percentage points higher, a spread that is twice the historical average.

This gap has remained unusually wide despite the Fed's buying hundreds of billions in mortgage-backed securities. If the traditional relationships were restored, the interest rate on a 30-year mortgage would be less than 4% percent. This change alone could reduce the annual interest costs on a $250,000 mortgage by more than $4,000 a year, which would clearly stimulate housing demand.

Furthermore, a significant reduction in interest rates can be realized at little or no cost to the federal government.

How is this possible? The government must explicitly and unambiguously guarantee new mortgage-backed securities issued by the two housing government-sponsored enterprises, Fannie Mae and Freddie Mac — something it is already doing for hundreds of billions of dollars of other types of private-sector lending.

Under the current conservatorship arrangement, the debt and MBS of Fannie and Freddie have what their regulator has called an "effective guarantee." However, an "effective guarantee" confers no legal rights and, consequently, financial markets have discounted it. By replacing the suspect "effective" guarantee of Fannie and Freddie MBS with an "explicit" full-faith and credit guarantee of the federal government, the cost of mortgages ought to drop significantly.

This proposal could be implemented at little or no cost to the taxpayers. Under current federal government budget rules the cost of a credit guarantee — like the one I am proposing — is the expected loss the government will incur on the guaranteed loan. If the government receives a fee from the GSEs that is greater than the expected loss, there is no budgetary charge and no cost to the taxpayers.

The GSEs currently charge a guarantee fee, or "G Fee," on all mortgages they purchase. The guarantee fee is set to cover losses that may result from defaults by borrowers. This fee structure provides sufficient revenues for Fannie and Freddie to pay the federal government a fee that would more than cover any expected losses that the federal government might incur as a result of its MBS guarantee.

Furthermore, expected losses on these mortgage-backed securities and the fees to cover them will be quite small. The troubles at Fannie and Freddie were caused primarily by the downturn in the housing market as a whole, the collapse of housing prices, and losses on investments: not their core business of underwriting, purchasing, and selling prime conforming fixed-rate mortgages. In fact, Fannie and Freddie are widely recognized for knowing how to set and assure sound credit underwriting for those mortgages they purchase — and they did so successfully for decades.

The federal government is burning through money to deal with the economic crisis at a record rate. Not even the federal government and the Federal Reserve have the resources to buy every troubled asset and bail out every troubled financial institution. We need to start using our money more carefully and wisely. Guaranteeing Fannie and Freddie MBS is one such alternative. It would lower interest rates for prime conforming mortgages, jump-start housing demand, and assist in the recovery of the U.S. housing market and the economy as a whole — and it can be done at no cost to taxpayers.

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