For the past two years, 96 percent of all financing for housing in the United States has been provided by the federal government. Fannie Mae, Freddie Mac, and the Federal Housing Administration (FHA) have become the mainstays of financing for both homeownership and rental housing. Since the federal government’s takeover of Fannie Mae and Freddie Mac and the collapse of Lehman Brothers, the private mortgage market has become little more than a memory.

The prospects for its quick recovery are not promising. One reason is that the administration is committed to keeping mortgage rates low in an effort to maintain the fragile housing recovery. To do this, Fannie Mae, Freddie Mac, Ginnie Mae, and to a lesser extent the Federal Home Loan Banks—all of which are known collectively as governmentsponsored entities (GSEs)—are setting mortgage rates at levels below those with which the private market can compete.

Absent an unexpected surge of inflation, it will continue to be federal policy to keep mortgage rates low until national home prices have stabilized and the production and sale of homes returns to healthy levels. Unfortunately, because the housing recovery will be slow, it will be several years before mortgage rates return to more normal levels.

Some are calling for Fannie Mae and Freddie Mac in particular to reduce their purchases of mortgages and begin reducing the size of their mortgage portfolios by selling mortgages into the market. There are those who even advocate the complete dissolution of Fannie and Freddie in several years in the belief that this will restore the private market.

Most analysts, including those in the administration, take a contrary view, however—that were Fannie and Freddie to reduce their mortgage activities and begin selling down their portfolios, now with a face value of over $1 trillion, credit for the housing industry would inevitably tighten and mortgage rates rise. For this reason, there is likely to be little change in Fannie and Freddie’s current activities for several years, and they are likely to continue to displace the private market for the foreseeable future.

Another reason for the slow recovery of the private mortgage market is uncertainty about the financial regulatory reforms being debated in Congress as this is written. The legislation appears headed for enactment. Both the House and Senate versions have provisions reforming the mortgage markets; while they differ somewhat, their substance is much the same, and some combination of them is likely to be included in the final law. The result will be to restructure the U.S. mortgage markets in significant and largely unpredictable ways. The uncertainties caused by this new legislation will have to be resolved before a robust private market can reemerge.

A central provision in the new legislation that will affect mortgage markets, among others, is risk retention, commonly known as “skin in the game”: it would require institutions that originate, pool, or securitize mortgages to retain a portion of the risk of default unless they met standards set by federal regulators. In theory, this would lead to sounder underwriting and to mortgage-backed securities composed of stronger mortgage pools than existed during the housing bubble.

Major reforms are definitely needed in the U.S. mortgage markets to prevent the kind of cowboy capitalism that caused the housing bubble and its collapse. That said, requiring the retention of risk is not without its own hazards.

The risk-retention provisions in the House and Senate differ, but both would require originators and securitizers to retain 5 percent—more or less—of the risk. Many essential aspects of how this requirement would work would be left to federal regulators to determine, such as whether the retained risk would be first loss, how long it would have to be retained, and how prohibitions on hedging the risk would work.

A fundamental issue to be resolved is what the impact will be of such a provision on the balance sheets of originators and securitizers and whether additional capital would be required. Because that would be a cost banks would try to avoid, the result of this provision could be to reduce the flow of mortgage funds to the market during a period of growing demand for housing.

Over the next ten years, the population of the United States is projected to grow by 30 million people. Average household size is 2.6 persons and falling; to meet the demand of new households, the country will need some 1.2 million new homes per year—a figure understated because household formation is severely constrained today by the high unemployment rate.

Household formation topped 1.5 million per year before the recession, but dropped to 600,000 a year for the past two years. Once jobs return, members of generation Y—now in their 20s and early 30s, and the largest generation in U.S. history at over 80 million—will move back into the housing markets with a vengeance.

When that happens, the United States will need 1.8 million to 2 million new homes and apartments per year. Constraining capital to the housing markets at a time of such high demand may drive up interest rates and reduce the affordability of housing to a generation already financially burdened by unemployment and school loans.

The provisions being considered in Congress, however, generally provide ways for originators and securitizers to avoid retaining risk under certain, limited circumstances. For instance, the bill passed by the House last December would permit mortgage originators to not retain any risk on those mortgages deemed by regulators to be sound.

“Safe harbor” provisions such as this, if enacted, would give federal regulators the ability to effectively control most of the mortgage products offered to the public by the private market because the bulk of mortgages offered by most originators would fall into a safer harbor, thus allowing originators to avoid the cost of adding capital to cover any retained risk. This is not necessarily a bad thing, because federal regulators presumably would exclude the most problematic mortgage products from safe harbors, such as those that led to the housing collapse.

Similar risk-retention and related safe-harbor provisions are being considered for banks that securitize loans, in an effort to encourage safety and soundness in the mortgage-backed securities industry. The impact of these rules on the overall flow of capital into the housing markets is at least as critical as those affecting originators.

Once the housing recession is over, housing will need $1.5 trillion to $2 trillion a year to finance the sale of new and existing homes and provide capital for the multifamily industry. This puts Congress and federal regulators in an unenviable position.

Without strict new rules on the origination and securitization of mortgages, it will be only a matter of time before another housing bubble begins, putting the U.S. economy at risk of recession once again. On the other hand, the kinds of sensible changes being considered—requiring banks to offer reasonable products and sound underwriting—may, if only inadvertently, significantly reduce the overall flow of capital to the private housing market.

The timing of these needed but potentially problematic changes could not be worse. The United States will be emerging from the housing recession for several more years before markets are robust nationally. Once unemployment drops, demand for housing should be strong but will be limited by flat incomes, heavy personal debt loads, and the loss of trillions of dollars of personal net worth from the recession. Anything that drives up the cost of capital may severely constrain demand.

Meanwhile, the private market is unlikely to fully recover until the new rules and their impact become clear; this is likely to be several years off. Even then, what the eventual size of the markets will be and on what terms they will offer mortgages will remain unknown for some time.