Guest blog from BusinessWeek Banking Editor Mara Der Hovanesian:

Bill Frey, an avid investor in mortgage securities, seems to put his money where his mouth is. This summer, he vowed to sue banks over forced mortgage modifications, arguing that they would bilk bondholders like him out of promised income. Indeed, on Dec. 1, he lodged a class action lawsuit against Bank of America for its plans to change the terms on some 400,000 home loans. Frey believes that if these contracts are broken they will forever damage the secondary market for mortgages, which has been the financing engine for funding home purchases in America for decades. See our story on Frey’s lawsuit here. But that’s not the end of Frey’s radical ideas. He’s been writing Congress about some ways to fix the housing market. He’s certainly not going to win any popularity contests with these suggestions, but the ideas seem to be grounded in common sense. A Dec. 2007 article in the Atlantic broached the subject of eliminating the mortgage-interest deduction. Maybe these other ideas will also gain traction.

Read on for an edited version of Frey’s ideas:

1. Eliminate the 30-year fixed rate loan Frey says that the 30-year mortgage, a mainstay in home lending, should be eliminated because the time line is far too long and poses far too much risk for investors. Banks and investors must hedge their bets against prepayments (which are rampant in refinance booms for one) and as a result often stretch and take risks or use accounting gimmickry to do so. His solution is to introduce loans with 30-year amortization, but that are renegotiated every five years. These types of loans are common in Canada and other countries.

2. Set underwriting standards for loans that are securitized Creating a maximum loan-to-value (LTV) underwriting standard for securitizations would raise the quality of loans across the board. This standard LTV, while subjective, should probably be 80%. Loans originated above this threshold should stay on banks’ books. This would force a more careful credit review by originators of such loans.

3. Phase out the home mortgage deduction A tax subsidy encourages homeowners to take on too much debt, which places the risk on society in general. Better to give favorable tax treatment for the equity in the home, starting with the down payment. This credit would obviously need limits, but the concept of subsidizing equity, as opposed to the debt, would remove some of the systemic risk placed on society by high loan-to-value mortgages. Furthermore, additional periodic principal pay downs could trigger some sort of partial tax credit in the first few years of a loan’s existence. This period has historically been the time in which defaults have occurred.

4. Limit the use of home equity loans The logical limit for the use of home equity loans would be to forbid their use in the purchase of a home. Instead of using home equity loans as down payments, prospective homeowners would have to actually save and place their savings into a house as a down payment. While this concept may seem logical, it was forgotten over the last several years. Furthermore, post-purchase limits based on home purchase price or current market value should also be in place. Large scale use of homes as piggy banks places the financial system at an unacceptable level of risk.

5. Force Wall Street firms or underwriters of mortgage securities to own a portion of what they sell off to investors The issuer of mortgage securities should swallow the first 1% of losses on the mortgages it sells as securities. It should be required to hold this position for no less than three years. This would insure that any errors in packaging and underwriting would be taken as a loss by one of the parties that are best able to avoid the bad loan decision.

6. Wall Street issuers of mortgage-backed securities should not indemnify the trustee of the MBS from bondholder lawsuits that result from improper servicing or other servicing errors Trustees of an MBS securitization are responsible for enforcing the contract rules as a fiduciary of the bondholders. Ironically, they themselves are protected, which is like the fox buying off the guard of the hen house. As a result, there is no one guarding the interests of the bondholders.

7. Homeowners should be penalized in the event of a foreclosure Laws must prevent borrowers from avoiding personal liability in the event of foreclosure. Such laws would encourage homebuyers that run into trouble to not abandon their homes. Post-foreclosure liabilities are common in England and discourage homeowners from walking away from their obligations. Such liabilities could, of course, be dismissed in the event of bankruptcy. While these changes may sound radical, they are essential to reducing the probability of a systemic housing meltdown and in mitigating that downturn, should this type of housing problem recur in the future.

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