The House has passed its GSE reform bill by 331 votes to 90, but the Senate bill is stalled. Rep. Richard Baker, the chairman of the GSE subcommittee has asked for ideas to keep things moving.

A number of important issues, some formerly quite contentious, are now widely agreed upon.

Everybody agrees that Fannie Mae, Freddie Mac, and the Federal Home Loan banks should be under a new combined housing GSE regulator that can oversee the entire $5 trillion sector. Everybody agrees that consequently the Federal Housing Finance Board and the OFHEO should be abolished.

Everybody agrees that the new regulator should have enhanced capital and new-activity authority, as well as receivership powers. This last point is particularly noteworthy, since it was the rock upon which GSE reform legislation crashed and sank in 2004. No one is now fighting it.

Though it would be a good idea to eliminate the GSEs' lines of credit with the U.S. Treasury, they are nowhere threatened. There is no legislative suggestion of privatization.

Meanwhile, the bill the Senate Banking Committee narrowly voted to move to the floor seems motionless, with no consensus, to say the least, in the Senate. As everyone knows, this reflects one overwhelming issue: Fannie and Freddie's mortgage portfolios.

The Senate bill's provision is radical. It would prohibit any purchase of conforming loans or mortgage-backed securities for Fannie's or Freddie's investment portfolios. The House bill has no such limitation.

That this issue is openly debated and, moreover, that such a draconian provision made its way out of committee are remarkable victories for the GSE reformers. But it is obvious that there is a huge negotiating space between no limitation at all and complete elimination.

What is the reasonable third way of reforming GSE legislation that could address the concerns of both sides?

Opponents of portfolio limitations are afraid of disrupting the giant, complex, socially critical mortgage finance system. Proponents argue that other investors will adjust and the system continue to function well. In fairness, it must be said that the matter is subject to considerable uncertainty, and that big changes create more uncertainty than smaller ones.

On the other hand, many market participants and observers, including me, have stressed over years of debate the duopoly market power and duopoly profits of Fannie and Freddie arising from their privileged dominance of the world's largest credit market. Eminent voices have also stressed the systemic risk caused by the exceptional concentration of mortgage interest rate risk that needs hedging in these two companies. Some limitation is certainly in order.

Therefore, we need to define a third way of GSE reform that recognizes the problems of market dominance and risk concentration posed by unlimited growth.

Such a third way, balancing the need for limitation with the need to avoid market disruption, can obviously be created by choosing an allowable growth rate for Fannie's and Freddie's portfolios.

The logical alternatives include the following:

• The allowable growth rate could be zero. The portfolios could maintain their current size, replacing runoff, but not growing. The portfolios would continuously shrink in real terms and shrink more rapidly relative to the economy and the mortgage market.
  
• The allowable growth rate could approximate the inflation rate, say 2.5% per year. The portfolios would maintain their current size in real terms but shrink, though less rapidly, relative to the economy and the mortgage market.
  
• The allowable growth rate could approximate nominal GDP growth and thus grow with the overall economy, say 5% per year. Since the trend growth rate of mortgage debt is faster than this, about 7% per year, the portfolios would represent a declining share of mortgage finance.
  
• The allowable growth rate could be the growth of the relevant mortgage market. This would cap the market share of the portfolios at the current level. An advantage to indexing to the growth of the market is that you do not have to pick a specific number or make a forecast of future economic or market outcomes. The most relevant market for Fannie's and Freddie's portfolios is clear: It is total outstanding fixed-rate conforming residential mortgage loans.

In any of these cases, it would be sensible to measure compliance by annual averages. The penalty for excess growth should be a nondeductible fee of 0.50% of any excess average outstanding portfolio. This would make any excess assets distinctly nonremunerative to Fannie's and Freddie's capital, but create a budget receipt for the Treasury.

Somewhere in this range of alternatives is the reasonable compromise that should clear the way for Senate action and enactment of GSE reform.

Alex J. Pollock is a resident fellow at AEI.