It’s a rare and wonderful thing to see a Republican agree with a Democrat, especially on an innovative idea. Yet when it comes to reforming our mortgage system, we need to tread carefully. Republican Congressman Scott Garrett of New Jersey and Democratic Senator Charles Schumer of New York are both considering proposing a Danish-type "covered" bond system. Treasury Secretary Timothy F. Geithner has also made favorable noises.

The covered bond system, which I will explain in detail below, is an admirable attempt to replace Fannie Mae, Freddie Mac and the Federal Housing Administration, which are now issuing 90 percent of all mortgages in our $11 trillion mortgage market. The reason they own the market is simple: They borrow money on the cheap, by pledging repayment by the taxpayer, and then they lend on the cheap. Private mortgage makers can’t compete.

If these agencies were headed by Warren Buffetts and making terrific investments, that would be swell. We’d want them to borrow every penny they could and invest not just in mortgages but in every other risky security the world has to offer. Our nation’s fiscal woes would be over.

But these agencies aren’t shrewd investors. They’re lousy investors. In our financial debacle, they held or guaranteed 70 percent of all toxic mortgages and lost, well, hmm we don’t know how much they’ve lost. If housing prices fall another 20 percent, as some gloomy analysts have predicted, their losses could total $1 trillion. That’s a lot of tax dollars or a lot of money that Federal Reserve Chairman Ben S. Bernanke would need to print -- which would, presumably, cause a great deal of inflation.

Bondholders Get Priority

The covered bond proposal would get the mortgage market back where it belongs -- in the private sector. Under the plan, banks would borrow (issue bonds) to get the money to buy mortgages, and would give the lenders priority claim to the mortgages they purchase. That is, the bondholders wouldn’t have to stand in line with all the bank’s other creditors if the bank failed or was otherwise unable to repay all its borrowing. The IOUs the banks would transmit to lenders are called covered bonds because the IOUs are backed, or covered, by the mortgages.

Covered bonds were dreamed up in the 18th century in Prussia and Denmark. They have served Denmark very well since. But whether such a system would work here is less clear. The banks guarantee their loans. But we know what bank guarantees are worth in this country – bubkes.

Don’t Trust Bankers

Fortunately, putting some teeth into those guarantees would be relatively easy. Rather than rely on bankers to verify mortgagees’ employment, income, house value, credit history and creditworthiness, let’s have the government organize this due diligence. Specifically, let’s have Uncle Sam establish the equivalent of the Food and Drug Administration for the financial sector -- call it the Federal Financial Authority.

This FFA would hire private companies to do the straightforward work of verification. The firms would work solely for the agency and thus have no conflicts of interest. Liar mortgages would be history. The FFA would move us from Trust Me Banking to Show Me Banking, and let covered bond purchasers see, in real time on the Web, precisely what they are buying.

Still, even with improvements in due diligence, the covered bond plan leaves other problems unaddressed. First, the banks would continue to make guarantees they would not be able to keep in the face of another widespread housing bust like we’re experiencing. Second, the banks would be forced to hold the mortgages that back the bonds they’ve issued. And because banks write local mortgages, they’d be at risk for a regional crunch in the housing market. Third, the Federal Deposit Insurance Corporation is understandably wary about allowing covered bond creditors senior claims to bank assets.

Equities not Bonds

The solution to all three problems is simple. We should establish a covered equities market, not a covered bond market, to make U.S. home mortgages. Mutual funds, rather than banks, would buy the mortgages. This would eliminate the FDIC’s concern, as it does not regulate or guarantee mutual funds. And the mutual funds would issue equities -- sell mutual fund shares, that is -- to raise the money to buy the mortgages.

In so doing, the mutual funds would make no guarantees about repayment. If housing prices collapsed and the mortgages held by the mortgage mutual funds did poorly, the mutual fund investors would suffer a loss in the value of their shares. But the mutual funds themselves would not go bankrupt.

Buyers Can Diversify

In sum, a housing-market collapse would not bring down the financial system as a whole. And even if the mutual funds invested in mortgages in particular parts of the country where we might see a localized collapse, shareholders could easily diversify their holdings of mortgages by buying different mortgage mutual funds.

The big question, of course, is whether mortgage rates under this system would be much higher than current rates. One way to keep the rates down would be to have the mutual funds compete by buying their mortgages at auction. For now, the government could boost the system by investing in mortgage mutual fund shares; gradually, it would limit these investments as it weaned the country off its cheap money.

Not only does a covered equities market make sense for mortgages, but it could be applied to all other types of borrowing, including student loans, credit-card debt, small business loans, corporate loans and so on. If applied broadly, it would give us a completely safe financial system. It would be safe for a good reason – it would have no banks!

(Laurence J. Kotlikoff, a professor of economics at Boston University, is a Bloomberg View columnist.)

To contact the writer of this column: Laurence Kotlikoff at kotlikoff@bu.edu

To contact the editor responsible for this story: Tobin Harshaw at tharshaw@bloomberg.net