There was a gap in the financial regulations Congress wrote after the 2008 crisis: the federal government's role in the mortgage market. Two U.S. senators now want to fill it.

Senators Bob Corker, Tennessee Republican, and Mark Warner, Virginia Democrat, announced new legislation yesterday that would shut down Fannie Mae and Freddie Mac, the two government-sponsored companies that package and guarantee mortgage securities, and replace them with a public reinsurer.

Their proposed Federal Mortgage Insurance Corp. wouldn't make, as Fannie and Freddie did, 100 percent guarantees of principal and interest payments on mortgage-backed securities. It would retain only a sliver of the risk, obligating private mortgage issuers to bear losses up to at least 10 percent of principal.

The bill requires issuers to stand ready for that loss with the same buffer of equity capital. The FMIC would insure the security beyond that point and charge fees for the protection. The fee revenue, in turn, would go to a fund that covers the public part of losses. Those events should be rare, as the 10 percent buffer would have been twice as much as needed to prevent public losses in 2008.

The Corker-Warner bill has the right idea. Fannie and Freddie expose public finances to risks that private companies should bear. But the coming debate will reveal something Corker and Warner have been less willing to discuss: the sea change this bill would produce in mortgage markets.

Fannie and Freddie's guarantees are central to the market as it works today. They back roughly 70 percent of all mortgage-backed securities issued. Individual investors don't have to analyze the underlying creditworthiness of the borrowers -- Fannie and Freddie do it once and forever. In fact, these agency securities are mostly traded on what's called a to-be-announced basis: Investors have basically no idea what they're buying.

This only works because of Fannie and Freddie's total guarantee, which establishes a large, liquid market for mortgage-backed securities. An agency bond that packages loans to elderly Floridians, say, is made interchangeable with a bundle of loans to young Californians. If the Corker-Warner bill kills the to-be-announced market, all that's left is the smaller, less-liquid specified-pool market, where investors know exactly what they're buying or selling.

This will raise interest rates on mortgages. The bigger risk with this legislation, though, is that nobody really knows if the new mortgage market will be liquid enough. If it isn't, lenders won't lend.

Larger private exposure plus a fractured mortgage market could also cause adverse selection in times of crisis. When buyers suspect sellers know something about a bond's fair value that they don't, they fear getting stuck with garbage, and so they don't buy.

The guarantee had eliminated this problem by absorbing the cost of default to private investors and making mortgage securities uniform. Now the uniformity is gone, and borrower quality matters. That's information investors may not have, as it's hard to know the quality of individual loans in mortgage securities. A future housing bust could therefore freeze mortgage markets again.

The Corker-Warner bill has two answers to these problems. First, it requires private mortgage insurers to assume much of the credit risk. That's fine in theory -- they would probably price risk better, and if they got it wrong, it would be their dime, not the taxpayers'. Still, it's uncertain that private insurers will step up.

Second, lending standards will have to rise. Fannie and Freddie played fast and loose; the FMIC can't afford to, as bad loans would worsen the adverse-selection problem. That's why Corker and Warner raise the bar for government guarantees. It might not be enough, as Peter J. Wallison of the American Enterprise Institute has argued.

Among the requirements: the maximum loan size for single-family homes would fall from $625,000 to $412,000, all loans would require a 5 percent down payment, and all loans would have to meet the Consumer Financial Protection Bureau's Qualified Mortgage standard, which bans lending to anyone whose debt payments exceed 43 percent of their income and other risky practices. These provisions will reduce the risk of bad loans and contain adverse-selection risks.

Corker and Warner are going to bring a revolution to mortgage markets. They'll need to focus on liquidity to make sure it isn't a bloody one.

(Evan Soltas is a contributor to the Ticker. Follow him on Twitter.)