Plans to 'tackle market imperfections' and ease the credit crunch and revive UK mortgage market were put forward today in a Treasury-backed report.
The preliminary findings by Sir James Crosby, deputy chairman of the Financial Services Authority (FSA) and former HBOS chief, predict the current credit squeeze to last until 2010 but states there are no easy answers to the crunch.
At the core of the problem is the retail mortgage-backed securities (RMBS) market, where banks sell on mortgage debt to raise funds.
Between 2000 and 2007, the total amount outstanding of UK RMBS and covered bonds rose from £13 billion to £257 billion, but when concerns over bank losses rose investors turned away from the bonds leaving a mortgaging funding gap.
It was this gap and inability to raise funds that led to the near-collapse and nationalisation of Northern Rock.
Sir James calls on the government to step away from establishing a government-backed agency to guarantee and securitise mortgages following the US Fannie Mae and Freddie Mac model.
Instead, he calls for the funding of mortgages to be left to the market.
Sir James finds the market for funding mortgages is changing, but the government should not seek "a return to previous market structures or levels of activity".
"The authorities must also avoid creating moral hazard; there should be no reduction in the incentives on market participants to behave responsibly," the report states.
Proposals for the government to guarantee billions of pounds worth of mortgage bonds are also downplayed.
The report finds: "It appears unlikely that an implicit government guarantee on mortgage-backed securities would be an appropriate model for the UK to adopt."
The Bank of England currently offers its Special Liquidity Scheme to aid lenders by swapping mortgage backed-securities for government bonds. However, this scheme does not cover new lending, only existing securities.
A final report from Sir James will be produced at the time of the 2008 pre-Budget Report this autumn.