A key industry group is proposing to replace Fannie Mae (FRE) and Freddie Mac (FRE) with a handful of small, shareholder-owned companies, subject to strict supervision and limits on their profits and activities.

The proposal, set to be released by the Mortgage Bankers Association Wednesday, comes as officials are grappling with how to reshape the government's role in ensuring the widespread availability of mortgage credit in the U.S.

Last fall's federal takeover of Fannie and Freddie amid the housing market storm illustrated the pitfalls of relying on two private companies with a public mission and lucrative ties to the government. Yet shifting away from that longstanding model is a complex task, requiring tough negotiations among various stakeholders and a plan for handling billions of bad assets at Fannie and Freddie.

The Mortgage Bankers have discussed their proposal with officials from Treasury, Fannie Mae and Freddie Mac and the companies' regulator, as well as with members of the White House economic team. MBA officials also detailed the proposal for Federal Reserve Chairman Ben Bernanke and Fed Vice Chairman Donald Kohn Tuesday. On Wednesday they will meet with other industry organizations.

Debate about the future of Fannie and Freddie will likely intensify in the coming months. The Obama administration plans to unveil a proposal when it releases its 2011 budget in February. Meanwhile, House Financial Services Chairman Barney Frank, D-Mass., is preparing legislation.

The mortgage behemoths were thrown into the conservatorship of their regulator after mounting mortgage defaults ate through their cushions of capital. Critics of the companies say they were able to accumulate excessive risks because investors believed - ultimately correctly - that the government would bail them out. Since it seized the companies nearly a year ago, the government has pumped nearly $100 billion into them to keep them afloat.

The Mortgage Bankers' proposal envisions a handful of government-chartered companies devoted to purchasing home mortgages from lenders and repackaging them into securities for investors. The companies, dubbed mortgage credit-guarantor entities, or MCGEs, would provide guarantees for investors against default of the underlying loans in the securities.

A government agency would then provide an explicit government guarantee of the timely payment of principal and interest on the mortgage securities as protection against some catastrophic event. The guarantee would be backed by a new insurance fund amassed through premium payments by the MCGEs. Surpluses from the fund could provide a source of funding for affordable housing, the Mortgage Bankers said.

The system of supports wouldn't bolster the entire $11 trillion U.S. mortgage market, only those "core" products deemed by the MCGE regulator as necessary for a vibrant U.S. mortgage market, according to the proposal.

Mortgage Bankers Vice Chairman Michael Berman argued the model would greatly decrease the risk of a future taxpayer bailout. The MCGEs would be fashioned after public utilities, subject to stringent capital standards and limits on their activities and their return on equity. They would also be barred from holding more than limited portfolios of mortgage-backed securities, eliminating a risky source of profits that helped to cause Fannie's and Freddie's undoing.

The companies' stock will be a "conservative investment" with low, steady returns that "will not attract the same kind of investor" that bought Fannie and Freddie stock, Berman predicted.

He also noted the government will have the power to charter new MCGEs in order to ensure none grows too big to fail. At least two to three should be chartered at the outset, Berman said, with the number growing to potentially six to ten over time.

Jim Vogel, a mortgage market analyst at FTN Financial, warned the model could run into trouble during a housing downturn. Without the implicit or explicit backing of the U.S. government or the flexibility to engage in other businesses, the MCGEs might have trouble maintaining their capital base if investors grow jittery about the housing market. As a result, mortgage credit could dry up just as the housing market comes under stress, Vogel argued.

National Housing Conference President Conrad Egan, who was briefed by the Mortgage Bankers on their proposal, argued the model could decrease the risk of a sharp housing downturn. The strict supervision of the MCGEs would foster tighter mortgage underwriting standards, he said.

A spokeswoman for the Treasury Department declined to comment on the proposal.

-Jessica Holzer, Dow Jones Newswires; 202-862-9228; jessica.holzer@dowjones.com