Ok, so Mitch McConnell, of all people, is talking about a new Federal program to offer 4% mortgages to anyone "credit-worthy." (If something like this happens while Barney Frank is in power, "credit-worthy" will be defined as "has a pulse," so Sen. McConnell probably ought to be careful what he wishes for.)
What will happen if we do this? It's basically the opposite of the things being discussed to fix the banking system. Wouldn't you assume that everyone in America will dash to refinance at 4%? This obviously wouldn't do anything to improve housing values per se, because of the overcapacity that still exists in those markets. But it would certainly make mortgages more affordable.
I'm not entirely sure yet, but my gut is that this wouldn't necessarily slaughter the banks and other holders of toxic MBS.
Those securities are toxic for a long chain of reasons, but the head of the chain is default risk. If every mortgage in America becomes issued and guaranteed by the government (well, more likely issued through the nationalized banking system, so we can feed some of the profits back to the Saudis and Chinese who own our banks), then the default risk becomes replaced by market (interest rate) risk.
But haven't mortgage securitizations always contained features to hedge against market risk (which in the case of mortgages takes the form of prepayments)? You basically expect that anyone who lends money for mortgages is holding a large slug of 10-year T-notes, or swaps, or some other derivative, which would show offsetting capital gains in case prevailing rates fall and prepayments rise.
Bottom line, this move might not be too destabilizing in the near term. Plus, there's historical precedent, because Roosevelt put up a program during the New Deal to do almost exactly what McConnell is proposing: to buy up every mortgage in America and replace private lenders with entities of government, and/or entities guaranteed by government.
The real risk here is that to fully socialize US housing finance (worth more than $10 trillion in all), you MUST MUST MUST never allow the 10-year T rate to rise above some historically-appropriate spread to the 4% mortgage target rate. (Today's spread is anomalously high, well over 200 basis points, which is why mortgages "feel" unaffordable now, even though the prevailing market rate, about 5.1%, is far below typical rates during the bubble.)
So if we pin long rates where they are now, we'll be creating a classic economic imbalance, just like the Chinese undervaluing their currency. The stress will come out somewhere, somehow, unless we get really lucky. The stress will most certainly appear if we have to keep deficit-spending at extraordinary levels for years to come. It will either show as high inflation, or a collapse of the dollar, or both.