(RTTNews) - Treasury Secretary Henry Paulson said Wednesday that the government should replace mortgage giants Fannie Mae and Freddie Mac with a system that either explicitly backs certain mortgage loans with government credit, or leaves housing to the market.

Paulson argued that another crisis could take place down the road if the structure of Fannie and Freddie was not changed.

Because they were chartered by Congress, these companies are known as Government Sponsored Entities, or GSEs. They were fully taken over by the government last year after the slump in housing prices pushed them near collapse.

Critics have long complained that the structure of Fannie and Freddie, which blurred the line between public and private entities, made them inherently dangerous to the financial markets, but political pressures made it difficult to make any changes.

Speaking at the Economic Club of Washington, Paulson provided suggestions about how the government should replace Fannie and Freddie, noting possibilities ranging from full privatization to creating a utility-like entity for securitizing mortgages.

"Government support needs to be either explicit or non-existent, and structured to resolve the conflict between public and private purposes," Paulson told his audience. "Any middle ground is a recipe for another crisis."

Paulson acknowledged that the structure of Fannie Mae and Freddie Mac is a politically charged issue, with Republicans generally blaming Democrats for supporting the companies in an attempt to extend homeownership in the country.

But while he noted the strong differences of opinion about the GSEs, Paulson said that no matter what course policymakers take, "there are structures and choices that can resolve the long-term conflict of purposes issues."

Explaining the basic design flaw that led to the problems with Fannie and Freddie, Paulson stated, "The inherent conflict in this structure is obvious - the GSEs served both a public mission and private shareholders - they received public support but operated for private shareholder gain."

But the treasury secretary noted how difficult it was before the financial crisis, which forced the government takeover of Fannie and Freddie, for lawmakers to change the structure of the companies.

"The GSE reform debate was largely frozen in place, or moving at glacial speed," Paulson said. "Then suddenly, the unprecedented housing correction shifted the ground under that debate and forced action."

The treasury secretary said he sees a role for government agencies like Ginnie Mae and the Federal Housing Administration, or FHA, which are both part of the Department of Housing and Urban Development.

"In the mortgage market of the future, I clearly see a role for the FHA and Ginnie Mae for first-time and low income homebuyers," Paulson stated.

He added, "Beyond the explicit guarantee provided to FHA and Ginnie Mae policymakers must decide how much to further subsidize mortgage credit risk, if at all, and must decide the role of private capital in any subsidy plan."

Paulson gave a series of suggestions about what the government could do to replace the GSEs, including expanding FHA and Ginnie Mae and providing a partial guarantee for mortgage backed securities.

The treasury secretary also suggested that the government could remove all public support, breaking up Fannie and Freddie to minimize risk and then privatizing them.

A housing utility could also be created, Paulson said, with Congress replacing Fannie Mae and Freddie Mac with private sector entities that would purchase and securitize mortgages with government-backed credit, but would not have investment portfolios.

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