News that the Treasury Department may use Fannie Mae and Freddie Mac's influence on mortgage markets to push interest rates on home loans down to 4.5 percent has raised hopes for a boost in home sales but sparked debate on whether it's wise to prop up housing prices.

The Wall Street Journal reports that the Treasury is considering using Fannie, Freddie and other government-sponsored entities to purchase securities backed by mortgages at a price equivalent to a rate of 4.5 percent.

Treasury officials have not commented, but the Federal Reserve announced a similar program on Nov. 25, saying it would spend $600 billion to buy mortgage-backed securities and debt issued by Fannie Mae, Freddie Mac and Ginnie Mae.

The announcement brought down interest rates on conforming loans by about 1 percent and sent mortgage applications soaring (see story).

Each 1 percent reduction in mortgage interest rate gives home buyers about 10 percent more purchasing power. That can not only get buyers off the fence, but also prop up home prices.

Stabilizing prices in markets where foreclosures have created a glut of homes for sale would be good for home builders struggling to clear backlogs of inventory. It's unclear if the Treasury plan would also help borrowers refinance, which would also reduce foreclosures.

In a speech today, Federal Reserve Chairman Ben Bernanke said problems in housing and mortgage markets "have become inextricably intertwined with broader financial and economic developments."

Lenders appear to be on track to initiate 2.25 million foreclosures in 2008, compared with less than 1 million a year before the financial crisis, Bernanke said.

While industry groups like the the National Association of Home Builders and the National Association of Realtors are all in favor of lower mortgage rates, some economists say home prices in some markets need to fall further before they return to affordable levels.

Appearing on Yahoo! Finance Tech Ticker today, economist Nouriel Roubini called the plan reportedly being considered by the Treasury "a direct bailout" of home builders. Roubini said prices need to fall another 15 percent to reach affordable levels.

Before news of the Treasury plan leaked Wednesday, Dean Baker, co-director of the Center for Economic Policy Research, issued a report advocating that Fannie and Freddie stop buying mortgages in markets where house prices continue to be out of line with rents, in order to bring prices down another 20 to 30 percent.

That would put more homeowners underwater -- owing more on their mortgage than their home is worth -- and could lead to more foreclosures. One solution suggested by Baker is to give homeowners who are foreclosed on the right to become long-term renters of their homes.

Baker argues that it's better to get price declines out of the way than to take measures that only prolong the inevitable.

"At the new lower prices, home buyers would be less fearful that there would be a further decline in prices," Baker said. "This should cause many potential home buyers -- who have been waiting for the price decline to stop -- to re-enter the market."

Bringing prices back in line with historical levels "is the most effective way to boost demand in the market and to begin to reduce the record vacancy rate."

Some observers fear that now that news that the Treasury is considering such a plan has leaked, it will hurt home sales because prospective buyers will stay on the sidelines until it is clear whether the government will take further action to bing down mortgage rates.

In theory, Treasury Secretary Hank Paulson could use the second half of the $700 billion troubled asset relief program (TARP) to buy up mortgage-backed securities.

Although the program was created on the premise that it would be used to buy troubled assets, so far Paulson has concentrated on shoring up banks by providing them billions in liquidity in exchange for an ownership stake (see story).

The Treasury Department hasn't embraced another propsal that FDIC chairwoman Sheila Bair says could be undertaken under TARP: partially insure lenders when they agree to modify as many as 2.2 million loans, at a cost of about $24 billion (see story).

The Treasury and Federal Reserve have been taking unprecedented measures to head off a collapse of the financial system that was initially sparked by falling home prices and a rise in foreclosures.

Bernanke said today that in many cases, lenders would be better off modifying borrower's loan terms than foreclosing. They may be missing opportunities to do loan modifications because the sheer volume of delinquent loans has overwhelmed the capacity of many servicers. The process is further complicated because most loans are packaged into securities sold to investors, and the rules governing the investments may discourage servicers from undertaking modifications, the Fed chairman said.

Bernanke said the FDIC plan, which aims to reduce monthly payments to 31 percent of the borrower's income, would standardize the process of restructuring loans, and minimize the government's involvement to when a re-default occurs. The FDIC assumes one in three modified loans would re-default, costing taxpayers $24.4 billion but preventing 1.5 million foreclosures by the end of next year.

Another step to prevent foreclosures might be to bring down the interest rate borrowers will pay under the Hope for Homeowners program, Bernanke said. The program allows delinquent homeowners to refinance into FHA-insured loans when their lender agrees to write off enough loan principal to create some equity for the borrower.

The Hope for Homeowners program hasn't been popular with lenders, and was modified under the same legislation that created the TARP program to reduce the amount of required write-downs on some loans, permit up-front payments to holders of second loans, and allow loan terms of up to 40 years.

Bernanke said the interest rate on the loans is still expected to be "quite high" -- roughly 8 percent. Treasury could bring down the rate by exercising its authority to purchase the securities issued by Ginnie Mae to fund the program, Bernkanke said, if Congress increased the debt ceiling to allow that.