SANTA FE, NM. It seems an unlikely place to talk about the largest of all the debt markets. But here we are, having lunch at the Santa Café and talking about the current upheaval in the nation's securitized mortgage market.

John Geanakoplos, the man sitting across from me, is a boyish 48 and a professor of economics at Yale. He was also the first director of the Economics Program at the Santa Fe Institute. Perhaps more important, he is a founding partner of Ellington Capital Management, a hedge fund.

His fund, which he sheepishly admits has assets over $1 billion, specializes in complex mortgage securities and their derivatives. A few weeks earlier I had listened to him give a Santa Fe Institute lecture on "Mortgages, Hedge Funds, and Market Crashes." He knows this subject well, having built the ill-fated mortgage securities department at Kidder Peabody in the early 90's and having survived his share of crashes.

Today, listening again, I get the same odd feeling as I did while listening to his lecture. While you and I are trying to make a simple decision about whether to refinance our mortgage, very talented people like John Geanakoplos are programming complex decision trees, borrowing gigantic sums of money, making earth shaking mega-bets on what we're about to do, and contributing to the liquidity of the credit market most important to most Americans.

Earlier, he had explained that the mortgage market was more than twice as large as the market for publicly held Treasury securities and that much of it had been securitized. (Securitized means that large numbers of home mortgages are pooled behind a bond and sold to investors, rather than held in institutional portfolios. The complicated part is that mortgage securities can "mature" at any time since you and I have the right to prepay our mortgages at will.)

The major goal of the mortgage securities market, he declared, was to "stretch" the very good collateral of our homes. This was done by creating new securities called CMOs (collateralized mortgage obligations) and by borrowing.

"Homes", he said, "don't run away or leave the country."

Good collateral.

"The problem is there are too many people borrowing too much money."

He wasn't talking about you and me. He was talking about the people who run hedge funds. Hedge funds, he says, are the "natural buyers" in this market.

All that debt leverage created liquidity in good times but resulted in crashes in bad times, such as 1994 and 1999. The same market also worked most of the time, he said, to reduce mortgage rates. Ordinary homebuyers benefit.

The problems come, he noted, when there are big changes in interest rates or worries about the market itself. Recent worry about accounting at Freddie Mac disturbs the market. And the sudden rise in Treasury interest rates, a second thread, didn't help.

When things like this happen, he said, lending institutions want their money back--- Immediately.

Basically, the lenders force sales precisely when all the buyers have run for cover. The result is crashed hedge funds, exaggerated declines in security prices, and big spikes in mortgage interest rates--- like the spike we're seeing now.

I asked if there is a way to make the system more stable.

"There isn't a complete programmatic fix. The whole purpose of the system is to stretch collateral. But there are piecemeal fixes," he said.

"First, there need to be better contracts between the lenders and the hedge funds. The current system maximizes the speed of (money) recovery for the lender. It makes them feel safe but it makes any crisis worse.

"Second, there should be more public awareness of the leverage in the system. And possibly some limits.

"Third, Fannie Mae and Freddie Mac (the two quasi public institutions that create most of the pools of mortgage securities) should be curtailed and their positions--- the amount of mortgage securities they hold--- should be reduced. They shouldn't be so exposed to risk. If they didn't hold anything at all they wouldn't have the information advantage they now have against other investors.

Will we get such reforms?

No one knows. Some have urged reform at Fannie Mae and Freddie Mac for years.

My personal bet--- and it's just that, a bet--- is that reform will happen. The U.S. Treasury has a $400 billion deficit to finance. They don't want the home mortgage market getting in the way.