Credit Crunch: The Sequel

So what can be done to revive the credit markets? Stabilizing Fannie and Freddie could be a good first step. Treasury intervention could take a number of forms, such as lending them cash or injecting capital. Armando Falcon, Fannie and Freddie's former top regulator, argues for a government takeover that would wipe out shareholders, bring in a new management team, and, he says, imbue the housing market with needed stability. "You remove the uncertainty of what's going to happen with these two companies, and you've...begun to lower interest rates on mortgages," Falcon says. Once they are nursed back to health, he says, Fannie and Freddie should be turned into small government agencies that support affordable housing, thereby allowing a competitive, private mortgage market to develop.

Democratic presidential nominee Barack Obama has said the government can't allow Fannie and Freddie to fail and needs to decide if the companies should be taken out of "the profit-making business." Republican nominee John McCain backs supporting Fannie and Freddie for now, but he says that as president he would shrink them and eliminate their ties to the government. The time is right for radical restructuring, says James Wilcox, a professor of financial institutions at the University of California-Berkeley. "The typical pattern in American financial regulations is that you get major structural reforms—some good, some bad—in times of crisis," Wilcox says. Indeed, Fannie Mae itself was created during the Great Depression.

As a second step, banks need to find a way to get those esoteric, mortgage-backed assets off their books once and for all. These securities have been at the core of the credit crisis from the start, as uncertainty about their value has repeatedly overwhelmed the Fed's efforts to get credit flowing normally. A bottom in housing prices would help a great deal in determining their value, but many analysts don't see that happening until well into next year, if then. Meantime, former Fed Vice Chairman Alan Blinder argues that the government should create a federal entity—modeled on the Resolution Trust Corp.—to purchase the debt from banks and resell it to private investors once demand returns. That would free up banks' balance sheets and promote confidence in the credit markets. However, Blinder believes that the political will for such a program doesn't yet exist—and that only more severe economic fallout from the credit crisis can generate it. "There are 535 people that need to get more scared," Blinder says, referring to members of Congress.

The folks on Wall Street, of course, are already plenty scared. And if timid lenders choke off credit further, it might not be long before this economic fear grips Washington too.