Wall Street got its hopes up on Mar 11. Elated by a Federal Reserve move to stop the credit crunch, the US stock market posted its biggest one-day gain in five years, with the Dow Jones industrial average rising more than 400 points.

Look out, though. Fed officials are the first to acknowledge that their initiative attacks only one problem, the liquidity squeeze at big banks. It does nothing about the central risk to the US economy: an unprecedented crash in home values that is sapping households' wealth and confidence while putting an enormous strain on the banking system.

• The financial crisis
• The Fed's revolution

How bad will this downturn get? No one can know because we've never experienced such a headlong slide in the housing market - and this comes at a time when its current value of $20 trillion accounts for the vast majority of most families' wealth.

Right now most economists expect the US to experience a mild, short recession in 2008. But there is at least a possibility of a steeper decline that the traditional recession remedies - interest-rate cuts here, deficit spending there - won't be able to handle.

What should be done? For policymakers in Washington - Fed Chairman Ben Bernanke, Treasury Secretary Henry Paulson, and congressional leaders - the sensible course is to insure against the small but scary possibility that things could go very wrong.

The potential 'insurance policies' are government actions that have a real cost but lessen the risk that a mild recession turns into something worse. The International Monetary Fund endorsed that approach on Mar. 12 as First Deputy Managing Director John Lipsky urged policymakers globally to 'think the unthinkable and guard against a downward credit spiral.'

• Street of fear

Broadly speaking, policymakers have three options for putting a safety net under the economy. Each has its pros and cons, and the cons become most apparent when the measures are taken to an extreme. That's why a three-pronged approach that uses each option in moderation may be the best way to go.

The first option is to depend mainly on aggressive measures by the Fed to flood the economy with liquidity. That's already under way. On Mar. 11, the central bank announced an innovative program to lend $200 billion in high-grade Treasury securities to big commercial and investment banks.

It will allow them to use, as collateral for the loans, valuable but harder-to-trade assets such as AAA-rated mortgage-backed securities. The measure could enable them to start lending and borrowing again. The cons: no direct help for distressed homeowners who don't qualify for refinancing.

A second option would be some sort of a government-led bailout of homeowners, which reduces the burden of looming debt and high interest rates, and limits foreclosures. The third option would be assistance to the lenders and holders of mortgage-backed securities in an effort to thaw the credit markets.

The trouble is, both of these options are seen as unfair by those who don't require bailouts. And it's up in the air who would have to bear the biggest share of the housing-related losses: homeowners, investors, or taxpayers.

It's indisputable, though, what policy changes cannot accomplish. There's no way to stop home prices from falling; they got way too high, and the current crisis won't end until they get back to what the market concludes is a sustainable level. It's not reasonable to try to avoid a recession, either.

When a sector as huge as housing goes into a deep dive, it's pretty much inevitable that the rest of the economy will be affected. "We saw a once-in-a-hundred-years runup in housing prices, and now we're seeing a once-in-a-hundred-years collapse," says Harvard University economist Kenneth S. Rogoff. "It's very, very difficult to do much about it."

Gamblers, liars, and sleazy lenders

The airwaves and blogosphere are alive with people who say nothing should be done. They argue that intervening now would only delay the inevitable liquidation of credit-fueled excesses. "Under proposed bailouts, responsible people lose and have to give their money to gamblers, liars, and sleazy lenders," says the widely followed Patrick.net housing blog.

But the "don't just do something, stand there!" philosophy is overly pessimistic. Policymakers have an obligation to make sure the downturn doesn't gather speed and turn into something along the lines of the long and deep 1973-75 recession. It is extremely dangerous for there to be millions of homeowners who have a clear financial incentive to abandon their homes because they are worth less than the mortgages on them.

• The few bright spots

Already there are signs that the stigma of abandoning a home is fading, as desperate homeowners flock to Web sites with names like walkawayplan.com and youwalkaway.com.

"People hate the banks," says Paul J. Helbert, a senior analyst and co-owner of Walk Away Plan in Glendale, Ariz. The entire capital of the US banking system would be wiped out many times over if everyone who was underwater on a mortgage turned the keys over to their lenders.

There's a social aspect, too. Concentrated foreclosures, voluntary and otherwise, can destroy neighborhoods because abandonment increases decay and crime. And the housing crash undermines the social compact. "Talk about the rich vs. the poor was to some extent buffered by rising house prices. Now all you have to do is stare at your paycheck and your negative home equity," frets University of Chicago Graduate School of Business economist Raghuram G Rajan.

The most urgent task is making sure that the financial system isn't so crippled by losses that it ceases to perform its critical function of moving capital from those who have it to those who need it. Asset deflations can damage the financial system.

Further complicating matters is that securitization and derivatives make it nearly impossible to figure out who's vulnerable to a big loss until things blow up.

The Federal Reserve is already on the case, intervening in a big way under the leadership of Bernanke, who earned his academic stripes studying the policy errors that led to the Great Depression of the 1930s.

The Fed's approach is double-barreled. Since last summer it has cut the federal funds rate from 5.25 per cent to 3 per cent, and markets are forecasting the central bank will cut to around 2 per cent before it finishes. The Fed may need to go even lower, though, perhaps to 1.5 per cent or even back to its 2003-04 level of 1 per cent.

Lower short-term interest rates allow banks to rebuild their damaged balance sheets by paying less for the debt they carry, and they should also pull down market interest rates, stimulating the economy with cheaper loans for homeowners and businesses.

The Fed's second tactic is to ease the credit crunch by convincing market players that suspect assets really are worth something. It's doing that by giving commercial and investment banks new options for backing up their loans.

The Fed's Mar 11 move is designed to help its primary dealers - 20 huge firms at the core of the financial system. They will be able to pledge a wider variety of collateral - including AAA-rated private label mortgage-backed securities - in exchange for top-quality Treasuries.

And the loans will be for 28 days instead of just overnight. One immediate beneficiary will be Bear Stearns, which will have an easier time getting its hands on Treasuries it can then use as collateral for loans from other financial institutions that have been increasingly concerned about its ability to repay.

But the Fed can't do it alone. Lower rates don't help homeowners who can't qualify for a new mortgage because their homes have lost too much value. Also, massive cuts raise the risk of inflation, which in turn pushes up long-term interest rates, partially neutralizing the Fed's efforts.

The Bush Administration's $152 billion economic-stimulus package will help a bit, but economists expect the lift to fade by the end of 2008, not long after the November elections.

That's why many analysts say the federal government will need to intervene directly in the housing market. "A month ago or two months ago I would have said the critical thing is to stimulate the economy.

"But the dysfunctional nature of the credit markets, particularly housing assets, I think is overwhelmingly important," says Martin Feldstein, a Harvard University economist who was President Ronald Reagan's chief economic adviser.

But one person's 'necessary intervention' is another's 'outrageous bailout'. When the government steps in, that's when the battle starts about who wins and who loses. Home mortgages account for 44 per cent of private nonfinancial debt, making them one of the main pillars of the debt market.

If the value of household real estate falls by 25 per cent - an amount many economists consider plausible - it would be a $5 trillion loss of wealth. Any type of government bailout plan will alter the eventual distribution of losses between homeowners and investors.

Bailouts: Choose a bucket

The purest form of bailing out homeowners would be forcing lenders to reduce the amounts borrowers owe. Such a 'cramdown' could be accomplished by legislative fiat or, more likely, by changing the federal bankruptcy law to allow judges to reduce mortgage debt in a Chapter 13 reorganization the same way they're allowed to reduce other debts. Bills to change the bankruptcy law have stalled in Congress but could gain traction if foreclosures keep rising.

The downside: In the short run, lenders might face even bigger losses. In the long run, they would charge higher interest rates for fear of future cramdowns. And Keith Hennessey, director of President Bush's National Economic Council, said in a Feb. 29 press breakfast that "injecting government through the courts into preexisting contracts" will drag out the housing bust by slowing the debt-adjustment process.

At the other extreme are ideas that would bail out the lenders without trying to prop up prices. Harvard's Feldstein, who publicized his plan in a Wall Street Journal op-ed piece on Mar. 7, would have the federal government make low-cost personal loans to families equaling 20 per cent of their mortgage debt.

The homeowners who took the offer would have to use all of the money to pay down their mortgages. That would give a huge shot of cash to lenders and would reduce the likelihood that borrowers would walk away from their homes since the remaining mortgage debt would be well under the home's value.

But it would expose taxpayers to risk while doing nothing to reduce the total indebtedness of households. And by letting lenders off easy, it would embolden them to think they could lend irresponsibly again with impunity.

Government can and should do more

Discouraging, huh? "Many people have struggled over the last six months to find effective forms of government intervention and have been disappointed by the paucity of good options," says Douglas W. Elmendorf, a senior fellow at the Brookings Institution.

Still, he says: "I think the government can and should do more." He favors bankruptcy reform that would help reduce homeowners' debts along with measures that would help the financial sector by buying up some loans with government money, albeit at a discount.

In the Presidential race, Republican Senator John McCain doesn't want to bail out either side, favoring private workouts between borrowers and lenders. Here's how he summed up his feelings on Mar11: "It is not the government's role to bail out investors...or lending institutions who didn't do their job."

Democratic Senators Barack Obama and Hillary Clinton both tilt toward homeowners, but Clinton is more aggressive, calling for a voluntary 5-year freeze on subprime mortgage rates and a 90-day moratorium on foreclosures.

One idea that's gaining support from some liberals and conservatives alike is the creation of a modern-day version of the Home Owners' Loan Corp., a Depression-era agency that bought mortgages at a discount and issued new, more affordable ones. Alex J. Pollock, a resident scholar at the American Enterprise Institute in Washington, says such an agency would help "avoid a serious downside overshoot where you get a self-reinforcing cycle of defaults, credit contraction, and falling home prices."

But Hennessey, the Bush adviser, likens the idea to a teacher who gives her class extra time on an assignment because someone isn't done: "The students who stayed up all night to finish the assignment are in fact quite upset."

Even if the warring parties agreed to such a plan, there would still be plenty of scope for conflict. Lenders and owners of mortgage-backed securities would seek to get as close as possible to 100 cents on the dollar for their loans, while borrowers and taxpayers would want a big discount so the new mortgages would be comfortably smaller than the homes' values.

Each side, naturally, would cloak its arguments in the public interest. Lenders would try to dump the worst-performing loans on the government and retain the healthy ones, notes Elmendorf. And any wide-ranging program would inevitably help many undeserving borrowers and lenders.

One danger is that political brawling will lead the debate away from what's best for the economy as a whole. There are many ways to get this wrong. In Japan in the 1990s, for example, insolvent but politically powerful companies got their banks to keep them alive with low-cost loans, which meant that the banks had no money left over to fund new businesses. That led to Japan's infamous Lost Decade of slow growth.

All that said, some inefficiency and political conflict may be an acceptable price to pay for programs that lessen the very real risk of a systemic financial meltdown.