Think the credit crunch is over? Think again

NEW YORK (Fortune) -- Careful optimism about the U.S. economy and financial system has given way to a resurgence of unease in the last couple of days, prompted by an announcement Monday of an extraordinary plan to pump liquidity into an important part of the debt markets and less-than-upbeat speeches from Federal Reserve chairman Ben Bernanke and Treasury Secretary Henry Paulson.

Suddenly, the credit crunch is being talked about as a serious phenomenon again. But, as is always the case on Wall Street, it won't be long before a gaggle of self-interested players make their way to center stage to tell us that recovery is just around the corner, seizing on any halfway optimistic shred of data to bolster their case.

So, in an effort to stay grounded amid the hype, it's worth making a shortlist of things that need to start happening before anyone can talk about the credit crunch coming to an end.

First: way more transparency. The movers and shakers need to tell us what's really happening and show that they understand the seriousness of the credit crunch.

Take the mess created by the so-called structured investment vehicles (SIVs), which Citigroup (Charts, Fortune 500), Bank of America (Charts, Fortune 500) and J.P. Morgan Chase (Charts, Fortune 500), under the sponsorship of the Treasury, are trying to shore up, according to a plan announced Monday. Citigroup has $83 billion of SIVs, which reside off its balance sheet. The Treasury-sponsored move is a clear sign the SIVs have problems, but Citigroup has not said why it can't solve its SIV problems on its own (not strong enough?) and it hasn't even begun to provide key data points, like losses racked up in its SIVs so far, the potential demands on Citi's balance sheet if the SIVs do have to come onto its balance sheet and amount of SIV debt it's actually been able to sell to replace debt that's coming due.

In short, the SIVs, because of their size - they hold about $400 billion of assets - are a massive cog in the credit machine, and the public knows nothing meaningful about them.

Second: greater realism. To be fair, this week, Bernanke and Paulson have started to acknowledge that the credit crunch is far from over.

Paulson, in a speech Tuesday, acknowledged something that half of Wall Street still won't recognize - that the mortgage mess is spreading beyond the subprime sector.

"Yet, the problem today is not limited to subprime mortgages as the number of homeowners having trouble making payments on prime mortgages is also increasing," Paulson said. And in a speech Monday night, Bernanke softly echoed this, saying, "...despite a few encouraging signs, conditions in mortgage markets remain difficult."

But something big that happened last week shows that the depth of the credit problems have not been fully recognized. The credit rating agency Moody's downgraded a massive number of mortgage-backed securities that hold subprime loans, and held up the possibility that there will many more downgrades to come.

When a much fewer number of bonds were downgraded in the summer (approximately 700 then versus 2,200 last week), there was a sharp negative reaction, but this time the market reacted with a shrug of the shoulders.

"This was a huge event that went almost unnoticed," says Joseph Mason, professor of finance at Drexel University. That makes no sense, says Mason, because this will have a huge negative impact on collateralized debt obligations, those weird and toxic debt securities that have already caused big hits to banks' balance sheets, and will only cause more after the downgrades.

Third, there has to be a complete discrediting of the view that says asset prices are not that out of line and it's only a matter of time before liquidity comes back to the market. The opposing view - that, in fact, liquidity can't return in earnest till bond prices fall to levels that look enticing - has to become the new orthodoxy, all the way up to the Fed.

Bernanke seems to be a committed proponent of the former view. In explaining the Fed's recent actions Monday, he said a central bank has to do things that will prevent sales of assets that "will drive the prices of those assets well below their longer-term fundamental values, raising the risk of widespread insolvency and intensifying the crisis."

But what if their fundamental values are actually much lower than the central bank thinks? Then the Fed would be delaying the inevitable, by doing things that keep assets at prices that are too high. Sure, drops in bond prices could cause even more markdowns than have taken place at the banks, but if they're going to occur anyway, it makes no sense to delay them. We need the banking sector as a whole to return to normal more than we need certain banks to survive or remain independent, which brings us to our fourth point.

The pace of consolidation in the financial industry has to pick up markedly. This will allow the stronger banks to swallow up weaker lenders, which would lead to a far more efficient use of the balance sheets.

If, say, China Citic Bank were to acquire a minority stake in Bear Stearns (Charts, Fortune 500), it'd be a great start to this process, but there'd have to be much larger deals. But, again, prices have to fall - in this case, the stock prices of the banks themselves.

Potential deals can already be seen. Bank of America no doubt would love to increase its effective stake in troubled mortgage lender Countrywide (Charts, Fortune 500), but probably at a stock price below the current $18.09.

And one event that could surely galvanize the financial markets is if Citigroup's stock, as a result of its SIV mess, fell to a point where an acquisition became interesting to rivals. Wounded banks are a huge drag on the economy - look at Japan in the '90s - so it always pays to have them quickly acquired.

And, finally, the credit crunch is not only a financial industry problem. It has occurred because borrowers took on way too much debt themselves. Sadly, it will take years to mend this. One statistic shows this more clearly than any other: Household liabilities as a percentage of the market value of total assets, which includes everything from houses to cars to stocks. At 19%, it's now at its highest level than at any time in the past 50 years.

It could take years to bring that ratio down. But one thing credit crunches are good at is forcing debt levels down so they become more manageable, preparing the ground for a recovery.

For individuals and the banks it's the same: For the credit crunch to end, we have to let it actually happen.