The unimaginable disruption in the securities markets as of late has been caused by a sense of freefall, and an utter lack of investor confidence. The cycle — value impairment leading to markdowns of asset values leading to credit downgrades and more markdowns — has to be broken. Ultimately, this will be done through a recovery in the housing market. The deterioration started there, and rebuilding will have to start there as well.

However, the contagion did not have to spread so wide. Wall Street could have stepped in and propped up certain markets, such as that for auction rate securities, which were absurdly devalued. Although the losses at Merrill Lynch, Citibank, and UBS arguably took them out of the game, other banks (like Goldman Sachs) could have stepped in and supported the auctions. In prior crises, such as the aftermath of the Long Term Capital Management collapse, such joint efforts have helped shore up the financial markets.

What has changed? First, the profit center on Wall Street has shifted from investment banking to the trading desk, where client relationships count for less. More important, the Wall Street firms are all publicly owned these days, and they have to answer to shareholders. Their willingness and ability to step in front of a declining market in hopes of providing some stability is limited.

Take the case of Carlyle Management’s founder, David Rubenstein. He was scheduled to speak at a conference held by JPMorgan Chase last week in Deer Valley, Utah. He left before the appointed hour, after reportedly finding out that his bankers — including JPMorgan Chase — had instigated a margin call on one of the firm’s funds.

It’s hard to know who might have been more embarrassed. Carlyle found itself in this position because it had reportedly leveraged the fund’s holdings 32 to one, counting on the triple-A credits in the portfolio to protect it from mishap. For most observers, such leverage entails an immensely large amount of risk, regardless of the underlying securities.

JPMorgan Chase, meanwhile, had a commitment to Carlyle, a long-term client and generator of enormous fees for banks in recent years.

Carlyle Capital has asked its lenders for a standstill agreement on further margin calls. A spokesman in London, Emma Goode, could not provide a timetable for a response from the lenders, and also could not confirm that JPMorgan Chase was involved in the lending group. She did confirm that JPMorgan Chase is listed as a lender in Carlyle’s year-end report.

Will the lenders give Carlyle some breathing room? Should they?

For those not involved with the financial markets, the reaction will most likely be: They deserve each other. If only it were so simple.

The meltdown in credit markets is not just having an impact on those responsible for its creation. The inability of businesses to get access to credit is damaging the entire economy, as has been seen in weakening retail sales, job losses, and the increasing odds of a recession.

What can be done?

Investors must be reassured that there is value in triple A-rated mortgage-backed securities, or in top-quality municipal bonds or other solid instruments that have recently come under pressure. This responsibility has to be shouldered by both the public and the private sectors.

That was the idea behind Treasury Secretary Paulson’s ill-fated Super SIV.

This proposal was a good idea, but nothing came of it. The banks that did not have corrosive exposure to the collapse of the leveraged loan market did not take it upon themselves to support those that did. Surprise, surprise. Ultimately, certain banks including Citigroup, which is one that felt the most impact, decided to take their SIVs back onto their balance sheets.

The importance of the Super SIV was that it gave financial markets the opportunity to establish prices for some of instruments that were so illiquid a market price was difficult to determine. It was this lack of transparency in regular SIVs that scared investors away. The banks that carried these SIV products on their books were faced with horrendous “marks to market ” kicking off losses and the possibility of credit downgrades. A former senior Treasury official, who spoke on condition of anonymity, says the government is thrilled that “all the garbage is out of the banks and into the market,” reducing the government’s responsibility for bailing out the banks. The government, however, is still on the hook.

The word on the Street is that the Treasury Department has been slow to fully comprehend the damage being done by the banks’ refusal to lend. They are not alone. The Federal Reserve has also been behind the curve on lowering rates. Despite aggressive action on the part of the Fed chairman, Ben Bernanke, rate cuts have typically followed, not led, the market. At the end of last week, it appeared that the Fed was open to broader measures to stabilize financial markets.

On Friday, the Fed announced that it planned to increase the amount of its Term Auction Facility to $100 billion or more. Also, it initiated a series of term repurchase agreements that could amount to $100 billion or more in which dealers can in effect borrow against agency mortgage-backed securities. These measures should begin to set a floor under Fannie Mae and Freddie Mac securities, at least. The next step will be for the Fed to actually purchase some of these assets, which could stop the price slide overnight.

That would be quicker than waiting for the housing market to recover, which will in turn be about as much fun as watching grass grow.

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