Fears about the two mortgage giants, Fannie Mae and Freddie Mac, have dragged down the stock market into a bear market and prompted doomsday discussions in Washington.

The worry is that the two will not able to weather the housing slump, as foreclosures surge (up 53 percent in June), and that the government will be forced to bail them out. A bailout of the two government-created, but investor-owned, companies would make the rescue of Bear Stearns look like a petty cash transaction. Fannie and Freddie, the two largest buyers of American mortgages, have some $5 trillion in mortgage-related debt—about half of the mortgage debt market.

"If Fannie or Freddie failed, it would be far worse than the fall of Bear Stearns," Sean Egan, head of credit-rating firm Egan Jones, told Katie Benner of Fortune. "It could throw the economy into depression or something close to it."

The former president of the Federal Reserve Bank of St. Louis, William Poole, tells Bloomberg News that under fair accounting rules, both Fannie and Freddie are technically insolvent.

"Congress ought to recognize that these firms are insolvent, that it is allowing these firms to continue to exist as bastions of privilege, financed by the taxpayer,'' Poole said in the interview with Bloomberg.

In early May, Charles Duhigg of the New York Times had a remarkably prescient report about the fears in Washington over the two companies. Following up on that, James Hagerty, Deborah Solomon, and Damian Paletta of the Wall Street Journal report today that such discussions within the Bush administration have stepped up in recent weeks.

The focus in Washington has been on now seemingly stalled housing legislation that would increase the might of the Federal Housing Administration and overhaul the way Fannie and Freddie are regulated. But the debate may have to turn sharply radical as the housing slump deepens.

Nationalization of the two is an idea, but Benner says it is unlikely in an election year and with a lame-duck administration.

What Congress should do is show the same initiative it did during the dark days of the Depression when Fannie and Freddie were born: Create a new government-sponsored enterprise to compete with the two and buy mortgages in the secondary market.

In other words, backstop the market, don't backstop Fannie and Freddie.

Bailing out Fannie and Freddie would reward years of aggressive use of derivatives, accounting shenanigans, and wasteful spending on top executives and lobbying. And both companies failed their public mission of making housing affordable.

A new housing G.S.E. would of course be a costly undertaking and thus, probably politically impossible. But in the end a government-owned corporation would arguably benefit homeowning taxpayers, whereas a bailout of Fannie and Freddie elevates the problem of moral hazard to a whole new level.

And the creation of a rival has been proposed before, although by conservative Congressional critics of Fannie and Freddie when times were good.

In 2001, the director of the Congressional Budget Office said that "if the number of companies granted a G.S.E charter was increased, the secondary market would become more competitive, resulting in a larger portion of the subsidy being passed through to borrowers."

These are desperate times that call for radical measures. Fiona Mo anyone? Frankie Morg?