America's economy confronts a vicious cycle of falling home prices and rising foreclosures, and the challenge for policymakers is how – and how much – to intervene.

Top economic officials are already taking some steps that are aimed, at least in part, at slowing the erosion of home prices. The Treasury has been prodding banks to rewrite the terms of loans rather than foreclose on mortgage holders who are in default.

One goal is to help ordinary Americans keep their homes and to keep neighborhoods from deteriorating.

Another rationale is to bolster an industry at the heart of the economy: the banking system on which consumers and businesses depend. When homes go into foreclosure, banks face a pileup of bad assets on their books. Already, that has caused banks to start tightening the spigot on new lending.

But even as US officials look for ways to help avert a deeper credit crunch, they face political and financial limits on how much the government can do to prop up the real estate market after a historic price run-up.

"We're entering an unprecedented period," says Richard Bitner, a former lender in subprime mortgages and author of a book on the industry. "I'm a believer that markets have a tendency to work their way through these things…. My great concern is that Congress is going to go too far."

Falling prices are a drag on borrowing

But "do nothing" doesn't look like an appealing option right now, either.

The problems in housing are part of a broader collapse of confidence among lenders and borrowers – a problem that makes it hard for markets to find an easy path back toward health and balance. An economy teetering on the edge of a recession makes the challenges more acute.

From student loans to corporate buyouts, investor dealings in various forms of debt have been freezing up, as the players reassess the value and risks involved.

Housing remains a central piece of this credit puzzle, because so many Americans buy homes and so many financial firms underwrite mortgages. With home prices falling, many borrowers and lenders are sitting on the sidelines.

"In this environment, buyers will be reluctant to commit to new purchases," Treasury Secretary Henry Paulson warned last month. "Until investors have confidence that [home] prices have stabilized," he added, "they will remain cautious about funding new mortgages."

Secretary Paulson has led Bush administration efforts to prod banks to modify the terms of at-risk home mortgages, rather than watch more borrowers fall into delinquency and then foreclosure.

Banks have been taking steps along that line. The economic stimulus package enacted recently by Congress will also permit government-sponsored enterprises, including Fannie Mae, to begin guaranteeing higher-value home loans. That's a bid to revive buying and lending in high-priced markets such as California.

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