Reuters reports that Carlyle Capital -- an affiliate of Carlyle Group that counts former President George H. W. Bush among its advisers -- can't pay back the $16.6 billion it owes banks. So its lenders are taking possession of its assets to try to recoup some of the money they lent. Interestingly, it said that the only assets held in its portfolio as of Wednesday were U.S. government agency AAA-rated residential mortgage-backed securities (MBSs). If these securities are indeed worth their AAA rating, I wonder how much of a "haircut" those lenders will take.

This latest collapse is evidence of two viciously destructive cycles in the global credit markets which government policy decisions are making even worse. The first cycle is driving down the stock market, setting inflation on fire, and hammering the dollar -- which is down 68% since 1/19/01 -- as the economy slows. The second cycle is reinforcing a chest-clutching decline in the value of the $6.1 trillion MBS market:

• The Bernanke call. As I've posted, this means that Federal Reserve Chairman Ben Bernanke's moves mark a ceiling below which the market keeps falling. The basic idea is that when the stock market falls, the Fed responds by flooding the market with money -- interest rates have fallen from 5.25% to 3% and are likely to hit 1% and then there's the "Term Auction Facilities" like this week's $200 billion month long swap of government securities for MBSs. The lower rates and added money spur inflation -- oil (+357% since 1/19/01), food prices rise (e.g., milk prices +12% in 2007) and gold futures hit $1,000 -- but do nothing to solve the basic problem -- which is to recapitalize banks. The market falls on the announcement of a new credit market problem, such as Carlyle's default, and the cycle begins anew.

• The MBS liquidation tumble. This vicious cycle ls driving down MBS prices with stunning speed. Sentiment is broadly negative and news of missed margin calls at large highly leveraged funds only elevates fear of a vicious cycle of more forced selling at deep loss, collateral shortfalls, and more missed margin calls. Today's announcement by Carlyle Capital is an example of this cycle in action.

Unfortunately, these two vicious cycles reinforce each other. The MBS liquidation tumble drives down the value of the very collateral that the Bernanke call is using in its latest effort to stop the credit crunch. The market will fall as a result and banks' MBS portfolios will have an even lower value than they did before. This will create a need for even more capital which they may try to raise by selling other, more liquid, assets.

Meanwhile, with the labor market heading south, people will find themselves squeezed between the rising prices of gasoline and food, their inability to borrow money, and their employers' unwillingness to pay them enough to keep up with their rising costs. This is reflected in an NBC/WSJ poll in which respondents said that they are worse off than they were four years ago.

It seems to me that the solution is for banks to write off all the bad assets and raise capital. (After writing this I read in today's Wall Street Journal that Nobel laureate Myron Scholes has made a proposal along these lines). I don't know why this is not happening, though several possibilities come to mind: there is not enough capital out there to refill their coffers, nobody knows how much those bad assets are worth, and/or the government does not want to be seen as bailing out the banks.

Sometimes society is faced with a choice between bad and worse. This is such a time.

Peter Cohan is President of Peter S. Cohan & Associates. He also teaches management at Babson College and edits The Cohan Letter.