I am a Democrat and I work on Wall Street. Here's my stab at your questions.

1. Individuals who are under water on their mortgages and Wall Street are two separate issues. They're obviously reacting to the same stimulus, but they are different. The immediate concern, since it spills into the whole economy, is the credit crunch (Wall Street's reaction to the RE bubble burst). A recession is defined as two consecutive quarters of negative growth. The economy cannot grow without available capital, so a credit crunch is a sure way to recession. A recession would impact all participants in the economy—not just those who got burned with a bad mortgage deal. So if we need to triage, the credit crunch needs to be addressed before the individuals with the negative amortized mortgage.
2. Finger pointing is imminent. We’ll see some legislation and accounting standards both here and abroad in the next few years. I expect a SOX-like thing coming, as well as some FASB changes. I have some opinions about who’s to blame, but I’ll hold off until things shake out a bit more. Interesting irony about legislation/standards: Last time we had a slate of accounting scandals the rules were supp’d up via SOX and BASEL II. One result of the additional scrutiny is that banks invested heavily into their market risk management tools. A good thing, right? Maybe not so much… After the investments in market risk paid off, Banks had lower capital charges (Think of a casino that needs to keep $X in their cashiers booth to cover their worst case scenario. The casino re-calibrates their slots for fewer winners, resulting in less cash required in the cashiers booth). Now we have a credit crunch, and the cash reserves are lower because of more effective market risk. Ooops! Of course mortgage-backed instruments are not part of market-risk management (they’re part of credit-risk management, the state of the art of which is in the dark-ages). If they had been, this fiasco might have been avoided or minimized.
3. Who would want to touch this thing if they didn’t have to? I see your point that one of our candidates should say something, but the whole mess is very toxic. On one hand talking about punishing the banks is counter-productive since you really cannot target the banks. Talking about helping the folks burned by their mortgages appeals only to a small part of the electorate (namely those with bad mortgages or real estate deals). In a perverse way, to be a populist in this debate might make you look like a corporate stooge.

Let me leave you with a sense of how complicated fixing the problem could be. First off, you need to understand that the capital markets are like an amorphous blob. If you try to mess with one part, the whole thing acts like jello. It’s hard to target specific things without unintended consequences. For example, a market risk measure looks at 18,000 different factors in it’s monte carlo simulation (a what-if calculation that uses current market data to predict many future results, and then summarizes the results as a risk measure). That means any one or two things in the 18,000 data points can effect any number of outcomes. It’s a gamble of unintended consequences. Like I alluded to before, when the banks were forced to fix their market risk practices the result was that they could put more of their capital at risk. No they’re getting burned in the credit markets, have less capital on hand, and a credit crunch that prevents them from borrowing.

Last thought. It’s no longer about sub-prime instruments. Last week Carlisle got calls from their banks on their heavily mortgage-backed leveraged positions. Carlisle’s inventory was all AAA. They may now be forced to dump all these AAA’s which will result is AAA values plummeting because of too much inventory, no buyers, and no credit for those who would like to buy, but do not have the cash.

A perfect storm is brewing.

JohnW--good ? re how rising home prices keep this scheme afloat.

Say you take out a loan you can't afford to buy a home you can't afford. This home is now your asset and if it appreciates, you're wealthier. You can extract some of that wealth by taking out a bigger loan (refi) against the increased value of your asset. You can use some of that money to pay off principal, and maybe lock in a lower rate, so you save on monthly payments too.

In reverse, the whole thing unwinds. Lots of folks are finding themselves 'underwater,' owing more on the mortgage than the value of the home.

Not quite like Enron. The instruments being traded are fixed income, not securities. As such they are more durable. The sub prime instruments carry more risk, which is hedged by higher interest rates.

Also, the mark-to-market requirements on fixed income is lighter than securities--for now, at any rate. It's fuzzier as to when you have to or how you declare impairment on fix incomes.

A lot of this grayness is fueling the fears on Wall Street. If we were talking about securities the rules are clearer (as a result of Enron, Worldcom, etc).