The recent troubles at U.S. mortgage giants Fannie Mae and Freddie Mac show that the credit crunch is far from over, and looks likely to hang over the economy for some time, say TD Bank economists in a special report released today.

The first year of this crisis saw excesses in the subprime segment work themselves out, TD says, adding that “U.S. credit markets remain in a catatonic state, and the second year looks likely to be dominated by difficulties among those highly leveraged to mortgage lending more broadly.”

The final stage of this crisis, “will see the spectrum of capital-constrained firms at worst, go out of business, or at best, unable to take full advantage of potential opportunities due to the lack of credit,” it suggests.

As the crisis works its way through the financial sector, the pain could shift from the U.S. and Europe to the U.S. and Asia. “Unlike the corporate [mortgage-backed securities] that drove losses over the last year and were principally held by U.S. and European investors, U.S. Agency debt is principally held by U.S. and Asian investors and central banks — suggesting mark to market losses and forced selling could be more muted but raising risks for Asian central banks,” it said.

“While the conservative streak in central bank portfolio managers will likely limit some volatility and the need to mark to market, this also poses a risk that an impaired flow of U.S. Agency debt could hamper the ability of Asian central banks to manage their currencies’ relative strength against the U.S. dollar,” TD adds.

As for the efforts to shore up Fannie and Freddie, TD says that expanding their lines of credit and making the Federal Reserve’s discount window available, “help to address lingering concerns of near term liquidity”.

“This is exactly what is needed to stem the crisis of confidence that has plagued these GSEs in the last week,” it notes. “This means the Agencies’ debt will not default but means nothing for stockholders except that their stake in the companies will be diluted [by] as much as is needed to keep the institutions running.”

If however, these actions are not enough to save Fannie and Freddie and the U.S. government has to entertain a full-scale bailout, “This action would certainly raise questions about the overall health of the U.S. financial system but should imply only a limited impact on the creditworthiness of the U.S. government itself,” it suggests.

In the meantime, while these latest steps ensure liquidity for the GSEs, “they do not create new appetite for MBS or forestall further losses in U.S. home prices and mortgage assets. As such, lenders and investors in MBS will continue to come under stress and see losses pressure balance sheets.”

“Rather than saying difficulties are spreading, though, we think it better to characterize them as moving forward. The financial flu has moved from the head to the chest and left a lot of congestion still to be cleared out. During this time, it will be impossible for the economy to operate at full capacity, difficult for the Federal Reserve to raise interest rates, and likely risk further firms falling prey to a crisis of confidence stemming from a lack of credibility,” it concludes.