You mentioned characters morphing in the second part of the film. Well, towards the end Fred's reality finally takes over. It happened after Pete made love to Alice. She told him that he can never have her. That's when Pete disappeared and Fred appeared, meaning he 'woke up'. Her words have ambiguous meaning - He can't have her because she's not real, or because he killed her (Renee), or because he never did have her (meaning his wife never loved him and was deceptive) and that's why he killed her. That's a rather cruel slap on the face of someone who wants to forget. Then Mystery Man tells him something like: "Her name is Renee. If she told you her name was Alice, she's lying. And your name? What the fuck is your name?" That's when Fred finally realizes who he is and what he's about to do. He kills Mr. Eddy/Dick Laurent and goes to tell himself that "Dick Laurent is dead", which we heard at the start of the film. Thus this story made a full circle.

That casts a new light on the first part of the film. Was that real, or was it another way for Fred to deceive himself and shift the responsibility for what he did onto Mystery Man. The first part of the film is very sinister and spooky and full of tension, something bad is going to happen or maybe it already happened (as we see on the tapes). I deliberately use past and future tense, because we're not really sure when in the film did he kill his wife, was it in the beginning or the end. But since the story is not linear but circular, and since Lynch plays a lot with time and non-time, it doesn't really matter. The consequences are the same and at least we know that when Fred's in jail, that's real and in present, as in now.