Dow's historic drop reflects financial system's challenges

The rejection of a taxpayer-backed bailout in the US House Monday propelled US stocks to historic losses – a harsh new signal of the difficulties facing America's financial system.

Even if the $700 billion bailout had succeeded, as massive as it would have been, it would have provided just one new leg for weakened credit markets to stand on. A recovery of the financial system will also depend on reviving the flow of private investment money, closing or consolidating weak banks, and a continuation of the extraordinary efforts by the Federal Reserve. Those may be the lessons of a rocky Monday in markets, as Congress wrestled with a Treasury-backed proposal to buy up bad debts that have clogged the banking system.

After the House of Representatives failed to approve the measure, already gloomy markets nose-dived:

• The Dow Jones Industrial Average saw its largest point-drop ever ‐ 778 points ‐ and a nearly 7 percent decline, its 18th worst ever percentage decline, just under the market's drop after 9/11. The broader S&P 500 market lost 8.8 percent and the technology-heavy Nasdaq, 9.1 percent.

•The "flight to safety" showed no significant easing, with Treasury bills retaining a highly unusual yield of nearly zero percent. It's the investment equivalent of putting cash under a mattress.

• Citigroup said it will acquire the banking operations of Wachovia Corp., another large bank. But because Wachovia has such a large pool or troubled loans, the deal had to be facilitated by the Federal Deposit Insurance Corp.

•The Federal Reserve announced more big moves to douse financial markets with needed liquidity. Since banks are scared to loan to each other, the Fed expanded its credit programs in coordination with central banks from Europe, Canada, and Japan.

As the Citi-Wachovia deal implies, many private firms have money that will play an important role in resolving the financial crisis. But even such private- and public-sector efforts combined don't mean a quick fix to restore normal functioning to the system.

"I don't think it's going to happen overnight," says Peter Nigro, an economist who has worked at the Treasury's Office of the Comptroller of the Currency. But "It's great that [private firms] want to play." He says that it's likely that under the right circumstances, big banks and private equity firms would bid alongside Treasury if it eventually begins to buy distressed assets (mainly mortgage securities with high default rates). "They should be allowed to play the game," so that the Treasury doesn't have to buy so many of the bad assets, says Mr. Nigro, who is now at Bryant University in Smithfield, R.I.

He says Bank of New York Mellon and PNC Bank are among the large banks, relatively unburdened by toxic assets of their own, that might participate. But at best, purchases by private firms would complement a large Treasury program, not substitute for it, he says.

The dollar volume of bad assets is so great, and the position of the financial industry so weakened, that many economists say a prominent role for government has become essential. The goal is not so much to prop up the private sector as to prevent a bad situation from becoming worse. The Treasury plan would have involved moving bad assets from banks to the government. Such a move might gradually revive investor confidence in the health of the banking system ‐ and stimulate private trading in mortgage-related assets.

Last week's move by Warren Buffett to invest in Goldman Sachs may be a positive signal ‐ a message to other "smart money" players that there's opportunity to make money amid the panic.

Goldman isn't the only firm that has successfully raised capital from investors lately. JPMorgan Chase, Citigroup, and Morgan Stanley are all moving to raise billions.

The big investment banks – Goldman and Morgan Stanley – are shifting to become bank holding companies. This is repositioning for a new era where high risk is out and having access to customer deposits – a steady source of short-term funding – is in.

So these two giants are on the prowl to expand their base of deposits, perhaps by acquiring small commercial banks.

Most banks remain healthy, as long as the credit crisis can be stabilized so that the economic downturn or recession does not turn into something worse. But there are enough banks on the FDIC's "watch list" that the agency could be kept busy for many months to come, trying to close or arrange merger deals for faltering banks before they add up to a big cost for the Treasury. In the Citigroup buyout of Wachovia's commercial banking operations, Citi will absorb up to $42 billion of losses from Wachovia's $312 billion loan portfolio. The FDIC agreed to cover any remaining losses and will get $12 billion worth of preferred stock and warrants from Citi, according to the Associated Press.

The deal comes days after the FDIC brokered a sale of another large bank, Washington Mutual, to JPMorgan Chase.

More FDIC bank shutdowns could come.

"You could do two, three, four resolutions a week if you wanted to," mostly of smaller banks, says Christopher Whalen of Institutional Risk Analytics, a firm that tracks the industry. "By the end of the year ... you could see the light of day at the end the tunnel" of the credit crisis.