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Dow's historic drop reflects financial system's challenges

After 778-point plunge, markets need private investment and bank restructuring for a recovery.

By Staff writer of The Christian Science Monitor / September 30, 2008

Members of the House of Representatives spoke to reporters on Capitol Hill in Washington after the House vote on the financial bailout package failed.

Susan Walsh/AP

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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.

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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.

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