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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.

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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.

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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.