Not a few buyout executives guffawed at Treasury Secretary Henry Paulson's suggestion on Nov. 12 that private equity act in concert with the federal government to prop up the nation's faltering commercial banks. He might just as well have invited them to go play in rush-hour traffic.

With or without the prospect of government involvement, "firms are afraid and nervous about investing in the banking sector now," says a partner at a leading private equity house. "Many have learned the hard way how complex and risky these investments are."

Indeed, the ugly truth is the vast majority of recent financial bailouts of banks and related businesses that buyout firms have attempted on their own have performed miserably, some disastrously. Months ago, before the subprime mortgage disturbance metastasized into the worst global financial crisis in decades, private equity was viewed by many as an ideal cure for ailing institutional balance sheets. Starting last December with Warburg Pincus' deal to inject $500 million in MBIA Inc., a bond insurer perilously exposed to mortgage derivatives, some of America's leading private equity houses led equity infusions totaling $21 billion or more in an array of U.S. banks and financial services providers and invested an additional $5 billion or more in troubled banks overseas.

When they were announced in April, the two biggest of these deals -- a $7 billion slug of equity in Seattle's Washington Mutual Inc., the nation's largest thrift, invested by a consortium organized by David Bonderman's TPG Capital, and a similarly sized investment two weeks later in a Cleveland regional bank, National City Corp., led by Corsair Capital LLC -- stood as models of the central role private equity aspired to play in cleaning up the mortgage mess and healing the financial sector's wounds.

But come autumn, as uncertainty mounted over the true extent of the sector's ills, Lehman Brothers Holdings Inc. imploded and fear ran riot. Depression-era-style deposit runs prompted the government to seize Washington Mutual and force National City into the arms of a healthier rival.

The mayhem has cut a swath through private equity, utterly obliterating TPG's huge investment in WaMu, squeezing Corsair out of what it thought would be a long-term investment in Nat City and ravaging values of most of the industry's remaining investments in the sector.

In the devastation's wake, the private equity industry has taken a collective deep breath. It has been forced to take stock of its losses and to regroup and to rethink the role buyout firms ought to play in the deleveraging and restructuring of the banking and financial services sector. How assertively should sponsors pump cash into needy institutions? Is the safest move the wisest -- namely, to swear off investing in the sector entirely for now?

There are no easy answers. And a handful of buyout industry executives and participants surveyed for this story turned up a range of views on the matter, from those saying they'll steer clear of the blighted sector to others who contend that the blight is sure to beget opportunity. No matter where they stood, all noted the sobering effect of the litany of losses.

"People are quite chastened following some of these balance-sheet-oriented deals," says one private equity player. "You saw some smart money going into the sector, and a few of the deals have been real disasters. That tends to give you pause."

Similarly, some institutional investors in buyout funds, like HarbourVest Partners LLC managing director John G. Morris, embrace the better-safe-than-sorry mindset: "We're elated that our buyout managers don't have a damn-the-torpedoes attitude, because many could find themselves sunk the way TPG did in WaMu," Morris says. "They're waiting for valuations to adjust and some sign we've reached a bottom."

Meanwhile, there are other, bolder buyout sponsors who, even though they've taken a breather, probably won't be idle for long. They yearn to capitalize on the financial industry's woes and on havoc in the broader markets.

Prices of assets have dropped so steeply they're hard to resist. Notwithstanding WaMu-style blowups and the slew of investments under water, some see considerable upside now in everything from private investments in public entities -- the PIPE investment TPG made in WaMu and Corsair made in Nat City -- to buying loans and junk bonds of LBO'd companies at fire-sale prices to snapping up subprime mortgage portfolios at pennies on the dollar.

For judicious investors sufficiently attuned to the risks, opportunities abound, argues Carlyle Group's Randy Quarles. "The sector isn't toxic -- just a certain portion of the assets are. You have to approach it with caution and understand the right way to invest in it," says Quarles, a former undersecretary of the Treasury in the Bush administration who co-heads Carlyle's financial services investment team.

Risk aside, the case remains compelling for private capital to have a role in overhauling the financial sector. Many large buyout houses are sitting on billions of dollars seeking an outlet at a time when the credit crunch has largely quashed traditional leveraged buyouts, especially big-cap buyouts.

What's more, the hole in the banking system that needs plugging has grown into a yawning abyss as asset valuations have plummeted, markdowns have accelerated and banks' capital foundations have eroded, making capital transfusions all the more necessary.

Says Andrew Senchak, president of Keefe, Bruyette & Woods Inc., "Most banks and thrifts are focused on getting government money" through Paulson's two-month-old, $700 billion bank rescue plan, the Troubled Assets Relief Program, or TARP. "As to what to do next, there still is a capital hole" that TARP alone won't suffice to fill, Senchak says.

Paulson admitted as much on Nov. 12, when he said, "We are carefully evaluating programs that would further leverage the impact of a TARP investment by attracting private capital, potentially through matching investments." Estimates of how much supplemental equity capital the banking system needs run as high as $250 billion.

Private equity's recent history in bailouts isn't simply an exercise in pain, experts say. It also contains lessons -- notably the cardinal rule that when you set out to brace up a bank, make sure you invest enough to wipe out the problem. That's the approach Paulson took in headline-grabbing rescues of American International Group Inc., Freddie Mac and Fannie Mae -- an approach that deviates sharply from some PIPE investments buyout firms have made.

"You can't tiptoe your way in. You can't put in a little and hope it works. If you do that, you might as well go to Vegas and roll the dice. Always put in enough to cover all the assets that could be impaired plus a little extra," advises Joshua Siegel, managing principal of StoneCastle Partners LLC, a New York investor in small and regional banks.

What if you don't? Siegel and others cite the WaMu deal as the symbol for the perils that might ensue. In April, when TPG engineered a $7 billion equity booster for WaMu -- the buyout firm put in $1.35 billion and took about an 11% stake; the rest of the capital came from institutions -- "most of the Street was saying [WaMu] would need $20 billion or $30 billion," says Siegel. Even though Siegel wasn't privy to WaMu's financials, two private equity investors who were, both of whom WaMu courted before selecting TPG, backed up Siegel's statement: One put his firm's estimate of the top range of WaMu's capital need at $19 billion to $22 billion. The second investor says: "Our number actually began with a three."

TPG turned down an interview request for this story, and the reasons why the firm arranged a $7 billion infusion aren't known. But by early September, it was abundantly clear that $7 billion hadn't done the job. As panic spread over WaMu's financial health, fanned by rumors the government was set to intervene, WaMu was hit with a vast wave of withdrawals by large depositors and began to totter. On Sept. 25, the government did step in, seizing control of WaMu's core operations and auctioning them to J.P. Morgan Chase & Co. for $1.9 billion. With the rest of WaMu's equity, TPG's entire investment was vaporized. It was among the largest losses in private equity history.

Corsair's contemporaneous investment in Nat City, meanwhile, tacks a disturbing addendum on to the lesson of WaMu: Namely, sometimes even a liberal infusion of capital that seemingly exceeds a target bank's possible write-offs won't suffice. A person familiar with Corsair's investment notes that the $7 billion Nat City received was $2 billion more than Corsair's financial models showed was needed. The $2 billion "cushion" effectively "derisked the deal from [Corsair's] perspective," the source says.

Nevertheless, justifiably or not, Nat City fell prey to a run on deposits the way WaMu had -- a run touched off in part by speculation that Nat City was under intense government pressure to sell itself to a financially sounder rival. The rumors were true, and on Oct. 24, the bank disclosed it would be sold to PNC Financial Services Group Inc. for $5.6 billion. Even though the $2.23 a share PNC said it would pay for Nat City was less than half Corsair's investment cost, the firm escaped with a modest profit on its own $850 million slice of the $7 billion, thanks to downside protections built into its Nat City investment contract.

Whether Nat City could have survived on its own is open to debate. After all, depositor runs can doom even an amply capitalized bank. Although Corsair declined to discuss Nat City, the firms' partners, sources say, firmly believe that the government's own maneuvers exacerbated Nat City's plight and made necessary a sale that might have been avoided.

From both Nat City and WaMu, private equity players derive a third lesson: that smaller institutions with uncomplicated balance sheets and relatively modest capital needs make the best investments.

"You don't need to take Sallie Mae private to make a living," one executive says. Similarly, Carlyle's Randy Quarles observes: "If you avoid the things that put you on page 1 and invest in the things that put you on page D7, you can actually make some money."

One smallish bank PIPE that conceivably could turn a profit is Carlyle's $75 million investment in July in Boston Private Financial Holdings Inc., a wealth manager and regional bank operator. Carlyle, says Quarles, spent weeks vetting Boston Private's assets to ensure that its money, along with $110 million raised through a rights offering, would erase the blight of bad real estate loans made by the company's southern California subsidiary. "The company was of a size we could understand, with problems we could understand," notes Quarles.

Most investors seem to agree. Of all the banking PIPE investment done by buyout firms since late 2007, Boston Private is the only one whose market value is above water.

There is considerable disagreement in private equity circles over one key matter: whether Paulson's plan for TARP and for private capital sources to join forces holds any appeal at all. Some contend that partnering with government always carries risks. "As Paulson's policy shifts over the last six months show, governments are not stable and predictable partners," says a partner at a well-known private equity firm. "They have agendas that are driven by more than just financial returns."

Quarles, by contrast, embraces Paulson's notion, arguing that private capital can serve as a counterweight to government influence. He'll discover soon enough whether that's the case, since Boston Private recently said it had obtained a $150 million TARP pledge.

In addition to considering PIPE investments, private equity firms increasingly are targeting fire-sale-priced assets -- everything from LBO-linked loans to junk bonds or mortgage securities -- being dumped by hedge funds or others. Like the buyout industry's investments in banking, many such purchases made over the past year have racked up hefty mark-to-market losses.

In the case of an estimated $80 billion in LBO loans that buyout firms bought from money center banks early this year at small discounts to par, the paper losses stand in the hundreds of millions.

But that experience hasn't necessarily blunted investor appetite for leveraged loans and bonds. If anything, says Michael Zupon, who heads Carlyle Group's U.S. leveraged finance team and oversees its investments in non-investment-grade debt, the plunge in prices has elevated their appeal. "Since this most recent selloff, our bias has shifted from being a heavy seller to a cautious buyer," Zupon says. "It's an unbelievable investment opportunity, but there are extraordinary risks right now."

Indeed, the risk that the bottom will continue to fall out of the market looms large. In that event, private equity faces the prospect of more debilitating losses -- and another round of painful lessons.