Chicago ? If the Federal Reserve thought its $85 billion rescue of insurance giant American International Group Inc. would restore confidence in the U.S. financial system, it was sorely disappointed Wednesday.

Banks are hoarding cash, investors are ravenous for “safe” U.S. Treasury bonds and the price of gold, a classic redoubt for the panicked investor, is through the roof.

The Dow Jones industrial average dropped 449 points Wednesday to a three-year low 10,609.66, 23 percent below where it was a year ago. Even strong financial companies like Morgan Stanley saw their stocks get pummeled as investors speculated that the worst may be yet to come.

What became clear on Wednesday was that the contagion infecting the U.S. financial system may be spreading faster than government regulators can contain. Anil Kashyap, a professor of economics and finance at the University of Chicago Graduate School of Business, said that the fundamental problem in the financial sector – not enough cash on balance sheets to cover the massive losses in mortgage-related securities – has eroded confidence to such a degree that the crisis is now creating its own set of problems.

“A huge part of the system works on the idea that funding will be available on reasonable terms,” Kashyap said. “When that expectation disappears, it causes real problems.”

There is no debate among market watchers that the problems infecting the financial system are brutal – as severe as many experts have ever seen. But some wonder whether the confidence vacuum sucking the air out of the markets is truly justified based on the fundamental condition of the economy and the financial sector.

Mark Zandi, chief economist of Moody’s Economy.com, said he was “shocked and perplexed” by the market’s reaction to the AIG bailout. Noting that the Federal Reserve has now cushioned the fall one of the nation’s largest investment banks (Bear Stearns), its two largest mortgage lenders (Fannie Mae and Freddie Mac) and its largest insurance company (AIG), Zandi said it’s clear the federal government is “going to put the full faith and credit behind the U.S. financial system” giving the economy breathing room to recover from the mortgage meltdown.

The housing crisis, which Zandi calls ground zero for the current turmoil, continues to claim its victims, as evidenced by the bankruptcy filing of investment bank Lehman Bros. on Monday.

But he believes an end to the bleeding in the housing markets is within sight. He estimates that foreclosures in the mortgage market will likely produce somewhere around $600 billion in losses – the same amount the financial system has already taken in write downs.

He’s not predicting an imminent end to the storm. But, he said, “the system has made a lot of progress in righting the wrongs it created.”

The danger is that problems are spreading and it’s not clear what will restore the kind of confidence the markets need to heal.