This computer is not a member of a domain...correct? What utility did you use to reset the admin password? Those utilities tend to blow up the Security Accounts Manager (SAM) file since this is where those password hashes get written when you use a change password utility...this would cause Winlogon to fail and Windows will barf up the message you've got. One easy way to fix it would be to restore back to a working install and fix the password FIRST...then once you've verified you have a valid admin account to use move on to fixing the other problems.
If you want to try to recover what you've got there I would:
- Mount the drive secondary as you said.
- copy sam and system.bak from the c:\windows\repair folder to c:\windows\system32\config
- Reboot and if admin password fails run change password utility again and pray that this time it doesn't blow up the SAM.
- You may have to reinstall some devices.
- If it doesn't work after that then I would stop pissing in the wind and grab the data before I reinstalled OS or possibly recover as you mentioned...I'd say that even if you do manage to get logged in it's only a matter of time before your friend will be running into trouble again with that installation.