The credit crisis shaking the global economy is forcing a dramatic reconfiguration of Wall Street, where the financial industry in recent years has been driven to take ever-greater risks on increasingly esoteric investments.
The fragility of Wall Street's architecture was exposed this week when two icons of investment banking and the world's largest insurance company were fed into the maw as their competitors pushed for a historic government bailout to help salvage their own shaky businesses.
It is too early to tell whether Wall Street has truly been transformed by the series of upheavals or is simply witnessing a shuffling of its players. But as dealmakers and policymakers now sift through the debris, some shifts are already evident, both in the structure of high finance and the culture of those who practice it.
"The competitive landscape of finance is changing before our eyes and the losers are the investment banks," said Roger Leeds, director of the Center for International Business and Public Policy at Johns Hopkins University. "What we're having now is a fundamental correction, not only of the market but of the institutions themselves."
Three out of five fallen
Three of the five free-standing investment banks have fallen. Bear Stearns was sold at a fire sale, 158-year-old Lehman Brothers went bankrupt and Merrill Lynch is being acquired by Bank of America. The surviving titans, Morgan Stanley and Goldman Sachs, remain under pressure and have been weighing their options.
As financial analysts survey the horizon, they see the emergence of a handful of giant, global firms that manage a wide range of business activities alongside several boutique advisory firms that court blue-chip clients. Newer players will remain on the scene, including hedge funds and private-equity firms -- both lightly regulated entities that manage pools of money for wealthy investors and often buy large holdings in securities or sometimes directly invest in companies.
These changes could be accompanied by a cultural shift as the sheen comes off a longtime career destination for those with the brains, ambition and fortitude to place high-stakes wagers in return for outsize paydays.
Already, the shakeout is costing jobs and ruining fortunes. New York Mayor Michael Bloomberg estimates 40,000 workers in New York state, including many well beyond Wall Street, could lose their jobs as a result of the financial crisis.
Birth of a new system?
Whether these changes portend a permanent remaking of Wall Street remains uncertain. The answer could turn in part on whether the government's rescue plan announced Friday succeeds. If the massive bailout fails, the destruction wrought on global financial markets could be staggering, ultimately clearing the way for the birth of a new system.
If the federal plan works, most of Wall Street could be spared and the business model that has powered it in recent years -- centered on complex securities, tremendous borrowing and opaque dealings -- could resume much as before. That is, unless the inevitable excesses are tamed by new regulation.
The fall of the investment bank was of its own making, analysts said. Starting in the 1980s, investment banks began straying from their traditional roles as intermediaries to mergers and acquisitions, investment advisers to corporations and individuals, traders of securities and portfolio managers for wealthy clients.
Driven by competition and the hunger for bigger profits, they began to aggressively push exotic products like asset-backed securities and other derivatives.
The investment banks not only sold these instruments to investors but also began purchasing them for the firms' own accounts, using larger and larger amounts of borrowed money. The more risks investment bankers took, the more money they made. Internal controls were lax.
"I don't think they had a good appreciation of the risks they were taking," said Ray Hill, a finance professor at Emory University.
Balkanized oversight
Nor were government regulators fully aware of the gathering storm. They were hobbled by balkanized oversight and gaps in disclosure rules.
"The problem is transparency because regulators weren't able to assess risks at investment banks in the way they are able to with commercial banks," said Mark Gertler, an economics professor at New York University.
Two of the big five investment houses have landed in the arms of commercial banks with Bank of America's purchase of Merrill and J.P. Morgan Chase's takeover of Bear Stearns. Meanwhile, the British bank Barclays is acquiring choice bits of Lehman (a bankruptcy judge in New York yesterday approved the sale of nearly all Lehman's assets), and Morgan Stanley is considering a merger with Wachovia, one of the country's largest commercial banks.
With the merger of investment banks into commercial banks and leaders of both political parties pressing for new regulations to enhance transparency and control over banks' investments, analysts say the new Wall Street could be a throwback to previous decades.
Investment and commercial banking was separated by law in 1933, when Congress passed the Glass-Steagall Act in response to a banking crisis that ushered in the Great Depression. By banning banks from selling stocks and bonds, the government aimed to end abuses that caused the collapse of thousands of banks across the country, wiping out the deposits of millions of customers who, at the time, did not have the benefit of federally guaranteed deposit insurance.
In recent decades U.S. banks, facing competition from foreign counterparts that had no restrictions barring them from owning brokerages, found loopholes in the law to open or acquire new business lines. In 1999, Congress conceded to the new reality, repealing the 1933 law with the passage of the Gramm-Leach-Bliley Act.
Commercial banks moved increasingly into the traditional domain of investment houses, in some cases acquiring them outright, such as the marquee purchase of Chase Manhattan Bank by J.P. Morgan in 2000. As investment banks faced heightened competition in their traditional business lines, these enterprises leveraged up with borrowed money and went looking for profits, betting on ever-riskier securities and derivatives. That is the trend the crisis of 2008 may reverse, at least for a time.
"It will tend to tone down some of the behaviors," said Thomas Atteberry, a partner in First Pacific Advisors, who moved 5 percent of his company's portfolio out of mortgage-related securities in 2006 in anticipation of a credit market meltdown.
'Take risks to get paid'
But even as the formal line between different stripes of banks became blurry, investment and commercial banking remained divided by culture.
"Investment bankers get paid for performance, so they take risks to get paid," said Sam Weiser, a former Citigroup employee who now is chief operating officer of the Chicago-based hedge fund Sellers Capital. "The prevailing goals of commercial bankers are to protect assets."
Investment banks also tend to be more decentralized. "What makes Merrill's investment banking model work is that they attract high-powered, entrepreneurial people who build businesses within a business, and commercial banks do not work that way," said Hill, the Emory finance professor. "The question is: Does the culture of Merrill that made it so successful, is that going to survive in a huge organization?"
Traditionally, many investment bankers shunned their colleagues on the commercial side as stodgy and risk-averse. But now, as institutions meld so must the psychology, analysts say.
"There will be a merger of two ways of doing business," said Seamus McMahon, a financial services partner at Booz & Co., a global management consulting firm. "The stand-alone investment bank may have been an accident of history. It had its run and it's over or at least vastly diminished."
The new management, analysts say, will emerge from the ranks of commercial bankers.
"That is the superior force, and that changes the nature of how things are approached," said Len Rushfield, adjunct professor of finance at Pepperdine University. "The commercial banking world is built on relationships and continuity and not on high levels of incentive compensation."
Future for compensation levels
The first test for the future of Wall Street banking could come over compensation levels: whether the investment banking stars who placed big bets and were awarded big salaries and bonuses in return continue to get paid.
When John Thain was still Merrill's chief executive earlier this year, for example, he hired a legendary trading manager from Goldman Sachs named Thomas K. Montag. The tab, disclosed in a filing with the Securities and Exchange Commission: annual salary of $600,000, signing bonus of $39.4 million plus a promise to reimburse him for Goldman shares he forfeited for an estimated total of $50 million.
Analysts wonder if Bank of America Chairman Kenneth D. Lewis would agree to pay that amount.
If Wall Street loses its lure of big riches, it could have trouble attracting top talent.
"Most business students don't go into investment banking because they love finance so much, but because it pays well," said Francisco Cabeza, a student at the University of Pennsylvania's Wharton School of Business who has a job offer at a private-equity firm in London.
Richard X. Bove, an analyst at Ladenburg Thalmann & Co., predicted that the crisis could spark a start-up boom on Wall Street, with hot demand for small boutique investment firms focused on one or two specialties. He said these firms could fill a niche as behemoths like Bank of America and Citigroup grow so large that they cannot serve all their corporate clients because of conflicts of interest.
World centers to benefit
Some analysts also see some of Wall Street's influence being redistributed overseas as business migrates to other places with money. "New York will be the first among equals but absolutely not the place. Normally it was London and New York," said McMahon, the management consultant. "I think we'll see Abu Dhabi grow. Singapore. I think we'll see India if they can get their regulations straightened out."
Nor was the earthquake that rocked U.S. financial markets a tragedy for all involved. For those with strong enough balance sheets and money to spend, the recent weeks have presented a unique chance to buy. Bank of America's Lewis was one notable winner.
Even Lewis posits that a chastened financial industry is entering a new phase.
"It seems unlikely that most companies would simply volunteer to pull back the reins on profit and growth in a hot market. But, in fact, that's precisely what needs to happen," said Lewis, according to a prepared text of a speech he gave Friday in Washington. "We must embrace the reality of what will be, at least in the short term, a smaller industry with a simpler approach to finance."
Special Correspondent Heather Landy in New York and staff writer Robin Shulman contributed.