The End of Wall Street

* http://online.wsj.com/article/SB122212648830465179.html

* Wall Street Jounral

* SEPTEMBER 23, 2008

The End of Wall Street

"The world had changed," said the Morgan Stanley spokesperson yesterday, and you can mark that down as the understatement of the year.

She was explaining the company's decision late Sunday night to convert back into a bank holding company some 75 years after the Glass-Steagall act sundered the House of Morgan into J.P. Morgan, the bank, and Morgan Stanley, the investment firm. Under pressure from the Federal Reserve, Goldman Sachs made the same choice this weekend.

And so, in a single week, the era of the independent investment bank has ended. Wall Street as we've known it for decades has ceased to exist. Six months ago there were five major investment banks. Two -- Lehman Brothers and Bear Stearns -- have failed, Merrill Lynch is selling itself to Bank of America, and now the last two are becoming commercial banks. Adam Smith, that great market disciplinarian, is punishing excesses and remaking American finance long before Congress can get into the act.

Both Morgan Stanley and Goldman Sachs will have two years in which to arrange their affairs to conform to the capital requirements and other rules that govern such commercial banks as Wells Fargo, BofA and Citigroup. That will mean less leverage -- assets that are perhaps 10 times their capital bases instead of the 20 or 30 to 1 they have sported as investment banks. That in turn means less risk and almost certainly less profit and lower compensation.

In exchange, they will be able to accept consumer savings deposits as a ready source of funds. They also get the promise of greater stability and continued access to Federal Reserve lending facilities such as the discount window. To be more pointed, they'll have a better chance at survival, not least because they also will be able to avoid certain "mark-to-market" accounting rules that have forced writedowns on troubled securities.

This year's market turmoil had called into question the viability of the investment-banking business model as far back as March, with Bear Stearns's collapse. The Fed gave the remaining banks access to emergency lending, but it was clear from the start that this taxpayer lifeline wasn't sustainable without a greater degree of federal oversight. What Morgan Stanley and Goldman did Sunday night was to choose their poison -- submitting themselves to commercial banking regulation rather than have it imposed on them either through legislation or merger, as Merrill recently did in selling itself to BofA.

The result will be a sturdier but also less-innovative financial system than we have had in recent decades. That has its benefits; we're paying the price for some of the more dubious innovations right now. The new system will have more capital and less direct lending through such vehicles as asset-backed securities. Direct lending is highly efficient and has provided funds for many useful ends. But it is also riskier in a panic because it lacks a capital cushion to absorb the losses when asset values decline. In another sign of this new world, Morgan Stanley followed the weekend's news by announcing that it had sold a 20% stake to Japan 's Mitsubishi.

Wall Street's transformation also means that private equity companies and hedge funds will be the new financial innovators and move further onto investment banking's traditional turf. But both hedge funds and private equity have intrinsic limitations on their ability to raise money and fund their activities, so neither is a perfect substitute for the former role of the investment banks.

In some sense, the pure-play investment bank was itself a regulatory artifact. In the depths of the Depression, separating the investment functions from the banks was considered necessary for the stability of the commercial banks. Thus Glass-Steagall was born, and this week that separation can finally be said to be undone.

As for the long-term effects, expect them to be as hard to predict as the full effects of Glass-Steagall were in 1933. Adaptation and innovation have been hallmarks of our financial system since before there was a Goldman Sachs or Morgan Stanley. If Congress is wise next year as it attempts to reorganize our financial system, it will recognize the benefits of a sturdier system without crushing its ability to innovate.