The debacles involving Lehman Brothers and Merrill Lynch have many wondering if the economic barometer can reinvent itself yet again.

Share story

The old Wall Street is giving way to a new one.

As the tectonic shifts within the American financial industry shook the world’s markets on Monday, many experts predicted that events of the past 72 hours heralded a new period of painful change for Wall Street.

The predictions were sobering. Investment banks will be smaller. Their profits will be leaner. Jobs in finance will be scarcer. And the outsize role of Wall Street in the nation’s economy will shrink.

As investors tried to comprehend the abrupt downfall of two of Wall Street’s mightiest firms — Lehman Brothers, which spiraled into bankruptcy, and Merrill Lynch, which rushed into the arms of Bank of America — even optimists said the immediate future would be difficult. Treasury Secretary Henry Paulson and the Federal Reserve are paving the way for the few strong survivors to lead an industry turnaround, while letting the weaker ones fail or be subsumed by larger rivals.

“We’ve gone from a golden era of banking and financial services,” Kenneth Lewis, the chief executive of Bank of America, said in a press briefing on Monday, as the bank he heads prepared to buy Merrill Lynch.

“It’s going to be tougher,” Lewis said. “There are going to be fewer companies, and we are going to have to be better at what we do.”

While Wall Street has gone through tough times before only to emerge bigger and stronger, some question whether the industry can rebound quickly after using high levels of leverage, or borrowed money, to binge on risky investments.

Those investments have proved to be disastrous. Worldwide, financial companies have reported more than $500 billion in charges and losses stemming from the credit crisis — a figure some experts say could eventually exceed $1 trillion.

Missteps in the mortgage market cost Merrill Lynch, a brokerage whose “Bullish on America” TV ad campaign made it practically synonymous with Wall Street to many people on Main Street, more than $45 billion over the past year. Its sale could be a step toward the broader consolidation within the industry.

“We are all in this business conditioned to cycles in crises and we’re also conditioned to markets snapping back relatively quickly because the crisis can be identified and measured,” said Donald B. Marron, chief executive of the financial-services focused private equity firm Lightyear Capital and former chief of PaineWebber Group. “What’s different now is you can’t do either.”

The marriage of Bank of America and Merrill Lynch, if completed, in a sense would hearken back to the past. During the Depression, Congress separated commercial banks, which take deposits and make loans, from investment banks, which underwrite and trade securities. The investment banks were allowed to do business with less oversight, while commercial banks operated with tighter supervision.

But after Congress repealed those Depression-era laws in 1999, commercial banks began muscling in on Wall Street’s turf. As the new competition whittled down profit margins, investment banks began using more of their capital to trade securities and also began developing financial derivatives in order to fuel profits.

Now, executives like John A. Thain, the chief executive of Merrill and a former Goldman Sachs executive, say investment banks will need large bases of deposits to shore up their capital for times of trouble. “As we go forward, size is going to matter,” Thain said Monday.

Paulson has told Wall Street executives that greater consolidation on Wall Street could increase risk in the financial system, because the risks will be concentrated in a smaller number of firms. But Treasury officials view risk as the lesser of two evils, if the alternative is to prop up sick firms and increase instability.

Meanwhile, the Federal Reserve is expanding its backdoor channel for financing what officials hope is an orderly shakeout on Wall Street.

But the Fed, and ultimately taxpayers, could get left holding the bag. In allowing borrowers to post collateral that includes stocks, junk bonds and subprime mortgage-backed securities, the Fed said it would be mirroring the rules of two industry-operated overnight lending systems, known as tri-party repo systems, operated by JPMorgan Chase and Bank of New York Mellon.

Fed officials have themselves expressed concern that the tri-party lending programs needed to reassess their practices because lenders were holding collateral that might prove difficult to sell.

What seems to be clear to most everyone on Wall Street is that the era of high-octane trading profits and deals fueled by extreme bank borrowing is over, at least for now.

Wall Street has always used other people’s money to amplify its profits, but in recent years, the use of debt ballooned. The finance industry’s credit market instruments increased more than 1 ½ times in the past decade to $15 trillion last year, according to Moody’s, and climbed at a pace that was two times faster than the growth of the broad economy.

The borrowing helped the industry turn record profits, hire more people and pay out eye-popping bonuses. And it pumped up financial stocks, making them the largest segment of the Standard & Poor’s 500-share index from 2001 until this spring.

Wall Street, of course, reinvents itself all the time. Many executives say it will do so again, even as storied firms like Lehman and Merrill falter and others, like Goldman and Morgan Stanley, face questions about their futures.

“This industry is a dynamic industry that has evolved in unanticipated ways in the last 30 years and created pools of earnings that previously did not exist,” said James P. Gorman, co-president of Morgan Stanley.