The Wall Street that shaped the financial world for two decades ended Monday, when Goldman Sachs Group and Morgan Stanley concluded there was no point continuing as investment banks now that the model is broken.

The transformation of the financial giants caps weeks of chaos that sent Lehman Brothers Holdings into bankruptcy and led to the rushed sale of Merrill Lynch to Bank of America.

“The decision marks the end of Wall Street as we have known it,” said William Isaac, a former chairman of the Federal Deposit Insurance. “It’s too bad.”

Goldman, whose alumni include Henry Paulson, the Treasury Secretary presiding over a US$700 billion bank bailout, and Morgan Stanley, a product of the 1933 Glass-Steagall Act that cleaved investment and commercial banks, insisted they didn’t need to change course, even as their shares plunged and their borrowing costs soared last week.

By then, it was too late. As financial markets gyrated – the Dow Jones Industrial Average whipsawed 1,000 points in the week’s last two days – and clients defected, executives at the two firms concluded they had no choice. The Federal Reserve Board met late Sunday and considered applications delivered that day, said central bank spokeswoman Michelle Smith. The decision was unanimous, she said.

“Blood in the water”

“There’s blood in the water in the industry and the sharks are circling,” Peter Kovalski, who helps oversee about $10 billion at Alpine Woods Capital Investors, said at the end of last week. “It all comes down to perception and the current trust within the community.”

Morgan Stanley Monday rose 4.1 percent to $28.33 by 11:16 a.m. in German trading, after jumping 21 percent in New York on Friday. Goldman declined 1.2 percent to $128.28 in Germany Monday, after surging 20 percent three days ago in New York.

Wall Street hasn’t had such a shakeup since the 1980s, when firms including Morgan Stanley and Bear Stearns, went public and London’s financial markets were altered forever with the so-called big bang reforms implemented in 1986. Bear Stearns disappeared in March, when it was bought by JPMorgan Chase.

The announcement paves the way for the two New York-based firms, both of which will now be regulated by the U.S. central bank, to build their deposit base, potentially through acquisitions. That will allow them to rely more heavily on deposits from retail customers instead of using borrowed money – the leverage that ledto the undoing of Bear Stearns and Lehman.

Depositors rule

Morgan Stanley has taken $15.7 billion worth of writedowns and losses on mortgage-related securities and other types of loans since the credit crunch started last year. Goldman’s tally stands at about $4.9 billion. While both companies have remained profitable and avoided money-losing quarters suffered by Lehman and Merrill Lynch, their revenue from sales and trading and investment banking has been declining this year.

“Deposit-banking is king right now,” said David Hendler, an analyst at CreditSights in New York. “It’s the only meaningful critical-mass way to make money.”

Morgan Stanley may feel it has more time to contemplate alternatives to the deal that it began to shape last week with Wachovia Corp., said Tony Plath, a finance professor at the University of North Carolina at Charlotte.

“Certainty”

“This means Morgan Stanley is reassessing its plan for a merger with Wachovia,” Plath said. “Morgan Stanley is going to try to go it alone, and I expect it will try to buy a bank with a market-to-book ratio that is next to nothing. It means they are walking away from Wachovia.”

Morgan Stanley, the second-biggest securities firm until this week, had $36 billion worth of deposits and three million retail accounts at the end of August. The company plans to convert its Utah-based industrial bank into a national bank.

“This new bank holding structure will ensure that Morgan Stanley is in the strongest possible position,” Chairman and Chief Executive Officer John Mack, 63, said in a statement last night. “It also offers the marketplace certainty about the strength of our financial position and our access to funding.”

Goldman, the largest and most profitable of the U.S. securities firms, will become the fourth-largest bank holding company. The firm already has more than $20 billion in customer deposits in two subsidiaries and is creating a new one, GS Bank USA, which will have more than $150 billion worth of assets, making it one of the 10 largest banks in the U.S., the firm said in a statement on Sunday. The firm will increase its deposit base “through acquisitions and organically,” Goldman said.

Citigroup, JPMorgan

“Goldman Sachs, under Federal Reserve supervision, will be regarded as an even more secure institution with an exceptionally clean balance sheet and a greater diversity of funding sources,” Goldman Chairman and CEO Lloyd Blankfein said in the statement.

The Washington-based Fed is the primary regulator of bank-holding companies, which are firms that own or control banks. Citigroup Inc., Bank of America and JPMorgan are bank-holding companies regulated by the Fed.

Securities firms, by contrast, had been regulated by the Securities and Exchange Commission (SEC). The SEC’s future becomes dimmer with the change in Goldman and Morgan Stanley’s structures.

Less risky

“You can’t kiss goodbye to the last two important investment banks without noting that the house is empty,” said David Becker, a former SEC general counsel who is now a partner at Cleary Gottlieb Steen & Hamilton in Washington. “It’s a downward spiral where the less significant the population you regulate, the less your available resources.”

The change is also likely to lead to less risk-taking by the companies and possibly lower pay for their employees. Both Goldman and Morgan Stanley held more than $20 of assets for every $1 of shareholder equity, making them dependent on market funding to operate.

Goldman, in particular, has been remarkable for the high bonuses it pays to its employees. Goldman’s CEO and two co-presidents were each paid more than $67 million last year.

“They’re going to have to protect their deposit bases by law and the days of high leverage are gone,” said Charles Geisst, a finance professor at Manhattan College in New York, who wrote “Wall Street: A History.” “The days of the big bonuses are gone.”

Source: Bloomberg