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Are Wall Street’s Boom Times Over?

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 last 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.

That is the extreme case. But 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 M. Paulson Jr. 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 D. 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,” Mr. Lewis said. “There are going to be fewer companies, and we are going to have to be better at what we do.”

A debate is raging over what lies ahead for Wall Street now that only two major American investment banks, Goldman Sachs and Morgan Stanley , remain independent. 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 that is synonymous with Wall Street to many people on Main Street, more than $45 billion over the last 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 private equity firm Lightyear Capital, which is focused on financial services, and former chief of PaineWebber Group. “What’s different now is you can’t do either."

A marriage of Bank of America and Merrill Lynch in a sense would hark 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 used more of their capital to trade securities and also began developing financial derivatives to fuel profits.

Now, executives like John A. Thain, the chief executive of Merrill and a former Goldman 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,” Mr. Thain said Monday.

Mr. Paulson has told Wall Street executives that he isn’t happy about the shrinking number of investment banks, even though his own former firm, Goldman Sachs, is one of the two that are likely to benefit from the industry shakeout.

Mr. Paulson has told 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 back-door channel for financing what officials hope is an orderly shakeout on Wall Street.

But the Fed, and ultimately the taxpayers, could get left holding the bag. In allowing investment banks 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 .

Fed officials have themselves expressed concern that those lending programs needed to reassess their practices because lenders were holding collateral that might prove difficult to sell. In recent years, financial institutions have been making loans based on relatively less liquid assets, Donald Kohn, vice chairman of the Federal Reserve, warned in a speech last May.

Era is over

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. That will clamp down profits across the industry for some time. Just as Americans are finding it harder to borrow to build a new room or to buy a new car, big players on Wall Street are being forced to rein in the amounts they borrow.

Borrowed money kept the lights on at investment banks like Lehman, because such pure investment banks do not have the consumer deposit base.

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

At its peak last year, investment banks had borrowed $32 on average for every dollar of their assets, according to research from Ladenburg Thalmann. 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.

“This is a bubble in financial services that was very similar to every other bubble,” said Olivier Sarkozy, the head of financial service investing at the Carlyle Group, a private equity firm.

Already, Wall Street firms are reducing their debt levels, and regulators are expected to create new rules about leverage, liquidity and capital levels. The rules, if strict, could force Goldman and Morgan Stanley to merge with a bank that has customer deposits, a steady source of capital, and thus is buffered from collapse.

Wall Street veterans are divided over the extent of the industry’s problems. Some point out that Wall Street tends to go through a downturn or outright crisis every four or five years, and that it usually recovers quickly. But others argue what is happening now represents the end of a 30-year credit “superbubble” that affected the financial sector just as much as it did consumers.

Whatever the case, the financial sector seems poised for lower paydays across the board. “They can’t borrow, so they’re going to have cut down,” said Peter J. Solomon, chairman of an independent investment bank that bears his name. “As they cut down, they will have to fire people.”

The weekend’s events already increased analysts’ expectations of job losses. Most of Lehman’s 24,000 employees could lose their jobs, and Bank of America, the new owner of Merrill, is known for cost-cutting. Moody’s Economy.com raised its New York area job-loss figures on Monday by 20,000 people, to 65,000 by 2010.

“Massive leveraging created massive financial wealth, and that’s over,” said Orin Kramer, a partner at a hedge fund called Boston Provident and chair of the New Jersey State Investment Council.

As Wall Street firms of all size reduce their borrowing to reduce risk, it comes in some cases at the cost of higher profits. The shift has forced senior executives to rethink business models, and more firms are focusing on their tried and true asset management units. Industry observers say the firms are grappling with the loss of relationship banking that occurred 30 years ago.

“Wall Street for a number of years has been gripped by a quiet crisis, beneath all the financial wizardry and mathematical formulas, beneath all the financial engineering, there has been an increasingly desperate search for new sources of profit,” said Ron Chernow, the author of a book about J. P. Morgan’s empire, called “The House of Morgan.”

Wall Street reinvents itself all the time. Many executives say it will do so again, even as storied firms and others 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.

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