It has been a spectacle to behold. Watching the leaders of the Federal Reserve Board, Treasury Department and once-great private financial institutions behave like shoppers desperately rummaging through their wallets to find the one credit card they failed to max out is likely to leave an indelible impression on a generation of investors.

Two 40%-plus bear markets in one decade, an event not witnessed since the 1970s, coupled with a bursting housing bubble that triggered a credit crisis, will change investor behavior in ways that are only starting to emerge.
Some of the changes will be healthy. That's the belief of Tom Connelly, principal at Versant Capital Management in St. Paul, Minn. "People will be more realistic in terms of what they expect in risk premiums," he declares. "They already are."

Connelly, who reduced clients' equity exposure to between 20% and 50% of their portfolios early this year, admits to being shell-shocked by the events that unfolded in the five weeks after Labor Day. "I expect the psychology to change for maybe 20 years," he says. "It's good for our profession, those of us that are still in business."

Despite an early warning system that worked propitiously, Connelly acknowledges that most of his clients' portfolios are down on the year and many have seen their home values drop 20% or more. Other advisors share the view that clients are more likely to focus on needs and goals than raw returns.

While Connelly thought equities were somewhat expensive one year ago, they were hardly in bubble-land. The only markets that were in bubble territory were those in the BRIC emerging markets of Brazil, Russia, India and China.
One reason he is confident the change will be long lasting is the Japanese experience, even though he isn't suggesting the U.S. economy and markets will mirror the Japanese performance since Japan's equity and real estate bubbles burst in the late 1980s. "Look at Japan. They haven't had any bubbles in 20 years," he says.

"Japanese corporations have low multiples, lots of cash and they didn't get caught up in any of this."
Investor behavior and expectations may indeed change for the better, as a generation rapidly approaching retirement confronts reality. But it would be too much to expect the same from Washington regulators. The folks who were schizophrenic enough to allow financial institutions to increase their leverage ratios from 12:1 to 40:1 at the same time they were requiring banks and others to switch to mark-to-market accounting can't be relied upon to think rationally when addressing the concerns of constituents reeling from trillions of dollars in vaporized retirement savings.

"This time there could be a greater investor backlash," predicts Sam Stovall, chief equity strategist at Standard & Poor's. "Consumers could turn around and bite the regulators."

Overall, the financial services industry is likely to face more regulation of fewer players, Stovall says.

During a week when Italian Prime Minister Silvio Berlusconi suggested that the world's economic powers might want to follow the lead of Russia's Vladimir Putin and shut their stock markets down for a few days, Stovall was serene and calm. In past bear markets, he notes, market averages have tended to retrace one-third of their declines within 40 days after touching bottom.

Whither Wall Street?

Many observers believe the latest leg of the current bear market, one of the most sudden and sharp in history, has taken so many casualties that it portends the death of Wall Street as we know it. They're wrong.

Of course, consolidation among banks and brokerages is rapidly accelerating, but that is just a continuation of a trend that is 40 years old. Events have decimated the two basic business models that dominated the financial services industry since the Great Depression-the stand-alone investment bank and the wirehouse. But they won't disappear. If Bank of America has chosen to keep the U.S. Trust name, many observers believe it will probably keep the Merrill Lynch brand as well.

Ongoing structural transition is likely to require several years. Before the crisis began one year ago, the number of independent reps had surpassed the ranks of wirehouse brokers. Headline risk, evidenced by the stream of announcements of staggering write-downs at financial giants, isn't encouraging clients to stay with brokers, and the 40% decline in equities since October 2007 is bound to reduce the number of reps.

Indeed, Chet Helck, the president and chief operating officer of Raymond James Financial, says the big Wall Street firms were already trimming low-producing brokers before the credit crisis began. Raymond James offers advisors multiple ways to affiliate with the firm. These include the employee-broker format, as well as the independent contractor, bank rep and registered investment advisor models. Over the last year, the employee-broker arrangement has attracted the most new recruits, indicating that some brokers are as interested in security as entrepreneurial opportunities.

In a few cases, brokers have seen their lives turned upside down. Take the case of the old A.G. Edwards, which spent years at what was described as the most stable wirehouse. (Did its St. Louis headquarters contribute to stability?) Just as it was completing a rocky transition to Wachovia, that firm found itself in the middle of a takeover battle between Wells Fargo and Citigroup.

"People are looking at all the options," Helck says. "They don't want to have to do this very often."
Schwab, Fidelity, TD Ameritrade and Pershing all report greater interest than ever among breakaway brokers. Going forward, though, compliance consultants and other sources expect Wall Street firms to take a more aggressive legal stance with those who try to take their client accounts with them (see related story on page 65).

The two surviving investment-banking giants, Goldman Sachs and Morgan Stanley, converted to commercial bank models for several reasons. Both realize that any business model that forced them to go into the "repo market" every morning and borrow billions just to turn on their lights was no longer viable. Moreover, the government wanted them to do it so regulators could exert more control over their leverage and capital. In the investment-banking arena, Helck notes, that change may not be as radical as the media is portraying. "JP Morgan was a very big, viable investment bank before they took over Bear Stearns," he explains. "It just makes them bigger. We're going back to mega-organizations doing everything [almost] everywhere."

Whether the current pseudo-oligopolies emerging on Wall Street will remain intact remains to be seen. It's clear that the government has decreed that a handful of giant institutions will survive. This elite group includes JP Morgan, Bank of America, Wells Fargo, Morgan Stanley and Goldman Sachs.

But private equity firms and giant hedge funds like Citadel are carefully scrutinizing the playing field in search of opportunities that may arise when the dust settles. Citadel, for one, has built up a war chest of $6 billion and reportedly is looking at investing in new vehicles that may be spawned as the government tries to remake Wall Street, like an electronic exchange for the $60 trillion credit-default-swap market.

For now, the buzzword for the banking and securities businesses is convergence. "The new institutions will be a combination of bank and securities firm," notes Connelly.

With all the damage done to investor wealth, the powers that be in Washington are going to feel compelled to take action, whether or not it's productive. "It's likely you'll see a lot of new regulations" over the next few years, Helck predicts.

If business models are converging, one should expect more consistency across various channels of regulation. While the future for RIAs looks brighter than ever, there's no guarantee everything will go their way. Greater harmonization of regulation among banks, brokerages and RIAs would be unwelcome to many RIAs, since many strongly prefer the Securities and Exchange Commission as their regulator.

Unfortunately, the SEC's weaknesses have been exposed in glaring fashion during the crisis. Even though RIAs have been largely immune from the recent disasters, and all evidence would indicate the SEC has overseen this profession effectively, the commission's shortcomings in other areas overwhelm its success in a relatively small arena.

Some fear for the survival of the agency, as well as for other myriad regulatory agencies throughout the nation's capital. Treasury Secretary Henry Paulson has called for a complete overhaul of the antiquated system of supervision and regulation. While he's unlikely to have the final say, all parties will have much at stake when 2009 begins.