Washington Post Staff Writers

Monday, September 22, 2008; A01

The Federal Reserve approved the conversion last night of the two remaining investment titans on Wall Street, Goldman Sachs and Morgan Stanley, into bank holding companies, offering them broader government protection in exchange for tighter regulation and constraints on their once fabulously profitable business.

With the federal government continuing its rapid and radical reshaping of the U.S. financial system, the two investment banks agreed to transform themselves in an effort to escape the financial turmoil that last week put their existence in jeopardy.

The move, approved by the Fed with unusual haste, gives Goldman Sachs and Morgan Stanley greater latitude to borrow from the Fed and access to stable sources of funding -- namely, deposits from ordinary people and businesses. But the firms are also accepting regulation by the Fed that will make it far more expensive for them to borrow huge sums of money -- long an essential ingredient in their investment strategy -- and restrict what sorts of business activities they can engage in.

This development completes a sweeping transformation of Wall Street. Now extinct are the specialized trading houses that broke off from larger financial companies during the Great Depression, enterprises that once prized their independence of regulation and exploited their agility to make fortunes. Over the past 30 years, these firms even surpassed commercial banks as the prime funding source for corporate America.

The conversion of investment banks into the kind of banking companies that once were their rivals will have profound and long-lasting implications for the economy.

Seven months ago, there were five major independent investment banks, selling stocks and bonds, advising companies on mergers and engaging in ever more arcane financial engineering. Since then, Bear Stearns was bought in a fire sale by commercial bank J.P. Morgan Chase, Lehman Brothers went bankrupt, and Merrill Lynch agreed to be bought by Bank of America.

Now, the two biggest, strongest and most prestigious of those firms will become traditional commercial banks, too. The firms concluded that it was worth it to accept the safety net of government protection, even though it will probably lead to much more scrutiny by Fed regulators into what businesses they can engage in.

The change is likely to make easier, and could intensify, both companies' efforts to link up with commercial banks. Now that Goldman Sachs and Morgan Stanley have committed to using deposits to fund their operations, they have a tremendous incentive to gain access to the largest possible networks of bank branches.

In trying to save themselves, Goldman Sachs and Morgan Stanley are agreeing to surrender some of the activities that drove their profitability over the past decade. The two companies made massive bets while putting little money on the table. And they invested vast sums in a wide range of commercial enterprises.

As bank holding companies, Goldman and Morgan will be forced to put more money on the table when they make investment bets. Goldman Sachs, for example, currently holds about $1 for every $22 in investments. Morgan Stanley's ratio is even more dramatic. By contrast, Bank of America, which will soon be the nation's largest bank holding company, holds about $1 for every $11 in investments. And Goldman and Morgan will be sharply limited in their ability to make equity investments in non-financial companies.

"The marketplace won't give them leverage, the regulators won't give them leverage and so now we have formal confirmation that the model of freestanding investment banks is kaput," said Ed Yingling, president of the American Bankers Association.

Currently, the Fed has about a half-dozen examiners in Goldman and Morgan combined. By contrast, major bank holding companies host dozens of examiners, who monitor and restrict the firms' activities.

It's too early to tell what restrictions the Fed will put in place. The Fed must now send in its examiners and assess the companies' businesses, which are in flux.

Conventional banks, such as Bank of America and J.P. Morgan, have weathered the financial crisis much better than investment firms, despite incurring vast losses of their own. One key is that their deposits offer a steady source of funding, unlike the short-term debt that investment banks have relied on. That left them susceptible to runs, as Bear Stearns and then Lehman Brothers experienced.

It is in many ways a move to the business model used by banks in Europe, where large firms engage in both investment banking and commercial banking.

Also yesterday, the Treasury Department issued a major caveat to its Friday announcement that it would guarantee investments in money-market mutual funds, emulating the long-standing federal guarantee of deposits in bank accounts. The Treasury said yesterday that it would only guarantee existing investments in money-market funds.

The caveat came after loud pressure from the banking industry, which worried that a guarantee on new investments would encourage customers to pull money from bank accounts because money-market funds, which pay higher interest rates, would now be seen as equally safe. Both banks and banking regulators were concerned about how an exodus of deposits could impact already-struggling banks.