September 2008 will join September 1998 and October 1987 as dates that will live in infamy in the history of the global capital markets. But this time, the global financial services industry seems certain to be utterly transformed by the turmoil.

Compared with the events of this past month, the market crash of 1987 and collapse of Long-Term Capital Management in 1998 were mere bumps in the road. Now, the global financial system has hit the mother of all potholes, and many of its most important parts have been jarred loose.

As the impact of the credit crunch has intensified, some of the world’s biggest financial institutions have found themselves on the brink of failure. With money markets seizing up, interbank lending grinding to a halt, financial firms dangerously short of financing, the credit crunch has spilled over into the real economy in the form of an acute credit contraction. The sweeping changes to the industry landscape that are resulting are nothing short of breathtaking.

In short order, the U.S. Treasury and the U.S. Federal Reserve Board combined to bail out the teetering mortgage giants, Fannie Mae and Freddie Mac, which collectively represent more than half the U.S. mortgage market (and were underwriting the bulk of new mortgages this year); they also took over insurance colossus, American International Group Inc., exchanging an $85-billion credit facility for an 80% stake in the firm.

One of the world’s top investment banks, Lehman Brothers Inc., was allowed to fail and seek bankruptcy protection. Bank of America Corp.hastily struck a US$50-billion, all-stock deal for brokerage behemoth Merrill Lynch & Co. Inc. that came together in a matter of just two days. Britain’s largest mortgage lender, HBOS PLC, then fell into the hands of a rival half its size, Lloyds TSB PLC, in a deal that will create a domestic powerhouse.

Finally, amid debate over the viability of the independent investment bank model, the two remaining members of that club — Goldman Sachs and Morgan Stanley — announced they would abandon the model, convert into bank holding companies and submit to the regulation of the Fed.

Facing speculation that they would have to do deals of their own to survive, Goldman and Morgan Stanley were rumoured to be talking to firms — Wachovia Corp., for example — about a possible tie-up, soliciting sovereign wealth fund or other large foreign investor to take a stake. Morgan Stanley ultimately announced plans to sell a 20% stake to Japan’s Mitsubishi UFJ Financial Group Inc.

In addition to the corporate deal-making, the world’s central banks, too, scrambled to get financial markets working again. First, the Fed tried to boost liquidity by expanding the list of securities it would accept as collateral from borrowers.

When that failed to calm the waters, it teamed up with European Central Bank, Bank of England, Bank of Canada and Swiss National Bank to provide yet more liquidity with massive new swap arrangements among them. And it unveiled a plan to backstop the money market fund industry, as a few funds saw their net asset values tumble (collateral damage of the Lehman collapse).

Still, all of these efforts to grease the market machinery faltered — until the U.S. Treasury decided that the piecemeal approach wasn’t working and it needed a more comprehensive plan of action.

On Sept. 19, it announced that it was working with the Fed and Congress on a plan to buy massive amounts of illiquid mortgage securities. Henry Paulson, Secretary of the Treasury, estimated it would probably need hundreds of billions of dollars to unfreeze the credit markets, and the initial plan sought $700 billion to do the job.

Despite a lack of detail about how such a plan will work, the prospect of such a broad initiative was finally enough to cheer markets, and equities around the world rallied strongly on the news. Financial services stocks didn’t have much choice after the U.S. Securities and Exchange Commission and Britain’s Financial Services Authority both adopted temporary bans on short-selling financial services stocks. The Canadian Securities Administrators are supporting the SEC’s initiative with its own ban on shorting inter-listed financial services stocks.

All of this has left the authorities’ free market credentials in tatters. Between the various bailouts and the short-selling bans, it has become clear that they will sacrifice ideology and risk creating moral hazard for the sake of market stability. This suggests that financial services firms are sure to face a tougher regulatory environment in future.

@page_break@Indeed, in announcing his latest market-saving effort, Paulson admitted that the U.S. regulatory system would have to be overhauled, although he suggested that this was a debate for another day. However, some in Congress may insist that any effort to relieve financial services firms of their troubled securities must be contingent on a regulatory overhaul.

According to a research note from Donald Straszheim of Newport Beach, Calif.-based Roth Capital Partners: “A wholesale revamping of the entire financial sector is coming, requiring new legislation and regulations.”

The note predicts that the rash of bailouts means that, in the future, firms won’t be allowed to get large enough, or take risks big enough, to require a government rescue. “Such risks will be eliminated by either limits on size and or on behaviour,” it suggests. It adds that the businesses that will thrive are core functions such as wealth management, M&A advisory service, conventional corporate finance and institutional sales and trading — but not the highly leveraged, highly profitable businesses that have powered these firms in recent years.

Already, in a span of just seven days, the independent investment banking sector has essentially disappeared — a process that began with the earlier bailout of Bear Stearns, followed by the collapse of Lehman, the sale of Merrill and the decision of Morgan Stanley and Goldman to convert into bank holding companies.

This represents a stark reversal for the latter two companies, which had steadfastly insisted that they could remain independent. After announcing its latest quarterly earnings (which were down 70% from the same quarter a year earlier), Goldman’s chief financial officer David Viniar had told a conference call with analysts that investment banks could go it alone.

“It is not the business model,” he said. “It is the performance that matters.”

Nevertheless, the firms ultimately capitulated to the market’s feeling that independent investment-banking business models aren’t sustainable in the current environment.

A research note from UBS Securities LLC analyst Glenn Schorr says that the decision to seek bank status “creates some flexibility” for the firms as it gives them access to Fed lending, bolsters confidence in their international subsidiaries, and positions them to acquire or merge with a bank. On the downside, it probably spells weaker profits because of lower leverage and higher capital costs.

Indeed, not everyone is convinced that universal banks are the future. In a conference call with clients, Robert Hegarty, managing director with Needham, Ma.-based Tower Group Inc. , predicted that the marriage of commercial and investment banks will not last.

Hegarty suggests that these deals may make sense now — while the investment-banking model appears broken, and investment banks can be brought on the cheap — but that, ultimately, the track record of universal banks is not good. Once demand for investment-banking services surges again, these shops will probably be spun out.

In the meantime, it appears that the financial services industry is facing rocky waters. As Investment Executive went to press, the details of Paulson’s latest plan had not been finalized. He was seeking broad authority from Congress to carry out the bailout, but analysts had plenty of questions about how it would work — most importantly, what would the agency buy, who would it buy from and at what price?

Moreover, would the initiative need to offer some help to troubled homeowners to win Democratic support?

Despite the market’s apparent glee with Paulson’s latest plan, it is unlikely to end the turmoil.

Financial services companies still have to go through the de-leveraging process, and, whatever the final look of the MBS buyback plan, those firms will probably have to take further losses on these securities.

The Lehman bankruptcy and AIG bailout are massive undertakings that will reverberate throughout the financial system as firms determine — and confess — their exposure. This pain could be amplified by the huge, opaque credit default swaps market, which effectively multiplies the losses on corporate debt.

Then, there’s the prospect of tougher regulation facing the industry.

Finally, there’s the fact that the conditions underpinning this whole crisis remain. U.S. house prices are still falling and defaults are rising. Until those trends cease, it’s hard to imagine the financial system recovering its footing.

“As the initial euphoria dissipates and investors survey the economic landscape, they will find little else changed,” concludes New York-based Oppenheimer & Co. Inc.’ s managing director of global strategy, Steven Gluckstein. “The headwinds of rising unemployment, declining personal income and consumer spending, falling home prices and slowing global growth are blowing just as hard today as yesterday. It is far from over.” IE