NEW YORK Wall Street profits could take a big hit if the government toughens regulations in a proposed overhaul of the U.S. financial system, the manager of the world's biggest bond fund said on Monday.
The White House and some lawmakers have called for a regulatory sweep, not seen since the Great Depression, in the wake of the current turmoil in financial markets and the near-collapse of U.S. investment bank Bear Stearns BSC.N.
On Monday, Treasury Secretary Henry Paulson outlined a plan that permits the Federal Reserve to oversee the books of U.S. investment banks and other large non-bank financial companies which are currently treated differently from commercial banks and savings and loans and thrifts.
Gross, the chief investment officer of Pacific Investment Management Company, or PIMCO, anticipates such a regulatory revamp will result in higher capital standards for investment banks, bringing them closer to their commercial bank counterparts.
"There seems no way that current reserve requirements for banks will not in some nearly uniform way be imposed on investment banks," Gross, who manages the $120 billion PIMCO Total Return Fund, wrote in his latest monthly 'Investment Outlook' published on Monday.
Tougher regulations, with the goal to shore up the safety and soundness of the overall banking system, will likely slash the profits of major investment houses like Goldman Sachs (GS.N), Lehman Brothers LEH.N and Merrill Lynch MER.N, Gross said.
Gross referred to these Wall Street firms as "shadow banks" because they have raised billions in the capital markets, rather from savings and traditional lending. Less stringent regulations had allowed Wall Street to make riskier and more profitable bets than commercial banks.
This "shadow banking system," which consists of all the levered investment conduits, vehicles and structures created by Wall Street, is now facing liquidity constraints.
"Shadow banks will likely be forced to raise expensive capital and/or reduce the bottom line footings of their balance sheets," he said.
This would mean lower stock prices on higher borrowing costs for investment banks, he said.
Meanwhile, more stringent regulations would mean investors would demand wider risk spreads or higher return premiums, which could be a drag on the economy, according to Gross.
"Risk spreads - from corporate bonds to equities to commercial and residential real estate - will settle at permanently higher levels. The U.S. asset-based economy will morph into a more expensive hybrid that will reign supreme for years to come," he said.