A year after Lehman's collapse, bank industry is on new path

NEW YORK -- It helped trigger more than a generation's worth of catastrophes in the U.S. banking system. But it was just a year ago Monday that investment bank Lehman Bros. filed for bankruptcy protection — an event widely viewed as a pivotal moment in upending the financial world.

The banking system has been through a 12-month roller coaster — ranging from a period of terror and a complete loss of confidence in the financial system, with the U.S. government injecting billions of dollars, to a time today where the likes of JPMorgan Chase and Goldman Sachs are reporting record profits. "Pendulums don't stop in the middle," says David Wyss, chief economist at Standard & Poor's. "We moved into panic mode last year, and we are now moving in the other direction."

Bank stocks are a good gauge of where we stand. They are up 135% from a March low, as measured by the Financial Select Sector SPDR exchange traded fund xlf. However, scars remain: Bank stocks are still off 31% from pre-Lehman levels.

It's been a process that has made one fact clear: The financial system is vital to the functioning of the economy. And the government, having seen the fallout from Lehman's demise, now is much less likely to let the largest institutions fail.

Lehman's collapse sent shockwaves through the economy. Small and midsize companies suddenly couldn't make payroll or pay for supplies. Many rely on large banks to issue short-term commercial paper — basically, IOUs — to provide funds for those expenses, while others rely on bank lines of credit, which were also pulled. Some economists believe the credit squeeze exacerbated job losses and worsened the recession.

Banks stopped lending to each other, and the credit markets froze, leading even large companies to panic. Mall owner General Growth Properties sought bankruptcy protection after it couldn't refinance its loans. Building of schools and highways stopped as states were shut out of financing.

Today, fears about more such fallout have for a large part disappeared. However, it's hard not to view the industry with caution, especially because the economy is still struggling and banks continue to suffer from loan losses related to residential and commercial mortgages. Here's a look at how the banking landscape has changed since last year, in the period leading up to Lehman and after:

•The industry has contracted.Washington Mutual, the largest bank failure in history, was taken over by JPMorgan Chase jpm. Wachovia, another giant, is now part of Wells Fargowfc. Lehman disappeared, while rivals Bear Stearns and Merrill Lynch were swallowed by JPMorgan and Bank of Americabac. And 92 smaller banks have failed this year, compared with 25 last year. More failures loom as the government's list of problem banks tops 400.

•U.S. taxpayers are big bank investors. In total, close to $400 billion are tied up in small and large institutions such as Citigroupc, Bank of America, Wells Fargo, American International Groupaig, Fannie Mae fnm and Freddie Mac fre. Treasury Secretary Timothy Geithner in congressional testimony last week said he isn't keen on putting "on the brakes too early" and will unwind the investments only when "conditions permit."

•Strong survivors are having a gangbuster year. With fewer strong competitors, Goldman and JPMorgan have posted record revenue and profits. Richard Bove of Rochdale Securities has called it the beginning of a new "golden age."

And that means big payrolls are making a comeback. Goldman Sachs gs has set aside $11.3 billion for compensation and benefits in just the first six months of 2009, up 33% from last year. JPMorgan, too, has put aside $14.5 billion for pay in the same period, up 22%. And Morgan Stanleyms set aside $3.9 billion in just the second quarter for compensation, which represents 72% of its revenue for the quarter.

•Credit continues to be tight. The government injected more than $250 billion into banks, hoping to ignite lending. However, in its survey of loan officers, the Federal Reserve found the opposite to be true. Banks had tightened standards and terms on all major types of loans to businesses and households in the last three quarters. "Stimulus dollars have had a modest effect," says Eric Boyce, portfolio manager at Hester Capital Management.

•More regulation could mean lower profits. Banks will have less money to put to work in the future, because it is widely expected that regulators will mandate them to hold more capital on their balance sheets to prevent them from weakening as they did during the financial meltdown. "The government is standing behind the financial industry, and there will be a price to be paid for that," says Michael Holland of money manager Holland & Co.