March 31 (Bloomberg) -- Goldman Sachs Group Inc., Lehman Brothers Holdings Inc. and Merrill Lynch & Co. will earn less and face higher borrowing costs because of increased regulation of investment banks, Pacific Investment Management Co.'s Bill Gross said.

Treasury Secretary Henry Paulson today proposed the broadest overhaul of U.S. financial regulation since the Great Depression and said the Federal Reserve should expand its oversight. The Fed earlier this month engineered New York-based JPMorgan Chase & Co.'s purchase of Bear Stearns Cos. and became the lender of last resort to the biggest bond dealers.

Investment banks' invitation to borrow at the Fed's discount window will ``come with a price tag,'' Gross wrote on Pimco's Web site today. ``There seems no way that current reserve requirements for banks will not in some nearly uniform way be imposed on investment banks. Leverage and gearing ratios of securities firms therefore, will in a few years resemble those of commercial banks themselves resulting in reduced profitability for major houses such as Goldman, Lehman and Merrill Lynch,'' said Gross, who is based in Newport Beach, California. The three securities firms are all based in New York.

``These shadow banks will likely be forced to raise expensive capital and/or reduce the bottom line footings of their balance sheets,'' Gross said. This ``will be costly, and bond spreads as well as stock prices should begin to reflect it.''

Extra Yield

The extra yield, or spread, investors demand to own investment-grade broker bonds instead of Treasuries has already risen to 350 basis points from 211 basis points at year-end, according to index data compiled by Merrill Lynch. A basis point is 0.01 percentage point. Investment-grade bonds are those rated at least Baa3 by Moody's Investors Service and BBB- or higher by Standard & Poor's.

The Fed's direct lending to investment banks will also increase inflation, Gross said in his commentary. Consumer prices in the U.S. were unchanged in February, the Labor Department in Washington said this month.

``Because of this lender-of-last-resort operation, subsequent inflationary trends may have been fertilized because the debts that caused the crisis are now primarily in another private portfolio and not liquidated,'' Gross said. ``These debts have to be validated by policy makers through attempts to increase cash flows in the finance-based economy, which is another way of saying they are trying to reflate, which is another way of forecasting an increasing probability of higher inflation.''

To contact the reporter on this story: Caroline Salas in New York at csalas1@bloomberg.net

Last Updated: March 31, 2008 12:18 EDT