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Morgan Stanley's move cools Wachovia merger talks

A possible Wachovia-Morgan Stanley merger took an unexpected turn Monday when the New York investment bank instead sold a 20 percent stake in itself to a Japanese bank.

The development came as Morgan Stanley and Goldman Sachs – the last two major standalone investment banks – received approval on Sunday to convert to bank holding companies. This means the Wall Street stalwarts will now face the same stringent regulation as commercial banks such as Wachovia and Bank of America, but they also will be competing more fiercely for consumer deposits.

Morgan Stanley and Goldman said they made the move to shore up investor confidence in their business models. Commercial banks typically rely on a more stable deposit base to fund their operations, instead of short-term financing that has become dicey in the credit crunch.

The investment banks faced questions about their future after rivals Bear Stearns collapsed, Lehman Brothers fell into bankruptcy court and Merrill Lynch agreed to sell itself to Bank of America. As late as Sunday, Morgan appeared to be heading toward a merger with Wachovia, but on Monday the firm said it was forming a “strategic alliance” with Japan's largest bank, Mitsubishi UFJ Financial Group.

The move reportedly cooled talks with Wachovia, but analysts on Monday said more deals were still possible. “We cannot rule out that a blockbuster bank merger will still take place,” wrote CreditSights analysts David Hendler and Baylor Lancaster in a research note.

In fact, both Morgan and Goldman signaled expansion plans ahead. Morgan said it will look to “seize opportunities in a rapidly changing financial marketplace,” while Goldman said it expects to grow deposits on its own and through acquisitions.

For Wachovia, Morgan's steps were the latest twist in a tumultuous year.

The bank ousted chief executive Ken Thompson in June as the company reeled from rising mortgage losses and brought on Bob Steel, a former treasury official and Goldman Sachs executive, to lead a turnaround. He has stressed plans to keep the bank independent, but reportedly approached Morgan CEO John Mack about a possible deal. Merging with Morgan would have given Wachovia a much bigger investment banking presence but likely would have meant major job cuts among Charlotte investment banking ranks.

Wachovia spokeswoman Christy Phillips-Brown said the company doesn't comment on merger speculation or the actions of competitors. “We are focused on managing our company and serving our customers with vigilance,” she said. “Wachovia is strong and financially sound; it is well capitalized and its levels of liquidity are prudent.”

The conversion of Morgan and Goldman shakes up the rankings of bank holding companies, pushing Wachovia, with $796 billion in assets, down two spots to No. 6. Goldman becomes the No. 4 bank holding company with $1.08 trillion in assets, followed by Morgan Stanley with $988 billion.

Citigroup, Bank of America and JPMorgan Chase remain the largest, with Bank of America set to become No. 1 after its Merrill Lynch acquisition, with about $2.5 trillion in assets.

With their change in status, Morgan and Goldman abandoned a separation between commercial banking and investment banking established by the Glass-Steagall Act after the Great Depression. That division had already been disappearing as lawmakers lifted regulatory barriers and retail banks, including Bank of America and Wachovia, added their own brokerage and investment banking services to form so-called “universal banks.”

Morgan and Goldman already offered some traditional banking services, but they had avoided the strict regulation and capital requirements placed on commercial banks. Now they will fall under the supervision of the Fed. “The investment banks wanted to stay out of the clutches of Federal Reserve regulations,” said Virginia-based banking consultant Bert Ely. “That has come to an end.”

While large by asset size, the two Wall Street firms will have some catching up to do when it comes to deposits. Morgan said it had $36 billion in bank deposits, while Goldman said it had $20 billion. In comparison, Bank of America is No. 1 with $598 billion in deposits, followed by JPMorgan Chase ($469 billion) and Wachovia ($392 billion), according to the latest Federal Deposit Insurance Corp. data.

The investment banks could seek to lure customers with higher interest rates, but it will take them time to build their retail businesses, said Jeff Brown, principal with Deloitte Consulting in Charlotte. By becoming bank holding companies, “it gives them the potential, but they still need to set up their operations and do this,” he said.

The holding company conversions, as well as a government plan to buy up troubled mortgage-related assets, has stirred speculation that Merrill could regret selling to Bank of America. The merger agreement, however, requires Merrill to make “reasonable best efforts” to secure shareholder approval. If Merrill doesn't back the deal or seeks a merger with another suitor, Bank of America, under certain circumstances, would have the option of taking a 19.9 percent stake in the firm at a price of $17.05 per share. Merrill shares closed Monday at $28.05.

“We expect the purchase to close in early 2009,” Bank of America spokesman Scott Silvestri said.

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