Which way should Wachovia go?

Now that Wachovia Corp. is apparently done flirting with Morgan Stanley & Co., what's next for the Charlotte banking giant?

Chief executive Bob Steel could return to his original plan of cleaning up the bank's mortgage portfolio, cutting costs and selling off non-core assets, analysts said. But speculation is likely to continue over whether he plans to do a deal. In particular, the Morgan Stanley overture raises questions about his plans for the investment banking business.

And the big X-factor is ongoing negotiations in Congress to craft a bailout plan that could help banks shed some of their most troubled assets. Wachovia's biggest problem is its $122billion Pick-A-Payment loan portfolio, a source of huge loan losses.

Word surfaced of talks with Morgan Stanley last week, but the discussions appear to have ended this week. Steel, a former U.S. Treasury official and Goldman Sachs Group Inc. executive, reportedly made the first overture to Morgan Stanley, but Wachovia has repeatedly declined to comment on the existence of talks.

“We are focused on managing our company and serving our customers,” Wachovia spokeswoman Christy Phillips-Brown said, emphasizing the bank remains financially strong.

Amid turbulent times in the financial industry, Wachovia's future is critical for Charlotte, where it employs about 20,000 and is a major civic player. The bank appeared headed to a merger with Morgan Stanley last week, but instead the New York investment bank converted Sunday into a bank holding company and on Monday announced a capital infusion from a Japanese bank. With the talks apparently ended, here's a look at the two major paths Wachovia CEO Bob Steel can take:

Go it alone

When Steel came onboard in July to replace the ousted Ken Thompson, he stressed the bank had a strong outlook as a standalone company, supported by solid core businesses, despite its mortgage woes. In a CNBC interview last week, he reiterated the same point, but also noted Wachovia has a duty to its investors, who have seen their shares fall more than 63 percent this year.

“We have a great future as an independent company, but we're a public company, so we're going to do what's right for shareholders,” he told “Mad Money” host Jim Cramer.

The main task is to return the company to profitability – it lost $9.8 billion in the first half of the year – and make sure it has enough capital on hand to cover losses. In July, Steel outlined a plan to preserve $5 billion in capital by the end of 2009 by taking four major steps:

eliminating about 7,000 jobs, or 6 percent of the workforce.

cutting the quarterly dividend to 5 cents per share.

decreasing the size of the bank's Pick-A-Pay loan portfolio.

reducing total assets, which could include the sale of “noncore” businesses.

Since then, Steel has provided more details on his plan, including efforts to treat the Pick-A-Pay portfolio as a “distressed asset” separate from the rest of the bank. The bank is contacting borrowers about refinancing their loans into traditional mortgages that could be sold off to investors. The Pick-A-Pay loans are problematic because they are concentrated in troubled California and Florida housing markets and because they have a minimum payment option that allows the loan balance to grow instead of shrink.

The latest twist is the deepening of the credit crisis. The federal government is now weighing a bailout plan that could allow it to buy up to $700 billion in troubled assets from banks. Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke are pushing for a quick passage of legislation, but lawmakers have criticized the cost and skimpy details on how the program would work.

The big question is how much the government would pay for these troubled assets, said Morningstar analyst Jaime Peters. If the government buys these loans at the current value on the banks' books, then they can offload bad assets without taking losses and without having to raise capital to cover writedowns. If the government buys the loans at a discounted price, then the banks would take a loss and might have to raise more capital. The latter scenario might discourage banks from participating, she said.

“Wachovia at this point is in the same waiting game as everyone else,” Peters said.

Phillips-Brown, the Wachovia spokeswoman, said the bank applauds “these constructive steps toward restoring confidence and stability in our financial system” and is closely monitoring the situation.

Do a deal

Industry shifts that used to take years to develop have been happening at lightning speed in recent weeks. The failure of Lehman Brothers Holdings Inc., Merrill Lynch & Co.'s rushed sale to Bank of America Corp. and investor Warren Buffett's $5 billion infusion into Goldman Sachs all came in a little more than a week.

In this kind of environment, “it made sense for every company to talk to each other,” said Sandler O'Neill analyst Kevin Fitzsimmons. But the possibility of a Wachovia-Morgan Stanley tie-up left many investors wondering whether a deal made sense and questioning which company needed the other most, he said.

After converting to a bank holding company and getting the Mitsubishi UFJ Financial Group investment, Morgan Stanley appears ready to go it alone. Linking with a commercial bank offered a perception of stability, but investment banks have noted that they can't use deposits to fund many of their riskier capital markets trading activities anyway.

Goldman Sachs, the other remaining standalone Wall Street firm, has said it can stay independent, but it also has signaled plans to expand its commercial banking business after converting to a bank holding company like Morgan Stanley. It's getting a cash infusion from Buffett, but that doesn't mean it necessarily wants to go out and make a big purchase, Fitzsimmons said.

Steel's ties to Goldman have stirred speculation of a possible pairing since he took the job, but he has said he wasn't brought on to do a deal with his former employer. The Mitsubishi investment in Morgan also has raised the specter of foreign banks taking more stakes in struggling U.S. institutions. Speculation about the Wachovia-Morgan deal included talk of a cash infusion by a Chinese investment fund into the combined company.

Wachovia's talks with Morgan also focused attention on Steel's plans for investment banking. A merger with Morgan likely would have resulted in heavy cuts in Wachovia's unit, which is based in Charlotte, said investment bankers familiar with the operations. Morale in the unit is poor and many bankers get the impression that Steel isn't enamored of the unit's current makeup, which is much smaller than what he was used to at Goldman, these bankers said. Wachovia's corporate and investment bank has grown over the years, but one of its main profit centers, the creation of complex debt products, has dried up in the credit crunch.

Since taking over, Steel has called corporate and investment banking a core business and has cited ongoing efforts to focus on serving the needs of corporate clients, instead of producing exotic investment products. “We actually have the prospect of quite a constructive strategy that I would describe as much more client-centric, as opposed to a singular ambition,” he said at an investor conference earlier this month.

Fitzsimmons said he suspects that Steel is focused on his plan to get the company on solid footing on its own, but he expects speculation will continue about Wachovia's deal-making possibilities. “I wouldn't rule anything out,” he said, “but at this point there's no reason to think it has to happen.”