Morgan Stanley - one of the two last large independent, U.S.-based investment banks - is in advanced merger talks with Wachovia Bank, according to sources close to the company.
The talks with Wachovia follow preliminary discussions that began earlier this week and are going on even as Morgan continues to discuss raising capital from a Chinese bank.
According to people familiar with these discussions, Morgan Stanley Chief Executive John Mack is - at least for the moment - leaning toward a deal with Wachovia, but that deal will depend on due diligence, which is yet to be completed.
Morgan has put together a deal team to meet with the deal team from Wachovia .
People with knowledge of Mack's thinking say the situation is fluid, and Mack could reverse course, making the China deal his No. 1 priority, or begin talks to link up with another bank.
- Video: Gasparino on Mack's Next Move
- Video: Quadrangle's Rattner Reflects of Potential Morgan Deal
- Slideshow: Credit Crunch Timeline
- Special Report: Wall Street in Crisis
In fact, a source close to Mack says the firm would still like to remain independent, which is why Morgan continues to pursue obtaining additional capital from the Chinese government, which would ultimately direct a deal from anyone of a number of Chinese banks, including China Investment Corporation (CIC) and Citic. CIC already owns 9.9 percent of Morgan.
However, the recent turbulence in Morgan's share price has prompted Mack to begin official merger discussions with Wachovia.
Morgan's stock remained under pressure Thursday, as did shares of Goldman Sachs , which may also be out looking to raise additional funds, according to sources close to Morgan. A Goldman spokesman wasn't immediately available to comment.
As reported Monday, Morgan Stanley was weighing a possible deal, and Mack was ready to pull the trigger if the company fell victim to excessive short selling and counterparties pulling lines of credit from Morgan.
Amid the tumult, Mack began to lobby Washington decisions makers including Treasury Secretary Hank Paulson, Securities and Exchange Commission Chairman Chris Cox, Federal Reserve officials and even White House Chief of Staff John Bolton for tighter rules on short selling.
Despite reporting better-than-expected earnings on Monday, Morgan Stanley's stock has been crushed in recent days.
Mack believes short sellers spreading unsubstantiated rumors and manipulating Morgan's share price by shorting the stock and buying credit default swaps - which are insurance policies against Morgan defaulting on its debt - contributed to the pounding in Morgan shares in recent days.
Mack also lobbied these officials to relax regulations that could prevent the Chinese from buying a substantial portion of Morgan, as much as 49 percent, as a way for Morgan to remain independent.
But early Thursday Mack went a step further. On Wednesday he fielding calls from Citigroup CEO Vikram Pandit and Wachovia CEO Bob Steele. By the next morning, Mack decided to engage Wachovia in formal talks.
One person with knowledge of Mack's thinking says he has "several balls in the air," meaning that he hasn't decided which direction to take just yet.
One particular hurdle to a Wachovia deal is the bank's balance sheet - namely $120 billion in risky mortgages. But the bank also has $400 billion in deposits, which would diversify Morgan's funding. Like all investment banks, Morgan Stanley now relies solely on outside sources -traders, accounts with hedge funds and bank lines - to fund its ongoing operations.
One option would be to structure the deal so that it results in the formation of two new entities, with one holding the riskiest assets of both companies.
One analyst who covers Morgan says the combination of Morgan and Wachovia would be compelling from a business standpoint.
"They would combine all those deposits with a blue chip investment bank," he said.
Mack, who is 64 years old, would be able to turn the reigns of the combined firm to Wachovia's 57-year-old Steele, he said.
Morgan Stanley is considered the quintessential Wall Street investment bank and Wachovia is a North Carolina mainstay, but there are cultural links as well. Both Steele and Mack attended Duke University in North Carolina and Mack was raised in the state.
The discussions at Morgan Stanley come as the central banks rushed in $180 billion of extra liquidity to bring some calm to panicked stock and money markets.