Mergers for Washington Mutual and Morgan Stanley?

In the current financial crisis, there's growing sentiment that mergers for big firms like WaMu and Morgan Stanley may be the only move

It wasn't too many years ago that some federal regulators fretted about the dangers of letting commercial banks merge with the big investment houses on Wall Street. But in the current financial crisis, those mergers might be the only thing that saves some of Wall Street's most storied firms, such as Morgan Stanley (MS) and a troubled lender like Washington Mutual (WM).

With Lehman Brothers (LEH) now history, panicked Wall Street investors continued to sell off shares in both Morgan Stanley and Goldman Sachs (GS), despite the fact that both firms reported relatively strong earnings in recent days. Morgan Stanley's shares plunged 24% on Sept. 17, and lost another 18% in mid-day trading on Sept. 18, as investors worried the white-shoe firm would suffer the same liquidity crisis that felled Lehman and threatened Merrill Lynch (MER). At first, Morgan Stanley executives rushed to condemn the short-sellers they said were driving the sell-off. In a memo to employees (, 9/17/08), Morgan CEO John Mack expressed his view that the firm was "in the midst of a market controlled by fear and rumors, and short-sellers are driving our stock down."

But there's growing evidence that Morgan Stanley realizes it needs the help of a commercial bank to survive and is negotiating either a capital infusion or an all-out merger—or both. On Sept. 18, The New York Times reported online that Mack had "stepped up" merger talks with Charlotte-based Wachovia. Shares of Wachovia soared 40% on the developments. According to the Times, the two firms are also considering recruiting a third-party investor, most likely a sovereign wealth fund to infuse new capital into the combined entity. Among the outside investors cited by the Times and other media organizations are China's Citic Group and Singapore Investment Corp., one of the world's largest sovereign wealth funds. And according to reports, Morgan Stanley is also weighing yet another option: Splitting the company into a "good bank" and "bad bank," a structure designed to prevent its exposure to subprime loans and other shaky investments from poisoning the solid part of its businesses.

While Morgan Stanley may still have space to determine its own fate, that moment appears to have passed for Washington Mutual, the $307 billion Seattle-based thrift that is reeling from soured mortgage lending. On Sept. 17 a large WaMu investor, Texas-based TPG, disclosed that it had waived an anti-dilution measure that it had negotiated as part of a $7 billion infusion it made last April. That move would pave the way for a sale, and, according to the Times, the thrift has attracted several bidders, including JPMorgan Chase (JPM), Wells Fargo (WFC), and HSBC Holdings (HBC). WaMu declined to comment.

Drastic Times…

That such mergers are being broached would have been unfathomable not too many years ago. When the banking industry pressured Washington in the 1990s to dismantle the regulatory wall that had prevented banks from engaging in the activities of Wall Street firms—underwriting stock offerings, handling mergers, writing derivatives contracts—it got pushback from critics who recalled why Congress had imposed the restrictions in the 1930s. Many historians blamed the financial collapse that triggered the Great Depression in small part on the willingness of banks to let investors buy stocks on margin, feeding a bubble that eventually burst. And in the 1990s most Wall Street firms—mindful that banks, with their larger market capitalizations, would likely be the acquirers in any consolidation—lobbied Congress to keep the banks out of their business. Their warning to lawmakers: Banks would be reluctant to provide credit to corporate clients that didn't buy any of their investment banking services, an illegal practice known as "tying."

The banks won over Congress and received the right to compete with Wall Street firms on their own turf—but with little success. Bank of America (BAC) launched a well-publicized effort to build an investment bank from the ground up, but after a decidedly rough quarter last year, CEO Ken Lewis declared that he'd had "all the fun I can stand" in its capital-markets division.

And now, of course, fate is driving Wall Street firms into the arms of the commercial banks. Lewis' acquisition on Sept. 15 of Merrill Lynch gives him in one fell swoop an army of nearly 19,000 brokers to hawk his credit cards, mortgages, and other financial products. And while some analysts had begun speculating that Morgan Stanley and Goldman Sachs—the last two independent Wall Street banks—would eventually need to partner with a commercial bank to gain the security of a bank's stable funding, few expected a merger would occur this week.

Shotgun Wedding?

But if the raid on Morgan continues, and the wholesale funding that is the mother's milk of Wall Street firms continues to dry up, Mack may conclude that a shotgun marriage with Wachovia or another bank may be his firm's salvation. Despite its well-documented problems stemming from the acquisition of Golden West Financial, Wachovia has been insulated from the runs that felled Bear Stearns and Lehman, thanks to the $300 billion in low-cost deposits that have served as a stable funding base.

Wachovia's problems with Golden West—which could leave both earnings and Wachovia's stock price in the ditch for several years—could be reason enough for Mack to look abroad for a capital infusion. Among the possible candidates: HSBC and China's Citic International Financial Holdings. Mack and Wachovia CEO Bob Steel do share a few tribal bonds: Both are North Carolina natives who went to Duke University and then spent their careers on Wall Street, albeit at different firms. And though many analysts expected Steel wouldn't broach a merger until he had time to mend Wachovia's balance sheet, a chance to merge with Morgan Stanley—or even his old colleagues at Goldman Sachs—could be too tempting to pass on. In a Sept. 16 appearance on CNBC's Mad Money with Jim Cramer, Steel signaled that he'd be open to a merger. "We have a great future as an independent company, but we're a public company," he said. "So we're going to do what's right for shareholders. I can promise you that. But we're also focused on the very exciting prospects when we get things right going forward."

Years ago, banks and savings and loans lobbied for the right to grow nationally by arguing that it would give them the geographic diversity to ride out a local economic crisis, like the oil bust that doomed Texas banks in the late 1980s. But that didn't help players like Washington Mutual that became too dependent on one product—mortgages—as it suffered losses from its home loans in California and Florida. That means that regulators and bankers alike are now concluding the best defense is to build financial institutions that are as big, and as diversified, as possible. "The winning business is going to the universal bank model, similar to that in Europe and Asia," says Bob Ellis, senior vice-president at Celent, a Boston-based consulting firm that specializes in financial services. "You'll have a strong retail bank, a retail brokerage, and an investment bank. That's the winning model—by design or default," Ellis says. "The lesson I'm learning from WaMu is that it's dangerous to be a one-trick pony."

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