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Will courtship of Wachovia and Morgan Stanley result in shotgun wedding?

This article first appeared in the St. Louis Beacon: September 22, 2008 - What's the prospect, or wisdom, of a giant, lumbering bank holding company merging with a giant, staggering investment banking company?

When it comes to Wachovia Corp. and Morgan Stanley, the answer is "no one knows," because the economic landscape continues to shift dramatically and often.

"There's a lot of unknowns out there," says Radhakrishnan Gopalan, assistant professor of finance at Washington University's Olin Business School. "These are two weakened institutions."

Like other financial experts, Gopalan says he can't evaluate Wachovia, Morgan Stanley or any other financial institution until Congress formally responds to Treasury Secretary Henry Paulson's massive plan to rescue the financial services industry. "I expect Paulson to play hardball with all of these companies," Gopalan says.

Early last week, when several news organizations said Wachovia and Morgan Stanley were talking, a merger sounded like a risky, almost desperate idea.

Some analysts said a deal might help Morgan Stanley because it could gain access to a revenue cushion from Wachovia's traditional banking business. However, a merger also would combine Morgan Stanley's most immediate concern -- a need for short-term financing -- with Wachovia's dreadful mortgage portfolio.

"It is difficult for us to perceive a strategic benefit for Morgan Stanley, which would be merging with the weakest of the five major U.S. banks, and the bank with the most credit risk relative to its tangible capital, in our view," said a Sept. 18 Merrill Lynch report.

The mood brightened on Sept. 19 when Paulson announced his plan to try to repair the damage to the financial services industry caused by bad loans, bad investments, bad strategy and bad management. The cost of the industry-wide bailout has been estimated at $700 billion.

Balance sheet relief, some experts speculated, might make a Wachovia-Morgan Stanley deal more palatable especially if Wachovia's mortgage portfolio is included in Paulson's umbrella.

On Sunday night, the Federal Reserve gave more flexibility to Morgan Stanley and Goldman Sachs, saying they can be designated as bank holding companies.

"In return for increased scrutiny and stricter capital requirements, they will gain permanent access to the Fed discount window," says a Monday report by the independent financial research firm Morningstar.

This "could help them with short-term emergency funding, and an increased ability to collect deposits with which to partially fund themselves," says the report.

Although Morningstar didn't comment on a possible Wachovia-Morgan Stanley deal, the Fed's announcement appeared to give Morgan Stanley some flexibility.

On Monday, the mood for a Wachovia deal darkened as Morgan Stanley said Mitsubishi UFJ Financial Group would buy up to 20 percent of Morgan Stanley's stock, infusing as much as $8.4 billion. Mitsubishi UFJ is Japan's largest bank and the world's second largest bank holding company.

The deal gives Morgan Stanley financial support without having to engineer a transaction with Wachovia. In addition to its Morgan Stanley investment, the Japanese company is in the process of buying UnionBanCal Corp., a San Francisco-based bank holding company providing services primarily in California, Oregon and Washington. The California bank's market capitalization is about one-third the size of Wachovia's market value.

UNCERTAINTY REMAINS

About the only certainty is that Wachovia's stock will remain volatile for a while.

Since Sept. 15, the daily closing price has been on a roller coaster -- up 25 percent, down 7.5 percent, down 21 percent, up 59 percent, up 29 percent and, on Monday, down 11.5 percent to close at $16.60. That's about one-third of the stock's price versus 12 months ago.

Just before Morgan Stanley revealed its Japanese deal, Christopher Mutascio, a banking analyst at Stifel Nicolaus & Co. cut his rating on Wachovia to hold from buy. He said the jump in Wachovia's stock on Thursday and Friday was "simply too much too soon for the issues facing the company."

He attributed the two-day gain -- from a $9.12 closing price on Wednesday to an $18.75 closing price on Friday -- to the Securities and Exchange Commission's temporary ban on short-selling nearly 800 financial stocks and to the "euphoria" over Paulson's bailout plan. (Short-sellers bet that a stock will decline. They borrow shares from brokers, hoping to pay back the same amount at a lower price when the stock's value falls.)

Mutascio's biggest concern about Wachovia is how the final bailout plan will place a value on the bank's assets, most notably its troubled mortgages.

"Some may view Wachovia as one of the primary beneficiaries of the government bailout," says the analyst, who doesn't own shares and who had recommended buying Wachovia in early May when its stock was trading at about $30. "However, too many questions remain about the government's proposal to determine just how much Wachovia may benefit."

One question is how will the government determine a price for the assets. If Wachovia sells "a large portion" of its $120 billion option adjustable-rate mortgage portfolio to the federal government, "will it have to raise capital to absorb such cumulative losses?" Mutascio wrote. These mortgages allow borrowers to choose among several payment options.

These mortgages also have "reduced the value of the whole company," says Washington University's Gopalan.

Although anything is possible, it also appears a Wachovia-Morgan Stanley transaction would have created anxiety for Wachovia's St. Louis-based brokerage unit. Wachovia Securities is still integrating the operations of A.G. Edwards - a process that won't be completed until next year.

The A.G. Edwards acquisition combined the fourth and sixth largest retail brokerages in the U.S. to produce the second largest in terms of net revenue and number of Series 7 brokers. These brokers have the most training and the most responsibility for managing money.

When the deal was announced last year, the companies said their combined Series 7 workforce would be nearly 14,800. At the time, they said Morgan Stanley ranked third with nearly 8,000 brokers.

A combination of Wachovia's and Morgan Stanley's staff "would definitely cause turmoil in the retail brokerage business," says Gopalan. "Wachovia hasn't digested the earlier acquisition. If they did this, it could blow up in their face."

Robert W. Steyer, a freelance journalist living in New York, was a business reporter for the St. Louis Post Dispatch. 

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