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Morgan Stanley Said to Be in Talks With China's CIC (Update2)

By Christine Harper

Sept. 18 (Bloomberg) -- Morgan Stanley, the second-biggest independent U.S. securities firm, may sell a larger stake to China Investment Corp. and is in talks about a possible merger with Wachovia Corp., a person familiar with the matter said.

China's state-controlled fund may buy as much as 49 percent of the New York-based investment bank, said the person, who declined to be identified because the talks aren't public and may end in no agreement. Morgan Stanley resumed its decline on the New York Stock Exchange, falling as much as 22 percent.

Morgan Stanley, led by Chief Executive Officer John Mack, and Goldman Sachs Group Inc., the biggest U.S. securities firm, tumbled the most ever yesterday as the deepening credit crunch fueled concern their funding sources are drying up. Morgan Stanley shares plunged 42 percent this week through yesterday after Lehman Brothers Holdings Inc. filed for bankruptcy and Merrill Lynch & Co. sold itself to Bank of America Corp.

``Morgan Stanley must be talking to any suitor,'' said Roger Lister, a credit analyst at the DBRS Inc. rating firm in New York. ``But I'm not sure whether a merger with a bank will solve the problems. It's not a deposit-base issue but a crisis of confidence. And getting a capital infusion from the Chinese or somebody else brings huge dilution due to the depressed stock price, which scares investors even more.''

Morgan Stanley fell $4.32, or 20 percent, to $17.43 in New York Stock Exchange composite trading at 11:57 a.m. Wachovia rose 11.3 percent to $10.15.

Gao Xiqing in U.S.

China Investment Corp. bought a 9.9 percent stake in Morgan Stanley in December after the firm reported a quarterly loss. CIC's president, Gao Xiqing, is in the U.S. with Wei Christianson, who runs Morgan Stanley's business in China, the Financial Times reported today.

If Morgan Stanley ``could come out and say we're raising this slug of capital to stabilize our balance sheet and operate at a lower level of leverage going forward, that would help,'' said Ben Wallace, a securities analyst at Grimes & Co. in Westborough, Massachusetts, which manages $850 million. ``They're so levered that they need to have the confidence of the market, and they don't have that right now.''

Mack, 63, addressed employees this morning in a crowded meeting in New York, saying the firm's earnings and balance sheet were sound, according to people who attended or watched the firm- wide video broadcast. He said Morgan Stanley was in stronger shape than Lehman or Bear Stearns Co., which was forced to sell itself to JPMorgan Chase & Cos. earlier this year.

Talk With Pandit

Two of the attendees, who declined to be named because they weren't authorized to speak to the press, said Mack sounded upbeat and confident.

Mark Lake, a spokesman at Morgan Stanley in New York, declined to comment.

Mack tried unsuccessfully earlier this week to persuade Vikram Pandit, CEO of Citigroup Inc., to combine their two companies, the New York Times reported today, citing people briefed on the talks. A Citigroup spokeswoman, Christina Pretto, said comments the Times attributed to Mack were ``never stated.''

Mack got a call from Wachovia yesterday indicating interest, said a person with knowledge of the matter. Talks about a deal with Wachovia have ``advanced,'' CNBC reported today. A merger with Wachovia could involve dividing the assets of both companies into two separate entities, a ``good bank'' and a ``bad bank,'' the Wall Street Journal reported, citing an unidentified person familiar with the matter.

Wachovia Costs

``The smartest people at this firm are focused on solutions,'' Lake, the Morgan Stanley spokesman, said yesterday.

Wachovia spokeswoman Christy Phillips-Brown said it was bank policy not to comment on ``market rumors or merger speculation.''

Wachovia, the fourth-largest U.S. bank, plunged 21 percent yesterday after saying it would support $494 million of Lehman credits held by its Evergreen Investments money market funds. The lender, based in Charlotte, North Carolina, had a market value of $19.7 billion yesterday, 18 percent less than Morgan Stanley's $24.1 billion.

Wachovia Chief Executive Officer Robert Steel, hired in July to replace Kennedy Thompson, is cutting $1.5 billion of expenses and reducing risk to cope with mounting losses from Wachovia's $122 billion of option adjustable-rate mortgages.

Merrill analyst Guy Moszkowski called a deal with Wachovia ``unlikely'' and said in a note today that a combination with Wachovia would ``saddle Morgan Stanley with considerable credit risk.''

``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,'' Moszkowski wrote.

Short Sellers

Morgan Stanley and Goldman have defended their business model, saying they have adequate capital and don't need the deposit funding that banks have. Mack lambasted short sellers for pushing his firm's shares lower.

In a memo to employees yesterday, Mack said the management committee is ``taking every step possible to stop this irresponsible action in the market,'' and he urged employees to contact clients to reassure them that the firm is performing strongly and has plenty of capital.

``There is no rational basis for the movements in our stock or credit-default spreads,'' Mack wrote in the memo. ``We're in the midst of a market controlled by fear and rumors, and short sellers are driving our stock down.''

The U.S. Securities and Exchange Commission may require hedge funds to disclose their short-sale positions and plans to subpoena the funds for their communication records, Chairman Christopher Cox said in a statement late yesterday.

Default Swaps

Short sellers try to profit by betting stock prices will fall. In a short sale, traders borrow shares from their broker that they then sell. If the price drops, they buy back the stock, return it to their broker and pocket the difference.

Credit-default swaps on Morgan Stanley rose to 900 basis points after falling earlier to 870 basis points, according to broker Phoenix Partners Group. Contracts on Charlotte, North Carolina-based Wachovia, the fourth-largest U.S. bank, rose to 695 basis points after falling to as low as 685 basis points. They are down from 747 basis points yesterday, CMA data show.

Credit-default swaps are financial instruments based on bonds and loans used to speculate on a company's ability to repay debt or to hedge against losses. The value of the contracts increases when investor sentiment deteriorates and the cost of protection rises.

Morgan Stanley's plunge may add impetus to calls from Democrats in Congress for a broader effort by policy makers to address the financial crisis, including setting up a government agency to take on devalued assets.

`Unscrew It'

``The private market screwed itself up and they need the government to come and help them unscrew it,'' House Financial Services Committee Chairman Barney Frank, a Massachusetts Democrat, told reporters late yesterday after top lawmakers met with Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben S. Bernanke.

Frank this week proposed considering an agency to ``deal with all the bad paper out there'' and get financial markets ``out of the box'' they are in.

To contact the reporter on this story: Christine Harper in New York at charper@bloomberg.net.

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Now let me translate that last statement by Mr. Frank: We're gonna print some more money, which we'll use to prop up some bad businesses and which in turn will lower the purchasing power of all the people but first and foremost the purchasing power of the poor and the middle class even more. Now please vote for me so I can debase your currency even more!