(Update 1: noted Times retraction) Media reports are suggesting Thursday morning that Morgan Stanley (MS) — one of only two independent investment banks left standing — has begun the process of finding a merger partner. Whispers about the future of both Morgan Stanley and fellow independent i-bank Goldman Sachs (GS) have grown much louder in the back half of this week, in the wake of the failure of Lehman Brothers Holdings Inc. (LEH) on Monday. Perhaps the most telling report was filed late Wednesday by the New York Times, which ran a quote allegedly from Morgan Stanley CEO John Mack, before retracting the quote a few hours later. “We need a merger partner or we’re not going to make it,” the paper quoted him as telling Citigroup Inc. (C) CEO Vikram Pandit; Citi, for what it’s worth, appears to have shunned any deal involving the ailing investment bank. (The Times later retracted the quote, a rare move for the publication, as both Citi and Morgan Stanley vigorously denied the remarks ever being made; the Times sources originally responsible for providing the quote also could not verify that Mack actually said the words in question.) Various key sources on the Street have told HW that Mack is “much more pragmatic than [Lehman CEO Richard] Fuld,” and that he would look to find a deal before the clock runs out on his firm. And deal searching he appears to be, with various reports suggesting that Morgan Stanley has approached Citi and Wachovia Corp. (WB) about a possible merger in the past few days. The Wall Street Journal pulled out a laundry list of potential global deal partners Thursday morning, including HSBC Holdings PLC, Banco Santander SA, Nomura Holdings Inc., and even Bank of New York Mellon Corp. — essentially, any commercial banking operation that hasn’t been entirely wiped out by the current credit debacle. The paper said the names of potential suitors came from sources near Morgan Stanley. “Right now, it’s a game of musical chairs,” said one source, who asked not to be named in this story. “The fear at Morgan Stanley is that by waiting, Goldman may get the prize. Nobody wants to be out in the cold when the music stops here.” Indeed, such speculation about Goldman has been growing as well, although very little has leaked to the press regarding the investment bank’s intentions. The Wall Street Journal’s Heard on the Street column noted on Thursday that “Goldman could be left exposed” should Morgan Stanley choose to merge with a commercial banking operation. A merger with Wachovia, however, may prove to be problematic. The bank faces its own mortgage-led troubles surrounding an ill-fated purchase of option ARM specialist Golden West Financial in 2005; option ARMs constitute $122.2 billion of the bank’s $488.2 billion in total loans. No other U.S. bank has as much exposure to option ARMs in real-dollar terms. CEO Robert Steel said last week in an investor presentation that 66 percent of borrowers in its option ARM portfolio have some deferred interest balance, which has driven $3.9 billion in paper income for the bank. The current average loan-to-value ratio of its entire option ARM portfolio is now up to 90 percent — and that’s an estimate that is based on May 2008 data, meaning it’s already four months old. It’s a safe bet that the average LTV is now well over 90 percent. Nonetheless, CNBC’s Charlie Gasparino reported on Thursday morning that Morgan Stanley is in advanced discussions with Wachovia and will begin formal merger negotiations sometime before the end of today. Shares in Morgan Stanley were at $21.21, off 2.5 percent, when this story was published; the firm’s shares fell despite a broader rebound in the Dow Jones Industrials, which were up 175.95 points in early trading Thursday. Disclosure: The author held no relevant positions when this story was published; indirect holdings may exist via mutual fund investments. HW reporters and writers follow a strict disclosure policy, the first in the mortgage trade.

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