Is Wachovia Too Small to Save Morgan Stanley?

Did I say that today's liquidity injection should at least get us through the weekend? Well, by "us", clearly I didn't mean "Morgan Stanley". It's not trading at zero yet, but it's getting very close, and if the stock continues to fall at this rate MS will be trading at option value long before the markets close on Friday.

One thing worth remembering, though: we've now reached the point at which percentage moves in the MS stock price no longer mean anything. It's trading at $15 a share? It could rise by 50% and still be distressed; it could fall by another 30% and still be in essentially exactly the same position it's in right now.

I'm not sure I trust the CDS market to give me a reliable indication of what's going on, either. All the new liquidity in the system has changed the baseline, and a lot of people are buying protection not because they think Morgan Stanley is going to default but just because it's a necessary hedge right now.

I'm glad that Morgan Stanley is looking at a good bank/bad bank structure for any marriage with Wachovia, because if the two just enacted a plain-vanilla merger, the investment bank, with its trillion-dollar balance sheet, is entirely capable of taking the commercial bank down with it into bankruptcy. If things work well, the investment bank's trading book and all its counterparty risk will stay in the good bank, while a large part of its assets, including anything remotely housing-related, will get put into the bad bank.

But the problem for John Mack is that it's not obvious what the markets are ostensibly worried about. There's no David Einhorn going on the television pointing at Morgan Stanley's balance sheet and saying that this bit is toxic and that bit is probably OK. Instead, people are selling just because they have no idea what Morgan Stanley really owns and what those assets might be worth -- which makes it that much harder to draw a good bank/bad bank line and decide which assets the stock market would be happy owning.

Reportedly Mack talked to Citigroup about a possible merger, but those talks went nowhere -- that's unfortunate, because Citi is actually big enough to be able to absorb Morgan Stanley without having to ring-fence potentially toxic assets.

Do you remember how the amount of capital that AIG needed grew from $40 billion to $70 billion to $100 billion over the course of about 24 hours? My feeling is that the size of partner that Morgan Stanley needs is growing in a similar manner. Yesterday, maybe Wachovia would have been big enough. Today, that's not at all obvious any more.