Banks rush to do deals as Wall St crisis deepens

By Jack Reerink

NEW YORK (Reuters) - Wall Street's manic dealmaking reached a new pitch on Wednesday as U.S. share prices plummeted to three-year lows and forced increasingly desperate major banks to scramble for merger partners.

With the financial landscape undergoing its most dramatic transformation since the Great Depression, reports emerged of takeovers involving No. 2 U.S. investment bank Morgan Stanley, weakened top U.S. savings bank Washington Mutual and major UK mortgage lender HBOS.

"This is indicative of the changes that are shaking the foundation of the financial system in today's world," said Frank Husic, Managing Partner of Husic Capital Management in San Francisco.

The flurry of potential deals followed the surprise $85 billion rescue of insurer American International Group by the U.S. Federal Reserve on Tuesday that did little to calm investors' nerves.

"Stop The Insanity," pleaded a research note from Swiss bank UBS as U.S. financial shares appeared to be in free-fall. The U.S. stock market plunged 4.7 percent to a three-year low, the dollar slumped, while safe-haven U.S. Treasury bonds and gold soared.

The AIG rescue capped a week of bailouts, a bankruptcy on Wall Street and moves by central banks around the world to flood the financial system with funds to prevent it from seizing up.

The result: a seismic shift in the financial industry, with some of Wall Street's biggest names disappearing.

"The fear is who is next," said John O'Brien, senior vice president at MKM Partners in Cleveland. "It almost feels like people scour the books and say who is the next likely target that we can put a short on. And that spreads continuous fear."

DANCING PARTNERS

Shares of Morgan Stanley and larger rival Goldman fell as much as 43 percent and 27 percent respectively, even after both reported better-than-expected quarterly earnings on Tuesday.

That stoked talk Wall Street's two surviving investment banks may have to join up with a commercial bank to survive.

"I'm assuming that Goldman Sachs and Morgan Stanley are lining up dancing partners. They don't want to be ... this week's victim," said William Larkin, fixed income manager at Cabot Money Management in Salem, Massachusetts.

The dance music picked up pace after the close of trading.

Morgan Stanley was discussing a merger with regional banking powerhouse Wachovia, the New York Times reported. CEO John Mack got a phone call from Wachovia on Wednesday but is also pursuing other options, the paper said.

"In this market, anything's possible. It seems like the market wants the investment banking model to disappear," said Danielle Schembri, a bond analyst covering brokers at BNP Paribas in New York.