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Concerns over the health of investment banks facing increased skepticism from investors about the outlook for the stand-alone broker-dealer business model, in the current frenzied environment have dramatically intensified. This is particularly true after Lehman Brothers (LEH) filed for bankruptcy, and raising the question of how vulnerable other major American investment banks really are.

As the conditions in the financial sector continue to deteriorate, and as irrationality in some cases has turned into excessive fear, (Morgan Stanley’s (NYSE:MS) earnings report Sept. 16, handily beat expectations. Despite this fact, its shares came under renewed assault yesterday.). MS, which still enjoys a strong franchise and solid credit fundamentals, is considering a tie-up with the Wachovia Corporation (WB-OLD) or another bank.

According to NYT, the firm’s chief executive, John J. Mack, received a telephone call from Wachovia on Wednesday expressing interest in the Wall Street bank.

Other banks have also expressed interest in Morgan Stanley, which is considering various options. The talks with Wachovia, notes NYT, are only preliminary at this point, and no deal may emerge.

Also on Wednesday, Morgan Stanley’s shares experienced a precipitous decline and plummeted more than 30%. In addition, the cost of protecting the firm’s debt with credit-default swaps rose, reflecting more investor uncertainty about the financial sector. Stanley’s five-year CDS rose by 40 basis points to $796,000 a year to protect $10 million of debt.

According to Moody’s Investors Service, Morgan Stanley’s CDS are trading as though it were rated deep in junk territory at “B2.″ That, is 10 steps below its actual rating of “A1.”

Shares of Wachovia also fell yesterday with most other financial stocks, posting a nearly 21% loss to $9.12. On Monday, a director at WB bought one million shares for $10.99, at a cost of $11 million. This could be interpreted as a positive sign in the sense that perhaps the stock is probably not going to go away any time soon.

Disclosure: None 

Source: Is Wachovia Really Interested in Morgan Stanley?