Mergers for Washington Mutual and Morgan Stanley?

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The banks won over Congress and received the right to compete with Wall Street firms on their own turf—but with little success. Bank of America (BAC) launched a well-publicized effort to build an investment bank from the ground up, but after a decidedly rough quarter last year, CEO Ken Lewis declared that he'd had "all the fun I can stand" in its capital-markets division.

And now, of course, fate is driving Wall Street firms into the arms of the commercial banks. Lewis' acquisition on Sept. 15 of Merrill Lynch gives him in one fell swoop an army of nearly 19,000 brokers to hawk his credit cards, mortgages, and other financial products. And while some analysts had begun speculating that Morgan Stanley and Goldman Sachs—the last two independent Wall Street banks—would eventually need to partner with a commercial bank to gain the security of a bank's stable funding, few expected a merger would occur this week.

Shotgun Wedding?

But if the raid on Morgan continues, and the wholesale funding that is the mother's milk of Wall Street firms continues to dry up, Mack may conclude that a shotgun marriage with Wachovia or another bank may be his firm's salvation. Despite its well-documented problems stemming from the acquisition of Golden West Financial, Wachovia has been insulated from the runs that felled Bear Stearns and Lehman, thanks to the $300 billion in low-cost deposits that have served as a stable funding base.

Wachovia's problems with Golden West—which could leave both earnings and Wachovia's stock price in the ditch for several years—could be reason enough for Mack to look abroad for a capital infusion. Among the possible candidates: HSBC and China's Citic International Financial Holdings. Mack and Wachovia CEO Bob Steel do share a few tribal bonds: Both are North Carolina natives who went to Duke University and then spent their careers on Wall Street, albeit at different firms. And though many analysts expected Steel wouldn't broach a merger until he had time to mend Wachovia's balance sheet, a chance to merge with Morgan Stanley—or even his old colleagues at Goldman Sachs—could be too tempting to pass on. In a Sept. 16 appearance on CNBC's Mad Money with Jim Cramer, Steel signaled that he'd be open to a merger. "We have a great future as an independent company, but we're a public company," he said. "So we're going to do what's right for shareholders. I can promise you that. But we're also focused on the very exciting prospects when we get things right going forward."

Years ago, banks and savings and loans lobbied for the right to grow nationally by arguing that it would give them the geographic diversity to ride out a local economic crisis, like the oil bust that doomed Texas banks in the late 1980s. But that didn't help players like Washington Mutual that became too dependent on one product—mortgages—as it suffered losses from its home loans in California and Florida. That means that regulators and bankers alike are now concluding the best defense is to build financial institutions that are as big, and as diversified, as possible. "The winning business is going to the universal bank model, similar to that in Europe and Asia," says Bob Ellis, senior vice-president at Celent, a Boston-based consulting firm that specializes in financial services. "You'll have a strong retail bank, a retail brokerage, and an investment bank. That's the winning model—by design or default," Ellis says. "The lesson I'm learning from WaMu is that it's dangerous to be a one-trick pony."

Foust is chief of BusinessWeek's Atlanta bureau.