Morgan Stanley has advanced its discussions with Wachovia Corp. about a possible merger, which would leave Goldman, Sachs & Co. as the nation's lone remaining independent investment bank, reports said yesterday.

The two sides are apparently exploring a "good bank"/"bad bank" structure, which would create a separate entity to hold the company's exposure to subprime loans and other unwanted assets, reports said.

Morgan Stanley has also discussed having China Investment Corp. increase its investment in the firm, reports said. The sovereign wealth fund invested $5.6 billion in the firm last December and holds a 9.9% stake.

A deal with Wachovia would make Morgan Stanley the third investment bank to lose its independence in recent days. Lehman Brothers Holdings Inc. declared bankruptcy Monday before reaching a deal to sell its North American investment bank group to Barclays, while Merrill Lynch & Co. agreed to be bought by Bank of America Corp.

Moody's Investors Services yesterday released a report examining the potential changes to public finance ratings that could result from the turmoil, including the federal takeover of American International Group Inc.

The bankruptcy and subsequent downgrade of Lehman Brothers and its subsidiaries could impact the public finance market through Lehman's role as a counterparty in swaps, as a remarketing agent, and as the liquidity provider on tender-option bonds, Moody's said.

Moody's has already downgraded the Series 2008A Main Street Natural Gas Inc. gas project revenue bonds that Lehman served as a supplier and gas purchase agreement guarantor for. Moody's also downgraded 510 short-term ratings on tender-option bond series where a Lehman entity provided liquidity to speculative grade and 44 long-term ratings of tender-option bonds where Lehman provided credit enhancement to B3.

The rating agency said it will examine Lehman's role as a remarketing agent on variable-rate demand bonds, adding that the recent announcement about Barclays plans to buy Lehman's North American investment bank "may mitigate the risk of market disruption for transactions where Lehman is the remarketing agent."

Some issuers have already sought to replace Lehman as a remarketing agent, and Moody's said it will continue to watch these efforts and also those to supplement Lehman's position as a remarketer.

"We expect that payments to bondholders who tender their securities during this period would be paid either by the bank providing the dedicated liquidity facility or the by the issuer from its own resources, depending on the security provided for the tender feature," the report said

As a swap counterparty, Lehman could leave issuers with an unhedged position if the bank does not pay or if the swap is terminated and can't be replaced. Issuers may also have to pay a termination fee if the swap is out of the money, although this would likely only impact issuers with "limited liquidity and or inflexible cash flow," Moody's said.

If the issuer could find a counterparty for a swap similar to the one it paid to terminate, it would receive an offsetting payment roughly equal to the termination fee from the new counterparty.

"In most cases we do not expect these termination payments to be great enough to warrant a rating action due to the other credit and liquidity strengths of the issuers," the report said. "However, in some cases where liquidity or market access for the issuer may be limited, rating actions might be required."

For Bank of America, a recent downgrade should not have an impact on any public finance credits, Moody's said. It provides liquidity and credit support through its subsidiary Bank of America NA, which was not affected by the rating actions.

The potential upgrade of Merrill Lynch's senior debt has led Moody's to place six prepaid gas transactions it was involved in on review for possible upgrade. Moody's took no action on Merrill's short-term debt rating, thus no tender-option bond programs are affected.

Moody's said it continues to look at AIG's role in the housing sector, where the insurance company provided guaranteed investment contracts to many issuers. Moody's also downgraded a prepaid gas transaction AIG guaranteed a swap and GIC on.

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