Reuters Friday, September 19, 2008; 10:31 AM

NEW YORK (Reuters) - Historic efforts by U.S. government agencies to halt the decline in financial industry stocks have given embattled investment bank Morgan Stanley (MS.N) critical breathing room to sort out its next move.

The No. 2 Wall Street firm this week is in merger talks with several banks, notably Wachovia Corp (WB.N), and approached China Investment Corp to raise its stake in the firm after its stock price fell 50 percent and some securities were trading as if the firm's default were certain.

Yet Morgan stock rebounded Thursday after the U.S. Securities and Exchange Commission restricted short sales and the Treasury Department proposed a fund that could buy distressed assets from lenders.

Morgan Stanley shares rose by 27 percent Friday morning. Credit protection costs on its debt fell 21 percent to $673,000 a year, according to CMA DataVision. Morgan officials could not be immediately reached for comment.

Merrill Lynch analyst Guy Moszkowski told clients that improving market conditions make a Wachovia deal "more probable," a day after he dismissed the deal as unlikely.

"Morgan Stanley shares have remained volatile, raising the urgency of the situation for Morgan and making it more attractive for Wachovia to do a deal," he wrote. "Also, Wachovia's share price has jumped, making it easier for such a transaction with Wachovia as buyer."

Though the mood in the markets has improved, Moszkowski observed that short-term debt markets remain challenging and that a number of prime broker clients were anxious about doing business with Morgan Stanley.

On the other hand, the Merrill analyst reiterated his concern that Wachovia could saddle Morgan Stanley with enormous credit risks.

All that said, Morgan Stanley Chief Executive John Mack's efforts to strike some deals may not come to fruition.

A senior China Investment Corp official this morning dampened speculation that the state's investment fund would invest more capital in Morgan Stanley. CIC's $5.6 billion investment in December lost nearly half its value at the close of trading Thursday.

Some analysts contended Morgan Stanley is strong enough to remain independent.

"We believe Morgan Stanley is sound as an ongoing entity. We see significant opportunities for Morgan Stanley to outperform over the next six to 12 months," Goldman Sachs analyst William Tanona said.

He predicted Morgan Stanley shares could double from Thursday's closing price, a record low valuation of 80 percent of the bank's reported book value.

"While liquidity and funding issues may have plagued some of its peers, we believe Morgan has ample liquidity, no immediate funding requirements and access to a number of alternative funding sources if necessary," Tanona wrote.

Tanona estimates Morgan Stanley can avoid tapping public debt market for about a year.

(Editing by Derek Caney)