(Repeats to wider audience, with no changes to text)
* Paulson considers entity to deal with bad debt
* US govt, Congress to work this weekend on toxic debt plan
* Asian share markets rally
* Morgan Stanley, Wachovia in more formal talks - sources (For complete coverage, click [ID:nN13574113])
By Tony Munroe
HONG KONG, Sept 19 (Reuters) - A radical U.S. taxpayer-funded plan to restore confidence in battered financial markets by mopping up toxic mortgage-related debt triggered a rally in stocks, but raised questions over how long it would take and how it would work.
Morgan Stanley (MS.N), keeping options open after the independent investment banking model came under attack this week, held merger talks with Wachovia Corp WB.N and other banks, and discussed a possible increase in the stake held by China's sovereign wealth fund, sources familiar with the plans said.
HSBC Holdings (HSBA.L) (0005.HK), meanwhile, walked away on Friday from a $6.3 billion deal for a controlling stake in Korea Exchange Bank 004940.KS after months of regulatory delays and the plunge in financial stocks, fuelling speculation the UK lender may be gearing up to buy an embattled rival in the West.
Thursday's move by Washington and London's crackdown on short-selling of bank stocks had immediate and dramatic effect.
Asian shares rallied on Friday after U.S. stocks clocked their biggest percentage gain in six years, powering a rally in the dollar and pushing oil prices higher. The gold price slipped.
U.S. Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke plan to work through the weekend with Congress on a plan to deal with toxic bank assets choking the financial system. They met with Congressional leaders on Thursday night but did not talk directly about a fund afterwards.
"This is a more substantial and systemic solution than the ad hoc interventions we have seen in recent days, so it's justifiable for the markets to rally," said Dariusz Kowalczyk, chief investment strategist at CFC Seymour in Hong Kong.
"It's difficult to say how long the rally will last, but hopefully we are turning the corner," he said.
Shares in Asia picked up where U.S. markets left off, with the MSCI index of regional shares excluding Japan .MIAPJ0000PUS up 5.7 percent and Tokyo stocks .N225 gaining 3.3 percent. The Shanghai index .SSCE roared 9.5 percent higher after the Chinese government stepped in with a reform package to halt a 69 percent slide from last October's record high.
Details of the U.S. plan were scant.
"We have had umpteen measures to try to help the mortgage market and none of them have come to fruition," said Sean Darby, chief Asia strategist with Nomura in Hong Kong.
"I don't know how much more the U.S. government can do."
China Investment Corp, the sovereign wealth fund that is Morgan Stanley's (MS.N) largest shareholder with a 9.9 percent stake it bought for $5 billion in December, was in talks that could see its stake climb to as much as 49 percent, sources familiar with the matter said.
Beijing is wary of adding to its Morgan Stanley holding given that its existing holding is carried at a steep loss. Also, an unidentified CIC official said an increase in the stake would face U.S. political obstacles.
"Even if the CIC intended to buy a stake, it could be very hard now as the purchase of a stake, even one smaller than 10 percent, could be subject to the U.S. government foreign investment review," the official told the Xinhua news agency.
Morgan Stanley's discussions with Wachovia began Wednesday night with a proposal from Wachovia CEO Robert Steel to Morgan Stanley CEO John Mack and have since reached a more formal stage.
A U.S. fund would be similar to the Resolution Trust Corp, which was set up to clean up bad debts from the savings and loan crisis in the late 1980s at a $400 billion cost to taxpayers.
"We talked about a comprehensive approach that will require legislation to deal with illiquid assets on financial institutions' balance sheets," Paulson told reporters.
According to two Congressional aides, he has been shopping around a plan to create the fund.
Rep. Barney Frank, who is chairman of the House Financial Services Committee, said there is concern that establishing a formal entity to buy the assets would take too long.
"I think it will start to provide a floor to asset values and allow institutions to work through this in a systematic manner. They won't have to rush into the arms of suitors to avoid collapsing," said Haag Sherman, co-founder and managing director of Salient Partners in Houston.
Britain's Financial Services Authority imposed a four-month ban on short selling of financial stocks, and a source briefed on the matter said the U.S. Securities and Exchange Commission is weighing a temporary ban on short sales of some, or all, stocks.
"We are likely to take additional steps in the days ahead that are more particularly addressed to this urgent situation," SEC Chairman Christopher Cox told reporters.
In addition, New York's Attorney General Andrew Cuomo began a wide-ranging probe into possible illegal short-selling in the stocks of Wall Street firms such as Morgan Stanley and rival Goldman Sachs Group Inc (GS.N).
At one stage on Thursday, Morgan Stanley's stock dropped as much as 42 percent and Goldman as much as 25 percent, adding to several days of huge declines that have wiped out tens of billions of dollars of market value. However, after news of the moves by authorities in the United States and the UK, they recovered, and were both trading higher in after-hours trade.
Investors have been questioning whether the investment banking model is doomed after the failure earlier this week of one rival, Lehman Brothers Holdings Inc LEHMQ.PK LEH.N, and the proposed sale of another, Merrill Lynch MER.N.
There has even been speculation that Goldman, the most powerful investment bank and once seen as untouchable, may have to seek a partner, possibly by buying a retail bank. (Additional reporting by Kevin Plumberg; Editing by Jean Yoon)