Merrill Lynch is inching closer to a deal to relocate its headquarters to Midtown from Lower Manhattan. The investment bank, which has been headquartered downtown since its founding in 1914, has exchanged documents detailing a potential deal with Vornado Realty Trust to be the anchor tenant at a new office tower it plans to build across from Madison Square Garden.

Merrill Lynch is “trading paper with Vornado now” to relocate to a proposed 2.5 million-square-foot office tower at the site of the Hotel Pennsylvania, a real estate professional close to the negotiations said.

The news would be a blow to downtown, which would lose its second-largest employer after the city. Merrill Lynch boasts $36 billion in revenues and employs more than 9,000 highly paid workers. Its lease for 3 million square feet of space at the World Financial Center, where it occupies all of Tower 4 and a portion of Tower 2, expires in 2013.

While downtown advocates would be licking their wounds if the bank moved, the news couldn’t come at a better time for Vornado. The company, along with many other real estate investment trusts, has seen its stock butchered by turmoil in the credit markets. It closed at $103.37 yesterday, down from a high of $135.13 in February.

“It would be viewed as a very big positive for Vornado’s stock if they sign a lease with Merrill,” a portfolio manager at Urdang Securities Management, Dean Frankel, said. His company is a large Vornado shareholder, with more than 722,000 shares.

To nab Merrill Lynch as the anchor tenant for the Hotel Pennsylvania site would be a coup for the developer, which is working on an overhaul of the entire area. It has partnered with the Related Companies on a $14 billion plan to redevelop Pennsylvania Station and the Farley Post Office, and if the city agrees to a proposal to transfer development rights from the train station to nearby parcels, Vornado could end up owning more than 12 million square feet in the neighborhood. Already, it owns 5.6 million square feet, including nos. 1 and 2 Penn Plaza, and the Manhattan Mall.

A deal with Merrill “would not only create a lot of value for the building, but also for the entire Penn Station neighborhood,” Mr. Frankel said.

Vornado announced earlier this year plans to demolish the Hotel Pennsylvania in 2011. It would replace the building, which is not a landmark, with an office tower boasting six stories of trading floors and the possibility of an ownership stake for the a large tenant. With its stock in the doldrums, however, such a plan is unlikely to go ahead without a signed lease from an anchor tenant first.

In the meantime, the Hotel Pennsylvania, designed by McKim, Mead & White, is in operation. The hotel, which was the largest in the world when it opened in 1919, nets Vornado $30 million in gross profit annually.

“Vornado makes money from the hotel, but it would make a lot more money if it was an office tower,” a principal at the brokerage firm CRESA Partners, Robert Stella, said.

While Merrill does appear to be moving ahead with Vornado, there is no term sheet on the table. The investment bank also has six more years before its lease expires, and it is in ongoing discussions with Silverstein Properties about possibly relocating to one of the new towers at the World Trade Center site. Its current landlord at the World Financial Center, Brookfield Properties, is also working hard to keep its tenant, even proposing to build the bank a new 500,000-square-foot trading pavilion attached to Tower 2.

Calls to Jones Lang LaSalle, the brokerage firm representing Merrill Lynch, were not returned, and a spokesman for Vornado declined to comment. A spokeswoman for Merrill confirmed the bank was looking at several sites. “We are in the midst of evaluating our options, given that we have a lease expiration in 2013,” she said.