Wachovia: One Thompson Deal Too Many

The board referred to a series of setbacks, but paying $25 billion for Golden West Financial at the housing bubble's peak clearly led to the CEO's ouster

In his first five years as chief executive of First Union—later to become Wachovia (WB)—Ken Thompson was the antithesis of a big-bank CEO. While his predecessor, Ed Crutchfield Jr., famously said that during merger negotiations he "just kept stacking billion-dollar bills on the table" until the other party relented—a bet-the-bank approach that led to his ouster in 2000—Thompson was a master at carefully hedging his every bet.

Just a year into the job at First Union, Thompson deftly talked fellow North Carolina bank Wachovia into a "merger of equals." The deal gave Wachovia shareholders a scant 6% premium for their shares. (Thompson also took Wachovia's name for the combined bank, allowing him to bury the First Union brand, which had become tarnished by Crutchfield's disastrous dealmaking.) And in 2003, Thompson convinced Prudential Financial to enter a joint venture that pooled Prudential's 4,400 retail brokers with Wachovia's middling brokerage operations—without requiring Thompson to write a check. That gave Thompson a coast-to-coast network of 12,000 brokers to peddle Wachovia's mortgages, car loans, and other consumer-banking products as well as securities, for just the $400 million it would cost to close redundant branches and combine computer systems.

Under Thompson, Wachovia improved its customer service so much that it was the perennial top performer among banks in national surveys, such as those conducted by the University of Michigan. This attention to detail, coupled with his shrewd dealmaking, won Thompson many fans among Wall Street investors, who bid Wachovia shares up 40% by the time of the Prudential deal.

A Series of Missteps

But Thompson's reign ended abruptly on June 2, when Wachovia's board announced Thompson "had retired at the request of the board." It was just the first of two big blows for bank chiefs beset by mortgage woes: The same day, Washington Mutual (WM) said it was replacing Kerry Killinger as chairman. He remains CEO of the nation's largest savings and loan. Seattle-based WaMu said independent director Stephen Frank will take over July 1 as chairman. Killinger, 58, has been under mounting pressure over his bad bet on risky adjustable-rate mortgages. During the first quarter, WaMu lost more than $1.1 billion and set aside $3.5 billion to cover defaulted loans.

While the Wachovia board judiciously said Thompson's ouster wasn't due to any single event but rather to "a series of previous disappointments and setbacks," it was painfully clear Thompson's downfall stemmed from his one and only major deal: his $25 billion acquisition two years ago of Golden West Financial, a large mortgage lender that has been hammered by the housing busts in California and Florida.

In hindsight, it would be easy to ascribe Thompson's decision to buy a mortgage lender at the height of the housing bubble to executive hubris. But it may have been more that Thompson was battling the same problem that bedevils the rest of today's megabanks: The law of large numbers. Because by 2006, Thompson's many small deals—the Prudential venture, the acquisition of Alabama bank SouthTrust—weren't moving the needle in terms of profits. And it was about that time that Thompson began hunting bigger game: After taking a pass when FleetBoston Financial put itself on the block, Thompson flirted with MBNA before rival Bank of America (BAC) jumped in and walked away with the credit-card giant.

Golden West: A Problem from the Start

According to one Wachovia insider, Crutchfield's downfall came when "he stopped listening" to his other executives. Likewise, it's hard to believe Thompson didn't get resistance from his own management team about buying Golden West—and ignored it.

Because no one outside of Thompson and Golden West CEO Herb Sandler seemed to like the deal from the moment it was announced. Indeed, in the initial conference calls with analysts and investors after the deal, Thompson was on the defensive from the outset.

For Thompson, the Golden West purchase gave him the beachhead in California he had long desired. It also gave him an array of creative mortgage products to pump through his broker channel. But the ink was barely dry on the Golden West deal in late 2006 when the housing bubble in markets including California and Florida began to deflate. And by early this year, the mounting losses from Golden West, coupled with deteriorating credit quality in the rest of the bank's portfolio, began to hit Wachovia hard: The bank reported a $393 million loss in the first quarter and then amended the report in mid-May to say it really lost $708 million after a review of its portfolio of bank-owned life insurance. That forced the bank to cut its dividend by more than 40% and to sell $8 billion in new shares—a move that served to bolster Wachovia's equity but diluted the value of existing shareholders' stock.

And the amended report—which boosted the first-quarter losses by 80%—left shareholders convinced Thompson didn't have his arms around the problems and that more surprises lay ahead. "We continue to have a downward bias to our estimates and this move only heightens concerns about earnings and asset quality problems short-term," Deutsche Bank (DB) analyst Mike Mayo wrote in a June 2 note to clients.

Costly Deal

More surprises are likely in store for investors in coming quarters. Besides the temptation of the next CEO to take large write-offs to clear the decks for a recovery, it's clear the Golden West deal will haunt the bank for years to come. CNBC commentator Jim Cramer has estimated that Golden West could ultimately cost Wachovia $50 billion. Gary Townsend, a veteran bank analyst who is now a partner in Hill Townsend Capital, believes it could be half that, $25 billion—still, no small sum.

Townsend notes that Golden West is now sitting on deferred interest from its "negative amortization" mortgages—interest borrowers haven't paid, but that Wachovia has booked—which now stands at $3.5 billion, or three times the level at the time of the deal. What's more, the number of "Pick-a-Pay" mortgages—Golden West's signature product, which allows a borrower to pay just a portion of the full amount due each month—have risen fivefold in the past year, and now stand at 3.82% of Golden West's loans. That led to a 45% decline in Wachovia's stock value, to around $50 billion, and explains why shareholders wanted Thompson gone.

What happens next at Wachovia isn't clear. The board's decision to install director Lanty Smith as interim CEO indicates a lack of internal successors, and suggests that the next CEO will come from the outside. Some analysts are saying Wachovia could be vulnerable to a takeover. An acquisition of Wachovia would give Wells Fargo (WFC) the East Coast presence it has long coveted—but picking up Golden West would effectively mean doubling its exposure to the California real estate market. JPMorgan Chase (JPM) is another potential buyer, but only after it digests its takeover of Bear Stearns. Which means that Wachovia, the subject of takeover rumors when Thompson took over in 2000, has now come full circle. And for Thompson and the bank, the Golden West deal was a bridge too far.