Wachovia: Just the Plum Citigroup Needed

Citi fills a key void with its dirt-cheap buy of the retail banking franchise. Wachovia, meanwhile, can point to poor judgment in acquisitions

During the mid-1990s, Wachovia's merger-mad chief executive, Ed Crutchfield, once famously joked that the key to persuading another bank to sell to him was to simply stack "$1 billion bills" on the table until the target relented. Now, though, it's Wachovia (WB) that is being taken over, and its buyer, Citigroup (C), got Wachovia's core banking franchise for a mere buck a share, as the Federal Deposit Insurance Corp. gave Citi the rights to Wachovia's banking operations just for agreeing to assume a portion of any losses from its loan portfolio.

For Citigroup, the acquisition should go a long way toward giving CEO Vikram Pandit the retail banking franchise that has always been the one void in the Citi empire. And with that retail network comes more than $400 billion in deposits—a cheap, stable source of funding that provides a solid foundation at a time when many other funding sources are drying up overnight. And as part of the deal, Citi agreed to absorb $42 billion in prospective losses from Wachovia's $312 billion loan portfolio. The remaining $270 billion exposure, however, is being handed off to U.S. taxpayers in exchange for $12 billion in Citi preferred stock and warrants. But that's a deal Washington regulators and policymakers were willing to take. In a statement announcing the Wachovia deal, Treasury Secretary Henry Paulson noted that a "failure of Wachovia would have posed a systemic risk" to the financial system.

Some Bad Buys

For Wachovia, the fire sale to Citi is a sad ending for a company that had in a little more than two decades grown out of the tobacco fields and textile mills of North Carolina to become the nation's fifth-largest bank. But if either of the two big Charlotte banks—crosstown rival Bank of America (BAC) being the other—were to suffer this fate, it was certain to be Wachovia. As Wachovia grew larger, it had—unlike BofA—shown increasingly poor judgment in its acquisitions. The bank survived a near-death experience in the late 1990s after its acquisitions of CoreStates Financial and the Money Store left the bank nursing hefty losses and vulnerable to takeover.

Its fate was sealed when its May 2006 buyout of Golden West Financial—an impetuous deal that Crutchfield's successor, Ken Thompson, negotiated over a single weekend—proved to be an unmitigated disaster. Despite Golden West's vaunted reputation as one of the savviest risk managers in the mortgage industry, Wachovia was facing more than $30 billion in losses from Golden West's option ARM portfolio—and billions more from its own mistakes in commercial lending and investments. While many analysts have argued that Golden West became too sloppy in its underwriting, the truth is that it was some of the thrift's risk safeguards that inadvertently steered the California thrift into riskier areas. Case in point: Golden West management had imposed a $300,000 ceiling on the size of mortgages it would originate—a measure that was intended to limit its potential losses on any single borrower. But as housing prices in its two biggest markets—California and Florida—soared, that artificial ceiling had the effect of locking Golden West's loan officers out of many expensive—but stable—markets such as San Francisco and San Diego. To compensate, Golden West forged further into newer, and less stable, exurban markets like the Inland Empire region east of Los Angeles, an area now pocked with vacant, foreclosed homes.

Wachovia's fate as a takeover target was obvious after its board ousted Thompson this past June and replaced him with Robert Steel, a former Golden Sachs (GS) partner whose experience was not in consumer or commercial lending but in handling mergers as an investment banker. But Steel clearly didn't think it would come to this: As recently as Sept. 15, in an appearance on CNBC's Mad Money program, Steel delivered what appeared to be a convincing argument as to why Wachovia could weather the storm. Steel noted that, unlike the many banks that had originated or were now holding mortgages that had been bundled into bond-like securities, Wachovia was still holding the vast bulk of the $122 billion in option ARM mortgages that its Golden West subsidiary had made.

Playing for Time

So while many other banks had only two equally bad options with the mortgage-backed securities they held—sell at a loss, or mark down their value to the same low prices that similar bonds were fetching on Wall Street—Wachovia had the luxury of restructuring each of its loans in ways that would both enable the borrower to repay and give Wachovia a higher return on the loan. "We have lots of flexibility to figure out how to do this," Steel said. "We have lots of choices. So, basically, we're going to spend a lot of time."

But Steel didn't have time. While Wachovia management had argued that this flexibility could help it hold its losses to roughly 12% of Golden West's portfolio, Wall Street—and, more importantly, regulators—were increasingly convinced that the losses would be much higher: Shortly after JPMorgan Chase (JPM) took over Washington Mutual (WM), disclosures in regulatory filings led Wall Street analysts to assume that JPMorgan management was expecting that WaMu's portfolio of option ARMs would incur another 20% in losses beyond those that WaMu management had already recorded. Similarly, JPMorgan's filings convinced Wall Street analysts that the bank was expecting the loss rate on WaMu's home equity loans to top 30%. If those revised assumptions were extended to Wachovia, that meant that Steel & Co. could likely face another $15 billion in losses from the option ARMs alone—losses that would blow a huge hole in Wachovia's already depleted capital base.

That disclosure triggered a 31% plunge in Wachovia's stock on Sept. 26, to 9.45 a share, setting the stage for another one of the loss-of-confidence bank meltdowns that have become too common in recent weeks. And it convinced Steel to agree to a government-assisted buyout over the weekend.

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