Citi, Wells Fargo: Why the Wachovia Fight?

A few days ago Wachovia was near collapse, done in by the financial crisis. Now Citigroup and Wells Fargo are dueling over its takeover

Consolidation of the banking sector took a strange turn Oct. 3 when giant banks Citigroup (C) and Wells Fargo (WFC) began wrangling over the chance to take over Wachovia (WB), despite the fact that just a few days ago the troubled bank was near collapse.

Wells Fargo's offer of $15.1 billion in stock for all of Wachovia beats Citi's deal, announced Sept. 29, to buy parts of Wachovia for $2.2 billion in stock. Citi also relied on participation from the Federal Deposit Insurance Corp. to protect Citi from losses from Wachovia's troubled mortgage investments. But San Francisco-based Wells Fargo contends it doesn't need the government guarantee.

Citi strongly objected to Wells Fargo's one-upmanship. In a statement Oct. 3, Citi said the new merger deal was illegal, "in clear breach of an exclusivity agreement between Citi and Wachovia."

A Valuable Prize

The fierce competition over Wachovia is surprising given the bank's troubles: After seeing its stock fall 93% in the past year, the Charlotte (N.C.)-based bank looked ready to be seized by the FDIC a week ago. But despite Wachovia's problems, Wells Fargo and Citigroup both see an enormously valuable prize in the bank: its size. Many are betting that, when it comes to the future of the U.S. banking industry, bigger will be better. The financial crisis offers a "once in a lifetime" chance for the U.S.'s large banks to get truly huge, says Robert Ellis of the financial consulting firm Celent. "There's an opportunity to get big and get scale," he says.

During the crisis, federal regulators seem to be ignoring antitrust rules that had previously constricted the growth of national bank franchises such as Bank of America (BAC) and JPMorgan Chase (JPM). More important, Ellis says, the price is right: Banks with thousands of branches and billions of dollars in deposits are being forced into sales at rock-bottom prices.

In the past year, Bank of America has acquired mortgage giant Countrywide Financial and more recently brokerage Merrill Lynch (MER). JPMorgan has scooped up investment bank Bear Stearns and, on Sept. 25, Washington Mutual—with both sales essentially forced by the federal government after the firms looked to be near collapse.

Though Wachovia has had problems with exposure to bad mortgage debt and other troubled investments, it is one of the largest banks in the U.S., operating 3,300 branches in 21 states. Depositors had almost $450 billion in Wachovia accounts at the end of the second quarter.

"Cheap Deposits"

"Wachovia offers an opportunity to get a large amount of cheap deposits," says John Jay, a banking industry analyst at the Aite Group. In a time of crisis, when capital is scarce and expensive, those deposits are especially valuable. They offer relatively inexpensive funding for financial institutions dealing with large losses from bad investments.

It may be up to the courts whether Citi or Wells Fargo ultimately wins Wachovia. Several analysts, however, predicted Wells Fargo would be the victor.

"It's a better deal for Wachovia shareholders and a better deal for the FDIC, and therefore for taxpayers," says Matthew Warren, an equity analyst at Morningstar (MORN). Standard & Poor's equity analyst Stuart Plesser said he expects Citigroup may be able to "collect a fee for the breakup of the deal."

The potential collapse of the Citi-Wachovia merger robs Citi of a large opportunity. "This was a really good deal for Citi," Plesser says.

Trumping Citi?

Citi won't get the extra capital from Wachovia's deposits. Plus, Wells Fargo, and not Citi, will get the first chance to get big enough to challenge the larger BofA and JPMorgan Chase as national players.

With Washington Mutual already sold to JPMorgan, few very large institutions remain that would come at a cheap price. "There are not many more that will give you a national presence," Ellis says. Banks looking to get huge may need to make several smaller acquisitions of regional players to make up for one Wachovia deal.

Wells Fargo's ability to trump Citi is a sign of how differently the two banks have fared during the past year's credit crisis. Wells Fargo shares are down just 6.6% in the past year, while Citi's stock has dropped 62%, including an 18% plunge to 18.35 on Oct. 3. That reflects the far more significant damage to Citi's balance sheet from the credit crisis compared to Wells Fargo, which, through conservative lending and investment strategies, has avoided the worst of the mortgage-related woes. Wells Fargo shares dipped 1.7% to finish the week at 34.56.

Opportunities in Bad Times

In a Sept. 25 interview with BusinessWeek, before the Wachovia deal was announced, Wells Fargo Chief Executive Officer Dick Kovacevich said his bank still prefers smaller, conservative transactions. "We've always done more deals in the bad times than in good times and right now we have more opportunities than we've ever had," Kovacevich said. "We still prefer small to big deals and we prefer those deals in the geographies we're already in. We will only do deals that make sense, where we think the risk is manageable and where the downside is very, very low relative to the upside."

When it comes to banks, "the weak will get weaker and the strong will get stronger," Plesser says. "That's a trend that's playing out."

Citi says it will be fine without a Wachovia acquisition. "With or without this transaction, Citi maintains an unmatched, globally dominant franchise with strong liquidity, total deposits exceeding $800 billion, and a Tier 1 capital ratio of 8.7% as of the second quarter," Citi said in an Oct. 3 statement.

"Without the deal, [Citi] kind of lumbers along," Morningstar's Warren says. "They're in rebuilding mode." A new management team at Citi has focused on repairing the bank's troubled balance sheet, partly through sales of its many businesses around the world. Charlie Smith, chief investment officer at Fort Pitt Capital Group, which owns Citigroup stock, says Citi needs to continue this strategy rather than pursuing a major acquisition. "They need to get their own balance sheet in order," he says.

Who's Next?

After Wells Fargo, many are wondering if other big banks will pursue acquisitions. There's a shortage of big banks strong enough to make large acquisitions, Plesser says, but one possible acquirer that hasn't been active yet is U.S. Bancorp (USB). The nation's sixth-largest commercial bank, U.S. Bancorp, like Wells Fargo, has avoided the worst of the credit crisis and its shares have gained 5% in the past year.

Still, banks looking to bulk up might not want to wait too long. Until now, banks have been content to watch their troubled acquisition targets slip toward collapse or bankruptcy, and only then pounce with cheap buyout offers.

If the credit crisis continues to deepen, that strategy may continue to work. But if the credit situation stabilizes, analysts say, banks may prefer to remain independent rather than be sold at cheap prices.

With its hopes for a Wachovia acquisition fading, Citi may have to wait, rehabilitate its balance sheet, and then hope there are more good buyout opportunities still available. If not, even this global bank may start to feel small in a banking world dominated by a few huge players.

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