By Suzanne Kapner
Last updated: September 28 2010 18:34
It was a deal that almost did not happen. And yet, the tale of how Wells Fargo snapped up failing Wachovia from under Citigroup’s nose at the height of the financial crisis is likely to be regarded as one of the savviest negotiating moves of all time.
For Wells Fargo, which had grown from a small California lender into a regional powerhouse through dozens of acquisitions, it was the deal of a lifetime. The move would transform Wells Fargo from the fourth-largest US retail bank into the second largest, trailing only Bank of America – according to SNL Financial, the deal allowed the bank to double its branch network and nearly triple deposits.
But it was also a huge gamble on the US economy, which is now seeing considerable deleveraging by consumers, low interest rates and new regulations eat into bank profits.
In rushing to Wachovia’s rescue as it teetered on the verge of collapse, Wells Fargo was also making a bet that it could correctly estimate future losses on hard-to-value residential and commercial real estate loans that were going bad at a record pace. Scott Siefers, a Sandler O’Neill analyst, says: “The concern was that Wachovia would turn out to be a bottomless pit of losses”.
Post-crisis bank mergers
Timeline: Our interactive graphic charts the share prices of the two banks before the merger and the combined bank after. Click on: http://www.ft.com/cms/s/0/5e969dc0-c01f-11df-b77d-00144feab49a.html
These all appeared risks worth taking in September 2008, when, at the height of the financial crisis, the US government was desperately trying to prevent another bank failure just weeks after Lehman Brothers filed for bankruptcy protection.
Wachovia, after reporting a $9bn second-quarter loss on risky residential and commercial real estate loans, was near collapse. After a tense weekend of negotiations, the government had lined up a sale to Citigroup, which agreed to pay $2.16bn in stock and assume $53bn in debt to acquire Wachovia’s retail bank. The asset management, retail brokerage and wealth management divisions would remain in a separate company.
But the deal had a catch: to protect it against $312bn of bad mortgage loans on Wachovia’s books, Citigroup agreed to assume the first $42bn in losses, but demanded that the Federal Deposit Insurance Corporation absorb the rest.
As Citigroup negotiated the final details of its offer, Wells Fargo put together a competing bid that valued Wachovia at $15bn – with Wells Fargo taking on all of Wachovia’s outstanding debt. More importantly, Wells Fargo’s offer required no government assistance.
Wachovia’s board approved the proposal on October 2 and the two lenders jointly announced the acquisition the following day. Although Wells Fargo’s offer was substantially higher than Citigroup’s, it was still a third less than the likely pre-crisis asking price.
Richard Kovacevich, Wells Fargo’s chairman and architect of the deal, says the acquisition – involving 280,000 employees and 70m customers – will allow Wells Fargo to emerge from the financial carnage of the past few years as a much stronger bank. “We duplicated east of the Mississippi what we had to the west,” he says.
To make the combination really pay off, though, Wells Fargo – named for the six-horse stagecoach service that once thundered across the Wild West – will need to sell more of its accounts, mortgage and brokerage products to Wachovia customers and vice versa.
Wells Fargo hopes the practice, known as “cross-selling,” will allow it to increase revenue by 10 per cent a year, well above the industry average and the US economy as a whole.
Howard Atkins, its chief financial officer, says “The big strategic challenge of this acquisition is to take the products and skills of one bank and apply them to the customers of the other bank”.
Such cross-pollination has been the holy grail of banking for years, but analysts say Wells Fargo has been more successful at it than its peers.
Mr Siefers says:“Wells Fargo built the infrastructure to do this a decade before it was cool. They are the only bank of size to have done this effectively.”
At an investor day in May, Wells Fargo executives used the phrase “cross sell” 108 times, according to Jason Goldberg of Barclays. “It’s clearly something they are focused on,” he says.
That may be true, but so far success has been elusive. For the first six months of this year, Wells Fargo’s net income fell 10 per cent to $5.6bn year on year, while revenue slipped 2 per cent to $43bn.
Wells Fargo is by no means the only bank facing the industry headwinds of shrinking income from loans and deposits and analysts are striking a cautiously optimistic tone. “The acquisition appears to be getting off to a good start, but the jury is still out,” Mr Goldberg says.
Helping to ease the transition, Wells Fargo, which is based in San Francisco, but operates through a decentralised structure with offices around the country, did not force Wachovia executives, mainly based in Charlotte, North Carolina, to relocate.
Patricia Callahan, who is leading the transition, says Wells Fargo has another year and a half before all accounts and retail branches are converted, but adds that the bank is already on track to realise $5bn in annual cost savings from the deal.
Meanwhile, concern that Wachovia would turn out to be a black hole of bad loans appears unfounded. When the deal closed in December 2008, Wells Fargo wrote down $40bn of Wachovia’s residential mortgage and commercial real estate loans. To date, those loans have incurred $20bn in losses, “lower than we originally estimated”, Mr Atkins, the CFO, says.
Yet, Wells Fargo is still not in the clear. Fannie Mae and Freddie Mac, the government-owned mortgage finance companies, are demanding that banks repurchase loans that may not have adhered to proscribed underwriting guidelines.
Wells Fargo has set aside $1.4bn in reserves to meet those demands, but analysts worry that the final tally will be far higher. “There is a certain lack of transparency around what they may ultimately owe,” Mr Siefers says.
Mr Atkins says Wells Fargo has less exposure than other large banks because its underwriting standards tended to be higher. For instance, the loss rate in Wells Fargo’s mortgage portfolio is running at 8 per cent, compared with an industry average of 11 per cent, he says. Moreover, many of the troubled loans inherited from Wachovia were not sold into the secondary market, which makes them ineligible for repurchase.
Still, some observers remain unconvinced. “I’d much rather have the Wells Fargo franchise prior to Wachovia,” says Christopher Whalen of Institutional Risk Analytics, a financial advisory firm. Mr Whalen worries that the acquisition of Wachovia dragged Wells Fargo into high-cost eastern markets at a time when it is getting more expensive to acquire new customers.
Only time will tell if Wells Fargo’s acquisition of Wachovia will pay off. Either way, the bank, which has survived many financial meltdowns since it was founded in 1852 at the height of the San Francisco gold rush – and which now boasts 6,500 branches in 40 states – looks poised to emerge from this crisis as one of the winners.
Copyright The Financial Times Limited 2010.
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