This afternoon, Citigroup (NYSE: C) chose to walk away from its discussions to acquire Wachovia (NYSE: WB) but Citi will revive its $60 billion lawsuit against Wells Fargo (NYSE: WFC). Meanwhile, with its $122 billion portfolio of toxic option ARM mortgages -- which add gaps in borrowers' monthly payments to the loan principal -- Wachovia may be too radioactive for Wells Fargo to buy.
How did we get here? On September 29th, Citi thought it had a deal to buy Wachovia's banking operations for $2.2 billion -- Citi would absorb the first $42 billion in losses and stick the FDIC with the rest. In exchange, the FDIC would get $12 billion worth of Citi preferred stock. Last Thursday, Wells Fargo announced a deal to buy all of Wachovia for $15 billion without costing the FDIC anything. Citi sued, the FDIC encouraged the three parties to split the baby, and this afternoon Citi decided to withdraw.
But now that the field is open for Wells Fargo, should it continue with the deal or has it learned that Wachovia's bad assets will make the deal too costly? Although Wachovia would give Wells $448 billion in deposits in 3,300 branches in 21 states, it also has $122 billion worth of option ARM mortgages. These mortgages are likely to default in huge numbers over the next few years. That's because the average option ARM holder will see a 63% rise in monthly payments -- for an additional $1,053 per month. With the economy likely to deteriorate, that could burn a big hole in Wells' $48 billion in capital.
Although most people seem to think this is now a done deal -- and Wachovia's stock is up 10.6% after-hours -- the potential cost of those Wachovia mortgages should convince Wells to just walk away.
Update. Not surprisingly, it looks like the deal is going ahead. And in pre-market, Wachovia stock is now up 28%. Interestingly, Wells could save $25 billion in taxes due to an IRS ruling that lets it use losses from Wachovia's bad loans to offset taxable income for 20 years into the future. It remains to be seen whether this will be enough to offset the risk of those loans and the cost of settling Citi's $60 billion lawsuit.
Peter Cohan is President of Peter S. Cohan & Associates. He also teaches management at Babson College and edits The Cohan Letter. He owns Citigroup and Wells Fargo stock and has no financial interest in the other securities mentioned.
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Reader Comments (Page 1 of 1)
10-09-2008 @ 8:01PM
TERRENCE said...
WELLS FARGO COULD LESSEN THEIR DOWN SIDE GREATLY BY JUST OFFERING THE BORROWERS WITH THESE FLEX LOANS A LOAN MODIFICATION. THEY COULD ROLL THESE LOANS INTO A FIXED RATE MORTGAGE AT CURRENT FNMA OR FREDDIE MAC RATES, AND THEN SELL OFF THESE LOANS TO FNMA OR FREDDIE. THIS GIVES FNMA AND FREDDIE A LARGE NUMBER OF PERFORMING FIXED RATE LOANS AND IT REMOVES THE LOANS FROM WELLS FARGO'S PORTFOLIO. BY SELLING THESE LOANS SERVICING RETAINED, WELLS FARGO INCREASES ITS SERVICING INCOME WHILE LOWERING ITS MORTGAGE LOAN RISKS, AND THEY ALSO GET WHAT THEY ARE SEEKING, THE WACHOVIA DEPOSITS AND LOCATIONS.
EVERYONE WINS EXCEPT WACHOVIA SHAREHOLDERS, BUT IT IS A BETTER DEAL FOR THEM WITH WELLS FARGO THAN THAT OFFERED BY CITIBANK.
10-09-2008 @ 9:57PM
John said...
Not mentioned are the tax implications to Wells or the cost of settling the litigation with Citi? Each affects the parameters of the deal and if it should be continued. As a member of the Charlotte community I can tell you that sentiment is on a slow boil here. A clear definition is essential to getting Wachovians acceptance. this community is bracing for the loss of one of our biggest corporate contributors. The effects of this takeover will impact everything from real estate, the economy all the way to the culture. This is not a pleasant reality.
10-10-2008 @ 1:35AM
JP said...
The hole isn't actually burned, it's efficient use of tax dollars they were giving to the government anyway. WFC is gaining a huge wealth of deposits, which is the fundamental building block of lending creation. With the tax write-offs, WFC gets to write off the cost they bear to attain it.
$15 billion for $448 billion in deposits, a 3300 branch franchise, and a tax incentive to reverse a non-performing portfolio into a peforming mortgage portfolio by writing off each option ARM loan modification in taxes?
Sounds like the deal will begin performing and reflecting in earnings in about a year after the merger is complete. I wouldn't buy WFC tomorrow with this government talk of buying bank stakes, although WFC does demonstrate again how they've survived crisis after crisis for 150 years.
10-10-2008 @ 1:46AM
2cents said...
And Mr. and Mrs. Sandler are sitting back at home after selling their "devious" mortgage loan products at World Savings & Mortgage, to Wachovia. Thinking that they timed it just right. They should be in jail.
10-26-2008 @ 11:18PM
Robert Chapin said...
"The average option ARM holder will see a 63% rise in monthly payments"
Peter, the ARM holder is usually the bank. Are you saying Wachovia is expecting a 63% revenue increase? Or did you mean to say 'ARM writer'?
10-10-2008 @ 3:13PM
francas salliono said...
You might have it wrong??? it isn't the assets or the paper , it control. Can You not see hwat is going on in the World,, NWO , 1 bank thats why the U.S. China, Italy Japan France England and more have been in condference rlating to the World Market every 1 is being hurt by this played so well senario , so that the Winner's get the Spoils and it is on an international level.
10-10-2008 @ 6:30PM
Bob said...
Wachovia deserves to fail.Its deceptive comments and backdoor dealing left many investors for dead with Citi.Now its deal with WF comes a little late for many of us.I think WF is biting off a little more than it can chew here.