Six days: behind the scenes in the Wells Fargo-Wachovia deal

On Sunday morning, Wells Fargo Chairman Richard Kovacevich reportedly met Wachovia Corp.’s CEO for breakfast to discuss acquiring the failing financial institution.

Cold feet had set in by dinner time, though, and in a 7 o’clock conference call Kovacevich informed Wachovia that Wells Fargo wasn’t comfortable taking on its bad loans without a couple of weeks to complete its due diligence. It walked.

Wachovia executives “fell to the floor” in disappointment. according to the Wall Street Journal’s fly-on-the-wall coverage of the meeting, The Feds stepped in and, by morning, brokered a government-supported deal by which Citigroup would buy Wachovia’s mortgage portfolio.

Flash-forward to this morning. The financial world woke to a surprising press release proclaiming that Wells Fargo intends to acquire Wachovia after all.

And the Citigroup deal?

Wachovia sees Wells Fargo as a better fit
Wachovia said it prefers the one with Wells Fargo because it better preserves the value of the company than Citigroup’s government assisted bid does. (Citigroup accuses Wachovia of breaching an exclusivity agreement and may sue to block the merger.)

Wells Fargo has about 20,000 employees in Minnesota and is the second-largest private employer in the state, according to the latest Business Journal rankings. The combined company will operate community banks in 39 states and the District of Columbia.

So what about Wells Fargo’s reversal? What changed between late Sunday and early Friday to make the Wachovia acquisition suddenly the right move?

One factor may have been price. According to the Wall Street Journal, a figure of about $20 billion was being discussed over the weekend. The deal announced Friday morning called for a $15 billion stock-only purchase.

MarketWatch speculated today that two other factors sweetened the deal. First was an Internal Revenue Service rule change announced Tuesday that temporarily lifts a limit on how much loss a bank can write off from its tax bill after purchasing a troubled bank. Second was Congress’ progress toward passing the Troubled Asset Relief Plan, commonly known as “the bailout.”

The IRS rule change added some gravy to the deal, said Mark Sellner, director of the University of Minnesota’s graduate studies program in taxation. Alone, it probably wasn’t enough to make the acquisition work, but it might have been enough to tip the scales if it was on the fence.

Rule changes made deal easier to pull off
When a company loses money for a given year, the government allows it to deduct that loss from taxes it paid on profits from either the previous two years or the next 20 years. When a company buys another company with losses on its books, the acquiring company is normally restricted in how quickly it can deduct those pre-acquisition losses from its tax statements.

The rules are there to prevent profitable companies from buying up unprofitable ones at the end of the year to avoid paying taxes, Sellner said. The IRS on Tuesday announced it is waiving those restrictions for banks that buy up other banks that are struggling with bad loan portfolios.

“What it means is when Wells Fargo is profitable, it can use Wachovia’s losses without limitations [to reduce its taxes.],” Sellner said. “It’s really accelerating a write-off that would have been available anyway. … It’s just not making [Wells Fargo] wait 20 years to recover the whole thing.”

By Thursday, unlike last weekend, it also looked likely that Congress would approve a financial bailout bill. Its passage today brings much-needed certainty to the market, and that makes it a less risky environment for bank acquisitions in general, said Karen Grandstrand, chair of the bank and finance group at Frederikson & Byron in Minneapolis.

“For any acquirer, having some certainty of the rules of the game is key,” Grandstrand said.

The bailout establishes a system whereby banks can apply to the Treasury Department to either sell bad mortgages to the government or purchase insurance for those investments instead. Those provisions will allow banks like Wachovia to get rid of their troubled assets and start making new loans again, she said.

One new risk for Wells Fargo that didn’t exist Sunday is the risk of a lawsuit or other intervention by Citigroup and/or the federal government. Grandstrand said Wells Fargo must have assessed the legal risks of stepping in at this point.

Citi issues a statement today demanding that Wachovia and Wells Fargo “terminate and not proceed with any proposed transaction.”

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Comments (1)

  1. Submitted by Craig Westover on 10/06/2008 - 02:10 pm.

    “The rules are there to prevent profitable companies from buying up unprofitable ones at the end of the year to avoid paying taxes, Sellner said. The IRS on Tuesday announced it is waiving those restrictions for banks that buy up other banks that are struggling with bad loan portfolios.”

    It never ceases to amaze that when the government wants to stimulate something positive, one of the first things it always does is exempt someone from a rule government previously imposed, ostensibly because the rule was absolutely necessary.

    Of course, by doing this, the government is once again artificially directing the flow of capital to the financial industry at the expense of other industries that still must abide by the regulation. That’s exactly how we got into this mess – government making housing loans more attractive than other uses of capital by artificially reducing risk and encouraging risky loans while removing regulations.

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