Maybe Wells Fargo Will Buy Citi and Wachovia

Will Wells Fargo (WFC) wind up owning both Wachovia (WB) and Citigroup (C)? That may be the outcome of a legal battle that threatens to cloud the futures of all three of the big banking companies.

On Friday, WFC announced that it has a signed deal to merge with WB, which was in the process of selling its banking business to C. Citigroup has an unsigned deal to buy WB's banking business for $2.16 billion and is threatening to take WFC and WB to court because, it says, they violated an exclusivity agreement it had with WB. That agreement, which expires Oct. 6, said WB couldn't talk to other potential buyers.

More than 100 comments by lawyers on wsj.com's Law Blog show there is no agreement that C can profit from its exclusivity agreement with WB, which expires Monday. And there is no agreement that WFC can come out of the mess solvent or that WB could have ignored its fiduciary responsibility to its shareholders to consider the WFC $15 billion offer.

At this point, WFC can pay C a few billion to get it to drop out of its deal with WB, enter a years-long legal battle that would have an uncertain outcome or buy C as well as WB, if that makes economic sense, and I'm nowhere sure it does. The beauty of a three-way deal is that Wells Fargo is seen as the strongest surviving big bank. Its reputation was enhanced Friday when Warren Buffett told CNBC that the only stock in his personal portfolio besides his Berkshire Hathaway (BRK.A) (BRK.B) is Wells Fargo. And he said he's been adding to Berkshire's WFC holdings this year. Indeed, you could speculate that he might even throw in a few billion to make a WFC take over of C as well as WB deal work.

Here's the kicker: Under the bail out bill signed Friday by President Bush, the surviving company would be too big for the government to let it fail, and it would be able to sell its "toxic" assets to the new Troubled Assets Relief Program, TARP, which was created by the Emergency Economic Stabilization Act of 2008 (H.R. 1424).

To make the bailout of Wells Fargo and its new acquisitions a bit more palatable to voters and Congress, the government could buy those assets for, say, 40 cents on the dollar with the proviso that once the housing market recovers and the true value of those toxic assets are known, Wells Fargo would buy them back for, say, 50 cents on the dollar. That is, Wells Fargo would take a 60% loss when it sold the assets to the government. And then after the value of the assets recovered to 50 cents it would buy them at 50 cents. This means it ultimately would take a 70% loss, which could be cut if the assets turned out to be, say, worth 80% of par. This, then, would give the government a 25% profit on its investment and agreement to bail out WFC, C and WB. Insert your own numbers.

Another way to do a deal would be for the government to agree to buy a few of WFC's toxic assets at a price that would establish a market for the rest of it's toxic assets. That price could be set at a level that leaves the government to make a profit on the deal while at the same time giving WFC a manageable loss that would allow it to maintain its credit ratings and long-term viability. The question is, would this be a better long-term deal for taxpayers, shareholders in the three companies, the companies' employees and their customers than some of the alternatives. Those alternatives include having the FDIC and Treasury talk WFC into backing out of its deal with WB, having C back out or having WFC pay off C in an out-of-court deal or after it loses a court battle with C.

I'm assuming all concerned want a quick resolution. Nobody can afford prolonged negotiations or court battles. The rule against shorting financial stocks expires Wednesday, I think, and some observers believe that a deal has to be made before then. On Friday, WB traded as if the market believes it will be sold to WFC. Markets change their opinions in a flash, as WB shareholders saw last Monday when the price of the stock plunged in a couple of hours to below $1 from slightly above $10 a share in response to the Citigroup deal. On Friday, C plunged in response to the WFC-WB deal.

It's tough out there. Daily charts for WFC, C and WB are here. Click on a chart to see hourly, weekly and point and figure charts. I don't own these stocks.

Disclosure: None

Comments

[Ishortyou]

Now that the 'bail out' plan came through, Wachovia needs fast to take advantage of it, it needs to sell its toxic loan portafolio from its banking subsidiaries around 122 billion if not more to the government close to even cost prices and take serious advantage of the tax break plan and remediate their banking book of business. They also need to contact their customers that did the run on the bank like chickens without head to bring their deposits back and reassure them that they are ok and there is not reason to panic because of the talking heads of FOX news and rest of media and the incompetence of the FDIC. This strategy will demonstrate to the public that the current 'bail out' plan is working and that Wachovia is the first product of it.

[pgvinter]

The issue with this argument is that the sale of the toxic assets at anything near real value would result in a minimum of a $20B hit up front. I am of the opinion that the TARP was established for the insolvent and not for the solvent. It is an alternative to disorderly bankruptcies and the buildup of a further glut for these toxic securities as bankruptcy courts would force asset sales into a frozen market. The most confusing thing about WFC's involvement here is that they are grossly overpaying for WB. Even a modest 20% loss on the option ARM portfolio translates into $25B, a 70% loss as described above would translate to over $85B, that is not a hit that WFC could take even temporarily. This says nothing about the credit card or second mortgage portfolios, construction loans or other credit losses lurking on WB's balance sheet. This also assumes that WFC can somehow continue to avoid credit loss on its own portfolio and continue to report a default rate of below 1% on its own mortgage portfolio which contains a significant amount of ALT-A and Jumbo Prime loans with stated income documentation and thin asset reserves documented by the borrowers. Many of these loans were 5year interest only ARMs originated in 2005 and 2006.