U.S. Banker  |  Tuesday, October 13, 2009

By Jeff Horwitz

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A year has passed since the teetering Wachovia Corp. called off an expected merger deal with Citigroup and opted instead to accept an offer from Wells Fargo. The broad events leading up to – and through – those decisive moments are well know to many in the industry, but the behind-the-scenes maneuvering of those fateful days remains mostly untold.

The story that follows reveals much about the interactions between executives and policymakers in those chaotic days. It is the product of a six-month investigative project undertaken by author Jeff Horwitz as part of his fellowship at Columbia University's Graduate School of Journalism.

Through interviews with attorneys, bankers and high-level government officials, Horwitz learned that regulators had rejected a Wachovia proposal to essentially "rescue" itself and that Wells Fargo initially balked at a deal with Wachovia prior to Citi's acquisition pact because Wells officials "didn't understand" Wachovia's commercial loan portfolio. He also relates the story of meetings held in the weeks before the Wells deal was struck in which Wachovia had held merger talks with Goldman Sachs at the suggestion of Treasury Secretary Henry Paulson, a former Goldman CEO. Paulson would later back away over concerns about conflicts of interest.

What emerges is a story of a group of key players making, and sometimes reversing, rapid-fire decisions at the height of last year's financial crisis to avert the total collapse of one of the nation's largest banks.

While the conclusion resolved the situation around Wachovia specifically and brought some important lessons, the questions it raised about policy around systemically important institutions are by no means settled. That debate continues to this day and will for quite some time.

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On Sunday, Sept. 14, as Lehman Bros.' last suitors backed away and Merrill Lynch scrambled to find a buyer, Wachovia's top executives mulled over a comparatively trivial matter: the scheduled appearance of its chief executive, Robert Steel, on CNBC's Mad Money the following day.

Steel understood the gravity of what was happening on Wall Street. Before taking Wachovia's top job in July, he had been Henry Paulson's deputy secretary at the Treasury Department, responsible for credit-market triage after the collapse of Bear Stearns. Earlier, he'd worked with Paulson as head of global equities at Goldman Sachs.

But as dangerous as the crisis was to the remaining investment banks, the situation looked less dire from Wachovia's headquarters in Charlotte. Though the bank was staring at billions of dollars of losses on troubled mortgage loans, its $448 billion of stable deposits buffered it from the panic in the credit markets that had felled Lehman and left the surviving investment banks gasping for liquidity. Ultimately, Steel and his deputies concluded that canceling the CNBC appearance might spook investors.

Shortly after 6 p.m. on Monday the 15th, Steel strode onto Mad Money's cartoonishly cluttered set and shook host Jim Cramer's hand. Introduced as someone "who knows how bad things are, but also knows how they can get better," Steel spoke quickly and with conviction about the crisis and Wachovia's own resilience. The interview was almost over when Cramer brought up Merrill Lynch, which had just struck a deal to sell itself to Bank of America.

"Is the goal here to get it so that your bank is ready to be sold to a foreign bank, to someone else?" Cramer asked.

Steel had joined Wachovia with the intention of restoring its status one of the nation's strongest regional banks, and he had immediately bought one million shares of Wachovia's stock as a show of faith in the bank and himself. He gently shook his head.

"Jim, we have a great future as an independent company," he said, before adding that he would do whatever was in the best interest of shareholders.

There was reason for his slight hedging. The tumult following Lehman's collapse left Wachovia in need of more capital at exactly the moment when jittery investors were least inclined to provide it. While Steel projected cautious optimism, in private, he was also exploring options that included selling a stake in the bank, divesting core assets, or merging with another institution.

Three weeks later, of course, Wachovia ended up in the arms of Wells Fargo & Co., in a deal that was one of the defining events of the financial crisis.

With regulators involved every step of the way, the deal very likely saved the deposit insurance fund from what would have been the largest and costliest bank failure in history. A year later, the Wachovia rescue is also, in some ways, shaping the debate over the future of too-big-to-fail institutions. Wachovia was the first institution formally deemed to pose a systemic risk to the financial system, and its treatment, led by Federal Deposit Insurance Corp. Chairman Sheila Bair, stands in stark contrast to later interventions led by the Treasury Department and the Federal Reserve.

The FDIC is seeking the authority to unwind the nonbank financial arms of the institutions whose deposits it insures, which would allow it to shutter complex institutions without the Fed's help. Meanwhile, many members of Congress have latched onto Bair's proposal for a systemic risk regulatory council, a structure that would cement the FDIC resolution authority that it used to determine Wachovia's fate.

Even before Lehman's failure, Wachovia was doing contingency planning. One of the more unlikely scenarios its legal team contemplated that summer was laid out in a memo outlining what a FDIC open-bank assisted transaction might look like – a surprisingly grim notion to contemplate. An open-bank assisted transaction, in which the FDIC essentially pays one bank to stop another's failure, runs contrary to the government's goal of insuring bank deposits while leaving banks themselves exposed to risk. All but banned by Congress in 1993, the procedure was to be used only in the event that a bank threatened to take the rest of the financial markets down with it. It required approval from two-thirds of the FDIC board, two-thirds of the Federal Reserve's governors, the secretary of the Treasury, and the President.

Even Wachovia general counsel Jane Sherburne, who had requested the memo as part of the bank's contingency planning, thought such a scenario was far-fetched. A former special counsel to the Clinton Administration with the dark humor requisite for managing Whitewater scandal control, Sherburne had earned a reputation for troubleshooting at her previous job as head of the legal team for Citibank's global consumer division.

With no precedents to cite, the resulting document was short. Believing that it would never become relevant, Wachovia's legal team referred to it as "the black box memo." Steel was hired on July 9, 2008 – the same day Wachovia revealed that it had lost $8 billion in a single quarter. Steel had replaced the ousted Ken Thompson, whose disastrous 2006 acquisition of Golden West Financial was at the root of Wachovia's problems. The 123-branch thrift held a $122 billion portfolio of variable payment, adjustable-rate mortgages in California, and as the housing market degenerated, its once-vaunted "pick-a-pay" loans were souring at a rapid rate. Much of the problem stemmed from Wachovia's own

activities: Under Thompson, Wachovia had ramped up its pick-a-pay production and lowered underwriting standards to compete for market share.

With the help of two key deputies, Sherburne and brokerage division head David Carroll, Steel spent his first three months on the job offloading risk, slashing the bank's troubled investment banking and mortgage divisions, and exploring capital-raising options. Its troubles were severe, but all indications had suggested that Wachovia was headed for a slow, albeit painful, recovery without any further dilution of its shares.

After Lehman went down, though, Steel began thinking more seriously about finding a buyer. Despite the troubled loans on its books, Wachovia seemed a source of potential stability to liquidity-strapped, Wall Street giants.

Citigroup, whose anemic domestic deposits of around $200 billion left it in only a slightly better funding position than a primary broker dealer, was the first to call about a potential merger. If Wachovia wanted to do a deal, CEO Vikram Pandit said, Citi wanted its retail deposit base. Steel was noncommittal.

Second came Morgan Stanley CEO John Mack, whose investment bank was widely believed to be the next to fail. The men set up talks late in the week.