Wachovia Buy Closes Retail Gap Versus Top U.S. Rivals

Citigroup Inc.'s deal to buy Wachovia Corp.'s banking operation with federal aid catapults the New York money-center company into the Big Three of retail branch banking and, perhaps more important, gives its balance sheet the ringing endorsement of regulators as the punishing credit crisis deepens.

"In business, there are many high-return opportunities. Many of the high-return opportunities also come with high risk. There are very few that are high-return with contained or manageable risk. This is one of those very few," Vikram Pandit, Citi's chief executive officer, said on a conference call with analysts Monday. And despite agreeing to absorb billions of dollars of Wachovia's souring mortgage-related debt, analysts said Citi also won a race against time.

As the financial sector reels amid slumping housing markets and steep losses, observers are forecasting a wave of consolidation in banking, with the most coveted retail branch networks being gobbled up first by the largest and strongest. What's more, the very biggest — Citi's rivals — are quickly making moves to get even bigger, forcing Citi to act fast to keep pace.

Last week JPMorgan Chase & Co. struck a deal to buy Washington Mutual's banking business, and Bank of America Corp., already a giant in retail banking, complemented its current operations this month with a shotgun marriage to the investment bank Merrill Lynch & Co. Inc.

The Wachovia deal gives Citi, which bills itself as a global company, a sprawling retail banking operation with a strong presence in the Southeast and West. About 31% of Wachovia's branches are in Citi's markets, according to the companies.

The deal also gives Citi, which has struggled with its own capital problems in the face of bad bets on mortgage-backed securities, access to nearly $400 billion in Wachovia customer deposits, tripling Citi's retail deposits and helping it minimize the need for capital injections from outside investors.

"We have a deposit base that is truly unassailable," Gary Crittenden, Citi's chief financial officer, said on the call.

After the purchase, which is expected to close this year, Citi would have more than 4,300 U.S. branches and more than $600 billion in U.S. deposits, giving it about a 10% market share and making it a close third behind B of A and JPMorgan Chase, respectively.

The deal was put together hastily but carefully over the weekend, Mr. Pandit said, as about 200 Citi bankers pored over Wachovia's books to assess the scope of risk in a loan portfolio tainted by a big pile of option adjustable-rate mortgages tied to Wachovia's 2006 purchase of Golden West Financial Corp.

Citi, with the backing of regulators, ultimately agreed to buy Wachovia's banking operation and most of its assets for $2.1 billion of stock and the assumption of $53 billion of Wachovia debt. The Federal Deposit Insurance Corp. agreed to absorb a share of future losses, should Wachovia's mortgage portfolio deteriorate further, as Citi bankers expect it to.

Citi identified a pool of $312 billion of loans deemed at high risk of default. The arrangement with the FDIC calls for Citi to absorb $42 billion of losses but for the FDIC to cover anything beyond that. In exchange, Citi granted the FDIC $12 billion in preferred stock and warrants.

Wells Fargo & Co. in San Francisco also took a close look at Wachovia and was reportedly in advanced talks with the Charlotte company Sunday but ultimately balked at taking on Wachovia's risky debt. A Wells spokeswoman declined to comment Monday. (See related story.)

Wachovia lost $8.7 billion in the second quarter.

Mr. Pandit said the deal will be at least 10% accretive to Citi by the second year and that Wachovia's deposits will immediately strengthen its balance sheet. "The economics are exceptional," he said, and "the risk is capped."

Wall Street cheered the deal, and Citi's shares initially rose 5% Monday morning before the market was dragged down by the House defeat of the federal financial bailout plan. (See related story.)

The favorable view of Citi emerged despite a warning from Mr. Crittenden that it probably will report at least a $2.5 billion loss when it reports third-quarter results Oct. 16.

"The very clear upside is that Citi goes from subscale in branches to No. 3 — they are among the leaders," Jeffery Harte, an analyst at Sandler O'Neill & Partners LP, said in an interview Monday. "And the FDIC would not have brokered this sale into the hands of someone it viewed as weak, so you'd have to say this is a vote of confidence in Citigroup's balance sheet."

Bart Narter, an analyst and senior vice president of the banking group at Marsh & McLennan Cos.' Celent consulting firm, said in an interview Monday that, with the risk shared by the FDIC, Citi "could just have gotten a huge bargain."

Citi will not buy Wachovia's A.G. Edwards brokerage division or its Evergreen asset management unit. Mr. Pandit said Citi's brokerage arm already is sufficiently strong and that his company was not interested in an asset management division. The A.G. Edwards and Evergreen units will stay under the Wachovia name, and Wachovia will continue to trade as a public company, albeit a much smaller and different one.

The FDIC, in a press release Monday, emphasized that Wachovia did not fail but said a sale was necessary. Agency officials met Sunday with Citi executives and Wachovia CEO Robert Steel in New York. The FDIC brokered the deal and agreed to help Citi shoulder risk "under extraordinary circumstances," FDIC Chairman Sheila C. Bair said. "This action was necessary to maintain confidence in the banking industry, given current financial market conditions."

Citi said it will have to raise $10 billion in common equity and halve its dividend to maintain a strong capital position, including a Tier 1 capital ratio above 8%.

But Mr. Pandit said the deal should prove a major positive for Citi's branch network and its long-term profitability.

"It is my belief this will turn out to be one of those rare high-return" deals, he said.

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