By Binyamin Appelbaum
Washington Post Staff Writer
Saturday, October 4, 2008
Wells Fargo's deal for Wachovia could cost the federal government billions of dollars in lost revenue as the San Francisco company takes advantage of a new change in federal tax regulations designed to encourage bank mergers.
The change was made Tuesday by the Treasury Department, one day after Wachovia agreed to be rescued by Citigroup, and two days after Wells Fargo walked away from the table, leaving Citigroup as the only bidder.
With the change in place, Wells Fargo renewed its pursuit of Wachovia, and yesterday announced a surprise deal to buy the entire company for about $15.4 billion, topping Citigroup's $2.2 billion deal for most of it. Citigroup still could sue or make a counteroffer. The winner will become the largest bank in the Washington area.
In touting the deal, Wells Fargo executives said they did not need money from the Federal Deposit Insurance Corp., which had agreed to limit Citigroup's losses on a portfolio of Wachovia's most troubled loans.
"This agreement won't require even a penny from the FDIC," Wells Fargo chairman Richard Kovacevich said.
But experts in tax law said the Wells Fargo deal actually was likely to be more expensive for the government. Losses on Wachovia's portfolio of bad loans would have been absorbed by the FDIC, which is funded by the banking industry. Under the tax law change, those losses instead will allow Wells Fargo to reduce its taxable income.
"They said they're doing it without federal assistance, but in reality they are doing it with federal assistance. It's just tax assistance," said Robert Willens, an expert on tax accounting who runs a firm of the same name.
The amount of lost tax revenue would depend on the future profitability of Wells Fargo and the losses on Wachovia's loans, but based on Wells Fargo's financial disclosures, it could shelter $74 billion in profits from taxation.
The Treasury Department said the change in tax laws was not intended to benefit any particular company and had been under consideration for weeks. The change was announced with a handful of other measures designed to buttress the banking industry after the House of Representatives initially rejected the Treasury's bailout plan.
Wachovia said it had no involvement in the change. Wells Fargo declined to comment.
The Wells Fargo deal was greeted with joy by Wachovia shareholders, many of whom thought Citigroup had taken advantage of Wachovia's short-term financial problems to all but steal the company. Wachovia's stock rose 57 percent to $6.13 in trading yesterday. But that was still below the roughly $7 a share offered by Wells Fargo, reflecting continued uncertainty about which company will prevail.
Wachovia and Wells Fargo have signed a merger agreement and both boards have given their approval, although shareholders and regulators must still sign off. Of course, Wachovia's board also has approved a sale to Citigroup.
The New York company said it is reviewing its options. Citigroup and Wachovia signed an agreement to negotiate a final deal exclusively. The agreement, provided to The Washington Post by Citigroup, bars Wachovia from talking with other companies. And legal experts said that it appears to be unusually strong, giving Citigroup considerable legal leverage.
"Citigroup is now in a good bargaining position to go to Wachovia and Wells Fargo and say, 'You know something, clearly you breached this agreement,' " said Elizabeth Nowicki, a law professor at Tulane University and an expert on mergers and acquisitions.
Nowicki said Citigroup could simply demand a large payment or it could try to force Wachovia back to the negotiating table. Citigroup also could choose to raise its bid, perhaps taking advantage of the tax benefits now available to any bank that buys Wachovia.
Those tax advantages are the key to understanding the unusual events of the past week.
Wachovia was laid low by a series of bad deals in recent years, culminating in 2006 with the $25 billion acquisition of Golden West Financial, a major California mortgage lender. As the housing market and the economy weakened, Wachovia found itself holding hundreds of billions of dollars in troubled loans. By last weekend, federal regulators were increasingly concerned that the company might collapse, forcing the FDIC to cover its depositors.
Federal regulators thought Wells Fargo was ready to buy the bank, but the company walked away from the table Sunday afternoon, saying it could not afford to absorb the losses on Wachovia's loan portfolio.
That left Citigroup as the sole bidder. Government regulators negotiated with the company through the night before announcing a deal early Monday morning.
Citigroup agreed to buy Wachovia's banking business but not its retail brokerage or asset management business. In exchange, the FDIC promised to limit Citigroup's losses on a $312 billion portfolio of Wachovia's most troubled loans. The government agreed to absorb all losses beyond $42 billion in exchange for a $12 billion stake in Citigroup.
Wachovia and Citigroup immediately entered final talks on a merger agreement. And Citigroup began providing Wachovia with cash to stay in business.
Then, on Tuesday, Wachovia's troubled loan portfolio -- specifically its losses -- were transformed by the government from straw into gold.
Companies are allowed to shelter profits from taxation based on their past losses. When a profitable company buys a company with losses, however, the government historically has limited the profitable company's ability to shelter its income based on the acquired company's losses. In the case of Wells Fargo, the company could only have sheltered about $1 billion in income each year, said Willens, the accounting expert.
The Tuesday change, however, specifically removes limits on the income banks can shelter based on the losses of acquired companies. In announcing its deal for Wachovia, Wells Fargo estimates it would write down $74 billion in losses on Wachovia's loan portfolio.
Losses can be used to shelter income for as long as 20 years. So under the old law, Wells Fargo would have received a maximum benefit of $20 billion in tax protection, and only up to $1 billion each year. Now, the company could shelter from taxation its next $74 billion in profits.
The benefit is available to any bank. But right now, Wells Fargo is the rare bank with profits that might be taxed -- Citigroup, for example, is badly in the red -- because Wells Fargo has pursued an unusually cautious strategy since a 1998 merger made the bank one of the largest in the Western United States.
While Wells Fargo was one of the nation's largest mortgage lenders, and one of the largest subprime lenders, the company avoided the excesses of its rivals, dealing more cautiously with its customers. Wells Fargo also has little presence on Wall Street and largely avoided investments in mortgage-related securities that are damaging other banks.
Regulators were surprised by the Wells Fargo deal and initially issued statements expressing concern. But people familiar with the thinking of the regulators said they were reviewing the situation primarily to determine whether the government had any legal obligation to Citigroup, and that they were not inclined to intervene unless they were required to do so.
For the FDIC in particular, the deal could come as a welcome relief, ending its exposure to Citigroup's future losses. That is particularly important because the FDIC initially estimated Citigroup's losses were unlikely to exceed the $42 billion threshold. Wells Fargo's higher estimate of losses are likely to be imposed on Citigroup even if it prevailed, exposing the FDIC to billions of dollars in losses.
At the same time, the deal could complicate the FDIC's ability to deal with future bank failures by reducing the willingness of banks to bid for failed institutions.
Citigroup propped up Wachovia for a week and now may be left empty-handed.