Wachovia Runs Out of Ground

This post first appeared on Minyanville.

Saddled with mounting losses in its huge mortgage portfolio, Wachovia (WB) has become the latest bank to lose its independence.

Rumors swirled over the weekend: The company was said to be in advanced talks with both Wells Fargo (WFC) and Citigroup (C) about a potential merger. Formerly the nation's sixth-largest bank, Charlotte-based Wachovia would have provided either suitor a retail stronghold in its native southeast. For Wells Fargo in particular, this would have nicely complemented their strong presence on the West Coast.

In the end, Citigroup managed to close the deal, with a little help from its friends at the FDIC.

Citi will pick up the majority of Wachovia’s operations, as well as the bulk of its assets and liabilities. With respect to its $312 billion mortgage portfolio, the Wall Street Journal reports, Citi will assume the first $42 billion in losses and the FDIC will be on the hook for the rest. In return, the FDIC will receive $12 billion in preferred stock and warrants.

Notably, Wachovia didn’t fail, as Washington Mutual did just last week. Citigroup will be assuming the company’s senior and subordinated debt, which is good news for the credit default swap market. After the collapses of Lehman Brothers and WaMu triggered billions in insurance obligations, the giant unregulated market is struggling to sort out the chaos of tangled contracts.

The transaction’s sticking point was Wachovia’s massive portfolio of Option Adjustable Rate Mortgages, or Option ARMs. After its ill-fated purchase of California thrift Golden West at the peak of the housing market in 2006, Wachovia has seen falling home prices and rising delinquencies chew through its balance sheet.

Golden West was one of the biggest issuers of Option ARMs in California during the housing boom. These loans were used to jam homeowners into houses well beyond their means. Borrowers could choose to pay interest rates as low as 1% per month - but would see the balance of their loan grow over time. Known as a negative amortization mortgage, the difference between the low teaser rate and a market rate would be tacked on to the loan balance each month.

The scheme worked well when home prices were on the rise, as homeowners could simply sell their way out of trouble. When property values began to fall however, borrowers become stuck inside a ticking time bomb.

Option ARMs were popular with many now-extinct mortgage lenders; Countrywide, IndyMac, Bear Stearns and Washington Mutual were all leaders in the space. These major players literally competed with each other to see who could buy the loans faster, with less due diligence and at the highest price.

As the credit crisis evolved, so too did the extent of Wachovia’s woes. When the company reported earnings in July, I noted a myriad of unsavory business practices under investigation in addition to loan loss provisions 3100% higher than the previous year.

A month before that report, former Undersecretary of the Treasury Robert Steel replaced Kenneth Thompson as chief executive. In all likelihood, Steel traveled from Washington to Charlotte with the intention of finding a buyer for the troubled bank.

The merger marks the latest in rapidly developing consolidation in American’s banking landscape. Two of the most wounded players, WaMu and Wachovia are now off the field.

With many more, smaller casualties waiting on line to be carted off -- like National City (NCC), Downey Savings (DSL) and Zions Bancorp (ZION) -- this process has only just begun.