Riders on the storm

Stumpf, with strongbox, took over as CEO last year, succeeding Kovacevich, who built the empire who plans to retire as chairman.

Founded in 1852 by Henry Wells and William Fargo, the company built offices all over the West - like this one in Pescadero, Calif.

Callahan is in charge of merging Wells and Wachovia. "No time for partying," she says. "No spa, no cream cheese on the bagels."

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(Fortune Magazine) -- Dick Kovacevich ought to be happy. The sun is shining in San Francisco on an early April morning, shares of Wells Fargo, where Kovacevich is chairman of the board, have almost doubled in a month, and Wells appears to have survived the worst of the banking crisis with its reputation intact (so far).

Yet Kovacevich, at 65 a pugnacious and famously outspoken banker, is peeved, to put it mildly. He's miffed at short-sellers who have hammered Wells Fargo as if it were one of those troubled-asset repositories. He bemoans the media for failing to recognize Wells Fargo's achievements. Most of all, he's seething with anger at Washington for all sorts of bad decisions, from making a show of big-bank stress tests (which he has publicly called "asinine") to giving him exactly one hour to accept a $25 billion investment in October from the controversial Troubled Asset Relief Program, or TARP.

"I'm willing to say the emperor has no clothes," Kovacevich says, his face reddening as he loudly denounces the government's behavior. "The facts are so obvious," he booms. "It's just not credible that you would give $25 billion to someone who didn't need it."

In the financial crisis, however, the facts often support clashing theories. Wells Fargo (WFC, Fortune 500) is emerging as one of the best banking franchises in the country. Thanks to its core strength and acquisition of rival Wachovia, Wells for the first time is a coast-to-coast player, comparing, often favorably, with J.P. Morgan Chase (JPM, Fortune 500) and Bank of America (BAC, Fortune 500). But the $12.5 billion acquisition of troubled Wachovia has provoked serious and legitimate doubts as to whether Wells needs even more capital on top of the TARP money it received. Its stock price has skidded, along with that of every other big bank, on fears of everything from an inadequate capital cushion and hidden credit risks to the possibility of banking nationalization.

The Wachovia purchase has injected a note of tension into the story of Wells Fargo, which in every other way has been a rare upbeat tale amid the banking wreckage. Simplicity explains its success. Among the big banks, Wells has one of the lowest cost of funds, a steady stream of nonbanking revenue (from businesses like insurance brokering and mortgage-loan servicing), and, most of all, a history of avoiding the rest of the industry's dumbest mistakes. It never got into the type of structured investment vehicles, or SIVs, that tripped up Citigroup (C, Fortune 500), for example. (Says John Stumpf, Wells Fargo's CEO, who succeeded Kovacevich in that position last year: "When I first heard about an SIV, I thought it was a four-wheel-drive vehicle. Honestly.")

Despite having a major position in mortgage underwriting, Wells refused to join the crowd in offering no-documentation (or "liar") loans and option ARMs that let borrowers determine how much they'd pay each month. (Wachovia's 2006 purchase of Golden West Financial, which popularized option ARMs with its infamous Pick-A-Payment program, crippled Wachovia and led to its purchase by Wells.) As a result, Wells lost significant market share in the mortgage business from 2003 to 2007 - a setback that is now a sign of virtue. Such discipline makes Wells consistently more profitable than its peers, an enviable place to be - provided its uncharacteristic fling with risk by buying Wachovia doesn't prove its undoing.

***

Warren Buffett delights in telling an anecdote about Wells' banking relationship with his own company, Berkshire Hathaway (BRKA, Fortune 500). In 2001, when Berkshire and a partner bought Finova, a bankrupt lender, it solicited banks to become part of a loan syndicate. "Wells wasn't interested," says Buffett, who is Wells' largest shareholder, with 315 million shares, or a 7.4% stake. The others offered to lend Berkshire money at the ultralow rate of 0.2 percentage points above its cost, a loss leader intended to win follow-on investment-banking business from Berkshire. Not Wells. "I got a big kick out of that because that was exactly how they should think," says Buffett, with a hearty guffaw.

The tale speaks volumes about why, despite its size - second by market capitalization ($83 billion) and deposits ($800 billion), and fourth-ranked in terms of assets ($1.3 trillion) - Wells Fargo is so often overlooked. The tall and imposing Kovacevich, a pro-baseball prospect in his youth, gets downright defensive, blaming "you guys in the media" for not paying attention to banks "west of the Hudson." But that doesn't really explain the bank's low profile. In fact, Wells is less known because it concentrates on bread-and-butter banking rather than sexier activities like investment banking and trading for its own account. "The real insight you get about a banker is how they bank," says Buffett. "Their speeches don't make any difference. It's what they do and what they don't do. And what Wells didn't do is what defines its greatness."

Wells, more than any big bank, makes its money by lending. It focuses on consumers and midsize businesses, which tend to be more profitable customers than Fortune 1,000 corporations that can raise money from many sources. And Wells relentlessly cross-sells everything, including credit cards and mortgages (to consumers) and treasury-management services and insurance (to businesses). Wells persuades each retail customer to buy an average of almost six products, roughly twice the level of a decade ago. Business customers average almost eight products per customer.

This type of banking pays in two ways: Retail customers, once satisfactorily hooked, tend not to take their business elsewhere unless they relocate. Similarly, smaller companies tend to rely on their bankers for services that big corporations more often buy from specific consultants. A case in point is Morning Star Packing, a tomato processor in California's Central Valley with about $700 million in annual sales. Chris Rufer, its owner, has banked with Wells since 1983. His company has no board of directors and doesn't hire fancy-pants management consultants. That makes him appreciate Wells all the more, especially a Harvard MBA named Ken McCorkle, who runs the Wells agriculture industries group. "They've got people who are competent to understand our business," says Rufer.

Wells is consciously contrarian. About a decade ago it bought a large business-insurance brokerage, and since then it has been busy snapping up smaller agencies to complement its offering. (As a broker, Wells doesn't underwrite insurance, so it isn't a source of risk. Instead, insurance is simply another product Wells offers its business customers.) In 2008, when Wells' overall revenues grew 6%, to almost $42 billion, its insurance line jumped 20%, to $1.8 billion, making it the fourth-largest business-insurance broker in the country. One important component of the uptick was a thriving crop-insurance business that spiked with the rise in commodity prices.

Where Wells has truly distinguished (and differentiated) itself is in mortgages. Run out of offices in Des Moines - far from the California headquarters of the industry's two biggest blowups, Countrywide Financial and Golden West - the business began in 1906 as Iowa Securities Corp. Though a national force, the mortgage arm began losing ground to competitors in 2003 because it stayed away from the industry's riskiest products. It also alienated brokers by calling attention to what Wells saw as abusive practices.

Cara Heiden, co-head of the mortgage operation, says Wells' computer programs began flagging subprime mortgage applications from customers who could qualify for prime-priced loans. (Subprime loans carry higher rates and therefore pay higher fees to brokers.) "We would send the borrowers a prime-priced product - and cc the broker," she says. Predictably, Wells lost share, though its business continued to grow. Wells also dramatically cut back its roster of brokers, from a high of more than 25,000 in 2006 to just 8,100 today. Last year Wells regained the No. 1 position in the market for U.S. mortgage originations, with a 16% share. That should grow with the purchase of Wachovia, whose share, excluding the Pick-A-Payment business, was about 3%.

In the banking industry, loyal customers translate into cheap sources of capital. A family with a mortgage, a checking account, and a brokerage account is less likely to leave to chase higher CD rates, for example. As a result, Wells excels at making money the old-fashioned way, on the spread between deposit and lending rates. (Think: Borrow cheap, lend dear.) Its average cost of funds in the fourth quarter was just over 1.5%, compared with an industry average of 2.1%. "If you're the low-cost producer in any business - and money is your raw material in banking - you've got a hell of an edge," says Buffett, who caused a 20%-plus jump in Wells shares in March simply by expressing confidence in the bank on TV. "If you have a half-point edge - and they get that edge now on the Wachovia assets as well - half a point on $1 trillion is $5 billion a year."

***

Whether Wachovia's assets give Wells a critical edge or irreparably dull its momentum has been the biggest question mark surrounding the San Francisco bank for months. It is fitting that an epic acquisition would define Wells Fargo's future, because it has been a bank-buying machine for years. Founded in 1852, the modern Wells became takeover bait itself. In 1998, Norwest, the Minneapolis bank then headed by Kovacevich, bought Wells Fargo, assumed its name, and moved the headquarters to San Francisco. Kovacevich had once been a hotshot banker at Citibank, but after CEO John Reed passed him over for a key promotion, he moved to Norwest in 1986. The Minnesota bank bought more than 150 community banks, often in bad economic periods, in places like Colorado, Texas, and Arizona. Despite persistent speculation that he would pounce again after buying Wells, Kovacevich didn't make another big move, preferring to solidify his position west of the Mississippi.

Then came the crisis of last autumn, beginning with the collapse of Lehman Brothers and the government-arranged sales of Washington Mutual and Merrill Lynch. On the last weekend of September the FDIC conducted a forced auction for Wachovia, with Citigroup and Wells Fargo as the two bidders. Citi won that round, agreeing to pay $2 billion for Wachovia's banking franchise, with the government guaranteeing a portion of the losses Citi would assume. Wells thought it could pay more, so after two days, with Kovacevich in Manhattan negotiating with regulators and Stumpf in San Francisco leading a team of 300 numbers crunchers, Wells offered to pay $15.4 billion for all of Wachovia - without any help from Washington. Or so they thought.

Two weeks later, on Oct. 13, Kovacevich was sitting at a long conference table with eight other bank chiefs in Washington, listening to Treasury Secretary Hank Paulson tell them why they should take the government's money. Kovacevich says he protested, telling Paulson that compelling banks to accept TARP funds would lead to unintended consequences. It would erode confidence in the banking sector by making investors question the healthiest banks rather than instilling confidence in the neediest. Other industries undoubtedly would come to expect a bailout themselves. Still, Kovacevich took the money.

His displeasure leaked to the public, but what hasn't been reported is exactly how Paulson flipped the seasoned banker so quickly. In what an observer in the room describes as a "true Godfather moment," Paulson told all the assembled bankers, "Your regulator is sitting right there" - actually the industry's two biggest overlords were in attendance: John Dugan, comptroller of the currency, and FDIC chairwoman Sheila Bair - "and you're going to get a call tomorrow telling you you're undercapitalized and that you won't be able to raise money in the private markets."

For Kovacevich this broadside was the horse's head on his pillow. He and his bank were in an unfamiliar position of vulnerability. Wells had just agreed to buy Wachovia, a bank it had coveted for years, and it needed the government's approval - and, critically, the ability to raise money - to complete the deal. Reflecting on the episode with righteous indignation, Kovacevich points out that each of his warnings to Paulson was later validated. Yet he turns sheepish in explaining his decision. "You want to do what your country and your regulators want," he says quietly in his office, decorated with miniature replicas of Wells Fargo's iconic stagecoaches. "There was no ambiguity," he says, as to what was expected of him.

As the autumn progressed, the markets had begun to lump Wells Fargo in with every other big bank, and justifiably so. Investors were concerned that Wachovia's problems were so severe that Wells had bitten off more than it could chew. Wells Fargo set out to raise equity to finance the deal, but potential investors wanted to know why, if the government had just injected $25 billion into Wells, it needed additional money to buy Wachovia. It was a good question.

Kovacevich says the bank's regulators specifically asked Wells to go ahead with the fundraising so that Wells would have a bigger capital cushion. At $12.6 billion, Wells raised more money than any non-IPO on record, but less than the maximum $20 billion target it had set. The Wachovia deal closed on the last day of the year (for $12.5 billion, nearly $3 billion less than the original offer price), and Wells that day wrote down $37 billion of a $94 billion Wachovia loan portfolio.

The large write-down, a banking term referring to the reduction of the value of an asset, removed a significant amount of risk from Wells Fargo's balance sheet - but not enough for Wells' critics. The write-down had the effect of weakening what had become a key ratio investors had begun to watch called tangible common equity, or TCE. It measures a bank's capital cushion without giving it any credit for ephemeral assets like goodwill. As a result of the deal, Wells had a TCE ratio of 2.7%, less than the 3% that many banking investors consider a bare minimum for healthy banks.

As recently as October, Wells had claimed it didn't need additional capital. Yet here it was, a recipient of the government's money and still undercapitalized by one important measure. The new burden of TARP began to chafe in February, when word got out that Wells was hosting its annual "recognition event" for top-performing mortgage brokers in Las Vegas. A populist rage ensued at the boondoggle by a TARP recipient, and Wells promptly canceled the event. CEO Stumpf wrote a defiant letter to employees, which Wells published as an ad in national newspapers, saying that the real victims of the controversy were the hospitality-industry workers of Las Vegas. If Wells hadn't been on the map before, its gestures of rebellion were starting to draw attention and curiosity: Just who are these cowboys?

By late February the heat grew more substantial. The Treasury Department announced it would conduct confidential stress tests of the country's 19 biggest banks to understand how well they could survive an even deeper recession. (Kovacevich earned headlines weeks later for his remarks calling the move "asinine" on the grounds that regulators routinely conduct stress tests at banks.) Suddenly no bank was considered safe. Wells shares briefly fell below $8 - from more than $40 in the fall - and after relatively healthy competitors J.P. Morgan, U.S. Bank, and PNC Financial all cut their dividends, Wells did too, by 85%.

The dividend cut exposed a chink in Wells Fargo's armor. It had said repeatedly that it needed no new capital. But if that were true, it wouldn't have needed to slice the payout. By way of explanation, Stumpf, a 55-year-old Minnesotan who hails from a farming family and bakes bread as a hobby, says, "We're going through unprecedented times, and more capital is better than less capital."

It's a fair argument but not entirely persuasive. The dividend cut, announced in early March, should generate capital at a rate of $5 billion per year. Add that savings, the private fundraising of almost $13 billion, and the $25 billion in TARP money, and Wells will have accumulated $43 billion since October (not including earnings), about $23 billion more than it had said it needed to fund the Wachovia acquisition. Yet it still isn't in a position to repay the Treasury.

Investors worry that Wells has kept certain Wachovia portfolios off the combined bank's balance sheet. Frederick Cannon, an analyst with banking specialist Keefe Bruyette & Woods, highlights two potential problems, a $355 billion batch of commercial mortgages and $137 billion of exposure to credit derivatives. Were those assets added to Wells' balance sheet, the bank's need for capital would be even greater, says Cannon, who in a worst-case scenario can see Wells needing to raise another $25 billion. "They've built a great franchise," he says. "Wouldn't it be great if they just had a bigger cushion of capital?"

On April 9, Wells at least temporarily quieted its critics by pre-announcing first-quarter earnings of $3 billion, twice what Wall Street had expected, but without providing much in the way of operating metrics. Wells said the Wachovia integration was ahead of schedule, that it had funded $100 billion in mortgages, and that its tangible common equity ratio had hit 3.1%. The stock price surged 32%, to almost $20, and Wells Fargo single-handedly sparked a 246-point rally in the Dow. For a day, at least, the markets were paying attention to a suddenly very large bank with headquarters west of the Hudson River.

***

There would be far fewer questions about Wells Fargo, of course, if it had simply ceded Wachovia to Citi. But for all the factors Wells Fargo can't control, successfully integrating Wachovia is one it can. The monumental task has been entrusted to executive vice president Patricia Callahan, a 31-year Wells veteran who has worked at the bank (including a San Francisco predecessor) her entire career - in commercial lending, in compliance, and as head of human resources. The project will be grueling, creating a combined entity out of a network of 11,000 branches, 70 million customers, 12,000-plus ATMs, and 281,000 employees. Fortunately for Callahan, she recently completed a six-month sabbatical and says she returned refreshed. "This integration is complicated in terms of timing, systems, training, and logistics," she says. Through her efforts, Wells plans to slice $5 billion in annual operating costs from the combined banks' budgets by 2011, a 10% reduction.

Wells has a playbook in these matters, namely Norwest's three-year, painstaking acquisition of Wells Fargo a decade ago. Callahan says 21 business-unit and staff-function integration teams, and many more sub-teams, are at work mapping a calendar they intend to complete by the end of April. An all-hands integration team meeting in San Francisco in March drew 150 attendees in person and another 200 on the phone and went from 7 a.m. to 6 p.m. "No time for partying," she says, in a nod to the still-hurt feelings over the canceled "recognition event" in February. "No spa, no golf, no cream cheese on the bagels."

Though Wells and Wachovia operated largely in different parts of the country, overlap is a cost-saving opportunity. Each had significant operations in five states: Colorado, Arizona, Nevada, California, and Texas. Callahan says those states will get the makeover treatment first, with the bank converting no more than a few hundred branches at a time. The plan is to rebrand everything Wells Fargo; the Wachovia name is destined for the trash heap of bank brands.

In most areas Wells considers itself Wachovia's better. For example, Wells ATMs have capabilities that Wachovia's don't, like envelope-free deposits that customers love. So every Wachovia ATM will be upgraded. Stumpf ticks off the opportunities Wells will have with Wachovia's customer base, which before the merger was similar in size to Wells Fargo's. "We have twice the number of online customers that they do," he says, online banking representing a significant cost savings. "Thirty-eight percent of our customers carry our credit card. Eleven percent of theirs carry their credit card. Our debit-card penetration is much higher here. Our mortgage penetration is much higher here." And so on.

Wachovia had some advantages over Wells. Its wealth-management and brokerage arms are stronger, featuring a highly skilled sales force in the image of Merrill Lynch's. That unit, the remnant of Wachovia's acquisition of brokerage A.G. Edwards, will survive and be run by a Wachovia executive, David Carroll, the sole officer from the vanquished company to join the Wells executive management team. Wachovia also ranks higher than Wells on customer-satisfaction surveys, and some Wells customers chafe at constantly being asked to buy additional products. Wells says it will try to learn from Wachovia in this regard: for example, by adopting Wachovia's customer-tracking software.

At least one Wells Fargo "team member," as the San Francisco bank refers to its employees, certainly won't be around to see the Wachovia integration through. Kovacevich says he'll retire for good "by year-endish or early next year-ish," and maybe sooner.

Though Wells doesn't provide golden parachutes, Kovacevich already has done just fine. His pension is worth $30 million, and in 2006 and 2007 he exercised and sold stock options worth $77 million. He insists he'll take no other banking job, including the CEO position at Citigroup, which passed him over all those years ago. "I would never compete with Wells Fargo," says Kovacevich. "This has been my life." For years it was accepted in banking circles that Kovacevich coveted the Citi job, but that was before the bank's financial and leadership challenges. Then again, his demurral is far more believable today, considering that when Citi completes an exchange offer it has announced, the U.S. government could own as much as 36% of the company. Kovacevich working for the government officials he has so loudly criticized is a tough one to imagine.

REPORTER ASSOCIATE Doris Burke contributed to this article.