How Steel got the Wachovia deal done

FORTUNE -- This article is adapted from "Banktown: The Rise and Struggles of Charlotte's Big Banks" by Rick Rothacker, published by John F. Blair, Publisher (Winston-Salem).

Wachovia chief executive Bob Steel and lieutenant David Carroll met early Sunday morning with Dick Kovacevich in his suite at The Carlyle, an Art Deco hotel on Manhattan's Upper East Side that had hosted notable guests from United States presidents to Princess Diana.

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Kovacevich was one of the most respected bankers in the industry, and his reputation continued growing as rivals cratered. In perhaps the biggest sign of his success, Warren Buffett was Wells Fargo's largest investor.

In 2007, Kovacevich had handed the CEO title to his longtime number two, John Stumpf, but stayed on as chairman. He was set to off-load that title at the end of the year and fully retire. This would be his chance at one more gamechanging deal.

At the Sunday-morning meeting, Kovacevich again told Steel he thought Wells could make a stock offer for all of Wachovia without government help, pending the bank's review of Wachovia's books. Wells Fargo's price wouldn't be in the $20-per-share range, Kovacevich said.

Steel and Carroll left the meeting optimistic. The debate inside Wachovia was whether the offer from Wells would be in the high or mid-teens per share.

By the afternoon, Wells was growing comfortable with Wachovia's option adjustable-rate mortgage portfolio, but the credit team was starting to worry about some of the bank's commercial loans. Wells was experienced in the mortgage business but had little background in corporate and investment banking. Wachovia officials tried to assuage any concerns but started to worry about Wells Fargo's waning enthusiasm.

Kevin Warsh, at the Federal Reserve in Washington, talked with both Steel and Kovacevich during the weekend. On Sunday after the breakfast meeting, Steel seemed positive about a possible Wells deal. To Kovacevich, Warsh repeated the message he had sent to Goldman Sachs (GS, Fortune 500) when it was looking at Wachovia a week earlier: If Wells was willing to pay a positive share price, the Fed could help facilitate the talks, especially since it was the primary regulator that approved these types of bank deals. But if the bank wasn't, Kovacevich needed to talk to Federal Deposit Insurance Corp. Chairman Sheila Bair, whose agency had procedures for dealing with failing banks.

As Wells did more due diligence, the price Kovacevich told Warsh he was willing to pay kept coming down. By the afternoon, he was no longer willing to do the deal without government help. Inside the Fed, a debate raged over whether or not Wachovia should be turned over to the FDIC if an unassisted deal couldn't be worked out. Officials kicked around the idea of some type of bridge loan if Wachovia needed help staying afloat until a deal could be reached, but that idea didn't go far. In the end, Fed officials decided Wachovia's resolution should be handled by the FDIC.

That afternoon, Bair waited at home to see if Wells agreed to buy Wachovia, but word never came. She called Warren Buffett to get a number for John Stumpf, the Wells Fargo (WFC, Fortune 500) CEO. The deal was off, Stumpf told her.

Around four o'clock, she started notifying her staff and drove to the FDIC's headquarters in Washington a short distance from the White House.

Shortly after reaching her office, Bair got a call from Ben Bernanke. The Fed would be willing to make a "systemic risk" determination related to Wachovia, the designation required to allow an open-bank assisted transaction.

The FDIC was required to use the "least costly" method to the deposit insurance fund to resolve failed banks. Assistance to open banks was generally barred because it would benefit shareholders. But a 1991 law allowed the FDIC to make an exception to this requirement in the case of systemic risk to the financial system. The provision required the recommendation of two-thirds of the Fed board and two-thirds of the FDIC board, plus the approval of the Treasury secretary after consultation with the president. To date, regulators had never used this exception.

After Bernanke's call, Bair heard from President George W. Bush's chief of staff, Josh Bolten, a former Goldman Sachs banker. The White House supported a systemic risk determination as well. The Federal Reserve had approved Wachovia's purchase of option ARM lender Golden West Financial Corp., and the Office of the Comptroller of the Currency had been the Charlotte bank's primary regulator. But now the FDIC had to deal with Wachovia's collapse. The FDIC's receivership staff called Citi (C, Fortune 500) and Wells to let them know it was going to take bids that night for a government-assisted transaction. A deal had to be arranged by Monday morning.

Around seven o'clock that night, Kovacevich called Steel, who was waiting with the Wachovia team at Sullivan & Cromwell law offices in Midtown Manhattan. Wells wasn't prepared to do a deal on such a short timetable without government assistance, the Wells Fargo chairman told Steel.

It was a wrenching blow for a group that had thought it was close to an agreement after watching deal after deal fall apart in the past two exhausting weeks.

Most of the executives had been up since early Saturday. Few had found time for showers or naps. They were surviving on takeout food and adrenaline.

Now, some executives thought they might be out of options. They knew Citi was still out there, but government assistance wasn't a sure thing. The unthinkable was happening. The bank might fail.

Not long after that, Bair called Steel, whom she knew from his days at Treasury.

The government had determined that Wachovia was a systemic risk to the financial system, and the FDIC planned to use its open-bank assistance powers.

The FDIC had contacted bidders and would call back with the results. This doomsday scenario was actually good news for Wachovia.

At some point that evening, Bair, continuing to review all options, considered a more severe outcome for Wachovia.

The FDIC chairman mulled failing the bank and disposing of its assets without an assisted transaction. Such a move could wipe out shareholders and damage bondholders. But this approach could also potentially result in zero losses to the deposit insurance fund, as in the sale days earlier of Washington Mutual operations to JPMorgan Chase. FDIC accountants also worried that if the agency booked an unexpected loss from an assisted transaction, it would be legally required to levy special assessments on other banks, adding more stress to the financial system.

Officials at the Fed and the OCC pushed back. Failing Wachovia would be a disaster for a financial system already reeling from the collapse of Lehman Holdings Inc. and WaMu. The Charlotte bank was far bigger and much more complicated than the Seattle thrift. Seeing the resistance, Bair continued with the bidding process.

Around nine that night, Wachovia held a board meeting to update its directors. A decision was likely in the next several hours.

Around 11, someone in the conference room with Steel, Sullivan & Cromwell attorney Rodgin Cohen, and Wachovia general counsel Jane Sherburne said they should revive a proposal they had set aside earlier in the weekend: A request for government aid as a stand-alone company. The idea had lost traction when it appeared Wells was going to do an unassisted deal. Around the same time, investment bankers from Goldman and Perella Weinberg, who were advising Wachovia over the weekend, burst into the room with the same idea.

This brief moment of hope gave the demoralized team something to do while Wachovia awaited the FDIC's decision. In the offer Wachovia crafted, the FDIC would share losses on $200 billion to $225 billion of the bank's worst assets. Wachovia would take the first $25 billion in losses, issue the government $10 billion in preferred shares, and raise another $10 to $15 billion in capital.

Wachovia thought the offer was less expensive than Citi's, which would call for the FDIC to cover $312 billion in assets, with Citi taking the first $42 billion in losses. The other positives: It would require no shareholder vote, it could be done in seven to 10 days, and it would keep the company in one piece. Cohen e-mailed Bair with the proposal around 12:30 a.m.

The FDIC considered the proposal but rejected it based on economics and a concern that financial markets wouldn't perceive Wachovia as a viable standalone institution even with the aid. Bair thought Wachovia needed to be paired with a stronger institution. The FDIC wasn't in the business of rescuing banks that made bad business decisions.

As the night went on, Bair became increasingly exasperated by Wells. It was taking hours for the San Francisco bank to deliver its bid. Wachovia executives didn't even know Wells Fargo was still in the running.

The other regulators were also frustrated with Bair, whom they felt was still resistant to pulling the trigger on an assisted deal. The FDIC, however, had to weigh the merits of two deals and was analyzing if it might be forced by law to levy the special assessment on the rest of the banking system, which would hurt the earnings and capital levels of other struggling financial institutions.

The logjam finally broke when FDIC analysts determined the cost of the Citi package was likely zero. That was because Citi was taking the first losses on a pool of assets and paying the government $12 billion in preferred stock and warrants. In the Wells offer, the FDIC would share in the first loss on a pool of assets, guaranteeing that it took a hit.

At four in the morning on Monday, September 29, Bair declared Citi the winner of the auction. She called Steel with the news. He asked why the independent plan didn't win out and was told Wachovia needed a partner. The explanation made Wachovia officials wonder if Citi was also in need of help.

Wachovia had only a few hours to assent to a nonbinding "agreement-in-principle" that laid out the basic terms of the transaction. Under the offer, Citi would acquire Wachovia's banking operations for $2.16 billion in Citi cash and/or stock-essentially $1 per share-while the FDIC would assume up to $42 billion in losses on $312 billion in assets.

Wachovia continued to push Citi to buy all of the company but was rejected. An independent Wachovia holding company comprising asset management and brokerage businesses would remain after Citi plucked out the banking operations.

At 6:04 a.m., Bair presided over an FDIC board meeting to give approval for the agreement. More than two dozen officials participated either in person or by telephone. Normally much more formally dressed, the officials and staff members wore blue jeans and other casual clothes during the hectic weekend in the office.

Bair was stationed in her normal position on the dais at the front of the agency's wood-paneled boardroom. Since staff advised that Wachovia's banking units were "in danger of default," the five FDIC board members unanimously agreed to approve the Citi deal, finding Wachovia's failure would have "serious adverse effects on economic conditions or financial stability."

Treasury secretary Henry Paulson, limiting his contact with Wachovia because of Bob Steel's past role as one of his lieutenants, had gone to bed thinking the bank would be sold to Wells. That meant one of his deputies, David Nason, had to call Josh Bolten at the White House to officially get the president's systemic risk consent. The Fed also signed off on the decision, meeting the legal requirement for a systemic risk determination.

The Wachovia board met by telephone at 6:30 a.m. Steel had made a quick trip to his home in Greenwich, Connecticut, for a shower and a change of clothes and looked more refreshed than the others gathered in the Sullivan & Cromwell conference room. He explained the situation: Wachovia needed to sign the agreement-in-principle with Citi and the FDIC or face the prospect of being placed in receivership, resulting in a likely bankruptcy filing. The board didn't have much of a choice. The directors backed the Citi deal unanimously.

The board meeting lasted until about 7:30 a.m., leaving only a half-hour until the FDIC planned to publicly announce the deal. Lawyers from Citi's outside law firm, Davis Polk & Wardwell, e-mailed over the nonbinding agreement-in-principle, plus a second document.

Sherburne signed off on the agreement-in-principle but asked about the second document. A lawyer on speaker phone said it was an exclusivity agreement barring Wachovia from talking to any other parties about a deal.

"I have to read it," Sherburne said.

"Just sign it. Just sign it," the lawyer said.

"I'm not signing something I haven't read," she snapped before flipping through the pages.

Sherburne noticed the exclusivity agreement had no end date. She penned one in for a week later-October 6, 2008-and scribbled her initials.

At 7:55 a.m., Sheila Bair sent an e-mail with only a subject line to the FDIC board: "Wachovia and Citi Boards have approved the terms of the transaction."

--Rick Rothacker has been covering banking for the Charlotte Observer since 2001. "Banktown" is based on reporting for the Observer, new interviews, court documents, securities filings and other research.