Wachovia: One Thompson Deal Too Many

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Former Wachovia CEO Ken Thompson Bloomberg News/Landov

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Because no one outside of Thompson and Golden West CEO Herb Sandler seemed to like the deal from the moment it was announced. Indeed, in the initial conference calls with analysts and investors after the deal, Thompson was on the defensive from the outset.

For Thompson, the Golden West purchase gave him the beachhead in California he had long desired. It also gave him an array of creative mortgage products to pump through his broker channel. But the ink was barely dry on the Golden West deal in late 2006 when the housing bubble in markets including California and Florida began to deflate. And by early this year, the mounting losses from Golden West, coupled with deteriorating credit quality in the rest of the bank's portfolio, began to hit Wachovia hard: The bank reported a $393 million loss in the first quarter and then amended the report in mid-May to say it really lost $708 million after a review of its portfolio of bank-owned life insurance. That forced the bank to cut its dividend by more than 40% and to sell $8 billion in new shares—a move that served to bolster Wachovia's equity but diluted the value of existing shareholders' stock.

And the amended report—which boosted the first-quarter losses by 80%—left shareholders convinced Thompson didn't have his arms around the problems and that more surprises lay ahead. "We continue to have a downward bias to our estimates and this move only heightens concerns about earnings and asset quality problems short-term," Deutsche Bank (DB) analyst Mike Mayo wrote in a June 2 note to clients.

Costly Deal

More surprises are likely in store for investors in coming quarters. Besides the temptation of the next CEO to take large write-offs to clear the decks for a recovery, it's clear the Golden West deal will haunt the bank for years to come. CNBC commentator Jim Cramer has estimated that Golden West could ultimately cost Wachovia $50 billion. Gary Townsend, a veteran bank analyst who is now a partner in Hill Townsend Capital, believes it could be half that, $25 billion—still, no small sum.

Townsend notes that Golden West is now sitting on deferred interest from its "negative amortization" mortgages—interest borrowers haven't paid, but that Wachovia has booked—which now stands at $3.5 billion, or three times the level at the time of the deal. What's more, the number of "Pick-a-Pay" mortgages—Golden West's signature product, which allows a borrower to pay just a portion of the full amount due each month—have risen fivefold in the past year, and now stand at 3.82% of Golden West's loans. That led to a 45% decline in Wachovia's stock value, to around $50 billion, and explains why shareholders wanted Thompson gone.

What happens next at Wachovia isn't clear. The board's decision to install director Lanty Smith as interim CEO indicates a lack of internal successors, and suggests that the next CEO will come from the outside. Some analysts are saying Wachovia could be vulnerable to a takeover. An acquisition of Wachovia would give Wells Fargo (WFC) the East Coast presence it has long coveted—but picking up Golden West would effectively mean doubling its exposure to the California real estate market. JPMorgan Chase (JPM) is another potential buyer, but only after it digests its takeover of Bear Stearns. Which means that Wachovia, the subject of takeover rumors when Thompson took over in 2000, has now come full circle. And for Thompson and the bank, the Golden West deal was a bridge too far.

Foust is chief of BusinessWeek's Atlanta bureau .