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Wachovia 3Q loss paves way for Wells deal

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NEW YORK — How could a $24 billion loss possibly be good news? When it comes from Wachovia as an effort to primp itself for its acquisition by Wells Fargo.

Wachovia Corp.'s staggering loss for the third quarter resulted primarily because it wrote down the value of intangible assets by almost $19 billion and built up its loan loss reserves by $4.8 billion, moves that seemed to please its suitor.

"It was prudent for Wachovia to put these losses behind them," said Wells Fargo Chief Financial Officer Howard Atkins in a release. "The asset write-downs, reserve build, and other items are consistent with our acquisition assumptions."

The moves tidy up Wachovia's balance sheet so that it is more in line with that of the more conservative Wells Fargo, analysts said. At the same time, Wells Fargo can use the losses reported by Wachovia to shelter years of profits after it acquires the Charlotte, N.C.-based bank.

Late last month, the Internal Revenue Service issued a surprise ruling that boosts banks' ability to offset the losses from loans and other bad debts held by banks they acquire. The guidance allows banks to take larger tax write-offs against future profits and makes the bargain-basement $14 billion all-stock Wachovia deal all the more attractive for San Francisco-based Wells Fargo.

The ruling removes any limitation on how much a company can offset its income with the losses of an acquired company, said Walter Pagano, a partner at Eisner LLP and a former IRS revenue agent. Under the old ruling, companies could only write off a small portion of the losses, limiting how much of a tax benefit they could get.

The ruling comes in handy for Wells Fargo, which has said it expects to write down Wachovia's loan portfolio by about $74 billion.

To help finance the Wachovia deal, Wells Fargo plans to raise $20 billion from a stock offering. It also will receive a $25 billion capital investment, under a $250 billion plan by the government to take equity stakes in banks to help boost investor confidence and spur lending in the face of the worst financial crisis since the stock market crash of 1929.

Wachovia said its acquisition by Wells Fargo, which still needs the approval of shareholders, is on track to close in the fourth quarter.

For the period ended Sept. 30, Wachovia reported a net loss, after paying preferred dividends, of $23.89 billion, or $11.18 per share, compared with earnings of $1.62 billion, or 85 cents per share, a year earlier.

Excluding a goodwill impairment charge of $18.7 billion and merger-related and restructuring expense of $414 million, the bank lost $4.76 billion, or $2.23 per share.

Analysts polled by Thomson Reuters, on average, had expected earnings of 2 cents per share. Analyst estimates typically exclude one-time items.

Wells Fargo President and Chief Executive John Stumpf said Wachovia's results were in line with what the bank had expected. "We're more encouraged than ever by what we've seen in their franchise," he said in a statement.

A majority of Wachovia's $18.7 billion writedown relates to the bank's retail and small business unit, under which its troubled Pick-a-Pay mortgage portfolio is included.

Essentially, Wachovia was forced to write down the value of these assets because they were considered overvalued compared with the market value _ or what Wells Fargo was willing to pay. The charge has no impact on Wachovia's capital levels.

During the quarter, Wachovia set aside a $6.63 billion provision for credit losses. Included in this amount was $3.4 billion to build its reserves to cover losses in the Pick-a-Pay loan portfolio, which Wachovia inherited through its $25 billion acquisition of mortgage lender Golden West Financial Corp. in 2006, at the height of the nation's housing boom.

The current Pick-a-Pay mortgage loan balance totals $118.7 billion. Wachovia expects total cumulative losses of $26.1 billion on this portfolio, with about 90 percent of the credit costs incurred by the end of next year.

Third-quarter net interest income, the difference between how much it costs a bank to borrow money and how much it receives from lending money to customers, rose 10 percent to $5.04 billion from a year earlier. Total average loans grew 11 percent to $478.49 billion, representing 20 percent growth in average commercial loans and 6 percent growth in average consumer loans.

Period-end core deposits declined 8 percent from the second quarter to $370 billion, due to "sizable and abrupt" end-of-quarter outflows in commercial deposits sparked by the failure of West Coast rival Washington Mutual Inc.

Since quarter end, Wachovia said it has begun to see commercial deposit trends improve.

Net charge offs, or loans written off as unpaid, totaled $1.87 billion, or 1.57 percent of average net loans on an annualized basis. Total non-performing assets, including loans held for sale, were $15 billion.

Fee and other income dropped 75 percent to $733 million from nearly $3 billion in the prior-year quarter, due to losses on investments.

"On the surface, it seems it was ugly, but nothing that changes one's view of the pending deal right now," said Andrew Marquardt, an analyst at Fox-Pitt Kelton, adding that the disruption in deposits and continued credit deterioration was as expected.

Wachovia was ultimately sold after a bitter battle between two of the country's largest banks, as Citigroup and Wells Fargo fought for its lucrative deposits.

Wachovia had been struggling for some time, but the rush to a deal was prompted by a $5 billion run on deposits in late September that threatened the future of the bank, according to court documents.

Citigroup Inc. agreed to step in and buy Wachovia's banking operations for $2.1 billion with the help of the Federal Deposit Insurance Corp.

But only four days later, Wells Fargo made a higher offer that did not hinge on any government support. Originally, the deal was valued at $15.1 billion, or $7 a share, but Wells Fargo stock has declined since it was announced and the deal is now valued at about $14 billion.

Citigroup eventually walked away from the deal after the suitors failed to reach an agreement over how to split up Wachovia.

While Citigroup decided not to block the Wells Fargo-Wachovia deal, the bank is seeking $60 billion in damages for alleged interference in its agreement with Wachovia.

Wells Fargo, which reported a better-than-expected 25 percent drop in third-quarter profit last week, has been weathering the mortgage crisis much better than many of its peers as it largely avoided subprime loans, which have been the undoing of the financial industry.

Wachovia shares fell 38 cents, or 6 percent, to close Wednesday at $5.71. Wachovia has lost 84 percent of its market value in 2008. Wells Fargo shares, meanwhile, dropped $1.34, or 4.1 percent, to $31.30.