Wachovia Corp., under increasing pressure after shares of the sixth-biggest U.S. bank by assets plunged 47 percent last week, may be forced to seek a buyer or merger partner as losses from mortgage defaults mount.

Three days after Chief Executive Officer Robert Steel told employees Wachovia was ``strong and performing well,'' the Wall Street Journal reported today that the Charlotte, North Carolina- based bank was in advanced takeover talks with Wells Fargo & Co. Citigroup Inc. also may make a bid, the paper reported.
Wachovia's plight stems from the $24 billion acquisition of Golden West Financial Corp., a California lender that specialized in payment-option adjustable-rate mortgages. Former CEO Ken Thompson told shareholders in May 2007 the loans would help propel earnings to new highs. Instead, Wachovia now expects losses on 12 percent, or $14 billion, of the $122 billion option- ARM portfolio. Analysts at Fitch Ratings predict default rates on such loans packaged as securities may reach 45 percent.
``I don't see why Wells Fargo would take on $122 billion of option ARMs to work out after they've eschewed doing those kinds of loans over the past five years,'' said Nancy Bush, an independent bank analyst in Aiken, South Carolina.
``Citigroup isn't in a better position to bid than Wells. They've got their own problems.''
While Citigroup of New York and Spain's Banco Santander SA may bid for Wachovia, San Francisco-based Wells Fargo is the frontrunner in the current discussions, the Journal reported, citing unidentified people familiar with the situation. Option ARMs
Christy Phillips-Brown, a Wachovia spokeswoman, declined to comment, as did officials from Wells Fargo, Citigroup and Santander.
Wachovia is the largest holder of option ARMs, ahead of Washington Mutual Inc., the Seattle-based lender that collapsed last week. The mortgages, which the bank calls ``pick-a-pay,'' represent 73 percent of Wachovia's loan portfolio, according to its Web site. Three of the next four largest holders of option ARMs no longer exist, according to a ranking by Bethesda, Maryland-based industry newsletter Inside Mortgage Finance.
Washington Mutual, which held $52.9 billion at the end of the second quarter, was seized by U.S. regulators on Sept. 26 and New York-based JPMorgan Chase & Co. bought the company's assets. JPMorgan, the biggest U.S. bank by market value, said Washington Mutual's option-ARM losses would be at least 20 percent. Downey Financial
Countrywide Financial Corp. of Calabasas, California, was bought in July by Bank of America Corp. and Indymac Bancorp Inc., a Countrywide spin-off based in Pasadena, California, was taken over by the Federal Deposit Insurance Corp.
``Option ARMs are the main issue on everyone's minds,'' said Kevin Fitzsimmons, a bank analyst at Sandler O'Neill & Partners LP in New York. ``It's just a huge portfolio and it's a piece that is deteriorating quicker than other segments of its portfolio.''
Only Wachovia and Downey Financial Corp. in Newport Beach, California, remain in business. Downey had $6.9 billion of option ARMs at the end of the second quarter, representing 65 percent of the home loans they held. Downey has lost 97 percent of market value since May 2007.
As many as 45 percent of borrowers with option ARMs issued from 2004 to 2007 and bundled into securities may default, according to Fitch Ratings analysts Roelof Slump and Stefan Hilts. ``Option ARMs were used to shoehorn people into homes they couldn't afford in the hope that home price appreciation would cover for any loss in the future,'' said Guy Cecala, publisher of Inside Mortgage Finance.
Otion ARMs allow borrowers to skip part of their payment and add that sum to their principal. Monthly payments increase after five years or once the loan balance reaches a predetermined limit, usually 110 percent to 125 percent. Introductory interest rates can be as low as 1 percent.
Wachovia would be a natural fit to be acquired by Citigroup because it would increase the New York-based bank's retail branches four-fold so it could compete with JPMorgan Chase and Charlotte, North Carolina-based Bank of America Corp., said Kenneth Thomas, an independent bank consultant and economist in Miami.
``Option ARMs certainly are the biggest deterrent to a deal, but it's too dire a situation not to get this done,'' Thomas said. ``Fed officials are probably talking to Citigroup right now saying only a few people can get this deal done and we'll figure out a way to make it work.''
Congress, encouraged by Federal Reserve Chairman Ben S. Bernanke, is considering a bailout package for holders of distressed mortgage assets. What regulators want to avoid in the meantime is a bank run, Thomas said.
``Congress doesn't understand how dangerous this situation is,'' Thomas said. ``The biggest fear of regulators is seeing lines of people on TV trying to withdraw their money. A deal has to be done quickly.''
For the average option ARM borrower, payments will rise 63 percent, or by an additional $1,053 per month, when their rates reset, according to a Sept. 2 report by New York-based Fitch. Oakland, California-based Golden West was led by Herbert and Marion Sandler, a husband-and-wife team who increased profit 172 percent in five years by selling option ARMs. They sold the company to Wachovia in 2006 just as housing prices peaked. ``I think that 12 months or so from now people are going to look at the acquisition of Golden West as one that produced great success for Wachovia,'' Thompson said on the conference call in May 2007.
Seventeen months later, Thompson is gone and Wachovia has lost 82 percent of its market value.
Wachovia has worked with 26,000 borrowers in the past year to make their payments more manageable, said spokesman Don Vecchiarello. The bank is contacting pick-a-pay customers by phone, e-mail and direct mail to give them the option of refinancing into a Federal Housing Administration product or a fixed-rate loan guaranteed by Fannie Mae or Freddie Mac, the biggest U.S. mortgage financing companies, he said.
``There have been some issues with housing depreciation in California and Florida, where a lot of our loans were made,'' Vecchiarello said.
About 58 percent of Wachovia's option ARMs were in California, according to the bank's second-quarter earnings presentation to investors. California home prices fell a record 41 percent in August from a year earlier, according to the California Association of Realtors in Los Angeles.
The bank made 9 percent of its option ARM loans in Florida, the state with the fourth-highest foreclosure rate, according to industry data provider RealtyTrac Inc. in Irvine, California.
Wachovia's pick-a-pay portfolio consists of 448,000 loans with an average value of $271,000, according to a Sept. 9 presentation by Steel, who replaced Thompson in July.
Because Wachovia holds the mortgages, it's easier to modify them than if the loans were bundled into securities and sold to investors, Steel said.
``We have all the levers that any lender would have,'' Steel said. ``We basically have the ability to consider principal reduction. We can lower or adjust the interest rate. We can also adjust the term of the loan. I pledge to you that we're moving decisively and smartly as we think about this from that perspective.'' On his May 2007 conference call, Thompson said that ``credit quality is not an issue'' and the option ARM product line would ``hit the ball out of the park.''
Wachovia spokesperson Vecchiarello declined to comment on the Golden West acquisition.
(Source: Bloomberg)