In front of a ballroom full of N.C. bankers in January 2006, Wachovia chief executive Ken Thompson warned of the dangers of “toxic” home loans.

A problem with so-called option adjustable-rate mortgages, he told the group, was that homeowners can end up owing more at the end of the month than the beginning, which can be a “tough situation” for customers and lenders.

“I have literally been amazed at the terms offered by some mortgage lenders, thankfully not at Wachovia and thankfully not so much in North Carolina,” he said.

Four months later in May 2006, Thompson took a $24 billion plunge into the mortgage business by buying Oakland, Calif.-based Golden West Financial. Its specialty? The same loans he had cautioned against: option ARMs.

Wachovia, a brand known for conservative lending, had changed course and forged its biggest deal ever. Two and a half years later, the purchase has played a central role in the Charlotte bank's near collapse and its planned sale to San Francisco-based Wells Fargo. Shareholders vote Tuesday on the takeover.

In buying Golden West, Thompson and his board exposed the bank to a nontraditional lender with 60 percent of its mortgages in California even as experts warned of a housing bubble and the perils of option ARMs. The purchase left the bank especially vulnerable in the global financial crisis that ensued. Now the acquisition is a key chapter in a tragic tale that has cost investors billions and threatened thousands of jobs.

So why did Thompson do it? The purchase fit his goals of establishing a major presence in California and building his mortgage business. His competitors were reaping profits from the housing frenzy. And he became comfortable with Golden West's lending tactics and sterling track record.

But the deal seemed out of character. It came together in a matter of days. Some key executives weren't consulted. The two cultures collided at a bank known for smooth mergers. And perhaps most remarkably, Wachovia kept pushing Golden West's option ARMs, even as other lenders backed away.

Had Wachovia executives passed on the deal, the company might still have a future on its own. But once they placed the bet on Golden West, it's debatable whether they could have escaped the financial meltdown that would follow. “If you look back on it, who could have predicted that?” asks former Wachovia director Robert Brown, who voted to approve the deal.

In the aftermath, federal officials are investigating the sale, and shareholders have filed lawsuits against Wachovia and company officials.

Thompson, 58, declined to comment for this story. He was dismissed in June. In a statement, Wachovia said the deal was an attractive fit when it was announced and “can only be evaluated fairly based on circumstances existing at that time.”

Thompson a selective deal maker

Thompson took over then-First Union in 2000 with the bank suffering from fast-paced deals and plunging profits.

Well-liked throughout the ranks, the company veteran from Rocky Mount launched a massive restructuring, presided over a smooth merger with Winston-Salem's Wachovia in 2001 and preached a devotion to customer service.

He also became known as a selective deal maker. In 2003, he passed on FleetBoston Financial. Two years later, he turned down credit card giant MBNA. In both cases, he didn't budge on price and resisted taking on too much risk for a bank of Wachovia's size. Its bigger crosstown rival, Bank of America, later swooped in to score both $35 billion-plus deals.

Thompson, however, had declared his desire to expand his retail banking presence into California. Flush with deposits, he also wanted to make more loans to consumers.

In 2005, banks were making big profits in a roaring housing market. Average U.S. home prices increased nearly 13 percent, climbing at a near-record pace. In California, home prices were up more than 117 percent over five years.

But late in the year, loan delinquencies and foreclosures edged up. Economists warned of the possible risks of a slowing housing boom. Regulators also began increasing scrutiny of nontraditional loans.

In September 2005, Thompson showed a tolerance for more risk in buying two small California lenders that made some subprime loans to borrowers with weaker credit. At that time, Wachovia was largely building its traditional mortgage business by hiring loan officers and investing in technology. A big acquisition would be a faster way to grow.

In late April 2006, Thompson learned Golden West might be for sale. The tip came from a chance encounter between an investment banker working for Golden West and an attorney who advised Wachovia. A few days later, Thompson and his chief financial officer, Tom Wurtz, were on a plane for California.

Acquisition takes shape

In more than four decades at the helm of Golden West, husband-and-wife co-CEOs Herb and Marion Sandler had turned a savings and loan with a few locations into a top 20 mortgage lender with 285 branches.

Along the way, the company was heralded for posting double-digit profit growth year after year. But with an aging leadership team and a dependency on just one type of mortgage, Golden West began to explore its alternatives, Herb Sandler said in an interview.

On Tuesday May 2, 2006, Thompson and Wurtz met with the Sandlers and other top Golden West executives at a downtown San Francisco hotel. Herb Sandler, then in his mid-70s, says he and his team had investigated Wachovia and heard good things about Thompson and how he handled mergers.

Thompson and Wurtz seemed to know a lot about the company's business already, Sandler said. It may have helped that Wurtz, with the N.C. bank since the mid-1990s, previously worked for the Office of Thrift Supervision, which regulated Golden West. At the agency, the lender was seen as a model outfit.

Thompson grew comfortable with the lender's nontraditional loans, later praising its “conservative” approach.

Its option ARMs, known as Pick-A-Payment loans, gave customers monthly payment options, including a minimum payment that didn't cover all of the interest owed. Choosing that option caused the loan balance to grow, instead of shrink, a worry for regulators and consumer advocates.

The lender had pioneered its option ARM in the 1980s, but faced increasing competition from the likes of Countrywide Financial and Washington Mutual. Golden West boasted numerous safeguards, including a cap on how much the minimum payment could increase each month. Unlike most rivals, it held onto its loans, a major incentive to make good mortgages.

And Golden West had a record of virtually no loan losses – even in downturns.

The meeting, which included no-frills sandwiches for lunch, concluded with a deal well under way. Both sides moved into investigating each other's operations, a process known as due diligence.

Thompson was back in Charlotte the next day to play golf with tour star Vijay Singh in the Wachovia Championship pro-am event. In the coming days, Thompson juggled his tournament hosting duties with high-stakes deal making.

‘It was very different'

During the rest of the week, a Wachovia team including chief risk officer Don Truslow and Ben Jenkins, head of the general banking operations, visited Golden West sites in California and Texas.

Top Wachovia mortgage executives were notified the purchase was in the works but they weren't drawn deeply into the due diligence. That contrasted with earlier deals investigated by the bank. Only a few months earlier, for example, mortgage executives helped vet a possible investment in mortgage and auto lender GMAC and recommended against the move. Thompson didn't do the deal.

Some technology executives who had helped check out past acquisitions weren't clued in. “From everything I saw it was very different,” one former executive said of Golden West. “It was a done deal. Make it work.”

Wachovia reviewed Golden West's loan portfolio, but to what level of detail is unclear. Dozens were involved in the entire due diligence process.

Wachovia executives were impressed with Golden West's low loan losses during a major California downturn in the early 1990s, when housing prices fell 20 percent and unemployment hit 10 percent.

Thompson and other executives also took comfort in the relatively small size of Golden West's loans – less than $250,000 on average. That stemmed from a strategy to avoid the potentially more volatile high-end of the housing market. In more expensive California, the lender's average loan size was about $338,000.

The focus on smaller size loans “gives you incredible confidence” partly because these mortgages would get hit less than larger ones “in a difficult environment,” Thompson would say days later.

During his tenure as CEO, Thompson was known for a consensus-style approach to management. In an August 2006 interview, he said he was hands-on when needed but also gave his executives room to lead. Asked if he had any weaknesses, he said he needed a “really good CFO, and I've got one, because I'm not a numbers guy.”

Three of the top executives involved in the deal – Wurtz, Truslow and Jenkins – declined to comment for this story.

Bank analyst Gary Townsend, now with Maryland-based Hill-Townsend Capital, said he met with Wurtz in August 2006 and the CFO indicated that he had overcome initial reservations about the Golden West deal after meeting with the Sandlers.

As chief risk officer, Truslow's role was to help evaluate the loan portfolio. Seen as a quiet leader, he joined the bank in 2001 with the Wachovia merger. General banking chief Jenkins, who had come up through the ranks with Thompson, was already leading an effort to build new branches in California.

A voice absent from Thompson's executive suite was longtime CFO Bob Kelly, who had departed about three months before the deal to become CEO of what is now Bank of New York Mellon. Kelly was known for speaking his mind and for sometimes offering contrarian opinions, several current and former executives said. In hindsight, they wonder whether he would have questioned the deal.

“He'd say, ‘Let's step back and look at this a different way,'” says a former executive. Kelly declined to comment.

Wall Street reacts

The time it takes to pull together a big bank deal can vary widely. Thompson spent months weighing the 2001 First Union-Wachovia merger. Bank of America looked over MBNA in a little more than a week in 2005. In the current financial crisis, companies are being cobbled together in weekends.

The Golden West deal, from first contact to announcement, took 11 days, with the formal due diligence covering no more than six days.

With speed comes more risk, said Townsend, the analyst, who emerged as a critic of the deal. “I think Ken Thompson wanted to buy Golden West,” he said. “Why they pulled the trigger so quickly, I don't know. I don't think there was another bidder.”

It's been reported that Citigroup and HSBC passed on Golden West before its talks with Wachovia. But no other bidder ever publicly stepped forward.

On the morning of Sunday, May 7, 2006, Thompson and his team made a final presentation to the Wachovia board, including an assessment of credit quality and risk management.

The directors, who met at least three times during the due diligence period, had an extensive discussion, says Brown, the retired director. “The fact of the matter,” the High Point public relations specialist says, “is that when the discussion took place – go back and check the fact book – Golden West had one of the lowest loan default rates in the country.”

He also notes that a “major consideration for us was that they had a lot of branches in California and the West.”

The directors unanimously approved the acquisition. The next morning at an investor presentation in New York, Thompson told analysts he was “thrilled” with the deal. Sandler called it “a perfect cultural fit.”

Asked about the timing, Sandler dismissed TV pundits he'd heard that morning criticizing the option ARM and the possibility of a real estate crisis. “That is a bunch of garbage,” he said.

Investors balked. In the first day of trading, Wachovia's stock price dropped nearly 7 percent. As the bank's shares slipped further that week, Wurtz held an unusual follow-up conference call with analysts.

One asked about Golden West's average loan size, wondering whether this implied its customers were less creditworthy. Wurtz said that wasn't necessarily true. He pointed to the smaller loans as a sign of Golden West's lending discipline.

Another question was whether the Sandlers sold at the top of the market. “They have said very specifically that that is not the motivation for their sale,” Wurtz said, “ … and I believe them.”

Culture clashes emerge

Shortly after the acquisition's announcement, more than two dozen executives from both sides gathered at Wachovia's uptown headquarters complex. It was a get-to-know-you session.

Sitting in on the meeting was Jim Judd, a top Golden West executive who had long piloted the lender's mortgage machine with a no-nonsense, even combative management style. Now, in his late 60s, he would soon be charged with leading the combined mortgage unit – even though his company was the one being bought.

As a Wachovia mortgage executive explained the bank's customer satisfaction surveys, Judd questioned how the data was used. The Wachovia executive said the surveys helped gauge employee performance and calculate incentive pay.

Judd dismissed the effort as stupid, recall sources at the meeting.

Wachovia executives were shocked by the remark, which seemed to disparage Wachovia's ingrained focus on customer service. The summit, in which Thompson made an appearance, would be the beginning of a culture clash that would embroil the combined mortgage unit. Judd could not be reached for this story.

The companies were different in many ways. Wachovia's mortgage unit, part of a giant financial services company, pitched a variety of traditional mortgage products mostly to its banking customers. Golden West largely offered its signature product, option ARMs.

Wachovia mortgage executives didn't see Golden West counterparts as true mortgage bankers, skilled in making a variety of loans and packaging them into securities for investors. Instead, they saw them as slick salesmen who used less than sophisticated tactics. They were aghast at proposals to pitch loans at flea markets and shopping malls.

Golden West executives were frustrated by Wachovia's polite, deliberative culture. At Golden West, they prided themselves on walking out of boring meetings and grilling each other before making decisions. They were bewildered by Wachovia's complex management structure. They bemoaned mind-numbing conference calls in which scores of people dialed in and no decisions were made.

At Golden West's headquarters in Oakland during a regular visit, Sandler met with Thompson and outlined some of his concerns, ranging from management structure to employee incentive pay.

Thompson was a “consummate gentleman,” but Sandler says he thinks the Wachovia CEO was a little angry. “Like, ‘Who am I to be talking to him like that?'” Sandler says. “My obligation was to make Wachovia a better company.”

A source familiar with the situation said Thompson listened to Sandler's concerns over time and acted on some.

After the purchase closed in October 2006, Sandler, a major Golden West shareholder, said he was disappointed that Wachovia rarely asked for help.

Meanwhile, more than a half dozen of Wachovia's top mortgage executives soon left the company, either uneasy with the unit's direction or squeezed out.

Pick-A-Payment loans continue

In summer 2007, Wachovia named one of its own to run the mortgage unit in anticipation of Judd's retirement at the end of that year.

David Pope was a well-respected executive with a diplomat's touch. He had overseen some mortgage functions in the past but was known more for his experience in retail and business banking.

While he might be able to ease tensions between the warring factions, some questioned whether Pope was the right person to navigate what had become one of the worst housing market collapses in history. “Do you want a nice guy or do you want someone who knows the industry and can get you through this environment?” one former Wachovia executive says.

The change in leadership didn't halt Wachovia's sale of Pick-A-Payment loans. Two of Pope's top deputies were from Golden West and backed the product.

By early 2008, the subprime mortgage business had collapsed, and now investors were losing their appetite for other nontraditional loans. Rivals such as Bank of America and Washington Mutual were abandoning option ARMs or tightening standards. Wachovia was diving in deeper.

Golden West specialized in selling Pick-A-Payment loans mostly through outside brokers, a type of sales force that drew criticism for pumping out mortgages with little regard to their suitability for borrowers. Now, in addition to these brokers, the goal was to sell the loans through Wachovia's more than 3,000 branches coast to coast.

“We thought it was a good product at the time the decision was made to merge with Golden West,” Pope said in a February 2008 interview. “We think it's a good product today. We think it will be a good product in the future.” He declined to comment for this story.

As the housing crisis worsened early this year, Wachovia loan officers told the Observer their jobs were threatened for not selling enough of the loans, which some felt weren't appropriate for most customers. Executives who came from Golden West called the loan officers whiners who didn't understand the product.

Both sides also sparred over underwriting standards. Wachovia relied heavily on credit scores. Golden West analyzed a borrower's credit history on its own, but didn't always require full documentation of income.

Pope took steps to better merge operations and to craft a long-term mortgage strategy, but the environment inside the unit was worsening, employees said. Initially, Pope's appointment appeared to be a sign Wachovia was reclaiming the unit, a former mortgage employee says, “but there didn't seem to be any action.”

California a liability

In late 2007, Wachovia began pointing to “several pockets” in California as the main source of its rising loan delinquencies.

California's Inland Empire and Central Valley regions, where Golden West had about 17 percent of all of its loans, were suffering steep declines in housing prices. These drops would exceed 40 percent in some areas, topping national rankings.

Wachovia would later say Golden West's concentration in these markets was an unintended consequence of its strategy to make loans on moderately priced homes. As home values skyrocketed in California, Golden West was priced out of expensive coastal areas and made more loans in the state's interior.

Now as home prices fell in these once fast-growing areas, foreclosures climbed. Blue-collar workers defaulted as construction-related jobs dried up. Commuters soured on distant neighborhoods as gas prices rose, feeding the downward spiral in home prices. Some borrowers stopped making mortgage payments when the equity in their homes vanished, a new behavior that befuddled bankers.

Once seen as a major attraction, Golden West's presence in California was becoming a liability.

In early 2008, Wachovia executives began acknowledging the bad timing of the deal. But they kept echoing Golden West's faith in the portfolio.

In a January conference call reporting fourth-quarter earnings, Thompson pointed to Golden West's minuscule losses in the 1994 California housing slump. Even if it got worse, he said, “our Pick-a-Pay portfolio will generate very meaningful bottom line profits in 2008 – and I do not believe that investors grasp that fact today.”

The picture grew grimmer in February and March as Wachovia's risk managers, led by Truslow, adopted new modeling techniques for predicting defaults. Wachovia now expected cumulative losses of 7.5 percent in the $121 billion portfolio, in contrast to Golden West's history of virtually none. That meant the bank had to start setting aside much more money to cover current and future Pick-A-Payment losses.

That contributed to stunning news April 14. Wachovia revealed a $393 million first-quarter loss, a cut to the lucrative shareholder dividend and plans to raise capital. Thompson was contrite: “I know these actions are not without costs, and I wish they were not necessary, but they are.”

Along with the earnings announcement, Wachovia disclosed some potentially troubling statistics about the Pick-A-Payment portfolio. In 2005 and 2006, at the height of the housing boom, Golden West had made more loans to borrowers with lower credit scores than in the past. Also, the amount of deferred interest in the portfolio – the result of borrowers choosing the minimum payment – had climbed to $3.5 billion, or 3 percent of the loan book, up from $449 million, or 0.39 percent, in 2005.

In an interview the day of the earnings report, Thompson said the company was analyzing its mortgage strategy but he expected the bank to offer an array of products, including Pick-A-Payment loans. Around then, Wachovia began tightening Pick-A-Payment lending standards, requiring minimum credit scores and income verification.

Cascade of problems

A week later on April 22 at Wachovia's annual meeting, investors, who had seen their shares fall by about half since the Golden West deal was announced, called for Thompson's job. Soon after, Wachovia disclosed an embarrassing cascade of unrelated problems, including a settlement of up to $144million over ties to telemarketers who scammed its elderly customers.

Thompson was losing his hold on the company. In May, lead director Lanty Smith, who had backed him at the shareholder meeting, assumed Thompson's chairman title. In an effort to bring in outside help, Thompson contacted former Bank of America CFO Al de Molina about a possible role. Thompson also worked on changes to the bank's finance and risk management structure. He didn't get the chance to test his plans.

On Thursday May 29, Smith called him into his 40th-floor office. Thompson's more than three-decade career at the company was over. He later reviewed the language in the June 2 news release. He wanted it clear that he had been asked to step down, stressing, “I didn't throw in the towel.”

Smith, who took over as interim CEO, attributed the move to a series of missteps, not just one incident. He began the search for Thompson's successor immediately, but the vacuum in the corner office rattled investors and earned the board criticism for not having a ready replacement. Smith declined to comment for this story.

In June, Wachovia stopped making Pick-A-Payment loans.

Regulators step in

The following month, Smith tapped a new CEO: Bob Steel, a U.S. Treasury official and friend from the Duke University board of trustees. Steel began crafting a recovery strategy, building on some of the work already underway.

For the mortgage unit – where Wachovia now said Pick-A-Payment losses would reach 12 percent – he announced plans to refinance existing customers into traditional loans and to slash mortgage jobs.

Soon after, CFO Wurtz and risk officer Truslow announced their departures. In a meeting with analysts from research firm CreditSights, they admitted Wachovia was caught off guard by a steep decline in home values. They said the company's policy of making mid-sized loans backfired by leading to the concentration of mortgages in California's Inland Empire and Central Valley regions.

They also acknowledged another weakness in the Pick-A-Payment product:

“It seems that borrowers who choose a mortgage with the option of lower minimum payments may in fact be indicating to the lender that there is more likelihood that they will not have the resources to cover the (full) payment,” the analysts wrote.

In addition, they wrote, “Wachovia was frank that it had missed an opportunity” to aggressively “sell down” the portfolio in early 2007 when the loans were still attractive to investors.

By mid-September, Steel's plans became moot. The failure of investment bank Lehman Brothers roared through the credit markets. The Sept. 25 collapse of Washington Mutual, a major option ARM lender, ratcheted up investor anxiety about Wachovia's loans. A federal bailout plan intended to calm roiling markets stalled in Congress.

In a frenzied last weekend of September, federal regulators ordered Wachovia to sell most of its operations to New York-based Citigroup. Days later, Wells Fargo trumped it with a rival offer. In November, Steel said the bank ran out of time to deal with its troubled loans amid historic economic times.

As Sandler sees it, Golden West has been unfairly blamed for Wachovia's myriad problems, and he suspects the bank has overestimated potential losses in the portfolio. He attributes the rising delinquencies to plunging housing prices and Golden West's concentration in California markets – not the nature of its product.

“I plead guilty to being a residential lender,” he says. “This has nothing to do with the quality of the lending.”

He acknowledges the lender may not have flagged problems in the Inland Empire and Central Valley soon enough. In the past, Golden West had identified overheated markets such as Las Vegas and pulled back.

“Maybe, you could say, ‘Gee, we shouldn't have made loans in certain parts of California,'” Sandler says. “We used to pride ourselves in getting out. We probably were not as quick in Inland Empire and Valley areas.”

Last month, the U.S. attorney in San Francisco said the Justice Department and the Securities and Exchange Commission were investigating Golden West's lending practices and whether it misrepresented its portfolio to Wachovia during the sale. Wachovia faces lawsuits by shareholders over the deal and from customers who allege improper lending practices.

The Wells deal, pending shareholder approval, is expected to close by year's end.

Wells Fargo has said it plans to phase out the Golden West portfolio. The bank said efforts to work with struggling borrowers show promise, but it's still projecting losses to reach $36 billion – or 29 percent of the portfolio. That's nearly four times Wachovia's initial 7.5 percent estimate in April.

“As we've always said,” Wells Fargo CEO John Stumpf told analysts this month, “we do not like the option ARM product.”

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