Wells Fargo's deal for Wachovia could cost the federal government billions of dollars in lost revenues as the San Francisco company takes advantage of a new change in federal tax regulations designed to encourage bank mergers.
The change was made Tuesday by the Treasury Department, one day after Wachovia had agreed to be rescued by Citigroup, and two days after Wells Fargo had walked away from the table, leaving Citigroup as the only bidder.
With the change in place, Wells Fargo renewed its pursuit of Wachovia, and Friday announced a surprise deal to buy the entire company for about $15 billion, topping Citigroup's $2.2 billion deal for most of the company. Citigroup still could sue or make a counteroffer.
In touting the deal, Wells Fargo executives said they did not need money from the Federal Deposit Insurance Corp., which had agreed to limit Citigroup's losses on a portfolio of Wachovia's most troubled loans.
“This agreement won't require even a penny from the FDIC,” said Wells Fargo Chairman Richard Kovacevich said.
But experts in tax law said the Wells Fargo deal actually was likely to be more expensive for the government.
Losses on Wachovia's portfolio of bad loans would have been absorbed by the FDIC, which is funded by the banking industry. Under the tax law change, those losses instead will allow Wells Fargo to reduce its taxable income.
“They said they're doing it without federal assistance, but in reality they are doing it with federal assistance. It's just tax assistance,” said Robert Willens, an expert on tax accounting who runs a firm of the same name.
The exact amount of lost tax revenue would depends on the future profitability of Wells Fargo and the losses on Wachovia's loans, but based on Wells Fargo's financial disclosures, it could shelter $74 billion in profits from taxation.
The Treasury Department said the change in tax laws was not intended to benefit any particular company and had been under consideration for weeks.
The change was announced along with a handful of other measures designed to buttress the banking industry after the House of Representatives initially rejected the Treasury's bailout plan.
Wachovia said it had no involvement in the change. Wells Fargo declined to comment.
The Wells Fargo deal was greeted with joy by Wachovia shareholders, many of whom felt Citigroup had taken advantage of Wachovia's short-term financial problems to all but steal the company. Wachovia's stock rose 59 percent to $6.21 in trading Friday. But that was still below the roughly $7 per a share offered by Wells Fargo, reflecting continued uncertainty about which company will prevail.
New York-based Citigroup said it is reviewing its options.
If Citigroup were to raise its bid, it could perhaps take advantage of the tax benefits that are now available to any bank that buys Wachovia.
Those tax advantages are the key to understanding the unusual events of the past week.
Available to any bank
Companies are allowed to shelter profits from taxation based on their past losses. When a profitable company buys a company with losses, however, the government historically has limited the profitable company's ability to shelter its income based on the acquired company's losses.
In the case of Wells Fargo, the company could have sheltered only about $1 billion in income each year, said Willens, the accounting expert.
Tuesday's change, however, specifically removes any limits on the amount of income that banks can shelter based on the losses of acquired companies. In announcing its deal for Wachovia, Wells Fargo estimate it would write down $74 billion in losses on Wachovia's loan portfolio.
Losses can be used to shelter income for up to as long as 20 years. So under the old law, Wells Fargo would have received a maximum benefit of $20 billion in tax protection, and only up to $1 billion each year. Now, the company could shelter from taxation its next $74 billion in profits.
The benefit is available to any bank. But right now, Wells Fargo is the rare bank with profits that might be taxed – Citigroup, for example, is badly in the red – because Wells Fargo has pursued an unusually cautious strategy since a 1998 merger made the company bank one of the largest banks in the Western United States.
Regulators were surprised by the Wells deal and initially issued statements expressing concern. But people familiar with the thinking of the regulators said they were reviewing the situation primarily to determine if whether the government had any legal obligation to Citigroup, and that they were not inclined to intervene unless they were required to do so.
For the FDIC in particular, the deal could come as a welcome relief, ending its exposure to Citigroup's future losses. That is particularly important because the FDIC initially estimated Citigroup's losses were unlikely to exceed the $42 billion threshold. Wells Fargo's higher estimate of losses likely would be imposed on Citigroup even if it prevailed, exposing the FDIC to billions of dollars in losses.
At the same time, the deal could complicate the FDIC's ability to deal with future bank failures by reducing the willingness of banks to bid for failed institutions. Citigroup propped up Wachovia for a week, and now may be left empty-handed.