Wachovia Whiplash

Can Wells Fargo captain Richard Kovacevich grab Wachovia from Citi? Get ready for the fireworks.

When Wachovia switched merger partners to Wells Fargo from Citigroup in a $15 billion deal struck in the wee hours of the night Friday, it was the M&A headfake of the decade. But now the sun is up, and they're facing the scorn of Citi and federal regulators.

Citigroup (nyse: C - news - people ), whose executives learned of the negotiations after midnight Friday even after meeting with Wachovia (nyse: WB - news - people ) executives Thursday evening, vows to fight the deal. In a statement, the company said it "has demanded that Wachovia and Wells Fargo (nyse: WFC - news - people ) terminate and not proceed with any proposed transaction," citing tortuous interference with an exclusivity agreement.

Wachovia used the same outside advisers in both transactions: Perella Weinberg, Goldman Sachs (nyse: GS - news - people ) and Sullivan & Cromwell.

Regulators also appeared to be taken off guard. The Federal Deposit Insurance Corp. (FDIC), which helped broker the deal between Citi and Wachovia last weekend, said it "stands behind" the Citigroup agreement but will be reviewing all proposals to reach a conclusion that "serves the public interest."

The Federal Reserve and the Office of the Comptroller of the Currency already extensively reviewed Citi's merger plan and said Friday they hadn't looked at the Wells Fargo proposal but, like the FDIC, said they would work to achieve the best solution.

When they do, they may find that in many ways the Wells Fargo alignment makes more sense. Wells Fargo and Wachovia have no meaningful branch overlaps, dominate separate areas of the U.S. in branch banking and have similar sales-oriented branch cultures.

Wells Fargo lacks a significant investment banking operation, which Wachovia brings, along with a significant retail brokerage operation. Citi already had both and shared many of the same retail markets with Wachovia.

Still, it was Citi that won last weekend's bidding war for Wachovia, with a $2 billion deal to buy only its deposits, assets and holding company debt, orphaning the retail brokerage and asset management divisions. The federal government was to assist the sale by agreeing to backstop $270 billion of Wachovia's $312 billion assets identified as risky. Citi would be on the hook for the first $42 billion of losses.

Citi planned to raise $10 billion in capital after the deal closed.

Wells Fargo didn't give up so easily, though. Friday's announced transaction takes the whole Wachovia, bad assets and all, for $15 billion, or $7 a share. The impaired assets would be marked at fair value, and Wells would incur $10 billion in merger and integration charges.

More significantly, the deal involves no government backing. Wells Fargo would raise $20 billion of capital. The company says it removes the risk to the taxpayer by taking the FDIC out of the equation. But the deal was announced on the same day Congress is set to vote on a $700 billion plan that would allow the Treasury to buy distressed assets from banks.

Signs of friction between Citi and Wachovia popped up earlier this week, though without much notice. Tuesday, the day after the deal was announced and the markets swooned after the House of Representatives failed to pass the $700 billion economic bailout package, Citi put out another press release reaffirming its commitment to the deal.

One bone of contention was competition between Citi's Smith Barney brokerage operation and Wachovia's brokerage division, which was not included.

"Citigroup, after yesterday morning's announcement of the sale of certain Wachovia businesses to Citigroup, is committed to the orderly consummation of the transaction, including the viability of the businesses that will remain with Wachovia Corp.," the statement said. "Citigroup continues to do business on normal terms with both the businesses to be acquired and those that will continue in Wachovia Corp."

It was a coup for Wells Fargo Chairman and former Chief Executive Richard Kovacevich, a shrewd deal maker whose last major transaction was the 1998 merger of his company, Norwest, with Wells Fargo.

Kovacevich is never one to enter high-premium transactions and has been unwilling to expand Wells Fargo far east of the Mississippi River. Wells is a dominant bank in California, where it is based, and in the Midwest, West and Southwest.

It was only a matter of time before Wells would come east. In addition to Wachovia, it was seen as a possible suitor for SunTrust Banks (nyse: STI - news - people ) of Atlanta.

Kovacevich called the deal "an unbeatable combination."

Wells Fargo and Wachovia combined would have $1.4 trillion of assets, $787 billion of deposits and $258 billion of assets under management. It would also have 10,761 branches.

Citi, which has been providing liquidity support to Wachovia all week, is sounding ready for a fight. Without the Wachovia transaction, analysts said it probably wouldn't aggressively bid on other troubled banks unless the FDIC came calling. The company said Monday it sees $6 billion of write-downs and losses in the third quarter and rising credit costs.

"Citi’s own collective of problem assets and operational challenges make it likely that any future deal will have to be very attractive strategically and immediately accretive," said Fox Pitt Kelton analyst David Trone.

The sharply worded statement Friday made it clear Citi isn't going to back away quietly. The exclusivity agreement said that Wachovia couldn't enter a deal with another company or even discuss or negotiate one. "The parties would be irreparably harmed by any breach of the agreement," the statement said. "Citi was negotiating in good faith and nearly completed the definitive agreements." Nearly.