Wachovia ( WB) has probably gotten its best possible outcome now that Citigroup ( C) has decided to walk away from its bid and let Wells Fargo ( WFC) go through with its merger.

Wells Fargo's $15 billion proposal, announced a week ago, is clearly the better deal for Wachovia shareholders, employees and U.S. taxpayers, but Citi's planned legal action has put somewhat of a damper on the fate of the troubled North Carolina bank.

But in the end, even with Wells Fargo's unorthodox counteroffer, the best bank for the transaction won out. (For more on this, see Jilted Citi Needs to Move On.)

"We like this deal. We believe it makes greater sense from a strategic standpoint and pricing standpoint," writes Christopher Mutascio, an analyst at Stifel Nicolaus. "It provides Wells Fargo with the opportunity to become a national banking franchise at a much lower cost (and in a more timely manner) than cobbling several one-off transactions together."

Citi said on late Thursday that it was breaking off negotiations with Wells Fargo to come to a compromise regarding the ownership of Wachovia. But the company said it was still proceeding with a lawsuit against Wachovia and Wells Fargo seeking "compensatory and punitive damages for bad faith breach of contract and tortious interference" in the $60 billion lawsuit it filed Monday.

Citi, however, said it would not seek to block the deal between Wachovia and Wells after failing to come to an agreement after days of negotiations. Citi cited "dramatic differences" in the views over the transaction's structure and the risks involved. The dueling banks had initially agreed to halt litigation related to the competing deals through 8 a.m. on Friday.

"I suspect that as Citi and Wells Fargo frankly dug into more of what was under the covers at Wachovia the debt might have been greater than what was expected, and Citi was probably looking at not getting enough out of the deal to make it worthwhile to keep battling," says Nancy Atkinson, a senior industry analyst at Aite Group.

"To me it's a better market play for it to be Wells," she says. "Wells now really moves up into the top four banks in the U.S. By expanding across the country, Wells really has the opportunity to grow their franchise. I think the Citi deal would have been a bit more focused on cost cutting and efficiencies than growth."

Citi on Sept. 29 had agreed to take over Wachovia's banking operations for $2.16 billion, or about $1 a share, in a deal pushed forward by the Federal Deposit Insurance Corp. On Oct. 3, Wells trumped that plan with its own offer of $15.1 billion, or $7 a share, to acquire all of Wachovia. Wells' offer did not require FDIC assistance, while Citi's needed the government to take on potential losses on part of Wachovia's loan portfolio

Citi said that without its willingness to acquire Wachovia, the bank would have failed in a matter of days. It said Wells had "walked away" from a deal prior to the FDIC reaching out to Citi.

Industry observers had said last week that instead of beginning a legal battle that could take months, Citi should just step aside, regardless of the fact that it came forward when the FDIC needed it.

"Citi is crazy," said Cassandra Toroian, the president and chief investment officer of Bell Rock Capital, which has a small position in Wachovia, last Friday. "The legal fees and time on this is not something they should be bothering with. They need to go find another deal."

A Wells Fargo and Wachovia merger makes a lot of sense for the two companies, said Bart Narter, the senior vice president of Celent's banking group, at the time of the announcement.

"Wachovia and Wells Fargo are nearly perfect complements to one another, with strengths on both the East and West Coasts, respectively," Narter says. "Wachovia's recent acquisition of Golden West gives it an overlapping branch footprint in California and both also have major activities in Texas. Other than these two very competitive markets, the two banks are the yin and yang of retail branch banking."

On the other hand, a Citi and Wachovia combination would have given the New York-based financial titan the kick-start its struggling domestic retail franchise needed to be competitive against other large players, including Bank of America ( BAC), JPMorgan Chase ( JPM) and Wells Fargo, as well as a significant addition to its deposit base -- something that banks these days are coveting as they struggle to fund their businesses in a deteriorating economic environment.

Wells Fargo, according to presentation materials last week, will now become the nation's largest bank, with 6,675 locations, $1.4 trillion in assets and close to $800 billion in deposits, surpassing JPMorgan Chase, even with the addition of Washington Mutual, which it took over last month.

Citi had planned to fold its U.S. retail bank into the Wachovia platform. The takeover also would have provided some much-needed stable funding and liquidity through Wachovia's deposit base. Citi had said that it would have had more than $600 billion in deposits just in the U.S. and more than $1.3 trillion globally.

Following Citi's decision to stand aside, Moody's said the company will remain on review for a possible downgrade.

For Citi, a deal with Wachovia would likely have detracted the firm from continuing its mission to shed $400 billion in noncore assets and businesses from its balance sheet, despite Pandit's reassurances that nothing would "take our eye off the ball in getting fit."

Pandit said Thursday that Citi will apply the same "discipline" it used in the Wachovia deal to future transactions. It will also "redouble" its focus on capital and risk management, as well as controlling expenses, he said in a statement.

Wells does still have to deal with the $122-billion Option ARM portfolio that is at the heart of Wachovia's troubles, among other souring loans, such as residential construction and land loans. Wells Fargo executives on a conference call Oct. 3 to discuss the deal had estimated that losses would total $74 billion from a combination of credit losses and writedowns.

But executives were vague when asked by an analyst about how exactly they would deal with Wachovia's Option ARM book, and simply said that they would look at a variety of measures, including refinancings and asset sales.

Stifel's Mutascio worries about Wells Fargo's own home equity, credit card and commercial loan portfolios, which are all posting "higher-than-average" losses compared with other large banks, he writes.

Because of that, combined with a deteriorating residential mortgage portfolio, on top of the poor loans Wells Fargo will be adding from Wachovia, the bank is likely to have further loan-loss provisioning in the coming quarters, Mutascio writes.

Wells Chairman Dick Kovacevich said in a statement Thursday that the merger is "simply an incredible fit that will result in an immensely strong, stable financial services company."

Wachovia CEO Robert Steel said in a statement on Friday that the company is "delighted to stride ahead with Wells Fargo in creating a coast-to-coast financial institution -- one of the strongest financial firms in the world."

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