Wachovia, the embattled American bank, dramatically reneged yesterday on a deal struck last Monday to be taken over by Citigroup. It has turned instead to a better offer from Wells Fargo.

Citigroup immediately demanded that Wachovia honour its agreement and threatened legal action.

The Federal Deposit Insurance Corporation (FDIC), the regulator that brokered the transaction with Citigroup, said that it stood behind the original deal. Citigroup was also thought to be considering increasing its offer.

Wachovia said that it had decided to go with Wells Fargo because its proposal offered superior value and would enable the group to remain intact. On top of that, it did not need the FDIC to use taxpayers’ money to backstop any losses beyond $42 billion (£23.6 billion), as would have been the case with the Citigroup deal.

Citigroup had agreed in principle to pay $2.16 billion for the banking operations in a deal that would have involved Wachovia continuing as an independent public brokerage and asset manager, managing the AG Edwards and Evergreen brands.

Under the agreement reached with Wachovia, Wells Fargo will pay $15.4 billion for the group, as it looks to strengthen its presence on the East Coast of America. The retail bank also held preliminary discussions to buy Washington Mutual before the savings and loans institute was sold to JPMorgan Chase last week for $1.9 billion.

A Citigroup spokeswoman said: “[This] is in clear breach of an exclusivity agreement between Citi and Wachovia. Citi has substantial legal rights regarding Wachovia and this transaction.”

Sheila Bair, the chairman of FDIC, added: “The FDIC stands behind its previously announced agreement with Citigroup. The FDIC will be reviewing all proposals and working with the primary regulators of all three institutions to pursue a resolution that serves the public interest.”

Citigroup’s shares fell by $1.98 to $20.52 in early trading amid concerns that it would lose an acquisition that would have quadrupled its number of retail branches in the United States and significantly increased its retail customer deposit base.

Robert Steel, Wachovia’s chief executive, said the deal created one of the strongest financial firms in the world and “was great for all Wachovia constituencies: our shareholders, customers, colleagues and communities”.

David Trone, an analyst at Fox-Pitt Kelton, said: “Citigroup loses an attractive, accretive deal, complete with government assistance. The deal was struck at the eleventh hour and clearly had not been completed.”

Wells Fargo’s shares rose by $2.64 to stand at $37.80 in early trading. Wachovia soared by $2.98 to $6.90.

Wells Fargo said thjat it expected to record about $10 billion of charges against the acquisition and planned to raise up to $20 billion through the sale of new shares to boost the combined group’s capital reserves.

Wells Fargo was close to clinching a deal to buy Wachovia for more than $20 billion when, late on Sunday, it changed its mind. This reignited Wachovia’s talks with Citigroup, the parties talking all night and announcing a deal first thing on Monday. An agreement was seen as essential to avoid a ratings cut.

By Thursday night, Wells Fargo had agreed a deal with Wachovia, which Wachovia decided to take over the Citigroup transaction.

The hunt for a buyer for some or all of Wachovia’s business intensified last week after JPMorgan bought Washington Mutual and said that it would need to write down the value of its $176 billion mortgage portfolio by $31 billion.

Much of that writedown related to so-called option-ARM mortgages, an extremely high-risk home loan in which WaMu is a big player – but Wachovia is the largest of all. Wachovia, America’s sixth-largest bank, reported $9.7 billion of losses in the first half of 2008 as writedowns on its mortgage book dragged the group into the red. The bank’s troubles largely stem from the $26 billion acquisition of Golden West Financial in 2006 at the height of the property boom.

The group specialised in the toxic option-ARM mortgages. These are prone to default because they allow borrowers to skip interest payments and add them to the principal. As house prices fell, many borrowers were left with mortgages that far exceeded the value of their homes just as the economic downturn reduced their ability to meet repayments.

Wachovia holds $122 billion of option-ARMs. Fitch Ratings predicts that default rates on securities backed by these loans could reach 45 per cent.

Men at the controls

Robert Steel

Wachovia's past is firmly rooted in local banking, but there is nothing small town about its new chief executive, Robert Steel. A Goldman Sachs veteran, he is closely linked to Henry Paulson, the US Treasury Sectretary.

Steel joined Goldman, the investment power house in 1976, where he worked for Mr Paulson, and in 2004 Mr Steel moved to the US Treasury, again working under Mr Paulson, but left the US Treasury as undersecretary abruptly in July this year to head the rudderless Wachovia, apparently because he realised that he was not in line for the No 2 job at the Treasury.

Once at Wachovia's Charlotte, North Carolina offices, he replaced his finance director and chief risk officer and began cutting thousands of jobs. It became clear he would not be able, as he had hoped, to return the bank to its roots as a regional lender. Thre weeks ago, he was already seeking a buyer for the group.

John Strumpf

John Stumpf had big shoes to fill in June 2007 when taking over from Dick Kovacevich as chief executive of Wells Fargo, the San Francisco-based lender – the second-biggest in America – which had avoided the kind of toxic mortgages that brought down Washington Mutual and Wachovia.

Mr Stumpf had come a long way to do it, too, since working the loan administration department of Norwest Corporation, the Minneapolis-based mortgage lender, in 1982. Wells Fargo bought Norwest ten years ago and made him head of lending for Arizona, New Mexico and Texas. Within two years, his empire had extended to ten states.

By 2000, Mr Stumpf got a taste of doing a big deal, leading the integration process of First Security Corporation, the Salt Lake City lender that Wells Fargo acquired for $23 billion. Not bad for one of eleven children, raised on a chicken farm in Minnesota.

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