Banking maven Chris Whalen has a must-read piece on the reckless real estate risk taking underway at Wells Fargo, the sanctimonious #4 bank. While I sometimes take issue with Chris on his readings on capital markets related businesses, he is solid on his knowledge of traditional banking and also has access to very good intelligence in that arena.

Thanks to the crisis just past, we tend to think of banks as creating danger to bystanders via their over-the-counter trading operations: securitizations, CDOs, derivatives, all that stuff that is now loosely termed as “shadow banking.” But the US crisis prior to that was the S&L and the less widely recognized LBO debt meltdown of the early 1990s, both traditional bank lending. Even though economists airily wave it away as damaging but not catastrophic, it didn’t look that way at the time. Citibank nearly failed and the entire banking sector was really wobbly. Greenspan engineered an extremely steep yield curve to help banks earn their way out of the hole faster.

Wells is in the awkward position of being a monster traditional bank, when its big retail bank competitors, Citi, Bank of America, JP Morgan Chase, also have substantial capital markets businesses. Citi has long had a leading foreign exchange and money markets business, and has a corporate cash management operation which in and of itself makes it too complicated to fail. Bank of America absorbed Merrill. JP Morgan, in addition to having a large investment banking business, also has a huge derivatives/tri party repo clearing business. That means they have more diversified sources of earnings.

Whalen points out how real estate dependent Wells is. In this way, it is not unlike Lehman and Bear, subscale players in investment banking who put their chips on real estate as a way to (hopefully) grow faster and catch up with the big boys. The difference between the now-dead investment banks is that they were at a competitive disadvantage by being smaller (in a crude simplification, you have to have pretty close to 100% of the infrastructure of the leaders, and since there are real returns to scale, for instance, big network effects in trading, the further you are away from 100% of their trading volume, the worse your economics are. That means competitors can poach not just individuals but entire teams, since they will produce more on a platform with bigger activity). Wells isn’t so much at a competitive disadvantage via not being as big, but is instead a prisoner of having been overweight real estate historically.

As Whalen makes clear, Wells is engaging in accounting games to make it look better than it is. The San Francisco bank is hardly alone it that, but Whalen depicts it as worse in this regard than its peers. It is only taking losses on its least bad real estate loans, and using those to value the rest of its portfolio. On top of that, as we pointed out, Wells has been releasing loss reserves aggressively since early 2009, something which we suspect will prove to have been ill advised (oh, except for the senior executives who collected bonuses between then and now). And lacking other high margin businesses to earn its way out of its hole, Wells is doubling down in real estate lending, and on top of that, engaging in yet more dodgy accounting. Per Whalen:

There is an old saying on Wall Street that when a company does not say anything to investors and the analyst community, then it is all bad. Since the start of the crisis, Wells has made an art form out of failure to disclose, particularly when it comes to the credit loss, doubtful and past-due experience on the bank’s retained loan portfolio and related loss reserves. While Wells’ peers among the largest banks have increased written and oral disclosure regarding loan losses and related data during the past three years, Wells consistently has stonewalled the investment and analyst communities. Most recently, Wells has even defied a subpoena from the SEC, failing to produce documents for a formal investigation regarding possible fraud in the creation of residential mortgage backed securities that the bank sees as “inappropriate.”… Several participants at the HW conference told me that Wells is literally buying market share by writing loans which are not economic, but then enhance current earnings by booking the estimated value of the “customer relationship” up front in the quarter when the loan is closed. If this type of accounting gimmickry makes you recall the days of the dot.com bubble, then you are on the right page.

Whalen argues that Wells will take a hit when Basel III is implemented because banks will no longer be able to afford to retain mortgage servicing rights. This is his only worry that I discount, because Basel II was never adopted in the US and there are reasons to think Basel III will not be either.

The picture is just as troubling on the commercial real estate side:

Wells has become the leading lender to commercial property developers. One of the oldest and most respected players in the New York commercial real estate community tells HousingWire that Wells is writing business that is at least half a point lower in cost than loans available from other banks and with far easier terms.

Note that you can lose more than 100% of your money on development lending. You foreclose, losing the value of your loan, and you have to raze the partly completed project. Back to Whalen:

But to the point about Wells Fargo, the bank’s aggressive lending to both retail and commercial borrowers could come back to haunt the giant lender in years to come. Many of those commercial property financings that the largest U.S. mortgage lending is putting on its books in the New York market are premised on the idea of rising lease rates in the next few years, but nothing could be further from the case. In fact, say most of the commercial real estate developers I know in New York, lease rates are likely to keep trending lower over the next few years as the oversupply of real estate starts to become a glut. Some of the most prominent office buildings in the city are half empty, including the showcase structure at 9 West 57th St. where your humble commentator is writing this missive. The developers are pulling the space off the market rather than accept the $50-60 per square foot that is commonly paid for prime Manhattan office space today. The private equity firms that are buying these Manhattan commercial deals funded with loans from Wells Fargo are assuming that the Silicon Valley world of media is somehow going to soak up all of the empty commercial space in New York City… But the sad fact is that most of the large financial institutions I know are pushing back against rent increases in major New York properties – and moving offices to reduce expenses.

This has the smell of something that will end badly, but it may take a couple of years to play out. As Whalen said, stay tuned.