Wells Fargo Is Developing A Big Problem

The latest in our series about bank safety, titled "Wells Fargo Is Developing A Big Problem."

As part of our ongoing series of articles on bank stability, and at the request of many of our clients, we wanted to address the major risks we foresee for bank stability in the coming years.

But before we begin, I want to take this opportunity to remind you that we have reviewed many larger banks in our public articles. But I must warn you: The substance of that analysis is not looking too good for the future of the larger banks in the United States, details for which are here.

Moreover, if you believe that the banking issues have been addressed, I'm sorry to inform you that you likely only saw the tip of the iceberg. We were able to identify the exact reasons in our public article which caused SVB to fail, well before anyone even considered these issues. And I can assure you that they have not been resolved. It's now only a matter of time.

A month ago, we published an article titled "Commercial Real Estate May Cause The Next Financial Crisis," in which we mentioned that CRE lending is one of the major issues for the stability of the U.S. banking system, and, importantly, this issue is often underestimated by mainstream financial media, rating agencies, and research departments of large banks. We said that CRE lending, together with consumer loans and C&I credit, would be in the spotlight when banks start reporting their 3Q numbers.

In this article, we would like to discuss Wells Fargo's (NYSE:WFC) Q3 numbers. In particular, we want to highlight a massive spike in the bank's non-performing CRE loans, which increased by more than half compared to the second quarter.

But before we start to look at Wells' numbers, we would like to remind you of our views on CRE lending. It's a very large credit segment of the banking system (more than $3T of outstanding loans), and it is crucial to understand that there are five major CRE property types: 1) Multifamily, 2) Office, 3) Retail, 4) Industrial, and 5) Hotel.

There's a common misconception that all the CRE lending segments are performing very poorly. Without a doubt, some of them do have major issues, but others are doing quite well, and in our previous article, we demonstrated the data that confirms these trends.

The second misconception is that only regional and smaller community banks are exposed to this risk. Surely, some smaller banks have major issues with their CRE loans, and all depositors should take a closer look at their banks' books. However, there are community banks that have excellent metrics for their CRE credits.

Some banks that we have recommended to our clients have exposure to CRE lending, and 20%-25% of their total loans were granted to this segment. Yet they're performing very well and were profitable even during the Great Recession. It's also worth mentioning that such a dramatic deterioration in CRE lending was posted by Wells, which is a top-5 US bank and not a small community lender.

So, let's move on to what we have seen in Wells' 3Q results.

The mainstream financial media reported that "Wells reported strong results, comfortably beating estimates." However, a deeper look at the numbers tells us a completely different story. Moreover, during the company's earnings call, Wells' management was quite cautious and even pessimistic, especially when they were discussing the current situation in the CRE space.

According to the bank's press release, its total non-performing loans were $8.2B in Q3, up 17% QoQ. Non-performing CRE loans were $3.9B, up by $1.4B QoQ, or by more than half. This increase was driven by office-related CRE loans. Obviously, when you see such an increase in bad loans, your first intention is probably to double-check the data, as such massive deterioration in credit quality occurs usually during severe recessions. It seems that the number was shocking even for Wells' management as they did not include their usual separate commercial real estate slide in the 3Q earnings presentation.

Here is what Wells' CFO told investors on the call:

"Vacancy rates continue to be high and the office market remains weak. Our CRE teams continue to focus on monitoring and derisking the portfolio, which includes reducing exposures.

…the hard part of office right now is that there aren't a lot of trades happening yet, right? There's a few in certain cities, and they're all a little bit different in their complexion. So you still have somewhat limited information in price discovery in a lot of places. And so we're doing - we do a lot of our own work to try to evaluate each of the underlying properties and what they could be worth in a bunch of different scenarios.

And then it's feeling like the appraisal market is starting to kind of catch up, where they're - we're seeing appraisals that are more realistic and more updated. So that's certainly bringing in different data points as we look at it. And as we looked at the quarter, we sort of look at all those data points and the underlying loans and try to do our best to come up what we think the different range of loss could look like here, and that's what's embedded in the results."

The sentence we have highlighted in bold suggests that this is just the beginning, as the appraisal market just started its revaluations, and, as such, the CRE segment will very likely see even more ugly numbers.

One might argue that WFC's CRE loans of $46B account for just 5% of the bank's total outstanding loans. However, this $46B looks much more significant when compared to Wells' tangible common equity of $136B.

Bottom Line

In our view, Wells' 3Q results are another indicator that CRE lending is very likely heading towards a severe crisis, and given its large size, this is a major risk for the stability of the banking system. As we said earlier, the system's total CRE book is more than $3T, and office-related loans account for a significant part of that. There are a lot of banks in the country that are heavily exposed to CRE office loans. As such, every retail depositor should do careful due diligence on their bank's credit portfolio.

At the end of the day, we're speaking of protecting your hard-earned money. Therefore, it behooves you to engage in due diligence regarding the banks which currently house your money.

You have a responsibility to yourself and your family to make sure your money resides in only the safest of institutions. And if you're relying on the FDIC, I suggest you read our prior articles which outline why such reliance will not be as prudent as you may believe in the coming years.

It's time for you to do a deep dive on the banks that house your hard-earned money in order to determine whether your bank is truly solid or not. Our due diligence methodology here.