Why Banks Do Not Lend On Certain Loans That Appear Conservative - Part 4

Most banks work off of a fairly slim arbitrage (due to competition), so it is not worth having loans in their portfolio that appear riskier. When a loan goes onto a "watch list" or goes into default, more of the bank's resources are tied up and not available to be deployed into new loans. Loans that are put onto the "watch list" would be those loans in which the loan to value is not as strong as the bank had originally determined. Although the borrower may not be late on any mortgage payments, the value of the property may have declined to where bank auditors have determined that there is a more than likely potential default.

For example, if the bank made a loan on a property two years ago for $100,000 on a property that had a value of $150,000 at the time the loan was made (67%), the bank would set aside a certain amount of reserves as prescribed by the FDIC. However, if the property declined in value to $117,000, the $100,000 loan (presuming the loan was interest only) now stood at over 85% LTV (Loan to Value). Under this scenario, the bank would be required to set aside more reserves. This creates a problem for the bank in that this means less money for the bank to lend out, as the extra reserves ties up more of the bank's capital and less is available to make loans. If the loan actually goes into default, substantially more reserves are needed to be set aside. After the mortgage crisis, stringent guidelines were handed down to banks, as the Federal Government did not want to bail more banks out. Thus, most banks found it was just not worth using their resources for potentially non-income earning activity.