Non Performing Assets: A Lender’s Perspective
US banks have probably been the envy of their European competitors with the Federal Reserve stepping in with its bank bailout program. A point that is often overlooked in most financial systems however, is the presence of prudential controls upon the banking systems of most developed economies of the world.
In the US, the regulatory body monitoring banks is the Federal Deposit Insurance Corporation (FDIC). The FDIC insists that banks have a 10% capital reserves ratio; a percentage of risk weighted assets. In the event of anything less than this ideal it is tolerant up to a level of 5-6% where it will then take swift action to warn the bank, enforce corrective action or even declare it insolvent and become its trustee in receivership.
Such is the threat of being undercapitalized.
In essence, the bank needs to provide capital in order to meets cover its liabilities and its operating expenses and the FDIC capital reserves ratio seek to protect those interests. When mortgage repayments are 90 days in arrears, they are then deemed to be non-performing assets (NPA’s) and as such will reduce capital reserves due to the increased risk weighting of the non performing loans. With the ratings agencies making an art form of downgrading securities after the subprime mortgage crisis, many banks will find their capital reserve demands escalating dramatically as the risk weighting of these toxic assets increases with respect to capital.
Most of the stalwart banks such as JP Morgan, Citigroup, and Wells Fargo have a capital reserves ratio of between 10-13%. The bottom line for a bank when capital reserve ratios fall is consequential in many areas. In order to maintain the capital reserve requirements of the FDIC in the face of non-performing assets the banks have to cease buyback programs for shares, reduce dividend payouts and in fact issue more stock in order to survive in the marketplace. As survival in the market is more important than short term profit, banks effectively cease to invest for profit and focus all their energies into preserving their operations and avoiding the control of the FDIC watchdog.
This sad turn of events doesn’t end there. It also results in less finance being available for business and investment, which in turn contracts production and eventually increases unemployment. Household and consumer spending then cease, and the economy contracts. In the event of two consecutive negative quarters of growth, a technical recession is achieved. At best, as unemployment is a delayed indicator, a dramatic increase in unemployment may also suggest a recession is in effect.
So it can now be seen why the banks have such a genuine motivation toward getting non-performing assets off their balance sheets. During the GFC, many financial institutions failed to list their NPA’s on their balance sheets in a bid to avoid FDIC requirements, to escape a admonishing of their share price by the market, and also to continue trading for profits.
Therefore, banks will certainly entertain a short sale investor who is prepared to make a firm offer. Without a formal offer however, banks are unable to entertain the prospect of discounting the value of the non performing asset, and even when one is presented, in pursuance of policy & procedure guidelines, the lender will invariably enter into a procedure that will take considerable time for approval. At this stage, the prospective buyer has often flown the coup.
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