There is perhaps nothing more important to a bank than the loans they make. Loans are the way a bank makes money. When loans go bad, it can be fatal to a bank. In extreme cases the federal government is forced to step in and bail out the system, costing taxpayers money.
Loans are the lifeblood of a bank. All businesses sell products, and a bank's product is money. Banks make money by taking in funds from depositors and other sources and then lending money out to customers. The bank spread is the difference between what the interest a bank must pay to obtain the funds and the rate the bank charges on the loan. For example, a bank might pay two percent interest to a depositor and charge a customer six percent interest on a loan. The four percentage points is the bank's spread, and its profit.
Types of loans
Banks make all sorts of loans, but they can broadly be broken down into two categories: residential and commercial. Residential loans represent money lent to people looking to finance a home purchase with a mortgage. These can be fixed-rate or adjustable with terms varying from a few years to 40 years. Banks often sell their long-term mortgage loans rather than keeping them on their books as a protection against inflation. Commercial loans are loans made to people looking to start or expand a business.
When loans go bad
Banks expect that a certain percentage of loans will go bad. In other words, they know that some borrowers will be unable to make the payments. In these cases the bank takes back the property from the borrower, be it a home or commercial business. The bank then tries to resell the property as a foreclosure. In decent economic times, banks may be able to recoup the majority of their money on the loans by reselling the property for a good price. Also, banks build in reserves for loan losses, cushioning the blow.
Bad loans in a bad economy
Loan losses can hit banks especially hard during a poor economy, particularly if banks were too loose with their lending when times were good. A poor economy usually leads to falling prices on the properties backed by bank loans. That makes it hard for a bank to recoup its money if the loan payments stop coming in. For example a bank might have lent $8 million on a shopping center project that is worth just $3 million when the loan payments stop coming in. That can lead to costly losses for a bank.
A down economy can be fatal to banks that have too many of these bad loans and not enough reserves to cushion the blow. In these cases the Federal Deposit Insurance Corp. will step in to take over the bank and cover the deposits of its customers. Hundreds of U.S. banks may end up failing due to the speculative lending boom that occurred in this century. This has forced the U.S. Treasury Department to bail out many banks, and taxpayers ultimately foot the bill.