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How banks prepare for and handle inevitable mortgage loan losses is an area of public concern following in the wake of the financial meltdown. Banks which did not have sufficient financial reserves to contend with the number of sub-prime and other mortgages which defaulted contributed to collapse of some large financial institutions and the bailout by the federal government of many others. Many people still wonder if banks are keeping adequate assets to deal with these inevitable loan losses. There are several issues to consider in this discussion. First, are the bank managers keeping enough capital in reserve to deal with loan losses? When there are the inevitable shocks to the economy which will cause an increase in bad debts, will the banks have enough liquid assets to fund their operations? Additionally and perhaps most importantly, is the public aware of how loan loss reserves are calculated and reflected on the financial statements?
Let's take a look at what a loan loss reserve is, and how it is applied to the mortgage industry. Using accrual accounting methods, the bank will make an entry into their assets with what is known as a contra account. The purpose of the contra account is to decrease the asset account by a percentage of the total loan amount the bank expects will default. The percentage of loss expected, is determined by the management of the bank depending on a variety of factors which should correspond to the amount of loan losses the bank expects to have. The loan loss amount will change the bottom of the balance sheet by reducing the assets. In a simple example, if a bank determines it will have 5% defaults on all loans in a given year, and they expect to write $1,000,000 in loans, they should record $50,000 in their contra account Expected Bad Debt. The bank would also reduce their revenue amount by $50,000. This recording will communicate to anyone reading the financial statement that the bank expects income to be reduced by $50,000 due to bad debt. Loan loss reserves are sometimes know by their acronym Allowance of Loan and Lease Losses. (ALLL) Loan loss amounts need to be reflected as accurately as possible so that banks can adequately prepare for defaults.
It is important for banks to understand current and future economic conditions to adequately fund their reserve balances, and to avoid the costs associated with a higher than expected default rate. There are several methods to determine an adequate amount to keep in loan loss reserve. One is a simple percentage of sales method. A second, more complex analysis would be to estimate a percentage of collections based on the age of the past due accounts. Still other banks may put a policy in place to assign all accounts beyond a pre-determined time past due to a collection agency.
Since the loan loss amount kept in reserves is at the discretion of the management, there are valid concerns that the reserve amounts can be underestimated to inflate profits and earnings. When a banks' management decides to move money from the loan loss account to income, the balance sheet is affected in a positive way. If management is paid a bonus for profitability in a given quarter, the temptation to hold a lesser reserve is a relevant concern. This income change can also affect the share price of the stock, and if the bank will or will not pay a dividend. In the fourth quarter of 2010 J.P. Morgan moved 8.1 billion dollars into net income, from money they has set aside for loan loss reserves. This represented about 40% of J.P Morgans' total earnings. Citigroup reported a fourth quarter 2010 net income of 1.3 billion, which included the release of 2.3 billion from the loan loss reserves. Without the release of these reserves, Citigroup would have reported an income loss for the quarter. Citigroup can likely justify the asset movement because during this same period, it was also reported home loans ninety days past due fell by one half percent.
Individual stakeholders of firms which lend money need to have a basic idea how loan loss reserves work, and the affect they can have on the balance sheet. When a bank posts a headline grabbing income number, the average investor needs to look into the financial statement to understand where this income is coming from, and make an educated determination of the banks true profitability
Read more: http://www.articlesbase.com/accounting-articles/understanding-loan-loss-reserves-4562754.html#ixzz1Ulxq3eSK
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