Anatomy of a Bank Failure: Washington Mutual

So how does a bank like Washington Mutual fail and then need to be acquired by the Feds or another co like JPMorganChase ??

Banker A lends $100,000 to Borrower B in the form of a mortgage so Borrower B can buy a house valued at $100,000. The bank has the property to back the loan and the borrower gets the house thanks to the mortgage to pay off the seller. Borrower B can no longer pay his mortgage and the house goes into Foreclosure. So what happens to the bank?

The Bank now has 3 things they have to account for:

1) Loan loss provisions and Reserve Requirements
2) Tax and Financial Statement implications
3) The Property

As stated before, banks have loan loss provisions, which means that now this loan for $100,000 has gone bad, the bank must set aside $90,000 in cash. This means that $90,000 is taken out of lending circulation reducing the bank's liquidity and lending capacity. Why $90,000? The Federal Reserve has a reserve requirement on transactional loans of 10%. This means 10% of the value of the loan must be kept on deposit either at the bank or at the Fed. When a loan goes bad, this $$ has to still be set aside. but now, they have to set aside all 100% not just the 10% set aside when the loan was made. So problem # 1 for the bank is less $$ to lend to good credit customers.

Financial Statement implications seem like they wouldn't affect those of us not in the banking world that much but it does and certainly did in this case. Bad loans are 'marked to market', which means they are adjusted every year to their market value. A foreclosed loan is a loan with zero value since its non-performing and as a result, they now have a liability of a $100,000 loan that foreclosed and now immediately have $100,000 less in assets than they had when the loan was performing. The bank does have the property but needs to get rid of it in order to get this bad loan off their books. Is this loan really worth zero? No, its not but the problem for the bank is that no one wants to buy this loan even at a deep discount so on its books, it now looks immediately $100,000 less solvent than it was. So problem # 2 for the bank, is having to get rid of the property when property values are declining and a clear market value cannot be established.

This implication on financials seems only theoretical in that the loan has some value to someone but until the marketplace stabilizes and the loan can be sold, even at a loss, then this implication is very real and shows why a bank as large as WaMu can fail when they have the double whammy of $$ set aside against bad loans and loans marked down to a value of zero, even if temporarily.

The property is supposed to be the security against the loan but property values are declining. If the best offer the bank gets for the home with the $100,000 mortgage on it is only $60,000, does the bank accept? Problem # 3 for banks is a market of declining property values where the value of their security is unknown.

So does the bank really have $100,000 fewer assets because its value was marked to market at zero? No it doesn't but because the loan loss provisions have to be set aside and such an unstable marketplace exists for selling the underlying home, its impossible to assess the value of this loan and the underlying property and its for these reasons why a bank as large as WaMu can and did fail.