How does a bank fail?

[Zguy28]

I am definitely not economically inclined. I have a few basic ideas about how economics and such works but no real depth of understanding.

I understand that a bank failing is related to holding a bunch of mortgages that are being defaulted, but how do those cause it to fail? Maybe my synapses are cross circuiting, but can somebody give the basic layman's step by step explanation on this process for a bank failing? (perhaps somebody like Pleaseblitz or Techboy?)

[RyansRangers]

when the money you have leant out and the money you have taken from people to invest is more than the assets you have.... Basically if people called thier money you wouldnt have the money to give

[Zguy28]

when the money you have leant out and the money you have taken from people to invest is more than the assets you have.... Basically if people called thier money you wouldnt have the money to give

Okay. So basically they call it quits before the situation gets any worse?

Also, if that's the case then its directly related to poor lending practices e.g. lending folks more than they can afford?

[PleaseBlitz]

I am definitely not economically inclined. I have a few basic ideas about how economics and such works but no real depth of understanding.

I understand that a bank failing is related to holding a bunch of mortgages that are being defaulted, but how do those cause it to fail? Maybe my synapses are cross circuiting, but can somebody give the basic layman's step by step explanation on this process for a bank failing? (perhaps somebody like Pleaseblitz or Techboy?)

Do you mean specifically how did IndyMac or WaMu fail and Wachovia had to get a sponsor, or do you just mean in general how a bank can fail? There are a lot of possible reasons why a bank would close its doors.

[Zguy28]

Do you mean specifically how did IndyMac or WaMu fail and Wachovia had to get a sponsor, or do you just mean in general how a bank can fail? There are a lot of possible reasons why a bank would close its doors.

Yes, in particular like Wachovia or WaMu.

[Zguy28]

I found this article from 1999 in the NY Times. Is this part of what has caused these banks to go under?

Fannie Mae Eases Credit To Aid Mortgage Lending

http://query.nytimes.com/gst/fullpage.html?res=9C0DE7DB153EF933A0575AC0A96F958260

Full article at link

By STEVEN A. HOLMES

Published: September 30, 1999

In a move that could help increase home ownership rates among minorities and low-income consumers, the Fannie Mae Corporation is easing the credit requirements on loans that it will purchase from banks and other lenders.

The action, which will begin as a pilot program involving 24 banks in 15 markets -- including the New York metropolitan region -- will encourage those banks to extend home mortgages to individuals whose credit is generally not good enough to qualify for conventional loans. Fannie Mae officials say they hope to make it a nationwide program by next spring.

Fannie Mae, the nation's biggest underwriter of home mortgages, has been under increasing pressure from the Clinton Administration to expand mortgage loans among low and moderate income people and felt pressure from stock holders to maintain its phenomenal growth in profits.

In addition, banks, thrift institutions and mortgage companies have been pressing Fannie Mae to help them make more loans to so-called subprime borrowers. These borrowers whose incomes, credit ratings and savings are not good enough to qualify for conventional loans, can only get loans from finance companies that charge much higher interest rates -- anywhere from three to four percentage points higher than conventional loans.

''Fannie Mae has expanded home ownership for millions of families in the 1990's by reducing down payment requirements,'' said Franklin D. Raines, Fannie Mae's chairman and chief executive officer. ''Yet there remain too many borrowers whose credit is just a notch below what our underwriting has required who have been relegated to paying significantly higher mortgage rates in the so-called subprime market.''

Demographic information on these borrowers is sketchy. But at least one study indicates that 18 percent of the loans in the subprime market went to black borrowers, compared to 5 per cent of loans in the conventional loan market.

In moving, even tentatively, into this new area of lending, Fannie Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times. But the government-subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the savings and loan industry in the 1980's.

''From the perspective of many people, including me, this is another thrift industry growing up around us,'' said Peter Wallison a resident fellow at the American Enterprise Institute. ''If they fail, the government will have to step up and bail them out the way it stepped up and bailed out the thrift industry.''

[JMS]

Banks fail when they don't have enough money to meet their obligations. Obligations can be paying interest to other banks, or salaries to employees or covering depositors withdrawls. When folks go to take their money out and are told they can't because the bank doesn't have it.. That's the biggest and most likely cause of failure...

Failed morgages hurt banks because they represent stagnant capital. A normal morgage is a monthly income for banks. A failed morgage isn't. Worse than that, when property values go down like they are; banks sometimes will have more money into the home than they are worth. So the bank has a vested interest to hold the asset until the price recovers so they can get all their money out. Problem is if they hold onto them; they bog themselves down and bleed money. In this situation the loan goes from a net positive income for the bank to a net loss.

.....................

Why Increasing Federal Deposit Insurance coverage is a good idea.

During the depression many undercapitalized banks failed, but also many well run banks failed. This is because as the poor banks failed, it caused panic among investers in all banks to withdraw money. They call such paniced withdrawls, "a run on the bank". So even well capitalized banks could not keep up with their depositers panicing to get their money before they lost it.

During the depression the nation took their money out of banks en mass, and started to hide their money in their homes, under their matresses. This is why the federal deposit insurance came into being. When folks hoard their money in their matresses, banks can't use that money to make loans and it puts huge pressure on the system. Worse it can actually cause the bank to fail. We are starting to see this behavior again today.

In 1933 FDR spoke to the nation to reasure it that banks were safe, and put the governments full and total backing behind banks to stop the panic in the form of federally backed deposit insurance. Today the Federal Depositi insurance covers 100,000 dollars. They want to increase that number because folks who have more than 100,000 dollars in their account are going to the mattresses, and causing problems, because they are running the real risk their money will disapear if the bank fails... Increasing the insurance is a tactic to quell the panic and thus can help the government avoid paying out any money...

[PleaseBlitz]

Yes, in particular like Wachovia or WaMu.

You want it simple and easy to understand or long and complicated?

Edit: JMS did a pretty good job with simple and easy to understand.

[PeterMP]

Okay. So basically they call it quits before the situation gets any worse?

Also, if that's the case then its directly related to poor lending practices e.g. lending folks more than they can afford?

If it gets to bad, the federal goverment steps in and seizes it (remember the deposiots are insured) (I believe they did just that to WaMu.).

Many banks own assets other than loans. Any combination of decrease of assets below a certain point as compared to money they are suppossed to have can result in goverment seizure. I don't know what that ratio has to be for the goverment to leave you alone.

Certainly, recently, the failures have been related to lending practices/the drop in the housing market. If people can't make their payments, it isn't really bad for the bank if it can make up the difference (what you paid vs. what they gave you) by selling the property. Recently, they haven't been able to do that.

The big thing is some cases these mortgages have been made by one company, bundeled, and then sold to another. I think the company that gave me my mortgage had it less than a month (I don't think I even made a payment to them) before they sold it to Wells Fargo. I don't know for sure, but Wells Fargo probably bought a bunch of them, including mine, as part of a package. In that case, Wells Fargo presumably even paid more because the company that gave me the mortgage also had to make money. Sometimes these things were traded/sold back and forth w/ every person having to pay a little more so that the last person could make money.

[Zguy28]

You want it simple and easy to understand or long and complicated?

Edit: JMS did a pretty good job with simple and easy to understand.

I think I got it.

[PeterMP]

I found this article from 1999 in the NY Times. Is this part of what has caused these banks to go under?

Fannie Mae Eases Credit To Aid Mortgage Lending

http://query.nytimes.com/gst/fullpage.html?res=9C0DE7DB153EF933A0575AC0A96F958260

Full article at link

This might help you:

http://en.wikipedia.org/wiki/Federal_Deposit_Insurance_Corporation

And that was certainly a contributing factor.

[PleaseBlitz]

Another factor that i havent heard anyone say a word about is bankruptcy laws in this country. What happens to someone when they default on a loan? Not a whole lot. You're credit gets pummelled, but that'll be ok in 5 years. You lose whatever investment you have put into the house, but with 100% LTV loans and interest only options, that is probably very little. Its not like you are going to debtors prison. You just move out of your house, wait for the bank to seize it, suck up having ****ty credit for a few years, and you come out the other side just fine.

But in an election year, NO ONE is going to dare point a finger at 'the people.'

[PeterMP]

Another factor that i havent heard anyone say a word about is bankruptcy laws in this country. What happens to someone when they default on a loan? Not a whole lot. You're credit gets pummelled, but that'll be ok in 5 years. You lose whatever investment you have put into the house, but with 100% LTV loans and interest only options, that is probably very little. Its not like you are going to debtors prison. You just move out of your house, wait for the bank to seize it, suck up having ****ty credit for a few years, and you come out the other side just fine.

But in an election year, NO ONE is going to dare point a finger at 'the people.'

Are there laws that cover credit recover?

If banks wanted a more punative system with respect to credit scores, couldn't they institute one?

[JMS]

Are there laws that cover credit recover?

If banks wanted a more punative system with respect to credit scores, couldn't they institute one?

I believe bankrupcy laws have been totally re-written by the Bush Administration and previous Republican congress and senate. I believe it's much harder to declair bankrupcy today, it stays on your record longer when you do, and even when you do; you don't avoid paying back the debt like you used to. The debt us just restructured...

Why do banks fail in general. I gave the complicated answer above not the simple answer. The simple answer is panic. That's why most banks fail.

[Zguy28]

I believe bankrupcy laws have been totally re-written by the Bush Administration and previous Republican congress and senate. I believe it's much harder to declair bankrupcy today, it stays on your record longer when you do, and even when you do; you don't avoid paying back the debt like you used to. The debt us just restructured...

Why do banks fail in general. I gave the complicated answer above not the simple answer. The simple answer is panic. That's why most banks fail.

I thought bankruptcy used to worse not easier? I thought it used to be that you were ruined for a decade or so?

[PleaseBlitz]

I believe bankrupcy laws have been totally re-written by the Bush Administration and previous Republican congress and senate. I believe it's much harder to declair bankrupcy today, it stays on your record longer when you do, and even when you do; you don't avoid paying back the debt like you used to. The debt us just restructured...

Thats not entirely true. There are 2 kinds of bankrupcy, Chapter 7 and Chapter 13. Chapter 13 is a restructuring. Chapter 7 is a liquidation. In both cases, bankruptcy has gotten easier in recent years, not harder.

And im willing to bet (but i dont have any stats on it) that 80%+ of people being foreclosed on dont even file for bankruptcy. They just walk away, leave the keys, and life goes on. The bank takes their house, which is worth $100,000 less than what they owe.

[JMS]

Thats not entirely true. There are 2 kinds of bankrupcy, Chapter 7 and Chapter 13. Chapter 13 is a restructuring. Chapter 7 is a liquidation. In both cases, bankruptcy has gotten easier in recent years, not harder.

I'm no expert, I only know what I read at the time.. The new laws say if your income is higher than the median income for your state and your family size you can no lnoger file for chapter 7. The median income here in Virginia where I live is 40k, median family income is around 50k. Used to be which type of bankrupcy you filed for was up to you, not any longer..

Restricted Eligibility for Chapter 7 Bankruptcy

Under the old rules, most filers could choose the type of bankruptcy that seemed best for them -- and most chose Chapter 7 bankruptcy (liquidation) over Chapter 13 bankruptcy (repayment). The new law prohibits some filers with higher incomes from using Chapter 7 bankruptcy.

Under the new rules, the first step in figuring out whether you can file for Chapter 7 bankruptcy is to measure your "current monthly income" against the median income for a household of your size in your state. If your income is less than or equal to the median, you can file for Chapter 7 bankruptcy. If it is more than the median, however, you must pass "the means test" -- another requirement of the new law -- in order to file for Chapter 7.

http://www.nolo.com/article.cfm/objectId/B0B66870-4C52-4303-919B10B9611D3EF9/213/161/176/ART/

And im willing to bet (but i dont have any stats on it) that 80%+ of people being foreclosed on dont even file for bankruptcy. They just walk away, leave the keys, and life goes on. The bank takes their house, which is worth $100,000 less than what they owe.

Yeah I agree with that. I don't know if the banks can still come after them or not after the house is liquidated if the banks end up loosing money.

[PleaseBlitz]

Yeah I agree with that. I don't know if the banks can still come after them or not after the house is liquidated if the banks end up loosing money.

They can, but it's expensive, and banks have such a huge amount of foreclosures, they dont have the resources. Plus, its probably not worth it most of the time to go after the remaining assets of someone that cant make a house payment every month.

[JMS]

They can, but it's expensive, and banks have such a huge amount of foreclosures, they dont have the resources. Plus, its probably not worth it most of the time to go after the remaining assets of someone that cant make a house payment every month.

So that's when they sell the debt to a collection agency for pennies on the dollar. It's a huge freaking mess.

I don't think the bank would walk away from the debt. But I'm just guessing.

PleaseBlitz, thanks your your clarifications..

[Smoot Point Really]

Simple answer: It doesn't have enough money (or credit) to meet obligations.