Another aspect that impacted banks ’ ability to make loans to less than stellar borrowers is that they are similar to corporations in that they rely on their good ratings [ from S & P and Moody ’ s for example ] in attracting either deposits or floating paper themselves [ through Wall Street ’ s ability to attract bond financing ]. From a deposit standpoint , although deposits are FDIC insured up to $ 250,000 , many banks that have lower than AAA ratings find they have to pay higher yields to depositors in order to attract money . From a bond offering standpoint , the higher the rating , the lower rate the banks have to pay their bond holders . If a bank makes loans that appear “ questionable ”, they risk having their rating lowered and it ends up costing them in the long run . They find it better to avoid loans that may potentially give the bank a blemish , even though they would have earned a higher yield on the mortgage being provided to the borrower who appears to be below triple A in terms of ability to repay .
Most banks work off of a fairly slim arbitrage [ due to competition ], so it is not worth having loans in their portfolio that appear riskier . When a loan goes onto a “ watch list ” or goes into default , more of the bank ’ s resources are tied up and not available to be deployed into new loans . Loans that are put onto the “ watch list ” would be those loans in which the loan to value is not as strong as the bank had originally determined . Although the borrower may not be late on any mortgage payments , the value of the property may have declined to where bank auditors have determined that there is a more than likely potential default . For example , if the bank made a loan on a property two years ago for $ 100,000 on a property that had a value of $ 150,000 at the time the loan was made [ 67 %], the bank would set aside a certain amount of reserves as prescribed by the FDIC . However , if the property declined in value to $ 117,000 , the $ 100,000 loan [ presuming the loan was interest only ] now stood at over 85 % LTV [ Loan to Value ]. Under this scenario , the bank would be required to set aside more reserves . This creates a problem for the bank in that this means less money for the bank to lend out , as the extra reserves ties up more of the bank ’ s capital and less is available to make loans . If the loan actually goes into default , substantially more reserves are needed to be set aside . After the mortgage crisis , stringent guidelines were handed down to banks , as the Federal Government did not want to bail more banks out . Thus , most banks found it was just not worth using their resources for potentially nonincome earning activity .
Why Banks Do Not Lend on Certain Loans that Appear Conservative