Who Is Affected When Borrowers Default?

[RobertB]

Who Is Affected When Borrowers Default?
Mr Practical Sep 11, 2007 9:12 am

In today's world if a bank takes in $1,000 in deposits they will lend out $10,000!

Mr. Practical,

I believe I remember from Finance 101 how banks create money (I deposit $1,000, they lend out $900, I've still got my $1,000 and the recipient of the loan has $900, $900 "created"). My question is if the borrower defaults, does it "destroy" money or just the bank's balance sheet? Or perhaps the damage to the balance sheet is where the "destruction" happens? I've gathered from your missives that when debt's destroyed, deflation may/will ensue. I'm just trying to understand the mechanics.

Unfortunately, you probably went to school before the Fed (who has the authority) basically reduced margin requirements to zero.

In today's world if a bank takes in $1,000 in deposits they will lend out $10,000! Welcome to our brave new world of ponzi finance. On top of that no one really knows nor understands how much additional leverage is stored up in derivatives through interest rate swaps (when you swap out fixed for floating rates you get more leverage) or credit options.

When the borrower defaults there is basically no relative capital at banks to absorb the loss. The first hit goes to bank shareholders, who watch the stock go to zero. The second hit goes to those lending to the bank directly through CDs (unsecured). They are toast soon after. Then the depositors over FDIC insurance lose their money on deposit. Then all those secured lenders, like other banks and the Fed, begin to lose as they take their collateral back and try to sell it. This is when systemic risk really kicks in.

http://www.minyanville.com/articles/Fed-margin+requirements-default-banks-borrowers/index/a/14055/from/yahoo

[lilbitsyspider]

Everyone. The neighbor of the foreclosed property, the family, bank, investors in the bank, investors of other companies that supplied the money for the loan in the first place....and it keeps on going to now my money market and 401K at work.


My answer...EVERYONE!

[Ali Kat]

The people who actually pay their loans back are the one's that pick up the pieces of those that default. What happens is that the dedicated loan repayers end up having to foot the bill b/c as loans are defaulted interests rates will have to go up to make up for those defaults b/c the banks aren't going to take that kind of loss. Now banks are getting smart and not lending just anyone money, so hopefully this maddness will slow down a bit.

[Big Daddy]

Given the fact that the Fed will bail out banks that are run sloppily and do bad business by faulty lending, everyone pays for these defaulted loans.

If banks were left to fail for their faulty practice of lending to people that are likely to default or file bankruptcy, they would stop doing it. Instead, they stand to make the most money from people that are always late with payments and accrue the highest interest rates.

If you go bankrupt, you are even more desirable to a bank, because they now know a couple things that are in their interest. You are used being in debt. You will accept paying the minimum payment (forever), You can'nt file bankruptcy again for 7 years. They can charge you the highest interest rate.

They make most all their money on these type of borrowers. There is no risk to them, because in the worse case, if the bank is going to fail, the Fed will step in and bail them out. Either directly, by injecting money, or they will restructure the bank for aquisition by other banks. Really just moving the debts to other banks. The bank is no more, but the people that run them are still their and still making large salaries for their usary practices.

The banks are rewarded for bad business practices, it's where they make their most profit.