I did not go into banks and do an audit. Neither did I do an in-depth analysis of the current banking industry dilemma. I wrote this piece, however, just to explain in simple terms, how a bank can become insolvent because of poor credit policies and over-inflated assets.

Banks make money by making loans to people. The largest loans most consumers will ever take are home loans. The more home loans banks make, the more profit they make.

When a bank loans money — for example, \$100,000 — to a consumer to buy a home, that loan is carried as an asset on the bank’s balance sheet. The value of the loan is the loan, plus the interest. This seems simple, but there is one more fact that has to be calculated in. Not everyone is going to repay their loan. So, the value of the loan is discounted by the percentage chance that the person won’t pay it back.

Simple English: (This is a simplified example and doesn’t reflect real life numbers or factors such as the time value of money, or the rate and or schedule of repayment. It is only an illustration of how credit worthiness affects the value of a loan.)

Mr. Mork wants to buy a house. He applies to the bank for a \$100,000 mortgage.

The bank evaluates Mr. Mork’s credit and deems him 80% likely to repay the loan. The bank has a policy that says they can only loan money to people who are 80% likely or more. So, Mr. Mork qualifies.

The bank loans Mr. Mork \$100,000. With all of the interest that Mr. Mork will pay over the life of the loan, the loan is worth \$150,000. (These are not real numbers.) The value of the loan on the balance sheet, however, has to be discounted by 20%. So, it doesn’t go on the books as \$150,000. It goes as \$120,000.

The bank makes a profit of \$20,000.

The more loans the bank makes, the more money they make. So, it is in the bank’s interest to make more loans.

Mr. Warf and Mr. Data also apply for \$100,000 bank loans. The bank does a credit check and deems them 70% likely to repay the loans. So, they are denied.

The bank CEO wants to make a larger profit. His annual bonus and compensation package is based on a percentage of the total revenue of the bank as well as his annual performance. So, he wants to loan more money. He is not permitted to loan money to people with a 70% likelihood of repayment, because this is set in the bank charter (or other public document). He can’t change this policy because when the shareholders bought shares, they understood that this bank was only going to make loans to people who were 80% likely to repay. If the CEO started loaning money to un-creditworthy people, he would be violating that agreement.

Luckily, someone at the bank has an idea. They decide that their current credit evaluation procedures are too stringent. So, although they won’t loan money to anyone who is less than 80%, they will reduce the requirements to reach the 80% bracket. They reevaluate all of the loan applications from last year and under the new credit evaluation procedures, a number of people suddenly jumped to the 80% grid.

The CEO goes before the board and says, “My revolutionary new credit procedure will allow us to make three times the loans we made last year. So, our profit will increase 300%. And, I am happy to reassure you that we won’t be loaning money to anyone lower than 80%.”

Most of the board likes it. They don’t really understand what changes are being made behind the scenes, but they like it. A few board members have degrees in accounting. They see through this suicidal procedure and try to convince the others to block it.

The CEO or his PR people go before the shareholders. Before the meeting, they have already gone to the worst ghetto or trailer park imaginable. They come back with a poor, but honest, hard-working family, who “deserve” a place of their own.

“Would you deny Jorge and Roselda a decent house and a good school for little Pablo and Conchita? You fatcats sit back in your beautiful homes in suburban America. Your kids go to private schools. You sit back and collect dividend checks based on the sweat and labor of thousands of people like Jorge and Roselda, but now you are denying them a home.” If the shareholders are not in tears yet, he begins quoting Jimmy Stewart, from “It’s a Wonderful Life.”

It is people like Jorge and Roselda who do most of the working, and, paying and dying in this town. Is it too much to ask that they do it in four decent rooms with a bath?”

The credit evaluation policies are changed. The bank makes three times the number of loans they did the previous year. Two thirds of those loans would not have qualified the previous year. The CEO triples the income of the bank. He gets a huge bonus. Often, new policies are accompanied by a “golden parachute.” There is a fear that a CEO is will not try anything new, because if it fails, he could be left with nothing. So, to encourage executives to think out of the box and try to pioneer new policies and lines of business, risky businesses are often accompanied by a “golden parachute.” Basically this is an incredibly lucrative compensation package paid to an executive if his “brain-child” revolutionary new idea fails.

There are other financial analysis that come into play here, but these are technical details. So far, this has been a simplified version of the problem. One more detail is this. People who default on home loan don’t usually miss their first or second monthly payment. The credit analysts would know, with some certainty, when a particular person would likely default. Maybe, for example, the average loan will default after four years or five years. So, the CEO announces that this last major program is the crowning achievement of his career. He will oversee it for five years and then go into retirement. At which point, he will collect his percentages for the brilliant increase in the bank’s revenues.

The problem worsens.

What is an overvalued asset?

The banks borrow money from a central bank, in order to loan money to the public. They also sometimes sell debts to outside companies, in order to get cash to loan to other people. Banks, like everyone else, have to qualify as being credit-worthy. So, when a bank wants to borrow money, they have to show their assets listed on their balance sheet.

Now, Jorge and Rosalinda’s mortgage was \$100,000 and they were meant to repay \$150,000 with a 20% probability of failure to repay, so their home loan is valued at \$120,000 on the bank’s balance sheets. So, they borrow money accordingly. But, according to last year’s policies. This loan would not have been made, because Jorge and Rosalina were only deemed 70% likely to repay the loan, which means the real value of the loan is only \$105,000. So, the bank is over-extended. It can’t make good on the money it borrowed.