Definition of Write-Down of a Loan Portfolio
For many banks, a loan portfolio represents the largest and most important asset held by the company. The valuation of the loans in a portfolio is an important number that can rise or fall as loans are generated and repaid, or not repaid. A write-down, if necessary, is a critical step in this process.
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Definition
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In accounting language, a write-down is a downward adjustment in the book value of an asset. This can occur because the asset is lost or damaged, or depreciating. For intangible property such as a loan, the asset may be depreciating as a process of amortization is taking place---the loan is gradually being paid off. Write-downs also occur as a result of loans not being repaid.
Loans as Assets
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Loans are accounted for by banks and other lending institutions as assets. For lenders that simply generate and hold the loan, the value of this particular asset is equal to the amortized cost, which is basically the remaining principle amount. As the loan is gradually repaid by the borrower, the principle amount decreases along with the value. A portfolio of loans represents all the loans made by the bank for a specific class of properties, such as homes.
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Valuation
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Some loans are actively bought and sold on the secondary mortgage market. If the bank is using the loan as a trading vehicle, then the asset is valued at the lower of the amortized cost and the fair-market value. The latter is also known as the "mark-to-market" value. The bundle of loans in a portfolio can be valued collectively the same way.
Renegotiation
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If a borrower can no longer make timely payments on a loan, then the loan may be renegotiated. Although they are not required to, banks may offer to write down (lessen) the outstanding principle amount. This makes the loan more affordable for the borrower. Banks are extremely reluctant to take this step, however, as they see it as an incentive for homeowners to default, or threaten to default, on their loans. In addition, the IRS requires that you report any write down of your mortgage loan, although by the Mortgage Forgiveness Debt Relief Act of 2007 you may not have to include that amount in your income.
Defaults and Early Repayments
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If the lender agrees to adjust the principle amount downward, then it must write down the value of the loan on its books. If the loan defaults, leading to a foreclosure action, then the asset value becomes zero. In addition, if the borrower pays the loan off early, the asset value again becomes zero. Both actions can affect the value of a loan portfolio and require the lender to write down the portfolio valuation. By federal banking laws, banks must maintain a minimum ratio of assets to liabilities (basically, loans vs. deposits), thus the valuation of their loan portfolios is crucial to their continued operation and financial health.
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References
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