Here's how the accounting for bad debt works for a bank.

Bank examiners and the public accountants require that assets on a bank's books be "marked to market". For a bank a loan is an asset. Let's say that a bank had a $100,000 mortgage loan on a house. When the loan was made, let's say the house was worth $120,000. As real estate market values dropped, let's say the market value of the house--the collateral for the loan--dropped to $80,000.

Everything would be OK for the bank so long as the borrower stayed current with his mortgage payments. However, once the borrower became delinquent in his payments, the examiners and accountants would require that the bank mark the loan to market. Using the above example, the bank would have to write off the portion of the loan greater than the value of the collateral less the estimated expenses of liquidating the collateral. Again, using the above example the bank would probably write the value of it's loan down to around $70,000-75,000 (the $80,000 alue of the house less another $5,000-10,000 that it might take to foreclose, maintain and sell the house).

If the bank's proceeds from the sale of the house after expenses were less than the marked to market value they had in their books, they'd have to take another write-off to reflect that amount. If they actually received more from the sale of the house than they had already written off, they would take that amount into income.

The bottom line on houses that have to be foreclosed on and then sold by the lender is that there is no income to tax--only a substantial loss. Of course, if the bank has other lines of businesses that are profitable like credit cards or investment banking, the losses they take on their home mortgage business would offset any income the bank earned on those other businesses and any taxes would only apply to the net income.

Another real problem for banks is the effect of bad debts on their balance sheet and capital accounts. A bank, whether regulated by either the federal or state governments, is required to maintain a certain "capital ratio". Let's say that the required capital ratio is 20% of the assets on a bank's books. When he bank writes off assets, it reduces their capital accounts directly. So unless they add capital by retaining earnings or selling more equity, they have no choice other than to reduce assets to maintain the capital ratio.

That's what's behind the Fed's investing in the banks in the form of preferred stock. That investment can be added to the bank's capital to permit them to either maintain the assets on their books or even create more assets (loans) based on their new capital ratio. The problem that the banks seem to be facing now is that the amount of money invested by the Fed is insufficient to increase their capital ratios because the losses they are experiencing, as the result of more and more loan deliquencies and forecloses are greater than the amount of new capital the Fed is injecting into the banks.

So my theoretical question that started this thread has very real consequences that will effect all of us. The more borrowers who decide to simply walk away from their houses because their value is less than the amount borrowed simply makes the banks weaker and weaker. Their capital simply won't permit them to increase lending. In fact, they may have to continue reducing the amount of their loans.

While the American public tends to think that the $700 billion approved by Congress is a big number, it really isn't when compared to how much the European countries have injected to save their banks. It's a sad thing to say, but even what we consider to be a huge outlay of taxpayer money does not appear to be even close to what will be needed to permit the banks to begin lending again--getting money into the economy in order to begin the process of economic growth.

We are all facing very tough times--much of which history will say was caused by too much debt created by both the public as well as our government. This problem is going to take quite a while to get fixed--probably years.