Show pageOld revisionsBacklinksBack to top This page is read only. You can view the source, but not change it. Ask your administrator if you think this is wrong. ======Credit Loss====== A Credit Loss (also known as a Loan Loss) is the financial pain a lender feels when a borrower ghosts them on a debt. Imagine you lend your friend $100, and they disappear without a trace. That $100 is your credit loss. For banks and other financial institutions, this is a fundamental risk of being in the business of lending money. It represents the portion of a debt that the lender doesn't expect to get back after a borrower fails to make their payments. This isn't just a minor hiccup; it's a direct blow to a company's profits and a crucial indicator of its health. When you hear news anchors talking about a bank "writing off bad loans," they are talking about the bank officially accepting these losses. ===== Why Credit Losses Matter to Investors ===== For a company that lends money—like a bank, credit union, or even a company with a large financing arm (think auto manufacturers)—loans are its primary asset. A credit loss is like a baker having to throw away burnt bread; it's a loss of inventory and potential revenue. For you, the investor, understanding a company's credit losses is like having a secret window into the quality of its business and management. Persistently high or unexpectedly rising credit losses can signal several problems: * **Sloppy Lending:** The company might be too relaxed with its lending standards, giving money to borrowers who were risky from the start. * **Economic Storms:** It can be an early warning sign of a weakening economy. When people lose jobs and businesses struggle, they stop paying their debts, causing credit losses to spike across the board. * **Falling Profits:** Every dollar lost to a bad loan is a dollar that doesn't flow to the bottom line. These losses are recorded as an expense on the [[income statement]], directly reducing the company's reported profit and, consequently, its ability to pay dividends or reinvest in the business. Ultimately, the stock market hates nasty surprises. A sudden jump in credit losses can spook investors, sending the company's stock price tumbling. ===== The Nitty-Gritty of Accounting for Credit Loss ===== Companies don't just wait for a loan to go bad and then say, "Oops, we lost money." Accounting rules require them to anticipate and plan for these losses. This is where a couple of key concepts come into play. ==== The Allowance for Credit Losses (ACL) ==== Think of the [[Allowance for Credit Losses]] as a bank's "rainy day fund" for bad loans. It's a pool of money that a company sets aside based on its //estimate// of how much it will lose from its current loan portfolio in the future. This is a crucial concept. The company is proactively estimating future pain rather than reacting to it. This allowance is a //contra-asset// account. On the [[balance sheet]], a bank lists its total loans as an asset. The ACL is then subtracted from this total to arrive at a more realistic, net value of the loans the bank actually expects to collect. For example, if a bank has $100 billion in loans and an ACL of $2 billion, the net value of its loans reported on the balance sheet is $98 billion. ==== The Provision and the Charge-Off ==== While they sound similar, these two terms describe different actions in the lifecycle of a credit loss. * **The Provision:** This is the money the company //adds// to the rainy day fund (the ACL) each quarter. This action is recorded as an expense on the income statement, called the [[loan loss provision]]. When you hear that a bank is "increasing its provisions," it means they are beefing up their allowance, which reduces their profits for that period. This is a forward-looking action based on their assessment of future risk. * **The Charge-Off:** This is the moment of truth. When a specific loan is officially declared uncollectible, the bank "charges it off." This means the specific bad loan's value is removed from the bank's books, and an equal amount is deducted from the Allowance for Credit Losses. Notice that the charge-off itself doesn't hit the income statement—the pain was already felt when the provisions were made. Occasionally, a bank gets lucky and recovers money from a loan it previously charged-off. These [[recoveries]] are added back to the allowance. ===== A Value Investor's Playbook ===== A savvy [[value investor]] doesn't just look at a bank's reported profit; they dig into the quality of that profit by scrutinizing its credit loss trends. ==== Reading the Tea Leaves ==== When analyzing a financial company, pay close attention to these metrics: * **Trend in Provisions:** Is the loan loss provision steadily increasing? A big, sudden jump is a major red flag that management sees trouble ahead. * **Allowance vs. Total Loans:** How big is the rainy day fund (ACL) compared to the total loan portfolio? A bank with a tiny allowance relative to its risky loans might be overly optimistic and unprepared for a downturn. * **Net Charge-Offs:** Look at [[net charge-offs]] (total charge-offs minus recoveries) as a percentage of total loans. This ratio tells you how much of the loan book actually went bad in a period. Comparing this ratio across different banks can reveal which ones have more prudent lending practices. ==== The Cyclical Nature of Banking ==== Credit losses are intensely cyclical. During an economic boom, they can fall to almost nothing, making bank profits look spectacular. During a [[recession]], they can surge, crushing bank earnings and stock prices. A wise investor understands this rhythm. They become cautious when credit losses are at historic lows and everyone is euphoric—it's often a sign the cycle is about to turn. Conversely, the best time to find bargains in bank stocks is often when fear is at its peak, and credit losses are high. If you can identify a well-managed bank with enough capital to survive the storm, you can often buy a great business at a ridiculously low price while others are panic-selling.