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When a financial institution, including a bank, fails to make money on a product, property, or loan, that item becomes a nonperforming asset. Economic conditions that become constrained can contribute to an asset becoming a nonperforming asset. After an investor or banking client fails to make payments to that financial entity for a certain period of time, such as 90 days, the asset becomes a problem and likely falls into the nonperforming asset category.
Financial institutions that are in the business of issuing loans such as mortgages normally earmark a certain amount of money every quarter to protect against a nonperforming asset. These funds may go into a provision portfolio or a problem loan portfolio. The greater the amount of money that is set aside for provisions, the more stress a regional economy is likely to be under. As economic conditions improve, a bank expects that consumers are less likely to fall into default with a loan and create a nonperforming asset, and the size of the provisional portfolio can decrease.
When a bank extends any type of loan, including a mortgage, the risks associated with a potential default on an agreement are factored in. In a worst-case scenario, the bank will have to charge off the nonperforming asset and accept that no money will be earned as had been previously expected. As the number of problem assets decreases and the number of quality assets rises, it improves the overall profitability picture at the bank. Less money needs to be devoted to managing and resolving the issues surrounding nonperforming assets.
Tangible assets, such as real estate and property, can certainly become nonperforming assets. Several factors can contribute to a piece of land becoming a nonperforming asset. The first sign is, of course, missed payments. Also, if there is any collateral used to back a loan and if that collateral is worth less than the balance on the property, the asset is closer to being nonperforming. If the land becomes worth less than the balance on a nonperforming loan, the property may have to be written off.
Once a bank or other lender has accumulated nonperforming assets, those assets can be sold. If the problem assets are pieces of property, the owner may choose to sell them just to unload them. The seller may need to sell the property at a discount price and earn nothing more than book value, which is the value of assets on a balance sheet less any depreciation or liabilities on the asset.