With loan balances declining, several banks this quarter reduced their loan loss reserve accruals. And a few, even went so far as to release reserves.Of the many "subjective" line items on a bank's balance sheet, few are subject to as much controversy as loan loss reserves -- they're either too big or too small, never just right.But contrary to what you may think, smaller loan portfolios do not necessarily translate to smaller loan loss reserves. And, by way of analogy, let me explain why.As a kid, my sister and I had a lemonade stand and getting the mix right between the lemon juice and the sugar water was always a struggle. Too many lemons and the lemonade was sour, too much sugar water and the mix was way too sweet.I have long believed that loan portfolios are like lemonade. Too many lemons (bad loans) means a bank took too much risk; too much sugar water (good loans) and there was not enough risk. Unfortunately, knowing whether the mix was too sweet or too sour only comes with hindsight.Over the past 18 months, there has been a notable transfiguration of sugar water into lemon juice, as high unemployment and low levels of market liquidity has caused good credits to deteriorate into bad. And across all loan categories, the industry has seen increases in both delinquencies and charge-offs. Needless to say, today, the mix is pretty sour, as the percentage of bad loans is at record highs.At the request of the regulators, banks have been aggressively reserving for and charging off bad loans – reducing the overall amount of lemonade, by directly pulling out the lemon juice, hoping to leave the remaining balance sweeter tasting.If this were all that were happening in loan portfolios, I suppose I could see some lowering of the rate of increase in loan loss reserve provisioning as appropriate -- although I will admit that reductions in loan loss reserves at this point seems woefully premature, as I continue to believe that extended high rates of unemployment and low industrial capacity utilization will transform more good credits into bad.But deterioration in loan quality is not the only thing going on in bank loan portfolios today. Something, as if not more important, is also happening. And that is that good credit is deleveraging, by paying down debt. (What might this mean for creditors -- from BAC ) ro C ) to COF )?)Last week, AXP ) noted that their affluent clients have substantially reduced their charge activity, and this has contributed to the overall decline in account balances. Similarly, since March, we have seen a staggering volume of equity offerings and bond issues by corporate borrowers, with the primary use of proceeds being to pay down bank debt.To go back to my lemonade analogy: Good borrowers are leaving -- and taking the sugar water with them.Finally, there is one other important factor at work in bank loan portfolios and that is loan modifications. I, for one, think bank analysts have grossly underestimated the impact that loan modifications and aggressive preemptive re-aging of accounts is having on currently reported loan loss and delinquency figures. (And loan modifications work to transform lemons into sugar water, which in turn drives loan loss reserve calculations. Should modified loans deteriorate, as several recent studies suggest, what appears sweet today could quickly become very sour.)To me, the net result of it all is smaller, sourer -- not sweeter -- bank loan portfolios. (And, for what its worth, with revised credit requirements dramatically reducing the volume of new loans, little to any new sugar water is being added to the mix. And don't forget too that smaller loan portfolios mean fewer net interest margin dollars available to cover charge offs.)The old line says "When God gives you lemons, make lemonade." Well, the banks did. Unfortunately, I'm afraid this one may leave a lot of folks with a very bad taste in their mouths.