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Dallas Regional Outlook - Fourth Quarter 1999

Regional Perspectives The Dallas Region's economy continues to moderate, experiencing slower growth from very robust levels in the mid-1990s to a more sustainable 2 to 3 percent in the past year. Housing demand in the Region remains fairly strong and mortgage rates are still relatively low; however, home building peaked in 1998 and is expected to taper off in 1999 and 2000. Overall, financial institutions in the Dallas Region are reporting healthy conditions; however, Oklahoma agricultural banks are beginning to show signs of stress. The Region's financial institutions continue to elect S corporation tax status in dramatic numbers and currently account for 24 percent of all S corporation banks nationwide. Dallas Region Subchapter S banks report twice the return on assets of all other banks but also have a much higher dividend payout ratio to help shareholders pay their pass-through tax liability. Mortgage-backed securities with lengthening maturities may be exposing the Region's balance sheet to rising interest rates. Dallas Region Economy Continued to Moderate The Dallas Region's economy continued to moderate during the second quarter. With payroll employment as an indicator, three of the Region's four states-Oklahoma, Colorado, and New Mexico-grew at or below the national average of 2.2 percent for the 12 months ending August 1999 (see Table 1). Texas' 2.7 percent employment growth rate continues to exceed the national average. However, with the exception of New Mexico, each of the Region's states experienced slowing growth rates from very robust levels in the mid-1990s to a slower but more sustainable 2 to 3 percent in the past year because of tight labor markets. New Mexico, however, continues to underperform the nation with an employment growth rate of less than 2 percent. The construction, transportation, and services sectors continue as sources of strength for the Region's economy. In contrast, weaknesses in mining, which includes the oil and gas industry, and manufacturing resulted in lost jobs contributing to the slower growth rate. Recent mining employment data suggest that the industry may be stabilizing because of rising oil prices; after 15 consecutive months of job losses in the mining sector, employment finally touched bottom in July 1999. All states in the Region continue to experience declining unemployment rates for the 12 months ending August 1999 (see Table 1). Reductions in unemployment continue to reflect tight labor markets and may have influenced recent market interest rate hikes. These interest rate hikes are expected to influence consumer decisions on purchasing and financing new and existing housing. The next section of this article discusses the importance of the housing industry to the Region and the potential effects of rising home prices and increasing mortgage rates. Region's Hot Housing Market Expected to Cool by Year-End Housing Has Been a Source of Strength throughout This Expansion A strong housing market and stock market contributed to strong domestic consumption and economic growth in the Dallas Region throughout much of this expansion. The effects of home building on the local economy are significant. For example, the National Association of Home Builders estimates that for every 1,000 single-family homes built, 2,448 full-time jobs in construction and construction-related industries are created, $79.4 million in wages are paid, and $42.5 million in government revenues are generated. Building permits for approximately 155,000 single-family homes were authorized last year in the Dallas Region, the highest total this decade. Home building creates additional jobs and income in ancillary industries such as mortgage banking, furniture and appliances, home security, and landscaping. Finally, the combination of rising home values and lower mortgage rates allowed many homeowners to obtain cash-out refinancing or reduce monthly loan payments, fueling additional spending. During this expansion, Dallas Region households have spent at an average annual growth rate of 5 to 8 percent compared with the nation's rate of 4 to 5 percent. Higher Mortgage Rates Have Not Yet Deterred the Region's Hot Housing Market Despite mortgage interest rates rising to their highest level in two years, new and existing home sales and residential building permits remained strong through the summer (see Chart 1, below). According to the Federal Home Loan Mortgage Corporation, the monthly average commitment rate1 on 30-year fixed-rate mortgages reached a low of 6.71 percent in October 1998. Mortgage rates, however, did not begin escalating until after April 1999, rising 71 basis points in three months to 7.63 percent in July 1999. The Mortgage Bankers Association of America reported that average contract interest rates for 30-year fixed-rate mortgages reached as high as 8.15 percent in mid-August. Chart 1 1Commitment rate is the interest rate a lender would charge to lend mortgage money to a qualified borrower exclusive of the fees and points required by the lender. This commitment rate applies only to conventional financing on conforming mortgages with loan-to-value ratios of 80 percent or less. Despite the higher rates, single-family building permits for the first seven months of 1999 exceeded last year's pace by 5 percent, reflecting the strong underlying demand for new homes in the Dallas Region. How has the Region's housing demand remained strong at a time when mortgage rates are rising? Contributing factors include the following: Moderately strong job growth. Nonfarm employment continues to grow at a healthy clip of 2.5 percent, slightly faster than the nation, and a rate that would result in approximately 350,000 new jobs in the Dallas Region in 1999. Job growth, even more than mortgage interest rates, is considered the most important variable driving housing demand. Moderately strong levels of in-migration. The Dallas Region recently has enjoyed significant success in attracting relocating businesses and families. These in-migrants have an immediate effect on housing demand. The Region's population growth is twice that of the nation; in recent years, both domestic and foreign in-migration contributed to the strong housing demand. Rising home prices and mortgage rates. In the near term, concern about rising home prices and mortgage interest rates may encourage potential home buyers to enter the housing market as quickly as possible. Alternative mortgage products. The renewed popularity of adjustable-rate mortgages (ARMs) and the introduction of hybrid ARM products have provided homebuyers with access to low mortgage rates, benefiting those who might otherwise have been shut out of the housing market. Affordable housing. Seven of the ten most affordable housing markets in the nation are in Oklahoma and Texas, according to Coldwell Banker Real Estate Corporation's twenty-first annual home price comparison index.2 Low-cost housing and a significant number of first-time home buyers have helped keep average and median home prices low in the Dallas Region. 2 The Coldwell Banker Real Estate Corporation home price comparison index surveys 300 major U.S. housing markets with the following characteristics: 2,200 square feet, four bedrooms, two and a half baths, a family room (or equivalent), and a two-car garage. Surveyed homes and neighborhoods are typical for corporate middle-management transferees. However, Home-Building Activity Is Expected to Cool Later This Year While the housing market has been strong this year, a slight slowing in residential building permits is anticipated later this year and into 2000 because of the following factors: Slower job growth. Economists from Regional Financial Associates are forecasting a further slowing in employment growth, from 2.3 percent in 1999 to 1.9 percent in 2000. Slower job growth can be attributed, in part, to a moderating U.S. economy (according to the August 1999 Blue Chip Consensus Forecast, economic growth is expected to slow from 3.9 percent in 1999 to 2.6 percent in 2000) and tight labor markets. Regional labor force growth decelerated to 1.4 percent in July 1999 from 2.8 percent a year earlier. Higher mortgage rates. Even though mortgage rates are considerably lower than they were five years ago, their recent rise is expected to have a negative effect on housing demand, particularly among first-time homebuyers (see Chart 1). Many housing analysts believe mortgage rates will continue to fluctuate between 7.75 percent and 8.25 percent over the near term. Higher home values. Many local realtor real estate associations in the Region are reporting a shortage of available housing. In many places, homes that would sell in six months in a stable market are now selling in only three to four months. In addition, builders' backlogs have lengthened considerably because of shortages in raw materials and skilled labor. These low housing inventories and shortages in labor and materials have caused a sharp increase in home values. Denver home prices are rising at a double-digit rate; one local real estate agent estimates that home prices in the Denver market are increasing $2,000 to $3,000 a month. Although many of the Region's housing markets are some of the more affordable in the nation, prices are much higher than a year ago in several metropolitan markets. In summary, housing demand in the Region remains fairly strong, and mortgage rates are relatively low. However, home building peaked in 1998 and is expected to slow in 1999 and 2000. Looking at rates over the past ten years, it is clear that mortgage and unemployment rates have strongly influenced the number of residential building permits.3 In fact, the regional unemployment rate, more so than the level of mortgage rates, was strongly related to the number of building permits. For example, a percentage point increase in the Region's unemployment rate, on average, resulted in a reduction in the number of residential building permits in the Dallas Region by approximately 34,500. Similarly, a 100-basis-point increase in mortgage rates (with a two-month lag) resulted, on average, in a decline of 28,300 residential building permits in the Region. The fact that the demand for building permits remains strong may be attributed to the strong regional economy mitigating the effects of slightly higher mortgage rates, which is what the model would predict given that the Region's unemployment rate continues to decline. In addition, the recent rise in mortgage rates is unlikely to show up in the building permit data until fourth quarter 1999. 3 The following linear regression model developed by the Dallas Region office was estimated: , where is the dependent variable building permit; and are the independent variables Mortgage Rate and Unemployment Rate, respectively; , , and are unknown parameters; and is the error term. This model proved to be statistically significant with the independent variables explaining 92 percent () of the variation in the dependent variable. The independent variables tested are both statistically significant at the 0.001 alpha level. In addition, a first-order autoregressive technique was applied to obtain unbiased estimators. Dallas Region Financial Institutions Report Healthy Conditions The strength of banks' and thrifts' earnings is evidenced by the strong return on assets (ROA) and the decrease in the percentage of unprofitable institutions (see Table 2). The average ROA for the Dallas Region was 1.34 percent for the second quarter of 1999, 13 basis points higher than the nation and 23 basis points higher than the Region's first-quarter ROA. The Region has tracked at or above national ROA averages since 1990, when it recovered from the bank and thrift crisis of the late 1980s. The Region's average charge-off and past-due rates show improvement over the previous quarter and compare favorably with the national averages. While Oklahoma banks and thrifts appear to be performing in line with the nation and the Region, one group is showing signs of stress. Even though the average Oklahoma agricultural bank4 reported an ROA of 1.25 percent, slightly below rates reported for the Region, past-due ratios remain relatively high. As of June 30, 1999, the overall past-due ratio for Oklahoma agricultural banks was 3.43 percent, significantly higher than the 2.63 percent for all other agricultural banks in the nation. Moreover, this represents a significantly higher past-due ratio than reported by the nation at 1.98 percent or the Region at 2.22 percent. The largest past-due portfolio segments for Oklahoma agricultural banks include agricultural real estate loans (3.54 percent) and commercial and industrial loans (4.30 percent), which include commercial loans to agricultural producers. Credit quality deterioration is attributed to weather-related problems and, more recently, to low commodity prices that are often below breakeven levels for many producers. Another year of depressed commodity prices will further stress agricultural producers and their local economies and likely will have a negative effect on banks' performance. In addition, oil prices, until recently at record lows,5 continue to pressure Oklahoma rural economies. 4 Agricultural banks are defined as banks with over 25 percent of total assets deployed in agricultural land or production loans. 5 As discussed in previous issues of Regional Outlook. The appearance of strength in the composite agricultural bank ROA may be misleading because 36 of the 107 Oklahoma agricultural banks are Subchapter S banks. These banks reported an average ROA of 1.71 percent for the second quarter of 1999, which can be attributed, in part, to the favorable tax treatment associated with S corporation status. The remaining 71 non-S corporation Oklahoma agricultural banks reported an ROA of only 1.07 percent for the same period, down 9 basis points from second-quarter 1998. 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