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New York Regional Outlook, Second Quarter 2000

Regional Perspectives Although the Region's economic growth rate lagged the nation's in 1999, this gap narrowed because of the strong stock market and a growing concentration of new high-value-added jobs. The Region's banks benefited from increased noninterest income, stable credit quality, and a steeper yield curve in fourth quarter 1999. Lower charge-off rates reported by the Region's credit card specialists partially offset the effect of competitive pressures on margins. Profitability levels of the Region's mortgage specialists, which represent more than one-third of all banks in the Region, could be vulnerable to rising interest rates as consumer preferences for mortgage products change. The Region's Economic and Banking Conditions Economic Conditions Remain Robust The nation's economy ended the decade in the midst of its longest expansion on record, which is expected to continue in 2000, although at a gradually slowing pace. The Blue Chip Economic Indicators, a survey of 50 of the nation's prominent economists, calls for a 4.5 percent increase in gross domestic product, the broadest measure of the nation's economic activity, in 2000.1 This forecast follows three consecutive years of economic expansion in excess of 4 percent. Forecasts for the Region also call for economic growth to continue but at a slower pace than the nation. During the 1990s, the Region's economy performed well, although its rate of growth was only two-thirds of the national rate, primarily because of slower population growth and higher business costs (see Chart 1). Although the Region's economic growth rate lags the national average, the gap narrowed in 1999 because of the strong stock market and a growing concentration of new high-value-added jobs in the Region.2 Chart 1 1 Represents the April 2000 survey. 2 The Region's and states' economies are measured by the gross state products. Forecasts for the Region are made by the Regional Financial Associates; forecasts are as of January 2000. While the Region's economy is expected to expand in 2000, the rate of growth will vary among the states. According to Regional Financial Associates (RFA), the economies of Maryland and New York State are expected to expand more rapidly than the economies of other states in the Region and to match the nation's strong economic performance (see Table 1). The economies of Delaware and New Jersey also are expected to perform well, although forecasts call for a rate of growth somewhat slower than the nation's. Economic growth in Pennsylvania is expected to slow in 2000, primarily because of limited population growth, tight labor markets, and reduced manufacturing activity. Table 1 Consumer spending, an important driver in the nation's and Region's economies, is expected to grow at a healthy pace based on surveys conducted by the New York and Philadelphia Federal Reserve Banks. Those surveys, which include most of the Region's states, estimate retail sales increases between 3 percent and 7 percent through the first three months of 2000, consistent with national trends.3 Spending gains on home furnishings, apparel, appliances, and cosmetics were highlighted. The surveys indicate that merchants expect "a good selling climate" to prevail during the first half of 2000, and preliminary data during the first few months of 2000 show that spending is equal to or exceeds last year's volume. Conference Board surveys of consumer expectations suggest that despite some recent concern about oil prices and stock market volatility, consumers generally remain confident about the future (see Chart 2). Chart 2 3 New York and Philadelphia Federal Reserve Bank Beige Books. January 19, 2000, and March 8, 2000. Gains in the financial services, high-tech, and computer-related industries also have contributed to the Region's economic growth. An RFA study stated that the information technology industry is growing in importance to the nation and Region.4 Technology has been responsible for a significant share of the nation's improved productivity and job growth. In fact, the RFA study states that between 10 and 12 percent of the Region's jobs are related to information technology industries, roughly equal to the national average. Technology centers are being developed, particularly in the Washington, D.C.-Maryland corridor, Philadelphia suburbs, and New York City. New, but smaller, technology centers also could help invigorate the economies of Rochester, New York, and Pittsburgh, Pennsylvania, where local economic growth has lagged the rest of the Region. While information technology companies are a growing and vital component of the New Economy (see "Banking Risk in the New Economy"), some of these entrants could be at risk if their performance does not meet Wall Street expectations or if equity and venture capital financing becomes more difficult to obtain. 4 Zandi, Mark. September 1999. Information Economy. Regional Financial Review. Commercial Real Estate Markets Tighten The strong economy has increased demand for commercial real estate in the Region, particularly in the large urban areas. Vacancy rates in New York City, Washington, D.C., and Wilmington, Delaware, are almost half the nation's average. Office space is so tight in New York City that rents easily exceed $50 per square foot in many class-A buildings and are approaching $100 per square foot in some areas. Office vacancy rates in downtown Baltimore stood at 9.1 percent in the third quarter of 1999, down from 18.1 percent two years earlier. While the 12.6 percent office vacancy rate in downtown Philadelphia was above the national average of 9 percent for downtown areas, the city's suburban vacancy rate was 8.5 percent, below the 10.1 percent national average. At this late stage in the current economic expansion, vacancy rate trends in the Region's major metropolitan areas differ from those experienced immediately prior to the recession of the early 1990s. While vacancy rates for many metro areas were lower than the national average at that time, vacancies had started to rise in some of the Region's major cities. The recession of the early 1990s hit the Region's real estate markets harder than other parts of the nation, in part because a significant amount of new office construction was being completed just as the Region's economy was contracting and demand for space was declining. Many of the Region's cities reported declining vacancy rates through most of 1999.5 As a result, the Region's commercial real estate markets appear better positioned in case of an economic downturn than these markets were ten years ago. 5 Vacancy rate data as of the third quarter of 1999. Source: C.B. Richard Ellis. Although vacancy rates are still declining in most of the Region's cities, there are some areas of concern. For example, construction of office space has increased in eastern New Jersey, primarily in areas within commuting distance to higher-rent areas in New York City. Increased construction also is evident in the suburbs of Philadelphia and the Washington, D.C.-Baltimore area, and anecdotal evidence exists of speculative office development in the Pittsburgh; Albany, New York; and northern New Jersey markets. Although new office construction presently is substantially less than just before the last recession, an economic slowdown, depending on its depth and duration, could hurt the Region's office markets. Because developers traditionally initiate projects based on current market conditions rather than economic forecasts, the amount of office construction should be closely monitored. Housing markets in many parts of the Region also are robust, following several years of stagnant prices, although they have not attained the growth rates of the late 1980s. Demand for new homes and resales has been particularly strong in areas experiencing the greatest levels of job growth. Home sales and residential construction increased in the latter half of the 1990s, particularly in the suburbs of New York City, Philadelphia, and the Washington, D.C.-Baltimore area; however, activity is still below levels reached during the 1980s in many of the Region's cities. According to the National Association of Realtors, the median price for a single-family home in the Washington, D.C., metropolitan area, for example, rose 4.4 percent between December 1998 and year-end 1999. In contrast, home prices in this area rose 12 percent in 1987 and 15 percent in 1988. Permits for new single-family homes slowed in 1999, possibly in response to higher interest rates, rising 4 percent nationwide in 1999, compared with a 12 percent increase in 1998. In the first two months of 2000, permit growth slowed further to 1.2 percent, compared with the same period in 1999. The Region experienced a similar rate of permit growth. In 1998, permits for new single-family homes increased at double-digit rates in Delaware, Maryland, and New York. In New Jersey and Pennsylvania, the increase was close to 9 percent. In 1999, however, growth slowed to less than 3 percent in most of the Region's states. New York was the exception: new permits increased 6 percent, slightly higher than the nation's growth rate. Region's Dependence on Wall Street Increases The stock market has contributed greatly to the Region's economic expansion, more so than in other parts of the nation. According to a recent Federal Reserve Board Survey, stocks, mutual funds, and retirement accounts represented two-thirds of household financial assets6 at year-end 1998, up from 42 percent at year-end 1989. Furthermore, nearly half of all households owned stocks in 1998, either directly or in mutual funds, compared with 32 percent of families ten years ago.7 Stock ownership is more concentrated in the New York Region than in other Regions. Studies show that the Region's investors hold almost one-quarter of the nation's total equity investments.8 In addition, Wall Street and related financial services industries have represented the primary source of earnings growth in New York City. Between 1994 and 1998, securities firms contributed approximately $23 billion to New York City's economy, or more than one-third of the increase in total salaries, compared with 4.3 percent for the nation.9 The average salary for New York State's 186,000 securities and commodity brokers was approximately $230,000,10 and the New York State Comptroller's Office estimated that bonuses on Wall Street totaled $11.4 billion in 1999, up 18 percent from one year ago. The economic multiplier of Wall Street is so significant that, for example, although the securities industry accounts for only 2 percent of the jobs in New York State, it was responsible for almost 60 percent of the increase in the state's gross product between 1992 and 1997. Because of the Region's dependence on Wall Street, a downturn in the stock market, if deep and sustained, could weaken the economy in the Region more than in other areas of the nation. 6 Household financial assets include savings and checking accounts, stock, bonds, mutual funds, retirement accounts, cash value of life insurance policies, and other managed assets. 7 Kennickell, Arthur B., Martha Starr-McCluer, and Brian J. Surette. 1999. Recent Changes in U.S. Family Finances, Results from the 1998 Survey of Consumer Finances. Federal Reserve Board, Division of Research and Statistics. 8 The Investment Company Institute. 1995. State Distribution, Mutual Fund, Assets and Accounts. 9 Securities Industry Association. March 2000 Update. The New York Securities Industry: Its Economic Impact on New York State and City. 10 Based on 1997 earnings data supplied by the Bureau of Economic analysis. Represents most recent data available. Strong Economy Helps Region's Insured Institutions and Credit Card Specialists The Region's banks reported generally healthy conditions for the fourth quarter of 1999. Insured institutions benefited from stable credit quality, a steeper yield curve, increased noninterest income, and effective expense control.11 With a flatter yield curve prevalent during 1998, the Region's average net interest margin (NIM) declined during the year. In the latter half of 1999, however, the average NIM rebounded as the yield curve steepened following increases in the Federal Funds rate. The ratio of loans to deposits also rose during the year, but the Region's banks faced competition for core deposits, which declined marginally as a percentage of assets (see Charts 3 and 4). Credit quality ratios improved for most loan segments, except for commercial and industrial loans, which showed a slight increase in the charge-off rate. Chart 3 Chart 4 11 Excludes banks that received charters after December 31, 1996, and banks that specialize in credit card lending. Results of the Region's credit card specialists12 reflected intense competition and increased consolidation among credit card lenders. The increase in the number of credit cards held by consumers has slowed as response rates on mailed card solicitations declined from a peak of 2.8 percent in 1992 to 1 percent in 1999, an all-time annual low. In the past, response rates have declined as the volume of mailings increased, but in 1999 the number of mailed credit card solicitations actually declined. According to BAI Global, Inc., a market research firm that tracks credit card solicitations, direct mail solicitations dropped 17 percent in 1999 from record mailings of 3.45 billion in 1998.13 Some of the decline was attributed to the elimination of overlapping programs as card lenders merged or acquired competitors. Other lenders reduced mailings to combat margin pressures or shifted focus to new solicitation methods, including Internet-based marketing programs. Market saturation also contributed to lower response rates, as many consumers feel they have enough credit cards. With introductory rates on some credit cards nearing zero percent, card lenders have fewer ways to compete as the differences among card programs become less tangible. 12 Credit card specialists are defined as insured institutions that report at least 50 percent of assets as loans and at least 50 percent of loans as credit card receivables. 13BAI Global, Inc. 1999. Credit Card Mail Volume Declines, As Consumer Response Rates Reach All-Time Low. Industry trends affected the results of the Region's credit card specialists. The Region's nine credit card specialists, which accounted for 32.5 percent of total managed card receivables14 reported by insured institutions nationwide as of December 31, 1999, reported a lower average return on assets (ROA) and average NIM for the fourth quarter of 1999 than the previous year. These trends were consistent with credit card specialists nationwide. Yields earned on prime credit card loans have declined as lenders have reduced rates to compete for accounts. Higher noninterest income buffered the effect of lower NIMs (see Charts 5 and 6). Card lenders increasingly have turned to additional forms of noninterest income, such as higher fees on late accounts and charges for balance inquiries, to counter lower yields earned on traditional credit card loans. (For more information, see "Noninterest Income Grows in Importance" in the New York Regional Outlook, first quarter 2000.) The Region's credit card lenders also benefited from a decline in the credit card charge-off rate. Lower personal bankruptcy filings (which declined by 8.3 percent in 1999), a strong economy, an influx of cash from mortgage refinancing, and improved underwriting and risk-based pricing enhanced credit quality ratios reported by the Region's credit card specialists. Although the number of bankruptcy filings is high historically, preliminary studies show that the downward trend in personal bankruptcy filings has continued through the beginning of 2000.15 Chart 5 Chart 6 14 Managed credit card receivables include on-balance sheet and securitized credit card loans. 15 CIBC World Markets. March 23, 2000. Credit Card Industry. Weekly filings through March 4, 2000. Although returns on credit card lending continue to exceed returns earned by most of the banking industry, and credit quality measures improved in 1999, the outlook for the credit card segment nationwide is mixed. As interest rates declined from 1997 through the first half of 1999, some consumers paid off credit debt with proceeds from refinanced mortgage loans, alleviating pressure on credit card loans. Refinancings have declined, however, as interest rates climbed in early 2000, and a potentially slower economy could have implications for consumer credit quality. Although average credit card delinquency and charge-off rates have improved, the consumer debt service burden (the ratio of debt service payments on household consumer and mortgage debt as a percentage of disposable personal income) is rising; it reached 13.5 percent for 1999, the highest annual level since 1989.16 Higher charge-off rates on credit card loans generally have tracked rising debt service burden (see Chart 7). Consumers, of course, have benefited from stock market gains, which are excluded from disposable income; however, instability in the stock market could disrupt this supplemental repayment source. Chart 7 Rising Interest Rates Could Pose Risk to Region's Economy and Insured Institutions The Federal Reserve Board increased the Federal Funds target rate on five occasions between June 1999 and March 2000, for a total of 125 basis points. These increases have resulted in higher short- and long-term interest rates since December 1998 (see Chart 8). The ten-year Treasury bond rate, for example, was 180 basis points higher at the end of first quarter 2000 than fourth quarter 1998. The Region's economic growth declined more than the nation's following hikes in the Federal Funds rate in the mid-1990s and could follow a similar pattern if rates continue to rise. (See "Higher Interest Rates May Curtail the Region's Economic Expansion" in New York Regional Outlook, fourth quarter 1999.) Chart 8 The decline and subsequent rise in interest rates during the latter half of the 1990s could affect interest margins earned by the Region's banks, particularly banks that specialize in mortgage lending. During 1997 and 1998, as long-term interest rates declined and the yield curve flattened, home purchasers and consumers who refinanced existing mortgages favored longer-term, fixed-rate loans over short-term adjustable rate mortgages (ARMs). Banks and other mortgage lenders responded to market demand by supplying long-term products at lower interest rates. During 1999, as long-term interest rates rose and the yield curve steepened, consumers switched to ARMs (see Chart 9). Refinancing activity and mortgage prepayments subsequently slowed, because it was no longer advantageous to refinance the 1997 and 1998 vintage mortgages at 1999's higher rates (see Chart 10). Chart 9 Chart 10 The Region's banks could be more sensitive to rising interest rates and changes in mortgage preferences than banks elsewhere in the nation because almost one-third of the Region's banks are mortgage specialists, compared with 11 percent of banks elsewhere in the nation.17 Mortgage specialists' NIMs could be constrained if interest rates continue to rise because the maturity distribution of mortgage portfolios has lengthened since 1997, reflecting consumers' preference for longer-term mortgages (see Chart 11). Concurrently, the proportion of volatile liabilities18 at these banks has risen as reliance on shorter-term, noncore funding has increased, reflecting stiffer competition for core deposits (see Chart 12). Although the Region's mortgage specialists reported a higher ratio of core deposits to assets than the average for all banks in the nation, the percentage has declined over the past five years. Higher interest rates could squeeze earnings if the mismatch between the maturity and pricing intervals of loan portfolios relative to a bank's liabilities is significant. Furthermore, banks and other mortgage holders may be faced with holding these lower-rate, long-term mortgages in their portfolios or selling them at a loss until rates decline below pre-1999 levels. In addition, while a reduced pace of refinancings could stabilize the Region's mortgage servicing income, a drop in mortgage originations could result in lower mortgage fees, an important source of income for mortgage lenders. Chart 11 Chart 12 18 Volatile liabilities are funding sources that typically have short-term maturities or are subject to repricing in the short term. Not only are mortgage specialists vulnerable to rising interest rates because of changes in mortgage demand, but they rely on spread income more than the rest of the industry. Although the proportion of interest income to operating income has declined, the Region's mortgage specialists generated almost 75 percent of operating income from interest income in fourth quarter 1999, compared with 47 percent for the rest of the Region's banks. Furthermore, mortgage specialists also generate lower NIMs because yields on traditional mortgages tend to be lower than for other types of loans. In fourth quarter 1999, the average NIM for the Region's mortgage specialists was approximately 100 basis points lower than the average NIM for all banks in the Region, consistent with past years. Rising interest rates also could affect the valuation of bank securities portfolios. Mortgage specialists may be more vulnerable to changes in securities values because this group holds a larger percentage of assets in securities. As of December 31, 1999, the Region's mortgage specialists held almost one-third of total assets in securities, compared with 19 percent for all banks in the Region. This relationship was similar for all banks nationwide. Furthermore, the maturity structure of securities portfolios held by the Region's mortgage specialists lengthened during the past two years. At year-end 1999, approximately 31 percent of securities held by these institutions had maturities greater than 15 years, compared with just under 10 percent one year earlier. In contrast, securities with maturities greater than 15 years represented between 20 and 23 percent of securities for the rest of the Region's banks during the same period. Because security prices move inversely with interest rates and prices of longer-term securities are more sensitive to interest rate changes than shorter-term securities are, the value of security portfolios held by the Region's mortgage specialists could be at greater risk in a rising rate environment. In fact, in fourth quarter 1999, the Region's 117 commercial banks that specialize in mortgage lending reported net depreciation in securities' value equal to 9.8 percent of average Tier 1 capital compared with net depreciation equal to 5.1 percent for the rest of the Region's banks.19 19Bank Call Report. Thrifts do not report securities' appreciation and depreciation. Net appreciation and depreciation amounts were calculated on changes in values for securities held to maturity and unrealized gains or losses on securities held for sale. Implications Swings in mortgage preferences, reduced levels of refinancings, and rising interest rates could challenge the interest rate risk management programs of the Region's mortgage specialists. During the past two years, the maturity of mortgage assets reported by the Region's mortgage specialists has lengthened as homeowners took advantage of declining interest rates by refinancing into or originating new long-term, fixed-rate mortgages. During the same time, the proportion of shorter-term, volatile liabilities reported by the Region's mortgage specialists rose, reflecting increased competition for core deposits. Absent effective interest-rate hedging programs, mortgage specialists' margins may be pressured if funding costs increase faster than returns earned on assets. Furthermore, because mortgage specialists reported a larger portion of long-term securities than other banks in the Region, the value of their investment portfolios may be more vulnerable to rising long-term interest rates. Faced with margin compression, some mortgage specialists may be tempted to invest in higher-yielding, traditionally higher-risk securities to supplement income. Although mortgage specialists should benefit from increases in the spread between Treasury benchmarks and mortgage rates that occurred in early 2000,20 changes in mortgage demand coupled with rising interest rates could stress the profitability of the Region's mortgage specialists. 20 Barta, Patrick. April 7, 2000. Mortgage Rates, Strangely, Remain Aloft. The Wall Street Journal. Kathy R. Kalser, Regional Manager Robert DiChiara, Financial Analyst Norman Gertner, Regional Economist Alexander J.G. 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