Construction Employment Could Slow

Employment in the construction sector grew more rapidly than employment in any other sector in the Region during the first five months of 2000, expanding 6.9 percent. Expansion was concentrated in residential and commercial building activity; infrastructure construction activity (e.g., road construction employment) grew much more slowly. Housing permit growth in the Region was only 1.1 percent during the first five months of the year, which suggests that construction employment growth may slow by year-end. Single-family permits declined by 2 percent, while multifamily permits, which include apartment buildings and condominium units, increased by 11 percent. Housing permits increased 11.7 percent in California, where housing construction was at very low levels during the 1990s compared with the 1980s. In contrast, housing permits declined somewhat in two of the Region's hottest markets in recent years, Arizona and Nevada. Higher mortgage interest rates likely are an important reason for this slowdown.

Manufacturing Employment Declines Slightly

Manufacturing sector employment declined 0.3 percent during the first five months of 2000. Slippage in the high-tech and aerospace subsectors was offset by gains in other subsectors.²

² High-tech manufacturing and services is a complex mix of companies defined differently by various analysts. High-tech firms typically devote at least 10 percent of revenues to research and development. On an aggregate level, it is generally convenient to group together such employers as computer and telecommunications manufacturers, software developers, and biotechnology companies.

High-tech manufacturing employment has been an important driver of the Region's growth during the past several years. However, during the first five months of 2000, employment in electronic equipment and instruments declined from a year ago.³ This decline can be attributed in part to significant increases in labor productivity in high-tech manufacturing, as well as outsourcing to foreign plants. This decline has occurred despite the reported successes and high stock-market valuations of many firms in this sector.⁴ Recent developments in high-tech manufacturing and services and the role of venture capital in the Region are discussed below.

³ The growing use of contract or contingent workers by many firms makes interpretation of employment data by sector more difficult. Many high-tech firms, which tend to have relatively volatile labor requirements, have turned to employee contract agencies. Such employees are usually included under the business services sector rather than the sector in which they actually work.

⁴ March 22, 2000. High-Tech Jobs Index Continues to Decline. The Wall Street Journal ("California" insert).

The Region's commercial aircraft sector declined significantly over the past two years, almost exclusively as a result of layoffs from Seattle-based Boeing. Air travel nationwide increased during the past several years in line with the continuing U.S. economic expansion. However, passenger and freight traffic in other parts of the world has been adversely affected by the Asian financial crises that peaked in 1998. Furthermore, Boeing is competing worldwide with its single major competitor for large-scale passenger aircraft, Airbus Industrie. Boeing's Washington and Southern California employment declined by 35,000 between mid-1998 and mid-2000, a 24 percent reduction.⁵

⁵ Boeing website (www.boeing.com/employment), June 22, 2000.

In contrast to high-tech and aerospace manufacturing, other types of manufacturing activities have expanded. For example, lumber and wood products employment increased 1.6 percent during the first five months of the year despite ongoing environmental/conservation debates and restrictions regarding lumber cutting in several western states. Furniture and fixtures manufacturing employment increased 4.3 percent during the same period. These two industries have been expanding, likely in response to the high rate of home building in both the Region and the nation.

Agriculture Is Performing Well in California, But Showing Weakness in the Rocky Mountain Area

The agricultural sector presents a mixed picture in the western United States. The weather during early 2000 in the Rocky Mountain area--which includes portions of Montana, Wyoming, Utah, and Arizona--ranged from abnormally dry to a first-stage drought. Montana was particularly hard hit. The price of wheat, the state's major crop, declined significantly in 1999 and only recently has begun to stabilize. In contrast, Northern California experienced above-average precipitation during the winter of 1999-2000; as a result, the state's Central Valley should have plenty of water for irrigation in 2000.

Over the longer run, the allocation of water among agricultural, urban and industrial, and environmental uses will continue to be a contentious political issue in California. The agricultural sector uses more than 80 percent of the state's available water supplies and has been under pressure from other sectors for many years to consume less of this resource. Shifting water allocations or raising water's effective price could hurt some farmers.

The Region's most important products in terms of sales as of 1997, the most recent year for which data are available, are fruits, nuts, and berries; cattle and calves (primarily for meat products); dairy products; and vegetables and melons.⁶ Prices have generally improved in these sectors.⁷ Beef cattle prices have increased from year-ago levels, although they still were below levels of the early 1990s.

⁶ U.S. Department of Agriculture website (www.nass.usda.gov/.census/census97/rankings/wklstate.htm).

⁷ U.S. Department of Agriculture website (usda.mannlib.cornell.edu/reports/nassr/pric/pap_bb/2000/agpr0500.txt).

International Trade Drives Port Activity Up Sharply

U.S. exports, which declined in response to the economic problems of Asia in 1998, are growing again. In contrast, imports have increased almost continuously during the past decade. West Coast ports benefit from growing international trade regardless of whether U.S. imports exceed exports. Water transportation jobs in California increased 14.1 percent during the first five months of the year.

The Region's strong economy is reflected in insured institutions' earnings. The combined annualized return on assets (ROA) for the Region's insured institutions was 1.35 percent during first quarter 2000, slightly lower than during the past four quarters. ROAs at the Region's largest commercial banks fell from recent record high levels, resulting in weaker aggregate performance. Thrifts, influenced by performance of the largest institutions, experienced the highest aggregate ROA during the past five quarters. Net interest margins held steady or increased for a large majority of the Region's insured institutions during the first quarter, compared with a year ago.

Reported aggregate asset quality continued to be strong in the first quarter of 2000, with the Region's total past-due loan ratio unchanged at 1.69 percent and loan charge-off levels holding steady. Commercial banks' past-due loan ratio increased slightly, while thrifts' past-due ratio declined. However, just over half of the Region's insured institutions reported higher past-due ratios during first quarter 2000. Institutions with more than 25 percent of their loan portfolios in agricultural and consumer loans are represented disproportionately in the group with past-due loan ratios above 5 percent. Agricultural banks were the most likely to have experienced a significant, greater than 100-basis-point rise in the past-due loan ratio, reflecting the ongoing weakness of many grain and oil seed farms.

Loan portfolios of the Region's insured institutions continue to grow briskly, particularly in the commercial real estate (CRE) category. Median overall loan growth of 22 percent, reported in the first quarter of 2000, reflected strength in the Region's economy. Much of this growth is attributed to an increase in CRE loans, which have grown as a share of total assets at two-thirds of the Region's insured institutions from first quarter 1999 through first quarter 2000. As a result, concentrations in CRE lending have been rising.⁸ In addition, 85 percent of the Region's insured institutions reported an increase in construction and development (C&D) lending as a share of total assets. A significant share of the CRE and C&D growth is occurring at institutions located in markets benefiting from strong growth in the high-tech sector.

⁸ The median ratio of CRE loans to total assets in the Region's insured institutions was almost 25 percent at the end of first quarter 2000, compared with just under 20 percent a year earlier.

Although some weakness has been noted recently, the Region's high-tech sector experienced steady employment growth during the last half of the 1990s.⁹ In addition, analysts have credited the sector with fueling gains in export activity, wage increases, and research and development activities. Between 1993 and 1998,¹⁰ the Region's high-tech sector created approximately 304,000 jobs, primarily in California, Washington, Oregon, and Arizona.¹¹ California is the nation's leader in the level of high-tech employment; the state has more than twice as many high-tech workers as Texas, which ranks second in the nation. California is home to 9 of the top 20 information technology companies in the world, including Siebel Systems, Oracle, and Sun Microsystems, as ranked in Business Week's Information Technology Annual Report. Washington, home to Microsoft, is also regarded as one of the nation's leaders in the high-tech industry, in large part because it boasts the highest average wage level in the sector, indicative of companies' willingness to pay wages necessary to attract high-quality talent. Oregon and Arizona are important states as well for high-tech manufacturing. Companies in Oregon's "Silicon Forest," most notably Intel, generally specialize in manufacturing semiconductors, computer chips, and other electronic devices, while Arizona's high-tech manufacturing operations are primarily in the computer and office equipment, communications equipment, and electronic components subsectors.

⁹ The high-tech sector is defined for this subsection as including biotechnology (Standard Industry Classification (SIC) 283 and 384), computers and electronics (SIC 357, 367, and 382), telecommunications (SIC 366 and 481), and computer and data processing (SIC 737).

¹⁰ All data in this section were analyzed over the five-year period from 1993 to 1998 (the most recent data for many items) unless otherwise specified.

¹¹ According to the American Electronics Association Cyberstates report.

While many of the Region's states are leaders in the high-tech sector, much of the Region's employment growth in this category has been concentrated in 13 metropolitan statistical areas (MSAs)--San Francisco, San Jose, Oakland, Santa Rosa, Santa Cruz, Sacramento, Ventura, Orange County, and San Diego in California as well as Phoenix, AZ; Boise, ID; Seattle, WA; and Portland, OR. From 1993 through 1998, these "high-tech MSAs" experienced more rapid growth in high-tech employment than the national average. In addition, each MSA reports a higher concentration of high-tech employment than the national average (see Chart 2).

¹³ The American Electronics Association is a trade group that represents the high-tech and information technology sectors.

The Region's most active high-tech markets--San Jose, San Francisco, and Seattle--have contributed significantly to the rapid growth in personal income. Some analysts attribute this growth to stock options given to high-tech company employees, particularly those working at headquarters locations where much of the entrepreneurial activity takes place. For example, software employees in Washington's King County (where Microsoft's headquarters is located) reported per capita annual wages¹⁴ of nearly $300,000 in 1998. Recently, the state's chief economist determined that the effect of the $15 drop in Microsoft's stock price during first quarter 2000, which still largely remained on paper in midsummer, approximately equaled the potential economic impact of the layoffs of 19,000 Boeing employees. Although this segment of workers accounts for a relatively small share of Seattle's total labor force, the large share of compensation they receive in stock options may make the area disproportionately vulnerable to a stock market downturn.

¹⁴ The annual wage figure includes salary compensation and stock options awarded to employees.

Residential Real Estate Markets Strong in High-Tech MSAs

Rapid growth in the high-tech sector also has affected the Region's residential real estate markets. Median home prices and housing permit issuance increased more rapidly in the 13 high-tech MSAs than in the rest of the Region's MSAs.

Home prices in many of the Region's high-tech MSAs increased quite rapidly from 1993 through 1999. In particular, median home prices in Portland, the San Francisco Bay Area, and Phoenix grew 56, 44, and 42 percent, respectively, compared with the national average of 30 percent during this period. While each MSA outperformed the Region, in part because of strong job growth in high-tech employment sectors, higher rates of home price appreciation in Portland and Phoenix are also a result of these MSAs starting from relatively low home price levels in 1993. In contrast, San Francisco continues to experience significant increases in reported median home price even though its price level is one of the highest in the nation.

Issuance of housing permits remained strong from 1993 through 1998. Housing permit issuance in the Region's high-tech MSAs increased significantly more than in non-high-tech MSAs during the same period (see Chart 5). In fact, the number of housing permits issued doubled in San Francisco, San Jose, San Diego, and Ventura. In comparison, housing permits in the Region's non-high-tech MSAs areas increased only 7 percent.

Chart 5

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Office Real Estate Markets in High-Tech MSAs Are Strong

Growth in high-tech jobs also has contributed to strength in CRE markets in the Region's high-tech MSAs, as evidenced by additional construction activity, rent increases, and declines in vacancy rates. San Francisco, San Jose, Seattle, San Diego, and Phoenix matched or exceeded the growth in average national rental rates for all grades of office space between 1993 and 1999. In addition, San Francisco and San Jose far exceeded the national average in 1999 as a result of strong demand outpacing tight supplies of office space. For example, as of first quarter 2000, the South of Market (SOMA) and Financial District San Francisco submarkets, home to many software and dot-com companies, reported average rental rates for Class A, B, and C space between $63 and $65 per square foot per year,¹⁵ compared with $59 in the aggregate San Francisco office market and $27 in the national market.¹⁶

¹⁵ According to CB Richard Ellis.

¹⁶ Forecast by Torto Wheaton Research for 2000.

The growth in high-tech jobs has contributed significantly to the decline in office vacancy rates, in some cases to record lows. The difference in vacancy rates between the Region's high-tech and non-high-tech MSAs is particularly apparent. The median vacancy rate for office space in the Region's high-tech MSAs was 8.6 percent at year-end 1999, compared with 13.5 percent in the non-high-tech MSAs. The demand for office space in some of the Region's most active high-tech markets, including San Francisco, San Jose, and Seattle, had driven vacancy rates below 5 percent at year-end 1999, much lower than the national rate of 8.2 percent.

Community Banks' ¹⁷ Portfolios in High-Tech Areas Are Becoming More Concentrated in Traditionally Higher-Risk Loan Types

¹⁷ This group of community banks includes commercial banks with less than $1 billion in total assets and excludes de novo institutions and credit card banks.

Although few of the Region's insured institutions lend directly to large high-tech companies, many do business in high-tech MSAs. In general, institutions in these areas have exhibited more rapid deposit and loan growth than institutions in non-high-tech MSAs.

In particular, rapid growth in high-tech jobs and related strength in CRE markets in high-tech areas have resulted in increasing concentrations of C&D, CRE, and commercial and industrial (C&I) loans in insured community institutions headquartered in these areas. As shown in Chart 6, insured institutions in the Region's high-tech MSAs have consistently reported a greater combined share of these three loan types for the past five years (reaching 51 percent in 1999) than the national average (42 percent in 1999). Not only are the Region's high-tech MSAs heavily concentrated in traditionally higher-risk loan types, but the growth rate of C&D and CRE loans in these MSAs has outpaced the national growth rate in all high-tech MSAs each year since 1997.

Chart 6

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In recent years, earnings of the Region's insured institutions in high-tech MSAs have differed from those in non-high-tech MSAs. However, the institutions in high-tech areas reported lower ROAs (1.08 percent in 1998 and 1.03 percent in 1999) than those in non-high-tech areas (1.11 percent in 1998 and 1.13 percent in 1999). Consistent with higher wages and CRE rents in high-tech areas noted earlier, slightly lower earnings could be attributed to the higher salary and premises expenses incurred by banks in high-tech MSAs.

Some Risk May Be Mitigated by Stronger Asset Quality

Community banks in the Region's high-tech areas, however, reported generally strong asset quality during the past five years. The median past-due loan ratio for insured institutions in high-tech MSAs was low at year-end 1999 at 0.84 percent, compared with 1.15 percent in non-high-tech MSAs.

In addition, a small group of larger institutions in California has recently increased lending to Internet-related firms, as evidenced by warrant income reported by some of the Region's bank holding companies. The level of warrant income reported by these companies in first quarter 2000 was nearly equal to the amount reported for all of 1999. Although analysts consider venture capital and warrant gains as nonrecurring income and tend to discount these gains when valuing a bank's stock, these gains do offer these institutions increased financial flexibility.

In conclusion, the high-tech sector's influence on many of the Region's MSAs has been positive. Employment and per capita personal income levels have risen, and activity in the residential and CRE markets has been strong. Insured institutions in high-tech MSAs also have benefited from healthy economic conditions. However, given the increased exposure to traditionally higher-risk and volatile asset types and relatively lower earnings reported in some institutions in the high-tech MSAs, there could be cause for concern in the event of a stock market downturn.

San Francisco Region Staff
Gary L. Beasley, Memphis Regional Manager
Robert L. Burns, Memphis Senior Financial Analyst