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National Edition Regional Outlook, Fourth Quarter 2001

Regional Perspectives

Atlanta Regional Perspectives

Declining Economic Growth and Implications for the Atlanta Region

The Atlanta Region economy does not exist in isolation and, consequently, can expect growth to be influenced by national and global conditions and specific events, such as the September 11, 2001, terrorist attacks. Over the past several quarters, growth, both nationally and internationally, has declined. The following analyzes the current economic slowdown in the context of recent history and attempts to determine what impact it has had on the Atlanta Region economy and, ultimately, what challenges the Region's banking industry may face.

The Recent National Slowdown and Comparisons with History

At the time this article was written, the nation's slowdown had not been classified by the National Bureau of Economic Research as recessionary. However, several indicators illustrate the current weakness in the nation's economy. Real gross domestic product figures indicate that growth declined significantly over the past several quarters and, by second quarter 2001, the economy expanded at an annual rate of just 0.3 percent. Another sign of the nation's weakening economic health is the upward trend in unemployment rates, which is typically a leading indicator of a recession.1 The nation's monthly unemployment rate was above year-ago levels for eight consecutive months through August 2001. Since the 1950s, every period of year-over-year rising unemployment rates lasting more than six months has coincided with a recession. Although the unemployment rate remained below 5 percent through the summer of 2001, history shows that jobless rates at the outset of some recessions started at even lower levels. Moreover, the unemployment rate has risen by a full percentage point, from 3.9 percent to 4.9 percent. During the post-World War II era, no such increase has occurred without the economy being in recession. Even without a recession, sustained weakness may result in some measure of distress as the banking industry adjusts to a lower level of economic growth.

1 Mark, Roger R. 1998. Handbook of Key Economic Indicators, 2nd Edition. McGraw-Hill, p. 32.

Growth in the Atlanta Region Slows but Outpaces the Nation

The Atlanta Region has not been immune to the effects of slowing growth nationally and globally. Since late 2000, economic growth in the Region has declined, but it remains above the national rate. However, the effects of weaker national growth have not been felt uniformly throughout the Region. Areas with concentrations in industries such as manufacturing and high-tech businesses have experienced the most dramatic declines in growth. These areas have been affected further as the effects of sectoral downturns have radiated throughout the local economies. In contrast, other areas of the Region continue to experience comparatively strong levels of growth as economic diversification or industries that have not experienced a downturn have bolstered the local economies.

Traditional Manufacturing: An Ongoing Area of Distress

Initially, much of the nation's slowdown has been concentrated in the manufacturing sector-a critical area of prolonged weakness in the Atlanta Region. Nationwide, 14 percent of the workforce is concentrated in manufacturing. The percentage of the labor force employed in manufacturing is significantly higher in North Carolina, Alabama, South Carolina, and Georgia. Until recently, the erosion in the Region's industrial base has proceeded at a faster pace than the nation. One reason for this higher rate is the fact that nearly half the manufacturing employment in the Region is in nondurable goods2 production-where losses have occurred at a much higher rate3-compared with 40 percent nationwide. By a wide margin, the Region's largest manufacturing subsector is textiles, which lost more than 70,000 jobs (22.5 percent of the sector's total) over the year ending second quarter 2001 (see Chart 1). Although employment has been declining for several years, such factors as slowing global growth and the strength of the U.S. dollar have exacerbated the sector's ongoing weakness. The Atlanta Region's unique industrial mix-which includes high exposures in nondurables production and in other traditional industries, such as lumber and furniture-has resulted in a much higher rate of job loss compared with the nation.

Chart 1


Chart1. Atlanta Region Manufacturing Job Losses Have Been Most Apparent in Older Industries

2 Nondurable goods manufacturing includes food products, tobacco, textiles, apparel, paper, printing and publishing, chemicals, petroleum and coal products, rubber and plastics, and leather. Durable goods production includes lumber and wood; furniture, stone, clay, and glass; primary and fabricated metals; industrial machinery and equipment; electronic equipment; transportation equipment; instruments; and other miscellaneous manufacturing.

3 During the period April 2001 through August 2001, however, the year-ago rate of manufacturing employment erosion nationally eclipsed that in the Atlanta Region as losses in durable goods industries accelerated.

High-Tech Manufacturing and "Dot-Bombs"

While losses in traditional manufacturing have had an ongoing effect, the Atlanta Region, like the nation, benefited substantially during the 1990s from rapid growth in high-tech industries4 (both manufacturing and service based). During the 1990s, the Region's high-tech employment swelled by nearly one-third compared with the national increase of 20 percent. Northern Virginia, Atlanta, Raleigh, Tampa, Orlando, Miami, Charlotte, Norfolk, and Huntsville are the Region's large urban area high-tech employers. As recent high-tech layoffs in several of these markets and declines in the NASDAQ illustrate, however, that the high-tech industries are not immune to downturns. Those areas that have experienced "booms" in high-tech growth in recent years also may be susceptible to "busts" if the slowdown in these industries persists.

4 For the purpose of this analysis, we use primarily a DRI-WEFA, Inc., definition based on multiple standard industrial codes (SICs), which includes: drugs (SIC 283), computer and office equipment (SIC 357), communications equipment (SIC 366), electronic components and accessories (SIC 367), aircraft and parts (SIC 372), guided missiles, space vehicles, and parts (SIC 376), search and navigation equipment (SIC 381), measuring and controlling devices (SIC 382), medical instruments and supplies (SIC 384), telephone communications (SIC 481), computer and data processing services (SIC 737), motion picture production and services (SIC 781), engineering and architectural services (SIC 871), and research and testing services (SIC 873).

Exposure to More than One Stressed Industry May Pose Greater Economic Risk to Local Economies

Economic conditions in local economies may be further aggravated if stress occurs simultaneously in multiple industries. Such a scenario emerged during late 2000 and 2001 in the Hickory, North Carolina, metropolitan area and surrounding counties, where the local economy has been dominated by manufacturing, which accounted for 40 percent of total employment in 2000. This reliance, historically, has been concentrated in traditional industries such as textiles, apparel, and furniture manufacturing. However, during the 1990s, the local economy diversified into telecommunications equipment (fiber optic and coaxial cable) manufacturing. By mid-2000, strong job growth had helped lower the area's not--seasonally-adjusted unemployment rate to just under 2 percent. Later that year, however, the economy began to soften as layoffs emerged in traditional industries. Already weakening economic conditions were exacerbated by the surprise job losses in cable manufacturing-an industry thought by many local residents to be "slowdown-proof."5 Subsequently, labor market conditions deteriorated rapidly, with the jobless rate rising from less than 3 percent in July 2000 to 7.2 percent one year later. The nearby Greensboro metropolitan area also has experienced deteriorating economic conditions for similar reasons. The events in Hickory and Greensboro illustrate how fast and to what depth economic conditions can deteriorate given retrenchment in multiple key industries. Insured institutions in both metropolitan areas may be starting to feel the effects of this deterioration. Community bank6 performance, as measured by median return on assets, declined somewhat during the first half of 2001 from a year earlier, while nonaccruals and charge-offs have increased.

5 Hager, George. July 30, 2001. "Hickory, NC: Struggling Town Showcases Slowdown's Impact." USA Today.

6 Locally headquartered commercial banks with assets less than $1 billion.

The Multiplier Effect? Service-Producing Industries and Real Estate Markets

Fallout from layoffs in manufacturing and high-tech industries has had a limited effect in the more diversified local economies in the Atlanta Region, primarily in larger metropolitan areas, which have absorbed losses and continued to expand. However, if the effects of these losses begin to radiate into previously unaffected sectors of the economy, via falling demand for goods and services, or if consumer confidence wavers further, growth could become constrained and have a greater impact on the banking industry.

The real estate market is one area that is experiencing weakness because of the slump in manufacturing and high-tech industries. In Virginia's Dulles Corridor, for example, office vacancy rates in Herndon and Reston quadrupled in second quarter 2001 from one year earlier as negative absorption rose in early 2001. Residential real estate markets may also be vulnerable as continued slow economic growth could surprise homeowners and lenders who have grown accustomed to a rapid pace of home price appreciation in recent years.7

7 Fletcher, June. September 5, 2001. "Slowdown Threatens Residential Real Estate." Wall Street Journal.

Local economies that had, until now, remained somewhat immune to the weakening economy may be affected if slow growth persists. One such industry could be tourism, if consumer confidence continues to slip, spending slows, or consumers postpone or cancel travel plans in light of the national tragedy of September 11, 2001. Areas such as Orlando could be negatively affected if such a situation emerges, particularly given the level of expansion in the hospitality-related industry that this metropolitan area experienced during the 1990s.

Banking Implications

Credit quality may be weakening in some areas of the Atlanta Region. This trend is most evident among banks in states such as Alabama and North Carolina, which to date have experienced the greatest degree of economic slowing. In Alabama, for example, this slowing is highlighted by increasing levels of mortgages 90-days or more past due and foreclosures started, which have eclipsed levels reached during the last recession. The weakness in consumer credit quality, in part, may result from the recent increases in personal bankruptcy filings.8 Record consumer debt burdens coupled with mounting layoffs could adversely affect consumer credit quality among the Region's banks and thrifts. Commercial credit quality at insured institutions in North Carolina also has weakened. Levels of delinquent commercial real estate and commercial and industrial loans have increased each quarter since second quarter 2000. Insured institutions in other areas of the Region may experience similar declines in commercial credit quality if business conditions continue to deteriorate.

8 Some of the increase, however, may be attributable to proposed legislation that would make it more difficult to file for bankruptcy.

In addition to credit quality issues, continued economic weakness could adversely affect industry profitability in other ways. For example, loan growth likely will slow along with the economy. Already, survey reports indicate that demand for new commercial and industrial loans from small and large borrowers is declining.9 Moreover, consumers may scale back borrowing, particularly if consumer confidence deteriorates. Margins also likely will be pressured by the dramatic fall in short-term interest rates, as there is little downward repricing opportunity for nonmaturity deposits at many insured institutions.

9 Federal Reserve Board. August 2001. Senior Loan Officer Opinion Survey.

The operating environment for the industry may be the most challenging it has been in a decade. Many insured institutions report comparatively high levels of concentration in their business lines. A large number of these institutions are located in areas that have previously experienced rapid economic growth. A moderation in the pace of expansion in these markets could surprise some borrowers and lenders who expected above--average levels of growth to continue. Now that economic growth is moderating, it may be prudent to lower expectations and give careful consideration to the selection of appropriate lending concentration levels.

Atlanta Regional Staff

Boston Regional Perspectives

The Region's Economy Will Follow the Nation's through the Current Downturn

Following the events of September 11, 2001, it is increasingly likely that the nation's and Boston Region's economies have entered a period of economic retrenchment. As of this writing, factors that will have a significant effect on economic growth through mid-2002 were continuing to evolve. However, even before September, the Region's economy had shown signs of slowing. For example, the Region's seasonally adjusted unemployment rate had risen to 3.8 percent in September, from an expansion low of 2.4 percent in December/January. Third quarter nonfarm job growth for the Region (on a year-ago basis) was also lower than it has been since late 1992. The heated advance in U.S. equity markets between late 1994 and March 2000 allowed many of the Region's households to accumulate significant wealth in their investment portfolios and to boost their spending, but a weak stock market since then has likely hampered consumer expenditures. However, lower mortgage rates should continue to support cash-out refinancing activity in the near term, allowing many home-owning households to partially offset declines in stock portfolio wealth or a disruption in income caused by the weaker economy.

Certain States and Sectors Are Expected to Show Greater Stress

Even before September 11, the Region was grappling with a secular decline in its significant information technology (IT) sector. The loss of jobs and income from this adjustment (which is expected to continue as long as the economy remains weak) likely will be amplified during the coming months. The events of September 11 and their aftermath have affected several industries negatively, both in the Region and nationally, with the added risk of further deterioration through early next year. These industries include air travel, commercial aerospace manufacturing, tourism-related businesses, insurance, and securities, many of which are large employers in the Region. Among the states in the Region, Connecticut has large concentrations of employment (or domiciled workers) in commercial aerospace, insurance, and securities. The state's tourism industry (including its large tribal casinos), which is largely dependent on local drive-in traffic, should not be as exposed as tourism businesses in other parts of the nation that rely heavily on fly-in visitors.

Although Massachusetts has experienced (and will continue to bear) the brunt of the IT meltdown in the Region, the state's securities industry is primarily in the form of asset management firms, which may be less affected by a downturn in the securities sector than more-traditional Wall Street firms. Beyond the immediate drop in tourism and convention volume in September, the ultimate effect on the Region's tourism industry is unclear. In general, a slowing economy is usually not positive for the cyclical tourism industry. However, an aversion to flying may result in more skier visits to New England this winter by Northeasterners who typically might fly to other destinations, thus offsetting some of the cyclical weakness expected at local resorts.

Office Markets around Boston Evidenced Some Cooling

Office real estate conditions worsened in the Boston Region during third quarter 2001. Office vacancy rates in Boston and Cambridge continued to increase as blocks of sublease space were returned to the market as a result of the slowdown in the IT sector. In the Cambridge submarket (which had held a high concentration of Internet firms), some estimates put current vacancy rates at their highest level since the recession in 1991. As a whole, Boston is faring better, but suburban vacancy rates (between 10 and 17 percent) are well above those for the financial district. Also, in downtown Boston, about 2 million square feet (roughly 4 percent of reported multitenant inventory) was on the market to be sublet through third quarter 2001-more than the total amount absorbed in 2000. According to the commercial real estate firm Meredith & Grew Inc., average rents have leveled off at $50 to $65 per square foot for Class A space, following steady increases through 2000. Boston-area industrial markets, particularly in the suburbs, continue to exhibit low vacancy rates. Hotel space remains in short supply around greater Boston, but demand, which was already softening as economic growth slowed, was curtailed even more following the September 11 attacks. Occupancy rates at downtown Boston hotels are falling, and many conventions planned in the city have been canceled or rescheduled.

Office vacancy rates in Stamford, Connecticut (and for all of Fairfield County) have increased significantly since year-end 2000. However, demand for the area's roughly 5 million square feet of unoccupied office space may increase because of recent events. The attacks in New York City removed 13 million square feet of office space and damaged another 16 million.1 Many displaced companies are relocating to Fairfield County and northern New Jersey, absorbing blocks of available space in each market. While long-term effects are unclear, this relocation may reduce office vacancy rates in Fairfield County, at least in the near term.

1 September 18, 2001. Grubb & Ellis Special Report. "NYC's Office Market-Assessing the Damage."

The Region's Banks Are Better Prepared for this Economic Downturn...

The Region's insured institutions enter this period of economic weakness in much better condition than was the case in 1990. Before the last recession, the New England economy was already weakening, and the overall condition of the banking industry reflected that weakness. As of June 30, 1990, the date that marked the beginning of the last recession, approximately 30 percent of the Region's insured institutions, comprising 58 percent of total assets, already had composite capital, assets, management, earnings, and liquidity (CAMELS) ratings of 3, 4, or 5. These percentages had been rising steadily since mid-1987, and by 1991, 58 percent of the banks, and nearly 70 percent of the Region's total assets, carried less than satisfactory CAMELS ratings. However, as of June 30, 2001, just 5 percent, by both count and total assets, were assigned to the weaker rating bands, suggesting that we will enter this downturn from a position of relative strength.

The improved health of the industry today is reflected in capital and reserves levels as well. The median ratio of capital and reserves to total assets has risen approximately 200 basis points since the late 1980s to nearly 10 percent today. More important, the asset mix of the Region's insured institutions is decidedly less risky than in the late 1980s. During that time, nearly 75 percent of all institutions had loan-to-asset ratios in excess of 70 percent. Today, fewer than 40 percent have similar ratios. Additionally, insured institutions have reduced exposure to historically high-risk loan categories (commercial and industrial, commercial real estate, and construction and development). In 1990, approximately 20 percent of all institutions had concentrations of investment in high-risk loans exceeding 600 percent of Tier 1 capital. Those institutions had a failure rate six times greater than institutions with high-risk loan concentrations under 400 percent of Tier 1 capital. Today, just 4 percent of the Region's banks and thrifts report concentration levels over 600 percent of Tier 1 capital; only 14 percent exceed the 400 percent threshold.

...but Earnings Will Remain under Pressure...

While the overall condition of the Region's banks is generally favorable heading into this economic downturn, several factors suggest that an elevated level of caution is warranted. First, earnings have been on a slow, steady decline since 1997, largely because of net interest margin erosion. The sharp decline in interest rates that began in January 2001 has accelerated the rate of earnings decline, as banks have been unable to bring down funding costs as rapidly as earning asset yields have fallen. Even traditionally "liability-sensitive" savings banks are feeling the squeeze because savings, NOW (negotiable order of withdrawal), and money market deposit rates, which were already low relative to market interest rates, had little room to move on the downside. Additionally, a renewed refinancing wave has pushed down asset yields much faster than was expected. This trend will likely persist into early 2002 as further rate cuts have driven refinancing activity to record levels. The sharp drop in short-term rates also will have a negative effect on commercial bank margins, particularly those of banks that have a high percentage of loans priced off variable indices such as the prime rate.

Additionally, the quality of bank earnings has diminished as many insured institutions have supported bottom-line profits by taking securities gains and reducing loan loss provisions to offset the decline in margins. While asset quality indicators remain highly favorable throughout the Region, modest deterioration is beginning to show in the form of rising delinquencies in rural areas, as well as continued deterioration in the commercial and consumer portfolios of nationally focused institutions. This trend is expected to continue, and institutions now face the prospect of building loan loss reserves for the first time in years. Also, the loan losses that will be realized during this downturn are, for the most part, already embedded in the portfolios of the Region's banks. Institutions that aggressively manage their portfolios from both a credit administration and a collection perspective will minimize potential loss exposure; however, the costs to carry out these functions effectively will put additional pressure on earnings. Finally, while securities gains will be available in this lower rate environment, the reinvestment process will put further downward pressure on net interest margins.

Continued erosion of net interest margins, higher loan loss provisions, and reduced prospects for new business opportunities resulting from a slowing economy (which will stifle growth and reduce transaction-based income sources) will continue to chip away at earnings in the short term. This situation will lower institutions' capacity to absorb any significant credit shock should the recession be deeper or longer than expected, underscoring the importance of maintaining strong loan portfolio management practices to minimize credit losses.

...and Longer-Term Interest Rate Risk Exposures Are Poised to Rise

The refinancing wave of the late 1990s exerted a significant effect on the interest rate risk profiles of the Region's savings banks. Among these institutions, there was a wholesale shift in the composition of residential loan portfolios from predominantly adjustable-rate mortgages (ARMs) to heavier concentrations in fixed-rate loans. As a result, there has been a significant increase in the number of institutions with concentrations in long-term assets (over five years). In the mid-1990s, fewer than 25 percent of all savings banks reported long-term assets exceeding 30 percent of earning assets. By year-end 1999, more than 70 percent of savings banks had reached this concentration level, and it has remained relatively constant. The current refinancing wave already has exceeded the 1998 wave in magnitude and likely will have a disproportionate effect on ARM holdings once again. Reinvesting prepayments from both loan and securities portfolios will be a difficult balancing act of mitigating margin erosion to the extent possible without jeopardizing future earnings prospects through undue concentrations in long-term assets. While the prospects for higher interest rates appear remote at present, rates will rise eventually, particularly short-term rates that drive the bulk of bank funding costs. Insured institutions should be positioned for this eventuality.

While usually not sufficient on its own to undermine earnings or capital, significant interest rate risk exposure could weaken a bank's earnings capacity at exactly the wrong time, making it more susceptible to other adverse shocks, such as a downturn in credit quality or a large-scale fraud. Sound interest rate risk management should preclude such an occurrence by ensuring that a bank's earnings stream is not affected unduly by fluctuating interest rates.

Boston Regional Staff

Chicago Regional Perspectives

Loan Quality Pressures Become More Widespread in the Region

Slowing economic conditions have started to affect loan quality in nearly every banking line of business. Indicators of loan performance have experienced deterioration, which could become more pronounced should loan demand continue to soften. The Chicago Region's insured financial institutions experienced increasing levels of past-due and nonaccrual (PDNA) loans in the year ending June 30, 2001. For several years, PDNA ratios have risen at the Region's largest institutions (see Chart 1). This development follows a national trend in which shared national credits are playing a large role in the deterioration of credit quality.1 The past year's upturn in PDNA ratios at the Region's banks and thrifts with assets of $10 billion and less reverses trends of recent years. This article examines credit quality developments at the Region's established community institutions2 among which the aggregate PDNA ratio rose to 2.31 percent on June 30, 2001, from 1.85 percent a year earlier.

Chart 1

[D]Chart1. Past-Due and Nonaccrual Loan Ratios Are Rising at Chicago Regionís Insured Institutions

1 For more details, see "Emerging Risks in an Aging Economic Expansion," FDIC Regional Outlook, fourth quarter 2000, pp. 6-8.

2 Community institutions are defined as banks and thrifts that have been in existence at least three years with assets of $1 billion or less, exclusive of credit card and other specialty institutions.

Among community institutions, the most pronounced deterioration, as gauged by the June 2001 PDNA ratio relative to the prior five-year average, occurred in the one-to-four family and commercial real estate loan (CRE) categories. The PDNA ratios for these lending segments are about 25 percent higher than the five-year averages, while charge-offs for these lines are approximately twice the average over the last five years. Commercial and industrial (C&I) loan quality also warrants attention, given the higher PDNA and charge-off rates and the fact that this loan category represents nearly 15 percent of total loans at the Region's community institutions (see Table 1).

Table 1

[D]Table 1 Loan Performance of Community Institutions Shows Some Weakening

Loans to Household Sector Show Moderate Increases in PDNA Ratios

Loans to consumers, including credit cards and home equity lines of credit, have shown some weakness in credit quality as the financial vibrancy of the household sector has waned. Some trends behind this weakening, which could affect households' financial cushions and repayment abilities, include the following:

  • Regional job growth decelerated to zero at midyear 2001 from 1.8 percent a year earlier. A 3.1 percent drop in manufacturing jobs and a noticeable slowdown in hiring by other sectors drove this deceleration. The Region's unemployment rate rose to 4.6 percent at mid-year 2001 from 3.9 percent one year earlier.

  • Rates of home price appreciation have varied considerably among communities. In those where it has been sizeable, new and refinanced mortgages based on recent sales valuations could be exposed to some erosion of collateral value as overall economic conditions weaken. In addition, some households undertook cash-out refinancing just before the economic slowdown became evident, and their increased leverage could heighten their vulnerability to any adverse events such as reduced hours of work or job layoffs.

  • Personal bankruptcy filings in the Region's states during the second quarter, 2001, were 28 percent to 42 percent higher than a year earlier, compared with a 25 percent increase nationally. This year's surge likely reflects financial strains among a growing number of households as well as the impetus earlier this year to accelerate filings before the potential passage of legislation to tighten bankruptcy terms.

Residential Real Estate: Typically, single-family mortgages have been associated with low loss rates compared with other lending lines at insured institutions. Although charge-offs remain low, the risk profile of residential real estate (RRE) portfolios may be changing. As competition for conventional mortgages heightens, profitability on these loans will remain thin. Institutions may choose to increase exposure to unconventional borrowers or nonconforming property types to offset margin compression. Furthermore, to the extent that loans meet the conventional criteria and are sold, community banks and thrifts could potentially be left with a less diversified and riskier mortgage portfolio. Some weakness in the loan quality of the Region's residential loan portfolio already is apparent as the past-due ratio in the one-to-four family loan segment rose to the highest level in a decade.

Commercial Lines Begin to Show Signs of Strain

Commercial Real Estate: For the past several years, robust economic activity has led to a resurgence of commercial real estate (CRE) lending and overall improved asset quality measures among insured financial institutions. However, as slowing economic conditions curtail business expansion, weakness in certain commercial real estate markets has led to softness in CRE loan performance. Despite some slowing, CRE loan growth remained at a strong 17 percent over the past year. During this period, PDNA CRE loan ratios at community banks and thrifts rose appreciably, though charge-offs remained low. The bulk of this deterioration was experienced by the 14 percent (222) of the Region's community institutions that had at least 200 percent of Tier 1 capital concentrated in CRE loans and that reported a CRE loan growth rate of 20 percent or more over the past year. Michigan and Wisconsin were home to the highest percentage of banks and thrifts with this level of growth and concentration. A significant number of these institutions are headquartered in the Grand Rapids and Madison metropolitan statistical areas (MSAs).

While growth in most loan categories subsided, construction and development (C&D) lending continued at a rapid clip; however, this category represents only a small portion of total loans. Nevertheless, C&D loan portfolios may be the most vulnerable CRE component during a slowing economy. Of the three classes of CRE credits, C&D loans experienced the greatest deterioration during the 12-month period ending June 30, 2001.

As preleasing commitments falter with the slowing economy, construction projects financed on a speculative basis, without meaningful presale, prelease, or takeout commitments, could face even greater challenges in a downward cycle. According to the most recent FDIC Report on Underwriting Practices,3 the proportion of banks nationally that either "frequently" or "commonly" made speculative construction loans rose from 26 percent to 29 percent over the six-month period ending March 31, 2001. The use of higher-risk lending practices, such as deferred interest payments and no equity financing, also increased during the latest survey period.

3 FDIC Report on Underwriting Practices. March 2001.

In the Chicago Region, 100 community institutions were identified at midyear as having at least 100 percent of Tier 1 capital concentrated in C&D loans, up from 80 at June 30, 2000. Seventy percent of these institutions reported a C&D loan growth rate above 20 percent for the period, making them potentially more vulnerable to continued economic weakness. As unemployment rates rise and economic growth slows, insured institutions experiencing this level of growth and concentration, particularly those in MSAs that are experiencing rising vacancy rates or increasing inventories of homes for sale, may realize further deterioration in C&D loan performance. Subsequently, overall CRE loan quality also may decline somewhat as the adverse effects of this combination of risk factors affects insured institutions throughout the Region. Chicago and Indianapolis are examples of metropolitan areas that are experiencing rising CRE vacancy rates at the same time insured institutions are increasing exposures to these traditionally higher-risk loan categories.

Commercial and Industrial: In addition to the more relaxed underwriting standards of the past, recent national trends, such as falling corporate profits and increased leverage, may be negatively affecting commercial and industrial (C&I) loan performance at community banks and thrifts. At June 30, 2001, PDNA C&I loans at the Region's community institutions grew to 3.42 percent, the highest level since third quarter 1998. C&I charge-offs remained low but rose 8 basis points during the past 12 months to 0.50 percent, the second consecutive annual increase.

One way to assess the potential risk associated with C&I lending is to look for a combination of C&I loan concentration relative to Tier 1 capital and rapid C&I loan growth. Institutions that have exhibited these characteristics in the past have generally experienced greater loan quality deterioration than other institutions. At midyear 2001, 230 institutions, or 14 percent of community banks and thrifts in the Region, reported a C&I concentration over 100 percent of Tier 1 capital and rapid C&I loan growth (20 percent or more over the past year); these institutions accounted for roughly 33 percent of the Region's total C&I exposure. Ninety-eight (43 percent) of these institutions are headquartered outside an MSA. In the aggregate, loan quality at these institutions deteriorated somewhat, as the PDNA ratio for C&I loans rose to 2.97 percent by June 30, 2001, from 2.70 percent a year earlier. Charge-offs increased by 11 basis points to 0.36 percent. Nonetheless, this group's C&I loan portfolio outperformed that of other community institutions in the Region. To compare, community institutions holding lower concentrations reported a C&I charge-off rate of 0.56 percent and a PDNA ratio of 3.63 percent, up 48 basis points from a year earlier.

Despite the evidence of slight weakening in C&I credit quality, the strong C&I loan growth at the 230 institutions may be masking the full extent of deterioration in loan quality. While most community banks and thrifts have reduced C&I loan exposure, the percentage of C&I loans held by the 230 institutions mentioned above rose to 24 percent of total loans by June 30, 2001, an increase of 400 basis points from June 30, 2000. Meanwhile, the percentage of C&I loans to total loans for other banks and thrifts in the Region fell noticeably, to 12 percent. However, the C&I lending concentrations held by the 230 institutions may accompany a level of management experience and expertise as well as portfolio diversification that helped mitigate the level of credit quality deterioration during the past year. Nonetheless, should economic weakness persist and business conditions continue to wane, these institutions could experience a rapid deterioration in credit quality that could become more apparent as loan demand slows.

Shocks from September 11 May Extend the Depth and Length of Economic Weakness, Exacerbating Loan Quality Issues

The probability of prolonged economic weakness has increased, in part because of economic disruptions related to the events of September 11. Should weakness continue, recent loan quality deterioration will likely become more pronounced. During the recession of the early 1990s, C&I and CRE loan quality deteriorated significantly, as measured by charge-off and delinquency levels. Since then, community banks have increased loan-to-asset levels and relative exposures to these historically riskier loan categories. The continued slowdown in business activity and increasing vacancy rates will likely keep commercial loan demand soft, moderating exposure to those categories in the near term. However, given the current relatively high -exposures to these lending segments, pressure on loan quality will likely continue in the presence of sustained economic weakness. In addition, recent residential real estate loan performance illustrates that some traditionally lower-risk loan segments may not perform as well during the current slowdown. Whether collateral on these loans remains sufficient will be a function of the extent to which consumers and banks have used cash-out refinancings or high loan-to-value ratios, as well as the health of residential real estate markets.

Chicago Regional Staff

Dallas Regional Perspectives

Shifting Economic Outlook. The economy of the Dallas Region has slowed during the past two years from a robust to a modest level of growth. An anemic national economy and an ailing high-tech sector have contributed significantly to this rapid slowing in job growth.

Before the attacks of September 11, 2001, economic indicators for the nation, including the Dallas Region, were suggesting an increased likelihood of recession. In the attacks' aftermath, there may well be additional negative repercussions on the spending patterns of consumers, businesses, and investors, and thus on the economy. As an indication of the potential for a decline in consumer spending (which to date has been a source of strength for the national economy), the results of a University of Michigan survey of U.S. consumer sentiment taken one day before the terrorist attacks showed a decline from 91.5 in August to 83.6 in September.1 Following the attacks, the Conference Board's Consumer Confidence Index plummeted to 97.6 in September from a revised 114.0 in August-the largest drop since the Persian Gulf War.2

1 September 2001. University of Michigan survey of U.S. consumer sentiment.

2 According to the Conference Board's website (http://www.conference-board.org), "survey results (for the September survey) conducted before and after the terrorist attacks on September 11 differed slightly, there was no reversal in the downward trend of the Index."

In the context of the ongoing uncertainty about the outlook for the economies of the nation and the Region, this article focuses on the overall deterioration in the Region's economy since the beginning of 2001, particularly as it relates to stress in the high-tech industry and effects on the commercial real estate sector and the banking industry.

Employment Growth Decelerates. Table 1 compares the Region's annual average nonfarm employment growth from 1993 to 2000 with the most recent year-to-year figures (July 2001). Job growth for all four states in the Region showed a marked deceleration-34 percent to 60 percent below previous trends. Both Colorado and Texas, which together account for 84 percent of the Region's total nonfarm employment, have experienced substantial slowing in job growth rates since February 2001, dragging down the Region's employment growth.

High-Tech Manufacturing and Government Are the Weak Links in the Region's Economy. Manufacturing job losses have accelerated. Declining sales, falling prices, and shrinking profits have plagued the high-tech capital goods and telecommunications industries. In addition, government agencies are paring payrolls. Slowing economic growth has affected revenue growth at all levels of government but particularly at the state and local levels, resulting in budget cutbacks and reduced employment. Both sectors combined for 28 percent of the Region's total nonfarm employment as of second quarter 2001.

Table 1

[D]Table 1. Employment Growth in the Dallas Region Has Fallen Well below Trend

Many market analysts believe that the telecommunications industry is currently experiencing significant excess capacity and an overhang of corporate debt, precluding an economic turnaround in that sector any time soon. Large high-tech regional employers-such as Dell, Nortel, Texas Instruments, Ericsson, Compaq, Nokia, and Qwest-have issued major layoff announcements in 2001, in some cases more than once. Major high-tech metropolitan statistical areas (MSAs), such as Denver and Dallas, have lost thousands of high-paying high-tech jobs and seen employment growth rates fall well below trends of the past eight years. Mid-sized MSAs that depend even more on the high-tech sector or exhibit comparatively less diversification are hurting even more. MSAs in this category include Austin, Albuquerque, Colorado Springs, Fort Worth, Oklahoma City, Sherman-Denison, Tulsa, and Waco.

Housing Activity and Consumer Spending Are Propping up the Economy...So Far. The telecommunications boom of the 1990s helped drive employment and population growth and housing construction activity throughout the Region, as well as office, industrial, and retail development. In fact, despite the current economic weakness, the Dallas Region continued to outpace the nation in job creation for the 12 months ending July 2001, thanks to continued strong housing activity and stable consumer spending. Retail sales for the Region's states were generally strong through the early part of this year; however, some weakness is beginning to emerge. Following the September 11 attacks, consumer spending can be expected to slow further, casting doubt on whether consumers can continue to be a source of strength for the economy.

Through the first half of 2001, Colorado and New Mexico were on a pace to set record highs in existing home sales, according to data from the National Association of Realtors, while Oklahoma and Texas were each likely to achieve their second best year. A major contributing factor to the Region's strong housing market was lower interest rates. Thirty-year conventional mortgage interest rates fell more than 100 basis points below year-ago levels, averaging 6.95 percent as of August 2001, according to the Federal Reserve Board. In spite of the low interest rates, recent events, including the slowing economy and the fallout from the September 11 attacks, could dampen housing activity throughout the Region for the remainder of the year.

Insured Institutions in the Dallas Region Continue to Increase Exposure to Commercial Real Estate. Commercial real estate (CRE) lending by banks and thrifts has increased significantly over the past 31/2 years (see Chart 1). CRE loans currently represent 30.7 percent of total loans, the highest level since 1988 and much higher than the average for insured institutions in the rest of the nation. Higher CRE concentrations are most pronounced among insured institutions with assets between $500 million and $1 billion. This group showed the greatest increase among all size categories, with CRE loan volume rising to over 40 percent of total loans as of June 30, 2001. The Region's strong economic growth, accompanied by robust employment growth and in-migration, increased demand for real estate construction loans during this period. The favorable economic environment also helped mitigate credit quality issues that might have emerged during a weaker economy.

Chart 1

[D]Chart 1. Expanded Commercial Real Estate Credit Exposure Increases Vulnerability to Weakening Markets in the Dallas Region

Past-due and charge-off rates among the CRE portfolios of the Region's insured institutions have increased slightly over the past several quarters but remain relatively low. However, CRE vacancy rates are beginning to rise, rapidly in some metropolitan markets with concentrations in high-tech employment. Although few expect a downturn in the Region's real estate market as serious as that of the 1980s, that experience highlights the potential risks of significant increases in CRE concentrations.

Vacancy Rate Increases Are a Signal for Caution. Several markets in the Dallas Region, including Houston, Dallas, and Oklahoma City, have reported office vacancy rates higher than the national average during much of the 1990s. These higher vacancy rates can be attributed in part to the overhang in supply from the late 1980s and early 1990s. For the most part, this excess supply has been factored into considerations of price and insured institution financial exposure and is less cause for concern than the sharp increases in vacancy rates recently seen in numerous high-tech markets.

Many of these high-tech markets have enjoyed significant economic growth during the past decade, prompting financial commitments in the CRE sector. However, an outgrowth of the recent decline in the high-tech industry, in addition to an overall slowing in employment and in-migration, is excess office space in some of the larger metropolitan markets, such as Austin and Denver-Boulder. Additional supply is also under construction in these markets, and an increase in sublease space is being reported in these and several other markets. The result is rising vacancy rates and declining rental rates. Similar signs of weakness are spreading to other segments of the real estate market, including industrial, retail, multifamily, and residential space.

The Austin and Houston Real Estate Markets Offer Interesting Contrasts. By a conservative estimate, Austin high-tech employment accounted for 10.3 percent of the MSA's total employment as of June 30, 2001.3 According to Torto Wheaton Research, the office vacancy rate for Austin at the same time stood at 11.8 percent, an unprecedented 680 basis point increase in six months. In fact, some analysts have argued that the true vacancy rate is closer to 20 percent when all space available for sublease is included. In addition, at year-end 2000, office space under construction totaled almost 10 percent of existing space. However, during the first six months of 2001, construction of several high profile office buildings, including the $124 million Intel complex downtown and a large Trammel Crow speculative building in north Austin, was put on hold. Even with these pullbacks, 450,000 square feet of new space came onto the market. At the same time, net absorption in the Austin market was a negative 1.3 million square feet, the highest level since 1987. The fallout from Austin's weakening high-tech sector has spread beyond office and industrial space into residential real estate, as described in a recent article in the Dallas Morning News that stated, "While preowned home sales in the area were down only about 6 percent as of June 2001, the number of homes on the market more than doubled."4

3 Source: Economy.com. Another estimate for the same period by AngelouEconomics places this figure at 19.7 percent.

4 Brown, Steve. June 1, 2001. "High-tech hotbed's building boom hits wall during slowdown." Dallas Morning News.

In contrast, Houston's office vacancy rate, although higher than that of the nation, rose by only 60 basis points during the first part of 2001. This contrast can be attributed in part to the fact that Houston has benefited greatly from a resurgence in the energy sector, which has offset the weakness in its high-tech industry.

Where Do We Go from Here? The Dallas Region has increasingly moved away from a natural-resource-based economy (e.g., energy and agriculture) to a more diversified one characterized by high tech, transportation, and financial and business services. Thus, the Region is likely to feel the effects of any national downturn. Insured financial institutions in the Region's metropolitan markets with significant exposures to the high-tech sector may experience declines in loan quality in other categories of their portfolios than CRE, such as residential real estate. Following the September 11 attacks, other industries, such as airlines, defense, and energy, could experience continued volatility, which may affect local economies and banking markets. At this time, the challenge for the Region's insured institutions is to ensure that risk management strategies are in place to respond to a rapidly changing economic environment.

Dallas Regional Staff

Kansas City Regional Perspectives

Agricultural sector performance in the Kansas City Region continues to lag behind that of the nation. However, even though the Region's farm banks report sound financial conditions, borrowers' dependence on government support payments is extremely high, making asset quality difficult to assess. Federal government policy could change substantially when the 1996 Federal Agriculture Improvement and Reform (FAIR) Act expires next year. Vulnerability to changes in the type or level of government support varies greatly among the Region's farm banks at the county level.

The Region Will Not Share Fully in 2001 National Farm Income Increases

Despite the fact that national farm income is projected to increase in 2001, growth in the Region may lag behind that of the nation. The U.S. Department of Agriculture (USDA) has forecast an 8.6 percent increase nationally in net farm income in 2001, from $46.4 billion in 2000 to $50.4 billion, because of stronger farming revenue. However, $6.5 billion, or more than one-half of the 2001 increase in farming revenue, is in dairy and poultry, which are not dominant in the Kansas City Region. Looking at the products that are important to this Region's farmers-notably wheat, corn, soybeans, cattle, and hogs-we see that revenue growth lags behind that of the nation's farm sector as a whole. In addition, the USDA estimates a 10 percent increase in the costs of manufactured inputs-pesticides, fertilizers and lime, petroleum fuels and oils, and electricity-that are used more intensively in the Kansas City Region. As a result, the Region's growth in farm income is not expected to be commensurate with that of the nation as a whole.

Moreover, the potential for the U.S. and world economies to slow further may have been heightened following the terrorist attacks of September 11, 2001. Should the global economy enter a recession, export demand for higher-valued commodities, such as processed meats, would be expected to decline, and commodity prices in the Region would likely remain low. Additionally, any future response to the attacks could cause some disruption in international agricultural trade.

Farm Bank Asset Quality Could Be Fragile

Reported asset quality indicators continue to suggest strong credit quality overall, which contrasts somewhat with anecdotal evidence that shows increasing strain. As of June 30, 2001, farm bank aggregate noncurrent loans and leases and net loan and lease charge-offs represented a relatively low 1.14 percent and 0.16 percent of total loans and leases, respectively. Although up slightly from year-ago levels, these ratios are consistent with figures reported over the past several years and are low compared with historical standards. For example, in 1996, in what is considered the best year for the industry during the 1990s, these ratios were 1.22 percent and 0.15 percent, respectively.

Capital protection levels also remain high, as farm banks report an aggregate equity capital ratio and loan loss reserve to total loans ratio at 10.7 percent and 1.5 percent, respectively, as of June 2001. This is in line with recent historical trends. By contrast, these ratios were much lower at the beginning of the 1980s agricultural crisis, at 8.7 percent and 1.0 percent, respectively.1

1See Table 3 in "Agricultural Sector Under Stress: The 1980s and Today," Kansas City Regional Outlook, third quarter 1999.

However, anecdotal reports about rising carryover debt levels suggest that asset quality is becoming somewhat strained. Chart 1 shows the results of examiner surveys about carryover debt levels. The rapid escalation in 1998 and 1999 reflects the effects of the plunge in commodity prices in 1997 and 1998. Despite four years of record direct government payments, the number of examiners indicating increased carryover debt has outnumbered those noting declines, indicating that farm loan portfolios may be weaker than the current loss and delinquency measures suggest.

Chart 1

[D]Chart1. Carryover Debt Levels Escalated Dramatically in 1998 and 1999 and Continue to Slowly Rise

Events of This Year Could Significantly Affect the 2002 Farm Bill Debate

The USDA estimates 2001 total direct government assistance of $20.4 billion. While this is almost 10 percent below the record high of $22.9 billion paid in 2000, it remains the third-highest amount ever paid and the third consecutive year that government payments have exceeded $20 billion.

The 1996 FAIR Act expires in 2002, and the debate can be expected to intensify about the fiscal role of the federal government in the agricultural sector. The direction that the next farm bill may take is highly uncertain, and any assessment at this point is preliminary. Only the House Agriculture Committee has drafted legislation; the Senate and the White House have yet to put forth their versions of a new farm bill. However, a changing economic outlook, which has become especially uncertain following the terrorist attacks on September 11, 2001, could affect the environment in which the farm bill is debated.

The House Agriculture Committee released its proposal in August, at which time large budget surpluses were forecast. Key provisions call for adding an additional countercyclical income payment to the current market transition and loan deficiency payments. Farmers participating in conservation programs would also benefit from additional funding, and more monies would be available for growers of commodities other than the traditional food grains, feed crops, and oil crops. The price tag over ten years would be $171 billion. When annualized, this is not much lower than the record-setting payments of the past four years and nearly double the amount of spending budgeted in the 2001 fiscal year budget.

However, these large budget surpluses appear to be dissolving quickly as both the Congressional Budget Office and the White House revised their fiscal year 2002 budget surplus forecasts downward by more than 40 percent. In addition, the terrorist attacks of September 11, 2001 enhance the uncertainty surrounding decisions related to future congressional and administration budget priorities. International trade negotiations could also affect the outcome of the farm bill debate. For example, the next meeting of the World Trade Organization is expected to include substantive debate about limiting farm subsidies.

Should the level of government payments decline and commodity prices not rebound, the quality of bank loans extended to borrowers concentrated primarily in food grains, feed crops, and oilseed production could deteriorate. As discussed in previous Kansas City Regional Perspectives articles, these commodities receive the large majority of direct government payments.2

2 "The Agricultural Sector Remains Depressed, with Low Commodity Prices," Regional Outlook National Edition, second quarter 2001, and "Farmers and Lenders Continue to Rely on Government Payments to Support Cash Flows and Farmland Values," Kansas City Regional Outlook, third quarter 2001.

Credit Risk Is Higher among Farm Banks in Counties Most Dependent on Government Payments

The Region's counties would be dissimilarly affected by a cut in government payments. Map 1 shows each county's dependence on direct government payments as a share of the county's total farming receipts in 1999 (government-payment dependence ratio).3 The darker-shaded counties are those most dependent on government payments-at least 20 percent of their income is from such payments-and are referred to as "highly reliant" counties.

Map 1

[D]The Regionís Dependence on Government Payments Is High, Especially in North Dakota and Kansas

3 1999 is the most recent year that data on a county level were available. The data source is the Bureau of Economic Analysis, United States Department of Commerce. Total farm receipts is the combination of farm cash receipts and direct government payments.

Recall that the period 1990 through 1996 is the most recent period of generally stable farming conditions prior to the commodity price slump that began in 1997. During that period, only 1 percent of all counties in the Region would have been considered highly reliant, and one-half of all counties had a government-payment dependence ratio of 6.8 percent or more. By 1999, after three years of depressed commodity prices, one-quarter of the Region's counties were considered highly reliant, and the ratio for the top half of all counties more than doubled to 15.9 percent. Just as striking is that nearly every county in the Region is at least lightly shaded, indicating that 1999 government payments represented at least $1 out of every $10 in total farm receipts. North Dakota and Kansas are home to a disproportionate number of highly reliant counties with a concentrated production of heavily subsidized commodities, such as wheat, relative to the rest of the Region.

In general, farm banks in highly reliant counties have exhibited higher levels of credit risk than banks in other counties both before and during the recent agricultural slump. Chart 2 shows noncurrent loans as a percentage of total loans for farm banks headquartered in highly reliant counties and banks headquartered in all other counties. The trends show that government payments have similarly benefited the asset quality of both groups. Perhaps more important, banks in highly reliant counties consistently have reported a significantly higher noncurrent loan ratio, even during relatively good times, indicating heightened credit risk overall. Banks in counties showing the greatest reliance on government support payments already report higher levels of nonperforming loans. However, these institutions could experience greater loan quality deterioration should significant changes occur in government support programs.

Richard D. Cofer, Jr.
Senior Financial Analyst

Chart 2

[D]Chart2. Banks in Highly Reliant Counties Consistently Have Higher Noncurrent Loan Ratios

Memphis Regional Perspectives

Economic Conditions in the Region Continue to Weaken

Economic growth throughout much of the Memphis Region slowed to a standstill in third quarter 2001. Employment growth for the 12 months ended August 2001 was flat, with more recent job formation turning negative.1 The Region's economy is at its weakest since the 1990-1991 national recession and is currently underperforming the national economy because of its high reliance on the contracting manufacturing sector. To cope with sluggish product demand, manufacturers in the Region shed approximately 75,000 jobs from August 2000 to August 2001.2 Job losses have spread to other sectors, most notably the construction sector but recently to the retail and transportation sectors as well. Employment growth in the service sector, which had previously compensated for job losses in other sectors, was virtually nonexistent in the three-month period ended August 2001.

1 From May 2001 to August 2001, the Region suffered a net loss of 9,000 jobs; that is, 9,000 more jobs were lost than created. State employment surveys (from which these regional data are derived) do not reflect the degree of slowing in employment growth shown by the more statistically valid national employment survey, suggesting that the Region's employment situation may be considerably worse than indicated.

2 One important exception to negative trends in the Region's manufacturing sector during the previous year is automobile production. In Tennessee, Saturn and Nissan employ more than 14,000 people, and in Kentucky, Ford and Toyota employ approximately 16,000. National automotive sales in the first half of 2001 fared well, averaging 17 million units on an annualized basis, thanks in large part to low interest rates and considerable incentives. Declining consumer confidence and retail spending, however, could begin to affect automobile sales and production adversely if economic conditions remain weak.

The downturn in manufacturing and the spillover effects to other sectors have been most pronounced in Mississippi, Arkansas, and Tennessee. Mississippi has suffered considerably more than any other state in the nation, reporting more than 21,000 net job losses during the previous year,3 more than double the number of job losses in the state during the 1990-1991 downturn. With both global and national economies weakening, conditions in the Region, which is already somewhat stressed by a prolonged localized downturn, could deteriorate further.

3 Although the contraction in the manufacturing sector has been a driving force in Mississippi's economic downturn, every major sector in the state except government reported negative job formation from August 2000 to August 2001.

Reduced Travel and Tourism Will Have a Greater Adverse Effect on Certain Markets in the Region

While the entire Region will continue to suffer the effects of a continuing economic slowdown, certain sectors and locations may be particularly hard hit by the sharp reduction in travel and tourism in the aftermath of September 11, 2001. The sectors include air transportation, recreation, and lodging.

  • Air Transportation: With the airline industry reducing flights and laying off approximately 20 percent of its workforce nationwide, areas with high exposure to the industry, such as Memphis and Louisville, will be hurt. The air transportation sector in both cities includes significant air cargo operations as well as commercial airline carriers, which mitigates the direct effects of reduced personal air travel to some extent. High exposure to air cargo operations, however, leaves the air transportation segment of these local economies heavily exposed to the overall national slowdown.

  • Recreation and Lodging: Popular tourist locations, such as Biloxi and New Orleans, also are affected. In Biloxi, for example, air and water transportation, amusement/recreation, and hotel/lodging sector employment collectively represents 12.9 percent of total employment, the fifth highest concentration of any metropolitan market in the nation.

Bank Credit Quality Has Deteriorated with the Downturn in Economic Conditions

Delinquencies and loan loss rates in the Memphis Region climbed from year-ago levels, and the current economic outlook suggests the potential for further deterioration. Median past-due and nonaccrual loans among the Region's community banks and thrifts (those with less than $1 billion in total assets) rose to 2.6 percent of total loans, up from 2.0 percent one year ago and now the highest among all FDIC Regions. The deterioration in credit quality has been widespread, with more than two-thirds of banks and thrifts in the Region reporting higher delinquencies than one year ago and almost half of all insured institutions reporting at least a 50 basis point increase in delinquencies. The current level of past-due and nonaccrual loans at most banks and thrifts remains at manageable levels, well below those reported during the prior national downturn. However, recent trends demonstrate some weakening in asset quality through the first half of 2001, consistent with slowing economic conditions. To date, consumer credit quality appears to have been affected most (see Chart 1), but given the potential for further broad deterioration in economic conditions, credit quality across all loan types may suffer in the near term.

Consumer Loans: Mounting job losses combined with high consumer debt levels have contributed to weaker financial conditions for many households. Personal bankruptcy filings in the Region in the first half of 2001 were up 27 percent from a year ago.4 Although the number of filings may have been influenced by efforts to tighten bankruptcy legislation, the increase likely reflects the growing financial difficulties many borrowers face. Memphis Region banks and thrifts may be particularly susceptible to continuing deterioration in consumer loan portfolios, given the high proportion of low-income borrowers in the Region.5

Chart 1

[D]Chart1. Credit Quality Weakens among the Regionís Community Banks

4 The 27 percent surge in personal bankruptcy filings in the Region during the first half of 2001 is higher than the 21 percent increase reported nationally. Among the Region's states, Arkansas reported the sharpest increase in personal bankruptcy filings at 37 percent. Louisiana was the only one of the Region's states to report a smaller increase than the nation, consistent with that state's relatively stable economy.

5 Studies suggesting that debt burdens have increased most among low-income borrowers during the recent expansion are described in more detail in "Changing Economic Conditions Affect Bank and Thrift Earnings and Asset Quality," Regional Outlook, third quarter 2001.

Residential Loans: The quality of residential loan portfolios also could be affected adversely by the deterioration in household financial conditions. Credit risk in residential loans has been historically low and remains moderate compared with other loan types. Dramatic changes in residential lending during the 1990s, however, likely have increased the overall credit risk in residential portfolios. New loan products and programs facilitated financing for many first-time home buyers who might not previously have qualified for loans and allowed existing homeowners to increase their home-secured debt levels substantially. As a result, loss rates on residential loan portfolios at community banks could rise higher than previously experienced.

Commercial Real Estate Loans: Commercial real estate loans reported by commercial banks consist of three general types: loans secured by nonresidential properties, construction and development loans for both commercial and residential properties, and loans secured by multifamily properties. Delinquency ratios increased for all three types, but increased most for construction and development loans. Growing inventories of unsold new homes are driving the increases in construction loan past-due ratios. Delinquencies on nonresidential properties were also higher as an uncertain economic outlook led to sharply reduced demand for commercial real estate in the first half of 2001 and to rising commercial vacancy rates in both the Region and the nation.

Commercial and Industrial Loans: Unlike other major loan categories, the median ratio of past-due and nonaccrual commercial and industrial loans as of June 30, 2001, declined from year-ago levels. This apparent improvement in commercial credit quality was not widespread, however, as larger financial institutions reported higher commercial loan delinquencies. The 25 largest insured institutions in the Region-those with total assets in excess of $1 billion-reported an 80 basis point increase in median commercial loan delinquencies. Furthermore, 58 percent of banks with total assets ranging from $250 million to $1 billion reported an increase in past-due and nonaccrual levels from one year ago. These trends in larger institutions, along with declining corporate profitability and a slowing national economy, suggest that commercial loan credit quality for institutions of all asset sizes could deteriorate. Historically, commercial lending has experienced the sharpest increase in nonperforming loan levels and loan losses during economic downturns.

Agricultural Loans: Despite continued low commodity prices, agricultural credit quality has remained generally sound, primarily because of record government subsidies and previously strong growth in off-farm income. Going forward, however, both sources of support may decline and adversely affect agricultural loan credit quality. Government support levels could diminish when the 1996 Freedom to Farm Act expires in 2002. Budgetary pressures caused by a slowing national economy and a shift in national priorities after the September 11 attacks could result in less government support under the new farm bill. Off-farm income is likely to fall with swelling job losses; many agricultural borrowers are small operations that draw a significant share of total household income from off-farm sources.

Further Deterioration in Credit Quality Could Have a Pronounced Adverse Effect on Earnings Performance

Earnings performance was already under pressure.6 Net interest margins (NIMs) at most banks and thrifts in the Region have declined steadily since the mid-1990s, largely as a result of intense competitive pressures that affected both loan pricing and funding costs. In the first half of 2001, NIMs were further pressured as a result of rapidly declining interest rates. Most insured financial institutions were unable to lower funding costs at a pace commensurate with the steep reductions in asset yields. This trend is likely to continue in the near term, given further interest rate declines in third quarter 2001. While bank and thrift earnings performance should benefit in the longer term from the recent steepening of the yield curve, any resulting improvements in NIMs7 could be offset by increased provision expenses.

6 The annualized median return on assets (ROA) for insured institutions in the Memphis Region for the first six months of 2001 was 0.98 percent, down sharply from the 1.19 percent ROA reported in the first half of 2000. The median NIM for second quarter 2001 was 4.02, the lowest level reported in the 17 years that the data have been collected. For comparison, the median NIM in second quarter 2000 was 4.39 percent.

7 The positive effects of a steepening yield curve may be offset in part by declining loan volumes. As loan demand wanes with weaker economic conditions, the resulting shift from loans to lower-yielding assets could affect margins adversely.

Throughout the 1990s, insured financial institutions made provisions to the allowance for loan and lease losses (ALLL) well in excess of loan loss experience. However, the additions did not keep pace with the growth in total loans, and ALLL levels declined relative to total loans. This decline presented little cause for concern, as overall loan quality improved throughout the mid-1990s and remained strong in the late 1990s. Although ALLL levels were declining relative to total loans, allowance coverage of nonperforming loans remained high. Since mid-2000, however, allowance coverage levels have fallen sharply (see Chart 2), as nonperforming loan levels have climbed. While the adequacy of allowance protection at banks and thrifts is influenced by many factors specific to the individual institution, aggregate trends suggest that some banks and thrifts may need to increase provisions to the ALLL if credit quality continues to deteriorate, further pressuring earnings performance.

Chart 2

[D]Chart2. Allowance Coverage of Nonperforming Loans Declines among the Regionís Community Banks

The effects of any continued deterioration in credit quality on ALLL adequacy, earnings performance, and ultimately on capital may be magnified by currently high credit exposure levels. Loan-to-asset (LTA) ratios reported by the Region's insured financial institutions at mid-2001 were near historically high levels and were considerably higher than those reported in previous economic cycles.8 The Region's insured financial institutions reported a median LTA ratio of 64.5 percent as of June 30, 2001, compared with a median LTA ratio of 55.4 percent prior to the 1990-1991 national downturn. Furthermore, the increase in loan levels has been driven primarily by growth in traditionally higher-risk loan types, such as commercial real estate and commercial loans. Because of this markedly elevated credit exposure entering the current downturn, any increases in loan loss rates and nonperforming asset levels likely will have a more pronounced effect on earnings and capital than was the case during previous periods of economic weakness.

8 The historical high for median LTA levels among insured financial institutions in the Memphis Region was reached on September 30, 2000, at 66.1 percent. From 1972 to the mid-1990s, the median LTA ratio typically ranged from 50 to 56 percent.

Memphis Regional Staff

New York Regional Perspectives

Economic Landscape Dramatically Altered

The tragic events of September 11, 2001, dramatically altered the economic landscape of the nation and the Region. Repercussions from the massive destruction and loss of life reverberated through the nation and the world. Before the attack, the Region's economy, although weakening, had enjoyed stronger growth than that of the nation. Although estimates of the severity and longevity vary, the widespread economic disruption that followed the attack could tip the nation's and Region's economies into recession.

New York City: Damage Estimates Climb

The attack on the World Trade Center left 22 office buildings in downtown New York destroyed or damaged.1 These buildings represented 9 percent of Manhattan's total office market and encompassed 30.3 million square feet,2 roughly equivalent to the total amount of office market space in the central business districts of Kansas City, Milwaukee, and Nashville combined. Early estimates of the structural damage exceed $20 billion, while total economic losses have been estimated as high as $105 billion over two years for New York City alone.3 Federal funding of $20 billion and insurance payments estimated to reach as high as $70 billion will offset a portion of lower Manhattan's cleanup and rebuilding costs.4

1 Grubb & Ellis estimated that approximately 13 million square feet of damaged office space could return to the market within three to 12 months. Grubb & Ellis Research. September 2001.

2 October 2001. "Evaluating the Impact of the World Trade Center Disaster on the New York Office Leasing Market." Reis Reports.

3 October 4, 2001. "The Impact of the September 11 WTC Attack on NYC's Economy and City Revenues." New York City Comptroller's Office.

According to the New York State Department of Labor, job losses emanating from the attack exceed 100,000, or approximately 3 percent of the city's workforce.5 Airlines and tourism-related businesses have been the hardest hit, reflecting the immediate cessation of tourism and business travel to the area. Securities firms, which had endured declining earnings before September 11, now face further pressure to curb costs. The securities industry, which accounts for 5 percent of Manhattan's workforce but approximately 20 percent of its economic output, cut 15,000 jobs in the nation over the past year, with another 12,000 layoffs announced but not enacted before the attacks. In the weeks following September 11, several large financial services firms announced plans to reduce staff significantly. In addition, compensation in the securities industry likely will decline. Year-end bonuses, which typically make up a significant portion of salaries, are expected to decline by 40 to 60 percent in 2001, severely dampening consumer spending in New York City and the surrounding areas.6 Because the securities industry is an important economic driver, a significant decline in compensation could hinder the Region's economy. Softness also can be expected in many industries that support the securities industry, including advertising, printing, and publishing.

4 September 15, 2001. "The Biggest Bill of All." The Economist.

5 Pristin, Terry, and Leslie Eaton. September 26, 2001. "Disaster's Aftershocks: Number of Workers Out of a Job Is Rising." New York Times.

6 McGeehan, Patrick. September 26, 2001. "Struggling Wall Street Is Loath to Cut Jobs." New York Times.

A few of the area's industry sectors may benefit during the post-attack period. Neighboring commercial real estate markets, including those in Brooklyn, Westchester, midtown Manhattan, and northern New Jersey, are poised to benefit as displaced firms relocate. This demand comes precisely as office market conditions had been weakening. Furthermore, construction, security, and industrial sanitation workers may be needed to assist in the cleanup.

Economic Damage Spills Over to Other Parts of the Region

Many of the Region's other areas have been affected by the attack. According to Economy.com, estimated gross product or economic output for many of the Region's largest metropolitan statistical areas declined significantly following the attack (see Table 1). Newark, Pittsburgh, and Washington, D.C., in particular, are vulnerable to declines in air traffic because of high-concentrations of airline jobs. While the $15 billion financial aid package to the airline industry should help financially troubled airlines, cities that serve as hubs may be affected more seriously. Pittsburgh is a major hub for U.S. Airways, which is considered one of the more financially vulnerable airlines.7 Philadelphia and Baltimore face job losses as U.S. Airways contracts operations in those cities. Continental Airlines, which also announced job cuts, has a significant presence at Newark International Airport. The temporary closure of Reagan Washington National Airport near the nation's capital could result in substantial loss of jobs and revenues in neighboring areas. Other transportation providers, including shipping and trucking companies, also have been seriously affected. These industries, which are significant in Jersey City and Gloucester County, New Jersey, and Harrisburg, Pennsylvania, face decreasing demand as the nation's economy slows and increasing costs as security measures are implemented.

Table 1

[D]Table 1.Regionís Projected Economic Growth Declined Significantly following September 11th

7 James, Raymond. September 25, 2001. "Equity Research."

A decline in revenue from tourism also has hurt many of the Region's other cities. Estimated losses from convention cancellations in Baltimore exceed $20 million, and hotels in the city's Inner Harbor, a popular tourist area, have released a quarter of their staff. Puerto Rico's tourism industry could suffer from reduced air traffic. Tourism accounts for 14,000 jobs, less than 2 percent of the island's workforce, but this sector contributed over $2 billion to the economy in 2000.8 Although Atlantic City has one of the nation's highest employment concentrations in tourism-related businesses, it may be less affected than other destinations because only 2 percent of its visitors arrive by air. 9

8 September 20, 2001. "A Big Blow to Tourism." Caribbean Business.

9 Swavy, Joseph. September 22, 2001. "Area Has Few Flying Tourists to Lose." Press Plus Online: The Press of Atlantic City.

Increased Uncertainty Clouds Economic Outlook

Preliminary forecasts suggest that the duration of this economic downturn may be shorter for the Region and New York State than the 1990-1991 recession. According to Economy.com, during the 1990 recession, New York State's economy contracted for five consecutive quarters from third quarter 1990 through third quarter 1991, contracting by almost 8 percent in first quarter 1991. After September 11, baseline forecasts call for New York's gross state product, the broadest measure of the economy, to decline significantly during the second half of 2001 but then begin to expand, albeit very modestly, in first quarter 2002.10

10 Economy.com. October 22, 2001, forecasts.

New York City's economic downturn is forecast to be more significant and to last longer than the state's. The city's economic growth is not expected to return to pre-attack levels until mid-2003.11 The infusion of financial aid (the economic effects of which typically are felt within six to nine months), and favorable changes in federal monetary and fiscal policies should help cushion the city's economy during the cleanup period. Additionally, stronger office market fundamentals than a decade ago should buffer the effects of the attack on the city's economy over the short term. While home prices in the New York City metropolitan area have declined, reflecting the weakened economy, price declines are estimated to be less than in some other parts of the country.12 Nevertheless, lower home prices translate into less household wealth, which could constrain consumer spending severely. The city's long-term outlook will depend, in part, on the extent to which companies and people permanently relocate out of Manhattan. Additional terrorist acts in the United States and future military actions abroad could erode consumer confidence further and undermine the economy.

11 Ibid.

12 According to the Wall Street Journal, the median home price in the New York area is expected to decline by 0.7 percent over the next year, far less than the 3.1 percent decline forecast for San Francisco. September 21, 2001. "Where's Housing Headed?"

Banks Face Increased Credit Quality and Earnings Pressures

Increased economic slowing following the attack will place additional pressure on credit quality and bank earnings. Unlike the 1990-1991 recession, when loan portfolios were hurt primarily by problem commercial real estate loans, credit problems in this downturn likely will be concentrated in commercial and industrial (C&I) loans. Before September 11, the Region's large banks (those with assets greater than $10 billion) had reported credit quality deterioration, which generally reflected weakness in large syndicated loans. At June 30, 2001, large banks reported a C&I delinquency rate of 2.29 percent, a seven-year high but significantly below the peak delinquency rate of 7.0 percent reached at the height of the 1990-1991 recession.13 Net charge-off rates on C&I loans reported by the Region's large banks also have increased but remain well below heights reached a decade ago. Before the attacks, large bank credit quality weakness was primarily concentrated in a few industries, such as telecommunications, entertainment, and health care; however, weakness could spread to other industries as the nation's economy weakens more broadly. The ability of some large banks to sell problem loans to investors may partially mitigate the effect of credit quality weakness on delinquency and charge-off ratios. In addition to potentially higher credit costs, large bank earnings will be constrained by lower capital market revenues and additional venture capital losses, reflecting both losses during the days the financial markets were closed and further slowdown in capital market activities.

13 The banking analysis excludes banks in operation less than three years, credit card institutions, and specialty banks. Median figures are used unless otherwise noted.

The Region's smaller institutions, particularly those in New York City, also face a more challenging banking environment after September 11. Institutions that have a concentration in loans to businesses that operate in the city could experience strained credit quality, reflecting business closures and a generally weaker economy.14

14 Banks with at least 25 percent of total assets in C&I and commercial real estate loans are defined as commercial lenders. There are 48 commercial lenders with total assets less than $10 billion in the New York City metropolitan statistical area (MSA), comprising 56 percent of total established institutions in the MSA.

Institutions that specialize in residential real estate lending in New York City and surrounding suburbs also could face increased credit quality weakness should residential home values soften significantly. However, the average past-due loan ratio for residential real estate lenders in the New York City area remained low through the first half of 2001, below that of residential real estate lenders in the Region and the nation.15

Furthermore, lower interest rates have resulted in increased refinancing activity, which should help consumers' debt repayment capacity and mortgage loan quality. Although lower short-term interest rates should alleviate pressure on net interest margins, the benefits may be somewhat diminished because loan yields may decline more than deposit rates, which may be near floor levels for some institutions. As a result, banks with a greater reliance on wholesale funds may benefit from declining short-term rates more than those that rely on retail deposits.

15 Residential real estate lenders are defined as those that have at least 50 percent of assets in residential real estate loans and mortgage-backed securities. The New York City area includes the New York City MSA and the seven surrounding MSAs.

Economic Uncertainty Is High, but Institutions Appear Better Positioned than a Decade Ago

The high degree of economic uncertainty could pressure bank earnings and credit quality. Nevertheless, the Region's institutions, in aggregate, appear better positioned for an economic downturn than in the early 1990s. As of June 2001, the percentage of the Region's institutions with concentrations in traditionally higher risk loan categories expressed as a percentage of equity capital was less than before the 1990-1991 recession (see Chart 1).16 Institutions in the Region's major metropolitan areas increased risk profiles more modestly during the 1990s' business expansion than during the similar 1980s' period. Loan growth rates and concentration levels of traditionally higher-risk loans for many of the Region's banks are less than in some other parts of the country, such as the Southeast and West. Furthermore, while approximately half the Region's institutions reported increased loan delinquency and charge-off rates over the past year, average past-due loan and charge-off ratios remained well below those of the period before the last recession. Slightly higher aggregate capital ratios also should help cushion banks from lower earnings and credit quality deterioration.

Chart 1

[D]Chart1. High-Risk Loan Concentrations Increase but Remain Lower than in the 1980s

16 Higher-risk loans are defined as commercial real estate, construction and development, and C&I loans. Institutions exclude credit card banks, specialty banks, and institutions in operation less than three years.

Kathy R. Kalser, Regional Manager
Robert M. DiChiara, Financial Analyst
Norman Gertner, Regional Economist
Alexander J.G. Gilchrist, Economic Analyst

San Francisco Regional Perspectives

The Region's Slowing High-Tech Sector Has Dampened Employment Growth and Demand for Commercial Real Estate

Softening in the San Francisco Region's high-tech sector contributed to slower employment growth during the first half of 2001 and to rising vacancy rates in several commercial real estate (CRE) markets. In the second quarter of 2001, the Region's nonfarm seasonally adjusted employment growth rate was 2 percent, higher than the national rate but much slower than recent periods. Job growth deceleration was especially prominent in Oregon, Washington, Arizona, and the San Francisco Bay Area, where high-tech industries are important.1 Furthermore, during the first six months of 2001, companies based in Silicon Valley, the Pacific Northwest, Arizona, and Southern California experienced steep declines in venture capital financing, a key source of funding for the high-tech boom.2

1 As used here, the high-tech sector includes the following industry groupings: biotechnology, computers and electronics, telecommunications, and computer and data processing. The sector is important to several MSAs where high-tech employment has grown more rapidly than the national average. In addition, several MSAs report a higher concentration of high-tech employment than the national average. For additional information see "San Francisco Regional Perspectives," Regional Outlook, third quarter 2000.

2 Sources: http://www.ventureone.com and http://www.pwmoneytree.com.

Layoffs and declining venture capital in several formerly "hot" high-tech markets-such as the San Francisco, San Jose, Oakland, Seattle, and Phoenix-Mesa metropolitan statistical areas (MSAs)-also contributed to negative net absorption and rising office availability rates3 in the first half of 2001.4 Compounding the problem, 9.6 million square feet of office space were added in these five markets, pushing the aggregate office vacancy rate from 5.4 percent to 10.9 percent over the first six months of 2001. In addition, the amount of available industrial space increased in the first half of 2001 in several of the Region's MSAs, and some planned projects have slowed or halted. Softening in certain industrial markets is largely attributed to curtailed storage requirements and the resulting declining demand for warehouse space. In the aggregate, the industrial availability rate in the Region's major metropolitan areas as of midyear 2001 was 7.4 percent, compared with a national rate of 8.2 percent. Given ongoing economic softening aggravated by the terrorist attacks in September 2001, the office, industrial, hotel, and retail property markets may experience further weakening.

3 The availability rate indicates the percentage of commercial real estate space that is physically vacant or available for lease by the current occupant.

4 Murray, Tom. Third quarter 2001. "Slowing Economy Reduces Demand for U.S. Office Space."Regional Outlook.

Continued CRE market softening could pressure asset quality, particularly among insured institutions lending in high-tech and tourism-dependent markets, where CRE loan concentrations tend to be high. For instance, institutions headquartered in the San Francisco, San Jose, Oakland, Seattle, and Phoenix-Mesa MSAs reported a median CRE loan-to-Tier 1 capital ratio of 375 percent as of second quarter 2001, compared with 194 percent for insured institutions headquartered in all other MSAs in the nation. Although CRE loan concentrations in these areas have historically exceeded national benchmarks, they have increased substantially since 1990, when the median CRE loan-to-Tier 1 capital ratio in these five markets was 256 percent. Commercial construction loans in these markets could be particularly vulnerable to default risk if completed projects encounter unexpectedly high vacancy rates, low rental rates, and high capitalization rates.

Home Price, Underwriting, and Household Leverage Trends Could Increase the Vulnerability of Some of the Region's Residential Lenders, Given Recent Refinancing Activity

Although home sale volumes were robust in many markets during the first half of 2001, residential lenders could face increasing credit risk because deteriorating affordability and softening economic conditions could adversely affect home values in some areas. Mortgage credit quality could also come under pressure, given relatively narrower mortgage collateral margins and rising household debt levels. In addition, a significant volume of home loans was originated in 2001 in response to falling interest rates, and such loans may be predicated on unsustainable home values.

Several California Markets Could Be Vulnerable to Housing Price Bubbles

Between 1995 and 2000, housing prices increased significantly in several of the Region's MSAs; however, household income levels did not keep pace in some markets, leading to deteriorating affordability. According to the Office of Federal Housing Enterprise Oversight, a "prolonged and rapid" increase in the ratio of home prices to household income might be a sign of "an overshooting cycle, or a bubble."5 On the basis of median home price and household income levels and trends, 9 of the Region's 55 MSAs could be vulnerable to housing price bubbles (see Table 1). These metropolitan areas have low Housing Affordability Indices (HAI), and their HAIs have deteriorated by 15 percent or more over the past five years.6 Not surprisingly, all of the Region's markets with low and significantly deteriorating housing affordability are in or near areas with concentrations in high-tech employment (i.e., high-tech jobs account for at least 5 percent of all nonfarm employment). In fact, seven of these nine markets are adjacent to California's Silicon Valley. Recent volatility in high-tech stock prices, sagging venture capital funding, and the recent significant number of layoff announcements could also pressure home prices in these markets.

Table 1

[D]Table 1 Housing Affordability Was Low and Deteriorated Rapidly in Nine California MSAs

5 March 1, 2001. Office of Federal Housing Enterprise Oversight. House Price Index, Fourth Quarter 2000. 7-8.

6 As calculated by Economy.com. The HAI measures the extent to which a median family income can afford a median-priced home within a market, given certain assumptions, such as a 20 percent down payment. A declining HAI indicates that growth in median home prices has outpaced median household incomes.

The potential for home price softening, however, is not limited to the San Francisco Bay Area, Orange County, and San Diego metropolitan areas. Given generally weakening economic conditions and rising household leverage, MSAs throughout the Region might face slowed or negative home price appreciation in the near future. Additionally, effects of the September 11, 2001, terrorist attacks could challenge consumer confidence and possibly dampen home sales activity nationwide. Realtor surveys and market data suggest that in some areas home prices are already falling and that the average number of days on the market is lengthening.7 Based on historical experience of downturns, high-end homes could face the largest adjustments in value, because the available pool of qualified buyers tends to be smaller.

7 California Association of Realtors. July 2001. Trends in California Real Estate.

Underwriting Standards Have Loosened and Consumer Leverage Has Increased

Many residential lenders have eased underwriting standards over the past decade. For instance, between 1990 and 2001, the proportion of home purchase loans with loan-to-value ratios exceeding 90 percent increased from one-tenth to nearly one-quarter.8 Although lenders often obtain private mortgage insurance (PMI) to offset collateral risks, the risk profile of several major PMI issuers may be rising, given their increased involvement in subprime mortgage loans and pools. PMI companies have reported that the premiums associated with these new lending risks will offset any losses; however, the ability of PMI issuers to sustain subprime defaults through a complete business cycle is largely untested.

8 Federal Housing Finance Board via Haver Analytics. Note: This statistic is based on average loan-to-price ratios for "purchase money" mortgages only (i.e., collateral ratios on loans used to buy homes). These data could understate the proportion of highly leveraged homes, because it does not include borrowers who have used a second-lien mortgage to finance a portion of the home purchase (e.g., an "80-10-10" loan), and it also excludes loan-to-value ratios on mortgages used to refinance existing debt.

Rising household debt levels could also pressure mortgage credit quality. Federal Reserve data suggest that household leverage is increasing and debt serviceability is deteriorating (see San Francisco Regional Perspectives, first quarter 2001). Falling interest rates could ease debt service ratios in the near term. However, many households have used the latest drop in interest rates to further leverage their homes via "cash out" mortgages.9 Also, mortgage delinquency and personal bankruptcy rates rose in many of the Region's states in the first half of 2001, despite declining interest rates.

9 A "cash out" mortgage is a loan that provides additional cash to the borrower beyond amounts paid to refinance existing mortgage debt.

Affordability, Underwriting, and Household Leverage Trends Could Pressure Mortgage Lenders

In the event of continued economic softening, the combination of rapidly deteriorating housing affordability, elevated loan-to-value ratios, and high consumer leverage could expose some lenders to increasing residential mortgage defaults. The timing of the recent refinancing boom could add to the challenges facing insured institutions. According to some estimates, nearly one out of every three mortgage dollars will have been underwritten in 2001.10 Given that appraisers rely on historical data to estimate home values and that some lenders have begun using automated home valuation services, recent loans could be predicated on unsustainable home values in some areas. In particular, community mortgage lenders11 headquartered in the nine California markets listed in Table 1 could be vulnerable if mortgage portfolios are concentrated in these locations. Lenders specializing in speculative residential construction, subprime mortgages, or high loan-to-value second liens could also sustain elevated losses if home values decline.

10 The Mortgage Bankers Association projects 2001 residential loan originations approximating $1.5 trillion, or 32 percent of all estimated home mortgage debt.

11 Community mortgage lenders include insured institutions with total assets of less than $1 billion and residential mortgage loan exposures exceeding Tier 1 capital.

The Agricultural Economy in Some of the Region's Rural Areas Is Under Stress

Agricultural loan portfolios at some of the Region's insured institutions are facing increasing stress, given persistent drought conditions in states such as Washington, Oregon, Montana, and Idaho and projected declines in government subsidy payments. Nearly 15 percent of the Region's insured institutions, headquartered primarily in the rural areas of Montana, Wyoming, Washington, Oregon, and Idaho, report agricultural production and farm real estate loans exceeding Tier 1 capital levels. The confluence of continued low commodity prices, emerging drought conditions, and potential declines in government farm subsidy payments could especially affect insured institutions lending in Montana, Washington, and Oregon.

Drought Conditions Have Persisted

Several agriculture-dependent areas of the Region endured moderate to severe drought conditions in spring and summer 2001, following an already dry 2000 growing season. Summer precipitation levels in the Pacific Northwest were the lowest since 1977,12 and drought conditions were expected to persist at least through year-end 2001.13 Concerns are amplified by already low prices for commodities, such as wheat and potatoes, and rising farm energy costs in several western states. Consequently, the condition and yield of some grain and potato crops in Montana and Idaho are reported to have deteriorated. Furthermore, a number of farmers in Oregon's Klamath River basin have been without irrigation water since early April 2001 because of a federal decision to stop irrigation in order to protect endangered fish. In addition, the lack of water in several areas of the Region has caused deterioration in pasture feed and hay, resulting in higher costs to ranchers who have to purchase additional feed for livestock.

12 The Pacific Northwest includes Washington, Oregon, and Idaho. Data are 12-month moving averages.

13 Source: U.S. Drought Monitor, Climate Prediction Center, National Oceanic and Atmospheric Administration (NOAA), as of August 17, 2001.

Some States Rely Heavily on Government Subsidies

Recently, some states in the Region have relied heavily on government payments to supplement low commodity prices and compensate for emergency situations; consequently, these areas have become increasingly vulnerable to projected payment reductions during 2001.14 Moreover, future farm bill payments face new uncertainties-recent budget pressures could reduce or limit the amount of federally funded farm relief. Farm subsidy reductions could affect agricultural producers in Montana and Washington in particular, where government payments accounted for 168 and 44 percent of these states' respective net farm incomes in 2000. Thus far, such payments have helped mitigate farmers' or agricultural lenders' losses. However, the quality of farm loan portfolios of several insured institutions in subsidy-dependent areas could deteriorate if the level of government payments declines substantially.

14 Nationally, government payments reached a new high of $22.9 billion in 2000, but the U.S. Department of Agriculture expects subsidies to fall to $20 billion in 2001.

Financial Condition of the Region's Rural Banks Has Exhibited Some Softening

In aggregate, the Region's 117 agricultural lenders15 reported sound financial conditions as of midyear 2001. However, for the one-year period ending June 30, 2001, many of these institutions reported lower return on average asset ratios, declining leverage capital ratios, and rising levels of loan delinquencies. Furthermore, the results of an American Bankers Association survey detailed in a U.S. Department of Agriculture publication indicates that a large share of farm borrowers in the West16 are "loaned-up to the practical limit" (see Chart 1).17 If farm borrowers in the West are further stressed by drought conditions or subsidy cuts, they might face repayment problems on loans to insured institutions.

Chart 1

[D]Chart1. Farmers in the West Have Taken on More Debt in Recent Years

15 Defined as insured institutions with total assets of less than $1 billion that have agricultural lines and farm real estate loans exceeding Tier 1 leverage capital.

16 The West includes Alaska, Arizona, California, Colorado, Hawaii, Idaho, Montana, Nevada, New Mexico, Oregon, Utah, Washington, and Wyoming.

17 Stam, Jerome B., Daniel L. Milkove, and George B. Wallace. February 2000. Indicators of Financial Stress in Agriculture Reported by Agricultural Banks, 1982-1999. Washington, D.C.: Economic Research Service/USDA.

San Francisco Regional Staff

Regional Outlook Information
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Last Updated 12/10/2001 insurance-research@fdic.gov