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Boston Regional Outlook, First Quarter 2002

Regional Perspectives Home price appreciation continued throughout the Region during 2001, but moderated in some areas with higher-priced homes. Long-term asset concentrations have grown significantly among the Region's savings institutions, heightening exposure to rising interest rates. Liability duration has not kept pace with the lengthening of assets; in response, institutions are relying more on managing core deposit costs as a way to mitigate interest rate risk during a rising rate environment. Region's Economic Conditions Nation and New England Fall into Recession in 2001 The New England economy slowed along with that of the nation through 2001; the ten-year economic expansion, the longest on record, ended in the first quarter. According to Economy.com, Connecticut and New Hampshire were in a recession, and the rest of the New England states were close to a recession as of year-end 2001. The six states in the Boston Region reported unemployment rates below the national average as of December; however, rates have been rising since first-quarter 2001. Unemployment rates in Massachusetts, Maine, and New Hampshire have risen more than 1.5 percentage points from record lows at the beginning of the year. Personal bankruptcy filings in the Region also continued to trend higher through third-quarter 2001.1 1 The number of year-to-date filings through third-quarter 2001 was 12 percent higher than one year ago. The current economic environment in the Region differs from the recession of the early 1990s, when cyclical weakness was compounded by a downsizing defense industry and overbuilt commercial real estate sector. The current recession reflects a cyclical downturn, although certain white-collar industries, such as software and telecommunications, have been affected more significantly. A recent study conducted by Northeastern University reported that layoff announcements in Massachusetts have been concentrated among information technology (IT) companies, such as Cisco Systems, EMC, and Lucent Technologies.2 In fact, unemployment claims in the third quarter were rising three to five times faster in areas with concentrations in IT employment. 2 Boston Globe, "State job losses soar; those who rode tech boom are hit hardest," December 20, 2001. Housing Market Pushes On The Region's housing market is cooling but remains a faint bright spot in the economy. Growth in existing home sales in the Region was weak through third-quarter 2001 compared with the nation, but remained positive. New home construction (measured by building permit issuance) slowed in the Region through 2001, following strong gains in the late 1990s. Vermont was the only state in the Region with an increase in new home construction over the past 12 months. Despite the softening economy, home price appreciation continued in metropolitan areas throughout the Region in 2001, suggesting that the weakness in sales was not due to a softening in demand. According to data reported for 14 of the Region's metropolitan markets from the Office of Federal Housing Enterprise Oversight (OFHEO), only Hartford, Connecticut, experienced an increase in home prices that was slightly less than the national average of 8.3 percent through third-quarter 2001. In fact, half the Region's metropolitan areas reported double-digit increases in home prices over the period, following robust gains in 2000. The strongest appreciation occurred in the areas surrounding greater Boston--including Lawrence, Lowell, and Worcester, Massachusetts, and Manchester, New Hampshire--which have lagged Boston in the past. The Slowing Economy Has Affected Home Prices in Certain Towns While aggregate home prices in the Region's metropolitan areas continued to rise, certain pockets began to experience weakening conditions following years of gain. Town-level data provided by The Warren Group3 for southern New England4 show that urban areas that prospered most during the late 1990s boom witnessed the largest gains in median home prices (see Map 1). At the same time, several towns in rural areas, such as western Massachusetts and northwestern Connecticut, experienced modest growth from 1995 to 2000. Through October 2001, however, price appreciation moderated in some areas that experienced rapid price appreciation over the past five years. Specifically, many towns in southwestern Connecticut and eastern Massachusetts--areas where employment is concentrated in finance or technology--showed little or no growth in median prices year-to-date through October 2001, while some registered declines in median prices compared with 2000. Some of the larger towns include Greenwich and Westport, Connecticut, and North Reading and Swampscott, Massachusetts. Map 1 [D] 3 The Warren Group is a Boston-based publishing and information services firm serving professionals in real estate, banking, and commerce. 4 Data are available for Massachusetts, Connecticut, and Rhode Island. Moreover, anecdotal evidence suggests that prices of high-end homes in several towns have increased only moderately or even declined. Because the current downturn has affected the Region's IT sector disproportionately, it has led to some price weakness in the market for high-end properties concentrated in these areas. This situation differs from the previous recession, when the market for starter homes and condominiums suffered more as manufacturing and other blue-collar industries bore the brunt of the downturn. As noted in the In Focus article, the Northeast is prone to volatile home prices and has experienced declines in affordability over the past five years; however, the fundamentals of the current housing market are stronger than during the previous recession. Residential real estate markets in the Boston Region have seen little speculative building, and there is a limited inventory of unsold homes. However, should the economic downturn continue for some time, softening in housing prices could become widespread. Rising Concentrations in Long-Term Assets Are Elevating the Interest Rate Risk Profiles of the Region's Savings Institutions The volume of long-term assets held by the Region's insured institutions has increased steadily since the mid-1990s. While growth moderated following the refinancing boom of 1998, concentration levels are again on the rise as a result of a resurgence of refinancing activity in 2001. For many of the Region's insured institutions, the growing concentration of investment in long-term assets may be creating significant exposure to future increases in interest rates. This concern was addressed in the Boston Regional Outlook, Second Quarter 2000, and remains relevant today. This article evaluates recent trends and factors that are contributing to this growing exposure, as well as trends related to the funding side of the balance sheet that may complicate interest rate risk management. The rising exposure is particularly pronounced among the Region's small savings institutions (total assets less than $1 billion). This article focuses on those institutions, which comprise nearly two-thirds of the Region's insured institutions; however, many of the trends noted for these institutions are present in large savings banks and commercial banks as well, albeit to a lesser degree. Eroding Net Interest Margins Spur Investment in Longer-Term Assets It appears that a major contributing factor to the growing concentration in long-term assets is the persistent decline in net interest margins (NIMs) that has eroded earnings steadily over the past few years. For example, the median NIM for the Region's savings institutions dropped 58 basis points from its 1993 peak to 3.54 percent for the nine months ending September 2001. In 1994, only 15 percent of savings institutions reported a NIM of less than 3.5 percent (see Chart 1); that percentage had steadily increased to 48 percent by September 30, 2001. Chart 1 [D] It is interesting to note that during the last significant Fed easing in the early 1990s, savings bank NIMs improved considerably. Two deposit-related factors contributed to this improvement. Between 1992 and 1993, institutions departed from the previous industry practice of paying a fixed rate on savings and negotiable order of withdrawal (NOW) accounts. This change caused a significant one-time drop in funding costs. In addition, and perhaps more significant, the pricing mentality in New England changed as the banking crisis unwound. Between 1988 and 1990, the median deposit cost for the Region's banks was approximately 60 basis points above the median for the rest of the country. By 1993, the median was 7 basis points below the median for the rest of the country. The ratcheting down of rates on savings and NOW accounts, combined with the unwinding of the competitive premium for deposits in the Region, provided a shot in the arm for savings and commercial banks alike. These greatly improved margins allowed institutions to maintain a largely variable-rate asset mix, as there was no need to buffer margins by emphasizing higher-yielding fixed-rate assets. Despite a significant refinancing wave during the early 1990s, the Region's median ratio of long-term assets to earning assets remained fairly low and stable throughout the period. Unfortunately, in the current low rate environment, circumstances are vastly different. Nonmaturity deposit costs have been maintained at low levels since they were driven down in 1993. In fact, in that year, the federal funds rate averaged 3.02 percent and the median cost of savings deposits (including money market deposit accounts) for the Region's banks was 2.87 percent. In 2000, the federal funds rate averaged 6.24 percent and the median cost of savings accounts was only 2.89 percent; thus, these accounts had far less room to respond to the decline in interest rates than was the case in the early 1990s. Also, for the first nine months of 2001, the median deposit cost in the Region was 55 basis points below the median for the rest of the country. Thus, the Region's insured institutions may find it difficult to boost margins by lowering offered rates, particularly on certificates of deposit, without risking deposit flight. As a result, many institutions are holding higher-yielding, long-term, fixed-rate assets in an effort to keep margins from falling further. The current interest rate environment (steep yield curve) has created an even greater incentive to retain longer-term assets, as the reinvestment opportunities on the short end of the curve provide significantly lower returns than those that can be had by retaining long-term, fixed-rate, mortgage-related assets. These efforts to protect the current earnings stream may place longer-term earnings at risk if interest rate risk management practices are not implemented to contain exposure to rising interest rates. Only 10 percent of savings institutions reported that long-term assets exceeded 40 percent of earning assets in 1995 (see Chart 2). As of September 30, 2001, more than half reported a similar concentration level, a clear indication of the extent to which asset duration has increased among the Region's savings institutions. Chart 2 [D] Banks Experience a New Refinancing Wave The record level of refinancing that occurred in fourth-quarter 2001 (see Chart 3) will likely result in higher long-term asset concentration levels in the short term. As shown in the chart, nationally, only about 20 percent of the dollar volume of new loans applied for in 2001 were adjustable-rate mortgages (ARMs). Chart 3 [D] A recent increase in the loan amount for qualifying, conforming loans may extend the refinancing wave into 2002 even without further rate cuts and may spur a large group of borrowers to refinance. The previous conforming limit of $275,000 was raised in January 2002, to $300,700. Fannie Mae and Freddie Mac estimate that, nationwide, 120,000 jumbo mortgages will refinance as a result of the increased limit.5 This increase in the jumbo limit is expected to be a factor in the Boston Region, particularly in portions of Massachusetts and Connecticut, where home prices are among the highest in the country. 5 "Few See Rerun Soon of GSEs' Cap Hike," American Banker, December 10, 2001. Borrower preference for fixed-rate loans continues to erode the ARM portfolios of small savings banks.6 In 1997, the median percentage of ARMs to total residential first mortgages for these institutions was 64 percent. By September 2001, that percentage had fallen to 41 percent. While comparable data are not reported for thrifts, the median percentage of ARMs to total mortgage-related assets (including passthrough mortgage-backed securities) fell from 60 percent in September 1996 to 36 percent by September 2001. Residential loans make up the largest share of earning assets for small savings banks, and the significant shift from adjustable- to fixed-rate loans has contributed to the asset extension reflected in Chart 2. Borrower preference for fixed-rate loans has resulted in a significant lengthening of nonresidential portfolios as well. 6 Call Filers only--excludes savings and loans (thrifts). The tremendous volume of refinancing activity over the past few years has been dominated by fixed-rate origination. Institutions have been faced with the decision either to book the long-term loans or sell them and reinvest the proceeds in shorter-duration investments, which would put downward pressure on earnings. Rather than hold the loans in portfolios that were becoming heavily concentrated in fixed-rate loans, many institutions securitized the loans and retained them as securities to bolster asset yields. The decision to hold these assets has contributed to the rising concentration in long-term assets. As of September 30, 2001, the median percentage of mortgage passthrough securities that mature or reprice in five years or more was 88 percent for small savings institutions, compared with 43 percent in 1997. In addition, the median percentage of all other debt securities with a comparable repricing horizon increased from 7 percent to 20 percent over the same period, suggesting that the securities portfolios are not being managed actively to mitigate the rising interest rate risk in the loan portfolios. Liabilities Come Up Short While the balance sheets of insured institutions have shifted toward longer-term assets, the liability side consists of relatively short-term instruments. Seventy-five percent of time deposits in the Region's savings institutions mature or reprice in one year or less. This percentage has risen over the past few years, as customers have become less willing to invest in longer-term instruments, particularly when yield spreads (over U.S. Treasuries) offered by shorter-term instruments have become more favorable than those for longer-term instruments. Savings institutions have tried to increase the duration of liabilities by extending the maturity of borrowings. As of September 30, 2001, 51 percent of all other borrowings were reported to mature or reprice in three years or more, an increase from 14 percent in 1997. However, this lengthening of maturities may not be reducing exposure to higher interest rates. Longer-term borrowings may contain options that allow the issuer to call the advances when interest rates rise. The Federal Home Loan Bank (FHLB) of Boston is the primary source of term borrowings for the Region's savings institutions. The FHLB's 2000 Annual Report indicates that, as of year-end 2000, approximately 63 percent of outstanding advances with a remaining maturity of three years or more could be redeemed early (at the FHLB's option), with most callable within one year. This suggests that a high percentage of the longer-maturity borrowings reported on Call Reports are, in effect, short-maturity liabilities in the event of a rising rate environment and do little to offset the rising interest rate risk that may accompany increased long-term asset concentrations. Another area in which option risk may be rising is in certificates of deposit (CDs). In the current interest rate environment, new CDs are being written at historically low interest rates; therefore, existing prepayment penalties may not be sufficient to deter customers from redeeming CDs in a rising rate environment. A modest increase in rates may be all that is necessary to negate the penalty and trigger a redemption. An evaluation of prepayment penalties may be worthwhile in light of the low rates being paid on new CDs. As noted in our previous article on interest rate risk, there appears to be little change in the maturity structure of on-balance-sheet liabilities to offset the continued growth of long-term assets. From an off-balance-sheet perspective, 7 percent of small savings institutions continue to report some use of interest rate derivatives (primarily interest rate swaps and options). This percentage has stayed fairly constant since long-term asset concentration levels began to rise in the mid-1990s. While rising interest rate risk can be mitigated through active management of securities portfolios, extension of funding sources, or off-balance-sheet mechanisms (such as interest rate swaps), these options come at a cost that could pressure already deteriorating margins. However, it will be very difficult to correct existing imbalances through the normal course of business in a reasonably short time. Prepayment rates on the long-term assets booked over the past few years are likely to be modest and, in a rising rate environment, are likely to slow considerably. The ability to control funding costs when interest rates rise is paramount, but it may prove difficult. As mentioned previously, CDs may offer only a limited means of holding down rates because of the already low prevailing rate environment in the Region relative to the rest of the country and the higher level of competition for this type of funding. Nonmaturity deposits are a significant portion of interest-bearing liabilities. Rates paid on these deposits historically have not been as volatile as those paid on borrowings and time deposits, particularly in a rising rate environment. However, in such an environment, institutions that lag the market are more likely to lose balances as funds move into better-yielding instruments, either within the institution or elsewhere. Under either scenario, costs to the institution rise. Clearly, sensitivity exists to interest rate movements, no matter what pricing philosophy an institution adopts. The question is how much sensitivity? Customer behavior is difficult to predict, and an overreliance on management of core deposit costs to mitigate interest rate risk may prove problematic for some institutions. Conclusion Clearly, interest rate risk is rising among the Region's savings institutions. Asset maturities continue to lengthen, while liabilities remain short. Optionality is becoming a key funding issue, and measuring and projecting the sensitivity of nonmaturity deposits or retail CDs to rising rates will prove difficult. As a result, interest rate risk measurement and management are becoming increasingly complex. As mentioned in the Boston Regional Outlook, Second Quarter 2000, interest rate risk management must ensure that an institution can weather conditions that can reasonably be expected to occur. A sharp rise in short-term rates of up to 400 basis points has not been particularly uncommon in the past; on the basis of the current level of short-term rates, the possibility of a significant rise should not be underestimated. A modest rise in long-term rates at the same time would dampen prepayment speeds on long-term assets significantly. In such a scenario, many institutions likely would suffer further margin erosion--some significantly. Steps certainly can be taken to mitigate some of the risk; however, there will be a trade-off between short-term profits and long-term earnings stability. Now is a good time for institutions to take action. When the rate cycle begins to turn, risk reduction strategies may be much more difficult to implement. By the Boston Region Staff Regional Outlook Information Return to Boston Edition main page Return to Regional Outlook main page