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National Edition of Regional Outlook, Summer 2003

Regional Perspectives Atlanta Regional Perspectives Implications of State and Local Government Budget Deficits State and local government finances in the Atlanta Region have been affected adversely by losses in U.S. equity markets and the lingering effects of the recent recession. Declines in tax revenues, the burden of funding commitments made during the 1990s for government programs and projects, increased Medicaid costs, and the escalating costs of homeland defense have converted budget surpluses into deficits. These deficits, in combination with statutes that require states to maintain balanced budgets, have forced governments to seek ways to cut spending and boost revenues. This article analyzes the implications of such contractionary fiscal policies and discusses the potential effects of government policies in the Atlanta Region on the local banking industry. Large State and Local Budget Deficits Have Emerged Quickly since 2001 The reversal in state and local government fiscal conditions nationally has been unprecedented in terms of scale and rapidity since World War II (see Chart 1). Surpluses peaked at nearly $60 billion in early 1999 as capital gains and the record-long economic expansion supported robust state and local government tax revenue increases. Program and project funding expanded, and permanent tax cuts were enacted. The piercing of the stock market bubble and the decline in economic growth from 2000 through 2001, however, significantly constrained revenue growth, while spending commitments continued to rise (see Chart 2). Other factors have also aggravated the deteriorating fiscal conditions, including the costs of homeland defense, the spiraling costs of federally mandated programs such as Medicaid, and, recently, sharp increases in energy prices. Commitments to public assistance programs, such as unemployment insurance benefits, also helped inflate expenditures. (Between 2000 and 2001, initial unemployment insurance claims rose 33 percent.) The record surpluses of the late 1990s evaporated in less than two years, and the rapid erosion in fiscal balance sheets has contributed to what many governors have described as the worst fiscal crisis for states since World War II. Even with a more robust recovery, this crisis is expected to persist into the future.1 Chart 1 [D] Chart 2 [D] States Have Three Policy Options for Closing Budget Deficits To close budget deficits, as constitutionally mandated by all states except Vermont, states are being forced to adopt, or at least consider, policies that generally fall into three categories: increasing revenues, cutting expenditures, and borrowing. Many policy options may be politically difficult to realize, however, given the continued weakness of the economic recovery. Governments Are Seeking More Revenues As average real year-over-year growth in total receipts in 2002 slumped to 0.2 percent—one-tenth the average of the latter half of the 1990s—state and local governments nationwide have expanded efforts to identify additional sources of revenue. As revenues are drawn from a variety of sources (see Table 1), governments have explored several options for increasing receipts while attempting to minimize the costs borne by citizens. Table 1 Sales Taxes Account for Largest Share of State and Local Government Revenue Nationwide Current Receipts Share of Total Receipts (%) Federal Grants-in-aid 23 Personal Tax and Nontax Receipts 21 Income Taxes 16 Nontaxes 3 Other 2 Corporate Profits Tax Accruals 3 Indirect Business Tax and Nontax Accruals 53 Sales Taxes 26 Property Taxes 20 Other 7 Contributions for Social Insurance 1 Source: Bureau of Economic Analysis, 2002Q3 Government Expenditures Are Being Cut During fiscal year 2003, more than half the states cut spending, the most common way of reducing budget deficits. Despite these cuts, however, expenditures continued to increase faster than revenues. Cutting spending, like raising taxes, may be difficult during periods of sluggish growth. Transfer payments through a variety of programs account for one quarter of all state and local outlays. During downturns, public assistance programs can stabilize the economy but subsequently may entail even greater expenditures. Also, efforts to constrain spending are complicated by the increasing demands of federally mandated programs. Higher education represents one area of state government spending that has seen cuts. Governments have also explored deferring investments in infrastructure. One of the fastest methods to cut expenditures that does not directly entail service cuts is to lay off employees. In 1999, salaries and wages accounted for nearly one-third of state and local government costs. Several states have explored staff cuts, early retirement initiatives, and wage freezes (or cuts) to pare direct expenditures. Chart 3 [D] Borrowing Is Increasingly Common Cutting expenditures and increasing taxes have been essential budget-balancing tools during previous downturns; however, state and local governments are increasingly turning to borrowing to fill gaps. In real terms, borrowings were more than twice as high as of third quarter 2002 as year-ago levels and at the highest levels since World War II. A recent USA Today article2 quotes Utah Deputy Treasurer Richard Ellis saying that such a policy is “like using a credit card to pay your bills.” Low interest rates have helped minimize the cost of state borrowing, but weak economic conditions and heavy borrowing have affected some states’ credit ratings adversely, and debt payments may be a burden on state budgets in future years. Reducing Deficits May Have Negative Implications for Local Economies in the Short Run Efforts by state and local governments to close budget gaps may exacerbate the prevailing weak economic conditions. Reduced government spending and tax increases that reduce disposable personal income could adversely affect economic performance in the short run. An expected worsening in state balance sheets in fiscal year 2004 may require additional expenditure cuts and tax increases. Contractionary fiscal policies at the state and local levels may be offset in part by the expansionary policies of the federal government; however, the increased federal expenditures may not be distributed as evenly as those made by state and local authorities. State and local government spending represents a large share of total government spending; federal efforts to stimulate the nation’s economy may be less effective. Moreover, some analysts argue that recent federal tax cut proposals to spur growth may inadvertently worsen the financial condition of states.3 States will receive, however, a one-time $20 billion transfer from the federal government as part of the recently enacted stimulus package. Budget Deficits Exist in the Atlanta Region State and local governments in the Atlanta Region have not been immune to the effects of equity market declines and slower national and regional economic growth. Florida and North Carolina are projected to have the largest budget deficits in the Region at approximately $2 billion each.4 In absolute size, however, state budget deficits in the Atlanta Region are small compared with those in larger states, such as California, Texas, and New York. Nonetheless, as a percentage of state budgets, deficits in the Region are significant, with Alabama, Florida, and North Carolina estimated in the double digits (see Chart 4). Chart 4 [D] Proposed government policies and actions in the Region since fiscal year 2002 have attempted to address the issue of budget deficits; so far, states have been more successful in cutting expenditures than boosting revenues. Most states, including Alabama and North and South Carolina, have tapped their reserve or rainy-day funds as a stopgap financing measure. Increases in “sin taxes”—particularly on tobacco products—also have been considered but have been difficult to enact in tobacco-growing states. Recently, Georgia’s new governor proposed increases in sin taxes as a way to cut two-thirds of the state’s budget deficit. In West Virginia, the Senate Finance Committee voted down a proposal in early 2003 to nearly double the tax on cigarettes. Many local governments have been increasing property taxes to raise revenues. Higher education, in particular, has been a target for state funding cuts. As a result, public universities have been forced to increase tuition sharply, scale back planned expansions, and lay off faculty and staff.5 Funding cuts could significantly hurt communities, such as Athens, Charlottesville, and Tuscaloosa, that are highly dependent on the economic contributions of public universities and that, until now, have been insulated from the worst effects of the recession. Most states in the Atlanta Region have cut funding for programs such as education, economic development, and some social services, either through across-the-board spending cuts or by targeting specific programs. Layoffs have been essential to cutting expenditures in Virginia and North Carolina. Layoffs in government, as in other sectors of the economy, can affect local economic conditions adversely. Although state -government employment is concentrated in urban areas, particularly state capitals, the effects of such layoffs on local economic conditions vary according to the relative importance of the government sector to the local economy. For example, Raleigh is home to the largest number of state government workers in the Region—63,300 workers in 2002. Atlanta is second, with just over 60,000, followed by Tallahassee, with 51,900. Even though the concentration of state government employment in the Atlanta Region is less than the national average, the shares in Raleigh and Tallahassee are nearly three and nine times the national average, respectively.6 Thus, in the event of layoffs, some metropolitan areas may be hit harder than others. Municipal Revenues May Be More Stable than State Revenues The same developments that have contributed to state budget deficits may have affected metropolitan areas negatively, but fiscal conditions at local levels generally are more stable, according to a recent Standard & Poor’s report,7 because they are less likely to rely on cyclical sources of funding, such as income tax collections. Property taxes account for just over one quarter of all municipal revenue. Continued strong home sales and home price appreciation during the recent recession have bolstered this component of municipal revenue, helping to avert more serious deterioration in fiscal conditions. Some municipalities, however, have encountered declining fiscal conditions. In Atlanta, for example, government officials dealt aggressively with a $90 million deficit in 2002 (a 20 percent budget gap) through a combination of tax hikes and layoffs. These policies proved effective as the city ended the year with a $47 million surplus. Continued economic weakness or a retrenchment in the housing market, however, could place additional burdens on municipalities such as Atlanta. The Atlanta Region's Banking Industry Remains Strong but Should Be Watchful State and local efforts to address budget deficits could have adverse effects on the Region’s banking industry. Indirect spending cuts in the form of layoffs in areas where state government is a critical component of the local economy could weaken overall economic conditions further. As a result, credit quality could deteriorate and demand for loans could decline. Cuts in education and social service program funding also could affect credit quality negatively as consumers are forced to pay more expenses out of their own pockets. These funding cuts and tax increases could make debt service more difficult for consumers as disposable incomes decline, leading to weaker credit quality. Although Call Report data suggest that banks have weathered the recent recession remarkably well, record trends in personal bankruptcy filings, residential foreclosures, and corporate defaults, as well as the effects of contractionary state and local fiscal policies, could begin to adversely affect the performance of insured financial institutions. Institutions in the Atlanta Region may be directly exposed to state and local government agencies through their holdings of municipal bonds (munis). According to Call Report data, commercial banks with assets less than $1 billion headquartered in Alabama, Florida, and North Carolina increased muni holdings more rapidly than the nation in 2002. Munis are not “default-free,” and recent ratings downgrades for several states and municipalities illustrate the rising default risk of holding these securities.8 Also, munis are not as liquid as Treasuries, and because of current fiscal difficulties, the market’s preference for revenue bonds over general obligation issues may increase. Recent proposals to end double taxation on dividends may affect market yields of tax-exempt munis adversely as the benefits of holding equities increase. Bank management should monitor developments and trends affecting municipal borrowers’ fiscal condition as well as the impact of tax policy on yields to identify risks to municipal bond holdings. 1 See, for example, Dennis Cauchon, “State, Local Spending Up Despite Downturn,” USA Today, January 15, 2003, page 1A, and “U.S. Governors Say Deficits Worst in Decades, Seek Federal Aid,” Todd Zeranksi, Bloomberg.com, February 22, 2003. 2 Dennis Cauchon, “States Choose Debt to Fill Gaps,” USA Today, February 26, 2003. 3 Iris J. Lay, “President’s Tax Proposals Would Reduce State Revenues by $64 Billion Over 10 Years,” Center on Budget and Policy Priorities, February 4, 2003. 4 Estimates of budget deficits vary widely depending on the source data. Also, as the issue of state budget deficits is evolving rapidly, revised estimates occur frequently and can change substantially. Although we considered various estimates, we relied heavily for this analysis on data from the Center on Budget and Policy Priorities. 5 Private colleges and universities also have encountered funding difficulties as the prolonged equities market downturn has reduced the size of endowments. 6 This measurement is commonly referred to as the Location Quotient. See Atlanta Regional Outlook, first quarter 2003, for an explanation of this statistic. 7 Karl Jacob, Michael Zinman, Robin Prunty, Jeffrey Panger, Edward McGlade, David Hitchcock, John Kenward, Jane Ridley, James Wiemken, James Breeding, Alexander Fraser, Jeanie Yarbrough, Geoffrey Buswick, Kenneth Gear, Gabriel Petek, and Ian Carroll, “Public Finance Report Card: The Largest Cities,” Standard and Poor’s Ratings Direct, February 19, 2003. 8 Ted Hampton, “Municipal Bond Credit Rating Cuts Increase 40 Percent Moody’s Says,” Bloomberg.com, February 4, 2003. Jack M. W. Phelps, CFA Scott C. Hughes Pamela R. Stallings Ronald W. Sims, II, CFA Chicago Regional Perspectives Asset Quality Deterioration May Have Peaked for Many, but Not All, Insured Institutions Despite an economic recovery that has been in place for several quarters, delinquency trends suggest that asset quality could deteriorate further. The median past-due1 ratio among the Region’s insured institutions declined slightly during 2002, from 2.20 percent to 2.14 percent. However, during the fourth quarter, delinquencies rose yet again. In 2002, both the largest and smallest institutions reported year-over-year declines in delinquency levels, while institutions that hold between $250 million and $1 billion in total assets reported a rise in delinquencies. Despite rising delinquencies for these midsize banks, the overall past-due levels remained relatively favorable at 1.75 percent. Geographically, the highest delinquency rate in the Chicago Region is among insured institutions based in Indiana, where the median level was 2.47 percent, 13 basis points higher than a year ago. While the slight improvement in overall delinquencies in 2002 is encouraging, the share of noncurrent loans did not decline. The year-over-year improvement in loans 30 to 89 days past due may indicate that overall asset quality concerns have peaked in the Region, but perhaps not for all locations or types of banks. For instance, overall past-due and noncurrent rates continue to rise among banks based in Michigan and Indiana. With the Region below prerecession levels of economic activity and job losses continuing, the economy may not do much to buoy asset quality in the near future. Furthermore, recent weakness in the Region’s commercial real estate (CRE2) markets may affect overall asset quality negatively in the near term. CRE Fundamentals Present Some Concerns Commercial real estate fundamentals have deteriorated in the Region and across much of the nation. The recession and the sluggish economic recovery led to net job losses and diminished demand for office and industrial space. As a result, many leaseholders feel pressured to vacate or terminate leases before they expire or renegotiate lease terms. This weakening is evident in higher vacancy rates and lower rental rates for many property types in the Region’s larger markets (see Table 1). With lease agreements often spanning several years, the full effects of softening CRE fundamentals can take time to emerge. When they do, lower cash flows may make debt repayment more challenging for some borrowers. Table 1 Commercial Real Estate Vacancy Rates Increased among the Larger Chicago Region Markets Percentage   Apartment Office Retail Warehouse Hotel   2002 2000 2002 2000 2002 2000 2002 2000 2002 2000 Chicago 4.1 2.5 16.6 10.5 11.7 9.2 10.4 7.3 40.2 30.9 Cincinnati 7.8 6.4 14.8 9.6 15.1 10.8 9.5 7.2 48.4 44.1 Cleveland 7.1 6.3 18.1 11.5 13.7 11.2 10.5 7.8 45.1 38.7 Columbus 8.7 7.6 17.1 10.2 14.8 9.7 13.0 9.8 43.1 36.0 Detroit 5.6 3.7 17.1 9.4 14.6 11.3 9.3 6.4 43.2 33.5 Indianapolis 9.5 8.1 17.0 12.9 15.1 10.2 10.8 6.8 44.5 39.5 Milwaukee 7.7 7.3 17.2 12.3 11.9 10.3 7.0 4.6 43.2 38.1 St. Louis 7.1 5.6 15.4 10.6 13.0 9.4 8.5 5.2 36.5 37.2 Note: Shaded = Largest increase in each submarket. Source: Property & Portfolio Research, Inc.  [D]  Commercial real estate is a diverse category, and economic trends affect CRE properties at different times and to different degrees. For instance, employment trends can significantly affect vacancy rates for office space. Year-over-year growth in “office employment”3 in the Chicago Region has declined since 1997 and was virtually nonexistent during 2002. Declining employment among office-using firms in the services sector often affects net absorption of office space rather quickly, while employment trends in the finance, insurance, and real estate (FIRE) sectors affect net absorption more slowly.4 Companies in the FIRE sectors typically have more square footage per employee and can therefore hire additional personnel without immediately needing more space. Employment in all of the Region’s larger office markets5 is deteriorating. Profits have been erratic since 1999 and did not grow in the retail sector during third quarter 2002. Retail sales growth is not likely to accelerate substantially in coming quarters for several reasons. Recent strong levels of vehicle purchases likely are waning, job and income growth are not robust, and many consumers may defer major purchases because of concerns about employment security. In this environment, any property owner trying to let or sublease retail space likely will face ample supply on the market. CRE Exposure Has Grown Dramatically among Insured Institutions Based in the Chicago Region during the Past Ten Years As of December 31, 2002, the median level of CRE to Tier 1 capital among banks in the Chicago Region was 149 percent, steadily increasing during the past ten years from 89 percent (see Chart 1). The CRE concentration levels of institutions in the 90th percentile rose to a greater extent during the same period, showing that much of the growth in CRE has been among institutions that already held substantial CRE exposure. Although regional exposure levels have risen dramatically, the median CRE exposure in the Chicago Region remains in line with that of the nation. Chart 1 [D] Institutions with more than $250 million in assets (21 percent of the Region’s insured institutions) report a median CRE concentration to capital that exceeds 200 percent. Smaller insured institutions based in the Region tend to hold less CRE exposure. The highest current exposures in the Region are among insured institutions based in Michigan (223 percent) and Wisconsin (182 percent). The Grand Rapids, Michigan, metropolitan statistical area (MSA) is home to institutions with the highest CRE exposure of any large MSA in the Region, with a median exposure of 410 percent of Tier 1 capital. Exposures are also relatively high among banks based in the Ann Arbor (337 percent), Milwaukee (305 percent), Lexington (282 percent), and Chicago (281 percent) MSAs. Nonresidential Real Estate Lending Has Fueled Most of the Growth in the CRE Portfolio The median level of nonresidential real estate lending is 106 percent of Tier 1 capital, up from 60 percent ten years ago. Increases have occurred among institutions of all sizes and among banks based in all the Region’s states. Again, the smallest institutions (less than $250 million in assets) have considerably less exposure to nonresidential real estate lending. Multifamily residential real estate lending is a relatively small segment and has not experienced the growth evident in construction and development (C&D) and nonresidential loan segments. The current median level of multifamily real estate lending is 5 percent of Tier 1 capital, up slightly from ten years earlier. C&D Lending Presents Additional Challenges Although C&D lending represents a relatively small segment of the CRE portfolio, this loan category likely presents the greatest challenges to lenders. Construction lending can take many forms. The primary types of construction loans insured institutions make are unsecured front money, land development, commercial, and residential. The characteristics of each of these business lines vary; however, in all cases the properties usually achieve appraised values only after funds are advanced and improvements are made. Consequently, C&D lending is typically one of the higher-risk lending segments. C&D lending has grown considerably among insured institutions in the Chicago Region during the past ten years. The median ratio of C&D lending to Tier 1 capital was 20 percent at year-end 2002, up from 8 percent ten years earlier. In the Region, 194 insured institutions hold concentrations that exceed 100 percent of Tier 1 capital, up from 46 insured institutions ten years ago. Recently, C&D lending performance among banks based in the Region generally has been positive. The C&D portfolios of most of the Region’s insured institutions have performed reasonably well to date. Overall, C&D underwriting appears satisfactory. However, the Federal Deposit Insurance Corporation’s (FDIC’s) September 2002 survey of underwriting practices noted that the proportion of banks active in construction lending that either “frequently” or “commonly” made speculative loans for residential construction projects had increased from 26 percent to 29 percent. Also, institutions that frequently or commonly failed to use realistic appraisal values increased from 12 percent to 14 percent. Despite Increasing Concentrations and Weakening Market Fundamentals, CRE Loan Quality Remains Sound Although CRE loan portfolios generally performed well during 2002 (see Table 2), the full effect of weakening CRE fundamentals may not have emerged yet. The median CRE past-due rate among insured institutions based in the Region was 0.92 percent as of December 31, 2002, down from 1.06 percent 12 months earlier. Nevertheless, only the Dallas Region (including the Memphis area) reported a higher overall CRE past-due rate. CRE delinquencies among banks in the Chicago Region declined, except for insured institutions holding assets between $500 million and $1 billion, which reported a slight increase. Table 2 Recent Median Commercial Real Estate Delinquency Trends Varied among the Chicago Region's States   4Q02 (%) 4Q01 (%) 4Q00 (%) 4Q99 (%) 4Q98 (%) Chicago Region 0.92   1.06 0.36 0.24 0.36 Illinois 0.59 0.73 0.19 0.10 0.32 Indiana 1.22 1.47 0.43 0.44 0.48 Kentucky 1.28 1.13 0.82 0.43 0.68 Michigan 1.22 1.18 0.15 0.00 0.00 Ohio 0.99 1.15 0.01 0.03 0.14 Wisconsin 1.10 1.27 0.61 0.43 0.47 Source: Bank and Thrift Call Reports Within the Chicago Region, CRE past-due levels and trends show some geographic variation. Insured institutions based in Kentucky report the highest CRE past-due rate and have experienced some deterioration in CRE loan quality. Deterioration among insured institutions based in Kentucky is concentrated in the smallest institutions (those holding less than $250 million in assets). Institutions headquartered in Indiana and Michigan also report relatively high past-due rates. However, past-dues reported by banks in Indiana have improved considerably, while institutions based in Michigan have reported some slight deterioration. Low Interest Rates and Industry Trends Contributed to Favorable Performance of CRE Portfolios Several factors have helped bolster CRE loan performance. Low interest rates enabled many property owners to reduce debt service requirements by refinancing. Also, even though rental rates fell in a large portion of the Region’s markets, many properties remain under more favorable leases. Essentially, property owners have been able to reduce debt service requirements without experiencing the full effects of lower current rental rates. Further improvement in debt service reduction may be limited, as interest rates may not decline significantly in the near term. Revenue streams, however, are likely to decline as leases expire. In some cases, there may be no demand for the space. Even when demand exists, the new lease rate may be less favorable to the lessor. Also enhancing CRE loan performance among insured institutions is the prevalence of securitized CRE lending, which has helped to spread risk among several lenders. Nonbanking entities, such as real estate investment trusts and insurance companies, fund many of the larger and more complex CRE projects. Conversely, smaller CRE relationships, in which the lender is “closer” to the borrower, likely are still heavily funded by insured financial institutions. Projects with a sufficient amount of owner equity are less likely to become nonperforming. The maximum loan-to-value limits instituted following the enactment of the Federal Deposit Insurance Corporation Improvement Act (FDICIA) may help to minimize the number of highly leveraged CRE projects funded by insured institutions. FDICIA prompted Part 365 of the FDIC’s Rules and Regulations, which requires insured institutions to establish loan-to-value policy limits of 65 percent for raw land, 80 percent for C&D, and 85 percent for 1- to 4-family residential development. While insured institutions may exceed these limits in certain instances, these regulations have provided a solid framework for operations. And finally, the downturn in the stock market has increased the attractiveness to some investors of hard assets, such as real estate. Lower interest rates and a preference for real estate have lowered capitalization rates, supporting property values and helping to maintain equity ratios. CRE Portfolios Will Benefit from Close Monitoring in the Current Environment CRE property values can fluctuate significantly with changing market conditions and underlying cash flows. As a result, some consider CRE lending inherently more risky than many other loan types. In fact, historically, C&D past-due and charge-off rates have demonstrated they can reach relatively high levels among insured institutions in the Chicago Region. CRE lending is not homogenous, and the risk characteristics may vary significantly by bank size, types of properties financed, and location of collateral. Many bankers likely have learned the lessons of the late 1980s and early 1990s. Nevertheless, given the growth in CRE exposures and the current softness in certain CRE markets, portfolio managers should continue to monitor fundamentals of local CRE markets and watch for early warning signs, which can include, but are not limited to, the following: Cash flow falling below projections in the original appraisal, often from rent concessions or sales discounts. Changes in concept or plan, such as a condominium project converting to an apartment project. Construction delays that lead to cost overruns or a renegotiation of loan terms. Slow leasing or lack of sustained sales activity, which could lead to protracted repayment or default. Construction draws that exceed the amount needed to cover construction costs and related overhead expenses. Property owners tapping into equity to keep payments current. 1 Past-due includes loans at least 30 days delinquent or in nonaccrual status. 2 Commercial real estate lending includes construction and development, multifamily, and nonresidential real estate lending. 3 Office employment is defined here as employment in the finance, insurance, and real estate (FIRE) sectors, plus 45 percent of services employment. 4 Winter 2003 Office Outlook, Torto Wheaton Research. 5 Detailed information about CRE fundamentals is generally not available for the Region's smaller markets. Dallas Regional Perspectives Insured Institutions in the Region Report Favorable Banking Conditions despite a Sluggish Economy The 2001 recession and the tepid recovery1 have resulted in weak annual average employment growth in all states in the Dallas Region during the past two years (see Table 1).2 Only the New Mexico economy has avoided recession. Strong gains in the government and services sectors have contributed to employment gains in the state. However, even though employment growth in New Mexico exceeds the national average, the growth rate slowed during 2002. Table 1 Employment Growth Is Expected to Be Modest during 2003 in the Dallas Region Average Annual Growth Rates (%) Area 1995 - 2000 2001 2002 2003F Arkansas 1.6% -0.4% -0.6% 0.2% Colorado 3.8% 0.6% -1.9% 0.0% Louisiana 1.6% -0.1% -1.0% -0.1% Mississippi 1.4% -2.0% -0.3% 0.2% New Mexico 1.8% 1.7% 1.1% 1.3% Oklahoma 2.5% 1.0% -1.5% -0.2% Tennessee 1.8% -1.5% -0.8% 0.3% Texas 3.3% 0.9% -1.0% 0.6% Dallas Region 2.7% 0.3% -0.9% 0.3% United States 2.4% 0.2% -0.9% 0.2% In sharp contrast, Colorado is the only state in the Region that remained in recession as of first quarter 2003.3 The downturn in the high-tech sector and ongoing weakness in the financial services sector and commercial real estate markets continue to affect the Colorado and Texas economies adversely. However, increases in defense spending, stronger levels of business investment, higher energy prices, and improved corporate profitability should promote an upswing in employment growth rates for these states during 2003. Arkansas, Louisiana, Mississippi, and Tennessee (states that entered recession before the national downturn) recorded a second consecutive year of employment losses during 2002. The key manufacturing sectors in these states were hurt by cheaper imports or a decline in exports as well as the national recession. In addition to a sluggish manufacturing sector, weakness in the hospitality, mining, and construction sectors adversely affected the Louisiana economy and spilled into the retail trade and services sectors. Employment in Louisiana is forecast to decline for the third consecutive year during 2003 because of poor demographics and a lack of growth industries and skilled labor.4 However, except in Louisiana, a weakening U.S. dollar (which should contribute to higher levels of exports), improving commodity prices, and a recovery in regional tourism should improve prospects for employment growth. Although most of the states in the Region appear poised for job gains in 2003, growth is expected to be modest. Five quarters into the U.S. recovery, the Region has yet to show positive job growth, an unfavorable comparison with what occurred during the economic recovery that began in 1991 (see Chart 1). Geopolitical uncertainties, a sustained period of high energy prices, a volatile U.S. dollar, and significant state budget deficits are the greatest constraints to the Region’s economic recovery. Chart 1 [D] Although economic conditions remain sluggish, insured institutions based in the Dallas Region reported favorable conditions at year-end 2002. Historically low short-term interest rates and an upward-sloping yield curve benefited banks and thrifts based in the Region as the net interest margin and average return on assets reached their highest levels in the past 20 years.5 A dramatic drop in the median cost of funds to record lows is one of several factors contributing to positive earnings performance.6 Additions to provision expenses were not necessary, as past-due and charge-off rates remained moderate for all segments of the portfolio except consumer loans. Equity capital levels remain strong, as evidenced by a median leverage ratio of 9.15 percent—among the highest levels in a decade. Several factors could explain the apparent disconnect between weak economic conditions and strong insured institution performance. First, merger and acquisition activity has contributed to increased geographic diversification in the loan portfolio, minimizing the level of concentration risk. Second, insured institutions have improved techniques for gathering data related to consumer and corporate borrowers, which has helped to improve credit quality. Finally, the increased use of securitization has allowed many institutions to sell loans, thereby spreading risk. Should economic weakness continue, however, insured institution performance could be affected adversely, particularly in the consumer loan portfolio. Rising Debt Levels Coupled with Weak Economic Conditions Could Stress Consumers Nationally, consumer debt levels grew through the recession of 2001 and have continued to grow. Aggregate household debt increased to 10.7 percent in fourth quarter 2002, the highest level since 1989.7 Debt service levels8 reached a historic high in fourth quarter 2001 and declined slightly in 2002 (see Chart 2).9 The rise in debt service levels can be attributed to increased mortgage and other types of consumer borrowing. Chart 2 [D] Nationally, several factors contributed to an increase in debt service levels. The rise in home equity values contributed to a surge in cash-out refinancing activity. Similarly, historically low interest rates prompted consumers to increase borrowing for durable goods, such as automobiles and personal computers, and boosted home sales to record highs. The increasing availability of credit, facilitated by the use of credit-scoring programs, also contributed to growth in consumer debt levels. Although many of these factors apply to the Dallas Region, this Region also has experienced a more severe economic decline than elsewhere in the nation. For example, job losses have been significant since the mid-1990s in rural areas of the Region that rely heavily on the manufacturing sector. Financial stress caused by higher debt levels and prolonged economic weakness is evident in bankruptcy filings that have risen to the highest level since the 1990–1991 recession. As of fourth quarter 2002, Tennessee, Arkansas, Mississippi, and Oklahoma ranked among the top ten states nationwide in per capita bankruptcy filing rates.10 Higher debt service levels are a key contributing factor to the relatively high rate of consumer bankruptcies in the Region. Results of the Federal Reserve Board Survey of Consumer Finances show that families with incomes in the lowest two quintiles are most likely to be financially overextended.11 This relationship is particularly relevant in the Dallas Region, because per capita income levels are among the lowest in the nation, suggesting that more consumers in this Region are more heavily indebted.12 Furthermore, many of the manufacturing job losses have occurred in the lower-skilled and generally lower-paying jobs. Taken together, these trends make it more difficult for consumers to remain current on their debt payments. Consumer Loan Portfolios13 Weaken as the Regional Economy Struggles to Recover Lingering economic weakness and debt consolidation, made possible by cash-out mortgage financing, contributed to slow consumer loan growth among insured institutions based in the Dallas Region. Consumer loan levels have steadily declined since mid-2001; this is the only segment of the portfolio that exhibited negative growth at year-end 2002 (see Chart 3). However, this decline was more than offset by an increase in residential and other loan categories.14 Chart 3 [D] Consumer credit quality has deteriorated recently among community banks headquartered in the Dallas Region. Consumer past-due loans increased in fourth quarter 2002 to the highest levels since first quarter 1988. The median ratio of total past-due consumer loans to total consumer loans was 3.0 percent, significantly exceeding the past-due ratio for residential loans.15 Levels of past-due consumer loans were also relatively high compared with other areas of the country, and levels varied among states in the Region. Not surprisingly, past-due levels were highest among banks and thrifts based in states that experienced the longest and deepest period of economic weakness (see Table 2). Banks headquartered in rural areas of the Region may be more vulnerable to deteriorating consumer credit quality because of higher exposures16 and weaker economic conditions. In contrast to the trend in past-due levels, the share of total loan losses attributable to consumer loans has begun to drop. However, loss rates remain high relative to other types, such as residential loans.17 Furthermore, recent increases in past-due loan levels suggest the potential for an increase in consumer loan loss rates, particularly if the Region’s employment picture remains weak for the balance of 2003. Table 2 Past-Due Levels among Insured Institutions Based in the Dallas Region Raise Concerns about Credit Quality   Ratio of consumer past-due loans to total consumer loans (median %)*     Area 4Q01 3Q02 4Q02 4Q0 National Rank Arkansas 1.6% -0.4% -0.6% 0.2% Colorado 3.8% 0.6% -1.9% 0.0% Louisiana 1.6% -0.1% -1.0% -0.1% Mississippi 1.4% -2.0% -0.3% 0.2% New Mexico 1.8% 1.7% 1.1% 1.3% Oklahoma 2.5% 1.0% -1.5% -0.2% Tennessee 1.8% -1.5% -0.8% 0.3% Texas 3.3% 0.9% -1.0% 0.6% All other states 2.7% 0.3% -0.9% 0.3% *States with at least 10 established community banks. Source: Bank and Thrift Call Reports Looking Ahead In light of the weak economic and employment trends that are persisting in the Dallas Region, insured institution management should continue to monitor trends in the consumer loan portfolio. In addition, management should consider offering or supporting programs that will enhance financial literacy, such as the FDIC’s Money Smart program.18 1 For purposes of this article, the U.S. recovery is assumed to have begun in fourth quarter 2001, when real gross domestic product returned to positive growth. 2 Newly revised payroll employment data from the U.S. Bureau of Labor Statistics revealed downward revisions for most states in the Region in 2001 and 2002, with significant revisions occurring in Louisiana, Oklahoma, and Tennessee. 3 Economy.com, Regional Outlook forecast, February 19, 2003. 4 Economy.com, Louisiana State Précis Report, March 2003. 5 The net interest margin and return-on-assets ratio for insured institutions based in the Dallas Region were 4.35 percent and 1.42 percent, respectively, for the four quarters ending December 31, 2002. 6 The cost of funding earning assets dropped to 2.15 percent in fourth quarter 2002, a decline of 129 basis points from a year ago. 7 Federal Reserve Board Flow of Funds data. 8 The debt service level, commonly referred to as debt service burden, is calculated by dividing the sum of required principal and interest payments by after-tax personal income (often referred to as disposable personal income). 9 In contrast to the growth reflected in the Flow of Funds data, the Federal Reserve Board Survey of Consumer Finances (SCF) series indicates that consumer debt service levels declined from 14.4 percent in 1998 to 12.5 percent in 2001. The SCF calculations include income data from 2000, a period when income levels were increasing rapidly. 10 The share of employment in the manufacturing sector in these states, except for Oklahoma, exceeds that of the nation. 11 SCF, 2001. Families in the lowest two income quintiles reported the highest percentages of debt, with debt service burdens greater than 40 percent. 12 Mississippi and Arkansas reported the lowest per capita personal income levels in the nation in fourth quarter 2001 (the most recent data available), followed closely by New Mexico, Louisiana, and Oklahoma. 13 Consumer loans include loans to individuals for household, family, and other personal expenditures, excluding loans secured by mortgages on residential properties. 14 Residential loan levels increased 5.8 percent in fourth quarter 2002 from one year ago. Conversely, consumer loan growth was minus 2.7 percent for the same period and was below growth reported for the period following the 1990-1991 recession. Nationally, consumer loan growth dropped 9.5 percent in fourth quarter 2002 from one year ago. 15 Past-due residential loans were 2.3 percent of total residential loans in fourth quarter 2002, compared with 2.5 percent one year earlier. 16 Consumer loans represented 8.3 percent of total assets in fourth quarter 2002 among rural banks in the Dallas Region, relatively unchanged from one year ago but higher than in the other FDIC Regions. Conversely, banks in metro areas held consumer loans at 6.5 percent of assets in fourth quarter 2002, down 100 basis points from one year ago. 17 Established community institutions hold assets less than $1 billion and have been in existence for at least three years. Consumer loan losses were 39.1 percent of total loan losses in fourth quarter 2002, relatively unchanged from one year ago and slightly down from one quarter ago. 18 The FDIC's Money Smart program enhances consumers' ability to manage their personal finances. Refer to the Consumers and Communities section of the FDIC's website at www.fdic.gov. Kansas City Regional Perspectives The Region’s Economy Is Improving, and Banks Report Continued Strong Conditions The Kansas City Region economy was affected adversely in 2002 by the recession. Job growth in most states, although remaining negative during fourth quarter 2002, improved by year-end. In particular, employment improved in Nebraska, Minnesota, and South Dakota, as laid-off employees began to be absorbed into new jobs. Employment was most robust in Kansas, as strength in the transportation and government sectors helped to offset losses in the telecommunications and aircraft manufacturing industries. In fact, Kansas is the only state in the Region to post positive employment growth each quarter during the past three years. On the other hand, the Missouri economy continues to struggle with massive layoffs in the manufacturing and retail sectors, two industries that represent a disproportionately high share of the state’s employment.1 Overall, insured financial institutions in the Region reported sound operating results during 2002. Community banks2 and farm banks3 reported improved earnings in 2002 as measured by post- and pre-tax measures (see Table 1). Net interest margins were bolstered in early 2002 by a steeply sloped yield curve, which helped banks recover some of the margin losses caused by rapidly declining interest rates during 2001. Levels of past-due loans remained moderate in the aggregate at year-end 2002. However, a subset of banks is reporting elevated levels of problem loans; 11 percent of both the Region’s community banks and farm banks reported past-due ratios that exceed 5 percent, a relatively high industry benchmark. Overall, capital levels increased in 2002 and remain high compared with historical levels, and loan loss reserves are stable compared with total loan and problem loan levels. Table 1 Community Banks and Farm Banks in the Region Continue to Report Sound Operating Results   Community Banks Farm Banks   2002 2001 2000 2002 2001 2000 Number of Banks 1,821 1,860 1,918 1,129 1,159 1,211 Return on Assets (%) 1.28 1.16 1.24 1.27 1.12 1.21 Pretax ROA (%) 1.59 1.47 1.63 1.58 1.40 1.56 Net Interest Margin (%) 4.26 4.14 4.31 4.16 4.00 4.10 Past-Due and Nonaccrual Loan Ratio (%) 2.29 2.39 2.14 2.39 2.44 2.13 Leverage Capital Ratio (%) 10.40 10.07 10.03 10.68 10.39 10.28 Loan Loss Reserves/Loans (%) 1.42 1.42 1.41 1.52 1.50 1.51 ROA = Return on Assets Notes: “Community banks” are defined here as commercial banks with less than $250 million in assets, excluding new banks and specialty banks. “Farm banks” are insured financial institutions at which at least 25 percent of total loans are farm operating loans or loans secured by agricultural real estate. Nearly all farm banks are also considered community banks. Source: Bank and Thrift Call Reports Drought Conditions Are Worsening and Adversely Affecting Insured Institution Performance Severe drought conditions continue to affect much of the Region. Normally, drought conditions abate considerably with precipitation during the fall and winter, but continued dry weather has contributed to deteriorating conditions (see Map 1). Although the drought was confined to the Region's western states last summer, dry conditions have now spread eastward into Iowa and Missouri, and Minnesota is experiencing abnormally dry conditions. Nebraska continues to be most adversely affected, with approximately two-thirds of the state experiencing at least "extreme" drought conditions. The state's corn, wheat, and soybean harvests declined approximately 20 percent from 2001 levels, and hard-hit pasturelands made it difficult for ranchers to feed herds. Farmers' strong equity positions and reliance on crop insurance appear to have mitigated much of the drought's negative effect on loan quality during 2002. However, should drought conditions continue into the summer of 2003, local economies that depend on the agricultural sector may weaken considerably. Map 1 [D] Although farm banks in the aggregate reported solid financial results during 2002, the drought has begun to affect the performance of banks in areas that have experienced a second year of drought: 53 counties in eastern Nebraska and 8 counties in the northwestern corner of Kansas. The 143 farm banks in these counties reported earnings and capital performance similar to that of other farm banks in the Region; however, the aggregate past-due ratio4 for this group of institutions was 2.98 percent at year-end 2002, compared with 2.39 percent for all farm banks in the Region. Fifteen percent of the farm banks in counties that have experienced prolonged drought conditions reported a past-due ratio of at least 5 percent. These numbers do not reflect a significant degree of deterioration; however, should the drought continue for a third year, asset quality among these institutions could be affected significantly. In addition, asset quality among farm banks in areas that experienced a first year of drought in 2002 could deteriorate to the same extent as farm banks in second-year drought areas. Some of the Region’s Markets Are Home to a Significant Number of New Institutions Minimal levels of new bank formation occurred in the Region in the years following the 1990–1991 recession; however, activity has surged during the past five years. New institutions now represent a sizable presence in many of the Region’s metropolitan centers, and 2001 marked the first year that these institutions operated during an economic downturn. Our analysis allows us to compare current financial conditions between new and established institutions and evaluate any differences in light of a continuing fragile economy. Consolidation throughout the Region Has Obscured a Growing Presence of New Institutions Consolidation among banks and thrifts headquartered in the Region has been significant since the 1980s. Nearly one-third of the insured institutions present in the Region at the end of the last recession are no longer present; the rate of decline peaked in the mid-1990s. In the aggregate, the consolidation trend was similar between insured institutions headquartered in metropolitan statistical areas (MSAs) and nonmetropolitan areas; however, differences exist at the individual MSA level. The level of merger activity tends to obscure the fact that the Region has experienced a significant level of new bank activity during the past few years. The Federal Deposit Insurance Corporation (FDIC) granted 202 new deposit insurance charters in the Region between April 1991, when the 1990–1991 recession ended, and year-end 2002. The headquarters locations of the 202 charters are shown in Map 2, which indicates that the majority of charter activity was centered in and around MSAs, in particular Minneapolis, St. Louis, Kansas City, and Springfield. Depopulation has occurred among the Region’s rural areas during the past few decades; therefore, it is not surprising that new charter activity has been centered in metropolitan areas.5 Map 2 [D] The 125 light blue dots on Map 2 represent charters granted to institutions affiliated with multibank holding companies or otherwise controlled by a chain banking organization or other financial services company. Much of this “affiliated charter” activity appears to be targeted at new market penetration. Many of the dots are concentrated in Iowa and Nebraska, states that have relatively more restrictive branching. Thirty-eight of these 125 affiliated charters are no longer in existence, primarily because of mergers involving affiliated acquirers. The 77 dark blue dots represent charters to institutions that have no substantive affiliation with multibank holding companies, financial services companies, or other financial institutions. These independent new institutions are less likely to be able to rely on outside expertise and support than nonindependent startups that have a close affiliation with parent or sister financial institutions or financial services companies. The remainder of this article focuses on 72 of the 77 independent new banks that remain in operation6 and examines how the financial performance of these institutions fared in the sluggish economy. New Bank Entrants since 1991 Are Experiencing an Economic Slowdown for the First Time The emergence of new banks in the Region could be problematic because newly chartered institutions historically have exhibited higher risk profiles than established institutions. Results of other regulatory studies suggest that de novo institutions are more likely to be assigned “weak”7 examination ratings and are more likely than established institutions to fail during a recession.8 Historically, well-run institutions have outperformed other institutions during economic downturns. Although well-run institutions can experience problems related to poor market conditions, they generally do not fail because of an economic downturn. Additionally, management teams that have been through economic slumps benefit from firsthand knowledge of how quickly asset quality can deteriorate and how costly it can be to deal with troubled assets. A strong majority (85 percent) of the 72 new banks were established between 1997 and 2002, and these new banks represent significant proportions of insured institutions presently headquartered in the Minneapolis, St. Louis, Kansas City, and Springfield MSAs mentioned earlier (see Table 2). Although these MSAs were hurt by the same economic trends that contributed to the national recession, they remain in better condition than the hardest-hit MSAs nationally. However, employment growth in these four MSAs has slowed, particularly in the manufacturing sector, and commercial vacancy rates have increased, reaching or exceeding historical highs set in the early 1990s. Table 2 New Bank Activity Has Been Recent and Centered in Four of the Region’s Metropolitan Areas Community Number of Newly Chartered Institutions1 Total Number 2 of Institutions Newly Chartered as Percentage of Total 1991 to 1996 1997 to 2002 Total No MSA 2 20 22 1,573 1 Minneapolis, MN 2 19 21 115 18 Springfield, MO 2 5 7 24 29 Kansas City, MO 2 5 7 96 7 St. Louis, MO 1 5 6 54 11 Des Moines, IA 1 2 3 26 12 Dubuque, IA 0 1 1 7 14 Waterloo, IA 0 1 1 7 14 Joplin, MO 0 1 1 8 13 Davenport, IA 1 0 1 11 9 St. Cloud, MN 0 1 1 21 5 Wichita, KS 0 1 1 27 4 Grand Total 11 61 72 1,969 4 1 As of December 31, 2002, 72 out of 77 independent institutions chartered since 1991 were still in operation. 2 Total FDIC-insured institutions as of December 31, 2002. Source: Bank and Thrift Call Reports, Kansas City Region Given these economic conditions, the following sections compare new bank performance with that of established institutions in the aforementioned MSAs. This discussion draws heavily from data shown in Table 3. Financial results generally do not stabilize until an institution has been in existence for at least three years; as a result, Table 3 includes data on the 45 new banks chartered before year-end 2000. Table 3 New Banks' Financial Performance Ratios Differ Considerably from Established Institutions   New Banks Established Institutions   Median Figures as of Year-End 2002 Earnings Pretax Return on Assets 1.14 1.56 Net Interest Margin 3.83 4.38 Yield on Earning Assets 6.73 6.73 Yield on Total loans 7.18 7.66 Cost of Funds 2.77 2.32 Funding Tier 1 Leverage Capital Ratio 7.80 8.51 Core Deposits to Total Assets 66.69 75.98 Other Borrowings to Total Assets 8.15 3.50 Credit Risk Loan-to-Asset Ratio 79.34 67.14 CRE Loans to Tier 1 Capital 324.09 222.88 Past-Due and Nonaccrual Loans to Total Loans 1.08 1.65 Loan Loss Reserves to Total Loans 1.07 1.26 Net Charge-Off Ratio 0.08 0.14 New banks represent 45 of the 72 institutions shown in Table 2 that have been in existence at least three years. Established institutions represent MSA-headquartered banks and thrifts established prior to April 1, 1991, with total assets under $1 billion, excluding specialty institutions. Source: Bank and Thrift Call Reports, Kansas City Region Earning Lag Those of Established Institutions Pretax return on assets (pretax ROA) ratios and net interest margins (NIMs) indicate that new bank earnings performance lags that of established institutions. In fact, almost three quarters of established institutions report higher pretax ROAs than the median level for new banks. New banks’ lower margins can be explained by higher funding costs, as these institutions typically pay higher rates to attract depositors. In addition, new banks generally rely more on noncore deposits and other borrowings, which can be more costly than core funding. New bank loan yields also lag those of established banks. New banks may offer rate concessions to attract loan business, thereby lowering yields. Lower yields also could be attributed, at least in part, to high-quality, low-yielding loans that “walk” to new charters with loan officers hired from established institutions. However, as a way of compensating for lower loan yields, new banks typically report higher loan-to-asset (LTA) ratios than established banks, potentially implying heightened credit risk for new banks.9 Funding Levels Are Lower than Those of Established Institutions After three years of operation, new banks typically are operating with lower levels of capital funding than established institutions. In addition, new banks rely more on noncore deposits and other borrowings. The median core deposits-to-total assets ratio of new banks is typically 9 percentage points lower than that of established institutions, and the cost of funds ratio is nearly 50 basis points higher. New banks would be expected to fare less well than established institutions, given their higher LTAs and greater reliance on noncore funds. Credit Risk Is Higher than That of Established Institutions The median past-due loan ratio for new banks is considerably lower that that of established banks; however, two factors suggest that new banks may take on higher levels of credit risk. First, the median LTA ratio for new banks is 12 percentage points higher than the median LTA of established institutions, and only about one quarter of all established institutions report higher LTAs than the new bank median. Since loan-to-asset ratios tend to indicate the tolerance of management for taking on additional risk, higher LTA ratios typically suggest higher credit risk in new bank portfolios. In addition, new banks exhibit significantly higher exposure to commercial real estate (CRE) lending, historically a higher-risk lending category. Concern about higher CRE-to-capital concentrations is compounded by the fact that commercial real estate markets have weakened considerably across the country during the past two years. Nearly two-thirds of new bank activity in the Region is concentrated in or around four markets: Minneapolis, St. Louis, Kansas City, and Springfield (see Table 2). Office vacancy rates in the first three were 19.6 percent, 17.7 percent, and 18.6 percent as of fourth quarter 2002, eclipsing highs reached in the early 1990s.10 While most lending institutions based in the Region have not reported increased delinquency levels because of deteriorating CRE markets, continued weakness could affect credit quality adversely, particularly among new banks. Conclusion New bank activity in the Region is a positive sign, suggesting heightened economic demand for community banking services. Although new banks typically exhibit greater levels of credit risk and report weaker earnings prospects, at least initially, than established institutions, new charters overall performed well during the 2001–2002 recession. However, new charters may be more vulnerable to continued economic weakness than established institutions. 1 For a deeper look into each state’s economic situation, see the FDIC State Profiles at www.fdic.gov. 2 “Community banks” are defined in this article as insured institutions that hold $250 million or less in assets, excluding de novo and specialty institutions. Thrifts are excluded because of dissimilarities to commercial banks. 3 “Farm banks” are defined as insured institutions that hold at least 25 percent of total loans in farm operating loans or loans secured by agricultural real estate. 4 Defined as the sum of loans 30 to 89 days past due and in nonaccrual status, divided by total loans. 5 Refer to the Kansas City Regional Outlook, first quarter 2003, for a discussion of depopulation trends. 6 For the remainder of this article, the term "new banks" denotes active FDIC-insured institutions headquartered in the Kansas City Region that were granted charters between April 1, 1991, and December 31, 2002, and that are considered independent of any multibank holding company or any other parent or sister financial institution or financial services company. The term "new bank" includes thrift activity. 7 A "weak" examination rating is defined here as a composite Uniform Bank Rating of 3, 4, or 5. 8 For further discussion of de novo bank performance compared to established bank performance in recessionary times, see Robert DeYoung, “Birth, Growth, and Life or Death of Newly Chartered Banks,” Economic Perspectives, Federal Reserve Bank of Chicago, third quarter 1999, and “De Novo Banking in the Atlanta Region,” Atlanta Regional Outlook, first quarter 2000. 9 LTA ratios were a key barometer of whether a bank would fail during the 1980s agricultural crisis. Federal Deposit Insurance Corporation, History of the Eighties—Lessons for the Future. Vol I: An Examination of the Banking Crisis of the 1980s and Early 1990s, Chapter 8. Washington, DC: FDIC, 1997. See www.fdic.gov/bank/historical/history/index.html. 10 Torto Wheaton Research for Minneapolis, St. Louis, and Kansas City. New York Regional Perspectives New York Region Economic Performance Is Mixed Economic growth in the New York Region1 during 2002 remained modest and uneven, like that of the nation. The Region’s total nonfarm employment declined about 1 percent (the same as the nation’s), while the unemployment rate rose about a percentage point, averaging 5.5 percent in 2002. Labor markets deteriorated to the greatest extent among formerly rapidly growing state economies, with concentrations of employment in the information technology and financial services sectors—for example, in Massachusetts, New York, Delaware, Connecticut, and New Hampshire. Given lackluster labor markets, regional per capita personal income growth decelerated markedly during the first three quarters of 2002 (on a year-ago basis). However, significant tax relief during the year mitigated the effects of weak labor markets on disposable income growth.2 The Region’s housing sector held up well during 2002. Historically low mortgage rates continued to support home sales, even in states exhibiting net job losses and sluggish income growth. Although the rate of home price appreciation eased somewhat in certain areas, year-ago home price growth remained at double-digit rates through fourth quarter 2002 in 7 of the Region’s 12 states. Pennsylvania, Vermont, Delaware, Maine, and Connecticut were the exceptions, though the latter two states posted gains just under 10 percent. Meanwhile, new home construction tracked the national rate, with significant strength evident in some of the Region’s markets, such as the District of Columbia, New Hampshire, Maine, Rhode Island, and Delaware. Without further strengthening in economic growth, the Region’s pace of home sales may slow this year. Should this occur, home price gains may moderate in certain markets, especially those (mentioned above) in which construction activity has accelerated. Although the potential for continued malaise in job and income growth remains a downside risk, aggregate household financial stress in the Region is still below the national average. Bank Earnings Improved despite the Weak Recovery Despite the sluggish economic recovery, insured institutions in the New York Region3 posted a 13 percent increase in net income during 2002 (see Table 1). Funding costs declined early in the year, contributing to a widening of net interest margins. However, funding costs are now extremely low and unlikely to fall any further. As a result, margins began to narrow late in 2002 as asset yields declined with falling interest rates. Table 1 New York Region Insured Institutions Continue to Report Healthy Conditions   Commercial Banks < $10 billion Savings Institutions < $10 billion Insured Institutions > $10 billion   Dec-02 Dec-01 Dec-00 Dec-02 Dec-01 Dec-00 Dec-02 Dec-01 Dec-00 Return on Assets (ROA) (YTD) 1.17 1.02 1.13 1.02 0.91 0.91 1.04 0.97 1.28 Median ROA 1.05 1.00 1.07 0.80 0.70 0.77 1.34 1.06 1.18 Net Interest Margin (YTD) 3.73 3.75 3.83 3.49 3.32 3.36 3.56 3.21 3.28 Past-Due Ratio 2.28 2.36 2.20 1.44 1.50 1.36 3.39 2.94 2.30 Earning Asset Yield 5.95 7.16 7.95 6.24 7.16 7.51 5.83 6.68 7.80 Cost of Funding Earning Assets 2.23 3.41 4.13 2.76 3.84 4.14 2.27 3.47 4.52 Total Loan Growth (year over year) 5.55 3.59 9.74 3.49 6.50 10.12 4.39 2.00 6.20 Tier 1 Leverage Ratio 8.20 8.31 8.55 9.30 9.36 9.59 6.88 6.76 7.04 YTD = Year to Date All figures are percentages. Note: All data exclude credit card institutions, de novos, and other small specialty institutions. Source: Bank and Thrift Call Reports, reported on a merger-adjusted basis. Commercial banks holding assets less than $10 billion reported increases in net income as a result of gains on the sale of securities, lower noninterest expenses, and declining provision expenses. Overall, loan growth is moderate, but it remains strong in commercial real estate, construction, and home equity portfolios. Despite the weak recovery, credit quality, as evidenced by the steady past-due ratio, has remained sound. Savings institutions holding assets less than $10 billion relied on net interest income to generate earnings. Despite declining asset yields across much of the industry, the Region’s savings institutions reported increasing margins throughout the year. Overall loan growth slowed in 2002 but remains strong in higher-yielding commercial and noncommercial real estate, multifamily, and home equity loans. Credit quality remains strong among the Region’s thrifts. However, should sluggish economic growth continue, deterioration could emerge in the traditionally higher-risk segments of the portfolio. The Region’s large institutions boosted income levels by increasing net interest income, noninterest income, and gains on the sale of securities. Noninterest expenses increased slightly but more slowly than net operating revenue (net interest income plus noninterest income). As a result, the efficiency ratio4 for large banks improved during 2002. The cost of funds remains at a historically low level. These costs are highly sensitive to changes in short-term interest rates and can reprice quickly, increasing exposure to interest rate risk and ultimately affecting profitability. The past-due ratio5 for large banks increased significantly during the past three years and now exceeds the ratio for smaller commercial banks by more than 100 basis points. Large bank credit problems are centered in exposures to troubled industries, such as the telecommunications, high-tech, and airline industries. The Sluggish Economy Has Taken Its Toll on State Budgets The New York Region Faces Budget Shortfalls As of first quarter 2003, budgets were balanced for the current fiscal year in Rhode Island, Vermont, and Delaware, while the remaining states must close deficits by the end of June. States face a much bleaker situation for fiscal year 2004 because of lower-than-expected revenues and rising expenditures as a result of the recent recession and the lackluster recovery. States in the New York Region have a combined $20.5 billion deficit for the next fiscal year, roughly one-fourth of the estimated total gap for all states in the nation. New Jersey, Massachusetts, Connecticut, and Maine estimate that shortfalls will exceed 10 percent of each state’s budget, and New York expects a 24 percent deficit—roughly $9 billion (see Table 2).6 Table 2 States Must Close Growing Budget Gaps   Fiscal Year 2003 Fiscal Year 2004   Deficit ($mil) % budget Deficit ($mil) % budget Connecticut 650 5.4 1,700 12.7 Delaware 0 0.0 196 7.7 District of Columbia 128 3.5 N/A N/A Maine 43 1.7 475 16.3 Maryland 414 4.0 853 7.8 Massachusetts 650 3.1 3,000 13.0 New Hampshire 58 4.7 148 6.0 New Jersey 1,100 4.7 4,600 18.5 New York 2,500 6.3 9,300 24.0 Pennsylvania 433 2.1 2,400 11.4 Rhode Island 0 0.0 174 6.1 Vermont 0 0.0 30 3.4 Sources: National Conference of State Legislators State Budget Update, February 2003; District of Columbia and Pennsylvania Budget Offices Policy Actions Have Been Implemented States in the Region have implemented a variety of initiatives to reduce expenditures. However, many states must also raise revenue to close budget gaps. Some states instituted small tax and fee increases during FY 2003 rather than increase sales or income taxes, to minimize the effects on residents. Most states have increased cigarette taxes, and Connecticut and Rhode Island have raised fuel taxes. New Jersey increased the corporate income tax, and Connecticut imposed a minimum tax on limited liability partnerships and S corporations. These actions are expected to correct the imbalances for FY 2003; however, more severe measures will be required to address the worsening situation during FY 2004. For example, Connecticut and New Jersey are proposing personal income tax increases, New York may eliminate the sales tax exemption for clothing, and Maryland and Massachusetts are considering gaming proposals to increase revenues.7 Some Local Areas May Be More Affected Government layoffs have occurred primarily at the state level, as state payrolls have declined in Massachusetts, Rhode Island, Delaware, New Jersey, and the District of Columbia.8 However, job losses may trickle down to municipalities. Stable levels of property tax collections have enabled most local government budgets to weather the downturn. However, many states have announced plans to scale back aid to local governments during FY 2004, which could result in spending cuts and tax increases among some municipalities. The Boston, Philadelphia, New York City, and Washington, DC, metro areas are home to at least 200,000 state and local government jobs, although as a share of total employment, exposures are less than the national average. Employment concentrations in local government exceed the national average in the Barre-Montpelier, Trenton, Vineland, State College, Albany, Binghamton, and Dover metropolitan statistical areas.9 As a result, these areas could be more adversely affected by layoffs. Insured Institutions Must Remain Alert Overall asset quality remained stable among insured institutions headquartered in the New York Region during the 2001 recession. However, consumer loan delinquencies increased during 2002 as household balance sheets were affected adversely by layoffs and weak per capita personal income growth. Substantial state and local tax increases could offset the proposed federal income tax cuts and could contribute to declining levels of disposable income. Households that are budgeting for education will be affected by the decision of many state universities to raise tuition to compensate for lower state funding. In addition, job losses and rising debt levels could pressure consumer credit quality. Although the effects likely will be relatively small, the quality of consumer and mortgage portfolios at some institutions could be affected by borrowers’ attempts to solve fiscal problems. State and local governments increased debt levels to avoid tax increases during FY 2002. Borrowed money represented almost 10 percent of state and local revenue in 2002, the highest level since the 1950s, according to the Commerce Department, and this share has almost tripled during the past three years. During that time, Standard & Poor’s lowered the credit rating for New Jersey because of significant declines in projected revenues. The “stable” outlook for Connecticut and Maine was downgraded to “negative,” and the “positive” outlook for Massachusetts and Rhode Island was downgraded to “stable.”10 The outlook for New York City was also recently downgraded from “stable” to “negative,” reflecting escalating budget gaps.11 Highly leveraged state and local governments that experience revenue shortfalls could face further downgrades in credit ratings. Such downgrades would increase the cost of borrowing. As of fourth quarter 2002, roughly 11 percent of insured institutions based in the New York Region held at least one quarter of their securities portfolios in municipal holdings. Institutions that hold these relatively high concentrations should continue to analyze any proposals that would have an adverse effect on the financial condition of state and local governments and their ability to repay debt obligations. New York Region Financial Services Sector Hit Harder than Nation's The Region, primarily New York City, has sustained greater employment losses in the financial services sector than the nation. During 2002, jobs in the financial sector, which includes banking, securities, and real estate firms, increased by 0.6 percent nationwide, while the Region's financial employment declined by about 1 percent. Many of the Region's financial employment losses can be traced to New York City and Boston, and to a lesser extent to southern Connecticut and Bergen-Passaic counties in New Jersey. In New York City, financial-sector job losses have declined sharply since peaking in 2000 (see Chart 1). Chart 1 [D] Employment losses in the financial sector have hurt New York City and Boston more than the nation because financial-sector employment is a significant economic driver in these metropolitan areas. Financial-sector employment in the New York City metro area represented almost 12 percent of employment and more than 30 percent of nonfarm earnings during 2000.12 Although the Boston economy is slightly less concentrated in financial-sector jobs than New York, employment in this sector represented almost 9 percent of jobs and 12 percent of earnings, compared with 6 percent and 10 percent, respectively, for the nation. The greater decline in financial-sector employment in New York City stems from job losses in the securities industry, which makes up the largest part of the financial sector. Moreover, compensation in the securities industry (including salary and bonuses) generally is significantly greater than in other industries. During 2002, employment in the New York City securities industry fell almost 10 percent, while Wall Street bonuses, a significant component of total compensation, are estimated to have declined 37 percent in 2002, following a 35 percent drop in 2001. In Boston, securities employment declined by 5 percent, compared with a 4.5 percent decline in the nation. Layoffs in the securities industry have contributed to weakness in the Boston and New York office markets. Financial, law, and professional service firms lease about 68 percent of total office space in Boston.13 Financial-sector employment in New York City fell 6 percent between 2000 and 2002, primarily owing to layoffs in the securities industry. These losses contributed to a threefold increase in New York City office vacancy rates, from 2.8 percent to 9 percent.14 Financial-sector job losses in Boston and New York City are consistent with weak business conditions in the securities industry nationwide. In 2002, the U.S. stock market suffered the third consecutive year of losses; 2002 represented the greatest annual loss since 1977, and pretax profits in the securities industry fell to an eight-year low. Investment banking activity, including initial public offerings, equity underwriting, and mergers and acquisition activity, declined sharply in 2002. According to the Securities Industry Association, the value of announced mergers and acquisitions of U.S. companies in 2002 fell 41 percent, the lowest level since 1994 and down 74 percent from the peak in 2000.15 Commissions, trading activity, mutual fund sales, asset management fees, and margin revenue also were down sharply. The outlook for the financial sector is mixed. According to Moody’s Investors Service, factors such as high debt service burdens, weak U.S. corporate investing and capital spending, and ongoing litigation faced by many securities firms may delay a recovery in securities industry profits,16 which will, in turn, constrain any rehiring on Wall Street. On the other hand, the boom in mortgage refinancing has boosted employment in mortgage banking, offsetting some job losses in the securities industry. Nonetheless, the impact of the securities industry on the New York City economy is apparent, and any continued weakness and consolidation could undermine its economic recovery. Employment in the Boston financial sector, which is dependent on asset management companies such as Fidelity, likely will not rebound significantly until mutual fund investors gain more confidence in the equity markets, which have been buffeted by poor corporate earnings, corporate scandals, and an unstable international situation. 1 The New York Region includes the six New England states (CT, MA, ME, NH, RI, and VT), five Mid-Atlantic states (DE, MD, NJ, NY, and PA), the District of Columbia, Puerto Rico, and the U.S. Virgin Islands. Puerto Rico and the U.S. Virgin Islands were excluded in determining aggregate regional trends. 2 2002 state-level disposable personal income data were not available when this article was written. 3 Data exclude credit card lenders, de novo institutions open three years or less, and other small specialized institutions with less than $1 billion in total assets primarily operating nonlending business lines (e.g., trust business). 4 The efficiency ratio measures noninterest expense as a percentage of net operating revenue. 5 Past-due loans are 30 or more days delinquent plus loans on nonaccrual. 6 National Conference of State Legislatures, State Budget Update, February 2003. 7 National Association of State Budget Officers, Fiscal Report of States, November 2002. 8 Based on payroll employment data, year-ago percentage change from fourth quarter 2002. 9 The national average as of year-end 2002 was roughly 14.3 percent. 10 Standard & Poor’s Public Finance Report Card: The States, October 7, 2002. 11 Standard & Poor’s Public Finance Report Card: The Largest U.S. Cities, February 19, 2003. 12 Earning results are from 2000, the last year available. 13 Susan Diesenhouse, "Layoffs Create a Glut of Space in the Boston Area," New York Times, p. C-6, February 5, 2003. 14 Torto Wheaton Research. 15 15 Grace Toto, "Monthly Statistical Review," SIA Research Reports. Vol. IV, No. 1, January 31, 2003. 16 Moody’s Investors Service, 2003, U.S. Securities Industry Outlook, February 2003. San Francisco Regional Perspectives Payroll employment growth in the San Francisco Region slightly outperformed that of the nation during 2002, primarily thanks to strength in the government and services sectors. Robust hiring in the education sector, particularly at the local level, led employment growth in several states. The services sector in Nevada and Hawaii and in several of the Region’s metropolitan statistical areas (MSAs) also benefited from a recovery in tourism, which had declined significantly after 9/11. Insured institutions headquartered in the San Francisco Region have performed well during the recession; however, bank and thrift performance remains vulnerable to several trends, including the effects of continued slow job growth at home and unrest abroad. This article explores how the sluggish economy and international events have hurt the travel and tourism sector in the San Francisco Region and the implications of these trends for the Region’s insured institutions. Travel and Tourism Are Important Economic Drivers in Several of the San Francisco Region Markets Twelve of the Region’s MSAs that are home to at least five insured institutions rank within the top quintile nationally for travel- and tourism-related employment. Tourism-related job growth in most of these markets slowed considerably from 2000 through 2002 as a result of the recession and the 9/11 attacks (see Table 1). In addition, hotel revenues and occupancy rates have declined significantly during the past two years. Between 1995 and 2000, the robust economy, rapid construction of theme hotels in Las Vegas, and the 2000 Winter Olympics in Salt Lake City contributed to an annual employment growth rate in the tourism sector that exceeded 5 percent in several MSAs. Subsequent declines in business and leisure travel during 2001 and 2002 significantly dampened employment growth in this sector in the Las Vegas, Honolulu, San Francisco, Phoenix, and Seattle markets. Table 1 Travel and Tourism Employment Has Declined in the Honolulu, Seattle, and San Francisco MSAs during the Past Two Years Metropolitan Statistical1 Area (MSA) Travel and Tourism Employment Share in 2000: National Rank2 Compound Annual Tourism Employment Growth 1995–2000 (%) Compound Annual Tourism Employment Growth 2000–2002 (%) Count of Community Nonspecialty Institutions3 Share of Community Nonspecialty Institutions < 9 Yrs. Old (%) Median Past- Due Loan Ratio4 (%) Las Vegas, NV 2 5.3 -0.2 21 76 1.63 Honolulu, HI 9 -1.5 -2.8 8 0 1.5 Anchorage, AK 10 4.4 2.2 8 0 1.84 San Francisco,CA 13 4.2 -1.1 25 8 0.92 Salt Lake City, UT 27 8.2 2.1 14 36 2.97 Santa Barbara, CA 31 3.0 1.6 8 25 1.66 Billings, MT 34 6.4 4.9 6 17 2.73 Phoenix, AZ 37 3.9 -0.4 25 64 0.7 San Diego, CA 41 5.2 5.0 22 50 0.6 San Luis Obispo, CA 42 5.8 1.0 7 43 0.69 Orange County, CA 43 4.3 4.6 17 53 0.09 Seattle, WA 60 3.6 -2.1 37 49 1.12 Total U.S. 4.5 1.5 3,268 17 1.52 1 Includes MSAs in the San Francisco Region that rank in the top 20 percent of 318 MSAs nationally for employment concentrations in travel and tourism employment and that have a least five established community insured institutions based in each of those markets. 2 Travel and tourism employment includes jobs in lodging, recreation, and air transportation services. 3 Community institutions are defined as insured institutions holding less than $5 billion in total assets that are not specialty institutions or industrial loan companies. Figures for the U.S. are calculated on MSA-based institutions meeting the aforementioned definition. Honolulu and Anchorage data include nonspecialty insured institutions (regardless of size) headquartered in Hawaii and Alaska, respectively. 4 Includes loans that are 30 days or more past due or in nonaccrual status. Median was calculated on community nonspecialty institutions in operation at least three years. Sources: Global Insight; Bank and Thrift Call Reports (December 31, 2002) Declines in the Number of Air Passengers Adversely Affect Air Services and Aerospace Employment Although air travel recovered somewhat during 2002, the decline since 2000 continues to hurt airline employment. Airlines laid off around 13 percent of their workforce between August 2001 and December 2002.1 Airline profits remain pressured by declines in air travel caused by the war in Iraq, rising fuel prices, and escalating leverage. Several airports in the Region that are hubs for financially troubled airlines are particularly vulnerable to additional layoffs: San Francisco and Los Angeles (United), Honolulu (Hawaiian Air and Northwest), and Phoenix and Las Vegas (American). As of early April, United and Hawaiian Air had filed for bankruptcy during the past year. The slowdown in travel and tourism also has led to layoffs in the commercial aerospace industry, in particular at Boeing, the Seattle MSA’s largest employer. According to the Air Transport Association, orders for aircraft fell more than 35 percent during the last half of 2002 compared with the last half of 2000, continuing a two-year trend. Boeing eliminated 18 percent of its Washington workforce during 2002 and has announced plans to lay off more workers. The Seattle MSA, which continues to feel the impact of the high-tech downturn, is characterized by relatively high shares of employment in the tourism and aerospace industries. As a result, it remains vulnerable to continued weakness in these sectors. Lodging Employment Is Hurt by Reduced Travel The decline in foreign and domestic travelers has affected the San Francisco Region’s lodging industry adversely during the past two years. Although employment in the hospitality sector has improved since 9/11, the overall number of lodging jobs in the Honolulu, Las Vegas, Phoenix, Santa Barbara, and Seattle MSAs was lower at year-end 2002 than at the end of 2000.2 In addition, according to Torto Wheaton Research, revenue per available room (RevPAR) was sharply lower between 2000 and 2002 in the Region’s tourism-dependent markets, most notably San Francisco (see Chart 1). Trends in RevPAR are a key indicator of the health of the tourism industry, particularly in markets that rely heavily on lodging employment (see Chart 2). Chart 1 [D] Chart 2 [D] Most Insured Institutions Remain Strong Continued layoffs in the travel and tourism sectors and weak RevPAR levels could have an adverse effect on established community institutions3 headquartered in markets with relatively high shares of travel-related employment. Low interest rates likely have mitigated the effects of reduced travel on the ability of many businesses and individuals in tourism-dependent areas to service debts. In fact, at year-end 2002, the median past-due loan ratio had declined year-over-year in 9 of the Region’s 12 travel-exposed markets; however, delinquencies remained high among established community institutions headquartered in the Salt Lake City and Billings MSAs (see Table 1). In contrast, established community institutions based in Alaska and in the Santa Barbara and Las Vegas MSAs reported rising median past-due loan ratios. Loan and age mixes among insured institutions in the 12 tourism-dependent markets referred to in Table 1 could magnify asset quality and earnings pressures should weaknesses persist in the tourism and aerospace sectors. Insured institutions based in these markets hold elevated concentrations in commercial real estate4 and commercial and industrial loans, two traditionally higher-risk loan categories (see Chart 3). Moreover, a high proportion of insured institutions in some of these markets are relatively unseasoned, which could make them vulnerable should economic disruptions hamper loan growth or asset quality, both of which are important for break-even earnings performance in the early years of operation. As of fourth quarter 2002, 20 percent of all community institutions in these 12 markets were less than three years old, and another 26 percent were less than nine years old. As noted in Table 1, at least half of all community institutions in the Las Vegas, Phoenix, Orange County, and San Diego markets have been in operation less than nine years. Chart 3 [D] Conclusion The travel and tourism sector, although recovering from the effects of 9/11, remains vulnerable to global political and economic uncertainties, new terror alerts, and a weak national economy. Established community institutions based in most of the Region’s 12 travel-dependent MSAs have not reported rising past-due loan ratios despite tourism sector layoffs, airline bankruptcies, and declines in RevPAR. However, without a quick rebound in the travel sector, banks and thrifts operating in these markets remain vulnerable to asset quality and earnings pressures. 1 Air Transport Association, “Airlines in Crisis; the Perfect Economic Storm,” March 11, 2003, p. 14. (http://www.airlines.org/public/industry/bin/AirlinesInCrisis.pdf) 2 Based on estimates available from Global Insight. 3 For purposes of this analysis, outside of Anchorage and Honolulu, established community institutions are defined as insured institutions holding less than $5 billion in total assets that have been open more than three years and are not specialty institutions or industrial loan companies. These data restrictions were used to isolate insured institutions that might have loan concentrations within the headquarters MSA and to mitigate the effects of unseasoned loan portfolios or newly chartered institutions on performance measures. Because they typically derive a significant share of deposits from the MSA in which they are headquartered, institutions holding up to $5 billion in assets were included. Specialty institutions and industrial loan companies were excluded because they lack traditional bank asset mixes (e.g., low loan-to-asset ratios) or pursue loan niches with broader geographic reach. As a result, performance measures might not reflect economic conditions within the headquarters MSA. In the cases of Honolulu and Anchorage, statistics for all established nonspecialty insured institutions were used, given the isolated nature of these banking markets and the relatively small number of insured institutions. 4 Commercial real estate loans include mortgages secured by nonfarm-nonresidential, multifamily, and construction projects. San Francisco Staff Regional Outlook Information National Edition Regional Outlook main page Return to Regional Outlook main page

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