San Francisco Regional Outlook - Third Quarter 1998
Lending and Changing Residential Lending Practices Pose Risks to
San Francisco Region Banks
The Region's insured financial institutions continue to
report strong earnings, solid asset quality, and increased leverage
Amid reports of loosening underwriting standards, the recent
growth and high concentrations in construction lending at banks in
faster growing states warrant attention.
Residential lending standards have come under pressure from
nontraditional lending practices at large banks and nonbank
Most of the insured institutions in the San Francisco Region
performed admirably in the first quarter of 1998.
Strong asset quality and noninterest income growth, coupled
with ongoing gains in operating efficiency, continue to drive
earnings to record levels. The 873 insured institutions in the
Region posted a collective return on assets (ROA) of 1.27 percent
and a return on equity of 14.00 percent. Both of these
profitability measures compare favorably with the national averages
of 1.2 percent and 14.42 percent, respectively, and represent solid
increases over prior-year performance.
Favorable economic conditions also translated into improvement
in reported asset quality. As of March 31, 1998, loans that were
reported 30 days or more past due plus nonaccrual loans as a
percentage of total loans fell to 1.96 percent, well below the
national average of 2.23 percent.
Excellent earnings and minimal asset growth boosted the
Region's leverage capital ratio to 7.73 percent, the highest level
in over a decade, despite a 73 percent dividend payout ratio.
Although the Region as a whole performed well, the following states
are showing signs of deterioration:
Hawaii's prolonged recession continues to have a negative
effect on the state's insured financial institutions. As a group,
these institutions are the weakest in the Region. During the first
quarter of 1998, ROA declined to 0.94 percent from 0.99 percent a
year earlier. These returns are well below both the Region's and
the nation's ROAs of 1.27 percent and 1.22 percent, respectively.
Problem assets in Hawaii are also on the rise. Loans and leases
past due 30 days or more plus nonaccrual loans inched up from 3.23
percent to 3.30 percent of total loans during the past 12 months.
Problem assets are centered primarily in residential real estate
loans and secondarily in commercial real estate loans. Hawaii's
recession has hit community banks (less than $1 billion in total
assets) the hardest, since they lack the geographic diversity of
larger institutions. Although profits at community banks improved
during the past 12 months, their ROA of 0.82 percent continues to
lag large banks' ROA of 1.01 percent. Furthermore, asset quality at
community banks continues to deteriorate. The ratio of loans and
leases past due 30 days or more plus nonaccrual loans to total
loans at these institutions climbed from 6.64 percent to 7.28
percent during the past 12 months.
The ripple effect of slower economic conditions in Montana
is showing up in the financials of the state's insured financial
institutions, which reported slightly lower profits and an increase
in nonperforming assets during the past 12 months. Residential real
estate, commercial real estate, and construction loan portfolios
accounted for the bulk of the deterioration. The dollar volume of
foreclosed properties almost doubled, to $8,149 million. Community
banks appear to be bearing the brunt of the state's economic
slowdown; their ratio of foreclosed assets plus noncurrent loans to
total assets, at 1.12 percent, is the second highest in the Region,
behind only Hawaii's community banks.
Community Bank Construction Lending Soars in Some
Real estate markets in much of the San Francisco Region are
experiencing a boom that is fueling a resurgence in construction
lending. Although both banks and thrifts are actively involved in
construction lending, banks hold the predominant share of
construction loans in the San Francisco Region. Furthermore, Chart 1 shows that the construction loan
exposure at the Region's community banks1 is well above
the exposure for the Region's large banks (non-credit-card banks
with over $1 billion in assets). Among these community banks, those
in the Region's faster growing states have a higher level of
construction loans than peer institutions in other states. The
increased concentration of construction loans in some states raises
some concerns, given the apparent loosening of construction loan
underwriting standards noted by bank examiners nationwide and the
traditionally higher risk of construction lending.
1 Community banks are defined here as non-credit-card
banks with total assets less than $1 billion.
Although the Region's community banks are less heavily exposed to
construction loans in aggregate than they were prior to the 1990-91
recession, Nevada and Oregon, two of the Region's
faster growing states, have much higher levels of exposure than
they did during that period. Chart 2 shows
that, while community banks as a whole in 1990 had about 8.3
percent of their assets invested in construction loans, community
banks in Nevada and Oregon currently have 14.7 and 9.2 percent,
respectively, of their total assets in construction loans. Chart 2 also reveals that community bank
exposure in Nevada far exceeds the level that California's
community banks had prior to the 1990-91 recession.
Not only are construction loans at record levels in some states,
but growth in construction loans at the Region's community banks
increased a robust 28 percent from the first quarter of 1997 to the
first quarter of 1998.2 However, growth has not been
uniform across the Region. Community banks in states showing strong
economic growth--such as Nevada, Arizona, Oregon,
Utah, and Washington--registered some of the largest
increases in the percentage of assets held in construction loans.
Nevada's community banks, for example, registered an increase of
almost 50 percent in construction loans since the first quarter of
1997, while community banks in Arizona, Oregon, and Washington all
recorded growth in excess of 30 percent. By contrast, community
banks in Hawaii recorded overall declines in construction loans.
2 A constant sample of banks during this period was
utilized to minimize the effects of industry mergers, acquisitions,
FDIC examiners throughout the nation have noted a steady
deterioration in construction loan underwriting standards since
September 1996, according to the FDIC's Report on
Underwriting Practices. Chart 3
shows a growing share of banks making speculative construction
loans, financing borrower interest payments during the loan term,
and relying solely on the project for repayment. In particular, Chart 3 shows that the percentage of banks
frequently or commonly funding speculative construction loans
increased from about 11 percent as of September 1996 to almost 40
percent as of March 1998. Prudent underwriting standards are often
an institution's best means of limiting the risk associated with a
concentration in a particular category of assets. Looser
underwriting standards can weaken a bank's ability to withstand a
downturn in the economy.
Several factors make construction lending a risky line of business
for a bank. First, the construction industry is one of the most
highly cyclical sectors of the economy and is extremely dependent
on favorable economic conditions and interest rates (see Signs of a Pause in the Prolonged
Residential Housing Boom Raise Concerns about Banks' Exposure to
Construction Lending). Second, some key risks are
inherent in all construction lending: cost overruns; the
uncertainty of the value of the project upon completion; the
lengthy lags between project planning, construction, and
completion; and the fact that partially completed projects
typically have substantially less value than completed projects.
While some risks in construction lending (such as its dependence on
interest rates and economic conditions) are beyond bank
management's control, management can somewhat mitigate these
macroeconomic risks with concentration limitations, prudent
underwriting practices, and increased capital and reserve levels.
Implications: Community banks in some of the Region's faster
growing states have much higher levels of exposure to construction
lending than they did before the 1990-91 recession, and recent
growth in construction lending at these institutions has been
especially strong. Furthermore, economic factors such as the
slowdown in population growth and the gap between permits issued
and new household formation in some of the faster growing states
could negatively affect banks concentrated in construction lending
in these states. Loosening underwriting standards and the
traditionally higher risk of construction lending also pose risks
in the event of an economic downturn. Managers of insured financial
institutions with high concentrations in construction loans should
closely monitor local economic and real estate market conditions.
Residential Lending Standards Come under Pressure from Large
Banks and Nonbank Lenders
In addition to increasing their exposure to construction loans, it
appears that some banks may be easing credit standards in an effort
to compete for residential mortgages and other consumer loans.
Throughout the nation, finance companies and other subprime lenders
are offering loan packages that allow the consumer to consolidate
all mortgage, home equity, and credit card debts into one loan
secured by the borrower's residence. Debt consolidation loans are
not a new idea; however, some institutions have acknowledged
increasing the maximum threshold amount financed in relation to the
value of the collateral. Loan-to-value (LTV) ratios have increased
from previous standards of 80 to 90 percent to as much as 125
percent of appraised value.
Some banks in this Region are joining this trend toward high LTV
residential lending: A number of institutions routinely offer 100
percent financing. Institutions extending this type of credit also
are permitting extended periods of interest-only payments, in some
cases as long as ten years. It appears that most small community
banks are not actively seeking these types of loans. However,
interest in participating in high LTV residential loan programs
could increase if both consumer demand and competition from larger
institutions continue to grow.
Residential mortgage lending represents a significant business for
insured financial institutions in the Region. A total of 272
institutions hold portfolios of residential mortgage loans that
exceed 25 percent of total loans and 100 percent of Tier 1 capital.
By the first quarter of 1998, insured institutions in the Region
had over $281 billion or about 41 percent of their total loans in
1- to 4-family mortgages, making residential lending the largest
single loan category for the Region's institutions. The Region's
banks currently have approximately 37 percent of the Region's total
outstanding 1- to 4-family mortgages, up from 25 percent as of
Underwriters of high LTV mortgages should be careful not to make
credit and pricing decisions based on assumptions that the
favorable economic conditions experienced over the past six years
will continue indefinitely. Low interest rates, coupled with high
employment and rising income levels, have contributed to consumers'
ability to service increasing debt loads. These circumstances also
are major factors in the increasing value of residential properties
in most of the Region's major markets. Adverse changes in these key
factors could increase potential credit losses from this type of
lending. There are additional considerations that lenders should
take into account:
Loans collateralized by 1- to 4-family dwellings with high LTVs
generally will not meet secondary market standards set by
government-sponsored enterprises, such as Fannie Mae and Freddie
Mac, meaning the loans will likely be less liquid and will remain
in the loan portfolio (at least initially).
Banks that engage in this type of lending may be more exposed
to changing economic conditions that adversely affect consumer
income levels and the value of residential properties.
While consolidating unsecured debt into a secured loan structure
may provide some comfort to the lender, the possibility remains
that some consumers will simply increase credit card debt after the
consolidation is completed, thereby increasing the likelihood of
Implications: Single-family residential mortgage lending is
the most significant loan category for insured financial
institutions in the San Francisco Region. Some institutions have
loosened underwriting standards in response to increased
competition from finance companies and subprime lenders. High LTV
debt consolidation financing is more common now than in the past.
The performance of these loans is at greater risk in the event of
an economic downturn than traditional single-family mortgage loans.
Consequently, management needs to ensure that changes in the credit
risk profile of the loan portfolio caused by eased underwriting
standards are incorporated into the bank's allowance for loan and
lease loss adequacy reviews.
Millen L. Simpson, Financial Analyst Catherine I.
Phillips-Olsen, Regional Manager