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Federal Deposit
Insurance Corporation

Each depositor insured to at least $250,000 per insured bank

Home > Industry Analysis > Research & Analysis > San Francisco Regional Outlook - Third Quarter 1998

San Francisco Regional Outlook - Third Quarter 1998

Regular Features

Increased Construction 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 capital ratios.
  • 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 competitors.


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 States

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.

Chart 1

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.

Chart 2

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, and consolidations.

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.

Chart 3

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 year-end 1984.

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 bankruptcy.

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

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Last Updated 7/26/1999

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