A Recovery in Some Atlanta Region Commercial Real Estate Markets Remains
Constrained by Weak Economic Growth
The recent recession was particularly problematic for commercial real
estate (CRE) markets in the Atlanta Region. The subsequent "jobless"
recovery has contributed to low absorption rates that have prevented some
markets from rebounding. This article examines CRE market conditions by
property type in the Region's major metropolitan areas, evaluates levels
of community bank exposure to CRE lending, and identifies areas where
prolonged weak economic growth and market downturns have resulted in CRE
asset quality deterioration.
Office Markets Have Been Hit Hard by the Recent Recession
The recent recession adversely affected office real estate markets in
the Atlanta Region. Unlike past economic downturns, net absorption rates
turned negative in many areas as layoffs disproportionately affected salaried
office workers. Simultaneously, new space remained in the construction
pipeline because of developers' prior expectations of continued economic
growth. Subsequently, market conditions in many instances deteriorated
rapidly as vacancy rates rose significantly (see Chart
1). Some metropolitan areas that previously had been characterized
as tight markets suddenly faced the prospect of double-digit vacancy rates.
Until recently, low interest rates had helped support market values; however,
as leases expire and rent appreciation remains weak owing to continued
fragile economic growth, these markets may come under pressure. During
first quarter 2003, office market values declined nationwide.1
Widespread deterioration in fundamentals continued to occur in the Region's
major metropolitan statistical areas (MSAs) as office employment growth
remained lackluster in the face of further layoffs, and as space offered
for sublease continued to inflate vacancy rates.
Office markets in metropolitan
areas that are home to large concentrations of high-tech employment (Atlanta,
Raleigh, Northern Virginia) generally experienced the greatest deterioration.
The Raleigh and Atlanta MSAs reported the Region's highest office vacancy
rates in first quarter 2003, while rates in Atlanta and Northern Virginia
have more than doubled during the past few years. Some submarket vacancy
rates in Raleigh and Northern Virginia recently have spiralled to above
30 percent.2 Though submarket vacancies
in Atlanta have yet to reach that level, some local developers speculate
that the downturn in the local office market may be the worst in nearly
three decades.3 In contrast, vacancy rates
in office markets characterized by significant back office operations
and call centers, such as Tampa, have declined during
the year ending first quarter 2003.
Industrial Real Estate Market Conditions Continued to Weaken in Early
Industrial real estate market conditions in the Atlanta Region began to
deteriorate with the onset of the recent recession as employment in manufacturing,
wholesale trade, and high-tech industries started to erode. Average vacancy
rates in all major regional markets have increased significantly. This
trend was particularly evident in Atlanta, as net absorption rates turned
negative even as new completions continued. Job losses in the nation's
manufacturing sector did moderate in late 2002; however, by early 2003,
the sector, particularly among high-tech industries, weakened again. As
a result, the Region's industrial markets experienced negative net absorption
(see Chart 2) at levels rivaling those at the
beginning of the recent recession. Nonetheless, vacancy rate increases
were not as great as during the onset of the recent recession, as completions
were much lower.4 Continued job losses in
manufacturing likely will forestall a rapid recovery in the Region's industrial
real estate markets.
Retail Real Estate Has Outperformed Other Commercial Real Estate Types
in Several Atlanta Region Markets
Retail real estate generally has outperformed other market types during
and following the recent recession. Typically, during an economic downturn,
retail real estate is pressured by declines in consumption as incomes
fall and consumers attempt to reduce debt. In the recent downturn, however,
consumer spending remained strong and debt levels increased, supporting
growth in the retail real estate market. However, prolonged weak job growth,
the potential for a retrenchment in consumer spending, and the risk of
a "double-dip" recession may increase the vulnerability of this
market type going forward.
Following the recent
recession, rent appreciation in the Orlando and Miami MSAs declined
significantly as domestic and international visitor spending cooled retail
markets. Subsequently, however, rents have appreciated strongly in most
of the Region's retail real estate markets (see Chart
3). Rental rates in the Jacksonville, West Palm Beach, and
Tampa MSAs have deviated from this pattern during the past year, a
trend that in part may be due to continued market space expansion. Since
1999, total retail stock in the Tampa metro area has increased more than
10 percent, nearly twice the growth rate of major markets nationally.
Year-to-date third quarter 2002 new space construction in the Jacksonville
metro area was up more than 120 percent from the previous year. Such supply
increases prompted one investment bank earlier this year to characterize
this MSA as having the greatest vulnerability to oversupply in the state.5
The recent recession had a chilling
effect on the Atlanta Region hotel industry, as tourism and convention
business declined significantly. Double-digit year-ago declines occurred
in revenue per available room (RevPAR) in all major markets except Columbia,
by fourth quarter 2001 as occupancy and room rates fell substantially.
This trend was particularly evident in the Orlando and Atlanta
MSAs, where the tourism and convention businesses are essential components
of the local economy. By late 2002, the tourism industry was showing signs
of an emerging recovery, allowing RevPAR to rebound from the lows of the
previous year. However, in early 2003 the looming military campaign in
Iraq and apparent weakening economic growth dealt another round of setbacks
to the tourism industry. As Chart 4 shows, RevPAR
declined from a year earlier in all major markets except Fort Lauderdale,
Washington, DC, and Miami for full- and limited-service hotels during
first quarter 2003. The events of early 2003 highlight the vulnerability
of the hotel real estate market to economic and geopolitical uncertainties
that could continue to pressure any further near-term recovery. Many analysts
consider the hotel sector the property class most likely to experience
defaults.6 Limited-service properties operated by independent
owners appear more vulnerable to default than full-service properties
and chains operated by large corporate owners.7
Weak Economic Growth, Continued Construction, and an Increase in Home
Ownership Have Pressured Multifamily Markets
The "jobless" recovery and record levels of home ownership brought about
by low interest rates have contributed to rising apartment vacancies (see
Chart 5), while new construction continues to
inflate multifamily stock in the Atlanta Region. Rental vacancies have
increased across the Region during the past two years, while rent inflation
remains below the U.S. average in all areas except the Miami and Washington,
DC, MSAs. Nominal rents declined during the year ending fourth quarter
2002 in the Charlotte, Greensboro, and Atlanta metro areas. Persistent
low rent inflation across the Region could constrain cash flows for property
owners and, as a result, adversely affect their credit quality.
CRE Lenders Have Performed Well, but Caution Is Warranted
CRE lenders in the Region have performed fairly well throughout this cycle.
Profitability has remained solid while capital levels and reserves have
held steady.8 Despite this positive performance,
modest signs of asset quality weakness have emerged. Total noncurrent
loans have risen in each of the past two 12-month periods ending March
31, 2003, driven primarily by deterioration in commercial and industrial,
construction and development, and 1- to 4-family loans. Noncurrent nonresidential
loan levels also have increased moderately. Nevertheless, 34 percent of
CRE lenders reported an increase in noncurrent CRE loan levels at March
31, 2003, compared to only 28 percent a year earlier.
In the Atlanta Region, community institutions are the primary funding
source of nonresidential real estate loans.9
In fact, median CRE exposure among community banks in major CRE markets
was 21 percent as of March 31, 2003, 6 percentage points higher than the
median CRE exposure among mid-tier banks in these same markets.10
However, community banks headquartered in areas such as Atlanta, Raleigh,
and Miami, where office vacancy rates have risen by at least 7 percentage
points during the past year, have reported a significant divergence in
asset performance. Community banks based in the Atlanta MSA reported a
noticeable increase of 52 basis points (to 0.94 percent) in noncurrent
CRE loans during the 12-month period ending March 31, 2003. This compares
to 0.73 percent among all CRE lenders across the Region. The exposure
of the Atlanta MSA to industries that have been hard hit during the past
18 months, such as technology, telecom, and tourism, increases the vulnerability
of institutions headquartered there to rising office vacancy rates. In
addition, a study conducted by Smith Barney suggests that
community banks based in the Atlanta area are niche lenders to limited-service
hotels.11 Given the pressure on the travel
industry, hotels are considered the weakest property class in the study.
A significant exposure to this industry segment may contribute to further
credit quality weakness. Because Call Report data do not allow for separation
of loans by property type, it is difficult to discern the level of bank
and thrift industry exposure to the hotel sector.
By contrast, despite noticeable increases in office vacancy rates, community
banks headquartered in the Raleigh and Miami MSAs have reported improving
CRE asset quality. The ratio of noncurrent nonresidential loans held by
community banks in each of these MSAs declined during the 12 months ending
March 31, 2003, to roughly 0.22 percent. Nonresidential loans in both
areas have surged during the past two years. CRE loans as a percentage
of total loans have risen approximately 28 percentage points, to 48 percent
among banks based in the Raleigh MSA. This ratio increased almost 12 percentage
points among banks based in the Miami MSA, to roughly 51 percent. Regionally,
CRE loan portfolios grew just under 7 percentage points during this period
to 44 percent of total loans.
According to Torto Wheaton Research, forecasts calling for steady increases
in office employment during each of the next six years may be fueling
growth in CRE loan levels.12 However, at
year-end March 31, 2003, a robust pace of loan growth may have masked
higher past-due loan amounts. Management of insured institutions should
be aware that deterioration in asset quality often lags the business cycle,
so lenders should monitor concentration levels carefully in the near term.
Job creation is expected to remain stagnant until business investment
and economic growth accelerate. As a result, capital levels may be vulnerable
among community banks headquartered in areas with significantly higher
vacancy rates and CRE exposures, such as the Atlanta, Raleigh, and Miami
MSAs. Continued economic weakness could contribute to an increase in office
foreclosures and higher charge-offs among local institutions.
Perspectives from the FDIC Regional Director
In the past few years,
examinations of banks with concentrations of commercial real estate (CRE)
have generally reflected sound risk management practices and overall satisfactory
conditions. Nevertheless, the macro trends cited in the accompanying article,
particularly with regard to the office market, prompted the Division of
Supervision and Consumer Protection to initiate a CRE credit risk analysis
pilot program in January 2003. The purpose of the pilot was to gather
significantly more CRE lending data than are available from call reports
and briefly to assess risk management in Atlanta-area banks with large
CRE concentrations. Preliminary results indicate that Federal Deposit
Insurance Corporation-supervised banks continue to avoid high concentrations
in the types of CRE loans identified as primarily susceptible to declining
market conditions (i.e., office, industrial, retail, hotel, and multifamily).
As a general rule, the banks included in the program were focused on the
development and construction of residential properties, a market that
remains relatively strong. Further, banks are well aware of CRE lending
risks and are managing those risks in a satisfactory manner. As analysis
of the pilot program data is completed, additional information will be
presented. It is also likely that, as part of our ongoing supervisory
efforts, the program will be expanded to other geographic areas that exhibit
considerable stress in CRE markets.
Mark S. Schmidt
Thus far, the Region has experienced
no significant deterioration in CRE property values. Falling capitalization
rates and robust investor demand have supported prices. Low interest rates
and cost-cutting measures also have allowed many owners to break even
at lower occupancy rates. In cases where cash flow has been negative,
anecdotal reports indicate that owners have been able to sell the property
for more than the debt outstanding. The ability of property owners to
sell in order to repay debt may diminish should property values weaken.
Property valuations could soften if fundamentals continue to erode. Property
cash flow, particularly in the office sector, will be reduced as expiring
leases reprice downward. Also, technology may lower the demand for office
space and lead to lower rental rates. Computer servers have greater capacity
but are physically smaller and require less square footage than they did
even five years ago. Electronic storage costs continue to fall, allowing
firms to migrate from paper document retention systems, which lessens
the need for file room. Improvements in telecommunications have allowed
many firms to outsource work to remote locations, reducing their need
for space. The recent productivity gains from computing technologies,
if sustained, will likely reduce the demand for office employment. These
factors imply that occupancy rates may be lower going forward. Lower occupancy
rates suggest that rental growth rates will be much slower in the next
expansionary cycle than the last. A reduction in cash flow from these
structural and cyclical forcesreduced occupancy rates and slower rent
growthwould offset low capitalization rates and likely lead to lower
valuations. In the current cycle, rising property values have contributed
to generally strong CRE loan performance among insured institutions. Therefore,
going forward, market participants should monitor property valuations
for signs that any of the key fundamentals are weakening.
Dean Starkman, "Property Values Finally Decline With Office Space Falling
1.7%," Wall Street Journal, May 28, 2003.
Northern Virginia submarkets: Herndon and Sterling. Raleigh submarkets:
Cary, Glenwood/Creedmoor, Northeast Wake County.
Jarred Schenke, "Developer: Atlanta Office Recession May Rival '73-'75,"
Atlanta Business Chronicle, March 21, 2003.
Average vacancy rates in the Washington, DC, Fort Lauderdale,
and Raleigh MSAs declined modestly in first quarter 2003 from a year earlier.
Gregory Richards, "Is City Building Its Way into a Retail Space Glut?"
Florida Times-Union, April 4, 2003.
"CRE Losses Likely to Be Modest in this Cycle," Citigroup Smith Barney:
Equity Research Banks, June 3, 2003.
Peter Henderson, "Hotel Industry Sees Downturn Moving Deals," Reuters,
June 5, 2003; Barbara DeLollis, "Hotels Upgrade Freebies to Fill Empty
Rooms; Meals, Sweepstakes Offered," USA Today, July 8, 2003.
For purposes of this analysis, CRE lenders hold at least 25 percent of
assets in nonresidential real estate loans.
Community banks hold assets less than $1 billion and exclude de novos
and specialty institutions.
Major CRE markets in the Atlanta Region are Atlanta, Charlotte, Fort Lauderdale,
Jacksonville, Miami, Orlando, Raleigh, Tampa, and West Palm Beach.
"CRE Exposure for the Banking Industry," Smith Barney: Bank Weekly,
March 4, 2003.
Improved Security Is Vital
as Information Technology Grows More Complex
Perhaps no area of banking
has changed as significantly during the past ten years as information
technology (IT). For instance, insured institutions increasingly have
made banking services and data available to customers through automatic
teller machines (ATMs) and transactional websites. The complexity of maintaining
a secure IT environment undoubtedly will increase as banks continue to
enhance technological capabilities and delivery channels.
At the same time,
attacks on IT systems are increasing. Every day, new vulnerabilities,
labeled with such arcane names as denial of service attacks, buffer overflow
attacks, and session hijacking, are reported nationwide.1
Experts estimate that the number of attacks in 2003 will be twice that
in 2002. The results of a recent Computer Security Institute/Federal
Bureau of Investigation (CSI/FBI) survey showed that the vast
majority of companies polled had experienced some type of attack in the
past 12 months, many resulting in substantial financial losses.2
The growing complexity of the
IT environment and the potential for substantial monetary losses increase
the importance of IT security. Vulnerability to security breaches has
been heightened as a weak economy during the last few years may have pressured
IT budgets. In an effort to cut costs, the outsourcing component of IT
budgets may grow the most; however, the decision to outsource brings with
it particular concerns.3
In addition, merger activity raises many IT issues, as complex networks
must be coordinated or combined.
IT Security Breaches Present
Substantial Risks for Insured Institutions
The potential damage from security breaches is not only monetary. Although
the potential for massive fraud exists if adequate controls are not in
place, the impact from lost data or a tarnished reputation is hard to
overestimate. While difficult to quantify, an insured institution's reputation
is critical to many customers, who expect their confidential financial
information to be secure. There are several sources of regulatory guidance
for insured institutions on safeguarding consumer data and best practices
for IT security.4
The increased use of Internet-connected
systems poses substantial vulnerability for bank-owned systems and data.
In fact, the CSI/FBI survey reports that Internet connections are becoming
an increasingly frequent point of attack. The Federal Deposit Insurance
Corporation (FDIC) has cautioned banks that maintain computer networks
connected to the Internet to be aware that such connections may pose risks
to their information assets and to ensure that their staff or service
providers perform regular reviews of security.
Technology Facilitates Retail
Delivery of Banking Services and Bolsters Bank Productivity
During the past decade, many relatively new technologies have become increasingly
common, even among smaller, community institutions. Banks are opening
their networks to provide enhanced services to customers through telephone
banking, ATMs, and transactional websites. The importance of these electronic
distribution mechanisms is underscored by some institutions' business
plans, which rely heavily on the anticipated benefits of increased customer
Internally, technological advances
have changed the dynamics within many insured institutions. For example,
some banks are using wireless technologies, and the use of customer relationship
management (CRM) software is growing.5
Wireless technologies have facilitated network connectivity within some
institutions and among branches. CRM software holds the promise of helping
banks navigate their complex relationships with customers, with the goal
of maximizing the profitability of these relationships.
New Technologies Pose New
Many technologiessuch as smart cards, electronic bill presentment, and
the migration of traditional banking into the on-line realmare poised
to alter further how banks do business (see Chart
1). More insured institutions are moving toward nonproprietary (often
very low cost) software, such as Linux, as alternatives to costly proprietary
operating systems. Banks may also adopt more advanced authentication schemes,
which help prove a user's identity on a computer network. Although many
bank customers can now access account information with an ATM card and
a password, biometric technologies, such as retinal or fingerprint scanners,
may eventually become the norm. Some institutions may be considering the
benefits of more established technologies, such as moving toward on-line
check imaging. Others are considering ways to reconfigure current systems
in order to implement real-time processing.
The use of shared application
services may grow in the near term as banks "rent" software
services or processing time, rather than buy expensive in-house systems.
More customers are now paying bills on-line; soon these customers may
receive bills on-line as well, and banks may play a critical role in developing
Against this backdrop of rapid
technological change, with its accompanying risks, this article explores
a key concept associated with maintaining a secure IT environmentlayered
"Defense in Depth"
Is Key to Successful IT Security
Perfect security does not exist,
and no one solution exists for all IT security needs. Persistent and skilled
perpetrators can eventually compromise any security system. Therefore,
bank management should not rely on one security mechanism. "Layered"
security, while not a new concept, remains highly effective. By layering
IT security, insured institutions can increase the likelihood that should
one security mechanism fail, another will prevent a breach. IT specialists
typically refer to this concept as "defense in depth." As one
chief technology officer said, "It's like an onion. The more layers
a hacker has to peel through, the longer it takes and more frustrating
it becomes to reach the center."7
The concept of layered network
security may be new to some community banks that have migrated only recently
to more complex computer networks or become more reliant on Internet-connected
systems. While each institution must ultimately assess the level of layered
security it needs, the following components, if incorporated into an overall
IT security strategy, can help minimize disruptions to, or compromises
of, a bank's technology infrastructure.
Segregation of networks:
Maintaining appropriate segregation among computer networks is vital.
For instance, data traffic originating from one (perhaps sensitive and
confidential) network segment need not be broadcast to all servers or
workstations on the local area network. IT managers may segment the network
by installing intelligent switches rather than network hubs. Similarly,
not all information that resides on network devices may require the same
level of access by all users. Further segmenting network information by
employing the "least privilege" concept, whereby employees are
given access on a "need to know" or "need to do" basis,
is also important.
Firewalls: A firewall
is a set of componentshardware and softwarethat resides between two
or more systems to block unauthorized traffic. Firewalls are useful in
segregating networks and are the minimum security for institutions that
maintain a connection to the Internet. Firewalls are essentially fences
around, and sometimes within, a network. Generally, a firewall protects
against unauthenticated logins to the internal network. Often, banks use
firewalls between internal networks and an Internet connection. Firewalls
may also create demilitarized zones, a computer host or small network
inserted as a "neutral zone" between a bank's private network
and the outside public network.8
A layered security process requires institutions to consider external
measures, which enable an institution to see its network from an outsider's
perspective. This approach allows monitoring of potential issues such
as website defacements, hijacking of sessions or transactions, the need
for software patch revisions, and open ports on a firewall and network.
assessments: All security organizations recognize running vulnerability
scans of an IT infrastructure as a best security practice. Unfortunately,
many companies run these scans only annually or quarterly. New vulnerabilities
occur daily; the CERT Coordination Center generally publishes
50 or more a week.9
Therefore, IT managers should consider continuous scanning, or at least
at more frequent intervals than quarterly. For example, frequent scanning
would have protected companies from vulnerability to the "SQLSlammer"
worm; information about this vulnerability was available in July 2002,
but the worm did not fully materialize until 2003.10
Software upgrades, installation of new services, and human error also
can contribute to the development of vulnerabilities. Instituting a scanning
process at appropriate intervals can help minimize any resulting disruption
to the IT infrastructure.
An intrusion detection system (IDS) represents another layer of securitya
"burglar alarm" that informs IT management when someone may
be attacking the network. An IDS typically scans for anomalies in network
traffic or data flows that match a known pattern of misuse. IT professionals
normally place an IDS in front of or behind the firewall as a network
monitor, or an IDS may reside on host systems. When placed on the host
system, the IDS will examine log files for evidence of misuse. An IDS
will detect attempted intrusions but will not stop or prevent them.
Encryption: When transmitting
sensitive data across the Internet or another untrusted medium, IT management
should ensure that the information is encrypted to prevent unauthorized
access. IT managers also should encrypt sensitive data any time the data
reside on a database that could be accessed by an unauthorized source-internal
A virus is a piece of programming code, usually disguised as something
else, that causes some unexpected and usually undesirable event. A worm
is a self-replicating virus that does not alter files but resides in active
memory and duplicates itself.11
Many viruses and worms exploit known vulnerabilities in operating systems
or commonly used applications. IT managers should consider using virus
protection methods for data entering bank networks, as well as periodic
scanning of files within the network. All hosts, both servers and workstations,
should be protected, and should have frequent virus definition updates.
Also, the FDIC has recommended that banks implement an effective software
patch management program as one of the best ways to prevent damage by
viruses or worms.12
trained staff and users: Placing appropriate emphasis on IT security
at the senior management and board of directors level is the first step
toward minimizing system breaches. By establishing effective policies
and procedures, boards of directors can promote an atmosphere that addresses
critical security areas and establishes appropriate guidelines and standards
for all employees. A well-educated staff also can help to prevent losses
resulting from "social engineering attacks," which occur when
users are tricked into bypassing security procedures (e.g., an employee
is tricked into revealing his password).
Successful IT Security
Requires Constant Vigilance
IT security is
not a one-time event, but a continuous, multifaceted process. The anticipated
growth in new technologies and the rapidly changing landscape of IT call
for heightened vigilance, as vulnerabilities can appear quickly and compromises
can be costly. A layered security approach, coupled with well-defined
exception thresholds and close monitoring, are essential. Each insured
institution must assess its own IT risk profile; an awareness of available
network security components and existing regulatory guidance will facilitate
Senior Financial Analyst,
Division of Insurance and Research
with contributions from the Chicago Region's
Division of Supervision and Consumer Protection
Denial of service attacks flood a computer network with data in order
to deny access to legitimate users. For financial institutions with a
heavy on-line presence, these types of attacks can be the most costly.
Appendix B to Part 364 of the FDIC's Rules and Regulations establishes
guidelines to help ensure that financial institutions appropriately safeguard
customer data. It calls for insured institutions to develop and implement
an information security program that involves the board of directors,
assesses risk, and manages and controls risk associated with protecting
customer information. Appendix B lists many security measures, some of
which are discussed later in this article.
FIL 8-2002, February 1, 2002, Guidance on Managing Risks Associated with
Wireless Networks and Wireless Customer Access, www.fdic.gov/news/news/financial/2002/fil0208.html;
and "Small Banks Seen Ready to Give CRM Another Look," American
Banker, February 4, 2003.
The concept of layered controls is referenced in the Information Security
Booklet of the Federal Financial Institutions Examination Council's Information
Technology Examination Handbook, December 2002, page 13. The handbook
can be downloaded from www.FFIEC.gov.
"Layering Security to Protect Bank Networks," Bank Technology
News, April 4, 2003.
The CERT® Coordination Center (www.cert.org)
is a federally funded research and development center that addresses computer
security incidents and vulnerabilities, publishes security alerts, researches
long-term changes in networked systems, and develops information and training
to help improve computer security.
The SQLSlammer worm led to the compromise of many vulnerable machines
and degraded performance on affected networks.
The Dallas Region's
economy is beginning to improve, suggesting that recovery from the 2001
recession may be taking hold. Total nonfarm employment in the Region was
essentially unchanged at midyear 2003 compared to midyear 2002, a significant
improvement from the loss of 280,000 jobs in the year-earlier period.
Positive employment trends are evident in the finance, insurance, and
real estate sector; health and education services; state and local governments;
wholesale trade; and professional business services. However, conditions
in the telecommunications and high-tech industries remain weak. Colorado,
Louisiana, and Oklahoma continued to lose jobs in the second
quarter of 2003 on a year-ago basis in the durable goods manufacturing,
telecommunications, and energy sectors.
While overall employment trends
are becoming more favorable, two factors point to a fragile economic recovery
in the Region. First, the manufacturing sector remains weak. Structural
and cyclical weaknesses have resulted in job losses, particularly in the
subsectors of industrial machinery and equipment, textiles and apparel,
and lumber and wood products. On a positive note, the pace of job loss
has declined, as many manufacturing plants have reached minimum staffing
levels necessary to continue operating.
Second, although government
hiring was a bright spot during the economic slowdown, financial stress
experienced by state and local governments may constrain the Region's
job growth going forward. As a result of the 2001 recession and subsequent
weak U.S. recovery, tax revenues are declining in half the Region's eight
states, and revenue growth in the other four states is well below the
trend of the late 1990s. In fact, budget deficits are forecast for six
of the Region's eight states in 2003.1
As a result of the budget problems, states and localities have begun to
aggressively scale back spending and raise taxes. For example, the Tennessee
state government mandated that all agencies cut spending by 9 percent,
permanently eliminated many vacant government positions, discontinued
health coverage for more than 160,000 workers, and significantly increased
tuition at state universities.
The fragile nature of the economic
recovery is also apparent in an analysis of the Region's metro and rural
metro areas continued to lose jobs in the first six months of 2003, though
a majority of metro counties showed positive employment growth. Rural
counties, on the other hand, showed aggregate employment growth of 0.6
percent in the first six months of 2003, compared to losses of 0.9 percent
and 0.8 percent for all of 2002 and 2001, respectively. The divergence
between metro and rural performance is not unprecedented during the early
stages of recovery. Rural areas have preceded the nation out of recession
several times in the past, and rural job losses occurred earlier in this
cycle.3 As shown
in Chart 1, the recent growth in rural employment
was led by improvement in the services sector and occurred despite continued
weakness in manufacturing.
Despite recent employment gains, rural areas
face many economic challenges in the months to come. Rural economies tend
to be less diversified than their metropolitan counterparts, and often
depend on a few industries. Structural shifts, such as the movement of
manufacturing production overseas, have resulted in the loss of many high-paying
jobs that will not return when the recovery becomes more robust. Moreover,
many of the economic factors that affect the demand for rural products
are typically global in naturesuch as the value of the U.S. dollar, foreign
incomes and preferences, and U.S. farm and trade policiesand are beyond
the control of rural businesses. In addition, the Region's rural areas
are linked closely to the agricultural sector, in which weakness continues
to pose challenges for rural economies and rural financial institutions.
The Agricultural Sector Is Showing Signs of Improvement, but Challenges
The Region's agricultural sector is vast, encompassing 473 million
acres, or 61 percent of the land area. Crops are highly diversified throughout
the Region; in addition to the southern staples of livestock, cotton,
corn, soybeans, and wheat, the Region's farmers produce timber, sugar
cane, rice, and aquaculture (catfish and shrimp). The Region produces
the majority of U.S. aquaculture and rice, but the annual dollar volume
is significantly less than is generated by other crops.
industry has been affected adversely by low prices for the past seven
years, primarily because of national and global overproduction (see Table
1). National net farm income peaked in 1996 at $54.8 billion but then
gradually fell through 2001, when it was $45.7 billion.4
In 2002, because of the severe drought that affected much of the Midwest
and West, as well as lower levels of government subsidies, net farm income
fell dramatically to $30.2 billion. Regional and national trends in farm
income are similar, and 2002 regional data (which will not be available
until late 2003) are expected to show a significant decline.
Prices Remain Weak, but Cattle and
Other Crop Prices Are Expected to Improve
Grain prices are for marketing year of each crop. Cotton quantities
are per pound; other crop quantities are per bushel; livestock are
per hundredweight. Broiler prices are set by individual contracts
and are not available for analysis.
Sources: USDA World Agricultural Supply and Demand Estimates, July
The U.S. Department of
Agriculture (USDA) forecasts national net farm income to recover
to $46.2 billion in 2003. However, a look at three products that are critical
to the Region's agricultural economy suggests a mixed outlook for the
Cattle: The Region produced
about one-third, or $13.3 billion worth, of all U.S. beef in 2001, making
livestock production a significant economic driver for many rural counties.
In 2002, drought destroyed grazing lands, forcing many ranchers to sell
off herds because of a shortage of feed. As a result, cattle prices declined
in late 2001 and 2002, and ranchers experienced the brunt of the declines
because cattle are not protected by federal farm programs. However, smaller
herds have contributed to a significant increase in prices during 2003
(see Table 1), a trend that bodes well for the
The Region's poultry industry, which is highly concentrated in Arkansas,
Mississippi, and Texas, produced $5.6 billion in cash receipts
in 2001 but is showing clear signs of weakness. Overall U.S. production
is expected to decline significantly in 2003 (down 1.1 percent from year-ago
levels), as companies are placing fewer chicks with producers in response
to declining overseas demand. Such a trend could hurt producers' incomes,
in both the Region and the nation, as most producers have significant
fixed infrastructure costs that must be covered by production volume.
In addition, producers are being affected adversely by outbreaks of avian
influenza and Newcastle disease, which could cost the industry more than
$100 million in 2003.5
Cotton: The Region's
cotton industry is significant ($2.4 billion in cash receipts in 2001,
about half the U.S. total) but troubled. Cotton prices have been below
the break-even point of approximately 73 cents per pound since 1996, largely
because of global overproduction, a situation that was aggravated in 2002
by the global recession. Fortunately for producers, the 1996 and 2002
Farm Bills have implemented favorable subsidy schedules for cotton producers.
However, these payments have also encouraged overproduction and therefore
have contributed to declining prices. This year, continued overproduction,
coupled with stable demand, could drive prices down about 10 cents per
pound by harvest time.6
Overall, the expected improvement
in cattle prices should bolster the Region's agricultural sector significantly,
offsetting weakness in the cotton and broiler markets. Prices for other
commodities, such as corn, wheat, and soybeans, are expected to improve
as well (see Table 1). However, the benefits
could be derailed by continued drought conditions. As shown in Map
1, which compares the summers of 2002 and 2003, drought remains significant
in New Mexico and Colorado, and abnormally dry conditions have
moved into much of Texas. On the positive side, drought conditions have
abated entirely in Louisiana, Arkansas, and Mississippi. Although drought
conditions usually contribute to higher crop prices because of smaller
harvests, the benefits accrue only to farmers who can raise normal crop
Rural Bank Performance
Is Showing the Effects of the Weak Rural Economy
Overall, rural community banks
continue to report relatively healthy financial ratios, but the strains
of the weak rural economy are emerging.7
Pretax earnings increased from 1.45 percent of average assets in 2001
to 1.60 percent in 2002 as low funding costs and a steepening yield curve
in the first half of the year increased net interest margins.8
However, asset quality trends have not been as favorable. Aggregate levels
of past-due and nonaccrual loans reached 3.23 percent at March 31, 2003,
up 18 basis points from a year earlier, and marking the highest first-quarter
level since 1993. It should be noted, however, that this level of problem
loans remains far less than what rural banks experienced during the agricultural
crisis of the 1980s. Loan charge-off rates continue to trend slowly upward,
also signifying some stress in lending portfolios. Capital levels, at
10.34 percent of total assets, continue to increase, providing protection
from economic swings.
Additional stress is evident
among community banks in cotton-producing areas. As illustrated in Map
2, the Region is home to 38 of the nation's top 50 cotton-producing
counties, and the aggregate performance of community banks headquartered
in these counties is considerably weaker than that of institutions elsewhere
in the Region. For example, community banks based in cotton-producing
counties reported pretax earnings of 1.24 percent of average assets in
2002, compared to 1.60 percent for rural community banks in the Region
as a whole. In addition, almost 9 percent of banks in these counties lost
money in 2002, compared with 4 percent of the Region's rural community
banks overall. Although overall past-due loan levels are roughly the same,
institutions based in the cotton-producing counties reported higher levels
of noncurrent loans (1.54 percent of total loans) than the Region's community
banks (1.27 percent) during first quarter 2003.9
Equity capital levels for insured institutions based in the cotton-producing
counties were reasonably strong at 9.97 percent of total assets but remain
37 basis points below those of all rural community banks in the Region.
The Region's rural economy
is showing signs of life despite a prolonged slump in the agricultural
and manufacturing sectors, but recovery is not assured. Higher cattle
prices should boost the agricultural sector, but continued drought conditions
in the western half of the Region could diminish any positive effects.
The Region's manufacturing sector remains weak and may stay sluggish for
an extended period even after the general economy recovers. Community
bank performance reflects the economic stress evident in rural areas but
is expected to improve when the agricultural and manufacturing sectors
To help rural bankers face
economic challenges, the Federal Deposit Insurance Corporation is actively
engaged in outreach to the banking community, particularly in areas that
rely significantly on the agricultural sector. These meetings, as well
as ongoing Director College programs, represent an effective way to maintain
a dialogue with bankers on the important risk management issues facing
the industry today.
State budget figures were reported in the National Conference of State
Legislatures' State Budget Update, February 2003. New Mexico
and Arkansas are not forecasting a budget deficit largely because of recent
favorable employment trends that have limited state revenue declines,
and they have been more successful in matching revenues with expenditures.
2 For this article, rural
areas are defined as counties that are not included in metropolitan statistical
areas. This definition is used in calculating employment growth rates
and banking performance numbers.
Henderson, Jason, "Will the Rural Economy Rebound With the
Rest of the Nation?" The Main Street Economist, January
Simon Romero, "Virus Takes a Toll on Texas Poultry Business,"
New York Times, May 6, 2003.
6 Carl G. Anderson, "Cotton
Market Comments," Texas A&M University. Vol. 10, No. 7, May 12,
7 The term "community
banks" includes all FDIC-insured banks and thrifts with total assets
of less than $1 billion, excluding institutions that have been in existence
less than three years, and specialty banks, such as credit card institutions.
8 Pretax earnings figures
are used because a large number of community banks have elected Subchapter
S Corporation status, which eliminates income tax at the bank level and
prevents accurate after-tax comparisons with banks that have not elected
Subchapter S status.
9 Noncurrent loans are those
that are past due 90 or more days or are on nonaccrual status.
City Regional Perspectives
Turmoil in the Airline Industry Does Not Bode Well for Some of the Region's
Communities and Insured Institutions
Airlines have experienced
historically high levels of operating losses as demand remains low due
to the aftermath of 9/11, the outbreak of severe acute respiratory syndrome
(SARS), the conflict in Iraq, and a fragile domestic and global economy.
Stress in the airline industry has spilled over into the aircraft manufacturing
sector. The aviation and aerospace industries are highly important to
the economies of some of the Region's states (see Table
1), and aviation and aerospace companies are among the top employers
in several of the Region's communities (see inset box later in this article).
However, the share of employment in these industries is greatest by far
in the Wichita metropolitan statistical area (MSA). The
sector's weak performance is expected to continue to affect the Wichita
economy adversely and could contribute to some credit quality deterioration
among local insured institutions.
Kansas Ranks Second Nationally in Aerospace and Aviation Industry Employment, Far Higher than Any Other State in the Region
Jobs per Capita
Number per 1,000 Workers
State's National Ranking
Number of Workers
Percentage Employed in Aircraft and Parts Manufacturing
Percentage Employed in Air Transportation
Ratio of Industry Wages to State Avg. Wage (%)
Source: Commission on the Future of the U.S. Aerospace Industry, 2001 Reports
The U.S. Airline
Industry Has Not Recovered to Pre-9/11 Levels
Demand for air travel, measured in passenger boardings, has declined significantly
since 2000. After growing at an annualized rate of 3.4 percent between
1995 and 2000, year-over-year enplanements were flat in 2001 (due to the
economic downturn and declining business travel) until 9/11 (see Chart
1). 1 Business
travel represents a greater proportion of boardings and revenue passenger
miles because of the frequent flights.2
Business travelers also are more likely to pay full price, as their travel
needs are more inflexible than those of leisure flyers. As a result, the
scaling back in business travel exerted a disproportionately adverse effect
on the airline industry's bottom line.
Although air travel rebounded
from a virtual standstill in late 2001, it has not recovered to pre-9/11
levels. In fact, air travel has continued to weaken, in large part because
of uncertainty about the conflict in Iraq and fears about SARS. No clear
positive signals have emerged, but many air carrier analysts are optimistic
that a rebound in the U.S. economy in the latter half of 2003 and subsiding
fears about SARS will contribute to an uptick in air travel. Recently,
airlines have drastically cut fares to stimulate demand; however, lower
fares have resulted in declining operating profit margins. Nominal January
fares for members of the Air Transportation Association (ATA) declined
precipitously from nearly $150 in 2001 to less than $120 in 2003, the
lowest level since 1987.3
Air carriers also are scaling back the number of flights, modifying routes,
and withdrawing aircraft from service to reduce supply; in addition, nearly
70,000 full-time and 20,000 part-time workers, or 13 percent of the labor
force, were laid off between August 2001 and December 2002.4
Airlines also face rising fuel
prices, the second largest operating expense after labor costs. Jet fuel
prices nearly doubled from $0.56 per gallon in December 2001 to $1.02
per gallon in February 2003, before declining to approximately $0.80 per
gallon. To give some perspective, after remaining below $0.60 per gallon
for much of the 1990s following the Gulf War, jet fuel prices have fallen
below that level for only three months since August 1999.
Despite Government Assistance,
the Financial Health of Air Carriers Remains Precarious
The substantial revenue declines coupled with fuel price increases have
contributed to record losses for the airline industry. The industry reported
approximately $16 billion in losses in 2001 and 2002 combined, the first
time losses have occurred in consecutive years.5
Industry analysts estimate losses for 2003 between $5 billion and $8 billion.
The federal government's initial
response to the problems caused by 9/11 was to enact the Air Transportation
Safety and System Stabilization Act on September 22, 2001, which authorized
$5 billion in direct compensation to air carriers affected by the attacks.6
This legislation also authorized the establishment of the Air Transportation
Stabilization Board (ATSB) with the authority to issue up to $10 billion
in federal loan guarantees on behalf of airlines. As of May 2003, $4.6
billion in direct compensation had been distributed to 426 air carriers.7
The ATSB approved 5 of 16 applications, resulting in $1.5 billion in air
carrier loan guarantees, $900 million of which is earmarked for US Airways,
Despite government aid, the
airline industry has accumulated staggering debt levels during the last
two years. The average debt-to-capital ratio has risen from a historical
70 to 80 percent range to 90 percent.9
The current situation could become more severe than that following the
Gulf War, when seven major carriers filed for bankruptcy or liquidated.10
UAL Corp. ($25.2 billion, parent company of United Airlines, Inc.) and
US Airways, Inc. ($7.9 billion) filed Chapter 11 bankruptcy in 2002.11
American Airlines narrowly averted bankruptcy earlier this year through
significant employee concessions. However, the airline's ability to avoid
a cash flow crunch is far from certain. The same holds true for many other
carriers, including Northwest Airlines.
The Aircraft Manufacturing
Industry Is Critical to the Wichita Economy
The Wichita MSA, known as the "Air Capital of the World," is heavily concentrated
in the aviation and aerospace industries. According to a report issued
in October 2002 by the Commission on the Future of the United States
Aerospace Industry, Wichita is more dependent on the aircraft
manufacturing industry than any other city in the nation, with 193 aerospace
and aviation sector employees per 1,000 workers. The Seattle MSA, known
for its strong ties to Boeing Corporation, is a distant second with 93
aerospace and aviation sector employees per 1,000 workers. Wichita's top-ten
list of employers is a who's who of aircraft manufacturers: for example,
Boeing Aircraft Wichita (rank 1, 13,650 employees), Cessna Aircraft Company
(rank 2, 11,400 employees), Raytheon Aircraft Company (rank 3, 8,100 employees),
and Bombardier Aerospace Learjet, Inc. (rank 6, 3,152 employees).12
The Fortunes of the Wichita
Economy Are Closely Tied to Airline Carriers
Following the decline in passenger boardings in 2001, ATA-member airlines
removed nearly 300 aircraft from service and reduced future aircraft delivery
plans. Annual aircraft orders declined from more than 1,000 between 1998
and 2000 to fewer than 750 between 2001 and 2002.13
Options on orders plummeted from nearly 2,750 aircraft in 2000 to fewer
than 1,750 in 2002.14
The sudden and steep reduction in aircraft orders has caused the "Big
4" employers to cut thousands of jobs; the effects of these cuts have
hurt hundreds of other small ancillary companies in the Wichita MSA (see
Does not include seven-week furlough of 6,000 beginning June 2003.
Sources: Wichita Business Journal, Book of Lists 2000; Wichita
Business Journal, March 3, 2003, March 6, 2003, March 20, 2003,
and June 2, 2003; Boeing Corporation at
Statistics from the
Kansas Department of Human Resources show that the unemployment
rate in Wichita in April 2003 was 6.0 percent, up from 5.6 percent one
year ago, and well above the 4.4 percent reported at year-end 2001.15
Statewide, the unemployment rate was 4.8 percent, down slightly from 5.0
percent one year ago. The number of bankruptcies increased 39 percent
between year-end 1999 and 2002 and is now 10 percentage points higher
than the previous peak in 1998.16
Despite the significant layoffs,
the housing market and retail business remained strong throughout 2002.
The number of single-family housing permits climbed from 2,226 in 2000
to 2,817 in 2002, a 27 percent increase.17
Existing home sales were also strong, with sales through the first three
quarters of 2002 nearly equal to the year-earlier period,18
and existing home prices rose from $90,700 in 2000 to $97,600 in 2002.19
Extended unemployment benefits
help explain why the Wichita economy has not slowed as much as might have
been expected. The Economic Security and Recovery Act of 2001, enacted
on March 9, 2002, extended the 26-week unemployment insurance program
by 13 weeks. The Unemployment Compensation Amendments of 2003 enacted
May 2003 extend unemployment benefits for displaced workers in the airline
and related industries an additional 13 weeks.20
However, softening in the housing
market and in consumers' personal financial conditions could be emerging.
First-quarter 2003 single-family building permit activity was 15 percent
below first-quarter 2002 levels, and existing home sales were flat.21
The average marketing period for existing home sales now exceeds four
and Aerospace Industry Is Among the Top Employers
in Several of the Region's Larger Communities
to Wichita, the aviation and aerospace industry is important to
the economies of Cedar Rapids, Kansas City, Minneapolis,
and St. Louis. The largest of these MSAs are in Kansas,
Minnesota, and Missouri, and these states rank in the
top 25 nationally by share of employment in these industries (see
Table 1). Kansas, because of the significant
employment concentration in the aviation sector in Wichita, ranks
second in the nation behind Washington.
Louis International Airport became a major hub for American Airlines,
Inc., with the airline's acquisition of Trans World Airlines,
Inc. (TWA) in 2001.22 With more
than 9,000 employees, American Airlines is one of the top 15 employers
in St. Louis.23 In addition, St.
Louis is home to one of Boeing's large aerospace divisions. Boeing
is the second largest employer in St. Louis, employing more than
15,300 workers in 2002.24Increased
defense spending could help bolster the St. Louis economy.
Paul is headquarters for Northwest Airlines, Inc., the world's
fourth largest airline company.25
Northwest Airlines was the sixth largest employer in Minneapolis-St.
Paul at year-end 2001, with 18,270 employees.26
has been home to TWA's (now American Airlines) overhaul and maintenance
facility since 1957.27 The facility
currently employs 2,250 workers.28
In addition, Vanguard Airlines, Inc., headquartered in Kansas
City with over 900 employees, filed Chapter 11 bankruptcy in 2002,
and is now liquidating.29
is the world headquarters of Rockwell Collins, Inc., an aircraft-electronics
spinoff of Rockwell International, Inc.30
Rockwell Collins is the metro area's top employer; the 7,150-person
local workforce represents about 6 percent of the city's employment,
far exceeding the number of workers employed by the number two
employer (Cedar Rapids Community School District, with 2,775 employees).31
Increased defense spending is expected to contribute positively
to the Cedar Rapids economy.
wage concessions in the airline industry have had a negative effect
on employment and aggregate personal income in these communities.
However, even though aviation and aerospace companies are among
the largest employers in these communities, the relatively high
level of industrial diversity helps mitigate the adverse effects
of the weak aviation sector. As a percentage of total employment,
air transportation ranks sixth in the Minneapolis MSA and twelfth
in St. Louis, where aircraft and parts ranks eighth.32
The aviation and aerospace sector does not rank in the top 25 industries
in the Kansas City MSA.
The Local Banking Industry
Remains Strong for Now, but Stress Is Likely
Despite the stress in the aviation industry, overall credit quality among
the 36 insured institutions headquartered in the Wichita MSA has not deteriorated
substantially. This can be explained in part because none of these institutions
reports direct exposure to large aircraft manufacturing companies, and
any commercial and industrial lending is concentrated in small-business
credits. However, in a community in which one of every five workers is
employed in the aircraft manufacturing industry, local bank performance
is expected to reflect the stress in this sector.
In Wichita MSA institutions,
the median past-due loan ratio was 1.76 percent as of March 31, 2003.
In comparison, the median past-due ratio for the Kansas City Region was
2.30 percent. Delinquencies in residential loan portfolios remained relatively
low at 2.12 percent, although this represents a significant increase from
0.40 percent two years ago. Again, the absence of increases in total nonperforming
loans may be attributed to the extension of unemployment benefits. However,
asset quality stress is becoming evident in a subgroup of institutions.
The number of institutions headquartered in the Wichita MSA reporting
delinquency ratios that exceed 5 percent has increased from one to seven
in the past two years. In addition, the proportion of institutions with
safety and soundness examinations showing Adversely Classified Assets
in excess of 25 percent of Tier 1 capital has more than doubled from 22
percent to 47 percent in the same period.
However, relatively high capital
and loan loss reserve levels provide a cushion for any asset quality weakness.
Insured institutions headquartered in the Wichita MSA reported a median
Tier 1 capital ratio of 9.09 percent as of March 31, 2003. Moreover, median
ratios of loan loss reserves to total loans and nonperforming loans were
high at 1.36 percent and 236.4 percent, respectively. Earnings remain
solid, with a median return on assets ratio of 1.00 percent. Fewer than
6 percent of the banks were unprofitable at the end of first quarter 2003.
Wichita Consumers May Face
Problems When Unemployment Benefits Expire
Air travel demand has yet to recover fully, and analysts expect airlines
to continue to post losses. Should the aviation industry experience weak
operating conditions into 2004, airline bankruptcies could rise, slowing
any recovery for the aircraft manufacturing sector. Consumers in the Wichita
MSA may find it difficult to continue their current spending levels and
service their debts, particularly when unemployment insurance benefit
Cofer, Jr., Senior Financial Analyst
Member airlines are Airborne Express, Alaska, Aloha, America West, American
(includes TWA), American Trans Air, Atlas Air, Continental, Delta, DHL
Airways, Emery Worldwide, Evergreen International, FedEx, Hawaiian, JetBlue,
Midwest Express, Northwest, Polar Air Cargo, Southwest, United, UPS Airlines,
and US Airways. Source is ATA's 2002 Annual Report, http://www.ata.org.
"A relatively small group of travelers (the frequent flyers who take more
than 10 trips a year) account for a significant portion of air travel.
While these flyers represent only eight percent of the total number of
passengers flying in a given year, they make about 40 percent of the trips."
www.airlines.org online handbook.
Airfare is for a 1,000-mile journey, exclusive of applicable taxes. Source:
Airlines in CrisisThe Perfect Economic Storm, Washington,
DC: Air Transport Association of America, Inc., http://www.airlines.org.
2001 airline industry losses totaled $8 billion. Source: Air Carrier
Financial Statistics Quarterly, U.S. Department of Transportation,
http://www.bts.gov/press_releases/. 2002 and 2003 loss estimates collected from variety of national newsprint and financial Web magazine articles.
ATSB has conditionally approved two of the remaining eleven applications
for approximately $117 million and rejected the other nine applications.
Sources of data are the ATSB Web site, http://www.treas.gov/offices/domestic-finance/atsb,
and an America West Airlines press release dated January 18, 2003, PRNewswire-FirstCall.
Between December 1990 and June 1992, six airlines filed Chapter 7 bankruptcy.
PanAm, Midway, and MarkAir liquidated. Continental, TWA, and America West
reorganized. In addition, Eastern Airlines liquidated during this period.
Source: Airlines in Crisis.
sharply in the Region during 2001; however, the rate of job loss has moderated
and is now tracking national trends (see Chart 1).1
Since March 2001, the beginning of the most recent recession, the Region
has lost about 2 percent of its employment base, virtually the same as
the nation. However, employment has declined more severely in some states,
such as New York and Delaware. Job losses in Massachusetts
reached almost 5 percent of the March 2001 level, more than double the
Several of the Region's
key industries have been hard hit by the economic slowdown. Compensation
has declined significantly in the securities industry. Wall Street bonuses
have been down sharply for two years, and layoffs since December 2000
in New York City alone (home to about 20 percent of the nation's
employment in this sector) total about 39,000, or 19 percent of the industry's
workforce. In addition, the Region's telecommunications, hotel and hospitality,
advertising, and computer consulting industries remain sluggish. The greater
Boston area, as well as parts of New Jersey that had benefited
from the high-tech and telecom boom of the 1990s, have experienced significant
layoffs in these troubled sectors. Employment declines also have occurred
in the Region's manufacturing sector; since the beginning of the 2001
recession, the Region has lost 14 percent of jobs in the manufacturing
sector, a slightly higher level than that of the nation.
in Certain Industry Sectors Will Benefit Parts of the Region
Like that of the nation,
the Region's economic outlook appears encouraging in the second half of
2003. Washington, DC, and suburban Baltimore have benefited
from increased federal spending and expanded employment related to homeland
security. In addition, population growth among the "echo boom" generation
(children of baby boomers) in some of the Region's larger metropolitan
areas has increased demand for teachers and other education professionals.
An aging baby boomer generation, in turn, has stimulated demand for health
A stock market rebound
is critical to any sustained economic recovery in the Region. The market
generates substantial compensation for Wall Street employees and affects
the business services sector, including accounting, legal, and printing
services. Moreover, stock market activity correlates strongly with the
Region's overall employment growth; the Region's (and the nation's) employment
has expanded with increases in equity markets during the past decade.2
Evidence suggests that conditions on Wall Street may be turning around,
a trend that would be expected to benefit the economies of New York City
and Boston. In fact, some analysts are anticipating a pickup in equity
underwriting and mergers and acquisition activity over the next 12 months,
although not to the record level of the late 1990s.3
According to a July 2003 report by the Securities Industry Association,
profitability in the securities industry significantly improved in early
2003, and industry compensation and employment are expected to increase
by year-end 2003.4
Despite these positive
signs, the Region's employment growth in the near term may lag that of
the nation. A relatively higher cost of doing business in some of the
Region's larger cities has resulted in the continued out-migration of
certain business sectors, such as manufacturing, to the western and southern
United States and overseas. In addition, several of the Region's states
and cities face serious budget constraints that could hinder a recovery
further. Sharply lower tax revenue collections in Massachusetts,
New York (particularly New York City), and New Jersey are contributing
to severe budget shortfalls. State and local governments have cut costs,
increased taxes, and restructured debt service in an effort to preserve
service levels and maintain balanced budgets. (For more information on
the Region's state budgetary problems, see FDIC Outlook,
New York Regional Perspectives, Summer 2003).
The Region's insured
institutions have performed well during the mild recession and weak recovery
by managing interest rate volatility, controlling expenses, and managing
credit risk. Their earnings continued to hold up well in first quarter
of 2003 despite economic softness and declining interest rates (see Table
1). Insured institutions reported declining net interest margins (NIMs)
in first quarter 2003 as yields on earning assets declined faster than
funding costs. The median NIM declined 29 basis points to 3.45 percent
as a percentage of average earning assets in the first quarter of 2003
compared to the first quarter of 2002. NIMs are under pressure as historically
low interest rates have contributed to lower yields on certain earning
assets, while interest paid on deposits may have reached an effective
New York Region Insured Institutions Continue to Report Healthy Conditions
All Insured Institutions
Commercial Banks < $10 billion
Savings Institutions < $10 billion
Insured Institutions > $10 billion
Return on Assets (ROA) (YTD)
Net Interest Margin (YTD)
Earning Asset Yield
Cost of Funding Earning Assets
Total Loan Growth (year over year)
Tier 1 Leverage Ratio
YTD = year to date. All figures are percentages. All data exclude
credit card institutions, de novos, and other small specialty institutions.
Source: Bank and Thrift Call Reports, reported on a merger-adjusted
as a percentage of average assets increased 11 basis points to 0.91 percent
(almost 14 percent) among the Region's savings institutions, but was more
than offset by a 14 basis point drop in net interest income to 3.09 percent.
A decline in noninterest income among the Region's commercial banks was
attributed to an 11 percent drop in trust income as the value of assets
under management declined. In addition, net interest income fell 30 basis
points to 2.94 percent. Overall, insured institutions reported declines
in noninterest expenses as they continued to control staffing levels and
employee costs. Commercial bank operating efficiency did not improve because
net interest income and noninterest income declined. However, the efficiency
ratio reported by the Region's savings institutions improved to 54.41
percent from 56.65 percent a year ago as noninterest expenses declined.
Lower interest rates
contributed to appreciation in many insured institutions' securities portfolios.
The vast majority of institutions sold appreciated securities, and, during
first quarter 2003, 86 percent of these institutions realized gains. The
gains represented 14 percent ($1.1 billion) of net income, up from 6 percent
a year ago. Should interest rates remain low, insured institutions can
supplement earnings, as unrealized gains on available-for-sale securities
are among the highest levels in a decade. However, if interest rates rise,
this source of income could dry up quickly.
The volume of long-term
assets (five years or greater) continued to grow among the Region's insured
institutions as mortgage refinancing activity remained strong during the
past year. Commercial banks reported a 9 percent median growth rate in
long-term assets, the seventh consecutive year of strong growth, as borrowers
preferred longer-term, fixed-rate loans. The 27 percent median ratio of
long-term assets to total assets is historically high among the Region's
commercial banks. The Region's savings banks reported 40 percent of assets
in the long-term category, although the growth has slowed. Savings institutions
have shifted portfolio emphasis into variable-rate commercial and commercial
real estate loans. These portfolios have experienced double-digit growth
since 1999 and grew at a median rate of more than 10 percent last year.
In addition to strong
loan growth, insured institutions reported robust deposit growth. The
median growth rate of non-interest-bearing deposits was about 13 percent
from March 2002 through March 2003. The growth in deposits can be attributed,
at least in part, to the fact that consumers are willing to accept the
trade-off between potentially higher, yet volatile, equity market returns
and the security of insured deposits during a period of stock market uncertainty.
During the same period, noncore funding increased at a median rate of
just over 10 percent. Meanwhile, institutions continued to use leverage
programs that raise low-cost, noncore funds and invest in assets to increase
net interest income. Deposits and borrowings represent an inexpensive
source of short-term funds, allowing insured institutions some control
over NIMs. However, as consumers become more confident in investing in
alternative products, funding costs could increase. Higher funding costs,
coupled with large concentrations of long-term assets, could heighten
interest rate risk, directly affecting the bottom line if interest rates
Despite the weak economy,
asset quality measures continue to appear favorable, helping to boost
profitability among the Region's insured institutions. On an aggregate
basis, during the past year total past-due loans declined; however, deterioration
has occurred among certain groups of banks and specific loan types. For
example, during the 12-month period ending March 2003, the median past-due
ratio for single-family residential real estate loans increased 40 basis
points to 1.16 percent among the Region's large savings institutions (those
with assets of at least $10 billion) and 19 basis points to 1.42 percent
among small commercial institutions (those with assets of less than $10
billion). The latter group also reported a 15 basis point increase in
the commercial loan past-due ratio to 1.65 percent during this period.
Although some insured institutions reported greater increases in past-due
loans, aggregate levels remain historically low and manageable. Loan losses
and provision expenses also remain low, helping to boost earnings.
Going forward, certain
trends could constrain insured institutions' profitability. Strong loan
growth may be masking some of the negative effects of the slow economy,
but should the Region's economy remain sluggish, commercial and commercial
real estate loan portfolios could begin to show deterioration, resulting
in higher charge-off rates and provision expenses. On the other hand,
even a recovering economy may present challenges, as rising interest rates
would affect the value of fixed-rate securities portfolios adversely and
could hurt NIMs in institutions that have invested significantly in long-term
For purposes of this article, the Region includes states in the Mid-Atlantic
and New England. The Mid-Atlantic includes Delaware, Maryland, New Jersey,
New York, Pennsylvania, and Washington, DC. New England includes Connecticut,
Maine, Massachusetts, New Hampshire, Rhode Island, and Vermont. Employment
data are through first quarter 2003.
The correlation coefficient between the Region's employment level and the Wilshire 5000 was 90 percent for the quarterly periods between first quarter 1990 and first quarter 2003.
Fleet Capital. "Capital Eyes: Monthly Insights on Middle-Market Leveraged
Finance," June 2003.
Fernandez, Frank A, Monahan, George R, "Securities Industry Update: Turning
the Corner," Securities Industry Association, July 24, 2003.
State Budget Deficits Could Constrain the Region's Economic Recovery
The fragile economy,
sustained weakness in the high-tech sector and stock markets, and a temporary
decline in oil prices during 2001 have affected state government tax collections
adversely and may constrain the economic recovery in the San Francisco
Region. State tax collections declined more than 10 percent in the Region
during fiscal year 2002 (see Table 1), following
almost a decade of average annual revenue growth of 6.7 percent. Tax collections
rebounded somewhat in fiscal year 2003, in part thanks to tax increases,
but budget gaps were expected to persist in most of the Region's states
through fiscal year 2004.1 Strategies used
by state governments to mitigate the effects of reduced tax collections,
such as eliminating staff, cutting expenditures, and raising taxes or
fees, could hurt local economies. This is particularly true in areas in
which strong job growth in the state and local government sector bolstered
local economies during the recent recession. This article assesses the
potential effects of these strategies on local economies as well as on
insured institutions headquartered in the San Francisco Region.
Declining State Taxes Could Hamper
Job Growth in the Region
Estimated 2004 Deficit(%)a
State Tax for Fiscal 2002
State and Local Gov. Job Sharec
San Francisco Region
a Estimated state deficit for the fiscal year ending June 30, 2004, as a percentage of the General Fund Budget. b Year-over-year percentage change for fiscal year 2002. c Represents state and local government employment as
a share of nonfarm employment for April 2003. d Because Nevada's information was not available for fiscal year 2004, the deficit and General Fund Budget data for fiscal year 2003 are shown.
Sources: National Conference of State Legislatures; Bureau of Labor Statistics; U.S. Census Bureau
The Severity of Budget Deficits Varies Across the Region
The size of projected 2004 state budget deficits varies significantly and depends greatly on each state's source of tax revenues. State economies that relied more heavily on volatile tax sources, such as personal income or corporate taxes, were affected more adversely during the 2001 recession and are not expected to recover quickly. In contrast, states that relied more on sales taxes exhibited less tax revenue stress.
Tax revenue declined
dramatically during fiscal year 2002 among the Region's state governments
that relied heavily on personal income tax collections. Significant job
losses, particularly in the high-paying technology sector, contributed
to personal income tax shortfalls in California, Idaho, Oregon,
and Arizona.2 Sustained
weakness in the stock market also contributed to declining personal income
tax collections as capital gains and employee stock option wealth evaporated.
Personal income taxes, which represented more than 35 percent of all state
tax collections in the Region during fiscal year 2002, declined 23 percent,
compared with 11 percent for the nation. Personal income tax collections
in the Region are not expected to recover soon because of the sluggish
near-term outlook in the high-tech industry and the stock market.
Corporate tax collections
have declined in states with a high concentration of employment in the
high-tech industry, which has slowed dramatically during the past couple
of years. In California, corporate tax collections declined almost 23
percent during fiscal year 2002, in large part because of stress in the
high-tech sector and the general economic downturn. In addition, a temporary
decline in oil prices during 2001 hurt corporate tax revenue in Alaska,
where collections fell by nearly one-third during fiscal year 2002.
As a result of declining
revenue from personal and corporate taxes, reliance on sales taxes has
increased. However, even among the states that generated a significant
share of revenue from sales taxes, Arizona and Nevada
are projecting two of the five highest relative budget shortfalls in the
Region. The key tourism sector slowed during the 2001 recession and after
9/11, contributing to declines in overall tax revenue. In addition, robust
employment growth in Arizona and Nevada during the past decade has pressured
state and local governments to keep pace with needed public services,
such as enhancements to infrastructure and education. Rising government
expenditures have left these states particularly vulnerable to the recent
slowdown in tax collections and the resulting shortfall.
State Budget Woes Could Affect Local Economies and Insured Institutions Adversely
The Region's state and local government sector represented one of the few sources of job growth during the recent recession; however, employment growth in this sector decelerated sharply during 2002 and early 2003 (see Chart
1).3 Layoffs in the state and local government sector could dampen the Region's recovery, impair the debt servicing ability of individuals and businesses, and challenge the performance of insured institutions. In addition, bank asset quality and liquidity could be affected adversely by exposures to municipal bonds, loans, or deposits during a time of increasing fiscal stress.
Decelerating growth in the state and local (nonfederal) government sector could have a disproportionate effect on insured institutions operating in states that have higher exposures to nonfederal government jobs and expect budget deficits in fiscal year 2004, such as Alaska, Nevada, Idaho, and Washington see Table
1. Alaska's relatively large reserve funds are expected to mitigate the risk of layoffs among its state and local government employees, however. Throughout the Region, less-populated, rural areas may be particularly vulnerable to additional layoffs because nonfederal government jobs typically represent a relatively high share of employment in rural counties.4 Job losses in rural areas could further pressure already high delinquent loan ratios reported among insured institutions based outside of metropolitan areas. Since 1998, established community banks headquartered in rural areas have reported higher past-due loan ratios than those based in metropolitan areas.5, 6
Job losses in the nonfederal government sector also could have a disproportionate effect on counties that are home to state capitals. For example, in counties surrounding seven of the Region's state capitals, at least 20 percent of nonfarm workers are employed in the nonfederal government sector-Juneau County, AK (37 percent); Thurston County, WA (37 percent); Carson City County, NV (30 percent); Sacramento County, CA (28 percent); Laramie County, WY (26 percent); Marion County, OR (24 percent); and Lewis and Clark County, MT (24 percent).7 Should deficit strategies prompt layoffs in the government sector, borrowers could find it more difficult to service their debts, and insured institution asset quality could weaken.
Fiscal woes also could
affect the quality of bonds issued by municipalities. As a result, insured
institutions could experience some weakening in securities portfolio credit
quality and liquidity. Across the Region, weaker tax revenues contributed
to fewer municipal bond rating upgrades during 2002 and early 2003.8
During the 15-month period ending March 2003, Moody's Investors Service
downgraded general obligation bonds issued by the states of California
and Oregon and several health, housing, education, lease, and redevelopment
bonds issued by local municipalities in Arizona, California, Hawaii,
Oregon, and Washington. Although municipal bond exposures among insured
banks based in California, Arizona, and Nevada (states experiencing some
of the Region's more severe deficits) are low, holdings among banks based
in the Region's more rural statesAlaska, Idaho, Wyoming,
Montana, and Oregonare higher (see Table
Municipal Securities and Deposit Exposures Tend to Be Higher Among Insured Institutions Based in the Region's Rural States
General Obligation Bond Ratings
Municipal Loans & Securities/Total Assets
Municipal Deposits/ Total Assets
Municipal Loans, Securities & Deposits/Total Assets
San Francisco Region
Notes: S&P = Standard
and Poor's. NR = Not rated, in part because these states had no
general obligation debt outstanding. Region data exclude insured
banks headquartered in American Samoa, Federated States of Micronesia,
Sources: Moody's Investors Service and Standard and Poor's
via Bloomberg (July 30, 2003); Bank Call Reports (March 31, 2003)
State and local budget deficits also could pressure liquidity among insured institutions that rely on state and local public deposits to fund assets. Declining tax revenues could constrain municipal deposit volumes should state and local payrolls decline or should municipalities have less excess cash available to invest in certificates of deposit. Liquidity pressures could be more significant among banks headquartered in Wyoming, Washington, Montana, Alaska, and Idaho, where median municipal deposit-to-total asset ratios are higher than in the Region as a whole (see Table
The Effects of Fiscal Stress on Local Economies and Insured Institutions Could Lag
Although budget deficits have been in the news for some time, some state and local governments have only begun to announce layoffs, cut services, and increase tax rates. Thus, the Region's local economies and insured institutions have not yet felt the full effects of this heightened fiscal stress. Bank management should continue to monitor any deterioration in credit quality or liquidity resulting from budget shortfalls and deficit reduction strategies.
John A. Roberts, Regional Economist
Judy H. Plock, Senior Financial Analyst
National Conference of State Legislatures, State Budget Update: April
2003, April 2003.
2 Idaho, Oregon, Arizona, and California ranked among the top seven states nationally during 2001 in the share of employment in the electronic component manufacturing industry.
3 Employment growth in the state and local government sector during 2001 was amplified somewhat by the reclassification of Native American tribal jobs into the sector beginning in January 2001. Even absent this reporting change, state and local government job increases during 2001 far outpaced growth rates reported in other major industry groupings.
4 As of 2000, the median ratio of state and local government employment to total nonfarm employment was 20 percent in counties with nonfarm labor forces of 150,000 or fewer, well above the 13 percent median in counties with larger workforces (includes only those counties that reported state or local government employment for 2000 via Global Insight).
5 This grouping excludes insured commercial banks open less than three years, industrial loan companies, and any insured banks reporting more than $1 billion in total assets, consumer loans exceeding 300 percent of Tier 1 capital, unfunded loan commitments exceeding total assets, or loan-to-asset ratios less than 25 percent. These criteria help isolate insured institutions that are more likely to invest a high share of assets in the headquarters county. Thrift Financial Report filers are excluded from this analysis because of data limitations.
6 As of March 31, 2003, the median past-due loan ratio among established community banks based outside of the Region's metropolitan statistical areas (MSAs) was 2.6 percent, compared with 1.1 percent among established community banks headquartered within MSAs. Disparities in median delinquencies could be due in part to differences in the geographic, size, and age composition or asset niche of MSA-based insured institutions compared with rural institutions.
7 Nonfederal government employment concentrations are based on employment estimates for 2000 from Global Insight.
8 For more information, see Moody's Investors Service, "Special Comment: Sluggish Economy Weighs Down Municipal Rating Revisions in 2002," January 2003, and "Special Comment: First Quarter Muni Upgrade/Downgrade Ratio Nears Parity; States' Fiscal Stress Hits Localities," April 2003.