Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION THIRD QUARTER 2002 

FDIC
 

Atlanta
 

Region
 

Division of
 

Insurance
 

and Research
 

Jack Phelps, CFA,
 

Regional Manager
 

Scott C. Hughes,
 

Regional Economist
 

Ronald W. Sims, II,
 

Senior Financial
 

Analyst
 

Pamela R. Stallings,
 

Senior Financial
 

Analyst
 

Regional Perspectives 

◆ The interest rate environment changed dramatically during 2001 as rapid 

rate cuts contributed to large changes in the yield curve. 

◆ Changes in the yield curve contributed to heightened exposure to interest 

rate risk among many of the Region’s community banks, as optionality in the 

loan portfolio increased and low short-term rates made liability repricing 

difficult. Moreover, the effectiveness of interest rate risk models was limited 

during 2001. 

◆ Responses by certain of the Region’s community banks to net interest 

margin compression may lead to higher credit, liquidity, or extension risk, 

depending on the robustness of future economic growth. See page 3. 

By the Atlanta Region Staff 

In Focus This Quarter 

◆ The Road to Recovery for Commercial Credit Quality: Not without a Few 

Hurdles Ahead—The recession that began in March 2001 has been especially 

hard on the corporate sector. Banks that made loans to affected firms felt the 

immediate effects of the recession through rising problem commercial loans. 

Large banks took the brunt of this commercial credit deterioration, as indicated 

by a somewhat larger uptick in problem commercial loans among large banks 

compared with smaller banks. This credit deterioration was more apparent 

at banks that participated in loan syndications, one of the financing vehicles 

available primarily to large corporate customers. Various indicators pointing 

toward economic recovery, as well as an apparent decline in rating downgrades 

and default rates among corporate bond issuers in recent weeks, suggest that 

improvement in commercial credit quality may be just ahead. This recovery, however, faces a few hurdles, including continued high leverage, weak earnings, and 

prospects for a more difficult funding environment, particularly for speculativegrade corporations with maturing debt. See page 9. 

By Cecilia Lee Barry, Senior Financial Analyst 

A Publication of the Division of Insurance and Research 
The Regional Outlook is published quarterly by the Division of Insurance and Research of the 

Federal Deposit Insurance Corporation as an information source on banking and economic issues 

for insured financial institutions and financial institution regulators. It is produced for the following eight geographic regions: 

Atlanta Region (AL, FL, GA, NC, SC, VA, WV)
 

Boston Region (CT, MA, ME, NH, RI, VT)
 

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The first and third quarter issues of the Regional Outlook feature in-depth coverage of the economy and the banking industry in each Region and consist of a national edition and eight regional editions. The second and fourth quarter issues are a single national edition that provides an overview 

of economic and banking risks and discusses how these risks relate to insured institutions in each 

FDIC Region. These issues tell the national story and, at the same time, alert the reader to specific 

trends and developments at the regional level. 

Single copy subscriptions of the Regional Outlook can be obtained by sending the subscription 

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The Regional Outlook is available on-line by visiting the FDIC’s website at www.fdic.gov. 

For more information or to provide comments or suggestions about the Atlanta Region’s Regional 

Outlook, please call Jack Phelps at (678) 916-2295 or send an e-mail to jphelps@fdic.gov. 

The views expressed in the Regional Outlook are those of the authors and do not necessarily reflect 

official positions of the Federal Deposit Insurance Corporation. Some of the information used in 

the preparation of this publication was obtained from publicly available sources that are considered 

reliable. However, the use of this information does not constitute an endorsement of its accuracy by 

the Federal Deposit Insurance Corporation. 

Chairman Donald E. Powell 

Director, Division of Insurance Arthur J. Murton 

and Research 

Executive Editor George E. French 

Writer/Editor Kim E. Lowry 

Editors Lynn A. Nejezchleb 

Maureen E. Sweeney 

Richard A. Brown 

Ronald L. Spieker 

Publications Manager Teresa J. Franks 
Regional Perspectives Regional Perspectives
 

Regional Perspectives 

Interest Rate Risk Has Changed in the Recent Recession 

The nation’s slide into recession in 2001, coupled with 

a slow recovery during the first half of 2002, has contributed to a changing interest rate environment for 

insured institutions. This environment has been particularly challenging for community banks1 in the Atlanta 

Region, most of which have experienced eroding net 

interest margins (NIMs). The rapidly changing rate 

environment in 2001 contributed to an increase in 

optionality risk,2 which limited the effectiveness of 

many interest rate risk modeling techniques. As an alternative method for assessing the exposure to interest rate 

risk (IRR) in 2001, the authors of this article used an 

interest rate/volume analysis to identify the degree of 

sensitivity to a changing rate environment of community bank net interest income (NII) and the NIM. The 

results of such an analysis were published in Atlanta 

Regional Outlook, second quarter 1998 and fourth 

quarter 2000, when NII and NIM performance was 

assessed during periods characterized by a flat yield 

curve.3 In contrast, the following discussion revisits the 

issue of IRR during 2001, when short-term interest rates 

declined significantly and the yield curve steepened. 

The Monetary Policy Response to the Economic 

Deterioration of 2001 Has Affected Interest 

Rate Risk 

Although the National Bureau of Economic Research 

designated March 2001 the official start of the nation’s 

1 Community banks are insured commercial banks with assets of 

$1 billion or less. We limited our sample to 667 community banks in 

the Atlanta Region with these characteristics: filed a Call Report at 

year-end 2001; in operation before January 1, 1997; and not involved 

in a bank merger and acquisition transaction during the past two years. 

Community banks that are part of a multibank holding company were 

excluded, as their interest rate risk may be managed on an organizational basis. 

2 Insured institutions frequently assume optionality risk in investment 

and loan portfolios. Prepayment is the most common form of an embedded option written by insured institutions. Frequently, no compensation 

is received for the written option, as fixed-rate loans are normally underwritten without a prepayment penalty. While mortgage-backed securities offer higher nominal yields, an option-adjusted spread analysis 

provides more accurate information about potential risks and rewards. 

3 The yield curve is the relationship between the maturity and yield on 

a debt instrument. Market participants use the U.S. Treasury yield 

curve, as it generally does not expose investors to credit (default) risk. 

recession, economic growth had been moderating for 

several quarters as performance of some economic sectors deteriorated before the onset of the downturn. The 

Federal Reserve attempted to mitigate the effects of 

the slowdown, cutting the targeted federal funds rate 

11 times, by 475 basis points, during 2001. The federal 

funds rate (end-of-period) stood at 6.50 percent at 

year-end 2000; one year later it was 1.75 percent (see 

Chart 1), with effective rates falling to the lowest levels 

since the early 1960s. By early 2002, the interest rate 

cuts had ceased as economic conditions appeared to 

be improving. 

The Yield Curve Has Changed Shape 

Dramatically 

The significant reduction in interest rates contributed to 

a dramatic change in the yield curve in 2001. At yearend 2000, the yield curve was partially inverted, with 

shorter maturities having higher yields (see Chart 2, 

next page). An inverted (negative) yield curve, historically, has been a leading indicator of an economic 

recession. Normally, the yield curve is upward (positively) sloping, with longer maturities having higher 

yields. During 2001, lower short-term interest rates 

resulted in a return to a positively sloped yield curve. 

Financial intermediaries typically profit from the spread 

by “borrowing short” while “lending long.” As a result, 

CHART 1 

Cuts in the Targeted Federal Funds Rate by the 

Federal Reserve Stopped in the First Half of 2002 

Source: Federal Open Market Committee/Haver Analytics Federal funds target rate (end of period, %) 

0 

1 

2 

3 

4 

5 

6 

7 

Jan ’00

Apr ’00

Jul ’00

Oct ’00

Jan ’01

Apr ’01

Jul ’01

Oct ’01

Jan ’02

Apr ’02 

Atlanta Regional Outlook 3 Third Quarter 2002 
Regional Perspectives
 

CHART 2 gin compression. On average, the NIM shrank 33 basis 

Federal Reserve Actions Have Affected 

the Shape of the Yield Curve 

* Treasury constant maturities 

Source: Federal Reserve Board Yield* (%) 

0 

1 

2 

3 

4 

5 

6 

7 

3­

month 

6­

month 

1­

year 

2­

year 

3­

year 

5­

year 

7­

year 

10­

year 

20­

year 

30­

year 

12/29/2000 

12/31/2001 

06/19/2002 

12/31/1999 

the inverted yield curve of year-end 2000 would not be 

expected to contribute positively to earnings. In contrast, the upward-sloping shape of the yield curve 

during most of 2001 typically would be expected to be 

more favorable. 

The rapid changes in the shape of the yield curve in 

2001 greatly affected NII and the NIM at most of the 

Region’s community banks. Optionality risk emerged 

unexpectedly as the rapid interest rate cuts in 2001 led 

to an unprecedented wave of refinancing activity. Many 

high-quality fixed-rate commercial borrowers refinanced loans at much lower rates as the prime rate4 fell 

from 9.50 percent at year-end 2000 to 4.84 percent a 

year later. The liability side of the balance sheet also 

presented challenges as low short-term rates became a 

points to 4.18 percent (see Chart 3). On a quarterly 

basis, however, the NIM compression slowed by yearend as maturity deposits started to reprice downward. 

More important, however, is a decline in NII that 

occurred among 41 percent of the Region’s community 

banks. In the instances where NII declined during the 

year, earning assets actually grew 6.9 percent. Additionally, the NIM within this subset of community 

banks fell by 67 basis points to 4.05 percent, compared 

with the 17 basis-point NIM decline among community 

banks that experienced an increase in NII. 

In addition, community banks that experienced a 

decline in NII in 2001 also exhibited a comparatively 

higher risk profile. This subset of community banks 

reported higher past-due loan and charge-off levels and 

lower rates of return on assets. Further, 8.42 percent of 

community banks that reported a decline in NII were 

unprofitable, compared with only 2.03 percent when 

NII increased. 

Interest rate/volume analysis is an effective tool to 

determine factors behind changes in interest margins 

and can be used as an ex post5 measure of IRR (see box 

CHART 3 

Most of the Region’s Community Banks* Experienced
 

Net Interest Margin Compression in 2001
 

250 

floor, limiting the downward repricing of many shortterm funding sources. As a result, NII and NIMs 

declined, although the yield curve was positively shaped 

for most of 2001. The decline in NII and the compression in NIM suggest that community banks may have 

had far more IRR inherent in their balance sheets than 

Call Report data estimated before the start of 2001. 

200 

* Community banks are commercial banks with assets of $1 billion or less. 

For this analysis, we limited the sample to community banks open since 

year-end 1996, not part of a multibank holding company, and not involved 

in a bank merger and acquisition transaction since year-end 1999. 

December 

2001 

December 

2000 

Median 

2001

Number of Community Banks 150 

100 

50 

0 

0.50 1.50 2.50 3.50 4.50 5.50 6.50 7.50 

–50 Net Interest Margin (%)

Community Bank Net Interest Rate Performance Source: Bank and Thrift Call Reports 

Has Declined 

The NIM and NII at many of the Region’s community 

banks declined during 2001. The NIM decline was systemic, as 80 percent of community banks reported mar4 The prime rate is an interest rate posted by a majority of the largest 

U.S. commercial banks that is used to price short-term commercial 

bank loans. 

5 A rate/volume analysis is a historical or backward-looking assessment 

of performance. Large fluctuations in NII resulting from changing 

interest rates imply that IRR existed during the assessment period. This 

technique may not be useful as a forward-looking measure of IRR, as 

risk managers can alter an insured institution’s sensitivity position. 

Another potential limitation of this technique is that volume shifts within a specific loan category could result in yield changes that are due 

solely to market forces or repricing imbalances. This was not a factor in 

this analysis, as volume shifts occurred into higher-yielding products. 

Atlanta Regional Outlook 4 Third Quarter 2002 
Regional Perspectives
 

Interest rate risk can be measured several ways. The 

more common methods include gap, duration, and 

simulation analyses, all of which are measures 

designed to estimate net interest income variability in 

future periods. To forecast the effects of rate changes 

on an insured institution’s earnings requires projections of, among other things, the direction of change 

for several key interest rates; the magnitude and timing 

of those changes; and the average volume and mix of 

earning assets and interest-bearing liabilities at the 

time of each change. Embedded optionality in many 

financial instruments, as well as off-balance sheet 

activities and the increased use of hedging programs, 

makes assessing interest rate risk more complex. It is 

even more difficult to apply these forward-looking 

measurement techniques off-site, as the necessary 

inputs mentioned above are not fully detailed in Call 

Reports or other public filings. With these limitations, 

an interest rate/volume analysis allows some insight 

into how sensitive net interest income has been to 

changes in interest rates during a specified period. 

Conceptually, rate/volume analysis breaks down net 

interest income into its component parts and measures 

the contribution of each component. Net interest 

income is a function of average earning assets and 

liability volumes and asset yields and the cost of 

interest-bearing liabilities during a given period. 

for further discussion). The variance in NII and NIM 

during a measurement period is due primarily to two 

factors. NII and the NIM are influenced by changes in 

the volume of earning assets and interest-bearing liabilities, and by changes in the average yield of earning 

assets and cost of interest-bearing liabilities. A rate/ 

volume analysis breaks down these drivers. Performance results for the Region’s community banks are 

shown in Table 1, next page. 

The results of the rate/volume analysis suggest that the 

Region’s community banks were exposed to a significant amount of IRR during 2001. This conclusion is 

supported by the large (21 basis point) drop in the average net interest spread (asset yield less liability cost) to 

3.39 percent. On the liability side, average funding costs 

declined only 46 basis points to 4.49 percent, while 

suggest that a higher percentage of loans actually were 

repriced. Anecdotal reports circulated that commercial 

bank fixed-rate borrowers were seriously considering 

moving their relationships if the loan facility was not 

repriced downward. 

IRR among Other Insured Institutions 

Differs from That of Community Banks 

The NIM performance among most of the Region’s 

large banks6 and thrifts differed from that of community banks during 2001. Last year, the NIM among large 

banks increased 16 basis points to 3.94 percent. The 

NIM declined only 4 basis points among the Region’s 

thrifts, to finish the year at 2.92 percent. The difference 

in NIM performance was primarily due to the composition of liabilities. Large banks and thrifts rely more on 

the use of wholesale funding. Generally, these funding 

sources repriced downward in tandem with interest rate 

cuts. Therefore, in 2001, greater reliance on core funding contributed to a greater likelihood that an institution’s NIM would decline as nonmaturity deposits were 

near floor levels and the repricing lags of maturity 

deposits were drawn out. Conversely, greater reliance on 

wholesale funding contributed to a greater likelihood 

that an institution’s NIM would expand. Hence, the IRR 

position of many large banks and thrifts in 2001 contributed to higher profits. Despite the positive outcome, 

the significant changes in NIM performance among 

large banks and thrifts suggest they also were exposed to 

elevated levels of IRR. 

CHART 4 

Loans Repriced Much Faster in 2001 

than Data Suggested 

35 

30 Dec ’00

Percentage of Total Losses

25 Dec ’01 

20 

15 

10 

5 

0 asset yields fell by 94 basis points. Thus, repricing of Less than 3–12 Over 3–5 5–15 Over deposits occurred more slowly than repricing of earning 3 months months 1 year years years 15 years 

assets (principally loans). Loan yields fell by more than Time Until First Repricing Opportunity 

a full percentage point to 8.65 percent during 2001. At Source: Bank and Thrift Call Reports 

the start of 2001, Call Report data indicated that only 

31.5 percent of loans would reprice in three months or
 

less (see Chart 4). The large decline in loan yields would 6 Large banks are commercial banks with assets of at least $1 billion.
 

Atlanta Regional Outlook 5 Third Quarter 2002 
Atlanta Regional Outlook TABLE 1 

6 Third Quarter 2002 

An Interest Rate/Volume Analysis Indicates that Interest Rate Risk 


was Prevalent at Many Community Banks* in the Atlanta Region during 200

2000 2001 Rate/Vol

Average Income/ Rate Average Income/ Rate 

Balance Cost (%) Balance Cost (%) Volume Rat

ASSETS INTEREST-EARNING ASSETS 

Short-Term Investments: 

Interest-Bearing Deposits 1,275,968 85,235 6.68 1,962,669 85,439 4.35 45,872 (29,Securities (including United States, Mortgage-Backed Securities, Subdivision, Equities) 34,314,448 2,086,232 6.08 35,061,255 2,064,927 5.89 45,404 (65,Fed Funds Sold/Repurchased 4,696,266 294,399 6.27 7,949,883 302,778 3.81 203,962 (115,Total 40,286,681 2,465,866 6.12 44,973,806 2,453,144 5.45 286,889 (268,

Loans: 

Real Estate 61,729,294 5,546,317 8.98 72,576,461 6,130,296 8.45 974,607 (332,Agriculture 189,017 77,176 40.83 528,859 48,121 9.10 138,759 (59,Commercial & Industrial 21,770,670 2,124,493 9.76 18,700,494 1,621,391 8.67 (299,603) (236,Consumer 15,570,135 1,983,881 12.74 13,454,774 1,444,398 10.74 (269,530) (312,

Total Loans 102,968,244 9,975,111 9.69 110,056,077 9,522,539 8.65 686,638 (1,065,Lease Financing Receivables 476,912 30,381 6.37 309,325 22,717 7.34 (10,676) 4

TOTAL INTEREST-EARNING ASSETS 143,731,837 12,523,195 8.71 155,339,207 12,071,937 7.77 1,011,337 (1,353,3LIABILITIES INTEREST-BEARING LIABILITIES 

Interest-Bearing Deposits 

Transaction Accounts 11,612,748 280,423 2.41 11,855,417 217,909 1.84 5,860 (66,Nontransaction Accounts 

Savings Deposits (including Money Market Deposit Accounts) 32,395,208 1,075,173 3.32 36,976,383 933,293 2.52 152,046 (257,Time Deposits > $100k 19,980,184 1,190,385 5.96 23,196,665 1,285,368 5.54 191,632 (83,Time Deposits All Other 40,009,762 2,322,613 5.81 43,134,295 2,402,405 5.57 181,383 (94,

Federal Funds 6,286,847 359,291 5.71 6,621,875 232,102 3.51 19,147 (138,Other Borrowed Money 8,232,383 587,180 7.13 7,721,680 442,176 5.73 (36,426) (115,

TOTAL INTEREST-BEARING LIABILITIES 118,517,130 5,902,987 4.98 129,506,314 5,588,173 4.31 547,339 (788,9CHANGE IN NET INTEREST INCOME 25,214,706 6,620,208 3.73 25,832,894 6,483,764 3.46 463,999 (564,3* Community banks are commercial banks with assets of $1 billion or less. For this analysis, we limited the sample to community ban

not part of a multibank holding company, and not involved in a bank merger and acquisition transaction since year-end 1999.
 Note: All columns (except rates) in dollars.
 Source: FDIC Call Reports
 
Regional Perspectives
 

Heightened Levels of IRR 

Have Other Consequences 

Many of the Region’s community banks may have 

assumed more credit risk to compensate for a lower 

NIM. These institutions aggressively originated real 

estate loans during 2001, with the volume of this lending 

category growing more than 18 percent. Further, this 

large-volume change in real estate loans was responsible 

for 90 percent of the change in interest income. The 

rapid growth in real estate loans occurred despite the 

economic slowdown. The majority of new real estate 

lending in the Region occurred in a traditionally higherrisk category—construction and development loans. 

Historically, construction projects delivered to the 

marketplace during an economic recession have posed 

greater credit risk. Moreover, a volume-driven growth 

strategy in a highly competitive environment may lead to 

underpricing of credit risk. 

Responses to lower NII and margin pressures during 

2001 could lead to liquidity risk in certain scenarios. 

During the long economic expansion of the 1990s, 

many institutions encountered funding challenges from 

two sources—strong local loan demand in excess of 

core deposit growth and heightened competition from 

nonbank investment alternatives. The decline in U.S. 

equity prices and the low level of short-term interest 

rates have greatly reduced nonbank investment competitiveness and have led to a re-intermediation of funds 

into insured institutions. These funds primarily have 

flowed into money market demand accounts and large 

time deposits.7 The permanence of these flows, however, is open to debate. Nevertheless, liquidity risk 

could arise if these funding sources are short-lived, as 

many community banks have used them to fund their 

rapid expansion in real estate loans. 

Another possible consequence of some community 

banks’ efforts to counter margin compression during 

2001 may pressure future earnings should interest 

rates rise sharply for a prolonged period. Institutions 

have increased holdings of long-maturity assets in a 

low interest-rate environment. These holdings could 

be subject to a phenomenon that is commonly known 

as extension risk. Residential mortgages and related 

products (mortgage-backed securities) are the most 

commonly held assets that pose extension risk for 

insured institutions. The large wave of mortgage and 

other commercial loan refinancing during 2001 and 

7 Large time deposits are those with a balance of $100,000 or more. 

the subsequent reinvestment in lower-yielding 

mortgage-related investments have contributed to an 

increase in extension risk. Extension risk, if unhedged, 

could pressure NIMs in a rising rate environment, as 

community banks would hold a large percentage 

of earning assets in investments with coupon yields 

well below market. 

IRR Models Vary in Sophistication 

The dramatic change in the shape and level of the yield 

curve in 2001 and the resultant increase in optionality 

risk limited the effectiveness of many IRR models. 

Bank managers generally use a sensitivity model or a 

stress test model to estimate IRR.8 Most sensitivity 

models estimate IRR by measuring the potential 

change in NII caused by a parallel shift (equal upward 

or downward change) in the yield curve. Typically, a 

maximum shock of +/– 300 basis points is used. Obviously, this type of model has many limitations, including an inability to estimate changes in NII caused by a 

nonparallel shift in the yield curve. A more sophisticated way to estimate a decline in portfolio value is 

through a scenario model such as a value-at-risk (VAR) 

model. A VAR model estimates the portfolio loss that 

would occur during a specified period given a certain 

event. There are several types of VAR models,9 but 

most community banks, if they use one, use a historical 

methodology, which employs a sample size of historical events in the loss estimation process. Often, the 

sample size does not include enough abnormal events 

(large market fluctuations). The probability of abnormal events occurring may be higher than predicted; 

hence, the amount of capital at risk is greater than 

forecasted. The interest rate cuts during 2001 and the 

subsequent twist (nonparallel shift) in the yield curve 

were unprecedented. Thus, it is very likely neither 

VAR models nor sensitivity models estimated this 

abnormal event, and, as a result, they underestimated 

the degree of IRR. 

8 See “The Essential Element,” Bank Oxygen, July 3, 2002, and July 

30, 2002, for further discussion. 

9 For further description of VAR model types and discussion of their 

strengths and weakness see Darryll Hendricks, April 1996, “Evaluation 

of Value-at-Risk Models Using Historical Data,” Economic Policy 

Review, Federal Reserve Bank of New York; and Thomas J. Linsmeier 

and Neil D. Pearson, July 1996, “Risk Measurement: An Introduction 

to Value at Risk,” University of Illinois at Urbana-Champaign. 

Atlanta Regional Outlook 7 Third Quarter 2002 
Regional Perspectives
 

Future Challenges 

IRR modeling could be difficult for the second half of 

2002 and early 2003. Continued slow economic growth, 

which restrains the Federal Reserve from raising rates, 

would likely benefit community bank NIMs. Maintaining low short-term rates along with a steep positively 

sloped yield curve will allow the repricing of maturity 

deposits to run its course. Large banks and thrifts likely 

have already experienced most of the NIM expansion 

that can be expected in this rate environment. Stronger 

economic growth, higher inflation, or a rapid decline in 

the relative value of the U.S. dollar could prompt an 

increase in short-term rates. The timing of such an 

increase could have a disparate effect on various types 

of insured institutions. However, a rapid rise in shortterm rates paired with a flattening yield curve (upward 

twist) would be disadvantageous to most insured institutions. Such a rapid rise in interest rates could extend 

the duration of certain earning assets. 

Given the various paths in which interest rates may 

move, IRR managers should use an interest rate forecast 

that is consistent with an institution’s overall strategic 

planning process. For example, if loan volume is expected to grow robustly thanks to an economic rebound, 

short-term rates likely will rise as the economy expands. 

It would be inconsistent to use a constant interest rate 

forecast in IRR models under this scenario. 

Bank managers’ attempts to mitigate the negative 

effects of IRR in 2001 may lead to unexpected challenges. In the case of insured institutions that relied 

on significant loan growth (particularly in the commercial real estate loan portfolio) to offset NIM compression, credit risk could arise if slow or negative 

economic growth causes a decline in real estate absorption rates. On the other hand, robust economic growth 

that leads to higher market interest rates could pressure 

earnings because of longer earning asset durations. A 

lesser concern under the robust growth scenario would 

be an increase in liquidity risk if nonbank investment 

alternatives become more attractive. Another concern 

arising from the optionality exposure in 2001 is that 

many banks may not adequately consider embedded 

options when pricing loans. Insured institutions that 

may be most vulnerable to an increasing rate environment are those that experienced the greatest drop in 

NII during 2001 (i.e., institutions whose loans have 

repriced at historically low levels and whose liabilities 

will reprice upward in a rising rate environment). Most 

such institutions are community banks headquartered 

in urban areas, primarily in Florida, Virginia, Georgia, 

and Alabama. 

Atlanta Region Staff 

Atlanta Regional Outlook 8 Third Quarter 2002 
In Focus This Quarter In Focus This Quarter
 

The Road to Recovery for Commercial Credit Quality:
 

Not without a Few Hurdles Ahead
 

Introduction 

The banking industry as a whole has performed well in 

recent years, despite increasing loan delinquencies, 

notably in commercial credits. Although the extent of 

commercial loan deterioration has not reached levels 

experienced in the early 1990s, it nonetheless warrants 

scrutiny. With a variety of economic indicators pointing 

toward recovery, the volume of problem commercial 

loans held by insured institutions could plateau during 

2002. Many banks tightened business loan underwriting 

standards beginning in early 2000, a trend that should 

contribute to an eventual turnaround in commercial loan 

quality. Nevertheless, several factors could delay this 

improvement. Corporate profitability has yet to recover 

fully, and many firms continue to operate with significant financial leverage. Highly leveraged firms are 

especially vulnerable to declining revenues, which 

reduce the cash flow available to service debt obligations. More significantly, lower investor tolerance for 

risk has created a far less hospitable financing market 

for speculative-grade firms, possibly straining liquidity 

and increasing the likelihood that these companies 

could default as debts mature. 

Commercial Credit Deterioration Should 

Subside with the Economic Recovery 

While the banking industry has fared well through the 

latest recession, it did not escape the effects of the troubled corporate sector. Large banks (those with assets 

greater than $1 billion), in particular, have seen a significant rise in noncurrent commercial and industrial 

(C&I) loan and loss rates.1 While total C&I loans represented 25 percent of all outstanding loans held by all 

insured commercial banks as of March 31, 2002, net 

C&I loan losses comprised 32 percent of all loan 

losses. In first quarter 2002, noncurrent C&I loans 

reached 2.6 percent of outstanding loans (2.8 percent 

for large banks), the highest level since fourth quarter 

1993. The four-quarter moving average C&I loss rate 

also rose among small and large banks; however, the 

rate of increase for large banks was significantly higher, 

as shown in Chart 1. 

1 Noncurrent loans are defined as loans 90 or more days past due or 

on nonaccrual status. 

CHART 1 

Large Banks Experience a Rapid Rise in 

Commercial and Industrial Loan Loss Rates 

Source: Bank Call Reports, FDIC Research Information System 

Large banks 

(> $1 billion in assets) 

Four-Quarter Moving Average Commercial

and Industrial Loss Rates (%)

Small banks 

(< $1 billion in assets) 

0.0 

0.2 

0.4 

0.6 

0.8 

1.0 

1.2 

1.4 

1.6 

1.8 

2.0 

2.2 

1Q90 3Q91 1Q93 3Q94 1Q96 3Q97 1Q99 3Q00 1Q02 

Improving economic conditions and tighter underwriting standards suggest that commercial credit quality 

should improve. A range of indicators suggests that economic recovery is under way, albeit more slowly than 

some expected earlier this year. The housing sector 

remains robust, job conditions have stabilized, and real 

gross domestic product (GDP) grew 5.0 percent in first 

quarter 2002. Although GDP grew at a slower pace of 

1.1 percent in second quarter 2002, business equipment 

spending increased 2.9 percent, in contrast to a decrease 

of 2.7 percent in first quarter 2002. Also, the manufacturing sector began to show signs of recovery with the 

Institute for Supply Management (ISM) index for 

manufacturing reaching 56.2 and 50.5 in June and July 

2002, respectively. The ISM index has remained above 

50, which signals an economic expansion, for the six 

consecutive months since February 2002. Also, the 

index of coincident indicators, a gauge of current economic activity, rose 0.3 percent in June 2002. Furthermore, a survey of 50 leading corporate economists by 

Blue Chip Economic Indicators shows that analysts 

expect the U.S. economy to grow at a rate of 3.3 percent 

in third quarter 2002.2 

Recent changes in underwriting standards also bode 

well for credit quality at commercial banks. The Federal 

2 Blue Chip Economic Indicators, July 2002. Also see Regional 

Outlook, Second Quarter 2002, “Back to the Future: How This 

Downturn Compares to Past Recessions.” See http://www.fdic.gov/ 

bank/analytical/regional/ro20022q/na/index.html. 

Atlanta Regional Outlook 9 Third Quarter 2002 
In Focus This Quarter In Focus This Quarter
 

Reserve Board’s Senior Loan Officer Opinion Survey 

on Bank Lending Practices, which focuses on 

changes in the supply of and demand for bank loans to 

businesses and households over the previous three 

months, has shown consistent tightening of business 

loan standards during the past two years. The April 

2002 survey indicated some further tightening of standards, but the percentage of banks reporting this tightening has declined since the January survey, consistent 

with the anticipation of a continued economic 

rebound.3 Since credit quality typically lags the business cycle, near-term recovery appears more likely, 

provided the economy continues to improve. This 

recovery in commercial credit quality, however, is not 

without a few hurdles ahead. 

High Default Rates, Rating Downgrades, 

and Bankruptcies Persist 

While the U.S. economy is showing signs of recovery 

and underwriting standards have tightened, corporate 

credit quality could continue to be affected by several 

adverse trends. The number of bankruptcies filed by 

public companies this year is on pace to challenge 

the record set in 2001.4 Furthermore, default rates for 

CHART 2 

Current U.S. Corporate Credit Deterioration Is 

U.S. speculative-grade corporate bond issuers remained 

high at 10.3 percent in June 2002, and the high ratio of 

corporate rating downgrades to upgrades indicates continuing weakness in the corporate sector (see Chart 2).5 

The main reasons for rating downgrades have been poor 

profitability and high leverage. 

Corporate Profitability Remains Fragile 

Corporate profitability has been depressed since first 

quarter 2001 (see Chart 3). However, this trend is improving slowly in 2002. U.S. corporate profits rose during 

second quarter 2002 for the first time in five quarters.6 

However, the rate of recovery is not expected to be strong 

in 2002, as some 93 companies in the Standard & Poor’s 

500 have announced that third quarter earnings will be 

less than expected, more than twice the number of companies that have announced they will beat estimates.7 In 

fact, earnings forecasts have been revised downward 

consistently for the past several months, and analysts 

have warned recently that earnings estimates for the 

second half of 2002 are likely to be reduced. The bright 

spot in earnings continues to be the consumer sector, 

with automobile manufacturers and certain retail areas 

posting strong sales. The worst-performing sectors on a 

CHART 3 

Corporate Profits Remained Depressed 

Approaching Early 1990s Levels 

0 

1 

2 

3 

4 

5 

6 

7 

8 

9 

10 

11 

0.0 

0.5 

1.0 

1.5 

2.0 

2.5 

3.0 

3.5 

4.0 

4.5 

5.0 

Percent Ratio 

Bank commercial and 

industrial noncurrent 

rate (left scale) 

U.S. speculative-grade bond 

issuer default rate (left scale) 

U.S. Corporate bond ratings downgrades 

to upgrades (right scale) 

1988 1990 1992 1994 1996 1998 2000 1Q02 

Year-over-year growth in net income from

continuing operations for all S&P 500 firms (%)

35 

25 

15 

5 

–5 

–15 

–25 

through the First Quarter of 2002 

1997 1998 1999 2000 2001 2002 

Sources: Moody’s, Bank Call Reports, FDIC Research Information System 

3 Senior Loan Officer Opinion Survey on Bank Lending Practices, 

The Federal Reserve Board, April 2002. The survey reported that the 

percentage of domestic banks that reported tightened standards on 

C&I loans to large and middle-market firms (annual sales of at least 

$50 million) since the January survey declined to 25 percent from 

45 percent. The percentage of domestic banks that report tightened 

standards on business loans to small firms declined more, from 42 

percent in January to 15 percent in April. 

4 Bankruptcydata.com reports that 257 publicly traded companies 

filed for bankruptcy in 2001, while 114 companies had filed by 

June 30, 2002. 

Source: Standard & Poor’s 

5 In the first half of 2002, Moody’s downgraded 262 companies and 

upgraded 59, producing a downgrades to upgrades ratio of 4.4:1. 

6 On a year-over-year basis, 371 companies in the Standard & Poor’s 

500 Index that reported earnings through July 26, 2002, posted 

profits. 

7 Danielle Sessa, “U.S. Stocks Slide as Johnson & Johnson, Pepsi 

Shares Tumble,” Bloomberg.com, July 19, 2002. 

Atlanta Regional Outlook 10 Third Quarter 2002 
In Focus This Quarter In Focus This Quarter
 

year-over-year basis appear to be energy, transportation, 

utilities, capital goods, and communications services.8 

The latest recession was driven primarily by the sharp 

decline in the demand for capital goods. With the slow 

economic recovery, businesses have continued to limit 

capital spending. The rate of recovery for corporate profitability will depend in large part on how soon and to 

what extent businesses resume spending. 

The prospect of slow earnings growth could be particularly problematic for many highly leveraged corporations. Debt levels relative to cash flow have been 

rising because of anemic earnings (see Chart 4). Negative earnings news also comes at a time when several 

well-publicized accounting irregularities have shaken 

investors’ confidence in corporate earnings reports. A 

Huron Consulting Group study of financial restatements indicates that during the past five calendar 

years, the number of restated financial statements filed 

by public companies has grown from approximately 

120 in 1997 to 270 in 2001.9 The number of restatements continued to grow in 2001, despite a reduction in 

the number of public companies. That study found that 

CHART 4 

the largest source of restatements relates to how companies recognize revenue. With depressed corporate 

profits and diminishing investor confidence, some 

firms with debts maturing in the near term may have 

difficulty refinancing. 

Firms with Maturing Debts Could Face 

a Critical Period in the Near Term 

Moody’s estimates that $141 billion worth of U.S. 

speculative-grade corporate bonds and rated bank debt 

will come due over the next three years: $27 billion 

(19 percent) in 2002, $54 billion (38 percent) in 2003, 

and $60 billion (43 percent) in 2004.10 To put these 

numbers into perspective, total U.S. corporate bond 

defaults were $115 billion in all of 2001, of which 

95 percent of those defaulting were speculative-grade 

borrowers. Although Moody’s expects the bulk of 

high-yield debt maturing in 2002 to be refinanced 

despite unfavorable market conditions, concern exists 

about the large percentage of issues rated B1 or lower 

that will come due in 2003 and 2004 (see Chart 5).11 

CHART 5 

Corporate Debt Continues to Rise 

Relative to Cash Flows 

Source: Federal Reserve Board Ratio of nonfarm, nonfinancial debt to cash flow 

3.5 

4.0 

4.5 

5.0 

5.5 

6.0 

1975 1978 1981 1984 1987 1990 1993 1996 1999 1Q02 

Forty-Seven Percent of U.S. Speculative-Grade
 

Bonds and Bank Debt Maturing in 2003–2004
 

Are Rated B1 or Lower
 

Ba1 to Ba3 

53% 

B1 to B3 

36% 

Caa1 or lower 

11% 

Source: Moody’s 

8 Charles L. Hill, et al., This Week in Earnings, Thomson First Call, 

July 22, 2002. 

9 A Study of Restatement Matters, for the five years ended December 

31, 2001, Huron Consulting Group, June 2002. This study excluded 

restatements caused by changes in accounting principles and 

nonfinancial-related restatements. 

10 Tom Marshella, et al., “Refunding Risk for U.S. Speculative Grade 

Borrowers, 2002–2004,” Global Credit Research, Moody’s Investors 

Service, December 2001. Figures related to refunding risk presented 

throughout this article are taken from Moody’s refunding risk studies, 

conducted annually since November 1998. 

11 Speculative-grade debt ratings assigned by Moody’s in the order of 

declining credit quality are as follows: Ba, B, Caa, Ca, and C. 

Moody’s also applies numerical modifiers 1, 2, and 3 in each generic 

rating classification. The modifier 1 indicates that the obligation 

ranks in the higher end of its generic rating category, while the 

modifier 3 indicates a ranking in the lower end of that generic rating 

category. 

Atlanta Regional Outlook 11 Third Quarter 2002 
In Focus This Quarter In Focus This Quarter
 

Credit deterioration of bank loans is similar to the cur- TABLE 1 

rent trend in corporate bonds. Migration of maturing 

loans into lower grade categories has accelerated in 

recent years (see Chart 6). This ratings decay reflects 

the borrowers’ deteriorated financial condition and the 

effects of liberal underwriting conditions from 1996 to 

1998, when speculative-grade originations were more 

common. For example, the 1999 and 2000 refunding 

risk studies conducted by Moody’s noted that 16 percent 

and 17 percent, respectively, of all rated bank loans 

maturing in 2002 were rated B1 or lower. The trend 

worsened significantly in 2001, when the study noted 

that 39 percent of bank loans maturing in 2002 were 

rated B1 or lower. When firms have to refinance lowgrade debts in today’s environment, they may face 

additional pressure on earnings and liquidity. 

Loss Severity Has Increased 

with Higher Default Rates 

Moody’s credit ratings reflect the likelihood of default 

and the severity of loss given default. As a result, the 

migration of maturing bonds and loans into lower 

grades implies a greater risk of default or increased loss 

severity upon default, or perhaps both. Moody’s notes, 

as part of its 15th annual study of global corporate 

defaults and ratings performance, that average recovery 

rates fell for the third straight year in 2001.12 The recovery rate has deteriorated for all levels of security and 

CHART 6 

The Proportion of Maturing Bank Loans Rated
 

B1 or Lower Is Increasing
 30 

Ba 25 

Average Speculative-Grade 

Recovery Rates in 2001 Show a 

Declining Trend in Nearly All Levels 

of Security and Subordination 

AVERAGE
 

RECOVERY
 

PER $100
 

1982– 

SENIORITY/SECURITY 2000 2001 

SENIOR SECURED BANK LOAN $67.06 $54.68 

EQUIPMENT TRUST $64.65 NA 

SENIOR SECURED BONDS $52.09 $58.00 

SENIOR UNSECURED BONDS $43.82 $36.20 

SENIOR SUBORDINATED BONDS $34.59 $19.90 

SUBORDINATED BONDS $31.83 $16.45 

JUNIOR SUBORDINATED BONDS $22.48 NA 

Note: NA=not available 

Source: Moody’s 

subordination except for senior secured bonds (see 

Table 1). 

Higher-Risk Borrowers Pay High Premiums 

A speculative-grade company refinancing debt today 

will face a much higher price, in terms of spreads over 

a cost of funds index or risk-free instruments, compared to several years ago. Yield spreads between 

investment-grade and speculative-grade bonds have 

widened significantly since early 2000 (see Chart 7), in 

part because of lower investor tolerance for risk, rising 

CHART 7 

$ Billions 

20 

15 

10 

5 

0 

B1 or Lower 

2002 2003 2004 

Credit Costs for Higher-Risk Borrowers Rose 

Dramatically in Recent Years 

Sources: Merrill Lynch Bond Global Bond Indices, Federal Reserve Board Basis point spread over ten-year constant-maturity Treasuries

Investment-grade bonds 

High-yield bonds 

0 

100 

200 

300 

400 

500 

600 

700 

800 

900 

1000 

Jun 

’98 

Dec 

’98 

Jun 

’99 

Dec 

’99 

Jun 

’00 

Dec 

’00 

Jun 

’01 

Dec 

’01 

Jun 

’02 

Source: Moody’s 

12 David Hamilton, et al., “Default & Recovery Rates of Corporate 

Bond Issuers: A Statistical Review of Moody’s Ratings Performance 

1970–2001,” Global Credit Research, Moody’s Investors Service, 

February 2002. The recovery rate is defined as the secondary market 

price of the defaulted instrument approximately one month after the 

time of default. 

Atlanta Regional Outlook 12 Third Quarter 2002 
In Focus This Quarter In Focus This Quarter
 

defaults, and weakening corporate cash flows. After 

narrowing a bit in first quarter 2002, spreads have 

widened again on renewed concerns about accounting 

irregularities and the realization that the economic 

recovery may come at a slower pace than anticipated. 

Lower investor tolerance for risk has affected not only 

speculative-grade borrowers but also some investmentgrade borrowers. For example, the commercial paper 

(CP) market, which many investment-grade borrowers 

have used as a cheap source of funding, is no longer 

readily available to all investment-grade borrowers.13 

Drawn-Down Commercial Paper Back-up Lines 

Heighten Commercial Bank Exposure14 

Since its peak at the end of 2000, the CP market for 

domestic nonfinancial companies has shrunk by almost 

50 percent (see Chart 8). A reduction in the need for 

working capital and heavy refinancing activity have 

contributed to this contraction. However, the record 

number of downgrades among issuers of CP in 2001 

also contributed to this decline. Money market funds 

cannot hold more than 5 percent of assets in CP graded 

less than A1/P1/F1.15 Thus, the recent flux of downgrades effectively squeezed some issuers out of this 

market and forced them to refinance with fixed-rate 

bonds.16 Also, fears of deteriorating credit quality have 

shut some investment-grade companies out of the CP 

market. Since the collapse of Enron, investors have been 

reluctant to hold the debt of certain companies. Some of 

these companies reported accounting irregularities, and 

the restatement of financial statements revealed previously hidden losses. In some cases, issuers that were not 

involved with accounting irregularities were forced to 

draw on bank credit lines when they were unable to roll 

over their CP because of the lack of demand or extreme13 Commercial paper is short-term promissory notes issued by large 

firms, generally maturing in nine months or less. It is an important 

source of short-term funding for corporations that need a steady 

stream of working capital. 

14 A CP back-up line is a commitment to provide a liquidity support 

for a company’s CP program. It is typically a revolving credit, a 

364-day facility. The rationale is that the borrower does not intend 

to use the back-up line, which generally costs more than issuing 

CP, unless the CP cannot be rolled over or repaid. 

15 The CP market can be divided into three tiers: Tier 1 (A1/P1/F1 or 

better), Tier 2 (A2/P2/F2), and Tier 3 (A3/P3/F3). The first two 

groups make up the bulk of the market. The first rating refers to a 

rating assigned by Standard & Poor’s, while the second and third 

reflect ratings assigned by Moody’s and Fitch, respectively. 

16 Moody’s Investors Service, Moody’s Credit Perspectives, December 

31, 2001. Moody’s downgraded 38 commercial paper programs from 

P1 in 2001. 

CHART 8 

Domestic Nonfinancial Commercial Paper 

Outstandings Have Declined amid Investors’ 

Jitters about Credit Quality 

Source: Federal Reserve Board (Haver Analytics) $ Billions 

100 

150 

200 

250 

300 

350 

2Q95 2Q96 2Q97 2Q98 2Q99 2Q00 2Q01 2Q02 

ly high rates demanded by investors. When a CP issuer 

draws down on the back-up line, rating agencies often 

view this as a weakness in the company’s liquidity, and 

a rating downgrade can occur. In turn, lower ratings lead 

to higher funding costs for the borrowers. 

The steepness of the current yield curve also results in 

significantly higher refinancing costs for investmentgrade corporations that no longer have access to shortterm funding through the CP market. As these 

companies are forced to borrow longer term, they face 

higher refinancing costs in the long-term end of the 

current yield curve.17 For example, if a Tier 1 corporation formerly issuing 90-day CP was forced to issue 

ten-year fixed-term debt in mid-July 2002, the cost 

would have been almost 350 basis points higher than 

issuing 90-day CP. 

Using back-up lines of credit when companies cannot 

roll over maturing CP has become expensive for some 

issuers. Bankers are realizing that initial pricing does 

not reflect the risk inherent in drawn-down lines. As a 

result, bankers have started to impose high utilization 

premiums on BBB-rated CP back-up lines. Also, borrowers recently have been seeking term-out options, 

another sign that refunding risk is a concern.18 Recent 

transactions reported by Loan Pricing Corporation 

show that some investment-grade companies are seek17Bloomberg Fair Market Sector Curves, July 5, 2002. The spread
 

between 60-day and five-year Treasury instruments was nearly 300
 

basis points. 


18 Once the back-up line has been drawn down, the borrower again has
 

to repay or roll over the debt. A revolving facility can be “termed out”
 

so that it becomes an installment loan with a much longer maturity,
 

such as three to five years. Such an option, however, can be costly.
 

Atlanta Regional Outlook 13 Third Quarter 2002 
In Focus This Quarter In Focus This Quarter
 

ing term-out options even at a fee of 200 basis points. 

The higher premiums demanded reflect both the volatility in the market and deteriorating credit quality indicated by high default rates and rating downgrades in 

recent quarters. 

Conclusion 

During the boom times of the late 1990s, corporations 

enjoyed an abundance of liquidity sources and easy 

access to capital. Many corporations used debt to 

finance business expansions, and rolling over maturing 

debt was not a significant concern. Recently, however, 

stock prices have been declining and investors have 

been concerned about the possibility of more corporate 

financial restatements. In this environment, highly 

leveraged borrowers worry about maturing debts and 

refunding risk implications. Lenders are demanding 

higher spreads because of the volatile financial markets 

and the deteriorated financial condition and debt ratings 

of many borrowers. In general, firms seeking to roll 

over maturing debt clearly face a less hospitable financing market today. With corporate profitability not yet 

strong, highly leveraged companies may find it increasingly difficult to meet debt service requirements and 

loan covenants. Despite these hurdles, the economy 

appears to be improving, and more companies are 

beginning to report higher earnings. With an economic 

recovery and tighter underwriting standards, the deterioration in commercial credit quality should stabilize 

and turn around. 

Cecilia Lee Barry, Senior Financial Analyst 

Atlanta Regional Outlook 14 Third Quarter 2002 

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