Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION FIRST QUARTER 1998 

FDIC
 

Chicago
 

Region
 

Division of
 

Insurance
 

John D. Weier,
 

Regional Manager
 

Joan D. Schneider,
 

Regional Economist
 

Michael J. Feeney,
 

Financial Analyst
 

In Focus This Quarter 

◆ Y2K—Preventing the Year 2000 (Y2K) computer problem is becoming ever more 

costly as the time and resources left to do so disappear. Equally costly, according to 

some estimates, will be the litigation that follows in the problem’s wake. A failure to 

address Y2K exposures immediately and successfully may amount to a gamble backed 

by the value of the bank franchise and the officers and directors who run it. See page 3. 

By Gary Ternullo 

◆ Trends in Commercial Real Estate Loan Pricing and 

Underwriting—An abundant supply of financing is placing pressure on commercial real estate loan pricing and underwriting standards. Underwriting standards are being increasingly influenced by the rapid growth in commercial 

mortgage-backed securities and real estate investment trusts. While many within the 

industry believe that broader public funding of commercial real estate projects will 

lead to greater market transparency and improved underwriting discipline, there 

are a number of unique risk considerations related to the rapid growth and continuing development of these alternative funding sources. See page 7. 

By Steven Burton 

◆ Total Return:A Useful Tool for Monitoring Investment Portfolio 

Risk—The Federal Financial Institutions Examination Council is rescinding the 

1991 policy that required “high-risk” testing for mortgage derivative products and 

has released for comment a policy encouraging risk management across all types of 

instruments on an investment portfolio basis. Total return, a concept that includes 

fluctuations in market value, is a useful tool for measuring the performance of an 

investment portfolio and providing information about market risk at the portfolio 

level. See page 13. 

By Allen Puwalski 

Regular Features 

◆ Regional Economy—The cyclical expansion is showing signs of age...this 

highly industrialized Region is quickly affected when expansions end...the contribution of rapid economic growth to the profitability of banks and thrifts may 

fade...borrowers and lenders may need to plan for a future in which downside risks 

could exceed upside potential. See page 16. 

By the Chicago Region Staff 

◆ Regional Banking—Many banks and thrifts in the Chicago Region have 

reduced the coverage of reserves set aside for future loan losses, and many have 

increased their concentrations in traditionally riskier loan categories...an improvement in traditional credit quality indicators may support some of the reduction in 

allowance for loan and lease losses (ALLL) coverage, but managers of insured institutions must consider additional factors when determining an acceptable range for 

the ALLL. See page 21. 

By the Chicago Region Staff 

A Publication of the Division of Insurance 
The Regional Outlook is published quarterly by the Division of Insurance of the Federal Deposit 

Insurance Corporation for the following eight geographic regions: 

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

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

Chicago Region (IL, IN, MI, OH, WI)
 

Dallas Region (CO, NM, OK, TX)
 

Kansas City Region (IA, KS, MN, MO, ND, NE, SD)
 

Memphis Region (AR, KY, LA, MS, TN)
 

New York Region (DC, DE, MD, NJ, NY, PA, PR, VI)
 

San Francisco Region (AK, AZ, CA, FJ, FM, GU, HI, ID, MT, NV, OR, UT, WA, WY)
 

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

form found on the back cover to the FDIC Public Information Center. Contact the Public 

Information Center for current pricing on bulk orders. 

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

publish/regout. For more information or to provide comments or suggestions about the Chicago 

Region’s Regional Outlook, please call John Weier at (312) 382-7512 or send an e-mail to 

jweier@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 Andrew C. Hove, Jr. 

Director, Division of Insurance Arthur J. Murton 

Editor George E. French 

Assistant Editors Daniel Frye 

Craig A. Rice 

Publications Manager Teresa J. Franks 
In Focus This Quarter
 

Y2K: Banking in the twenty-first century may provide
 

grand new opportunities—but you have to get there first
 

•	 As a result of a three-decades-old programming 

convention, January 1, 2000, may find some computer systems unable to function correctly, if at 

all. Links within and between systems and organizations make the problem a complex one. 

•	 Cures are expected to be difficult and costly. If 

those cures fail, litigation could be equally costly, 

and much of it may be aimed at directors and 

officers. 

•	 Accordingly, senior bank management should be 

actively involved in making sure the cure takes 

place. A failure to do so amounts to a gamble 

backed by the value of the bank franchise and 

those who run it. 

Complex Problem, Complex Cure 

By now the story is well known. At midnight on 

December 31, 1999, computer systems that process 

dates using only the last two digits of a year will cease 

to function correctly, if at all. Equipment that contains 

embedded systems—chips or circuitry designed to perform specific functions—also may fail. And the problem is pervasive. It lies within systems and between 

systems, in both software and hardware. The large number of ways dates are used, the number of places they 

can occur, and the number of creative ways for naming 

them confounds an accurate assessment. 

Fixing the Year 2000 (Y2K) problem will require considerable time and effort. Computers and applications 

must be inventoried, examined for date usage, corrected 

where necessary, and then tested—not just by themselves but in combination with every other system with 

which they interact. This includes not only a bank’s own 

systems but also those of its servicers, correspondents, 

customers, vendors, and trading counterparties. 

Moreover, there are a variety of ways to address the 

problem, ranging from expanding date fields to four 

digits to simply subtracting 28 years from every date 

before processing—any of which could introduce new 

incompatibility problems when systems that have been 

fixed in different ways attempt to interact.1 And because 

not all systems can be corrected at once, interfaces or 

bridges between corrected and uncorrected systems also 

must be developed to maintain business system continuity. Most important, it must all be done before the 

non-negotiable deadline of December 31, 1999. 

For bank management, there are two ways to find out 

how serious the problem will be. The first is to commit 

resources to determining just how exposed the bank’s 

systems are—the first concrete step in actually solving 

the problem. The second is to gamble the franchise by 

doing little or nothing and letting the century date 

change provide the ultimate stress test. 

Costs 

The costs of a cure are many. First, there are the costs of 

actually finding and fixing the problem. Estimates of 

this cost have ranged widely, although the Gartner 

Group’s estimate of $300 to $600 billion worldwide is 

the most widely quoted. Using a different approach, 

Software Productivity Research (SPR) places the global number at over $1.3 trillion, including a $176 billion 

slice for the United States alone. Then there are the estimated costs of litigation. At the low end, SPR places 

them at $300 billion globally and projects that fully onethird of that amount will be generated in the United 

States. At the high end, the Giga Information Group 

sees a much more litigious future—estimating that 

Y2K-related legal costs could exceed $1 trillion. 

Significant opportunity costs may accrue as well, and 

the degree to which Y2K-related outlays fail to provide 

1 Every 28 years the same combination of dates and days recurs. 

Subtracting 28 years from a date before processing and then adding 

them back upon output has been suggested as a temporary but partial 

remedy because it permits applications to continue measuring time by 

subtracting two-digit years from each other. Windowing is another 

partial correction whereby some two-digit years—say those less than 

“50,” for example—are assumed to be preceded by “20” (thus “49” 

becomes “2049” in date calculations) while the remainder are 

assumed to be preceded by a “19” (thus “50” becomes “1950”). Both 

approaches only delay the need for permanent corrections. 

Chicago Regional Outlook 3	 First Quarter 1998 
In Focus This Quarter
 

more efficient or functional systems will serve as a 

starting point for measuring the value of technology 

investments forgone. These forgone improvements will 

be especially costly for institutions that have started 

their repairs too late. They may find not only that the 

time for system improvements and upgrades has slipped 

away, but that they have insufficient time for anything 

beyond a patchwork solution that will continue to cost 

them beyond the year 2000. 

At the macro level, the tally of potential Y2K costs 

includes declining stock values, business failures, and 

recession. J.P. Morgan has estimated that as much as 40 

percent of organizations’ remediation costs have not 

been accounted for in their information technology budgets, presumably indicating that many firms will see 

their share value erode as the costs of Y2K fixes and 

related losses are priced into their future earnings. The 

cost of not being Y2K compliant might be substantial as 

well. According to the Gartner Group, as many as one 

in two firms may discover just how substantial as they 

head into 1999 with even their most mission-critical 

systems unfixed. The potential for these firms to fail 

looms large among the factors that have led Edward 

Yardeni, chief economist at Deutsche Morgan Grenfell, 

to assign a 40 percent chance of recession in the year 

2000. Peter de Jager, a consultant who also has commented extensively on Y2K issues, went even further, 

suggesting that 1 percent of all businesses would fail 

because of Y2K problems. Whatever the eventual 

number, many of these businesses will also be bank 

borrowers. 

Systems and Systemic Risks 

More immediate than the risk of borrower failures is the 

risk that a bank’s own systems may fail. Banks are heavily dependent on software applications that employ 

dates. Among other things, they use them for calculating interest paid or due and for managing the horizons 

of their assets and liabilities. If these applications begin 

returning erroneous calculations, bank operations could 

be seriously disrupted.2 If they fail altogether, the bank’s 

2 For example, interest due from borrowers for a one-year period 

beginning in 1999 and ending in 2000 might be calculated not as one 

year’s interest due but rather as nearly one century of interest payable 

(00 − 99 = − 99) if only the last two digits of the year are used in the 

calculation. Similarly, any other time calculation that straddles the 

century date change might return answers wrong in both size and 

sign. 

credibility—and hence its franchise value—can be substantially damaged or even irrevocably lost. 

The solution is often described in software terms, but 

executable software is not the only problem. Correcting 

software to process four-digit years does little good if 

bank databases that store the critical information about 

who owes what to whom and when still store them in 

two-digit form. Hardware is another critical area. 

Nearly all electronic devices have embedded, permanently programmed chips that can be difficult to find 

because the functions they perform are not always 

apparent. This situation could lead to a host of nuisances, with automated teller machines, point-of-sale 

terminals, bank vaults, check and credit card processing 

equipment, and even building systems succumbing to 

the Y2K problem. 

This dependence on external components and services 

creates a systemic exposure as well. The substantial 

efficiencies that now exist in transmitting payments 

among and between banks and borrowers are a direct 

result of technology. Servicers and 

clearinghouses fulfill computerintensive intermediary roles in this 

high-velocity business—pooling 

payments from those who owe and 

redistributing them among those 

to whom they are due. Anything 

that interrupts these flows can 

have a substantial impact on the ability of banks to settle with their customers and with each other. 

Accordingly, both the Bank for International 

Settlements and the U.S. Federal Reserve are concerned 

about the Y2K threat for two reasons—first because it 

can interrupt the operations of systems dedicated to 

making interbank payments and second because it can 

interrupt the operations of the individual participants 

and generate a liquidity shock that could cause other 

institutions to fail. 

Unfortunately for banks, even a fully successful, 

industry-wide Y2K fix will not completely mitigate 

their risk. The year 2000 story is simply too dramatic 

and lends itself too well to sensationalism. Therefore, 

in addition to managing the cure, bankers will have to 

manage the perceptions of their customers and of the 

public at large—a considerable challenge given that a 

loss of confidence by a small number of customers 

could precipitate liquidity problems for institutions 

even in the absence of a genuine threat. 

Chicago Regional Outlook 4 First Quarter 1998 
In Focus This Quarter
 

Liability in the Executive Suite 

It bears frequent repeating that Y2K is a business problem and not just a technical one. Its intricacies go 

beyond those of the systems themselves and extend into 

the labyrinth of business relationships and fiduciary 

obligations that bind directors and officers—and the 

assorted attorneys, auditors, consultants, and service 

providers who assist them—to their banks. Through this 

network could pass liability and litigation that could be 

several times the cost of fixing the problem itself. And 

although the problem may have had a technical origin, 

claims would likely be directed against those with deeper pockets who jointly and severally, it will be argued, 

should have corrected or disclosed the institution’s Y2K 

exposures. 

While the bank failures of the late 1980s and early 

1990s are often attributed to unforeseen economic 

events, it will be difficult to assert such a defense for a 

failure to address the Y2K problem. It is simply too visible and offers too much advance notice. This is one reason why the potential potency of Y2K litigation should 

be taken seriously. Moreover, placing the blame, no 

matter how well deserved, at the feet of vendors and 

consultants may offer little protection. The Federal 

Financial Institutions Examination Council (FFIEC) 

has indicated that senior bank management should be 

fully aware of their vendors’ progress and develop contingency plans should those vendors fail.3 This pronouncement has elevated the standard for prudent Y2K 

actions in such a way as to make imperative the active 

involvement of top bank management in both solving 

3 Safety and Soundness Guidelines Concerning the Year 2000 Business 

Risk, December 1997. The full text is available on the FFIEC website 

at www.ffiec.gov. 

Managing the Y2K Process 

On May 5, 1997, the Federal Financial Institutions Renovation. Renovation includes not only fixing the 

Examination Council—an interagency group com- problem internally but monitoring the efforts of cusposed of the Federal Deposit Insurance Corporation, tomers, counterparties, vendors, and service 

Federal Reserve, Office of the Comptroller of the providers. The prudent execution of due diligence and 

Currency, Office of Thrift Supervision, and National best practices at this stage will provide a measure of 

Credit Union Administration—released a statement confidence that exposures have been addressed. It 

on Year 2000 project management awareness that will also provide a measure of protection from liabilincluded an outline of the Y2K management process. ity claims should problems nevertheless emerge. 

That outline identified five phases that each financial 

institution would have to navigate in identifying and Validation. Validation means testing how a bank’s 

fixing its Y2K exposures: systems will respond on their own as well as when 

connected with those outside the bank. The FFIEC 

Awareness. Before Y2K exposures can be fixed, they believes that one full year should be available for testmust be seen as problems. Creating awareness, how- ing and correcting problems that either remain or are 

ever, is not easy because the pervasiveness of compo- introduced by the renovation process. Accordingly, 

nents and intersystem links that can harbor or pass the institutions should plan on completing the previous 

problem create complexities that are neither intuitive three phases by the end of 1998. 

nor easily quantified. However, it is critical that senior 

managers understand the problem and fully support Implementation. Testing corrected systems to ensure 

the commitment of resources to fixing it. their compliance does not complete the process. The 

final step is to gain acceptance by the users as to the 

Assessment. In this phase, all information systems, ability of the system to satisfy business requirements. 

electronic equipment, and building systems must be A failure at this stage will require further correction 

evaluated for specific Y2K exposures. Remediation or the implementation of contingency plans. 

plans must then be devised. In addition to plans for 

fixing the problem, contingency plans will be needed For the full text of this and other FFIEC guidance, see
 

as a precaution against unforeseen Y2K failures orig- the FFIEC website at www.ffiec.gov.
 

inating from both within and outside the bank.
 

Chicago Regional Outlook 5 First Quarter 1998 
In Focus This Quarter
 

the problem and ensuring that the franchise will be protected if one or more of those solutions fail. 

Betting the Franchise 

The FFIEC has divided Y2K remediation into five 

phases—awareness, assessment, renovation, validation, 

and implementation (see Inset 1, page 5). As a benchmark for progress, the FFIEC has indicated that the validation phase—the phase in which testing of Y2K fixes 

is conducted—should be well under way for all banks 

by the end of 1998. This leaves less than a year for laggards to complete the first three phases. Banks that are 

not devoting adequate resources to identify and address 

their exposures need to be aware that the consequences 

of delay or inaction could be severe. The bank supervisory agencies, Congress, and the financial markets are 

taking the risk to heart. So too are attorneys intent on 

sharing in what has been described as potentially the 

most expensive litigation in history. 

Insurance companies are concerned as well, as evidenced by extremely high Y2K policy premiums or outright refusal to write Y2K coverage. Thus, any business 

interruptions and liability that emerge may have to be 

financed from the bank income statement and balance 

sheet. As such, a bet that Y2K will not be a problem 

might well amount to a gamble backed by the bank franchise and those who run it. (See Inset 2 below for additional sources of information.) 

Gary Ternullo, Senior Financial Analyst 

gternullo@fdic.gov 

For Further Information 

Further information on the Y2K problem can be obtained from banking regulatory agencies at the websites shown 

below. 

Federal Deposit Insurance Corporation (FDIC) www.fdic.gov 

Federal Financial Institutions Examination Council (FFIEC) www.ffiec.gov 

U.S. Federal Reserve Board of Governors www.bog.frb.fed.us 

National Credit Union Administration (NCUA) www.ncua.gov 

Office of the Comptroller of the Currency (OCC) www.occ.treas.gov 

Office of Thrift Supervision (OTS) www.ots.treas.gov 

The following websites contain additional information concerning the Y2K problem. Their inclusion here does 

not serve as an endorsement by the FDIC of any information contained therein. 

Market Partners Inc.—Year 2000 Resources for Banks www.marketpartners.com 

Gartner Group—Technology Consultant www.gartner.com 

Software Productivity Research (SPR)—Technology Consultant www.spr.com 

De Jager LLC (Peter de Jager)—Technology Consultant www.year2000.com 

Giga Information Group—Technology Consultant www.gigaweb.com 

Y2K LLC (Williams, Mullen, Christian & Dobbins)—Attorneys www.Y2K.com 

Economics Network (Dr. Edward Yardeni)—Economist www.webcom.com/yardeni 

Chicago Regional Outlook 6 First Quarter 1998 
In Focus This Quarter
 

Trends in Commercial Real Estate
 

Loan Pricing and Underwriting
 

•	 An abundant supply of capital is placing significant pressure on commercial real estate loan 

pricing. 

•	 Considerable evidence suggests that a large percentage of insured institutions are easing commercial real estate and construction lending 

underwriting standards. 

•	 The rapid rise in commercial mortgage-backed 

securities and real estate investment trust funding 

could change the way banks underwrite commercial real estate loans and have important effects 

on their competitive position in the lending 

markets. 

As reported in last quarter’s Regional Outlook, banks 

provided the largest share of funding for commercial 

real estate during 1995 and 1996 compared with all 

other financing sources (see Strong Demand and 

Financial Innovation Fuel Rebounding Commercial 

Real Estate Markets). Chart 1 shows that banks’ commercial real estate and construction lending continues 

to increase and that year-over-year growth rates in these 

two loan categories are accelerating. At the same time, 

however, alternative funding sources in the form of 

commercial mortgage-backed securities (CMBS) and 

real estate investment trusts (REITs) are also experiencing significant growth. Commercial Mortgage Alert 

reports that $26 billion in CMBS was issued through 

September 1997, up from $17 billion for the same period in 1996. The same publication projects that CMBS 

issuance will top $40 billion during 1997, compared 

with last year’s record issuance of $29.8 billion. 

Measures of REIT activity also indicate impressive 

growth. According to the National Association of Real 

Estate Investment Trusts, REITs issued $26.3 billion in 

equity through October, compared with $12.3 billion 

for all of 1996. In addition, REIT market capitalization 

rose $50 billion (64 percent) through the first nine 

months of 1997. 

While it is good news to borrowers, the abundance of 

capital for commercial real estate projects raises the 

often-quoted concern that “too much money is chasing 

too few deals.” Market observers worry that fierce competition and an excessive supply of financing are leadCHART 1 

Banks’ Commercial Real Estate and 

Construction Lending Rebounds 

Year-over-Year (%) Growth

Source: Commercial Bank Call Reports 

–30 

–20 

–10 

0 

10 

20 

YE90 YE91 YE92 YE93 YE94 YE95 YE96 3Q97 

Construction Loans 

Commercial Real Estate Loans 

ing to both inadequate loan pricing relative to risks 

borne by lenders and looser loan underwriting standards. This article examines current trends in commercial real estate loan pricing and loan underwriting. It 

also explores the possible influences of CMBS and 

REITs on loan underwriting practices and commercial 

real estate markets. 

An Abundance of Capital Has Placed 

Significant Pressure on Commercial Real 

Estate Loan Pricing 

Chart 2 (next page) shows that prime-graded commercial mortgage spreads have steadily declined since 1992 

and are now at levels not seen since the real estate boom 

years of 1988 and 1989. At 113 basis points above tenyear treasuries, current spreads on ten-year commercial 

mortgages are only slightly higher than A-rated ten-year 

industrial corporate bonds, which traded at spreads of 

66 basis points over comparable-term treasuries as of 

September 1997. Some property sectors have experienced more narrowing of spreads than others. 

American Council of Life Insurance (ACLI) data show 

that mortgage spreads relative to treasuries compressed 

31 basis points for industrial, 22 basis points for hotel, 

21 basis points for retail, 11 basis points for multifamily, and 10 basis points for office real estate from March 

1996 to March 1997. Moreover, because of continuing 

downward pressure, current pricing varies little across 

Chicago Regional Outlook 7	 First Quarter 1998 
In Focus This Quarter
 

CHART 2 CHART 3 

Commercial Mortgage Spreads Are Pricing Narrows between High- and
 

Tightening 

Basis Point Spread over

Ten-Year Treasuries 

Source: Barron’s/John B. Levy 

0 

50 

100 

150 

200 

250 

Jan ’87Jan ’89Jan ’91Jan ’93Jan ’95Jan ’97 

Spread between AAA and BBB

Grades (Ten-Year Average Life)

Medium-Grade CMBS 

Basis Points 

140 

120 

100 

80 

60
 

40
 

20
 

0 

Q1 ’95Q3 ’95Q1 ’96Q3 ’96Q1 ’97Q3 ’97 

Source: Nomura Securities International 

the quality spectrum. For instance, Chart 3 indicates 

that spreads between AAA- and BBB-rated CMBS have 

narrowed considerably since year-end 1995, from 110 

basis points to a scant 28 basis points. 

It seems likely that competitive factors will continue to 

place pricing pressure on lenders. The relatively recent 

entrance of Wall Street firms into the financing arena 

via conduits is a striking example of just how competitive the market for commercial real estate financing has 

become.1 Conduits are rapidly becoming the dominant 

issuer of CMBS and underlie much of the rapid growth 

in CMBS noted above. Through the first nine months of 

1997, Commercial Mortgage Alert reported that conduits accounted for 50 percent of total CMBS issuance, 

compared with 30 percent during the same period in 

1996. 

Many industry participants see conduits and REITs as 

significant and increasing competitive threats to traditional lenders. For example, a recent issue of 

Commercial Real Estate South discussed the continuing expansion of conduit business into a much wider 

range of property and credit quality types. This publication noted that conduits have a particular incentive to 

aggressively pursue higher quality loans in order to 

strengthen pools that contain weaker credits. Such 

aggressiveness threatens to squeeze banks’ profit margins on low-risk deals, which might give banks an 

incentive to pursue lower quality credits. Given their 

focus on larger credits, conduits presently pose a competitive threat primarily to larger lenders. However, the 

1 Conduits are entities created to originate mortgage loans for distribution to investors in the secondary market. 

rapid growth of capital within the industry may eventually force larger lenders to target smaller markets, which 

would in turn increase competition at the regional or 

local community level. While their influence is less 

direct, the growing use of REITs to finance commercial 

real estate projects also places pressure on loan pricing 

spreads, since lenders must compete for a smaller pool 

of customers. With their access to a seemingly limitless 

source of public funding, REITs could pose a particular 

threat to community bankers by dominating certain geographic markets or property sectors. 

Narrowing pricing spreads raise concerns over whether 

lenders are being adequately compensated for the operational, funding, credit, and market risk inherent in 

originating, servicing, and holding commercial real 

estate loans. More important, tightening spreads raise 

prospects that lenders will ease other loan terms and 

relax loan standards to the extent that they are unable to 

differentiate their product based solely on price. While 

such easing may enable lenders to retain business in the 

face of stiff competition, imprudent underwriting could 

ultimately lead to higher loan losses than would otherwise be the case in the event of a downturn in commercial property markets. 

Are Commercial Real Estate Loan Underwriting 

Standards Becoming Looser? 

Most industry experts have argued that the memory of 

the real estate downturn of the late 1980s and early 

1990s keeps lenders from becoming overly aggressive 

in making commercial real estate loans despite the 

abundance of funding alternatives currently available to 

Chicago Regional Outlook 8 First Quarter 1998 
In Focus This Quarter
 

borrowers. These experts point out that today’s loan-tovalue (LTV) ratios are lower than they were at the peak 

of the last real estate boom, that lenders are concentrating more on obtaining adequate debt-coverage ratios, 

and that lenders are requiring borrowers to bring more 

cash equity to the table. One might also argue that practices have improved and become much more uniform 

with the implementation of regulatory appraisal standards and the adoption of interagency guidelines for 

real estate lending policies. Rating agencies impose 

additional guidelines and standards as lenders originate 

loans for possible sale into the secondary markets. 

While information about specific quantitative underwriting criteria applied to new loan originations by 

commercial banks is not readily available, some sense 

of industry trends may be gleaned from competitors’ 

practices. For example, the ACLI performs a quarterly 

survey of underwriting criteria for commercial real 

estate loan commitments originated by major life insurance lenders. The ACLI’s second quarter 1997 survey 

indicated that new commitments (total volume of $4.1 

billion) had a weighted average LTV for all property 

types of 66 percent and a weighted average debt-coverage ratio (DCR)2 of 1.6 times. These figures compare 

favorably to an LTV ratio in late 1989 approaching 75 

percent and a DCR just under 1.3 times. 

ACLI data suggest that recent commercial mortgage 

originations are better supported by borrower equity 

and property cash flows than they were in the late 

1980s. It is important to recognize, however, that LTV 

and DCR ratios are driven largely by market conditions 

and expectations. Property valuations take into account 

recent sales and expected cash flows, and cash flows 

available to service debt are based on projected net 

operating revenues, which often incorporate projected 

increases in rents and other revenue sources. In other 

words, the overwhelmingly favorable conditions in 

today’s real estate markets may also be a factor in the 

improved LTV and DCR ratios. Keeping in mind the 

cyclical nature of real estate, one can easily see how a 

shift from today’s positive outlook to a more pessimistic 

outlook might result in a sharp reversal in these commonly cited ratios. 

Notwithstanding these quantitative considerations, 

there are indications that banks are easing commercial 

2 The debt-coverage ratio measures annual net operating income generated by a property relative to annual principal and interest payments 

due on the underlying loan. 

real estate underwriting standards. This evidence, 

derived from industry and examiner surveys conducted 

by the three banking agencies, includes the following 

observations: 

•	 In the Office of the Comptroller of the Currency’s 

(OCC’s) 1997 Survey of Credit Underwriting 

Practices, OCC examiners reported eased commercial real estate lending standards in 38 percent of 

banking companies surveyed. For comparison purposes, the 1996 survey reported eased standards in 

16 percent of banking companies surveyed. Among 

institutions with eased lending standards in the 1997 

survey, examiners noted a 75 percent incidence of 

reductions in loan fees or rate spreads, a 43 percent 

incidence of eased guarantor requirements, and a 29 

percent incidence of lower collateral requirements. 

Examiners cited competitive factors and a change in 

economic outlook as the main reasons for changes in 

underwriting standards. 

•	 Chart 4 summarizes current and historical results of 

the Federal Reserve Board Senior Loan Officer 

Opinion Survey for responses to the question of 

whether bank credit standards for approving applications for commercial real estate loans have eased, 

tightened, or remained unchanged. These survey 

results show that banks have had a tendency to ease 

underwriting standards since the fourth quarter of 

1996. This tendency appears to have become 

stronger through the third quarter 1997 survey but 

moderated somewhat in the most recent survey. The 

most recent survey showed that large banks (over 

$15 billion in assets) were much more likely to indicate easing commercial real estate standards than 

CHART 4 

Survey Shows Tendency to Ease Commercial 

Real Estate Underwriting Standards 

Percentage 

Source: FRB Senior Loan Officer Opinion Surveys 

2Q96 3Q96 4Q96 1Q97 2Q97 3Q97 4Q97 

–15 

–10 

–5 

0 

5 

10 

15 

20 

25

 % Respondents Tightening

 % Respondents Easing

 Net % Tightening (Easing) 

Chicago Regional Outlook 9	 First Quarter 1998 
In Focus This Quarter
 

smaller banks. Specifically, 21 percent of large 

banks reported easing standards, while only 3 percent reported tightening standards. In comparison, 

only 9 percent of smaller banks reported easing 

standards, while 13 percent reported tightening 

standards. 

•	 Results from the FDIC Report on Underwriting 

Practices indicate possible easing of standards for 

construction and development (C&D) loans at 

FDIC-supervised banks. A comparison of examiner 

responses for the third quarter 1997 survey (covering 

examination reports filed from April through 

September 1997) with responses for the third quarter 

1996 survey leads to the following observations3: 

•	 The percentage of banks frequently or commonly 

originating C&D loans tied to speculative projects 

(that is, projects lacking meaningful preleasing or 

presales, or loans without a formal take-out commitment for permanent financing following completion 

of construction) rose markedly, from 11 percent to 

29 percent. 

•	 The percentage of banks frequently or commonly 

granting C&D loans without considering alternative 

repayment sources other than income generated by 

the project being financed rose significantly, from 8 

percent to 20 percent. 

•	 The percentage of banks frequently or commonly 

basing C&D loans on unrealistic appraisals rose 

from 5 percent to 11 percent. 

•	 The percentage of banks frequently or commonly 

funding or deferring interest payments during the 

term of construction loans rose from 7 percent to 15 

percent. 

Much of the commentary in recent issues of various 

trade journals echoes the results of these regulatory surveys.4 In brief, many industry participants are seeing a 

higher incidence of (1) banks funding construction loans 

without preleasing commitments on major portions of 

rentable space, (2) banks easing LTV ceilings, (3) 

3 The authors of this survey note that comparisons of survey results 

across time periods must be interpreted with caution since the survey 

samples are dictated principally by examination scheduling factors. 

As a result, sample populations may be materially different from one 

period to another. 

lenders curtailing reserve requirements for such items as 

tenant improvements and insurance, and (4) nonrecourse 

lending. Some industry participants have also noted the 

increasing acceptance of “trended rents,” whereby property valuations are based on positive rent projections 

extrapolated several years into the future. Of course, 

these trended rents will hold true only if economic circumstances remain favorable for extended periods— 

an assumption that may not be reasonable given 

the cyclical nature of real estate coupled with 

the advanced age of the current economic 

expansion. 

With a combination of relatively low 

interest rates, rising real estate prices, 

and an expanding economy, it is perhaps not too surprising that some 

lenders have eased commercial real 

estate underwriting standards. Such 

easing may be a natural response to 

improved confidence in the real estate 

markets. However, indicators that show 

loosening standards may also be warning flags that lenders have succumbed to tighter pricing 

and competitive pressures. To avoid losses like those 

sustained by banks during the last real estate downturn, 

prudent lenders will refrain from incorporating unrealistic expectations into their lending practices. 

CMBS Could Change the Way 

Lenders Underwrite Loans 

Much as residential mortgage lending standards were 

shaped by the advent of mortgage-backed securities, 

CMBS promise to change the way banks underwrite and 

service commercial real estate loans. For instance, lending terms and practices could become increasingly standardized as lenders attempt to improve the liquidity and 

marketability of their commercial mortgage portfolios. 

Banks that choose to deviate from these emerging standards will sacrifice flexibility in terms of their ability to 

manage portfolio risks and respond rapidly to liquidity 

demands. 

The ability to securitize commercial real estate loans 

also may fundamentally alter the way lending decisions 

4 See, for example, Commercial Real Estate South, “Public Markets 

Fuel Financing Glut” (October 1997); Midwest Real Estate News, 

“Wall Street and Main Street Squeeze Lenders” (October 1997); and 

Commercial Property News, “Michelson, Greenland Seize Low 

CMBS Spreads” (1 May 1997). 

Chicago Regional Outlook 10	 First Quarter 1998 
In Focus This Quarter
 

are made. Before the development of CMBS markets, 

loan approval was essentially a binary, good-or-bad, 

accept-or-reject decision whose primary focus was on 

the credit risk inherent in a single asset. In contrast, the 

most important elements in CMBS are deal structure, 

price execution for multiple tranches, credit enhancements, and portfolio composition. Here, the loan originator is more likely to use a portfolio approach in 

making credit decisions: That is, how will this loan 

enhance the expected return and risk diversification of 

the overall pool? 

External rating agencies will become increasingly 

important as CMBS markets expand, since these agencies’ guidelines will effectively dictate the underwriting 

standards applied to securitized loans. While such standardization could arguably improve market discipline 

and loan performance disclosure, there are several 

potential risks to consider as the CMBS markets evolve: 

•	 While rating agencies do incorporate qualitative 

considerations into their analysis, issue ratings and 

credit enhancement level decisions are driven primarily by quantitative factors, namely debt service 

coverage and expected loss levels. Moreover, most of 

the qualitative factors the agencies consider involve 

an analysis of portfolio balance and pool diversification. Hence, weak or poor qualitative standards (for 

example, lack of alternative repayment sources or 

minimal borrower equity in the project) applied to 

individual loans within the pool may receive only 

secondary consideration. A quantitative perspective 

also ignores such immeasurable factors as borrower 

“character” and the existence of long-standing 

lender-borrower relationships. 

•	 Rating agencies cannot be relied upon as a backstop 

to unsound underwriting practices. While they generally review a substantial volume of the loans within a pool, typically the largest individual credits, they 

are not practically able to review every credit in the 

securitization. Some within the industry have even 

suggested that investment bankers commonly move 

one problem property, discovered through one 

agency’s sample, into pools reviewed by another 

agency in the hope that it will not be sampled. 

•	 Competition among the rating agencies could 

become a factor in the underwriting process. This 

“shopping of the agencies” could result in continual 

pressure for rating agencies to ease their underwriting guidelines. 

•	 In theory, bank-issued CMBS transfer much of the 

underlying credit risk associated with commercial 

real estate lending to investors. However, like other 

types of asset securitization, CMBS raise concerns 

over the degree to which banks will voluntarily 

absorb investor losses. Bank issuers may be more 

likely than nonbank issuers to provide voluntary support to poorly performing CMBS for at least two reasons: A tarnished reputation in one aspect of a bank’s 

operations could carry over to other business activities like deposit taking and borrowing due to a bank’s 

broad brand name association within the marketplace; and banks often have greater financial 

resources than nonbanks with which to support securitization activities. 

Because the rapid growth in CMBS has been a relatively recent phenomenon, current underwriting guidelines 

applied by the rating agencies to CMBS have not been 

tested during a cyclical downturn in real estate prices. It 

remains to be seen how the market will react to rising 

loan losses that result in investor losses. 

Will Increased Public Funding through CMBS 

and REITs Improve Market Discipline? 

Many contend that the increased transparency brought 

to the market by CMBS will temper cyclical swings in 

real estate values. This viewpoint argues that investors 

will serve as a constraint against the natural tendency to 

overbuild commercial real estate during boom periods, 

since less funding will be allocated to segments of the 

market where excess capacity exists. This viewpoint 

presupposes that the investing public is sophisticated 

enough to recognize when markets are out of balance 

and when projects are economically infeasible. In this 

sense, CMBS shift much of the burden of monitoring 

credit quality standards and credit performance from 

lenders to public investors. 

In contrast, others have argued that lenders are much 

better suited than investors to make judgments about 

credit quality standards and project feasibility. This line 

of reasoning suggests that the increase in public ownership of property through CMBS and REITs could actually reduce market discipline, since the most 

sophisticated participants with access to the best information (that is, lenders) may come to have less at stake 

in making prudent credit decisions. Of course, excessive losses attributable to any one CMBS issuer might 

lead to differentiation in pricing based on investors’ 

Chicago Regional Outlook 11	 First Quarter 1998 
In Focus This Quarter
 

perceptions of the quality of underwriting applied by 

specific issuers.5 

Putting market efficiency arguments aside, the sheer 

volume of REIT and CMBS activity causes some concern over the extent to which such financing is driving 

property valuations. With such an abundance of capital 

flowing into the commercial real estate market, it is perhaps easy to see why lenders might opt to ease standards 

rather than lose business. However, to the extent securitization activities are driving decisions in today’s commercial real estate markets, lenders might wish to 

consider how property values would react if the availability of such financing were sharply diminished. The 

most recent real estate downturn provided a ready 

example of how tighter credit availability compounded 

the effects of declining commercial property values by 

limiting the ability of lenders to sell distressed properties. While there may not be consensus on whether 

CMBS and REITs will temper cyclical price swings, the 

underwriting standards and practices evolving in 

response to these financing vehicles will likely play a 

crucial role in determining the magnitude of losses 

experienced by investors and banks during the next 

downturn in commercial property values. 

Steven Burton, Senior Banking Analyst 

sburton@fdic.gov 

Selected Articles
 

for Further Reading
 

Bloomfield, Craig. “Michelson, Greenland Seize 

Low CMBS Spreads.” Commercial Property News. 

1 May 1997. p. 33. 

“CMBS Issuance Seen Topping $40 Billion.” 

Commercial Mortgage Alert. 10 November 1997. 

p. 1. 

Fitch Investor Services, Inc. “Commercial 

Mortgage Stress Test.” Fitch Research: Structured 

Finance Special Report. 8 June 1992. 

Office of the Comptroller of the Currency. Advisory 

Letter 97-3: Credit Underwriting Standards and 

Portfolio Credit Risk Management. 3 March 1997. 

Sinderman, Martin. “Public Markets Fuel 

Financing Glut.” Commercial Real Estate South. 

October 1997. p. 1. 

Wolf, Barney. “Wall Street and Main Street 

Squeeze Lenders.” Midwest Real Estate News. 

October 1997. p. 1. 

5 The evolution of the credit card securitization markets is one example of how investors now differentiate between issuers in terms of 

pricing. 

Chicago Regional Outlook 12 First Quarter 1998 
In Focus This Quarter
 

Total Return: A Useful Tool for
 

Monitoring Investment Portfolio Risk
 

•	 The Federal Financial Institutions Examination 

Council (FFIEC) is replacing the 1991 policy that 

contained a specific “high-risk test” for mortgage 

derivative products (MDPs) held by insured institutions with a policy that encourages risk management across all types of instruments on an 

investment portfolio basis. 

•	 A good way to start measuring portfolio risk is by 

monitoring an appropriate measure of return. 

•	 Total return, a concept that includes fluctuations 

in market value, is a more appropriate tool than 

simple yield for measuring the performance of an 

investment portfolio, especially one that contains 

bonds with embedded options. 

The Federal Financial Institutions Examination Council 

(FFIEC) has released for comment a new Joint Agency 

Policy Statement on Investment Securities and EndUser Derivatives Activities that will replace a statement 

issued February 3, 1992. While much of the content of 

the former statement has been retained, the section 

requiring specific “high-risk” testing for mortgage 

derivative products (MDPs) has been eliminated. The 

“high-risk” test applied specifically to bonds collateralized by residential mortgage pass-through certificates 

or whole loans but that distributed cash flows to bondholders on a basis other than pro rata.1 

The goal of the original policy statement was to deter 

banks from investing in products that presented risks 

that they were not able to adequately monitor and control. MDPs were singled out because of their rapid 

growth, nontraditional and potentially risky nature, and 

common use by insured financial institutions. The new 

policy states that, as a sound management practice, 

institutions should conduct prepurchase and ongoing 

analysis of all their investments at a level appropriate to 

the size and complexity of those holdings. 

1 A security was deemed “high risk” if it exhibited any of the following characteristics: (1) it had a weighted average life of more than ten 

years; (2) its average life extended by more than four years or shortened by more than six years from a 300 basis point parallel shift in 

rates; (3) its price changed by more than 17 percent given a 300 basis 

point parallel shift in rates. 

The policy change is in part a response to increasing 

bank investment in securities that have complex cash 

flows analogous to MDPs but that escaped the analysis 

requirement of the previous policy. Mortgage index 

amortizing notes are an example of popular bank investments that potentially exhibit all the risks of MDPs but 

were not subject to the testing requirement of the soonto-be rescinded policy because they are not collateralized by mortgages. Callable agency and “step-up” 

bonds are popular bank investments because they offer 

a slightly larger spread to Treasury than noncallable 

agency securities, and they were not subject to the 

“high-risk” test under the old policy. However, the additional yield offered on these kinds of securities compensates the investor for assuming additional risk. 

Appropriately measuring portfolio return can enhance 

the ability to monitor the extent to which these kinds of 

securities put future earnings at risk. 

Total Return Analysis Is a Useful Tool for 

Analyzing Risk at the Portfolio Level 

Total return analysis is a basic but useful tool that can 

alert management to the level of certain risks in an 

investment portfolio. It can also provide information 

that is useful for validating the assumptions used in 

more sophisticated models. Total return is calculated 

from three components: beginning price, income and 

reinvested cash flow, and ending price (market value) at 

a horizon date. Total return incorporates the change in 

the market value of the investment, resulting in a more 

comprehensive measure of performance than other 

measures that ignore such changes. Monitoring total 

return on a portfolio basis can provide institutions with 

important information about the risks inherent in the 

portfolio and how these risks may be changing over 

time. 

In two articles in the ABA Banking Journal,

2 Nicholas 

Betzold and Richard Berg convincingly dispute the 

2 The articles were published in December 1996 and April 1997. 

Reprints of the articles are available at the ABA Banking Journal website at http://www.banking.com.aba/backissues.htm. 

Chicago Regional Outlook 13	 First Quarter 1998 
In Focus This Quarter
 

view that if the investment strategy is to buy and hold to 

maturity, total return is not relevant. Consider the following example. In 1990, Bank A purchases a sevenyear security yielding 8.83 percent that is callable after 

three years. At the same time, Bank B buys a noncallable seven-year agency security yielding 8.53 percent. For three years, Bank A’s bond yields 30 basis 

points more than Bank B’s. However, from 1990 to 

1993, interest rates fell almost 300 basis points. Bank 

A’s bond would likely be called, forcing the bank to 

reinvest at a significantly lower rate for the remaining 

four years of the seven-year investment horizon. Over 

the seven-year horizon, Bank A could expect an average 

yield that is about 150 basis points less than Bank B’s. 

From the yield perspective, 

Bank A enjoyed three years of 

superior performance. However, during those three years, 

monitoring total return might 

have revealed a less favorable 

but more accurate picture of 

Bank A’s performance relative 

to Bank B’s. Here is why: As 

rates fell from 1990 to 1993, bonds gained in value. 

However, as rates fell, the market value of the callable 

security would have gained incrementally less than the 

noncallable bond because each downward tick in rates 

increased the expectation that the bond would be called, 

and the higher coupon would be earned over a shorter 

period. In contrast, the noncallable security’s market 

value would have enjoyed the full benefit of the falling 

rate environment because its maturity and cash flows 

are fixed. 

The disparate change in the market value of the two 

bonds reflects the fact that Bank A, in essence, sold a 

call option to the bond issuer. The issuer bought the 

right to repurchase the debt at par after three years. 

Bank A was compensated for selling this right to the 

issuer with increased yield. In the example, the issuer’s 

option to call the bond would have gained value as rates 

fell. The increasing positive value of the call option to 

the issuer represents an increasing negative value to the 

bondholder and erodes the value of the bond. 

Step-up bonds present reinvestment risk similar to that 

of generic callable bonds, but with the added complexity of a coupon that rises, usually annually, if the bonds 

are not called. Total return analysis would similarly 

reveal adverse changes in the value of the embedded 

call options and the extent to which the additional 

coupon is compensating for call risk. 

UBPR Yield 

Bank management often uses the portfolio yield that is 

calculated in the Uniform Bank Performance Report 

(UBPR) to assess performance of the bank’s securities 

portfolio against its peers. This yield measure is calculated by dividing annualized book income on a tax 

equivalent basis (plus or minus amortization or accretion of any premium or discount) by the amortized cost 

of the securities. This measure of present yield says little about potential future yield and the extent to which, 

because implicit options have been sold, the latter has 

been put at risk for the sake of the former. 

Total return measures the risk-adjusted return of a portfolio more closely than yield because it incorporates 

changes in reinvestment risk over time. Ultimately, a 

portfolio manager who earns total returns consistently 

higher than average will earn more in terms of simple 

yield. Conversely, a manager who earns less in terms of 

total return will eventually find an unfavorable reinvestment environment that will erode reported yield. 

The popularity of using yield to gauge the performance 

of bank securities portfolios may be due to the convenient presentation of bank peer portfolio yields in the 

UBPR. Some managers may be reticent to evaluate 

portfolio performance using total return without a peerlike benchmark for calibrating total return expectations. 

Betzold and Berg have devised an investment portfolio 

index (introduced in the April 1997 ABA Banking 

Journal) that is designed to track the total return of a 

typical bank portfolio composed of the same percentages of investment sectors as the average bank. The 

portfolio on which the index is based is rebalanced 

monthly as principal pays down, and it is rebalanced 

quarterly to reflect the latest Call Report data on portfolio allocations. Table 1 depicts the investment weighting of the index as of December 31, 1996, based on 

September 30, 1996, Call Report data. 

According to Betzold and Berg, this index produced 

total returns that closely approximated those of the actuChicago Regional Outlook 14 First Quarter 1998 
In Focus This Quarter
 

al median bank total portfolio measured by Call Report 

data from 1993 through third quarter 1997.3 They concluded that their index seems to provide a reasonable 

proxy for the total return of the “average” bank investment portfolio. 

Chart 1 shows the performance of the index so far this 

year.4 Changes in the index value over time can be translated into total returns that approximate the median 

bank portfolio’s total return. For example, the annualized total return for the index from year-end 1996 

through third quarter 1997 was 6.72 percent and is calculated as follows: 

Calculate the bond equivalent semiannual yield 

and express the semiannual bond equivalent yield 

as an effective annual yield. 

4

1 105.00 3

6.72% = 100 [(1) − 1

100.00 ]

The performance of the index for 1997 suggests that 

banks’ total investment portfolio returns were highly 

negatively correlated with changes in the five-year 

Treasury rate (see Chart 2). This finding indicates that 

changes in total return from period to period can provide useful information about the level of a portfolio’s 

interest rate sensitivity. As emphasized above, these 

changes in total return over time include the effects of 

changes in market value of any call options on a bank’s 

investment securities and hence provide information 

about the degree to which future income is at risk. 

Given the increasing level of optionality embedded in 

the average bank securities portfolio—even if it arises 

solely from callable agency debt and “step-up” structured notes—yield should not be the sole measure of 

overall portfolio performance. Total return analysis is an 

appropriate supplement that gauges the risk-return characteristics of an investment strategy that involves selling 

implicit options. 

Allen Puwalski, Senior Financial Analyst 

3 While the Call Report does not contain the information necessary to
 

compute total return precisely, the authors computed an estimate
 

using the reported yield and market value data.
 

4 The index is published monthly in the ABA Banking Journal.
 

TABLE 1 

Composition of Betzold Berg Index 

December 31, 1996 

PERCENT 

SECURITY TYPE OF INDEX 

TREASURIES 24.52 

AGENCIES 24.38 

MUNICIPAL BONDS 12.26 

FIXED-RATE MORTGAGE OR 

MORTGAGE-RELATED PRODUCTS 19.93 

OTHER SECURITIES 6.09 

ADJUSTABLE-RATE SECURITIES 13.00 

Source: Bank and Thrift Call Reports, September 30, 

1996 

CHART 1 Index Value 

Index Tracks the Total Return of an 

“Average” Bank Portfolio 

Source: ABA Banking Journal 

100.84 

104.31 

Dec Jan Feb Mar Apr 

100 

101 

102 

103 

104 

105 

106 

May Jun Jul Aug Sep 

100.51 100.71 

101.49 

102.23 

103.06 

104.03 

105.00 

100.00 

CHART 2 

Total Return Index Is Correlated 

to Changes in Interest Rates 

Source: ABA Banking Journal, Bloomberg 

5-year Treasury 

(right scale) 

Betzold Berg Index 

(left scale) 

Percent Change Percent Change 

–10 

–5 

0 

5 

10 

Jan-97

Feb-97

Mar-97

Apr-97

May-97

Jun-97

Jul-97

Aug-97

Sep-97 

–0.20 

0.00 

0.20 

0.40 

0.60 

0.80 

1.00 

Chicago Regional Outlook 15 First Quarter 1998 
Regular Features	 Regional Economy
 

Region’s Cyclical Sensitivity Highlights Importance 

of Looking and Planning Ahead 

•	 Historically, economic activity in the highly industrialized Chicago Region has slumped earlier and more 

steeply than in the nation as a whole when cyclical expansions ended. 

•	 The Region’s economy remains strong, but room for further robust growth may be limited. Thus, the contribution of rapid economic expansion to the profitability of banks and thrifts may fade. 

•	 Therefore, as the cyclical expansion continues to age, borrowers and lenders may need to plan for a future 

in which the downside risks may exceed the upside potential. 

As this cyclical expansion starts its eighth year in April, 

the Chicago Region is displaying some conditions typically experienced in the later stages of expansions, 

including slower job growth and flat manufacturing 

employment, low unemployment, lackluster growth in 

single-family housing starts, and rebounding activity in 

commercial real estate markets, conditions discussed in 

previous issues of Regional Outlook. Because the 

Region’s industrial composition heightens its sensitivity 

to shifting cyclical conditions, it is important to monitor 

such indicators for signs of strength or weakness. 

TABLE 1 

Industrial Composition Heightens the 

Region’s Cyclical Sensitivity 

In the Chicago Region, the role of manufacturing activity—which is among the sectors most affected by cyclical ups and downs—is considerably greater than for the 

nation as a whole. The manufacturing sector generates 

27.2 percent of the Region’s income, which is 51 percent higher than manufacturing’s share for the nation as 

a whole. 

The Chicago Region’s Economic Profile Relative to the Nation’s 

Region’s or state’s share of earnings relative to national share (as a ratio); 

1.0 means share is same as national share. 

REGION IL IN MI OH WI 

MANUFACTURING 1.51 1.10 1.78 1.83 1.52 1.57 

DURABLE-GOODS MANUFACTURING 1.72 1.08 2.09 2.41 1.72 1.59 

MOTOR VEHICLES & EQUIPMENT 3.84 0.65 4.10 10.33 2.78 1.24 

PRIMARY METALS 2.41 1.25 5.09 1.46 3.72 1.48 

FABRICATED METALS 2.13 1.56 1.93 2.70 2.36 2.20 

NONELECTRICAL MACHINERY 1.79 1.61 1.52 1.76 1.82 2.58 

FURNITURE & FIXTURES 1.58 0.67 2.34 3.06 0.85 1.77 

STONE, CLAY, GLASS 1.33 0.87 1.54 1.18 2.03 1.03 

NONDURABLE-GOODS MANUFACTURING 1.17 1.12 1.29 0.92 1.20 1.54 

RUBBER & MISC. PLASTICS 1.91 1.37 2.46 1.78 2.43 1.79 

PAPER & ALLIED PRODUCTS 1.36 0.92 0.88 0.85 1.24 4.37 

CHEMICALS & ALLIED PRODUCTS 1.23 1.16 1.98 1.03 1.41 0.52 

WHOLESALE TRADE 1.03 1.15 0.89 0.98 1.03 0.96 

CONSTRUCTION 0.99 0.97 1.13 0.89 0.97 1.11 

RETAIL TRADE 0.96 0.89 1.02 0.91 1.02 0.99 

TRANSPORTATION & UTILITIES 0.89 1.07 0.90 0.72 0.83 0.87 

FINANCE, INSURANCE, & REAL ESTATE 0.88 1.01 0.75 0.84 0.86 0.81 

SERVICES 0.85 1.16 0.68 0.65 0.74 0.81 

GOVERNMENT 0.84 0.83 0.80 0.83 0.85 0.89 

AGRICULTURAL SERVICES, FORESTRY, & FISHERIES 0.71 0.71 0.66 0.67 0.68 0.89 

MINING 0.38 0.40 0.43 0.27 0.51 0.16 

Source: U.S. Department of Commerce, Bureau of Economic Analysis, via Haver Analytics, Inc. 

Chicago Regional Outlook 16	 First Quarter 1998 
Regular Features	 Regional Economy
 

Within the Region’s manufacturing sector, production 

of durable goods is more dominant than production of 

nondurable goods. Topping the list by a large margin is 

output of motor vehicles and equipment. This industry’s 

concentration in the Region is 3.8 times that for the 

nation (see Table 1), while in Michigan it is 10.3 times 

greater. The Region’s share of income from the production of primary and fabricated metals is more than twice 

that for the nation, while the Region’s shares associated 

with rubber and plastics and with nonelectrical machinery are slightly less than twice those of the nation. 

This heavy dependence on manufacturing activity 

heightens the Region’s sensitivity to business cycles, 

especially around the peak and trough turning points at 

the end of expansions and recessions. Chart 1 illustrates 

that economic output in the Chicago Region typically 

•	 rebounds more vigorously than the nation for a year 

or two after a recession; 

•	 grows in line with or slightly slower than the nation 

during the middle stage of an expansion; and 

•	 slows sooner toward the end of an expansion and 

then experiences a steeper drop in output when a 

recession develops. 

Traditionally, areas dominated by manufacturers of 

durable goods for consumers (e.g., vehicles, appliances, 

CHART 1 

furniture) experience cyclical downturns and upswings 

earlier than areas dominated by manufacturers of 

durable equipment for businesses (e.g., engines, industrial machinery). 

The impact of cyclical changes can be magnified when 

diversity in an area’s economic base is limited. 

According to a Diversity Index calculated by the 

Division of Insurance, considerable variation exists 

among states in this Region (see Chart 2, next page). At 

one extreme, Illinois has an index reading of 93 and 

ranks as having the most diverse economic base among 

all 50 states. (A state or Region with the same mix of 

earnings from various sectors as the nation in 1996 

would have an index value of 100.) In contrast, 

Michigan’s heavy concentration of activity associated 

with motor vehicles and related equipment causes it to 

have an index reading of 40.8, making it the fifth least 

diverse state in the nation. 

Implications: This Region’s industrial composition and 

heavy reliance on manufacturing make it among the 

first to be affected by cyclical shifts. By the time a recession is recognized on the national level, many industries 

in this five-state Region already will have started trimming their payrolls and production schedules. In turn, 

weakening economic conditions reduce the ability of 

many households and businesses to assume additional 

debt and, in some cases, to meet the terms of outstanding obligations. 

–4 

0 

4 

8 

12 

Chicago Region 

U.S. 

rebound mid- and late expansion recession rebound

(July 1990-March 1991) 

mid- and late 

expansion 

estimates 

Sources: Bureau of Economic Analysis, via Haver Analytics, Inc.; FDIC’s Division of Insurance Real Output of Goods and Services (Percent Change) 

Chicago Region Is More Cyclically Sensitive than the Nation 

1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 

Chicago Regional Outlook 17	 First Quarter 1998 
Regular Features	 Regional Economy
 

CHART 2 

Economic Diversity among Region’s States 

Index: United States = 100

82.1 

0 

50 

100 

U.S.

Chicago

Region

WI

MI

IL

OH

IN 

100 

93.3 

80.7 77.6 69.9 

40.8 

Source: FDIC’s Division of Insurance 

Since banks and thrifts generally have limited control 

over the economic environment within which they operate, they may need to take steps to moderate how 

adverse changes in economic conditions might affect 

their performance. Proactive institutions 

•	 identify economic sectors to which they are vulnerable; 

•	 assess the risks associated with those vulnerabilities; 

and 

•	 structure their operations to moderate effects that are 

reasonably possible in the short and intermediate 

terms. 

A prerequisite for such planning is knowing where the 

economy currently stands and estimating where it may 

be headed. 

Expansion Continues but Growth Is Slowing: 

Warning Signs to Watch For 

When the current expansion will end is a question that 

forecasters wish they could answer. A consensus forecast for 1998 calls for real gross domestic product 

(GDP) growth to slow to around 2-1/2 percent, more 

than a percentage point less than in 1997. Forecasts of 

slower growth partly reflect the nation’s inability to 

grow robustly in light of current tightness in labor markets and production facilities. In addition, growth in 

demand for many cyclically sensitive products such as 

motor vehicles and new single-family homes is waning, 

and the current turmoil in Asian financial markets and 

economies also may trim U.S. growth a bit. 

In terms of longevity, the current expansion will start its 

eighth year in April, making it the third longest of the 

ten cyclical expansions since 1945. The longest lasted 

106 months (1961 to 1969), and the next longest lasted 

92 months (late 1982 to mid-1990). But advancing age 

alone does not doom a cyclical expansion. Rather, as 

expansions age, their growth momentum slows and 

becomes increasingly vulnerable to various imbalances, 

which typically dampen growth but do not necessarily 

end it. Examples of such imbalances include: 

•	 a significant amount of unplanned inventory 

accumulation; 

•	 escalation of speculative behavior or unsupportable 

price gains in the financial, real estate, or other 

markets; 

•	 extreme tightness in labor markets or production 

capacity, which leads to rapid increases in wages and 

prices, production bottlenecks, or both; 

•	 adoption of the attitude that the good times will go 

on forever, causing households and businesses to let 

down their guard or undertake riskier behavior; and 

•	 growing difficulties of borrowers with respect to 

handling their debt loads. 

To date, none of these imbalances appears severe 

enough to threaten the expansion’s continuation in 

either the Region or the nation as a whole. However, 

noticeable and simultaneous 

intensification of several of them 

would be cause for concern, not 

only in their own right but also 

because such a development 

would heighten the odds of policymakers responding by raising 

interest rates. That action, in 

turn, would further curb the 

strength of demand for many types of durable goods 

produced in this Region, whose purchase is typically 

financed by credit or debt. 

Chicago Regional Outlook 18	 First Quarter 1998 
Regular Features Regional Economy
 

Implications: The consensus outlook represents both CHART 3 

continuation of the expansion and its increasing vulner- Consumer Credit Growth Moves with Employment ability. It is this vulnerability and the attendant mix of (% change from year earlier) potential imbalances that create challenges for financial 

institutions in the later stage of an expansion. 

So far, tight labor markets and high output levels have 

not triggered accelerating inflation or rising short-term 

interest rates, as occurred late in previous expansions. 

But such conditions may yet arise, which suggests that 

the recent levels and stability of interest rates should not 

lull lenders or borrowers into a sense of complacency. 

Indeed, insured institutions likely will benefit from 

periodic review and updating of their interest rate and 

market risk controls. 

–4 

–2 

0 

2 

4 

6 

Credit 

(left scale) 

Employment 

(right scale) 

–4 

0 

4 

8 

12 

16 

20 

Q1:73Q1:75Q1:77Q1:79Q1:81Q1:83Q1:85Q1:87Q1:89Q1:91Q1:93Q1:95Q1:97 

Sources: Bureau of Labor Statistics, Federal Reserve Board, 

via Haver Analytics, Inc. 

In addition, fluctuations in loan demand and increasing 

pressure on credit quality tend to develop at this stage CHART 4

in a cycle. Already there has been a considerable slowdown in growth of consumer loans outstanding, which 

closely follows shifts in employment growth during a 

business cycle (see Chart 3, where the shaded bar indicates a recession). With a lag, growth in commercial 

and industrial (C&I) loans tends to follow suit, as do 

real estate loans, although their relationship is considerably less tight. 

Deteriorating credit quality also becomes a growing 

concern late in an expansion. Looking only at the 

previous cycle and consumer-loan portfolios, we see 

that the warning time was short between when real 

GDP growth started to plunge and past-due loans 

started rising rapidly (see Chart 4). All told, about 

half the deterioration in the Region’s consumer loan 

portfolios occurred before the national recession 

began in July 1990. Any similar rise ahead will occur 

on top of the recent surge in past-due consumer loans, 

which has occurred partly because of bankruptcy legislation and behavioral changes rather than economic 

conditions. 

With respect to both commercial and industrial loans 

and real estate loans, noticeable increases in past-due 

loans preceded the onset of the last recession by only 

two quarters (see Chart 5). Even so, more than 40 percent of the increase in the past-due rate for C&I loans 

took place before the recession officially began. 

Although the current past-due rate on C&I loans is low, 

experience suggests that some late-expansion developSources: Bureau of Economic Analysis, via Haver Analytics, Inc.; 

Bank and Thrift Call Reports 

Real GDP Growth and Chicago Region’s 

Past-Due Rate on Consumer Loans 

–4% 

0% 

4% 

8% 

Q1:83Q1:85Q1:87Q1:89Q1:91Q1:93Q1:95Q1:97 

0% 

1% 

2% 

3% 

4% 

Percentage of Consumer 

Loans Past Due 

(right scale) 

Real GDP Growth 

(left scale) 

CHART 5 

Sources: Bureau of Economic Analysis, via Haver Analytics, Inc.; 

Bank and Thrift Call Reports 

Real GDP Growth and Chicago Region’s 

Past-Due Rate on C&I Loans 

–4% 

0% 

4% 

8% 

Q1:83Q1:85Q1:87Q1:89Q1:91Q1:93Q1:95Q1:97 

–1% 

1% 

3% 

4% 

6% 

Real GDP Growth 

(left scale) 

Percentage of 

C&I Loans 

Past Due 

(right scale) 

Chicago Regional Outlook 19 First Quarter 1998 
Regular Features	 Regional Economy
 

ments can result in a build-up of credits with the following characteristics: 

•	 operating lines that are increasingly used to carry 

additional inventory, especially when the inventory 

build-up was unplanned; 

•	 credit lines that are extended on the basis of rising 

collateral values rather than customers’ cash flows; 

and 

•	 loans that are made under relaxed underwriting standards, in response to strong competitive conditions 

or a desire to maintain market share. 

Institutions with large volumes of such credits may be 

vulnerable and face rising risks, as some of their borrowers may lack the financial flexibility and resources 

needed to deal with an economic downturn. 

Chicago Region Staff 

Chicago Regional Outlook 20	 First Quarter 1998 
9 

Regular Features	 Regional Banking
 

Allowance for Loan and Lease Losses (ALLL):
 

Trends to Consider
 

•	 Many banks and thrifts in the Chicago Region, including many that have increased their concentrations in 

traditionally riskier loan categories, have reduced the coverage of reserves set aside for future loan losses. 

•	 An improvement in traditional credit quality indicators may well support some of the reduction in ALLL 

coverage now in evidence. However, managers of insured institutions must consider additional factors when 

determining an acceptable range for the ALLL. 

•	 Management must be able to evaluate the risks of new higher risk lending products, growth and changes in 

loan portfolio composition, and eased underwriting standards and terms where applicable. 

Overview 

Chicago Region banks and thrifts continue to report 

strong conditions (see Chart 1). Through the third quarter of 1997, they 

•	 increased aggregate leverage capital to more than 8 

percent of average assets; 

•	 recorded a solid aggregate return on assets of 1.21 

percent; and 

•	 maintained good overall asset quality—although 

many institutions are seeing modest growth in pastdue loans. 

While this performance is impressive, it should not 

result in a false sense of security. Banks and thrifts may 

CHART 1 

Chicago Region Institutions Continue to Show
 

Financial Strength
 

8 

7 

6 

5 

1996 

1995 YTD 1997

Percent 4 

3 

2 

1 

0 

Tier 1 Return on 

Leverage Assets 

Source: Bank and Thrift Call Reports 

Net Interest Past-Due
 

Margin Loans
 

well need the financial flexibility afforded by their current condition in order to meet challenges ahead. Many 

of these challenges, such as changing technologies, 

competition, and funding patterns, have been discussed 

in previous editions of this publication. This edition discusses similar issues, such as dealing with the Year 2000 

problem (see Y2K). 

In addition, the Region’s banks and thrifts have to plan 

for the possibility of adverse changes to the economy. 

Planning is especially important at this stage of an 

expansion because of the Chicago Region’s tendency to 

slump earlier and more steeply than the nation when 

expansions end (see Region’s Cyclical Sensitivity 

Highlights Importance of Looking and Planning 

Ahead). 

Many analysts are now focusing on credit quality trends 

to see if insured institutions will be prepared in the 

event of a downturn. In that regard, last quarter’s 

Regional Outlook specifically cited the following as 

areas of interest or concern in the Chicago Region: 

•	 continuing weaknesses in consumer loan portfolios; 

•	 possible migration of consumer lending problems to 

home equity and residential real estate portfolios; 

and 

•	 effects of eased underwriting on commercial and 

commercial real estate loans—especially in cases 

where growth has been significant or past-due levels 

are already high. 

This quarter we focus on a related topic, trends related 

to ALLL. 

Chicago Regional Outlook 21	 First Quarter 1998 
Regular Features Regional Banking
 

ALLL Coverage of Total Loans Has Declined CHART 3

over the Past Few Years 

Noncurrent Loan and Net Charge-Off 

Rates Have Declined since 1991/1992 Despite the fact that aggregate provisions have more 

2.5 than covered net loan losses at Chicago Region instituNoncurrent Loans 

Net Charge-Offs 

tions for the past several years, they have not kept pace 2.0 

Percent of Loans 

with overall loan portfolio growth. Therefore, the ALLL 

for the Region as a percentage of total loans has 1.5

declined from 1.67 percent at the end of 1993 to 1.45 1.0 percent at the third quarter of 1997 (see Chart 2). 

0.5 

Declining allowance coverage is a broad-based trend. 

About 61 percent of the Region’s banks and thrifts with 

differing asset sizes, geographic location, and business 

concentrations have experienced declines in ALLL cov0.0 Dec-90 Sep-91 Dec-92 Dec-93 Dec-94 Dec-95 Dec-96 Sep-97 

erage to total loans since year-end 1993. 

Traditional Measures of Problem Loans Support 

Current Trend, but Other Factors Need to Be 

Considered 

Some observers believe this trend toward lower ALLL 

coverage of gross loans will continue. They point out 

that traditional measures of credit quality, such as noncurrent loan and net loan charge-off rates, have 

improved from those noted in the early 1990s (see Chart 

3). Therefore, even though ALLL coverage of gross 

loans has declined, coverage of noncurrent loans 

approximates 170 percent for the Region—down from 

the high of 190 percent two years ago but still over 

twice what it was at the start of the decade. 

CHART 2 

Source: Chicago Region Bank and Thrift Call Reports 

Unfortunately, noncurrent loan rates tend to be a lagging indicator of credit quality. Therefore, prudent managers need to consider additional factors in determining 

an acceptable range for the ALLL. These factors include 

(but are not limited to) historical performance of significant portfolio segments, concentration levels, any new 

loan products, and operating environment. 

In considering these other factors, bank and thrift managers may want to be especially aware of the issues discussed below. 

Volatility of Reserve and Charge-Off Levels 

at Individual Institutions 

Reserve and charge-off levels for some institutions tend 

to be somewhat volatile over time. For example, Chart 4 

indicates that over 32 percent of currently operating 

ALLL Coverage of Total Loans Has 

Been Declining since 1993 

Source: Chicago Region Bank and Thrift Call Reports 

1.0 

1.2 

1.4 

1.6 

1.8 

2.0 

ALLL 

Percent of Loans 

Dec-90Sep-91Dec-92Dec-93Dec-94Dec-95Dec-96Sep-97 

banks and thrifts in this Region have seen their ALLL 

coverage of gross loans fluctuate by over 100 basis 

points (from highest to lowest year-end) since 

December 1987. Furthermore, 30 percent of all institutions have seen annual charge-off rates fluctuate by 

over 100 basis points during the same period. 

Banks and thrifts that exhibit such volatility may benefit from identifying the specific causes and estimating 

their vulnerability to future similar occurrences. For 

example, during the past few quarters, the average 

charge-off rate for credit card loans in the Region has 

significantly increased; it exceeded 6.75 percent (annualized rate) during the third quarter of 1997. This 

increase is attributed, at least in part, to a significant rise 

Chicago Regional Outlook 22 First Quarter 1998 
Regular Features	 Regional Banking
 

CHART 4 

ALLL to Loan Ratio Fluctuated* More than 100
 

Basis Points (BP) at Many Institutions
 

50 BP to 100 

100 BP to BP (38%) 

200 BP
 

(24%)
 

Over 200
 

BP (8%)
 Below 50 

BP (30%) 

* Highest year-end total compared to lowest since 1987 

Source: Chicago Region Bank and Thrift Call Reports 

in personal bankruptcies, and some analysts believe that 

the level of bankruptcies will not decline in the near 

term. Many institutions with large consumer credit 

exposures have had to incorporate these changing conditions into their ALLL provisioning decisions. 

Higher Risk Loan Products 

Another area to consider is the introduction of new loan 

products. Some institutions have increased their exposures to higher risk loan types such as subprime auto 

lending and high loan-to-value (LTV) mortgages and 

home equity loans. 

Performance problems on these credits tend to be higher than for more traditional lending portfolios. For 

example, a recent Office of Thrift Supervision publication indicates that mortgage loans are much more likely 

to become seriously delinquent as LTV ratios rise above 

90 percent (see Chart 5). Individual institutions need to 

take a hard look at the adequacy of reserves for these 

loans, given that their higher risk profile could be exacRegion institutions have registered very strong commercial and commercial real estate loan growth recently. As 

a result, since 1994, over half have increased the proportion of their loan portfolio that is allocated toward such 

loans, with about 250 (out of a total of 2,170) showing a 

significant increase of 10 percent or more. Since these 

types of credits traditionally have exhibited higher risk— 

especially when issued late in an economic cycle—it is 

interesting to note that only about half the institutions 

recognizing a significant shift increased their reserve 

coverage during that period. While current reserve levels 

may well be justified, institutions experiencing these 

changes may want to review their risk assessment procedures related to these portfolios. 

Survey Results Show Changes 

in Loan Underwriting 

Finally, institutions need to consider how changes in 

their underwriting practices may have affected credit 

risk in their portfolios. Such consideration is especially 

important in the current environment, where various 

underwriting surveys reflect an easing of terms and 

standards. 

•	 The Federal Reserve recently released the results of 

its national November 1997 Senior Loan Officer 

Opinion Survey on Bank Lending Practices. 

Among other things, the survey noted that increased 

competition has apparently led some banks to lower 

interest rates charged, increase the maximum size of 

credit lines, and adjust loan covenants on commerCHART 5 

Higher LTV Mortgages Are More
 

Likely to Become Past Due
 

3.0 

erbated by an adverse change in economic conditions. 

Loan Portfolio Composition Changes 

Loans More than

90 Days Past Due (%)

2.5 

2.0 

1.5 

1.0 

Based upon loans 

originated in 1995 with 

24 months of seasoning 

Loan portfolio composition is another area of change that 0.5 

many institutions in this Region need to review. Some 0.0 

institutions have lessened their credit risk profile by 

increasing the proportion of lower risk loans they hold, 

20-60

61-70

71-75

76-80

81-90

91-95

96-105 

Loan-to-Value (%) 

such as traditionally underwritten residential mortgages. 

Source: Office of Thrift Supervision Mortgage Market Trends On the other hand, a significant number of Chicago 

Chicago Regional Outlook 23	 First Quarter 1998 
Regular Features	 Regional Banking
 

cial and industrial loans during the previous three 

months. 

•	 The Office of the Comptroller of the Currency’s 

(OCC’s) national 1997 Survey of Credit Underwriting 

Practices indicates that there has been a discernible 

shift in underwriting standards since 1996, and most 

of the surveyed banks now have moderate or liberal 

underwriting standards. The survey notes that the 

trend toward eased standards was most pronounced in 

middle-market loans, syndicated and national credits, 

and commercial real estate (see Chart 6). 

•	 The FDIC’s Report on Underwriting Practices for 

April to November 1997 states that, on a national 

basis, lending for commercial real estate and construction should be closely monitored. It also indicates that slightly more banks recently examined in 

the Chicago Region had loosened rather than tightened underwriting standards. 

Eased underwriting terms and standards are always a 

potential concern, but even more so at this stage of an 

economic expansion and when growth rates for such 

credits are high. In the Chicago Region, more than 30 

percent of all insured institutions had growth rates 

CHART 6 

OCC 1997 Survey of Credit Underwriting
 

Practices Shows Shift Away from Conservative
 

Underwriting Standards
 

Moderate 54%
 

(1996 = 45%)
 

Conservative 38% 

(1996 = 52%) 

Liberal 8% 

(1996 = 3%) 

Source: Office of Comptroller of the Currency 

exceeding 20 percent in the commercial and commercial real estate lending categories over the past year. 

Certainly, management needs to ensure that changes in 

credit risk profile of the loan portfolio caused by easing 

of underwriting standards are incorporated into its 

ALLL adequacy reviews. 

Chicago Region Staff 

Chicago Regional Outlook 24	 First Quarter 1998 
✁
 

Subscription Form
 

To obtain a subscription to the FDIC Regional Outlook, please print or type the following information: 

Institution Name ______________________________________________________________ 

Contact Person ______________________________________________________________ 

Telephone ______________________________________________________________ 

Street Address ______________________________________________________________ 

City, State, Zip Code ______________________________________________________________ 

Please fax or mail this order form to:	 FDIC Public Information Center 

801 17th Street, N.W., Room 100 

Washington, D.C. 20434 

Fax Number (202) 416-2076 

Please indicate below each Region’s issue you wish to receive: 

Atlanta Boston Chicago 

Dallas Kansas City Memphis 

New York San Francisco All 

FDIC 

Federal Deposit Insurance Corporation 

Washington, DC 20429-9990 

OFFICIAL BUSINESS 

PENALTY FOR PRIVATE USE, $300 

BULK RATE
 

MAIL
 

Postage &
 

Fees Paid
 

FDIC
 

Permit No. G-36