Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION THIRD QUARTER 2002 

FDIC
 

Chicago
 

Edition
 

Division of
 

Insurance
 

and Research
 

John M. Anderlik,
 

Acting Regional
 

Manager
 

Joan D. Schneider,
 

Regional Economist
 

Michael Anas,
 

Senior Financial
 

Analyst
 

Regional Perspectives 

◆ Although an economic recovery is under way, the levels of employment and 

output in the Region at midyear 2002 remained below their previous peaks. 

◆ To date, the financial health of the Region’s community banks and thrifts 

has not been significantly strained by the 2001 recession. Although past-due 

and nonaccrual loans rose modestly, median return on assets and allowance 

for loan losses relative to total loans rose slightly in the year ending first quarter 

2002. 

◆ As the economic recovery unfolds and reduces some strains on borrowers 

and their lenders, insured institutions continue to face such challenges as 

ensuring adequate risk management, effective corporate governance, and 

adherence to internal controls and routines. See page 3. 

By the Chicago 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 8. 

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)
 

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, AS, AZ, CA, FM, GU, HI, ID, MT, NV, OR, UT, WA, WY)
 

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 

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. 

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

Outlook, please call John M. Anderlik at (816) 234-8198 or send an e-mail to janderlik@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
 

•	 Although an economic recovery is under way in the Region, the levels of employment and output at midyear 

2002 remained below their previous peaks. 

• To date, the financial health of the Region’s community banks and thrifts has not been significantly strained 

by the 2001 recession. Although the ratio of past-due and nonaccrual loans has risen modestly, the median 

return on assets and allowance for loan losses relative to total loans rose slightly in the year ending first 

quarter 2002. 

•	 As the economic recovery unfolds and reduces some strains on borrowers and their lenders, insured 

institutions continue to face such challenges as ensuring adequate risk management, effective corporate 

governance, and adherence to internal controls and routines. 

More than six months after the end of the 2001 recession, the Region’s economy at midyear 2002 is experiencing higher unemployment, elevated business and 

personal bankruptcies, and reduced activity in some key 

sectors relative to a year earlier, despite some gains in 

2002. Even so, any net adverse effect of the economic 

slump on the financial health of the Region’s community banks and thrifts1 appears limited. Although insured 

institutions are experiencing higher loan delinquencies, 

they also are benefiting from such developments as 

reduced funding costs and a steeply sloped yield curve. 

A variety of economic indicators at midyear 2002 suggest that a cyclical recovery began in late 2001 or early 

2002, although output and employment levels in many 

sectors remain lower than before the recession. For 

example, the Midwest Manufacturing Index2 in May 

2002 was more than 3 percent higher than its recession 

low in October 2001; however, it remains about 12 percent below its peak in 2000 (see Chart 1). Employment 

in the Region has yet to turn up, because increases in 

output to date reflect productivity gains and longer 

workweeks of existing employees. 

In this environment of modest cyclical improvement 

and slumping stock valuations, many businesses and 

households remain vulnerable to financial strains. 

Household income, for example, is not likely to grow 

noticeably until employment levels start rising, while 

the aggregate value of households’ financial assets is 

11 percent lower than two years earlier. Meanwhile, the 

1

Banks and thrifts that hold less than $1 billion in assets, excluding 

de novo and specialty institutions. 

2

The Midwest Manufacturing Index, produced by the Federal Reserve 

Bank of Chicago, reflects the output of four major industrial groups in 

the Federal Reserve System’s Chicago District. 

cushioning effect of last year’s decline in interest rates, 

reduction in personal income taxes, modest inflation, 

and drop in energy prices may be waning. 

Despite the cyclical recovery under way, adverse effects 

from the recession on lenders’ loan portfolios may 

linger. Some borrowers were operating with thin financial cushions when the recession began, and the slump 

may have absorbed that cushion and challenged their 

economic viability. The increasing number of households and businesses filing for bankruptcy, for example, 

provides an indication of financial stress among 

borrowers, which is contributing to rising loan delinquencies among lenders. 

Rising numbers of corporate bond defaults and debtrating downgrades in 2002, along with first quarter 

2002 corporate profits from current operations that 

were slightly lower than two years earlier, suggest that 

CHART 1 

Regional Economic Activity Remains Subdued 

Relative to Conditions prior to Recession 

Source: Federal Reserve Bank of Chicago and Bureau of Labor 

Statistics, via Haver Analytics, Inc. Midwest Manufacturing Index (index=100 in 1992)

Employment Level (millions of jobs) 

60 

80 

100 

120 

140 

160 

180 

Mar ’86 

17.0 

18.5 

20.0 

21.5 

23.0 

Total Employment 

(right scale) 

Midwest 

Manufacturing 

Index (left scale) 

Mar ’87

Mar ’88

Mar ’89

Mar ’90

Mar ’91

Mar ’92

Mar ’93

Mar ’94

Mar ’95

Mar ’96

Mar ’97

Mar ’98

Mar ’99

Mar ’00

Mar ’01

Mar ’02 

Chicago Regional Outlook 3	 Third Quarter 2002 
Regional Perspectives
 

banks will continue to face challenges from some business borrowers. Some households face parallel challenges in light of their relatively high debt obligations 

and the slow improvement in job markets and income 

growth. 

On another front, owners of commercial and industrial 

properties—or other businesses where income is shaped 

by multiyear leases and contracts—may face reduced 

cash flows despite the cyclical upturn in the economy as 

a whole. In response to relatively weak demand for 

commercial space, property owners reportedly are 

renegotiating existing leases or entering new ones on 

terms less favorable to them than in recent years. 

Through first quarter 2002, the Region’s insured community institutions appeared to be weathering the 2001 

economic recession relatively well (see Table 1). Profitability, as measured by aggregate return on assets, 

held close to 1 percent, and the rise in past-due and 

nonaccrual (PDNA) loans has been moderate. Tier 1 

leverage remained near 9.3 percent, and the ratio of 

allowance for loan and lease losses (ALLL) to total 

loans rose in the year ending first quarter 2002. However, the ALLL did not keep pace with the 37 percent 

rise in nonperforming loans, leading to a decline in the 

reserve coverage of nonperforming loans. 

TABLE 1 

Performance of Community 

Institutions Changed Modestly 

during the 2001 Recession 

1Q01 1Q02 

PERCENT 

RETURN ON ASSETS 0.99 1.09 

PAST-DUE AND 

NONACCRUAL 

LOAN RATE 2.20 2.42 

TIER 1 LEVERAGE 

RATIO 9.34 9.29 

ALLL TO TOTAL 

LOANS 1.10 1.17 

ALLL COVERAGE OF 

NONPERFORMING 

LOANS 135.65 110.07 

ALLL = allowance for loan and lease losses 

Note: Merger-adjusted aggregate data are shown. 

Source: Bank and Thrift Call Reports, March 31, 2002 

Behind the fairly moderate changes in broad measures 

of the financial condition of the Region’s banks and 

thrifts has been an increase in the number of institutions 

with weak composite CAMELS3 ratings of 3, 4, or 5. At 

the end of first quarter 2002, 139 institutions in the 

Region were rated weak, up from 116 a year earlier. 

Despite some current strains and problems, the 7.6 percent share of institutions with weak composite ratings is 

less than half the percentage recorded at the end of the 

1990–1991 recession. Geographically, these banks and 

thrifts are spread throughout the Region. Asset quality 

and management ratings are major contributors to the 

recent deterioration in composite CAMELS ratings, as 

roughly 10 percent of the Region’s institutions had weak 

asset quality or management ratings (or both) at the end 

of first quarter 2002. 

While weak economic conditions likely affected the 

health of most banks and thrifts, no failure has been 

directly attributed to the recession. However, eight 

insured financial institutions failed nationwide in the 

first six months of 2002, a number that exceeds the 

annual failure rate since 1999. These failures underscore the continued importance of prudent management 

oversight, regardless of economic trends.4 Critical 

shortcomings among lending institutions that failed 

tended to involve a lack of effective internal routines 

and controls; concentration in business lines where the 

market value of assets fell considerably below valuations used internally (e.g., auto lease portfolios or residuals from securitization of loan portfolios); entry into a 

line of business that carried operational or other risks 

not fully understood by management; or outright fraud. 

Several other insured institutions faced similar shortcomings but were able to continue operating despite 

significant losses. 

Community Bank Loan Portfolios 

Reflect Changing Conditions 

Recent developments in commercial and industrial 

(C&I) portfolios among large lending institutions are 

highlighted in this quarter’s In Focus article. The 

remainder of this article evaluates conditions among 

3 CAMELS examination ratings reflect insured institutions’ capital, 

asset quality, management, earnings, liquidity, and sensitivity to 

market risk. 

4 The importance of such traditional concerns was highlighted in a 

speech titled “Internal Controls, Fraud, and Other Red Flags” by Eugene 

Ludwig, former comptroller of the currency, at the 2002 Interagency 

Bank Supervision Conference, April 2002. 

Chicago Regional Outlook 4 Third Quarter 2002 
Regional Perspectives
 

community institutions in the Chicago Region, whose 

loan portfolios are typically insulated from some of the 

factors or sectors (e.g., telecommunications) causing 

problems at large institutions. 

Segments of loan portfolios in the Region’s community 

institutions fared differently during the recession. 

Aggregate loan growth among community banks and 

thrifts slowed to 5.5 percent in the year ending first 

quarter 2002, from 12 percent in 2000. Growth in C&I 

and commercial real estate (CRE) lending slowed but 

remained fairly healthy, while consumer and mortgage 

loan volume fell. Deterioration in loan quality occurred 

across most business lines, as illustrated in Table 2. 

Commercial and Industrial Portfolios: Although C&I 

loans at the Region’s community banks deteriorated 

somewhat, they are performing modestly better than 

C&I credits nationwide. C&I portfolios at the Region’s 

community banks grew 6 percent through the year ending March 31, 2002. Although C&I past-due and 

charge-off rates have increased during the past year, the 

TABLE 2 

level of delinquencies and charge-offs remains below 

the national level.5 Net C&I loan charge-offs at the 

Region’s community banks were 0.71 for 2001, up from 

0.47 for 2000 but well below the peak of 1.12 percent 

during the 1990–1991 recession. 

Commercial Real Estate Portfolios: Combined loans 

for construction and development (C&D), multifamily 

housing, and nonresidential building among the 

Region’s community banks rose by more than 15 percent in the year ending first quarter 2002. This strength 

may seem surprising in light of soft demand for commercial and industrial space and rising vacancy rates. 

However, rather than representing rising commercial 

real estate exposures (where properties’ cash flows are 

the basis for loan repayments) in a weak market, in some 

cases CRE loan growth may reflect caution by lenders 

as they take liens on borrowers’ real estate as collateral 

to back operating loans. In other cases, CRE loan 

growth may reflect that commitments made in the past 

few years are now being drawn upon as projects 

progress. 

Past-Due and Nonaccrual Rates Have Increased across Major Loan Categories 

LOAN SEGMENT SHARE OF LOANS PAST-DUE AND NONACCRUAL RATE 

(PERCENT) (PERCENT) 

MAR-02 MAR-02 MAR-01 MAR-91 

COMMERCIAL AND INDUSTRIAL LOANS 14.3 3.44 3.17 6.49 

COMMERCIAL REAL ESTATE LOANS 

CONSTRUCTION AND DEVELOPMENT 5.9 3.13 2.51 5.99 

NONRESIDENTIAL REAL ESTATE 20.4 2.16 1.93 2.98 

MULTIFAMILY RESIDENTIAL 3.3 1.36 0.89 1.36 

RESIDENTIAL LOANS 

1- TO 4-FAMILY RESIDENTIAL 36.5 2.35 2.10 1.29 

HOME EQUITY 4.0 0.85 1.27 1.17 

LOANS TO INDIVIDUALS 8.7 2.41 2.40 2.93 

CREDIT CARD LOANS 0.3 3.48 3.13 3.18 

OTHER CONSUMER LOANS 8.3 2.42 2.42 2.92 

FARM REAL ESTATE LOANS 3.1 2.35 2.17 3.47 

FARM PRODUCTION LOANS 2.4 2.10 2.00 0.43 

Source: Bank and Thrift Call Reports for Community Institutions 

5 Community banks in the Chicago Region reported a first quarter 

PDNA rate of 3.44 percent for C&I loans (up 27 basis points from a 

year ago) compared with 3.70 percent (up nearly a full percentage 

point) for community institutions nationwide. 

Chicago Regional Outlook 5 Third Quarter 2002 
Regional Perspectives
 

All categories of CRE lending—construction and 

development, multifamily housing, and nonresidential 

buildings—experienced rising delinquency rates during the year ending first quarter 2002, although net 

charge-offs for each subcategory are well below the 

peaks seen in the last recession, when real estate problems were widespread and sometimes extensive. Current credit quality deterioration in this portfolio has 

been modest; however, rising vacancy rates and an 

increase in office space available for sublease in many 

metropolitan statistical areas (MSAs) may foreshadow 

further weakness. 

Construction-and-development loans exhibit the second highest delinquency rate and the largest percentage point rise in delinquencies among major loan 

segments. Although C&D loans make up only 6 percent of the Region’s community institution loan portfolio, the median level of C&D exposure to capital 

has been trending higher. As of March 31, 2002, 135 

institutions held C&D concentrations greater than 

100 percent of Tier 1 capital, up from 123 institutions 

one year earlier. Many of the Region’s institutions 

with C&D concentrations are located in the Chicago, Grand Rapids, and Indianapolis markets. 

Although the risks associated with C&D lending vary 

greatly—from the minimal risk of presold residential 

construction to speculative development of commercial properties—the rising concentration levels underscore the need to monitor conditions in this loan 

category. 

Credit quality weakness also is apparent in loans 

secured by office, industrial, retail, and other commercial buildings. Although the increase in this loan category’s delinquency rate during the past year was 

modest, further weakness may develop in the near term. 

Property owners in buyers’ markets (where supply 

exceeds demand) may continue to experience weakened 

cash flows in coming quarters, because they either lose 

tenants or grant rent and other concessions in order to 

keep current tenants. 

Mortgage and Consumer Loan Portfolios: In contrast 

to the growth in C&I and CRE lending, mortgage loans 

held by the Region’s community institutions fell during 

the past year. One- to four-family residential loans, the 

Region’s largest loan category, declined 2.4 percent. 

Other forms of consumer lending, such as credit card, 

revolving credit line, and other consumer loans, followed suit, declining by 1.6 percent. 

The decline in mortgage and consumer loan volumes in 

part could reflect refinancing triggered by lower interest 

rates. Some consumers who refinanced existing debts 

likely used their improved cash flow to finance spending that otherwise would have boosted credit card and 

other consumer loans. Also, households that refinanced 

their debt may have done so with larger or out-of-region 

lenders in the increasingly competitive nationwide lending industry. Nonbank lenders are attracting some business that would have gone to community institutions a 

decade ago. More insured institutions also may be 

adopting a strategy of originating, but not holding, 

mortgage and consumer loans; this strategy limits 

growth in such loans on their books. 

The losses associated with one- to 

four-family mortgage lending 

traditionally have been less than 

those for most other loan categories. However, the credit risk 

associated with this portfolio may 

have risen, reflecting structural 

changes in the mortgage business 

during the 1990s. These changes 

include the increasing involvement by insured institutions in the 

higher-risk subprime credit market, the acceptance of 

higher leverage on home purchases, and the greater use 

of automated underwriting and collateral valuation 

processes (see In Focus, Regional Outlook, First Quarter 2002). Furthermore, many insured institutions are 

frequent sellers of highly liquid conforming mortgage 

loans, a strategy that could lead to a higher share of 

nonconforming, potentially higher-risk loans on bank 

balance sheets. 

Indeed, among the Region’s community insured institutions, the level of PDNA one- to four-family mortgage 

loans rose 25 basis points, to 2.35 percent, during the 

year ending first quarter 2002. This is the only major 

loan segment with a current delinquency rate higher 

than the peak experienced during the 1990–1991 

recession. The highest mortgage delinquency rates in 

the Region were reported among community banks 

headquartered in the Springfield, Milwaukee, Rockford, and Decatur MSAs, where exposure to mortgage 

loans is relatively modest. Mortgage PDNA rates are 

higher for the Region’s community banks than for comparable banks outside the Region, which reported a 

2.07 percent PDNA ratio, up only 7 basis points from a 

year ago. 

Chicago Regional Outlook 6 Third Quarter 2002 
Regional Perspectives
 

Ahead: Although most of the credit quality deterioration experienced to date has been modest, uncertainty 

surrounding the economic recovery leads to questions 

about which loan categories may present the most risk 

going forward. The 1990–1991 recession clearly 

demonstrated that C&I and CRE lending categories, 

particularly construction lending, have the potential 

for high delinquencies and charge-offs in a weak economic environment. Also, the risk profile of mortgage 

lending—the largest loan category—has certainly 

increased; however, the ultimate risk of loss in this 

category remains relatively low overall. 

As the Economy Recovers, Challenges Remain 

for the Region’s Insured Institutions 

Economic indicators suggest that the recession is 

over and insured institutions have weathered it well, 

but some challenges remain. These challenges, while 

not new to cyclical recoveries, include expected 

increases in interest rates and a flattening of the yield 

curve, structural changes and competitive forces in the 

financial services industry, and more traditional concerns, such as ensuring adequate risk management 

and other internal controls and routines. Meanwhile, 

credit quality problems may linger as household and 

business stresses from the recession are resolved 

and commercial real estate markets adjust to recent 

imbalances. Other potential challenges include the 

continuing financial fragility of some household and 

business borrowers. 

In this environment, insured institutions at some point 

will need to shift gears from asset-and-liability management strategies that worked well when short-term 

interest rates were falling and low to strategies more 

suitable in a rising rate environment. The recent wellpublicized accounting and management lapses at some 

major corporations underscore the importance of continually verifying the effectiveness of internal routines 

and controls, accounting practices, and adherence to 

board policies. 

Chicago Region Staff 

Chicago Regional Outlook 7 Third Quarter 2002 
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. 

Chicago Regional Outlook 8 Third Quarter 2002 
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. 

Chicago Regional Outlook 9 Third Quarter 2002 
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. 

Chicago Regional Outlook 10 Third Quarter 2002 
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. 

Chicago Regional Outlook 11 Third Quarter 2002 
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.
 

Chicago Regional Outlook 12 Third Quarter 2002 
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 

Chicago Regional Outlook 13 Third Quarter 2002 


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