Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION FOURTH QUARTER 2000 

FDIC
 

Boston
 

Region
 

Division of
 

Insurance
 

Daniel Frye,
 

Regional Manager
 

Norman Williams,
 

Regional Economist
 

Cameron Tabor,
 

Senior Financial
 

Analyst
 

Andrea Plante,
 

Economic Analyst
 

Regional Perspectives 

◆ Region’s Economic and Banking Conditions—Economic growth 

showed modest signs of cooling in 2000. Insured institutions reported stable conditions overall, but income and credit quality trends were not as favorable at larger 

banks. See page 3. 

◆ Liquidity and Funding—Core deposits have not been sufficient to fund loan 

and other asset growth; as a result, insured institutions have increasingly turned to 

alternative funding sources. These sources are more costly than core deposits and 

could encourage institutions to seek a higher-yielding, higher-risk asset mix to preserve interest margins. Also, increased use of noncore funding could limit liquidity 

and raise interest-rate risk. See page 5. 

By the Boston Region Staff 

In Focus This Quarter 

◆ Emerging Risks in an Aging Economic Expansion—This article 

focuses on the potential risks of current economic conditions to insured depository 

institutions. Although the current conditions may appear to be ideal, some imbalances are emerging: rising energy prices, tight labor markets, a less robust stock 

market, a large trade deficit and strong U.S. dollar, rising household debt burdens, 

increased corporate leverage and rising potential default risk, and, in some metropolitan areas, overheated housing and commercial real estate markets. At the same 

time, aggregate risk within the banking industry appears to have risen, as evidenced 

by softening profitability, growing reliance on noncore funding, heightened levels of 

interest rate risk, and increasing concentrations in traditionally higher-risk loan 

categories. A confluence of these trends could heighten the vulnerability of some 

insured institutions. See page 11. 

By the Division of Insurance 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 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, 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. For 

more information or to provide comments or suggestions about the Boston Region’s Regional Outlook, please call Daniel Frye at (781) 794-5678 or send an e-mail to dfrye@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 Donna Tanoue 

Director, Division of Insurance Arthur J. Murton 

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 

REVISION: 

The article “Ranking Metropolitan Areas at Risk for Commercial Real Estate Overbuilding” in 

the Third Quarter 2000 issue of the Regional Outlook has been revised to correct a data-related 

error. The revision affects Chart 4 and Chart 11 of the report. Please see www.fdic.gov/bank/ 

analytical/regional/ro20003q/correction.html for revised versions of Chart 4 and Chart 11, along 

with an additional explanation of how the revision affects the article. 
Regional Perspectives
 

Regional Perspectives
 

•	 The Region’s economic growth showed signs of slowing in 2000, but commercial real estate activity remained 

robust. 

•	 Insured institutions reported stable conditions; strong loan growth continued among the Region’s smaller 

banks. 

•	 Slow core deposit growth in the Region has led insured institutions to seek alternative funding sources. 

•	 Increased use of alternative funding sources may cause a decline in liquidity and an increase in credit and 

interest-rate risk. 

Regional Economic and Banking Conditions 

New England Economy: Cool-Down in Growth 

Accompanied Cool Summer Weather 

In one of the coolest summers in several years, it 

seemed only fitting that the Region’s economic growth 

should cool from its heated pace as well. The effects of 

rising interest rates and a general slowing in national 

economic growth were evident in the Boston Region 

through late summer 2000. August 2000 year-to-date 

total nonfarm job growth in the Region essentially 

matched its 1999 pace and continued to trail that of the 

nation by a modest margin; however, some sectors 

showed slowing growth. On the plus side, services and 

government sector job growth remained at or above 

1999 levels, and net job losses in manufacturing eased. 

On the minus side, job growth in all other sectors 

slowed through August 2000 from year-ago levels. The 

Region’s rate of decline in factory sector payrolls in 

2000 was less than half that of 1999; however, it was 

still double the national rate of decline. Of the states in 

the Region, only Maine’s year-to-date employment gain 

exceeded the nation’s. In fact, Maine’s labor market was 

strong enough this past summer to allow many of the 

4,800 striking workers from the Bath Iron Works shipyard to readily find other temporary work while on 

strike.1 

Seasonally adjusted unemployment rates in August 

2000 were well below the national rate in all the 

Region’s states except Rhode Island. Most of the 

Region’s states also saw summer unemployment rates 

that were at or below year-end 1999 levels. The exceptions were New Hampshire and Rhode Island, where 

August unemployment rates were significantly above 

December 1999 levels, in part because of slowing job 

growth. Connecticut continued to experience the 

Region’s lowest adjusted unemployment rate, with 

Massachusetts a close second. Per capita income 

growth during first quarter 2000 generally remained 

well above the national rate, continuing a five-year trend. 

The Region’s housing markets also showed some signs 

of cooling, as August year-to-date permit issuance was 

down about 7 percent from 1999, compared with a 4 

percent drop nationally. While the southern New England states accounted for much of the decline in new 

home building during the first eight months of 2000, 

Vermont also witnessed a drop in activity. Still, that 

state’s roughly 14 percent decline followed two years of 

surging growth, so a slowdown in 2000 was not altogether surprising. Further, about half the drop was due 

to a return to more normal levels of multifamily construction following a surge during 1998 and 1999. 

Much of the multifamily buildup was due to an increase 

in projects at the state’s ski resort areas. 

Office Vacancy Rates Continue to Decline 

Commercial real estate markets generally remained 

strong in the Boston Region. The Region’s office vacancy rates continued to decline compared with one year 

ago, thanks to a lack of construction and rising demand 

(see Table 1, next page). Rents continued to rise, in 

some locations around Boston by as much as 40 percent 

in third quarter 2000 from a year ago.2 However, the 

1

”No Lack of Work for BIW Strikers.” Portland Press Herald. Sep­ 2 “Rents Can’t Get Higher? Think Again.” Boston Business Journal. 

tember 17, 2000. August 28, 2000. 

Boston Regional Outlook 3 Fourth Quarter 2000 
Regional Perspectives
 

TABLE 1 

Office Vacancy Rates Continue to 

Fall in the Region 

(percentage of office space vacant) 

2Q00 2Q99 

BOSTON, MA* 2.0 4.9 

CAMBRIDGE, MA* 0.1 4.0 

HARTFORD, CT 15.3 16.0 

NEW HAVEN, CT 16.1 18.3 

STAMFORD, CT 7.4 11.0 

SOUTHERN NH 5.2 14.9 

* Vacancy rates for downtown areas. 

Source: Cushman & Wakefield; Spaulding & Slye Colliers; FW Dodge 

scarcity of office and certain kinds of industrial space, 

particularly around greater Boston, may be cause for 

concern. Demand continues to outpace construction, 

forcing tenants to commit to high rental rates in advance 

in order to meet future space needs. Some tenants 

reportedly are seeking to lock in new space as much as 

three years in advance. According to Meredith & Grew 

Inc., tenants are leasing space when it is available, even 

if they do not currently need it, in anticipation of future 

demand. Such practices not only inflate rents but may 

prove troublesome if market conditions falter, leaving 

tenants with high-rate rental contracts for space they 

will not occupy. 

In downtown Boston, average rents for class A space are 

at an all-time high, and with more than 4.5 million 

square feet of leasing transactions completed in 2000 

alone, the market continues to absorb any available 

TABLE 2 

space. According to Cushman & Wakefield, downtown 

Boston boasted a 2 percent vacancy rate as of the end of 

second quarter 2000. Some relief may be in sight within the next 24 months, as six new office towers are 

under construction, which will add a total of 3.9 million 

square feet to Boston’s market (or about 8 percent of 

existing inventory in the central business district). However, a significant portion of this space reportedly has 

been preleased. 

Hartford’s office market continues to improve. 

Although its overall vacancy rate of 15.3 percent is still 

high, it is the lowest rate since the mid-1980s. Demand 

has not improved uniformly; most of the city’s suburbs 

show markedly lower vacancy rates. Some analysts have 

indicated that office rents around Hartford are finally 

high enough to support new construction. However, 

given downtown Hartford’s 23 percent vacancy rate as 

of second quarter 2000, it seems unlikely that any new 

construction will occur there. More likely, any new 

building will accommodate growing demand in the 

city’s outlying areas first. 

Boston Region Banks Report Stable Conditions 

The Region’s insured institutions continue to report stable conditions (see Table 2). Excluding credit card specialists, the aggregate return on assets for the Region 

was 1.28 percent as of June 30, 2000. This is an increase 

of 7 basis points from the same period in 1999. Net 

interest margins (NIMs) in the Region’s largest institutions (assets greater than $25 billion) continued to 

decline, while margins at the medium-sized institutions 

Financial Performance of Region’s Insured 

Financial Institutions Remains Solid 

BOSTON REGION <$1 BILLION 

>$1 BILLION 

<$25 BILLION >$25 BILLION 

JUN-00 JUN-99 JUN-98 JUN-00 JUN-99 JUN-98 JUN-00 JUN-99 JUN-98 JUN-00 JUN-99 JUN-98 

RETURN ON ASSETS 

NET INTEREST MARGIN 

PAST-DUE RATIO 

NET CHARGE-OFF 

RATIO 

CORE DEPOSITS/ 

ASSETS 

1.28 

3.80 

1.62 

0.52 

47.86 

1.19 

3.84 

1.66 

0.40 

51.48 

1.22 

3.92 

1.61 

0.42 

54.77 

1.09 

3.92 

1.25 

0.09 

69.74 

1.05 

3.81 

1.56 

0.05 

71.05 

1.14 

3.98 

1.95 

0.09 

73.56 

1.19 

3.82 

1.08 

0.21 

60.32 

1.10 

3.53 

1.41 

0.20 

61.58 

1.13 

3.61 

1.61 

0.24 

65.31 

1.40 

3.84 

2.02 

0.85 

35.54 

1.27 

3.96 

1.80 

0.63 

41.04 

1.28 

4.00 

1.47 

0.63 

44.57 

NONCORE FUNDING/ 

ASSETS 38.69 36.28 34.03 19.65 17.70 14.68 30.84 29.02 25.55 48.38 45.40 43.74 

All data exclude credit card institutions.
 

Source: Bank and Thrift Call Reports; reported on a merger-adjusted basis
 

Boston Regional Outlook 4 Fourth Quarter 2000 
Regional Perspectives
 

(assets between $1 billion and $25 billion) rose. The 

Region’s small institutions (assets less than $1 billion) 

showed slight increases in NIMs compared with June 

1999, but margins were unchanged during the past three 

quarters. 

Some signs of weakening have emerged among the larger banks, as aggregate past-due loan and net charge-off 

ratios rose slightly. Nationally, many larger institutions 

have experienced increasing credit problems with syndicated commercial loans, and this is likely occurring in 

the Region’s larger banks as well. While the past-due 

ratio has increased for the large banks, it continued to 

fall for the Region’s smaller institutions and remained 

low in aggregate compared with that of the nation. Loan 

growth in small and medium-sized institutions continues to be robust, particularly in the commercial, commercial real estate, construction and development, and 

consumer sectors. The Region’s largest institutions 

showed essentially no loan growth, in part because of 

sales of loans associated with divestitures related to 

merger activity. 

Current Trends in Liquidity and Funding
 

Core deposits alone have not been sufficient to fund 

loan and asset growth. To compensate, insured institutions have turned increasingly to alternative funding 

sources. These alternatives may decrease liquidity and 

increase levels of credit and interest-rate risk. 

Core Deposit Growth Is Slow 

Core deposits, the primary funding source for the banking industry, are declining in importance. Historically, 

loan and asset growth have been generally tied to the 

amount of new core deposits generated in the economy. 

However, during the past decade, this relationship has 

not held true. Typically, annual loan and asset growth 

have outpaced core deposit growth in the Region since 

the early 1990s (see Chart 1). 

CHART 1 

Source: Bank and Thrift Call Reports, merger adjusted, Boston Region 

Typically, Region’s Assets Have Grown More 

Rapidly than Core Deposits in Recent Years 

% Change on Year Ago 

’00 

Core Deposits –10 

0 

10 

20 

30 

40 

Assets 

June 30 

’86 ’88 ’90 ’92 ’94 ’96 ’98 

Slow core deposit growth may be attributed in part to the 

public’s increased knowledge of, and access to, domestic 

and global capital markets. The recent high returns 

offered by the stock market are widely publicized and 

frequently advertised. The information obtained from 

advertisements and media sources such as the Internet 

and television could have encouraged many savers to 

select equities over traditional bank deposits. In addition, 

the advent of mutual funds and online trading on the 

Internet have made capital markets more accessible to 

less wealthy investors. Both mutual funds and online 

investing require less financial commitment and lower 

transaction costs than other methods of investing. 

The hypothesis that banks are losing deposits to capital 

markets appears to be credible in light of national trends 

in time and savings deposits against equities and mutual fund shares. Since 1990, time and savings deposits as 

a percentage of total personal financial assets have fallen from 21 percent to 10 percent, while equities and 

mutual funds have soared from 19 percent to 35 percent 

(see Chart 2). Indeed, many bankers have recognized 

the public’s preference for mutual funds and equities 

and have implemented nondeposit sales programs. 

These programs are designed to collect fee income from 

investors who management concedes would not otherwise deposit money at the bank. 

Although core deposit growth has been slow across all 

types and sizes of institutions in the Region, institutions 

with total assets greater than $25 billion have experienced the greatest decline in core deposits. In recent 

years, these banks have had very little success in obtaining or maintaining core deposits. As Chart 3 shows, the 

largest banking institutions have actually experienced 

Boston Regional Outlook 5 Fourth Quarter 2000 
Regional Perspectives
 

CHART 2	 CHART 3 

Nation’s Banks May Be Losing
 

Deposits to Capital Markets
 

Equities & Mutual 

Percentage of U.S. Total

Personal Financial Assets

Time & Savings 

Deposits 

Fund Shares 

’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 

0 

10 

20 

30 

40 

Source: Bank and Thrift Call Reports, Boston Region, merger adjusted 

As a Group, Region’s Largest Institutions 

Have Lost Core Deposits 

Core Deposits, $ Billions 

June 30 

’89 ’91 ’93 ’95 ’97 ’99 

60 

80 

100 

120 

140 

All Others 

Banking Subs of Largest 

Bank Holding Companies 

Source: Flow of Funds, Assets & Liabilities of the Household Sector 

declines in core deposits. This is in part because regulators have required some of the largest institutions to sell 

retail branches as a result of merger activity. However, 

some of the decline may result from management’s willingness to pursue alternative sources of funds rather 

than aggressively pursue or maintain core deposits. In 

addition, subsequent to mergers, some customers may 

leave the enlarged institution, believing they can obtain 

better service and value at a smaller institution. 

For other institutions, marginal core deposit growth can 

be measured relative to new loans or new assets. Over 

the past seven years, the Region’s insured institutions 

with less than $25 billion in total assets (excluding credit card banks) have matched every dollar of new loans 

with 74 cents in new core deposits. This fraction is reasonably consistent among all categories3 of institutions, 

regardless of asset size, ownership type, or geographic 

location. The same institutions over the same period 

have matched each dollar of new assets with 42 cents in 

new core deposits. This fraction is even lower (33 cents) 

for large public institutions with total assets between $1 

billion and $25 billion. The greater mismatch between 

core deposit and asset growth for these institutions may 

be related to stockholder pressures to increase returns 

through balance sheet expansion. 

Borrowings Are Increasing 

When core deposit growth does not match asset growth, 

other sources of funding are used. Regional data point 

3 Excludes credit card banks and insured institutions with more than 

$25 billion in total assets. 

primarily to borrowings, which are a more expensive 

and potentially volatile source of funds. They are expensive because the pricing structure is closely tied to the 

market, and borrowings are potentially volatile because 

lenders may either call the funds or withdraw them at 

maturity. Presumably, during a slowdown in the economy or when an institution experiences financial problems, the borrowings may become too expensive to 

maintain or may become unavailable for institutions 

without sufficient collateral or capital. To pay off the 

debt, management would have to sell assets or raise capital. As shown in Chart 4, despite the potentially volatile 

nature and expense of borrowings, borrowings as a percentage of assets are at an all-time high both in the 

Boston Region and nationally. 

Gramm-Leach-Bliley Act May Spur Borrowing 

Federal Home Loan Bank System (FHLB) advances are 

a primary source of credit for small banks and thrifts. 

As of June 30, 2000, FHLB advances to FDIC-insured 

institutions nationwide totaled $427 billion, or 29 percent of total borrowings outstanding. As shown in Chart 

5, advances to members both in volume and as a percentage of total borrowings have increased rapidly. 

Recent regulatory changes promulgated as a result of the 

Gramm-Leach-Bliley Act (GLBA) appear to facilitate 

even more borrowing. These changes are as follows: 

•	 All FDIC-insured institutions with less than $500 

million in assets (community financial institutions) 

may become members of the FHLB. (Before GLBA 

was passed, only institutions with 10 percent of 

assets in residential housing assets could join.) 

Boston Regional Outlook 6	 Fourth Quarter 2000 
Regional Perspectives
 

CHART 4	 CHART 5 

Source: Call Reports, excluding credit card banks (Region is merger adjusted) 

Insured Institutions Are Growing Increasingly 

Reliant on Borrowed Funds 

Borrowed Funds

Percentage of Total Assets 

’85 ’87 ’89 ’91 ’93 ’95 ’97 ’99 

Region 

Nation 

8 

10 

14 

16 

18 

20 

22 

12 

June 30 

Nation’s Banks and Thrifts Have Grown More 

Reliant on Home Loan Bank Borrowings 

Source: Federal Home Loan Bank and Call Reports 

Percent 

$ Billions 

Share of Borrowings (right axis) 

FHLB Advances to

 Banks & Thrifts (left axis) 

’94 ’95 ’96 ’97 ’98 ’99 June 

’00 

0 

5 

10 

15 

20 

25 

30 

0 

100 

200 

300 

400 

500 

•	 Advances to “nonqualified thrift lenders” are no 

longer restricted to 30 percent of total assets. 

•	 “Community financial institutions” may use 

advances to fund small business and small agricultural loans. 

•	 “Community financial institutions” may also use 

small business and small agriculture loans as collateral for advances. 

Increased exposure to borrowings may heighten risk 

levels for several reasons. First, some forms of borrowings carry regulatory risk. For instance, regulations, 

such as those promulgated as a result of the enactment 

of the GLBA, could be changed in the future and 

become more restrictive on FHLB borrowing. Second, 

borrowings tend to be relatively expensive and may 

cause significant earnings problems. Higher funding 

costs may entice return-conscious managers to assume 

more risk to compensate for the higher costs. Third, borrowings can be extremely sensitive to interest rates. 

Other features, such as callable advances, may also negatively affect funding costs. Fourth, borrowings increase 

liquidity risk by reducing the amount of available credit and lowering the amount of readily marketable assets. 

Typically, the most liquid investments are pledged as 

collateral for secured borrowings. 

Another perspective is that secured borrowings may 

lead to greater losses to the FDIC insurance funds. 

Because of the secured nature of the borrowings, the 

highest-quality assets become encumbered. Therefore, 

if an institution failed, the FDIC would presumably have 

lower-quality assets available for sale to satisfy its 

obligations to insured depositors. 

Funds Available from Asset Sales 

Are Declining Also 

In addition to borrowings and core deposits, funds can 

be obtained from asset sales. Essentially, the entire balance sheet can be sold. However, sales can come with a 

cost. Typically, the most liquid assets have the least 

embedded credit risk, and the sale can raise an institution’s risk profile. The most liquid major asset categories 

are short-term investments, securities, and residential 

loans underwritten to secondary market standards. 

In the Region, the amount of cash held by institutions 

with less than $25 billion in total assets (excluding credit card banks) has been consistent across all time periods at about 2 to 3 percent of total assets. Not 

surprisingly, interest-bearing assets (such as deposits 

with other banks) have declined from 2.2 percent of 

total assets in June 1990 to 0.3 percent of total assets as 

of June 2000. These assets earn very little compared 

with other earning assets and may be management’s 

first choice among the sources of funds. Federal funds 

sold and reverse repurchase agreements also appear to 

be stable at approximately 2 to 3 percent of total assets. 

As discussed earlier, many institutions, particularly 

large public institutions, are seeking to increase returns 

on equity. One method of doing so is to borrow money 

and invest the funds in higher-yielding securities and 

loans. As a result, the significant increase in borrowings 

in the Region has been accompanied by increases in 

Boston Regional Outlook 7	 Fourth Quarter 2000 
Regional Perspectives
 

available-for-sale securities and loans. Theoretically, CHART 6 

management could sell the loans and securities when Maturities of Assets Have funds are needed. However, certain restrictions or costs Lengthened in the Region may prohibit sale. The security or the loan could be 12 Percentage of Assets Maturing or Repricing after 15 Years 

pledged against a specific borrowing and may be 

Jun ’97 

Jun ’00 

unavailable for sale for any reason except to pay off the 

debt, or the resale market may be limited. Another reason might be that the security or the loan could carry 

unrealized losses that management does not wish to 

realize. As Chart 6 shows, Call Report filers in the 

Region appear to be shifting away from assets with 

short maturities to assets with longer maturities. This 

shift, along with recent increases in interest rates, has 

10 

8 

6 

4 

2 

caused unrealized losses. 0 

Another factor that may influence a loan’s liquidity is 

the loan type. Generally, loans secured by 1- to 4-family 

mortgages are the most liquid because of the size of the 

secondary market. Government-sponsored agencies 

such as Fannie Mae and Freddie Mac, as well as many 

other market participants, stand ready to buy these 

mortgages. In addition, these loans are a primary source 

of collateral for FHLB borrowings. However, this asset 

class is also declining. In the Region, loans secured by 

1- to 4-family mortgages represented over 28 percent of 

assets and 40 percent of loans in the early 1990s but 

represented only about 19 percent of assets and 30 percent of loans as of June 2000. While this decline is 

apparent in institutions of all sizes, it is most pronounced in those with assets of $1 billion or more. The 

Region’s small institutions, which typically are heavier 

residential lenders, show slight declines in single-family 

residential mortgages, but those loans still account for 

about 40 percent of total assets and 57 percent of total 

loans. 

Over the past decade, securitization activity has 

improved liquidity by allowing insured institutions to 

sell virtually any loan. However, the marketability of a 

loan depends on its quality. If loan quality declines, 

marketability may also decline. Moreover, the highestquality loans may be sold first, leaving the institution 

with the lower-quality, higher-risk assets. 

Other Sources of Liquidity 

Other sources of funds include net income, principal 

reductions on loans and securities, and issuance of new 

stock. Thanks in part to the strong economy, net income 

at most institutions in the Region is at all-time highs. 

However, the strong earnings may be offset by slower 

Securities Loans 

Source: Bank Call Reports, Boston Region, merger adjusted 

principal reduction. In the past few years, interest rates 

have been relatively low, enticing borrowers to refinance or take on new debt. Since then, market interest 

rates have climbed and dampened prepayment speeds. 

Consequently, many new loans that are amortized over 

extended periods of time will pay back very little in 

principal. Further, if higher interest rates persist, borrowers may be less likely to refinance or prepay their 

debt. Issuance of new bank stock may be inhibited by 

lower returns in comparison to the stock market. 

According to Smartmoney.com, the nation’s 58 largest 

commercial bank holding companies experienced an 

average stock price appreciation of 10 percent over the 

52-week period ending September 22, 2000. This rate 

compares unfavorably to the Dow Jones Industrial 

Average’s gain of 27 percent over the same period. 

Implications 

Bankers in the Boston Region are discovering that 

because of recent increases, alternative funding is 

becoming increasingly expensive. Higher funding costs 

put downward pressure on margins and may lead managers to take on additional risk in order to maintain 

income. This may already have happened at some institutions. Aggregate data for all categories of institutions 

show declines in historically lower-risk assets, such as 

residential loans, and increases in higher-risk assets, 

such as commercial loans. As long as the economy 

remains strong, higher-risk assets generally offer higher 

returns. These higher returns may offset funding cost 

increases in the short term but may exacerbate earnings 

problems if the economy turns down. Economic problems would also magnify the growing liquidity risk that 

Boston Regional Outlook 8 Fourth Quarter 2000 
Regional Perspectives
 

accompanies an increasingly higher-risk asset mix 

funded with potentially volatile funding sources. 

Boston Region Staff 

The Boston Region Staff would like to express 

their appreciation to Thomas Wiggins, Bank 

Examiner, Division of Supervision, for his 

contributions to this article. 

Boston Regional Outlook 9 Fourth Quarter 2000 
In Focus This Quarter
 

Emerging Risks in an Aging Economic Expansion
 

•	 The economy and the banking and thrift industries are reporting generally healthy conditions. 

However, the economic expansion is aging, and it 

is unlikely that the vigor experienced during the 

first half of 2000 can be sustained. 

•	 Likewise, record banking and thrift industry 

profits, healthy capital cushions, and good asset 

quality of recent years may not be sustainable. 

Declining net interest margins, rising commercial 

loan losses, tighter liquidity, and riskier asset 

composition are among the warning signs that 

industry performance may have peaked for this 

business cycle. 

•	 Specific areas of concern include growing reliance 

on noncore funding; heightened interest rate risk; 

increased exposure to market-sensitive revenues; 

deteriorating credit quality; rising leverage 

among businesses and households; and signs of 

imbalance in some residential and commercial 

real estate markets. 

Although no readily apparent situations or imbalances 

suggest that a recession or widespread banking problems will develop in the near term, warning signs are 

present. A highly competitive banking industry shapes 

the environment in which pressures on insured institutions are unfolding. The presence of a large share of 

newly chartered banks in some areas appears to be raising the risk profile among all institutions in certain markets. Publicly owned companies remain under intense 

pressure to grow earnings and increase shareholder 

value. In addition, local banking environments exist in 

which a confluence of risks is generating heightened 

vulnerability for all participants, even during healthy 

economic times. Complacency in these environments 

may have negative repercussions for many insured institutions going forward. 

Imbalances Are Appearing amid a Healthy 

Macroeconomic Environment 

The performance of the U.S. economy contributes to the 

opportunities and risks financial institutions face. The 

current cyclical expansion, now nine and one-half years 

old, is displaying signs of aging while setting a record 

for longevity. A consensus forecast calls for moderate 

real gross domestic product (GDP) growth through 

2001, following robust gains in the first half of 2000. 

Current conditions might be called a “soft landing,” in 

which real GDP growth slows to a sustainable noninflationary rate of 2.5 to 3.5 percent, and unemployment 

hovers around recent rates. 

Although the current macroeconomic environment 

might appear to be the best of all possible worlds, areas 

of concern exist. One is that sustained prosperity tends 

to foster higher levels of risk taking, overconfidence, 

and complacency. For example, the turmoil in world 

foreign exchange and financial markets during 1997 

and 1998 illustrates how dramatic imbalances can 

develop and trigger disruptive adjustments even during 

healthy economic times. 

Currently, no specific situation or imbalance seems to 

threaten the viability of the expansion. However, as 

detailed below, several likely will contribute to slower 

economic growth. Situations that warrant monitoring 

include the following: 

•	 The repercussions from higher energy prices are 

unfolding. Historically, oil price shocks have weakened several other long-lived economic expansions. 

•	 Short-term interest rates rose over the past year while 

longer-term rates declined, resulting in a modest 

inversion of the yield curve. This relationship may 

inhibit the profitability of some lenders’ practice of 

borrowing short term and lending longer term and 

also complicate the interest rate risk management 

process for some insured institutions. 

•	 Continuing low unemployment suggests that demand 

for additional workers will go unfilled, thus limiting 

economic growth or triggering bidding wars that 

increase workers’ compensation and, potentially, 

inflation. 

•	 Stock market sentiment is no longer strongly bullish. 

A pullback from high valuations and optimism could 

trigger negative repercussions on consumers’ net 

worth and spending as well as on the level of business investment. 

•	 A large international trade deficit and strong U.S. 

dollar may be an unsustainable combination over the 

Boston Regional Outlook 11	 Fourth Quarter 2000 
In Focus This Quarter
 

long run. Meanwhile, repatriated profits of U.S. corporations are being trimmed by the dollar’s strength 

relative to the euro and other currencies. 

•	 Household debt burdens are historically high, with 

leverage rising the most in recent years among lowand middle-income households. These households’ 

access to credit has increased as lenders competed 

more fiercely for customers. 

•	 Corporations are more highly leveraged, and potential default risk rose in the past year across a range of 

industries. Meanwhile, downgrades of publicly traded corporate debt issues are exceeding upgrades by a 

2 to 1 ratio. 

•	 In some metropolitan areas, overheated housing markets are developing, in which home prices are rising 

dramatically and exceeding gains in median 

incomes. 

•	 Potential signs of excess commercial real estate construction are appearing in several urban areas where 

banks’ construction loan growth also is strong. 

Economic indicators of what lies ahead are not clearcut, and each possible scenario contains a set of potential challenges for insured institutions and regulators. 

Should economic growth slow considerably, current 

vulnerabilities, such as highly leveraged borrowers’ 

debt loads and overheated housing markets, could worsen significantly. As evidenced by the rash of bank failures during the 1980s, it doesn’t always take a national 

recession for problems to develop. Alternatively, sustained rapid growth might foster new vulnerabilities and 

allow current imbalances to intensify or build up. For 

example, speculative construction could accelerate, 

stock market volatility could increase, or ballooning 

trade deficits could generate turmoil in foreign 

exchange markets. 

Signs of Strain Are Also Appearing 

amid Healthy Banking and Thrift Industries 

With the long economic expansion as a backdrop, 

insured institutions in the aggregate are performing 

very well. However, the record profits attained in recent 

years may not be sustainable. The losses posted recently by several large institutions are striking examples of 

increased appetite for risk resulting in significant financial loss during a period of strong economic growth. 

While these are isolated instances, they are indicative of 

the increasingly competitive environment facing the 

financial services industry. 

Overall industry profitability is beginning to soften, led 

primarily by rising commercial loan losses at large institutions and declining net interest margins in institutions 

of all sizes. Credit card loss rates, which had been 

steadily falling since late 1997, have stalled in recent 

quarters, suggesting that recent increases in interest 

rates and energy costs not only are affecting businesses 

but also are taking a toll on some consumers. Other 

signs suggesting that aggregate risk within the system 

has risen include the growing reliance on noncore funding to support asset growth, heightened interest rate risk 

at many institutions, growing concentrations in traditionally higher-risk loan classes, and a shift in institutions’ overall asset mix toward higher-risk categories. A 

brief discussion of these risks follows. 

Funding Patterns Heighten Liquidity Concerns 

Lackluster core deposit growth is placing pressure on 

bank earnings and contributing to rising liquidity risk in 

the banking system. During the past five years, the compounded annual rate of core deposit growth for all 

insured institutions was just 2.8 percent. Assets over this 

time grew at a 6.6 percent rate. Accordingly, a significant portion of the industry’s growth has been funded by 

noncore sources (see Chart 1). The higher cost and rate 

sensitivity of these funds put downward pressure on net 

interest margins, particularly in a rising rate environment. 

CHART 1 

Most of $2 Trillion of Asset Growth since 1995
 

Was Funded with Noncore Funds
 

Subordinated Debt 

and Other Liabilities

 5% 

9% 

Equity 

22%
 

Core Deposits
 

64%
 

Noncore Funding
 

Source: Bank and Thrift Call Reports, June 2000 and June 1995 

Boston Regional Outlook 12	 Fourth Quarter 2000 
In Focus This Quarter
 

To compensate for higher funding costs, the industry 

has pursued growth in higher-yielding asset classes that 

are traditionally both riskier and less liquid. For example, almost 37 percent of the asset growth in the past 

five years has come from nonresidential real estate and 

commercial and industrial loans. 

For institutions that fund illiquid assets with wholesale 

sources, any adverse events that trigger a lack of confidence in the institution may result in higher funding 

costs, thus placing further pressure on margins. In 

efforts to obtain funding, an institution also may pledge 

a greater portion of its best quality assets as collateral, 

further reducing liquidity. Finally, in instances where 

funding needs have exceeded available liquidity, the 

forced sale of illiquid assets to meet funding outflows 

could result in losses if market conditions are unfavorable. Presumably, the FDIC, as insurer, would suffer 

greater losses if such an institution failed, because it 

would be relying on proceeds from the liquidation of 

less liquid, and potentially lower-quality, assets to satisfy 

the claims of insured depositors. 

Subprime lenders, in particular, tend to rely heavily on 

noncore funding to pursue aggressive growth strategies. 

Chart 2 illustrates the extent to which noncore funding 

exceeds the level of liquid assets for this group. The 

chart suggests the difficulty these institutions may 

encounter if forced to convert assets to meet funding 

outflows. Although subprime lenders may use noncore 

sources to fund riskier assets to a greater extent than the 

industry at large, this illustration exemplifies a systemic 

trend that is raising liquidity risk industrywide and is 

increasing risk to the insurance funds. 

Increasing Levels of Interest Rate Risk 

Challenge Some Institutions 

The refinancing boom of the late 1990s spurred a significant shift into longer-maturity assets for many 

insured institutions. During this period, a vast majority 

of mortgage borrowers opted for longer-term, fixed-rate 

loans, which they obtained at historically low rates. A 

great deal of the higher-rate or adjustable-rate loans that 

borrowers refinanced were held in the portfolios of 

insured institutions, which contributed to a general 

lengthening of the maturity of assets held at insured 

institutions. 

The trend toward longer-term, fixed-rate assets has been 

particularly pronounced among mortgage lenders. For 

example, state-chartered savings banks, which are traditionally mortgage lenders, have experienced a dramatic 

increase in long-term assets. As of June 30, 2000, 

almost 45 percent of the median savings bank’s earning 

assets were not scheduled to reprice for five years or 

longer (see Chart 3). 

Fixed-rate mortgage-related assets at federally chartered thrifts have risen similarly. From year-end 1995 

through first quarter 2000, the percentage of fixed-rate 

mortgage-related assets at thrifts with assets less than 

$1 billion rose from 49 percent to 60 percent of 

mortgage-related assets. Some thrifts and savings 

banks, therefore, have significant exposure to rising 

rates from low-yielding long-term assets. 

CHART 2 $ Billions 

Source: FDIC Division of Supervision and Bank and Thrift Call Reports (data are 

merger adjusted) 

Subprime Lenders’ Growing Dependence

 on Noncore Funding Strains Liquidity 

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

0 

30 

60 

90 

All other loans 

Residential real estate loans 

Securities and shortterm investments 

Columns: Noncore funding 

CHART 3 

Growing Concentration in Long-Term 

Assets Elevates Interest Rate Risk 

Source: Bank Call Reports, excluding Thrift Financial Report filers 

Share of Assets Maturing or Repricing in Five Years or Longer 

Relative to Total Earning Assets (median percentage) 

Percent 

Savings Banks 

Commercial Banks 

50 

0 

10 

20 

30 

40 

’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00

Boston Regional Outlook 13 Fourth Quarter 2000 
In Focus This Quarter
 

While most commercial banks do not have as high 

exposure to rising rates as savings banks, some may 

have taken on significant risk. The median savings bank 

has a ratio of long-term assets to earning assets that corresponds to the ratio level for the 93rd percentile of 

commercial banks. Although the 93rd percentile is in 

the tail of the commercial bank distribution, almost 600 

commercial banks have a concentration in long-term 

assets that exceeds that of the median savings bank. 

These institutions may be exposed to significant interest rate risk as well. 

While assets have lengthened considerably for many 

institutions, there has not been a corresponding extension of liabilities. To the contrary, funding pressures are 

tending to make bank liabilities more rate sensitive. 

These diverging trends generate concern, especially in a 

rising interest rate environment. That is, rate increases 

drive up the cost of funds more rapidly than earning 

asset yields at institutions with liability-sensitive interest rate risk postures. In a significantly higher interest 

rate environment, many institutions’ current postures 

likely would cause heavy margin erosion. 

Most institutions that have high concentrations in longterm assets also have strong capital and an asset mix 

that contains lower credit risk than that of many other 

institutions. Among savings banks, interest rate risk primarily arises from significant concentrations in residential mortgage loans, whereas the typical commercial 

bank’s exposure is more likely to arise from large holdings of long-term securities. However, some institutions 

with concentrations in long-term assets also may have 

lower capital levels, a higher-risk asset mix, or poor 

earnings. Rising rates could weaken these institutions 

and make it more difficult for them to weather adverse 

economic or other developments. 

Dependence on Market-Sensitive Revenues 

Increases Earnings Volatility for Some 

Institutions 

During the recent generally favorable conditions in financial markets, the share of revenue earned from business 

lines susceptible to financial market volatility has 

increased substantially for some of the industry’s largest 

institutions. Among these revenue sources are fees and 

gains from asset management, brokerage, investment 

banking, venture capital, and trading activities. The 19 

institutions most active in these lines of business earned 

over 26 percent of their net operating income from such 

sources in the second quarter of 2000. Other large institutions also have reported a growing dependence on these 

volatile sources of revenue. 

Turbulence in the financial markets has led to greater 

earnings volatility for some of these institutions. Stress 

in the financial markets could weaken the demand for 

underwriting services or significantly reduce trading 

revenues or venture capital gains. Furthermore, the 

same factors that are causing volatility in the financial 

markets could hamper loan growth and lead to slower 

revenue growth from core business lines. Should 

increased earnings volatility from exposure to marketsensitive revenues combine with slower revenue growth 

from core business lines, some institutions could face 

significant earnings challenges. 

The Rising Level of Problem Business Loans 

Is Centered in Large Banks 

Second quarter 2000 commercial and industrial (C&I) 

credit quality indicators at banks deteriorated for the 

eighth consecutive quarter. Noncurrent C&I loans— 

those on nonaccrual status plus those 90 days or more 

past-due—rose 13 percent over first quarter 2000 levels 

to $14.5 billion, or 1.4 percent of total C&I loans. Noncurrent loan levels for the period ending June 2000 were 

40 percent higher than the year-earlier level. Net C&I 

loan loss rates also continue to edge higher but remain 

well below those experienced by banks in the late 1980s 

and early 1990s.1 

Large banks, particularly those active in syndicated 

lending, are bearing the brunt of deteriorating C&I loan 

quality. Recent increases in criticized and classified 

shared national credits (SNCs), which are loans exceeding $20 million that are shared among three or more 

lending institutions, are illustrated in Chart 4. In the 

2000 SNC review, criticized and classified credits 

increased 44 percent over 1999 levels to 5.1 percent of 

total SNC commitments. Furthermore, the bulk of the 

increase was in the more severe classified categories, 

which now comprise 64 percent of total criticized and 

classified credits, compared with 54 percent at the yearearlier review. 

11

During second quarter 2000, banks posted an annualized net C&I 

loss rate of 0.67 percent, up from 0.55 percent for second quarter 

1999. For comparison purposes, net quarterly annualized C&I loss 

rates averaged 1.11 percent from fourth quarter 1991 to fourth quarter 

1993. 

Boston Regional Outlook 14 Fourth Quarter 2000 
In Focus This Quarter
 

CHART 4 

Note: C&I = commercial and industrial; SNC = shared national credit 

Source: Shared National Credit Program 

Syndicated Loan Problems Are on the Rise 

Percent

$ Billions 

’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00 

Criticized and 

Classified SNC Loan 

Commitments (right 

scale) 

Percentage of SNC 

Commitments Criticized 

and Classified (left scale) 

0 

2 

4 

6 

8 

10 

12 

14 

16 

0 

20 

40 

60 

80 

100 

120 

140 

C&I loan quality indicators continue to deteriorate 

despite generally favorable economic conditions. Three 

factors explain much of this deterioration: certain weak 

industries, rising corporate debt burdens, and the seasoning of syndicated loans underwritten from 1997 to 

1998, when many banks significantly eased business 

lending standards. 

Industry Sector Weaknesses 

The financial stresses facing healthcare and entertainment companies (cinema operators in particular) have 

been well publicized. While the healthcare and entertainment sectors have contributed significantly to the 

decline in commercial credit quality, problems within 

these two sectors do not account for the full extent of 

the increase in noncurrent loans and problem SNC 

loans. Both of these sectors are within the broader services sector, which experienced a $4.6 billion increase 

in criticized and classified credits from the 1999 to the 

2000 SNC review. However, this increase accounts for 

only 15 percent of the $30.8 billion increase in criticized and classified SNCs overall.2 The expected 

default probabilities evident in market-based information can be used to identify other industry sectors experiencing financial stress. KMV LLC has developed a 

model that uses publicly available information to estimate the likelihood of default of individual firms.3 

2 See the interagency release of SNC results at www.occ.treas.gov/
 

ftp/release/2000-78a.pdf.
 

3 KMV Credit Monitor® uses information from a firm’s equity prices
 

and financial statements to derive KMV’s Expected Default Frequency (EDFTM), which is the probability of the firm defaulting within a
 

one-year period. The main determinants of a firm’s likelihood of
 

default: the firm’s asset value, the volatility of the firm’s asset value,
 

and the degree of financial leverage.
 

KMV’s model is used by many lenders to monitor and 

evaluate obligor risk and credit risk trends. Applied to 

the analysis of industries, the output of KMV’s model is 

just one of a number of indicators that suggest weaknesses in certain industry sectors. 

Sectors that include a high proportion of firms with 

high default probabilities (median one-year default 

probabilities exceeding 4 percent) are shown in Chart 5. 

Using entertainment as an example, the bars in the chart 

show that in September 2000, one-half of publicly held 

entertainment firms had greater than an 8 percent 

chance of defaulting on their obligations within one 

year. In September 1999, this same proportion of entertainment companies had a substantially smaller (6 percent) chance of defaulting within a 12-month period. 

The median likelihood of default for all the industries 

shown in the chart far exceeds that of Standard & 

Poor’s-rated, BB-grade (sub-investment-grade) obligors 

as of September 2000, as indicated by the dotted line in 

the chart. 

Rising Corporate Debt Burdens 

U.S. corporate debt burdens, as measured by the debtto-net-worth ratio for nonfarm, nonfinancial businesses, 

continue to increase. This ratio reached 83 percent in 

the second quarter of 2000, up from 72 percent as of 

year-end 1996. Although debt burdens remain below the 

1988–1992 average of almost 87 percent, U.S. businesses are nevertheless becoming increasingly vulnerable to rising credit costs and disruptions in credit 

availability. 

CHART 5 Median Expected Default Frequency (EDFTM) (percent) 

Various Industries Show High Levels 

of Expected Default Risk 

Comparative EDFTM

 of S&P Bonds Rated BB 

(as of September 2000) 

Source: Credit MonitorTM ©2000, KMV LLC, all rights reserved 

Entertainment 

HealthcareWholesale Trade 

Apparel &Textile

Misc. Manufac. LodgingMining 

AgricultureConstruction 

Retail

0 

1 

2 

3 

4 

5 

6 

7 

8 

9

 September 1999

 September 2000 

Boston Regional Outlook 15 Fourth Quarter 2000 
In Focus This Quarter
 

Seasoning of 1997–1998 Vintage Loans 

Results of recent supervisory surveys suggest that 

banks are tightening terms and conditions on loans to 

small-, middle-, and large-market obligors. However, 

this tightening follows a relaxation of standards in prior 

years that has contributed to a heightened level of risk 

in banks’ loan portfolios.4 Not coincidentally, the period 

between 1995 and 1998 saw a sharp rise in the proportion of lower-graded, higher-risk credits categorized as 

leveraged transactions by Loan Pricing Corporation. 

Leveraged loan originations—those priced at 150 basis 

points or more over the London Inter-Bank Offer Rate 

(LIBOR)—rose from 12 percent of total syndicated 

loan originations in 1995 to 31 percent in 1999. According to a recent Standard and Poor’s commentary, many 

banks have acknowledged that 1997 and 1998 vintage 

credits are beginning to produce higher problem loan 

levels.5 

Household Sector’s Leverage Is High, 

and Imbalances Are Appearing 

Consumers are enjoying the benefits of the economic 

expansion, as jobs are plentiful, home ownership 

remains generally affordable, and credit seems to be 

readily available for financing motor vehicles and other 

major purchases. These conditions contributed to record 

high sales of cars and light trucks during the first nine 

months of 2000, helping sustain the consumer spending 

growth shown in Chart 6. One corollary of high vehicle 

sales, however, is softening prices for used vehicles. 

Consequently, some lessors—including banks—are 

realizing lower-than-expected residual values on leased 

vehicles, which, in turn, are triggering losses in their 

lease portfolios. This situation illustrates one problem 

that lenders can encounter even in good economic 

times. 

Spending growth remained robust in recent quarters 

even as gains in disposable income slowed. The gap 

between income and spending growth is “financed” as 

households draw down savings, tap capital gains, refinance mortgages, assume more debt, or undertake some 

combination of these measures. 

4 See Federal Reserve Board’s Senior Loan Officer Opinion Survey on 

Bank Lending Practices for May and August 2000 and Surveys of 

Credit Underwriting Practices for 1999 and 2000 from the Office of 

the Comptroller of the Currency. 

5 “U.S. Bank Loan Portfolios Reflect Rise in Corporate Bond 

Defaults.” July 20, 2000. Standard and Poor’s Commentary. 

CHART 6 

Household Spending Growth 

Exceeds Income Growth 

Source: Bureau of Economic Analysis via Haver Analytics, Inc. 

Real Consumption Spending 

Real Disposable Income 

7 

–1 

0 

1 

2 

3 

4 

5 

6

Annual Growth Rate (percent) 

’86 ’87 ’88 ’89 ’90 ’91’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99’00 

Quarter 3 

From 1995 through 1998, and likely since then, the 

increase in both leverage and debt servicing burdens has 

been concentrated among low- and middle-income 

households. Among families holding debt in 1998, debt 

payments exceeded 40 percent of disposable income for 

nearly 20 percent in the $10,000 to $24,999 income 

group and nearly 14 percent in the $25,000 to $49,999 

group.6 One concern is that these debt-laden families 

may have inadequate financial resources to make payments should adverse conditions or job loss occur. In 

such instances, lenders could be doubly affected if 

households draw on their credit card and home equity 

lines of credit, further compromising their repayment 

ability, in order to sustain spending in excess of income. 

The recent rise in credit card losses in banks’ card portfolios and rising losses in the portfolios of subprime 

lending specialists may indicate that strains among 

some households are spilling over to lenders. Moody’s 

Investors Service expects credit card losses to rise 

through 2001, according to a recent analysis of 

prospects for the U.S. credit card industry. 

Overheated residential real estate markets in several 

metropolitan statistical areas (MSAs) may be another 

warning of economic imbalances. Dramatic gains in 

home resale prices in San Francisco stand out (see Chart 

7), but this market is not alone in experiencing appreciation considerably higher than income growth. In 

some markets, where financial-services or informationtechnology workers are concentrated, bidding wars for 

properties may reflect the fact that affordability is 

6 Kennickell, Arthur B., Martha Starr-McCluer, and Brian J. Surette. 

January 2000. “Recent Changes in U.S. Family Finances: Results 

from the 1998 Survey of Consumer Finances.” Federal Reserve 

Bulletin. Vol. 86, 1–29. 

Boston Regional Outlook 16 Fourth Quarter 2000 
In Focus This Quarter
 

enhanced by gains in wealth rather than in income. 

Even so, similar surges in home resale prices in the 

past often were not sustainable. The subsequent years 

of stagnant or falling collateral values caused financial 

stress among some homeowners and their lenders. 

Further concern about residential real estate lenders 

arises because pockets of speculative construction 

under way in some markets may produce units that 

become increasingly difficult to sell at anticipated asking prices. 

Construction and Development 

Loan Growth Is Accelerating 

Commercial real estate (CRE) construction across all 

property sectors has grown during this expansion, with 

office construction particularly active. The amount of 

office space completed in mid-2000 was the largest 

since 1989 and is projected by Torto Wheaton Research 

to continue rising. Not surprisingly, construction and 

development (C&D) loan volume, growth rates, and 

concentrations are trending upward rapidly. While total 

private real estate spending grew about 6.5 percent over 

the four quarters ending midyear 2000, C&D loans at 

insured institutions rose by 26 percent. C&D loan 

growth has remained above 20 percent since 1997, and 

the aggregate volume of C&D loans is the highest since 

1989. 

Such growth is contributing to higher concentrations of 

C&D loans relative to Tier 1 capital. At current levels, 

concentrations do not begin to approach those of the 

late 1980s. However, several metropolitan areas have a 

CHART 7 

Median Home Resale Prices Soar 

in San Francisco Bay Area 

Percent Change from

Four Quarters Earlier 

Quarter 1 

–10 

–5 

0 

5 

10 

15 

20 

25 

30 

35 

’80 

’82 

’84 

’86 

’88 

’90 

’92 

’94 

’96 

’98 

’00

large percentage of insured institutions reporting high 

and rising concentrations. Table 1 (next page) shows 

MSAs with at least 15 nonspecialized community 

banks7 and at least one-third of those institutions reporting concentrations in C&D loans equal to at least 100 

percent of Tier 1 capital. The Atlanta MSA stands out. 

Sixty-five percent of Atlanta’s 85 nonspecialized community institutions reported C&D loans exceeding 100 

percent of Tier 1 capital on June 30, 2000, and 35 percent reported a concentration exceeding 200 percent. 

The aggregate C&D concentration for all 85 institutions 

in the MSA was 156 percent, the highest among MSAs 

with at least 15 institutions of similar size and nature. 

Several other markets also include significant shares of 

institutions with high concentration levels. 

Nine of the 16 markets highlighted in Table 1 not only 

have a relatively high percentage of C&D loan exposure but also appear vulnerable to overbuilding in two 

or more property types.8 While these markets show no 

clear signs of emerging economic stress, lenders there 

clearly may be at greater risk should economic or real 

estate conditions sour. Other concerns regarding CRE 

lending arise from a recent Office of the Comptroller 

of the Currency survey, which reports heightened 

credit risk in CRE portfolios and predicts it will 

increase through 2001. In addition, respondents to a 

midyear 2000 FDIC survey of examiners reported 

more frequent comments about excess office and retail 

space. 

Increasing Share of De Novo Institutions 

Raises the Stakes in Some Markets 

A common element among the metropolitan markets 

listed in Table 1 (next page) is the presence of newer 

institutions. In 10 of the 16 markets, at least 20 percent 

of the nonspecialized community institutions are less 

than three years old. The drive to build market share 

among these institutions, particularly if they are publicly traded entities, is increasing the competitive pressure on banks and thrifts in these markets. In some 

instances, the aggregate cost of deposits within the 

MSAs has risen faster than in the nation as a whole, risk 

7 The term “nonspecialized community bank” refers to institutions 

with total assets under $1 billion that are not specialty institutions 

such as credit card or trust banks. 

8 See “Ranking Metropolitan Areas at Risk for Commercial Real 

Estate Overbuilding,” Regional Outlook, third quarter 2000, which 

identifies markets where new construction is high relative to existing 

stocks of space. 

Source: National Association of Realtors via Haver Analytics, Inc. 

Boston Regional Outlook 17 Fourth Quarter 2000 
In Focus This Quarter
 

TABLE 1 

High C&D Loan Exposure Appears in Various MSAs 

SHARE (%) OF AGGREGATE C&D LOANS 

MSAS WITH 15 OR INSTITUTIONS* WITH C&D RELATIVE TO AGGREGATE 

MORE NONSPECIALIZED CONCENTRATIONS > OR = TIER 1 CAPITAL (AS %) 

COMMUNITY INSTITUTIONS* 100% OF TIER 1 CAPITAL IN THIS MSA* 

ATLANTA, GA 65 156 

PHOENIX–MESA, AZ 56 131 

MEMPHIS, TN–AR–MS 52 154 

PORTLAND–VANCOUVER, OR–WA 47 146 

OAKLAND, CA 47 163 

NASHVILLE, TN 44 103 

RIVERSIDE–SAN BERNARDINO, CA 42 110 

SAN DIEGO, CA 41 90 

GRAND RAPIDS–MUSKEGON–HOLLAND, MI 40 81 

SEATTLE–BELLEVUE–EVERETT, WA 39 98 

SALT LAKE CITY–OGDEN, UT 38 56 

FORT WORTH–ARLINGTON, TX 38 110 

DALLAS, TX 36 95 

LAS VEGAS, NV–AZ 35 119 

LEXINGTON, KY 34 80 

DENVER, CO 33 113 

*Sample includes institutions with total assets under $1 billion that are not specialty institutions such as credit 

card or trust banks. 

Note: Boldface indicates major MSAs identified at risk for excess commercial real estate construction in Regional 

Outlook, third quarter 2000. 

C&D = construction and development, MSA = metropolitan statistical area 

Source: Bank and Thrift Call Reports for June 30, 2000 

profiles are being elevated, and aggregate leverage ratios 

are falling, despite the influx of capital from the new 

institutions. Highly competitive environments have the 

potential to increase risk taking by negatively affecting 

underwriting standards and balance sheet composition. 

Farm Sector Challenges Continue 

Much of the agricultural industry is experiencing 

stress because of low commodity prices, compounded 

in some areas by low yields resulting from weather- or 

disease-related problems. Strong global competition 

and high worldwide production during the past several years have resulted in large crop inventories, 

depressed prices, and limited prospects for a price 

turnaround in the near term. In the aggregate, record 

levels of government payments have helped the 

nation’s farms maintain a generally stable financial 

condition but have not eliminated the stress in this sector. In fact, the U.S. Department of Agriculture projects that at least one in four farm businesses in several regions9 will not cover net cash expenses in 2000, 

suggesting that the viability of highly leveraged farmers may be in question. 

Fortunately, the aggregate condition of nearly 2,100 

insured agricultural banks—institutions with 25 percent 

or more of loan portfolios in agricultural credits— 

remains healthy. Generally, agricultural banks continue 

to report favorable asset quality, earnings, and capital 

positions. However, they are experiencing somewhat 

elevated levels of noncurrent loans compared with 

nonagricultural institutions. Agricultural banks are disproportionately represented among the weakest 25 percent of institutions nationwide in terms of noncurrent 

9 These are USDA’s Basin and Range, Mississippi Portal, Fruitful 

Rim, and Southern Seaboard regions. See www.ers.usda.gov/ 

briefing/farmincome/fore/regional/regional.htm. 

Boston Regional Outlook 18 Fourth Quarter 2000 
In Focus This Quarter
 

loan levels. In addition, rising levels of carryover debt at 

farm banks may translate into higher losses in the future 

if commodity prices remain low. 

The strains in the farm sector also have implications for 

nonfarm banks in agricultural areas. In several agriculturedependent states, such as Montana and the Dakotas, for 

example, where farmers’ earnings are depressed and the 

economies not well diversified, nonagricultural banks 

are reporting higher noncurrent levels than insured 

institutions elsewhere in the nation. 

Summary 

The long-lived economic expansion has contributed to 

the banking and thrift industries’ record levels of profitability and asset quality. However, as the expansion has 

matured, both consumer and corporate leverage has risen 

considerably. Bank liquidity is becoming increasingly 

strained by lackluster core deposit growth, which has 

been insufficient to fund strong loan demand. This trend 

has resulted in a decided shift into higher-risk asset 

classes to mitigate margin pressures arising from the 

greater reliance on noncore-funding sources. Furthermore, interest rate risk has risen significantly for many 

institutions, and after nearly a decade of improving asset 

quality, the level of problem loans is increasing. 

Clearly, high levels of profitability in recent years have 

been achieved, in part, by an increased appetite for risk. 

Concern arises because insured institutions’ current 

profitability is being negatively affected by some recent 

trends, despite the sustained economic expansion. And, 

while capital levels have remained fairly stable, the 

amount of risk being leveraged on the industry’s capital 

base is on the rise. Just as a rising tide is said to float all 

boats, a strong economy can mask potential problems 

that will become evident should the economic tide turn, 

particularly in institutions or markets where aboveaverage risk is concentrated. Insured institutions’ safety 

and soundness may be most vulnerable in situations 

where banks and thrifts are exposed to multiple challenges, whether because of strategic decisions or 

because of repercussions from economic and banking 

forces beyond their control. 

Daniel Frye, Regional Manager 

Joan D. Schneider, Regional Economist 

Steve Burton, Senior Banking Analyst 

Allen Puwalski, Senior Financial Analyst 

Ronald Spieker, Chief, Regional Programs 

and Bank Analysis 

The authors would like to acknowledge 

the Washington and regional staff of 

both the Division of Insurance and 

the Division of Supervision for their 

analyses and comments, which were 

instrumental in writing this article. 

Boston Regional Outlook 19 Fourth Quarter 2000 
✁
 

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