Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION FOURTH QUARTER 1997 

FDIC
 

Boston
 

Region
 

Division of
 

Insurance
 

Daniel Frye,
 

Regional Manager
 

Norman Williams,
 

Regional Economist
 

Cameron Tabor,
 

Financial Analyst
 

In Focus This Quarter 

◆ Bank Earnings: Competitive Pressures and Cyclical 

Risks—Intense competition to preserve or attract business can lead to relaxed 

underwriting standards and other changes to risk management practices that can 

reduce banks’ ability to weather a downturn. As this economic expansion reaches 

an advanced age, prudent bankers will evaluate their lending standards and reserve 

adequacy with an eye to possible adverse changes in economic conditions. 

See page 3. 

By Ronald Spieker, Steve Linehan, George French 

◆ Strong Demand and Financial Innovation Fuel 

Rebounding Commercial Real Estate Markets—Commercial real 

estate markets in many parts of the United States have rebounded, and commercial 

banks are once again actively pursuing lending opportunities. Banks are not alone, 

however, as a broader and more competitive financing market has emerged. 

Securitization vehicles such as commercial mortgage-backed securities and real 

estate investment trusts are changing how real estate is owned and paid for. 

See page 9. 

By Steven Burton, Gary Ternullo 

Regular Features 

◆ Regional Economy—There are pockets of strength in residential housing markets, particularly around Boston...home prices are rising only modestly in 

most markets...in Boston, multifamily demand exceeds current inventory, 

particularly for high-end properties, spurring new building...Boston experiences 

pickup in office construction activity, mostly in suburbs. See page 14. 

By Norman Williams 

◆ Financial Markets—Bank holding companies of all sizes have issued 

trust preferred stock following the Federal Reserve’s decision in October 1996 to 

count these tax-advantaged, capital securities toward Tier 1 capital...rating agencies and investment analysts have argued that trust preferred stock is a weaker 

form of Tier 1 capital. See page 19. 

By Kathy R. Kalser 

◆ Regional Banking—Banking conditions remain upbeat...the push for 

greater efficiency drives structural changes...smaller institutions maintain a niche, 

but competition continues to pressure profitability...real estate lending increases 

in selected markets...is the shift toward higher-LTV mortgage loans adding risk? 

See page 23. 

By Daniel Frye, Cameron Tabor, Gregory Quint 

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

Insurance Corporation for the following eight geographic regions: 

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

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

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

Dallas Region (CO, NM, OK, TX)
 

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

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

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

San Francisco Region (AK, AZ, CA, 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) 320-1792 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 Andrew C. Hove, Jr. 

Director, Division of Insurance Arthur J. Murton 

Editor George E. French 

Managing Editor Stephen Linehan 

Associate Editor Maureen E. Sweeney 

Assistant Editors Suzannah L. Susser 

John D. Weier 

Publications Manager Teresa J. Franks 
In Focus This Quarter
 

Bank Earnings: Competitive Pressures
 

and Cyclical Risks
 

•	 Rapid loan growth, record low credit losses, 

vigorous expansion of income sources, and costcutting continue to propel bank earnings to 

record levels. 

•	 Intense competition to preserve and attract 

business can lead to aggressive loan pricing, 

relaxed loan underwriting standards, increased 

portfolio concentrations, and other changes to 

risk-management practices that can reduce 

banks’ ability to sustain earnings and capital 

through a downturn. 

•	 As this economic expansion approaches an 

advanced age, prudent bankers will allow for the 

possibility of an adverse change in economic 

conditions. 

As the U.S. economic expansion continues through its 

seventh year, the banking industry continues to run at 

full throttle. Earnings climb to ever-higher levels, driven by rapid loan growth, record low credit losses, 

aggressive expansion of income sources, and vigorous 

cost-cutting. Some analysts argue that banking has 

entered a new era in which the development of noninterest income sources and new risk-management techniques will insulate banks from swings in the business 

cycle. 

Yet banks face risks that should not be overlooked. 

Assertions that bank earnings will be less sensitive to 

business cycles remain untested. Meanwhile, competition to attract and maintain business can result in 

relaxed underwriting standards and easing of loan 

terms, or increased focus on business lines whose risks 

are difficult to manage. Policies that boost short-term 

shareholder returns, including high dividends and stock 

repurchase programs, can reduce banks’ capacity to 

weather a future downturn. There is evidence that these 

things are occurring to varying degrees in banking 

today. Accordingly, as this expansion reaches an 

advanced age, prudent bankers will give careful regard 

to the quality and sustainability of the earnings generated by today’s strategic decisions. 

Credit Quality 

Variations in credit quality have been and are likely to 

remain for some time the primary source of large 

swings in bank earnings (see Chart 1). Banks manage 

the risks of large swings in credit quality by adjusting 

underwriting standards and loan terms, by diversifying 

loan portfolio exposures, and by supplying adequate 

amounts to the allowance for loan losses. In large part, 

the degree to which bank earnings can be sustained during a downturn will depend on decisions made about 

these factors during the expansion. 

Some perspective on the cyclical nature of credit quality can be gleaned from Charts 2 and 3 (next page). As 

shown in Chart 2, bank loan growth has exceeded 

growth in gross domestic product (GDP) for ten of the 

past twelve quarters, even without considering the substantial volume of loans originated and sold in securitized pools. Moreover, Chart 3 shows that growth in 

loan losses has tended to follow episodes of rapid loan 

growth. 

Credit standards are important tools for individual 

banks to manage these cyclical fluctuations in credit 

quality. According to the Federal Reserve’s August 1997 

CHART 1 

Earnings Results Are Largely Driven by 

Provision Expenses 

-1.0% 

0.0% 

1.0% 

2.0% 

3.0% 

Return on Avg Assets 

Provision Exp/Avg Assets 

Source: Commercial Bank Call Reports 

-2.0% 

6-’85

12-’86

6-’88

12-’89

6-’91

12-’92

6-’94

6-’97

12-’95 

Boston Regional Outlook 3	 Fourth Quarter 1997 
In Focus This Quarter
 

CHART 2 CHART 3 

-15% 

-10% 

-5% 

0% 

5% 

10% 

15% 

20% 

1980 

GDP Growth 

Loan Growth 

Average Loan Growth Has Recently 

Outpaced Nominal GDP Growth 

Source: Commercial Bank Call Reports, Haver Analytics 1982 1984 1986 1988 1990

199219941996 

Source: Commercial Bank Call Reports Loan, GDP Growth (%)

Net Loan Loss Growth (%)

Loan Losses and Loan Growth Are Correlated 

-15 

-10 

-5 

0 

5 

10 

15 

-90 

-60 

-30 

0 

30 

60 

90 

Loan Growth 

Net Loan Loss Growth 

198019831986198919921995 

Senior Loan Officer Survey, during the preceding three 

months, a large percentage of banks had eased terms on 

commercial and commercial real estate loans, including 

reducing loan interest rates, increasing credit lines, and 

easing loan covenants and collateralization requirements. A “small but significant” share reported willingness to accept increased levels of risk on commercial 

real estate loans. In a similar vein, the Federal Deposit 

Insurance Corporation’s (FDIC) Report on Underwriting Practices (second quarter 1997) did not note 

any widespread problems with underwriting practices 

but reported that about 24 percent of institutions examined that were actively involved in construction lending 

were “frequently or commonly” funding speculative 

construction projects. About 18 percent of institutions 

examined that were actively involved in business lending “frequently or commonly” made unsecured business 

loans that lack documentation of financial strength. 

Maintaining an adequate allowance for loan losses is 

another important way for banks to sustain earnings and 

capital during downturns. The aggregate allowance held 

by commercial banks has decreased from 2.74 percent 

of total loans in the first quarter of 1992 to 1.90 percent 

in the second quarter of 1997; 166 banks reported negative loan loss provisions in the second quarter. 

Although in the aggregate these reserve numbers 

remain high relative to the early to mid-1980s, when 

reserve levels ranged from 1.20 percent to 1.74 percent, 

the Office of the Comptroller of the Currency (OCC) 

recently issued an advisory letter expressing concern 

about declining reserve levels and the need to maintain 

an adequate allowance. This letter was a response to 

weakness in the credit card sector and to trends in the 

market for syndicated commercial loans, including 

increasing leverage, declining spreads, and a weakening 

in other underwriting terms, all stemming from increasing competitive pressures. 

Diversifying loan portfolios is another way for banks to 

help reduce susceptibility to economic downturns. It 

has often been noted that the trend toward interstate 

banking and branching may improve loan diversification. It should also be noted, however, that many banks 

retain high concentrations of credit exposure to specific 

economic sectors. For example, commercial real estate 

lending and construction lending has been a source of 

volatility in bank earnings since the real estate investment trust (REIT) crisis of the 1970s. As discussed in 

Strong Demand and Financial Innovation Fuel 

Rebounding Commercial Real Estate Markets, banks 

are leading a resurgence in commercial real-estate lending. As Table 1 shows, 28 percent of FDIC-insured institutions grew their total commercial real estate and 

construction portfolios more than 30 percent from mid1996 to mid-1997, and 16 percent had total commercial 

real estate and construction exposures1 exceeding 200 

percent of equity and reserves. Concentrations and 

rapid growth do not necessarily portend difficulties, but 

the greater the concentration of credit to a specific sector, the greater the importance of strict adherence to 

sound underwriting policies and standards and the 

maintenance of adequate loss reserves. 

The most immediate concerns about credit quality have 

been expressed regarding credit cards and some other 

1 Includes loans secured by multifamily dwellings and nonfarm nonresidential structures, as well as construction loans. 

Boston Regional Outlook 4 Fourth Quarter 1997 
In Focus This Quarter
 

consumer debt. Despite seven years of economic expansion, commercial banks’ net credit card charge-offs at 

mid-1997 were running at 5.22 percent of average outstanding balances, matching levels not seen since the 

aftermath of a 56 percent run-up in charge-offs that 

accompanied the recession of 1990 to 1991. Noncurrent 

rates on these loans are at near-historic highs of 1.94 

percent, and some examiners are commenting that these 

rates would be even higher were it not for some of these 

balances being rolled over into home equity debt consolidation loans with loan-to-value ratios as high as 135 

percent. Home equity lines are a rapidly growing business for some banks; 25 percent of banks and thrifts 

grew their home equity lines by more than 30 percent 

during the year ending mid-1997 (see Table 1). 

Except for credit cards and some other consumer loans, 

loan losses are at historically low levels. Nevertheless, 

lending decisions that assume a continuation of favorable economic conditions should be closely examined 

this far into the expansion. Institutions that maintain 

strong underwriting standards, an adequate allowance 

for losses, and prudent diversification of the loan portfolio will be best positioned to sustain earnings and capital during a downturn in credit quality. 

Net Interest Margin 

Net interest margin (NIM) is another primary driver of 

bank earnings. Indeed, a sharp improvement in NIM 

TABLE 1 

CHART 4 

Rebound in ROA Since 1990 Fueled 

by Improved NIM and Asset Quality 

0.0% 

0.5% 

1.0% 

1.5% 

2.0% 

1984 1986 1988 1990 1992 1994 1996 

2.5% 

3.0% 

3.5% 

4.0% 

4.5% 

5.0% 

ROA 

Net charge-off ratio 

NIM 

Source: Commercial Bank Call Reports ROA, Net Charge-Off Ratio

NIM (%) 

helped lead the banking industry’s dramatic recovery 

from the last recession (see Chart 4). Commercial 

banks’ NIM has declined slightly in recent years, but at 

4.23 percent still remains near the top of the range 

within which it has fluctuated since 1984 (see Table 2, 

next page). 

The banking industry’s rapid loan growth in recent 

years has been one of the factors supporting the current 

high NIM. (Since loans generally yield more than 

securities, a higher proportion of loans generally 

results in a higher yield on the total portfolio of earning assets.) Economic fundamentals cannot sustain 

rapid loan growth indefinitely, however. Accordingly, a 

Rapid Loan Growth Is 

Occurring at a Significant 

Number of Institutions 

(4 qtrs growth ending 6/97) 

TOTAL LOANS AND LEASES 

CONSTRUCTION LOANS 

COMMERCIAL REAL ESTATE LOANS 

TOTAL CRE 

1-4 FAMILY RESIDENTIAL LOANS 

HOME EQUITY LINES 

TOTAL RESIDENTIAL 

CREDIT CARD LOANS AND RELATED PLANS 

OTHER CONSUMER LOANS 

TOTAL CONSUMER LOANS 

COMMERCIAL LOANS 

Source: Bank & Thrift Call Reports 

Boston Regional Outlook 

Percentage of Institutions with Loan 

Category Growth Approximating 

20% to 30% 30% or Total 

More Over 20% 

11 13 24 

4 36 40 

9 27 37 

10 28 38 

11 17 29 

4 25 29 

12 18 29 

4 17 21 

9 18 27 

9 18 27 

9 26 35 

5 Fourth Quarter 1997 
In Focus This Quarter
 

TABLE 2 

1997 Commercial Bank Performance Compared with Historical Averages 

INDUSTRY AVERAGES 

6/30/97 1984-1996 

ANNUALIZED LOW HIGH 

(%) (%) (%) 

NET INTEREST INCOME/AVERAGE EARNING ASSETS 4.23 3.89 4.36 

X AVERAGE EARNING ASSETS/AVERAGE ASSETS 86.50 86.21 88.42 

= NET INTEREST INCOME/AVERAGE ASSETS 3.66 3.36 3.89 

+ NONINTEREST INCOME/AVERAGE ASSETS 2.13 1.10 2.13 

− NONINTEREST EXPENSE/AVERAGE ASSETS 3.50 3.05 3.90 

− PROVISION EXPENSE/AVERAGE ASSETS 0.40 0.28 1.28 

+ OTHER ITEMS/AVERAGE ASSETS 0.03 − 0.02 0.15 

− TAXES/AVERAGE ASSETS 0.68 0.18 0.64 

= NET INCOME/AVERAGE ASSETS (ROA) 1.25 0.10 1.20 

Source: Bank & Thrift Call Reports 

risk in the current environment is that in the effort to 

support their NIM by generating new lending, banks 

may make compromises in loan underwriting, pricing, 

and portfolio diversification. 

Recent pricing trends have tended to weaken NIM, offsetting to a degree the effects of rapid loan growth. On 

the liability side, over the past six years, commercial 

banks’ average annual deposit growth rate of 3.2 percent 

has been outpaced by the 4.9 percent average annual 

growth rate of earning assets. As a result, nondeposit 

borrowings have increased significantly in importance, 

rising from about 12.6 percent of earning assets in 1991 

to 19.1 percent at mid-1997. Since the average cost of 

nondeposit borrowings has exceeded the average cost of 

deposits over the period by an average of 135 basis 

points, the greater use of relatively higher cost borrowings to fund earning asset growth has been an obstacle 

to wider margins. The slower deposit growth can perhaps be attributed to the increasing array of choices 

available to small savers; its effect is that bank funding 

is becoming more expensive and more interest-rate 

sensitive. 

On the asset side, pricing pressures also are frequently 

cited as contributing to sluggish NIM. For example, in 

the aforementioned syndicated lending market, average 

interest spreads charged to noninvestment-grade large 

customers have dropped more than 63 basis points 

between 1992 and 1996, while spreads on investmentgrade debt are at all-time lows. Reportedly, some deals 

are being done at minimal or no risk-adjusted spreads 

simply to preserve lending relationships. Increased 

securitization of various asset types has also had effects 

on pricing. By increasing the depth and liquidity of the 

market for the underlying loans, securitization has tended to lower spreads on these assets, thereby increasing 

competitive pressures on institutions not able to achieve 

the volumes necessary to efficiently utilize this new 

funding vehicle. 

The thin spreads available from high-quality lending 

may tempt some institutions to finance higher yielding, 

riskier credits in an effort to preserve or boost profit 

margins. For example, recent forays by some banks into 

subprime lending (see Subprime Lending: A Time for 

Caution, Third Quarter 1997) may be one indication of 

how competitive pressures on NIMs are affecting bank 

behavior. Over the long term, institutions that manage 

their NIMs with a prudent regard for how their newly 

booked business may fare during a cyclical downturn 

will have a better chance of sustaining earnings performance through the business cycle. 

Growth in Noninterest Income 

Industry analysts often cite the increasing contribution 

of fees and other sources of noninterest income as 

evidence of the evolution of the banking industry. As 

Chart 5 (next page) illustrates, for commercial banks 

with over $1 billion in assets, noninterest income now 

averages over 40 percent of net revenue (net interest 

income plus noninterest income). In contrast, banks 

Boston Regional Outlook 6 Fourth Quarter 1997 
In Focus This Quarter
 

CHART 5 Other measures of productivity have shown similar 

Noninterest Revenue to Net Revenue* 

Banks Over $1 Billion 

Banks Under $1 Billion 

Source: Commercial Bank Call Reports 

* Net Revenue = Net interest income plus noninterest income 

10 

20 

30 

40 

50 

6-’85 

Net Revenue (%) 

6-’876-’896-’916-’936-’956-’97 

improvement. For example, commercial banking assets 

per employee doubled, from $1.5 million to $3 million, 

between 1984 and 1997. 

Growth in overhead expense has been contained largely 

through consolidation, technological advances, and low 

levels of problem assets. Mergers have resulted in the 

wringing out of redundant expenses. Information technology (IT) has been deployed to trim underwriting 

expense, manage customer relationships, speed backoffice processing, and facilitate the creation of new 

products and services. Favorable economic conditions 

have reduced costs associated with loan collection and 

asset workouts. 

Whether the downward trend in overhead expenses will 

with under $1 billion show a profile of reliance on more 

traditional banking activities, with only 25 percent of 

revenue from these noninterest sources. 

Noninterest income growth is being driven both by new 

business lines and higher deposit-related fees. 

Examples include fees from sales of mutual funds and 

other nondeposit products, investment banking activities such as securities underwriting and asset management, and increases in traditional fee sources such as 

from automated teller machines. Increasing securitization of assets, in which the accounting conventions convert interest income to noninterest income, has also 

affected the growth in reported noninterest income. 

With the exception of trading revenue, noninterest 

income has historically shown a growth trend that has 

not been especially sensitive to economic cycles. 

However, newer fee-based businesses such as mortgage 

banking, mutual funds, and securities underwriting may 

ultimately share the same cyclical characteristics as traditional bank lines of business, and therefore may not 

reduce banks’ historical exposure to economic cycles. 

The Effect of Expense Control 

on Earnings Performance 

Cost-cutting efforts in banking continue to show their 

effects. Since 1991, commercial banks’ efficiency 

ratio,2 a measure of an institution’s effectiveness in generating revenue, has steadily improved (see Chart 6). 

continue is an open question. Should problem loans 

increase from their cyclical lows, collection and workout costs will increase (evidence of this effect can be 

discerned for the late 1980s in Chart 6). The rapid 

change in information technology may prompt increasing expenditures. The 1996 Atlantic Data Services/ 

Tower Group Survey of Information Technology 

Services in Banking noted that the banking industry is 

“faced with an aging IT infrastructure.” The survey 

suggests that most technology-related expenses could 

increase at a 5.6 percent compounded growth rate until 

the year 2000 and that expenses for outside services 

could increase 11 percent over the same period. The 

ability to generate future revenue gains may depend on 

additional bank investment not only in technology but 

also in the development of new products and services. 

CHART 6 

Commercial Banks’ Efficiency Ratio*
 

Is Steadily Improving
 

70% 

68% 

66% 

64% 

62% 

60% 

58% 

56% 

1984198619881990199219941996 

The efficiency ratio is normally defined as noninterest expense * Noninterest expense/(net interest income + noninterest income) 

Source: Commercial Bank Call Reports divided by the sum of net interest revenue and noninterest revenue.
 

Boston Regional Outlook 7 Fourth Quarter 1997
 

2 
In Focus This Quarter
 

In any event, cost-cutting is not without its risks. For 

example, reductions in personnel, or excessive reliance 

on automated underwriting procedures (see Will Credit 

Scoring Transform the Market for Small-Business 

Lending? Second Quarter 1997), may raise concerns 

about the effectiveness of internal administration and 

control processes. Cost-cutting that cuts too deeply into 

customer service can erode franchise value. Mergers 

can reduce redundant expense, but at some point there 

may be diseconomies to managing a large organization. 

The Role of Capital in the Management 

of Earnings 

Management, shareholders, and analysts often evaluate 

earnings in relation to the level of capital using measures such as return on equity (ROE) and earnings per 

share (EPS). One result has been pressure on banks to 

continue to grow ROE and EPS; these objectives have 

been made progressively more difficult to attain by the 

significant level of capital that has built up over the past 

five years. 

Finding effective ways to deploy historically high capital levels appears to be one driving force behind the 

recent rash of mergers and acquisitions, high dividend 

payout ratios, increased stock repurchases, and the 

development of alternative types of hybrid capital such 

as trust preferred stock (see Financial Markets). For 

example, during 1995 and 1996, major merger and 

acquisition deals included some $835 billion in bank 

and thrift assets. During 1996, commercial banks with 

over $1 billion in assets had an average dividend payout 

ratio over 89 percent, up significantly from the 67 percent payout rate of 1994. Banks with under $1 billion in 

assets averaged 55 percent for 1996 and 52 percent for 

1994. In addition, banks and bank holding companies 

have issued some $21 billion in trust preferred stock 

during the last nine months, some of which has been 

used to fund the almost $42 billion in share repurchase 

programs announced by large banks during 1996 and 

early 1997.3 

While the book value of equity and other capital ratios 

has increased at the aggregate industry level, a number 

of banks are reporting declines in equity capital and 

leverage capital ratios despite positive earnings (see 

Chart 7). For all institutions, the ability to actively man3 Salomon Brothers. 

CHART 7 

An Increasing Number of Profitable Banks Are
 

Reducing Tier 1 Capital*
 

Number of Banks 

800 

600 

400 

200 

0 

1992 1993 1994 1995 1996 

* Both Tier 1 dollar amount and ratio 

Source: Commercial Bank Call Reports 

age capital accounts going forward will depend largely 

on having earnings available above the levels needed to 

fund dividends and growth, after assuming capital protection adequate for the level of business risk. Bankers 

and examiners will need to carefully review strategies 

that increase bank leverage or increase business risk 

without considering the potential effects of a downturn 

in credit quality or other weakening in the economy. 

Summary 

The most profitable period for U.S. banks in the postWorld War II era is paradoxically occurring during a 

time when banks’ traditional business lines are coming 

under greater competitive pressure than ever. While the 

industry as a whole is adapting well to these competitive 

pressures, there may be a tendency for some insured 

institutions to respond by accepting greater risks to preserve or gain business. 

The nature of banking is to profit by taking calculated 

risks, and naturally more profits will be made during the 

expansionary phase of a cycle than during a downturn. 

Nevertheless, the institutions that are best able to sustain their earnings and capital over the complete cycle 

will be those that allow for the possibility of an adverse 

change in business conditions, and prudently balance 

the levels of risk taken with the expected returns. 

Ronald Spieker, Chief, Depository Institutions Section 

Steve Linehan, Assistant Director, Analysis Branch 

George French, Deputy Director 

Boston Regional Outlook 8 Fourth Quarter 1997 
In Focus This Quarter
 

Strong Demand and Financial Innovation Fuel
 

Rebounding Commercial Real Estate Markets
 

•	 Commercial banks are leading a resurgence in 

commercial real estate financing; many metropolitan markets are experiencing rapidly rising rents 

and single-digit vacancy rates, suggesting the likelihood of further development. 

•	 New funds directed toward commercial real estate 

are being increasingly supported by commercial 

mortgage-backed securities and real estate investment trusts. 

•	 Some analysts have expressed concern that these 

financing vehicles may serve to heighten competitive pressures that will lead to more aggressive 

loan pricing. 

In the wake of declining values and the large losses of 

the late 1980s and early 1990s, commercial real estate is 

making a comeback. There are two stories here of interest to lenders. The first entails the remarkable resurgence in commercial real estate demand. The second 

involves the major changes taking place in how real 

estate is owned and paid for and—of greater interest to 

banks—who is financing this expanding activity. 

Commercial Banks Show Renewed Interest 

in Commercial Real Estate 

Strong evidence of commercial real estate’s rebound 

can be seen in its renewed attractiveness to lenders. 

TABLE 1 

Federal Reserve figures show that nearly $58 billion of 

new commercial mortgage debt was added to the market in 1995 and 1996 (see Table 1). While this new net 

lending pales in comparison with that of the late 

1980s—when nearly $74 billion in net new debt was 

added in 1987 alone—it positively shines when compared with the $89 billion shrinkage of commercial real 

estate loans from 1991 to 1994. Table 1 shows that commercial banks are leading this resurgence with a $37 

billion net increase in mortgage lending during 1995 

and 1996. 

Perhaps the most convincing evidence of commercial 

real estate’s recovery comes from the market itself. 

Rising prices and tightening supplies of space in most 

major markets and for most property types suggest a 

growing demand for new commercial property stock. 

Numerous indices and market studies support this 

notion: 

•	 As measured by Koll/NREI national composites, 

prices and rents turned up sharply after 1993, with 

rents surpassing their 1988 to 1989 levels by 1995 

(see Chart 1, next page). For office properties in particular, the ten fastest-growing cities in terms of rental 

rates saw increases exceeding 20 percent in 1996.1 

1 Those cities are, in order, Minneapolis, Columbus, Dallas, Portland, 

Salt Lake City, Atlanta, San Jose, Phoenix, San Francisco, and San 

Diego. 

Banks Are Increasing Their Flow of Funds into Commercial Real Estate ($ Billions) 

1991 1992 1993 1994 1995 1996 

NET NEW BORROWING, ALL SOURCES $ − 15.6 $ − 47.1 $ − 21.5 $ − 4.4 $ 22.6 $ 35.1 

COMMERCIAL BANKS 3.1 − 8.4 − 4.3 7.5 18.0 18.7 

CMBSS 1.3 8.7 10.3 11.3 10.6 16.1 

SAVINGS INSTITUTIONS − 22.4 − 18.5 − 7.5 − 6.8 − 1.8 0.8 

LIFE INSURANCE COMPANIES − 5.6 − 15.1 − 13.4 − 10.5 − 3.3 − 2.5 

ALL OTHER SOURCES 8.0 − 13.5 − 6.6 − 5.9 − 0.9 2.3 

EQUITY CAPITAL FLOW, ALL SOURCES $ 4.9 $ 3.1 $ 17.4 $ 21.6 $ 21.5 $ 30.3 

REIT EQUITY OFFERINGS 1.6 2.0 13.2 11.1 8.2 13.0 

PENSION FUNDS − 4.8 − 4.3 − 0.7 9.6 13.8 14.3 

ALL OTHER SOURCES 8.1 5.4 5.0 0.9 − 0.5 3.0 

Sources: Federal Reserve, National Association of Real Estate Investment Trusts (NAREIT), LaSalle Advisors 

Investment Research 

Boston Regional Outlook 9	 Fourth Quarter 1997 
In Focus This Quarter
 

•	 Property capitalization rates, which measure the 

annual income generated by a property as a percentage of its purchase price, are falling (see Chart 2). 

These falling rates indicate that investors are paying 

higher prices for each dollar of current income generated by the property. Overall, however, prices have 

not yet caught up with rents, which now exceed their 

previous highs in some markets, suggesting that the 

current recovery is not yet peaking. 

•	 Declining vacancy rates reflect strong demand for 

office properties, which Grubb & Ellis cast as the 

hottest sector in its 1997 forecast. Nationwide, office 

vacancies have fallen dramatically, by 5 to 10 percentage points during the last four years (see Chart 

3). Moreover, Torto-Wheaton Research estimates 

that 21 of the 56 metropolitan areas it tracks had 

single-digit vacancy rates at the end of first quarter 

1997. Not surprisingly, many of the tightest markets 

are those with the greatest rent inflation. 

While the unrestrained commercial development of the 

1980s continues to cast a shadow over the industry, that 

shadow is fading as declining vacancy rates and rising 

rental rates for existing properties fuel optimism 

among lenders and investors and strengthen the case 

for new development. Lenders, examiners, and analysts, however, must be diligent in monitoring commercial real estate markets to identify possible imbalances 

between supply and demand. It is particularly important that lending decisions be made on the basis of economic feasibility and realistic property cash flow 

projections rather than solely on the basis of competitive pressures. 

Borrowers’ Financing Options Expanding 

Although banks are clearly the largest source of financing for resurgent commercial real estate markets, a 

broader and more competitive financing market has 

emerged. In this market, financing often bypasses 

banks, being funneled instead through entities that purchase and securitize commercial real-estate-secured 

debt or the properties themselves, parceling them into 

smaller, more standardized, and thus more liquid pieces 

that are attractive to institutional and individual 

investors alike. This trend is illustrated in Table 1, which 

shows the increasing roles commercial mortgagebacked securities (CMBSs) and real estate investment 

trusts (REITs) have played in funding commercial real 

estate over the past five years. This increase in public 

CHART 1 

Prices and Rents on Upswing Nationwide 

Index (1986 = 1.00)
 

1.30
 

1.20
 Rents
 

1.10
 

1.00
 Prices
 

0.90
 

0.80
 

1990 1991 1992 1993 1994 1995 1996 

Source: Koll National Real Estate Index 

CHART 2 

Property Capitalization Rates Dropping 

8.0 

8.5 

9.0 

9.5 

10.0 

10.5 

11.0 

11.5 

1990 1991 1992 1993 1994 1995 1996 1997 

Overall Cap Rates (%)

Office 

Retail 

Apartment 

Source: Donaldson, Lufkin & Jenrette 

CHART 3 

National Downtown and Suburban
 

Class A Vacancy Rates Falling
 

8 

13 

18 

23 

Downtown 

Suburban 

Vacancy Rates (%) 

1988 1989 1990 1991 1992 1993 1994 1995 1996 

Source: CB Commercial / Torto-Wheaton Research 

Boston Regional Outlook 10	 Fourth Quarter 1997 
In Focus This Quarter
 

financing left financial institutions in 1996 with 

approximately a one-third share of all new net commercial real estate financing, down from well over half just 

a decade before. 

From a lender’s perspective, CMBSs offer several 

advantages over traditional portfolio lending. Most significantly, lenders can generate fee income from loan 

production and servicing activities while avoiding the 

excessive concentrations of credit risk that plagued 

lenders during the last real estate downturn.2 According 

to Commercial Mortgage Alert, outstanding CMBSs 

reached $125 billion in 1996 on a record $30 billion of 

new issuance. While outstanding volume is still dwarfed 

by the $3 trillion market for residential mortgagebacked securities (MBSs), the growth in CMBS volume 

has been remarkable considering that such securities 

were virtually nonexistent prior to 1991. 

At present, most commercial banks are not active in 

issuing CMBSs, accounting for only $2.6 billion of 

CMBS issuance in 1996, according to E&Y Kenneth 

Leventhal Real Estate Group. Rather, the primary 

source of these securities is investment banks, which 

generate substantial fees by converting existing loans 

into securities. CMBS issues also are being increasingly underwritten by conduits, which are entities created 

to originate mortgage loans for distribution to investors 

in the secondary market. Nomura Securities 

International estimates that such conduits accounted 

for over one-third of CMBS issuance in 1996, nearly 

double the volume of 1995. Only a handful of the 

largest commercial banks have set up conduit programs—the five largest banks accounted for $3.3 billion of the $10.2 billion in conduit issuance during 

1996. Aside from this relatively small number of bank 

competitors, investment banks are among the largest 

and most active conduit issuers. 

There is no fundamental reason why banks cannot take 

greater part in the rapidly growing CMBS market. In 

fact, they possess many distinct advantages over investment banks. Their distribution networks, lending experience, and back-office capabilities are naturally suited 

to facilitating loan demand, evaluating repayment risk, 

servicing loans, and monitoring a project’s development. Obstacles of scale may preclude smaller institu2 While securitization of loans purports to shift credit risk to investors, 

many analysts and rating agencies have recently expressed concern 

over recourse arrangements, both contractual and voluntary, whereby 

the seller/servicer effectively assumes all or most of losses experienced by the security. 

tions from directly issuing CMBSs ($500 million in volume is often cited as a minimum for efficiently assembling a deal). However, if the CMBS market develops 

like that for MBSs, standardized underwriting may 

enable small institutions to remain competitive either by 

cooperatively forming their own conduits or by selling 

their loans to existing conduits. 

Whether or not banks take part, the continuing development of a market for securitized commercial real estate 

assets raises a number of efficiency issues for direct 

lenders. Securitization provides property developers and 

owners access to a much larger pool of potential funding 

sources and a wider array of funding options. Moreover, 

the costs of public financing reflect efficiencies born of 

standardization and liquidity. In short, investors, including banks, can price, enter, and exit their positions in 

securitized debt more easily than could be done with 

whole loans. While improved efficiencies are a positive 

aspect of the growth in securitized investments, these 

efficiencies threaten to dictate bank pricing, thereby 

potentially reducing margins or driving institutions to 

lend on less economically feasible projects in an effort to 

preserve margins and market share. 

REITs: An Alternative to Traditional 

Capital Sources 

Commercial real estate financing is evolving in other 

ways. REITs have become major players in the industry 

since 1993, accounting for fully one-fifth of funds flowing into real estate in 1996. REITs are much like mutual funds in that they allow indirect investment in real 

estate through purchases of equity in the REIT. The 

REIT itself holds title to the underlying properties and, 

provided it meets certain requirements, can directly pass 

through its earnings to investors without any intermediate tax. Although Moody’s estimates place REIT holdings at less than 3 percent of all U.S. commercial real 

estate, outstanding REIT shares have grown considerably, with market capitalization doubling nearly three 

times in just four years (see Chart 4, next page). 

Accompanying this rise in capitalization has been an 

equally dramatic rise in bank lending to REITs. 

According to Loan Pricing Corporation, bank lending 

to REITs surged to $12.8 billion in 1996, a 16 percent 

increase over 1995’s then-record volume and more than 

a tenfold increase over the period 1990 to 1992. 

The rise in REIT capitalization can be attributed in part 

to pent-up institutional demand for real estate. REITs 

Boston Regional Outlook 11 Fourth Quarter 1997 
In Focus This Quarter
 

CHART 4 

REIT Capitalization Soaring 

400 

350 

300 

250 

200 

150 

100 

50 

0 

1996

have a particular appeal to fund managers since they 

offer the benefits of investment diversification without 

the dual headaches of property management and asset 

illiquidity. Aside from the direct credit risk posed by 

lending to REITs, their rising popularity confronts banks 

with an indirect threat as well—the threat that banks 

could be crowded out of lending opportunities if 

investors find REIT funding structures more attractive 

from a cost and control standpoint. The degree to which 

this crowding out may occur is unclear, for according to 

Nomura Research, REITs historically have borrowed 40 

cents for each dollar of real estate held. However, well 

over half of this borrowing takes place through public 

offerings of secured and unsecured debt, leaving only a 

small portion to be financed by banks and other private 

lenders. Because REITs tend to focus on the highest 

quality projects, their increasing presence also creates 

concerns that banks may be driven to lend to less attractive or more risky properties to preserve market share. 

Many analysts have also expressed unease over the rapid 

rise in the valuations of REITs, some of whose shares 

are priced at a considerable premium to the properties 

themselves. Anecdotal evidence suggests that premiums 

as high as 40 percent over market value have been paid 

for some REIT shares in recent months. Such marketbased valuations create concern over the extent to which 

an REIT’s capital structure allows it to pay more for 

properties than an investor who employs greater financial leverage. Accordingly, while REITs may make up a 

fairly nominal amount of overall real estate holdings, 

they may be quite influential in determining how commercial properties are being valued or appraised. 

80

70 

60 

50 

40 

30 

20 

10 

0 

Market Capitalization (Left Scale) 

Number of REITs (Right Scale) 

$ Billions 

1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 

Source: National Association of Real Estate Investment Trusts

Commercial Real Estate Securitization: 

Some Broader Implications 

Maturing CMBS markets could eventually improve the 

overall stability of commercial real estate markets not 

only by improving market liquidity but also by enabling 

investors to diversify and share their credit exposures 

among a greater number of participants. In addition, 

loan performance could become increasingly transparent to the general marketplace, thereby encouraging 

more uniform and prudent underwriting standards. 

However, concern naturally arises because CMBSs are 

a major source of commercial real estate market funding that has not been tested through a serious market 

downturn. This situation leads to questions concerning 

the impact they will have on property values and market 

liquidity and whether today’s underwriting terms, driven 

largely by competitive factors, will stand up to tomorrow’s market downturn. Another question is whether the 

standardized structures underlying these securities offer 

enough flexibility to borrowers to renegotiate loan 

terms—a critical workout tool during times of financial 

stress. The answers to these questions will ultimately 

determine the extent to which lenders and investors suffer as a result of the inevitable cyclical swings in commercial property values. 

There are also questions about how REITs will affect 

commercial real estate markets. One argument is that 

the appetite for REIT investments, combined with the 

premiums that the trusts can pay for properties, will 

push the price of commercial space beyond sustainable 

levels. Those who hold this view see REITs, and other 

Wall Street innovations that increase the supply of funding, as potentially amplifying cyclical swings in real 

estate values. The contrary view holds that REITs will 

improve market efficiency by providing continuous 

pricing benchmarks through daily share price movements and thus enforce discipline upon developers and 

lenders. This discipline, it is argued, will prevent excessive development and dampen the severity of real estate 

cycles. 

As an investment, commercial real estate is quickly 

regaining the broad favor it lost during the last market 

downturn. But the channels through which a lender or 

investor can participate in this market are expanding 

even more dramatically. Investment exposures to real 

estate are no longer effectively limited to private equity 

or debt. The choices are multiplying, with liquid public 

markets for both debt and equity providing the foundation for existing and future commercial real estateBoston Regional Outlook 12 Fourth Quarter 1997 
In Focus This Quarter
 

based instruments—instruments such as swaps, options, 

and property derivatives—that will permit the tailoring, 

hedging, and even creation of synthetic real estate 

investment positions. Although financial institutions are 

participating in this revival, it is clearly a different world 

from the old, and one in which they will have to choose 

how best to compete against—or participate in—these 

new real estate financing strategies. 

Steven Burton, Senior Banking Analyst 

sburton@fdic.gov 

Gary Ternullo, Senior Financial Analyst 

gternullo@fdic.gov 

Boston Regional Outlook 13 Fourth Quarter 1997 
Regular Features	 Regional Economy
 

New England Real Estate Markets
 

Running Hot and Cold
 

•	 Home sales are strong in many parts of the Region, but prices generally remain subdued. Residential construction activity is gradually gaining steam. Greater Boston is the Region’s most active residential real 

estate market. 

•	 Rising demand for multifamily units in greater Boston, coupled with a dearth of inventory, has spawned a 

rush to build new apartment and condominium projects—posing a potential risk to lenders with exposure 

to this sector should the economy slump abruptly. 

•	 Commercial real estate markets remain slack in many of the Region’s major metro areas, including 

Hartford, Connecticut, and Providence, Rhode Island, but conditions in the greater Boston area are very 

tight. 

•	 A sizable increase in commercial office inventory is expected in the Boston suburbs before 1999, but strong 

absorption rates and little in the way of new construction downtown should mitigate any decline in occupancy rates and rents. 

Residential Markets Not Likely to 

Overheat Soon 

Home Sales Rising, but Prices Remain Subdued 

Existing home sales have been very strong throughout 

the Region. The National Association of Realtors 

(NAR) reported that home sales increased 13 percent in 

Massachusetts in the first half of 1997 versus a year 

earlier, following a gain of nearly 21 percent in 1996. 

The market in eastern Massachusetts has been so strong 

this year that the traditional summer slowdown in home 

shopping failed to emerge, especially in the most 

sought-after areas. Likewise, sales rose 6 percent 

through the first half of this year in Connecticut and 

were 13 percent higher in New Hampshire. Sales in 

Rhode Island, the Region’s poorest-performing economy by many measures, posted roughly 10 percent gains 

in 1996 and in the first half of 1997. Although they also 

have been improving modestly across the Region, home 

prices in the larger metropolitan markets, particularly in 

central Connecticut, remain subdued. Boston has been a 

notable exception to this trend (see Table 1). 

The figures in Table 1 are based on a survey of median 

prices by the NAR. Reported median prices can be 

skewed if properties in a certain price class (e.g., starter 

homes) have been predominant in recent sales activity. 

Another measure, an index by the Office of Federal 

Housing Enterprise Oversight (OFHEO), is based on 

average price changes in repeat sales or refinancings on 

the same properties—so-called paired-sales analysis. 

The price data are reported at the state level and cover 

all conforming conventional mortgages purchased or 

securitized by Fannie Mae or Freddie Mac—or about 37 

percent of all single-family mortgages in 1996. The 

OFHEO housing price index helps corroborate the NAR 

information, indicating that Massachusetts housing 

prices are again approximately where they were in the 

late 1980s (conditions in the Boston and Worcester 

markets likely drive the statewide figure). Prices are 

also mostly recovered in Vermont and Maine, while 

they remain down about 8 percent in Rhode Island. In 

Connecticut, the OFHEO index suggests that prices are 

TABLE 1 

Median Home Prices around the 

Region Still Subdued 

(Current prices relative to peak in 1988/89) 

INFLATIONNOMINAL ADJUSTED* 

BOSTON, MA +3.8% − 24.7% 

HARTFORD, CT − 18.2% − 54.0% 

NEW HAVEN– 

MERIDEN, CT − 19.2% − 55.0% 

PROVIDENCE, RI − 9.4% − 45.2% 

SPRINGFIELD, MA − 18.0% − 46.4% 

WORCESTER, MA − 6.7% − 42.5% 

*using change in Boston CPI-U between 1988/89 and 

1997 

Source: National Association of Realtors and Bureau 

of Labor Statistics 

Boston Regional Outlook 14	 Fourth Quarter 1997 
Regular Features Regional Economy
 

still off 13 percent from peak levels (Table 1 implies 

that some metro-area prices are even more depressed). 

Meanwhile, New Hampshire prices are also off by about 

13 percent from their recent peak. Chart 1 shows the 

trend for New England and U.S. home prices according 

to the OFHEO index. Prices are now only about 5 percent shy of their late-1980s peak for the Region as a 

whole. While still remaining well above the U.S. level, 

the price gap between New England and the United 

States has closed from almost 90 percent above the U.S. 

average in 1987 to about 40 percent above in 1997. This 

trend bodes well for the long-run competitiveness of the 

Region by helping to lower its notoriously high cost of 

living relative to other sections of the country. 

New Construction Picking Up Modestly 

After the extraordinary boom in residential construction 

in New England in the 1980s and subsequent collapse 

of housing prices, residential construction in New 

England’s metro areas seems to have returned to a 

steady growth path that is more in line with local economic conditions (see Chart 2). Single-family housing 

construction has increased about 26 percent from the 

trough reached in the last recession, driven primarily by 

increases in eastern Massachusetts. Most of the other 

states in the Region have also contributed to the recovery, but Rhode Island and Vermont have seen only modest gains in the past six years. Besides greater Boston, 

southern Maine also has experienced a sizable pickup in 

residential construction. 

The recent resurgence in multifamily permit issuance is 

perhaps more noteworthy than the gradual improvement 

in the single-family market. Massachusetts and 

Connecticut, because of their larger shares of the 

Region’s economy, are driving the rise in multifamily 

permits. However, Vermont also has seen a large percentage jump in multifamily construction in 1997 

(related to ski resort improvements), and New 

Hampshire is on course for an all-time high this year. 

Chart 2 shows the history of building activity, as measured by residential permits, for the Region. 

Boston: Growing Demand and Low Vacancies 

Spur New Multifamily Construction 

As in single-family construction, the greater Boston 

area is leading the Region in new multifamily projects. 

Near Boston, few apartment complexes were constructed between the early 1980s and 1994, except for those 

built with subsidies or with some share of units targeted for government housing programs. Coupled with a 

much stronger economy, this situation has resulted in an 

CHART 1 

Region’s Housing Prices Mostly Recovered 

(Quarterly index through 1997 Q1) 

Index 1980 Q1 = 100 

300 

250 

200 

150 

100 

50 

80 82 84 86 88 90 92 94 

Source: Office of Federal Housing Enterprise Oversight 

United States 

New England 

average apartment vacancy rate of 1.3 percent this year, 

versus a rate of 5.3 percent in late 1992, according to 

figures provided by the Greater Boston Real Estate 

Board (GBREB). Within the I-495 beltway, several 

projects already are under construction, while many 

more are in early planning. The recent strength in residential housing in eastern Massachusetts has not been 

duplicated in the western part of the state, primarily 

because economic growth west of Worcester has not 

been as robust. The GBREB reports that apartment 

vacancy rates are averaging 6.5 percent in the western 

metro areas and just above 6 percent in central 

Massachusetts. 

In addition to a lack of apartment space, strong demand 

for condominiums and town houses (some of it spurred 

by a dearth of rental opportunities) also is driving 

the upturn in multifamily permits, particularly in 

CHART 2 

Multifamily Construction Finally Rebounds 

(Building permits) 

Index 1980 = 100 

300 

0 

80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97* 

Source: U.S. Census Bureau * 97 is June year-to-date 

50 

100 

150 

200 

250 

Single Family 

5+ Unit Multifamily 

Boston Regional Outlook 15 Fourth Quarter 1997 

96 
Regular Features Regional Economy
 

the greater Boston area. During May 1997, the 

Massachusetts Association of Realtors reported that 

sales of condominiums exceeded 1,000 properties—the 

highest one-month total this decade. Much of the activity has centered in luxury or high-end properties in the 

city’s better neighborhoods, as the final elimination of 

rent controls in Boston has encouraged the conversion 

of apartments, lower-end office space, and even warehouse properties into new condominium projects. 

Despite the heated conditions in the greater Boston 

market, several aspects of the current acceleration in 

residential real estate differ from those in the period just 

before the market crashed in the early 1990s. First, condominium and town house demand is being driven primarily by owner-occupied purchases, not purchases by 

investors and speculators as in the late 1980s. Among 

these new owners are wealthy parents of foreign students attending area universities; young, well-paid 

urban professionals; empty-nesters trading suburban 

homes with massive accumulated equity for a place in 

the city; well-heeled out-of-state residents purchasing 

second and third homes; and corporations acquiring housing for 

transient or relocating executives. 

Second, as mentioned earlier, the 

volume of new construction 

remains far below what it was in 

1989, while market prices (unlike 

construction costs) have failed to 

rise with inflation over the past ten 

years. Third, outlying suburbs are 

increasingly exploring caps on 

building permits and higher taxes 

to fund land banks, thus limiting access to developable 

land. Finally, apartment construction, while picking up, 

will continue to face hurdles in terms of zoning requirements and other regulatory procedures, lawsuits by 

abutters in certain cases, and resistance in some areas of 

the city because of the perceived burdens on public services associated with high-density dwellings. 

Implications: Any risk to insured institutions from 

another 1980s-style bust in residential housing seems 

remote at this juncture. One potential problem could 

develop in greater Boston if multifamily construction 

continues to accelerate at the pace seen in the first half 

of 1997—permits more than doubled to 1,500, up from 

603 in the first half of 1996. As the number of condominiums available for sale increases, the odds are 

greater that a slowdown in the local economy, such as 

might arise from a protracted bear market in equities or 

a national downturn, might push many unsold owneroccupied units into the rental market. These would compete directly with a then much larger supply of 

apartments, possibly forcing rental rates below economically viable levels for both property types. 

Commercial Office Real Estate: 

In Boston, Hot—Elsewhere, Not 

Metro Office Markets Gradually Improving 

With few exceptions (most notably Boston), most metropolitan office markets in the Region continue to slowly recover from peak vacancy rates reached at the height 

of the last recession. Table 2 offers a snapshot of commercial office vacancy rates for those New England 

markets followed by the Society of Industrial and 

Office Realtors (SIOR). Office vacancy rates in central 

Connecticut and Providence, Rhode Island, remain 

fairly high. Hartford has seen only modest declines in 

its vacancy rate because of ongoing layoffs and restructuring associated with its major employers, such as the 

insurance industry (see the second quarter 1997 

Regional Outlook for more details). Meanwhile, the 

continued high vacancy rate in Providence reflects 

Rhode Island’s generally weak economy and modest 

office employment growth. Apart from Boston (discussed in the next section), only Portland and 

Springfield had single-digit (average Class A and B) 

vacancy rates in 1996. 

TABLE 2 

Many New England Office Markets 

Are Still Slack 

(Percent of Class A & B Office Space Vacant) 

1996 RECENT PEAK 

BOSTON, MA 6.0 20.0 

SPRINGFIELD, MA 9.9 28.5 

HARTFORD, CT 15.0 17.5 

STAMFORD, CT* 14.5 25.2 

NEW HAVEN, CT 21.7 30.0 

NASHUA, NH 12.0 24.1 

PORTLAND, ME* 6.4 10.6 

PROVIDENCE, RI* 18.6 25.9 

*data are incomplete; vacancy rates estimated by 

author 

Source: Society of Industrial and Office Realtors, 

via Teleres 

Boston Regional Outlook 16 Fourth Quarter 1997 
Regular Features Regional Economy
 

The improvement in Portland is not surprising given 

that market’s small size and minimal deterioration during the last recession. However, the 9.9 percent vacancy 

rate reported for Springfield for 1996 was down dramatically from 18 percent just one year earlier. This 

startling one-year improvement, according to the SIOR 

statistics, was due to significant declines in vacant 

space at Class A buildings, both in the central business 

district (CBD) and in the suburbs, and at Class B space 

outside the CBD. As remarkable as it seems, assuming 

occupancy rates of 250 square feet per worker, the modest growth in office employment seen in the Springfield 

metropolitan area during 1996 would have supported 

this hefty decline in vacant space (a net absorption of 

about 265,000 square feet). 

Greater Boston Office Market 

Poised for New Construction 

Because of the tight office market around Boston (see 

Table 2), industry experts believe rents in many parts of 

the metro area have been driven to levels that can support new construction. However, limited space and 

longer approval times in the CBD have made suburban 

markets prime candidates for new development. Greater 

Boston’s suburban area (inside I-495, but outside 

Suffolk County) has seen a significant increase in 

planned projects and new construction. According to 

F.W. Dodge, plans for new office space in greater 

Boston increased from 16.5 million square feet at the 

end of March 1997 to 18.4 million square feet just three 

months later. If realized, the midyear total of planned 

projects would result in a 12 percent increase in current 

inventory levels. Chart 3 provides a history of net 

absorption, net new space, and the average vacancy rate 

CHART 3 

for office space in the greater Boston market. Total 

inventory increased by 3.9 million square feet in the 

first half of 1997, according to Cushman & Wakefield, 

representing a gain of 3 percent. However, this was 

accompanied by a pace of absorption 40 percent greater 

than the prior year’s rate—1.8 million square feet in the 

first six months of 1997, versus 2.6 million square feet 

for all of 1996. In addition, many of the planned projects reported above may not be constructed, as many 

developers seem to be avoiding purely speculative 

buildings. Recent anecdotal reports suggest that developers typically are not proceeding with construction in 

earnest until at least one large tenant is secured. 

Today’s low vacancy rates are encouraging tenant 

behavior that could raise the risk of an overbuilt market. Because of limited space availability, many companies are engaging in defensive leasing, whereby they 

secure more space than they need (or secure space far in 

advance of their current lease expiration) in order to 

ensure they will have adequate room to meet expected 

growth. Also, some firms presently scattered among 

several office buildings plan to consolidate into single 

sites currently being built to suit their needs. Others are 

withholding space that otherwise would be available for 

sublet. Thus, as tenant companies relocate and consolidate their space needs, significant amounts of inventory 

may be left vacant. This condition would only be aggravated by the increasing amount of non-built-to-suit construction that is now occurring. Further, reported 

construction figures may not include the many rehabilitation or conversion projects currently under way. 

Despite these factors, it should be noted that today’s 

vacancy rates are much lower than those during the 

77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 

New Office Construction in Greater Boston Being Met by Strong Absorption ... for Now 

Sources: CB Commercial/Torto Wheaton (1977–96), Cushman & Wakefield (97H1) 

0 

2 

4 

6 

8 

0 

5 

10 

15 

20 

Net Absorption 

(left scale) 

Net New Supply 

(left scale) 

Vacancy Rate

 (right scale) 

Millions of square feet Percent 

Boston Regional Outlook 17 Fourth Quarter 1997 
Regular Features Regional Economy
 

building boom of 1987 to 1990—when significant new 

space was coming on-line despite double-digit vacancy 

rates (see Chart 3). 

Implications: In the author’s opinion, current commercial office construction trends are likely to result in at 

least a modest rise in vacancy rates, and a concomitant 

decline in rental rates, by late 1998. However, if new 

building in the CBD remains minimal, firms there 

would be expected to continue to expand operations into 

suburban areas, mitigating the potential decline in suburban rents. Insured institutions have been increasing 

their real estate lending activity in greater Boston during the past 18 months, including financing for office 

and industrial properties (see Regional Banking 

Conditions). Despite this pickup, overall exposure to 

commercial real estate remains far below the levels seen 

early this decade. Reticence by banks and an increase in 

funding by other sources, such as real estate investment 

trusts, has limited the number of insured depository 

institutions at risk in greater Boston from any downturn 

in office or industrial real estate. 

Norman Williams, Regional Economist 

Boston Regional Outlook 18 Fourth Quarter 1997 
Regular Features	 Financial Markets
 

Financial Markets
 

• Bank holding companies of all sizes have issued trust preferred stock following the Federal Reserve’s decision in October 1996 to count these tax-advantaged capital securities toward Tier 1 capital. 

•	 Although the tax-advantaged status of trust preferred stock was not eliminated in the federal budget this 

year, there still exists the possibility that the Internal Revenue Service may alter the tax treatment of trust 

preferred dividends. 

• Institutions contemplating issuing trust preferred stock should be aware of the concerns expressed by rating agencies and of the potential risks associated with excessive reliance on debt-like capital instruments. 

Bank holding company capital requirements were effectively relaxed in October 1996 when the Federal 

Reserve ruled that trust preferred stock may be included in the portion of cumulative preferred stock that can 

compose up to 25 percent of a bank holding company’s 

Tier 1 capital. In the wake of this decision, financial 

institutions moved quickly to issue trust preferred stock. 

Trust preferred stock can be a less expensive form of 

Tier 1 capital for bank holding companies because of 

the tax deductibility of the dividend payments paid on 

this type of preferred stock. 

Approximately 90 banking organizations issued an estimated $21 billion of trust preferred shares from October 

1996 through June 1997.1 The dollar amount of trust 

preferred stock issued represented almost 95 percent of 

the incremental amount of Tier 1 capital added by those 

institutions during the period. A number of these institutions used the proceeds of trust preferred stock issues 

to fund stock buyback programs. As an example of the 

relative importance of these stock buyback programs, 

one large bank holding company’s Tier 1 capital ratio 

would be 7.25 percent excluding the trust preferred 

shares, and 8.34 percent including the shares. 

Rating agencies and investment analysts have argued 

that trust preferred stock is a weaker form of Tier 1 capital because of its limited life and debt-like characteristics. These characteristics include the tax treatment of 

trust preferred dividends,2 the limited life of the shares, 

and the ability of investors to accelerate their claims 

against the bank holding company. Institutions contem1 The amount of trust preferred stock outstanding is not delineated in 

Call Reports. 

2 Trust preferred dividends, unlike dividends on traditional preferred 

stock, are treated as a tax-deductible expense at the bank holding 

company level and as taxable income by investors of the trust preferred shares. 

plating issuing trust preferred stock should be aware of 

the concerns expressed by rating agencies and of the 

possibility that excessive reliance on debt-like capital 

instruments could increase their financial fragility during times of economic stress. 

Trust Preferred Structure 

Provides a Tax-Advantaged 

Capital Funding Alternative 

Trust preferred shares, also 

known as capital securities, are 

traded under different names 

depending on the underwriter, payment terms, and 

maturity. Some of the more common acronyms include 

TOPRS (Trust Originated Preferred Shares), QUIPS 

(Quarterly Income Preferred Shares), and MIPS 

(Monthly Income Preferred Shares). 

Although trust preferreds are issued under different 

names, they share the same basic structure (see Chart 1, 

next page). A non-taxpaying subsidiary, or “trust,” of 

the bank holding company is formed. The trust issues 

two classes of stock: common and preferred shares. The 

common stock of the trust subsidiary is owned by the 

bank holding company, and the trust preferred stock is 

sold to investors. The trust upstreams the proceeds from 

the sale of the preferred shares to the bank holding company in exchange for a long-term, deeply subordinated 

note with terms identical to the trust preferred shares. 

(The subordinated note must be the sole asset of the 

trust and subordinated to all other debt of the bank holding company.) 

On a consolidated basis, the trust preferred stock is 

treated as a minority interest of the bank holding company, and the subordinated note is eliminated as interBoston Regional Outlook 19	 Fourth Quarter 1997 
Regular Features Financial Markets
 

CHART 1
 

How Is Trust Preferred Stock Structured 

to Count as Tier 1 Capital? 

Trust Preferred 

Proceeds 

Trust Preferred Shares 

Dividend Payments—funded by interest 

received on subordinated note 

Investors in Trust 

Preferred Shares 

Trust Subsidiary 

Issues trust preferred shares 

(structured as a non-taxpaying entity) 

Trust Preferred Proceeds 

(Trust preferred shares treated as 

minority interest by BHC and 

counted toward Tier 1 capital) 

Subordinated Note—same coupon 

and payment terms as trust preferred 

shares, booked as intercompany debt 

and eliminated upon consolidation 

Interest Payments—paid with 

before-tax dollars by the BHC 

Bank Holding Company 

(BHC) 

(BHC owns common stock of 

trust subsidiary) 

Boston Regional Outlook 20 Fourth Quarter 1997
 
Regular Features Financial Markets
 

company debt. The interest paid by the bank holding 

company on the subordinated note, which is taxdeductible at the bank holding company level, is used to 

fund the dividends on the trust preferred shares. In 

short, the issuing trust serves as a conduit for exchanging cash flows between the bank holding company and 

the investors in the trust preferred shares. 

To be eligible for Tier 1 capital treatment, trust preferred dividends may be cumulative, but dividends must 

be deferrable for a minimum of five years. If the dividends are not paid for more than five years, the trust 

preferred shares could be exchanged for junior subordinated debt of the trust. After the exchange, the trust preferred holder could declare an event of default and 

accelerate the claim against the bank holding company. 

Trust preferred shareholders would then be treated similarly to deeply subordinated debt holders or preferred 

stockholders of the bank holding company. 

Trust preferred shares typically have maturities of 30 

years or more and contain call options and redemption 

provisions. The redemption provisions, which are subject to Federal Reserve approval, permit the issuer to 

redeem or buy back the preferred shares prior to maturity upon an adverse event such as the loss of Tier 1 capital treatment or the tax deductible status. 

Banks are not permitted to count trust preferred stock 

toward Tier 1 capital because of the cumulative feature 

of trust preferred dividends. While bank holding companies are permitted to include up to 25 percent of Tier 

1 capital as cumulative preferred stock, including trust 

preferred shares, banks must exclude cumulative preferred stock from Tier 1 capital ratios pursuant to the 

Risk-Based Capital Standards set by the Basle Accord. 

Bank Holding Companies of All Sizes 

Have Issued Trust Preferred Stock 

The flood of trust preferred stock issuance was prompted in part by the threat of extinction under the 1997 

federal budget. Bank holding companies rushed to take 

advantage of a potentially short-lived tax loophole, 

while investors were attracted by the opportunity to 

earn higher rates than on similarly rated bank debt. 

Bank holding companies have used proceeds from trust 

preferred stock to retire or call more expensive outstanding preferred issues, to provide capital to bank 

subsidiaries, to finance acquisitions, and to buy back 

common stock. 

As the tax advantage of the trust preferred stock 

remained intact through the budget negotiations, the 

pace of trust preferred issuance subsided from an estimated $4.3 billion in the first quarter of 1997 to just 

under $2.5 billion in the second quarter. Trust preferred 

issuance by larger banks declined as some approached 

their limit on Tier 1 trust preferred, while more smaller 

banks took advantage of the market for trust preferred 

stock. (See Chart 2 for a distribution of the number of 

banks in various size categories that have issued trust 

preferred stock in recent quarters.) Investment bankers 

are reportedly working on new structures that may make 

it easier and more cost effective for smaller institutions 

to issue these capital securities, perhaps through some 

pooling arrangement. 

REIT Preferred Stock—Another Type 

of Tax-Advantaged Tier 1 Capital 

Prior to the Federal Reserve’s announcement last 

October, the REIT (real estate investment trust) preferred stock structure was the chosen way for financial 

institutions to issue tax-advantaged preferred shares. 

Bank-issued REIT preferreds lost favor once trust preferreds debuted, because the trust structure is less costly and easier to administer than REIT preferreds. 

In an REIT preferred structure, the issuer establishes a 

corporation that elects REIT tax status. Proceeds from 

the preferred shares that are sold to investors are used to 

purchase qualifying real estate assets such as mortgagebacked securities or equity interests in real property. 

Cash flow from the real estate assets funds the REIT’s 

CHART 2 

More Small Institutions Issue Trust
 

Preferred Stock
 

Bank Size 

Number of < $10 billion Banks 

$10-100 billion 30 

$100+ billion 25 

20 

15 

10 

5 

0 4Q96 1Q97 2Q97 

Source: Keefe, Bruyette & Woods 

Boston Regional Outlook 21 Fourth Quarter 1997 
Regular Features Financial Markets
 

operating costs and preferred dividends. As long as the 

subsidiary continues to qualify for REIT tax status,3 dividend payments on the common and preferred shares 

are tax deductible by the holding company. 

Will the Tax-Advantaged Status of Trust 

Preferred Stock Continue? 

Although the tax-advantaged status of trust preferred 

stock was not eliminated in the federal budget, the possibility still exists that the Internal Revenue Service 

(IRS) may alter the tax treatment of trust preferred dividends. (In the first half of 1997, the IRS issued a ruling 

that eliminated the tax-advantaged status of a specific 

type of preferred stock known as Step-Down preferred 

stock.) If the tax advantage is eliminated, REIT preferred shares might again become a more popular 

means of raising tax advantaged Tier 1 capital. 

Issues and Concerns 

A number of bank holding companies have embarked 

on stock buyback programs financed by trust preferred 

stock issuance, thereby boosting earnings per share by 

reducing the number of common shares outstanding, 

while maintaining Tier 1 regulatory capital ratios. 

Rating agencies and investment analysts, however, 

generally view trust preferreds as analogous to preferred stock or deeply subordinated debt of the issuer. 

In fact, Standard & Poor’s has announced that bank 

holding companies with trust preferred stock in excess 

of 10 percent of Tier 1 capital may be subject to a ratings review. This announcement reflects the view of 

some analysts that trust preferred stock is a weaker 

form of Tier 1 capital than other forms of capital such 

as common and perpetual preferred stock, because of 

its limited life and treatment upon a liquidation of the 

trust. 

A recent regulatory interpretation has underscored the 

debt-like nature of trust preferred stock. The Office of 

the Comptroller of the Currency (OCC) has determined 

that investments by banks in trust preferred stock 

should be treated as investments in debt securities.4 The 

OCC cited a number of similarities between trust preferred stock and debt securities, including the fact that 

an investment in trust preferred securities is functionally equivalent to an investment in the underlying subordinated debt issued by the bank holding company, and 

that the trading characteristics of trust preferred securities are similar to traditional debt securities. 

Banking organizations should be aware of the views of 

rating agencies and bank analysts toward trust preferred 

stock. In times of economic stress, excessive reliance on 

debt-like capital instruments could result in increased 

financial fragility of the overall organization, a higher 

cost of raising new capital, and potential ratings downgrades. In extreme scenarios, pressures on the bank to 

service the obligations (explicit or implicit) of the 

holding company could attract the attention of bank 

regulators. 

Kathy R. Kalser, Chief 

Financial Sector Analysis Section 

3 To qualify as an REIT, the subsidiary must comply with Section 856 

of the U.S. Federal Income Tax Code, which requires that 75 percent 

of the REIT’s income come from real property rents, interest income 

from mortgage debt on real property, and other related sources. In 

addition, the REIT must distribute at least 95 percent of its net income 

to shareholders. 

4 In a letter dated April 8, 1997, the OCC stated that subject to applicable rating and marketability requirements, bank investments in trust 

preferred stock would be treated as Type III investments under 12 

CFR Section 2 1.2 (k). 

Boston Regional Outlook 22 Fourth Quarter 1997 
Regular Features	 Regional Banking
 

Regional Banking Conditions
 

•	 Insured institutions continue to reflect financial strength. 

•	 In the face of ongoing industry consolidation, small institutions are growing profitably but may be doing so 

on thinner spreads or by relaxing underwriting standards. 

•	 Commercial real estate lending is on the rise in selected markets. 

•	 New types of lending may increase the risk profile of residential portfolios. 

Banking Conditions Remain Upbeat 

Minimal loan losses and improved operating efficiency 

continue to drive earnings of the Region’s insured institutions to new heights. The aggregate return on assets 

(ROA) for all institutions in the Region was 1.35 percent in the second quarter, well above the 1.19 percent 

ROA posted by the nation’s insured institutions as a 

whole. A low level of delinquencies and charge-offs has 

resulted in low provisions for loan and lease losses 

(PLLL) relative to the nation as a whole (0.22 percent 

versus 0.39 percent of average assets). Low provisions 

are the primary factor contributing to the higher earnings performance of the Region’s insured institutions. 

Net charge-offs continue to exceed the PLLL; however, 

at 1.74 percent of total loans, the allowance for loan and 

lease losses (ALLL) remains slightly above the national 

average (see Table 1). 

Strong earnings continue to bolster capital levels, 

despite asset growth of 7.5 percent over the past 12 

months and healthy dividend payouts by the Region’s 

stock-owned institutions. The aggregate Tier 1 leverage 

ratio for the Region’s insured institutions is now 8 perTABLE 1 

cent; for institutions with assets under $1 billion, the 

ratio is 10 percent. The improved financial posture of 

the Region’s banks is reflected in examination ratings. 

As of June 30, 1997, more than 98 percent of the 

Region’s aggregate assets were held by institutions 

accorded a composite CAMEL rating of 1 or 2 (see 

Chart 1) by their primary regulator. 

CHART 1 

85 86 87 88 89 90 91 92 93 94 95 96 97 

CAMEL Ratings Reflect Region’s Comeback 

Source: FDIC Structure Database 

0 

20 

40 

60 

80 

% of Assets Held by 

Institutions Rated 3, 4, or 5 

% of Institutions 

Rated 3, 4, or 5 

Low Provisions and Decreasing Delinquencies Enhance Earnings Performance 

NATION BOSTON REGION 

ASSET QUALITY RATIOS (%) 6/30/97 6/30/97 6/30/96 6/30/95 6/30/94 6/30/93 

ALLL/AVG LOANS 1.72 1.74 1.95 2.05 2.25 2.59 

ALLL/NONCURRENT LOANS 166.59 168.53 145.66 141.49 116.98 97.30 

PAST DUE LOANS & LEASES 2.25 2.09 2.65 2.77 3.39 4.60 

NET CHARGE-OFFS/AVG LOANS 0.56 0.40 0.38 0.44 0.74 1.02 

Source: Bank and Thrift Call Reports ALLL = Allowance for Loan and Lease Losses 

Boston Regional Outlook 23	 Fourth Quarter 1997 
Regular Features Regional Banking
 

Consumer problems persist, as evidenced by escalating 

personal bankruptcy filings and charge-off rates on consumer debt. However, excluding the credit card specialists, very few institutions in the Region have large 

concentrations of consumer loans. Consumer loans 

(excludes real estate) comprise only 6.0 percent of the 

Region’s assets, compared with about 10.5 percent for 

the nation as a whole. As discussed below, however, 

developments in mortgage lending pose a risk that 

weaknesses in consumer loan portfolios could migrate 

to some segments of single-family lending. 

Absent a severe regional or national recession, the 

Region’s institutions should continue to perform well, 

with poor competitive decisions (lax underwriting standards, improper pricing) or strategic initiatives among 

the major impediments to continued success. 

Structural Changes Are Reshaping 

the New England Banking 

Landscape 

The banking industry is undergoing 

substantial structural change, driven in 

part by competitive factors, technological innovation, and the increasing 

demands of investors for higher returns and 

earnings growth. Expanded powers and interstate banking and branching are regulatory 

changes that have resulted from these forces and have 

led to significant consolidation within the industry. 

New Englanders have witnessed a 35 percent reduction 

in the number of insured institutions since year-end 

1989, compared with a 29 percent reduction for the 

nation as a whole. A disproportionate share of the 

nation’s bank failures during this period, coupled with a 

dearth of de novo bank formations, contributed to this 

larger decline. 

Following the implementation of full interstate branching in June 1997, KeyCorp and First Union merged 

their major New England franchises into their operations based in Cleveland, Ohio, and Charlotte, North 

Carolina, respectively. Within-Region consolidation of 

affiliated banks across state lines also has occurred, 

with Fleet being the most notable example of this activity. Interstate and inter-Region mergers such as these 

will make it more difficult to monitor banking conditions in specific geographic locations and diminish the 

usefulness of bank and thrift Call Report data when 

evaluating regional banking conditions. 

Perhaps more significant than the decline in the number 

of insured institutions is the reduction in the number of 

banking offices operating within the Region’s six states. 

Since year-end 1989, there has been a net reduction of 

more than 900 branches in the Region, a 17 percent 

decline, versus a 0.2 percent decline for the rest of the 

nation. The significant decline in the number of banking offices in New England is a direct by-product of the 

expansion of the largest institutions in the Region 

through merger and acquisition of both failed and operating institutions. The push for greater efficiency 

through economies of scale has resulted in the elimination of many offices with overlapping geographic 

markets and has driven up the volume of loans and 

deposits supported by the remaining facilities. This 

push has also been necessitated by the lack of asset 

growth in the Region (essentially flat) relative to the 

nation as a whole (up 23 percent) over the same time 

frame. Additionally, many traditional “bricks and mortar” facilities have been closed in favor of new formats, 

including supermarket branches and expanded networks 

of automated teller machines (ATMs). For example, the 

Massachusetts Division of Banks reports that the number of bank-owned ATMs operated in the Bay State 

increased from 2,291 to 3,463 between 1991 and 1996. 

The Internet also offers potential as a cost-efficient 

mechanism for delivery of bank products and services. 

Technological advances and the ongoing desire to 

improve efficiency are likely to put continuing downward pressure on the number of traditional banking 

facilities. 

Small Institutions Are Carving Out Niches 

Consolidation within the Region has resulted in a growing concentration of assets in the largest banking companies. The five largest banking organizations in the 

Region today controlled 22 percent of the Region’s total 

assets in December 1989. At that time, there were 46 

banking organizations reporting assets greater than $1 

billion. Through failure or acquisition, 32 of those institutions no longer exist; many of these were absorbed by 

today’s large players. As a result, the concentration of 

assets in these five large companies has increased to 56 

percent. 

This increased concentration has raised concerns that 

the growing dominance of a few organizations may negatively affect the competitiveness of smaller institutions. An evaluation of the performance of smaller 

institutions in the Region indicates that they have sucBoston Regional Outlook 24 Fourth Quarter 1997 
Regular Features Regional Banking
 

cessfully maintained a niche in a market increasingly 

dominated by large institutions, although intense competition on both sides of the balance sheet will continue 

to place downward pressure on profitability. 

As of June 30, 1997, there were approximately 400 nonspecialized insured institutions in the Region that were 

part of organizations with total banking assets of less 

than $1 billion (excluding trust banks). Over the past 

three years, these institutions registered an annualized 

asset growth rate in excess of 7 percent, compared with 

just under 4 percent for the larger institutions. Loans 

have grown at nearly an 8 percent rate as the smaller 

institutions continue to demonstrate a willingness to 

fund real estate loans (see Chart 2), maintaining these 

investments at approximately 57 percent of total assets 

(versus 27 percent at larger institutions). Conversely, the 

larger institutions have continued to reduce direct exposure to real estate loans (down 2 percent), although it 

should be noted that some of the reduction has been 

transferred to commercial and industrial (C&I) portfolios in the form of working capital loans to real estate 

investment trusts (see Strong Demand and Financial 

Innovation Fuel Rebounding Commercial Real Estate 

Markets). 

Smaller institutions are making similar inroads on the 

commercial loan front. While C&I loans are a small 

portion of the asset mix of smaller institutions, these 

loans have grown at an annualized rate of 14 percent 

over the past three years, compared with 10 percent for 

the larger institutions. Concerns have been expressed 

that large institutions’ increased use of credit scoring for 

small-business loans would have a negative effect on the 

CHART 2 

smaller lenders. However, the smaller institutions in this 

Region have actually increased their share of smallbusiness loans (those under $1 million) to one-third of 

the total, up from 28 percent only two years earlier. 

Similarly, small institutions at mid-1997 held more than 

51 percent of all permanent mortgages on nonfarm, 

nonresidential properties with original amounts of $1 

million or less, up from approximately 45 percent in 

June 1995. 

Similar success has been met on the funding side of the 

balance sheet. Core deposits have been growing at an 

annualized 5 percent rate over the past 12 quarters but 

have been essentially flat for the larger institutions. The 

growth has been concentrated in higher-cost certificates 

of deposit. The shift in deposit mix to higher-cost funds, 

coupled with competitive pressure on both loan yields 

and deposit rates, has resulted in a steady erosion of 

margins at smaller institutions. Since the fourth quarter 

of 1994, the spread between the yield on earning assets 

and the cost of funds has fallen from 3.88 percent to 

3.47 percent. The net interest margin fell 25 basis points 

over the same period. 

Small institutions are growing at a steady rate but are 

doing so on thinner spreads, and they also may be relaxing underwriting standards or expanding into riskier 

forms of lending to capture new volume. These institutions should ensure that credit quality is maintained in 

the battle for new business, and that they are being compensated fairly for the risk inherent in that business. 

Recent FDIC underwriting surveys indicate that in nearly 25 percent of recently examined institutions in this 

Region, there is a failure to adjust loan pricing for inherLarge Banks Have Steadily Reduced Exposure to Real Estate Loans While Real Estate
 

Continues to Dominate Small Banks’ Portfolios
 

Banks with Assets > $1 billion Banks with Assets < $1 billion 

20 

40 

60 

80 

100 

% of Total Loans at Midyear

Residential Real Estate 

All Other 

Nonresidential Real Estate 

Commercial and Industrial 

% of Total Loans at Midyear 

60 

80 

100 All Other 

Nonresidential Real Estate 

Commercial and Industrial 40 

Residential Real Estate 20 

0 0 

89 90 91 92 93 94 95 96 97 89 90 91 92 93 94 95 96 97 

Boston Regional Outlook 25 Fourth Quarter 1997 
Regular Features Regional Banking
 

ent risk. Additionally, more than 25 percent of the institutions were found to have lending practices that differed at least moderately from written policies. 

Aggressive competition may be a factor here and underscores the importance of close monitoring of policy 

exceptions by institution management to ensure that 

loan quality is not compromised. 

Real Estate Lending Activity Increasing 

in Selected Markets 

Despite the improved real estate conditions discussed in 

the Regional Economy section, the aggregate real 

estate exposure of the Region’s insured institutions has 

fallen for the past several years, primarily in the larger 

institutions. Real estate portfolios are performing well, 

as evidenced by declining delinquencies and net chargeoffs in both the residential and nonresidential sectors 

(see Chart 3). Improved fundamentals and portfolio performance may give rise to a resurgence of new volume. 

While regional institutions appear to be proceeding cautiously, increased real estate lending activity is evident 

in selective market areas. 

While construction and development loans continue to 

represent only a small percentage of total real estate 

loans, several areas in the Region continue to show 

increases in construction lending. Smaller institutions 

(those with less than $1 billion in total assets) in the 

greater Boston metropolitan area (Essex, Middlesex, 

Norfolk, and Suffolk Counties) and in Fairfield 

County, Connecticut, have shown rapid growth in 

construction, real estate development, and multifamily 

CHART 3 

financing. The real estate portfolios of smaller regional 

institutions are generally more geographically concentrated than those of large institutions and provide a good 

indication of local market conditions. Over the previous 

24 months, banks based in greater Boston with assets 

under $1 billion have grown their construction and land 

development real estate portfolios approximately 20 

percent annually. Furthermore, there has been a sharp 

increase in the dollar volume of unfunded commitments 

for commercial real estate, construction, and land development. Construction and multifamily lending has also 

heated up in smaller Fairfield County institutions in 

1997, with annual growth rates approximating 20 percent. Although the dollars at risk represent a modest 

percentage of the total loans, it appears that locally 

based insured institutions are willing to once again 

expand their portfolios into lending categories that 

produced such high losses in the early 1990s. However, 

because far fewer institutions are concentrating in 

higher-risk real estate lending such as commercial real 

estate and construction, and because earnings and capital are both significantly better than before the previous 

recession, the overall risk profile of New England’s 

insured institutions remains relatively conservative. 

New Mortgage Products—Potential Risks 

The real estate lending market is ever changing. 

Lenders are competing for a larger market share and are 

introducing new, innovative products. One of the latest 

trends in the second mortgage and home equity loan 

market is loan products with a high loan-to-value ratio 

(LTV). Such a loan allows a borrower to have total 

Vastly Improved Performance of Non–1- to 4-Family Real Estate 

Portfolios May Spur New Loan Activity 

Delinquencies as a % of Total Loans Charge-Offs as a % of Average Loans 

20 4 17.42 

All Other Real Estate All Other Real Estate

15 3 

1- to 4-Family 10 Real Estate 2 1- to 4-Family 

Real Estate 

4.37 5 3.22 1 

1.97 

0 0 

Dec-91 Dec-92 Dec-93 Dec-94 Dec-95 Dec-96 Jun-97 Dec-91 Dec-92 Dec-93 Dec-94 Dec-95 Dec-96 Jun-97 

Boston Regional Outlook 26 Fourth Quarter 1997 
Regular Features Regional Banking
 

indebtedness on combined mortgages of as much as 125 

percent to 150 percent of the value of the underlying 

property. Rates on these loans are high relative to those 

on traditional mortgages but are lower than those on 

most credit cards and may offer tax advantages not 

available to credit card debt holders. High-LTV loans do 

not appear to be common at insured institutions in the 

Boston Region; however, such loans are being aggressively marketed by national mortgage companies. As 

area banks attempt to maintain market share and 

improve margins, these products may become more 

popular. 

While real estate portfolios are performing well, consumer loans continue to show weaknesses that could 

spread to the single-family loan category. In the aggregate, junior mortgages have grown at an annualized 14 

percent rate over the past three years, suggesting that 

banks’ appetite for this type of product is on the rise. 

While the Region’s insured institutions generally appear 

to be limiting maximum LTVs to 100 percent and exposures remain small, these junior mortgages do increase 

the risk inherent in single-family loan portfolios. 

A recent study by the Office of Thrift Supervision compared the relative performance of residential mortgages 

that had seasoned at least 24 months, on the basis of 

factors such as purpose (purchase or refinance), structure (rate, term, etc.), and LTV. The study evaluated 

originations from 1991 through 1995 and found that for 

loans with LTVs between 95 percent and 105 percent, 

the percentage that were seriously delinquent (more 

than 90 days past due or in foreclosure) was more than 

10 times what it was for loans with LTVs under 80 percent. The study also found that 26 percent of the 1995 

originations had LTVs over 90 percent, up from approximately 7 percent for the 1991 through 1993 period. A 

high level of refinancing during these years undoubtedly reduced the percentage of high-LTV loans; however, 

the numbers strongly suggest that 

high-LTV lending is on the rise. 

The higher rate of serious delinquency, coupled with low or no real 

equity for these loans, will translate into higher losses. These portfolios warrant close monitoring. 

% 

Junior mortgage products provide banks with an opportunity to capture higher yields; however, junior mortgages are often used for consumer purposes, including 

consolidation of credit card debt. Competition in the 

credit card industry is strong, and as high-LTV mortgages become more common, borrowers may simply 

consolidate credit card and other consumer debt into a 

junior mortgage and then tap their credit cards for future 

cash flow needs. As both junior mortgages and consumer debt escalate, the burden may become too heavy 

for some borrowers, possibly resulting in default and 

loss, particularly if economic conditions deteriorate. 

The ability of consumers to easily consolidate existing 

debt heightens the need for institutions to closely monitor and manage unused credit card lines, which may 

become the indirect source of payment on the “quasi” 

home equity loan. 

Daniel Frye, Regional Manager 

Cameron Tabor, Financial Analyst 

Gregory Quint, Bank Examiner 

Boston Regional Outlook 27 Fourth Quarter 1997 
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