Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION SECOND QUARTER 1998 

FDIC
 

New York
 

Region
 

Division of
 

Insurance
 

Suzannah L. Susser,
 

Regional Manager
 

Norman Gertner,
 

Regional Economist
 

Karen A. Wigder,
 

Financial Analyst
 

In Focus This Quarter 

◆ Gain-on-Sale Accounting Can Result in Unstable Capital Ratios and Volatile Earnings—The accounting for transferring and servicing financial assets causes asset sellers, particularly high-growth lenders, to recognize significant noncash income related to retained economic interests in the sold 

assets. This is true whether a company securitizes its own assets or sells its assets as 

a conduit to another securitizer. Values are often driven by management assumptions about future performance of the sold assets. Major writedowns of gain-on-sale 

assets by some finance and mortgage companies underscore the importance of careful scrutiny of these assumptions by banks and their supervisors. See page 3. 

By Allen Puwalski 

◆ How Will the Expansion End?—Analysts are now focusing on when 

and how the current expansion will end. Although no one can accurately predict 

when a recession will begin, two possible scenarios have emerged. Each scenario has 

important implications for lenders as they prepare for the possibility of slower economic growth or recession. See page 7. 

By Paul C. Bishop 

◆ Trends Affecting the Allowance for Loan and Lease Losses— 

In today’s environment, in which loan availability is abundant, growth is strong, and 

competition is fierce, some industry leaders and regulators have expressed concern 

about the loosening of underwriting standards and greater risk in bank loan portfolios. At the same time, the allowance for loan and lease losses (ALLL) relative to 

total loans at many insured institutions is declining. As the economic expansion 

reaches an advanced age, an important question for insured institutions is whether 

their ALLLs adequately reflect the risks associated with changing industry practices. See page 11. 

By Andrea Bazemore 

Regular Features 

◆ Regional Economy—Strong economic growth, flattening yield curves, 

and lower mortgage rates are stimulating home purchases and a surge of refinancings in the Region...banks in the Region may face tightening margins because of the 

large volume of refinancings in the pipeline...demographic trends may dampen 

housing market activity over the long term. See page 16. 

By Norman Gertner 

◆ Regional Banking—The Region’s financial institutions remain healthy 

despite weakness in credit cards and the Asian crisis...as more consumers refinance 

mortgages, savings banks and thrifts may see tighter margins because of their higher concentrations in residential real estate loans...a marked shift toward fixed-rate 

mortgages exposes financial institutions to increased interest rate risk in the long 

term. See page 20. 

By Karen A. Wigder 

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

Insurance Corporation for the following eight geographic regions: 

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

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

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

Dallas Region (CO, NM, OK, TX)
 

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

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

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

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

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

form found on the back cover to the FDIC Public Information Center. Contact the Public Information Center for current pricing on bulk orders. 

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

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

Region’s Regional Outlook, please call Suzannah Susser at (212) 704-1482 or send an e-mail to 

ssusser@fdic.gov. 

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

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

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

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

the Federal Deposit Insurance Corporation. 

Chairman Donna Tanoue 

Director, Division of Insurance Arthur J. Murton 

Editor George E. French 

Assistant Editors Gary L. Beasley 

Jack M.W. Phelps 

Publications Manager Teresa J. Franks 
In Focus This Quarter
 

Gain-on-Sale Accounting Can Result in Unstable
 

Capital Ratios and Volatile Earnings 


•	 Gains generated from asset sales under SFAS 125 

rely on management assumptions about the lifetime performance of the assets sold and may not 

materialize in cash if the assumptions prove 

incorrect. 

•	 Gain-on-sale accounting has been most significant to securitizers, but nonsecuritizers can and 

do retain economic interests that give rise to significant gain-on-sale assets. 

•	 Finance companies seeking to shift attention from 

gain-on-sale assumptions may find willing bank 

correspondents. 

•	 The rating services have modified capital and 

earnings analysis in order to lessen what they consider distortions caused by SFAS 125. 

Statement of Financial Accounting Standards No. 125 

(SFAS 125),Accounting for Transfers and Servicing of 

Financial Assets and Extinguishing of Liabilities, 

causes asset sellers, particularly high-growth lenders, to 

recognize significant noncash income. Applying SFAS 

125, which became effective on January 1, 1997, can 

give rise to significant noncash gains and related assets 

if an economic interest is retained in assets sold. The 

value of retained interests in assets sold is quantified on 

the basis of management’s assumptions about future 

charge-off rates, repayment rates, and the rate used to 

discount the expected cash flows from the loans sold. 

Because the value of these assets changes when actual 

performance deviates from the assumptions, the quality 

of earnings, capital, and liquidity for a lender that relies 

significantly on gains on sale must be considered carefully. 

The recent writedowns of interest-only (IO) assets by a 

few major finance companies have led to a higher level 

of scrutiny of companies whose financial statements are 

influenced significantly by gain-on-sale accounting. 

The Securities and Exchange Commission has recently 

increased its scrutiny of publicly traded companies that 

use gain-on-sale accounting, and it may soon require 

assumptions regarding defaults, prepayments, and discount rates to be disclosed in financial statements. The 

same companies that enjoyed soaring stock performance thanks to high earnings growth caused by gainon-sale accounting have seen their stock values tumble 

as they have had to write down their gain-on-salerelated assets. 

Several major credit rating companies have recognized 

the significant effect of gain-on-sale accounting under 

SFAS 125 on interpreting financial statements. These 

companies have issued comments or reports dealing 

with SFAS 125’s effect on the quality of earnings and 

capital of the companies they rate and how they adjust 

their analysis as a result. The consensus of these papers 

is that gain-on-sale accounting for companies that securitize often results in significantly higher reported earnings and equity compared to balance sheet 

lenders—without, in many cases, materially changing 

the underlying economics or credit risk to the originator 

of the assets.1 Generally, the rating services have modified capital and earnings analysis in order to lessen 

what they consider distortions caused by SFAS 125. 

There Are Risks Associated with Gain-on-Sale 

Accounting 

The asset booked in connection with an SFAS 125 loan 

sale is an IO strip that represents the present value of 

future excess spread cash flows generated by the transferred assets. Generally, asset-backed securitizations, 

including some classified as mortgage-backed securities, are structured so that each month the expected cash 

flows from the underlying assets will be sufficient to 

pay the investor coupon, the trust expenses, the servicing fee, and net charge-offs. The cash flow that the 

underlying assets will generate each month cannot be 

known with certainty because the underlying asset may 

allow for variable principal payments (e.g., credit card 

accounts), or the borrowers may default. Securitizations 

are structured so that there is enough cushion between 

the expected cash flows and the required payments and 

1 Duff & Phelps Credit Rating Company, “Securitization and Corporate Credit Risk.” Special Report Financial Services Industry, July 

1997; T. E. Foley and M. R. Foley. “Alternative Financial Ratios for 

the Effects of Securitization Tools for Analysis.” Moody’s Special 

Comment, September 1997; H. L. Moehlman, R. W. Merrit, and N. E. 

Stroker. “Capital Implications of Securitization and Effect of SFAS 

125.” Fitch Research, September 16, 1997. 

New York Regional Outlook 3	 Second Quarter 1998 
In Focus This Quarter
 

expected charge-offs to absorb fluctuations in actual 

cash flows and actual charge-offs. This cushion is 

excess spread. As actual cash flows vary from projections, so does the excess spread generated. 

According to SFAS 125, when a company sells assets 

and retains the right to future excess spread cash flows, 

the calculation of the gain on the sale includes the capitalization of this right. In many transactions, the gain 

on sale consists entirely of the fair value of the IO strip 

that represents this right—none of which is necessarily 

received in cash. In addition, with many transactions, 

cash receipt is further delayed while cash flows go to 

fund the spread account, which is analogous to an internal loan loss reserve. 

SFAS 125 states that quoted market prices in active 

markets are the best evidence of fair value and should 

be used whenever available. Although there have been 

some sales of these IO strips, the number of sales is not 

yet sufficient to constitute an active market. When market prices are not available, SFAS 125 states that the 

estimate of fair value should be based on the best information available. In practice, fair value of the excess 

spread is determined by present valuing the expected 

cash flows using a discounted cash flow model. 

The value of the right to future cash flows is determined 

on the basis of management’s assumptions about the 

charge-off rate, the average life of loans, and the rate 

used to discount the cash flows. These input assumptions drive the model results and, therefore, the magnitude of the gain. The stability of the value of the IO will 

depend greatly on the extent to which the input assumptions accurately describe the pool performance over the 

life of the transferred assets. Changes in economic or 

market conditions that were not anticipated in the initial 

cash-flow assumptions will likely cause the pool of 

loans to perform differently than initially projected. 

Gain-on-sale accounting is significant to securitizers. 

To illustrate the significance of the IO account to a 

securitizer’s reported income, consider one major subprime lender. During fiscal year 1997, this company’s 

IO asset grew by over $141 million. Despite a $28 million writedown of the IO asset, the net growth of the 

asset constituted over half of total revenue and over 

eight times net income. The revaluation of the IO was 

necessitated by higher-than-expected prepayment rates. 

Current market conditions were not anticipated by 

many companies that benefited from high earnings 

related to gain-on-sale accounting. Several other major 

securitizers have reduced the carrying value of their IO 

assets in the face of either rising charge-off rates or 

higher prepayment rates. Writing down an IO strip 

largely represents a company’s admission that it will not 

generate on a cash basis income that was booked previously. 

Chart 1 displays the cumulative charge-off rates by vintage for Moody’s index of home equity loan securitizations. The index consists mostly of prime mortgages, so 

the loss rates are still low. However, the rising trend in 

losses is noteworthy and reflects the growing influence 

of subprime securitizations on the index and the related 

decline in underwriting standards as competition has 

increased in this market. Loans originated in 1995 and 

1996 are causing progressively larger and earlier losses. 

After 21 months of seasoning, the cumulative loss rate 

on loans originated in 1996 is .17 percent—almost six 

times the loss rate experienced by the 1994-originated 

cohort at the same age. Despite the continued low loss 

rates for the home equity market in general, subprime 

lenders are experiencing accelerated loss rates that are 

eroding the value of their interests in excess spreads. 

There may be a tendency for management to base 

assumptions about expected loss rates on loans sold 

solely on past experience with similar loans. Such an 

approach may not capture changes in market conditions 

and trends. For example, the Moody’s data demonstrate 

that loss rates on home equity loans, including first 

liens, have been trending upward rapidly. This trend 

implies that when estimating loss rates, management 

should consider the potential for changes in market conCHART 1 

Vintage Analysis of Home Equity Loan 

Securitizations 

Source: Moody’s Investor Services 

0.00 

0.05 

0.10 

0.15 

0.20 

1 3 5 7 9 11 13 15 17 19 21 

Cumulative 

Loss (%) 

1994 

1995 

1996 

Months 

New York Regional Outlook 4 Second Quarter 1998 
In Focus This Quarter
 

ditions over the life of the sold assets as well as the past 

performance of similar assets. 

Like loss rates, prepayment rates have risen substantially in the subprime mortgage market. Several factors 

have contributed to the rise. One factor is the trend 

toward higher loan-to-value (LTV) loans in the mortgage market, which has allowed borrowers to obtain 

additional cash from their homes without waiting to pay 

down principal. Mortgage bankers report the tendency 

of some subprime borrowers, often debt consolidators, 

to maintain outstanding balances at the highest possible 

LTV. With maximum LTV ceilings rising, debt consolidators can refinance home equity loans without having 

to amortize existing debt. 

Another important factor contributing to rising prepayment rates is competition among lenders for volume 

growth. To continue to grow volume, lenders have been 

sacrificing margins on loans to offer a better rate to borrowers. When estimating prepayment rates for subprime 

borrowers, it has been normal to expect that they would 

need to improve their credit rating, or “credit cure,” 

before they would find it economical to refinance. Stiff 

competition for volume has allowed borrowers to find 

better rates without credit curing and has stimulated 

them to refinance prior to the time estimated at origination. Falling interest rates and a relatively flat yield 

curve are likely to increase prepayment rates. 

In standard finance theory, uncertainty about the future 

level of losses and prepayment rates is compensated for 

by discounting the cash flows at a higher rate. Some 

analysts advocate using a discount rate similar to the 

required rate of return for equity investments. Faced 

with changing conditions, one large finance company 

that specializes in high LTV lending announced in 

December 1997 that it was increasing the discount rate 

it uses to value new IO strips from 12.5 percent to 33 

percent. 

The IO Strip Asset Is Growing at Insured 

Depository Institutions 

As of December 31, 1997, only 30 institutions reported 

this IO asset at more than 5 percent of tier 1 capital. 

However, some institutions have booked gains that 

should have given rise to a call-reportable IO strip but 

did not properly report the assets. Therefore, the current 

reporting may understate the prevalence of the asset. 

Furthermore, the recent attention to gain-on-sale 

accounting from the public equity markets has at least a 

few large finance and mortgage companies seeking 

business strategies that shed IO strip-related volatility 

from their financial statements. One such strategy 

already in use is to leave the economic interest in excess 

spread with the correspondents that originate the loans. 

This is done as follows: The correspondent originates 

loans for purchase by a finance company. The finance 

company pays par for the loans, and instead of being 

paid an origination fee or a premium for the loans, the 

seller retains the right to excess spread generated over 

the life of the loan. The seller books a gain and an IO 

asset that capitalizes this right to receive future cash 

flows. The nature of the IO asset is exactly the same 

whether it arises directly from a securitization or from a 

sale of loans to a securitizer. If this strategy is used 

widely by finance and mortgage companies, then IO 

strips are likely to grow among institutions that originate loans for sale to these companies (see Chart 2). 

For insured depository institutions, the capital effects of 

SFAS 125 need to be evaluated carefully. Analysis of the 

financial statements and leverage ratios of insured institutions should consider fully issues related to the quality of earnings and the stability of capital posed by the 

volatility of the IO strip. Insured institutions that engage 

in significant asset sales while retaining economic interests that give rise to SFAS 125–related assets are subject 

to distortions similar to those of nonbank financial 

companies. 

The activity of originating and selling loans and booking associated gains can lead to capital ratios that 

CHART 2 

IO Strip Is Growing at Insured Institutions 

Source: Bank & Thrift Call Reports 

0.00 

0.50 

1.00 

1.50 

2.00 

2.50 

3.00 

1Q97 2Q97 3Q97 4Q97 

$Billion 

120 

130 

140 

150 

160 

Number of Institutions 

Number of Institutions 

IO Strip 

New York Regional Outlook 5 Second Quarter 1998 
In Focus This Quarter
 

appear high by traditional bank standards. For several 

reasons, the leverage ratio can appear particularly high. 

First, although the asset may be more volatile than 

mortgage serving rights, there is no limit to the amount 

of IO strip that a bank can include in tier 1 capital. Second, the amount of IO strip booked increases capital by 

a gain on the net of the tax effect. The extent to which 

the amount remains in capital depends, of course, on the 

institution’s dividend policy. Third, the denominator of 

the leverage ratio is reduced by the sale because the 

loans are no longer assets of the bank. The cumulative 

result can be a significant boost to the leverage ratio. 

Several insured institutions report an IO strip at greater 

than 25 percent of tier 1 capital. For an institution whose 

primary line of business is originating and selling subprime mortgages, the asset can quickly reach a level 

exceeding tier 1 capital. In a little more than a year of 

originating and selling subprime mortgages to a major 

securitizer, one institution has amassed IO assets that it 

has valued at more than 150 percent of tier 1 capital. 

The institutions that have concentrations of 25 percent 

or more of tier 1 capital in IO assets have a median 

leverage ratio of about 11 percent. In contrast, the median equity capital ratio for nonbank mortgage securitizers tracked by SNL DataSource is about 30 percent. 

Public debt markets or banks that lend to these finance 

companies appear to require significantly higher capital 

levels than regulatory minimums required for banks. 

The potential for growth of the IO 

strip asset at insured institutions 

seems strong. In some circumstances, minimum capital standards for banks may require 

significantly less capital for IO 

asset exposure than the public 

equity markets. Perhaps more 

important, the quick rise of the significance of gain-onsale accounting to the mortgage and consumer credit 

markets exemplifies the speed with which exposure to 

risk can be acquired through the securitization market. 

Strong demand for asset-backed securities coupled with 

changing accounting emphases, which in this case favor 

asset sellers, can lead quickly to substantial exposures. 

Allen Puwalski, Senior Financial Analyst 

Risk-Based Capital (RBC) Treatment of the Gain-on-Sale–Related IO Asset 

If the IO asset derives from excess spread that absorbs tions does not necessarily preclude subprime mortcharge-offs from the sold assets, then the IO strip con- gages in general from receiving the reduced risk 

stitutes recourse from the sold assets for RBC pur- weighting. Although the capital standards require that 

poses. RBC standards require capital to be held mortgages be prudently underwritten to qualify for 

against this exposure. In general, the capital require- the 50 percent risk weighting, it is not entirely clear 

ment for this exposure is the amount of capital that how the term “prudently underwritten” applies to subwould have been required for the assets had they not prime mortgages. A higher expected loss rate alone 

been sold. If the sold assets are one- to four-family may be insufficient cause for presuming that the 

residential mortgages, they may receive a 50 percent mortgages are not prudently underwritten. 

risk weighting. Subprime mortgages are not necessarily precluded from receiving this weighting. The rationale for reducing the capital requirement for 

traditional one- to four-family mortgage lending is 

In order to apply the 50 percent risk weighting, the related to the maturity of the market and consistently 

capital standards require that one- to four-family res- low loss rates. As noted above, the subprime mortgage 

idential mortgages be fully secured and prudently market is changing rapidly, and loss rates can be much 

underwritten. The “fully secured” requirement pre- higher than in traditional mortgage lending. Accordcludes high-LTV loans with LTV ratios of greater ingly, bank managements need to be aware of the 

than 100 percent from receiving reduced capital potential volatility and risks associated with gain-onrequirements, but the language of the RBC regula- sale assets associated with subprime mortgages. 

New York Regional Outlook 6 Second Quarter 1998 
In Focus This Quarter
 

How Will the Expansion End?
 

•	 Despite a very low unemployment rate and high 

industry capacity utilization, inflation has been 

unusually subdued during this expansion, with 

price declines in some sectors. 

•	 After seven years of expansion, most analysts 

expect the economy’s growth to slow in the coming 

months. 

•	 The last seven expansions have ended with an 

inflation-driven increase in short-term interest 

rates; in contrast, some analysts believe that the 

next recession will be caused by a period of falling 

prices for commodities, finished goods, and perhaps wages. 

•	 Insured institutions that base lending and strategic decisions on assumptions of continued robust 

economic growth should scrutinize and test those 

decisions against possible adverse change in economic conditions. 

The current economic expansion is the third longest on 

record since World War II. Since mid-1991, when the 

expansion began, more than 15 million new jobs have 

been created and inflation-adjusted gross domestic 

product (GDP) has increased by nearly 20 percent. In 

fact, the unemployment rate reached a 24-year low 

when it fell to 4.6 percent in November 1997 and again 

in February 1998. At the same time, inflation has 

remained unusually low, at only 2.3 percent during 

1997. 

Analysts are now focusing on when and under what circumstances the current expansion will end. While no 

one can accurately predict when the expansion will end, 

two related but competing theories about how it will end 

have emerged in recent months. The first and more 

familiar scenario occurs when the Federal Reserve 

increases short-term interest rates to prevent a rapid 

increase in inflation caused by an overheating economy. 

The second scenario, a deflation-induced contraction, is 

less familiar in the context of recent recessions. This 

scenario posits a period of falling prices for commodities, finished goods, and, under the most severe circumstances, even wages. 

Whatever the cause of the next downturn, its effects are 

likely to be important for the performance of lenders. 

During the 1990–91 recession, for example, the widespread deterioration of economic conditions was 

reflected in a number of indicators: Inflation-adjusted 

GDP fell by 2 percent; the number of business failures 

rose by nearly 40 percent; unemployment increased by 

more than 40 percent to 9.8 million; the unemployment 

rate peaked at more than 7 percent; single-family housing starts fell by almost 22 percent; and the bank card 

delinquency rate increased from 2.4 percent to 3.3 percent. This experience suggests that no matter what triggers the next downturn, dramatic adverse changes in the 

drivers of bank performance will likely result. 

How Have Economic Expansions 

Usually Ended? 

Although to some extent each business cycle is unique, 

virtually all of the post–World War II expansions have 

shown a similar characteristic: Toward the end of the 

expansion, inflation has accelerated. As the economy 

expands, the prices of inputs, including the wages of 

workers, are bid up as firms compete for resources to 

meet demand. The overall inflation rate will rise if 

prices increase across a large number of industries. Left 

unchecked, an increase in the overall price level may 

itself feed back into the labor market through demands 

for higher wages. 

By raising short-term interest rates, the Federal Reserve 

can limit what might otherwise lead to a rapid increase 

in both wages and prices. Higher interest rates will 

reduce sales of capital goods, housing, and consumer 

durables, the demand for which is very sensitive to the 

level of interest rates. One reflection of this sensitivity 

is the changing pattern of loan growth over the business 

cycle. During periods of expansion, the demand for 

loans grows rapidly as businesses and households borrow to finance purchases of capital goods and consumer 

durables. If short-term interest rates are increased in 

response to inflationary pressures, loan growth will 

slow as businesses and consumers reduce their demand 

for loans. If interest rates continue to increase, loan 

growth may decline as it has done before and during 

each recession. The cyclical movement of loan growth 

(with vertical bars indicating periods of recession) is 

shown in Chart 1 (next page). 

Looking more closely at short-term interest rates, Chart 

2 (next page) illustrates the federal funds rate during the 

New York Regional Outlook 7	 Second Quarter 1998 
In Focus This Quarter
 

CHART 1	 expansion began. During the expansion between 1975 

and 1980, for example, the inflation rate was nearly 12 Commercial Bank Loan Growth percent at the start of the expansion but fell to just over during the Business Cycle 6 percent after four quarters. Inflation remained at 

approximately 6 percent until the twelfth quarter of the 

–5 

0 

5 

10 

15 

20 

25 

1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 

Percent Change—Year Ago 

expansion, after which it accelerated to more than 12 

percent by the end of the 20-quarter expansion. 

The current inflation trend differs from previous expansions in two ways. First, by the later stages of previous 

expansions, inflation was accelerating (see Chart 3). In 

contrast, there are few signs of accelerating consumer 

price inflation during the current expansion. In fact, it 

appears that the rate of inflation is declining; the United 

States has experienced disinflation.1 Second, among 

Source: Federal Reserve 

last seven business cycles. While an increase in shortterm interest rates has preceded each recession, it 

should be noted that an increase in rates is not sufficient 

to induce a recession. An increase in rates in 1984 was 

followed by a period of rapid growth that lasted until 

1990. More recently, the increase in rates during 1994 

was accompanied by a slowdown in the economy, but 

not a recession. 

What Is Different about Inflation 

during This Expansion? 

With history as a guide, one would expect inflation to 

rise as the current expansion matures. Chart 3 illustrates 

consumer price inflation during the four longest postwar expansions, including the current one. The chart 

shows the inflation rate at various points after the 

CHART 2 

expansions that have lasted more than 20 quarters, the 

current rate of inflation is one of the lowest since World 

War II. Consumer inflation is both decreasing and low 

by historical standards. 

What Are the Two Views about 

Future Inflation? 

Two views have developed about how the current 

expansion will end. The debate, couched in terms of the 

expected rate of future inflation, is of more than academic concern. The Federal Reserve’s decision about 

1 In popular discussions of inflation rates and the price level, terminology is sometimes used loosely. To clarify, a declining rate of inflation, properly described as disinflation, means that prices are 

increasing at a progressively slower rate over time. Deflation is 

defined as a generally falling price level or, equivalently, a negative 

inflation rate. 

CHART 3 

Federal Funds Rate and Recent 

Recessions 

0 

5 

10 

15 

20 

1955 1959 1963 1967 1971 1975 1979 1983 1987 1991 1995 

Federal Funds Rate (percent) 

Source: Federal Reserve 

Consumer Price Inflation during Four Longest 

Postwar Expansions 

0 

2 

4 

6 

8 

10 

12 

14 

0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 32 34 

Quarters after Start of Expansion 

Percent 

1975–1980 

1982–1990 

1961–1969 

1991–present 

Note: Prices exclude food and energy 

Source: Bureau of Labor Statistics 

New York Regional Outlook 8	 Second Quarter 1998 
In Focus This Quarter
 

whether to change short-term interest rates may be 

influenced by arguments on either side of the debate. 

The Traditional View 

Although inflation has been tame during this expansion, 

adherents of the traditional view believe that impending 

inflation still poses a danger to the longevity of the 

expansion. Evidence cited to support this view includes 

a very low unemployment rate and rising inflationadjusted wages. The reasons for the low inflation rate 

include low energy prices, inexpensive imports, and 

brisk domestic and international competition. These 

factors have delayed the onset of inflationary pressures, 

but they will not remain favorable indefinitely. The 

underlying dynamics have not changed significantly 

from those that led to rising inflation during every other 

recent economic expansion. This is also the view of the 

Federal Reserve Open Market Committee, as stated in 

the minutes of its November 12, 1997, meeting: 

The reasons for the relative quiescence of inflation 

were not fully understood, but they undoubtedly 

included a number of special factors...the risks 

remained in the direction of rising price inflation 

though the extent and timing of that outcome were 

subject to considerable debate. 

—Federal Reserve Bulletin, February 1998, p. 104 

The Deflation View 

Alternatively, some analysts suggest that a recession 

may be brought about by a period of deflation. Advocates of this scenario base their view on the unusually 

low and falling inflation rate in the United States, even 

after seven years of economic expansion. They also suggest that the national economy of the 1990s is markedly different from that of the 1970s and 1980s. Intense 

global competition is now the norm and not the exception. Worker productivity growth is believed to be higher than the official data show, meaning that wage 

growth will not translate as readily as before into price 

increases. The U.S. economy is more prone to a period 

of falling prices than at any time in the recent past, especially in view of decreasing rates of inflation and deflationary forces originating from the ongoing Asian 

financial crisis. 

What Does the Evidence Show? 

Because determining economic policy is necessarily a 

forward-looking process, policymakers look at many 

indicators to determine the likely future course of inflation. A brief review of some of the more popular indicators reveals contradictory readings that can support 

either the inflation or deflation scenario. 

Wage Growth 

The national unemployment rate is currently very low, 

signaling that labor markets are near capacity in terms 

of their ability to create new jobs. The nation’s unemployment rate was below 5 percent for nine months during 1997. This rate has been well below what many 

analysts thought possible without a sharp rise in inflation. As labor market conditions have tightened, wage 

growth has increased. Since 1993 the rate of growth has 

been on a steady upward trend, from a low of just over 

2 percent to about 4 percent in the first quarter of 1998. 

Capacity Utilization 

Capacity utilization, the percentage of industrial capacity that is currently in use, has risen since early 1997. 

Utilization has been around 83 percent since mid-1997, 

a threshold rate that has traditionally signaled impending inflationary pressures at factories, mines, and utilities. 

Commodity Prices 

Many commodities, such as metals, crude oil, and 

unprocessed food products, have exhibited weak prices 

during the past several months. Between mid-1996 and 

early 1998, the Knight-Ridder Commodity Research 

Board Price Index fell by more than 15 percent. Key to 

the decline was a 35 percent decrease in crude oil 

prices. 

Finished Goods Prices 

Since the data show that both labor and physical capital 

are at high rates of utilization, the traditional inflation 

scenario suggests that there will be increasing price 

pressures. In the manufacturing sector, such price pressures would likely show up first in the prices of goods 

as they leave the factory. The price of finished goods 

rose by only 0.4 percent during 1997, however. On a 

monthly basis, prices declined during eight months in 

1997. 

Service Sector Prices 

The service sector accounts for a growing portion of all 

output and employment in the U.S. economy. Labor 

costs generally account for a much higher percentage of 

input costs in the service sector than in the manufacturNew York Regional Outlook 9 Second Quarter 1998 
In Focus This Quarter
 

ing industries. Additionally, many service industries 

operate in local markets and are insulated from national or global competition. Consequently, inflation rates 

in the service sector are generally higher than in the 

goods sector. Service sector inflation has, however, 

been on a downward trend, falling from 5.5 percent in 

1990 to 3.1 percent in 1997. 

Import Prices 

Since early 1996, import prices have fallen precipitously. The decline is due in part to the rising value of the 

dollar, which has reduced the cost of imports. Nonpetroleum import prices have fallen by 5 percent since 

early 1996. Within that group, capital goods prices have 

decreased by 12 percent over the same period. 

One factor that will continue to put downward pressure 

on prices is the turmoil in Asian markets. Asian 

exporters are now much more competitive with the rest 

of the world, following the drop in the value of their currencies. Consequently, U.S. firms that compete with 

Asian producers will be under greater pressure to cut 

prices. At the same time, reduced Asian demand for 

U.S. exports could lead to a ballooning trade deficit and 

a softening of export prices. In January 1998, for example, the United States reported a record-breaking trade 

deficit of $12 billion, caused in part by slower export 

growth. 

From this brief review, it is apparent that signs of 

impending inflation are at best mixed. Clearly, U.S. 

labor markets are at or near full effective capacity, and 

the utilization of factories and physical capital is also 

very high. There is little evidence that these factors are 

causing an increase in prices at either the producer or 

consumer levels. 

How Will the Expansion End? 

Although no one can accurately determine when the 

expansion will end, most analysts are predicting slower 

economic growth in the second half of 1998. Indicators 

such as the unemployment rate suggest that growth will 

be limited by the availability of labor needed to produce 

an increasing supply of goods and services. Weak or 

declining output prices in some sectors could act as a 

further constraint on economic growth. 

Among economists, the traditional view that the expansion will end following a rise in inflation and an 

increase in short-term interest rates appears to be the 

more prevalent view. Nevertheless, the possibility that 

the next economic downturn might be triggered by the 

ripple effects of declining output prices should not be 

dismissed, especially in light of the potentially adverse 

and less familiar risks associated with deflation. What is 

clear for insured institutions is that at this stage of the 

economic expansion, lending and strategic decisions 

predicated on an assumption of continued robust economic growth should be carefully scrutinized and considered in light of a possible deterioration of economic 

conditions. 

Paul C. Bishop, Economist 

Why Might Deflation 


Be a Concern?
 

The most significant difference between the inflation and deflation scenarios is reflected in the 

response of financial markets. One of the consequences of inflation is that a dollar in the future is 

of less value than today’s dollar. In a deflationary 

environment, the opposite is true—a dollar in the 

future will buy more goods and services than a dollar today. 

In a deflation scenario, debtors would see the real 

value of their financial obligations rise and might 

therefore be hesitant to borrow. A fixed monthly 

mortgage payment, for example, would be paid 

back with increasingly valuable dollars over time. 

Asset values could fall, especially since the purchase of an asset, such as a house, would require 

inflation-adjusted debt repayments that increase 

through time. Likewise, consumer credit debt obligations, such as payments on outstanding credit 

card balances, would become increasingly onerous. 

For households already experiencing credit problems, the prospect of a period of sustained deflation 

would worsen their financial position. At the very 

least, deterioration in credit quality would be 

expected, along with an increase in the number of 

business and personal bankruptcies. 

New York Regional Outlook 10 Second Quarter 1998 
In Focus This Quarter
 

Trends Affecting the Allowance for
 

Loan and Lease Losses
 

•	 Allowance for loan and lease loss (ALLL) levels 

are declining relative to total loans. 

•	 Some industry leaders and regulators have 

expressed concern about the loosening of underwriting standards and greater risk in bank loan 

portfolios. 

•	 Significant growth in riskier loan types calls 

attention to the need to scrutinize closely the adequacy of the allowance. 

Weakening underwriting standards and significant 

growth in riskier loan types have increased the risk 

exposures of some insured institutions to an economic 

downturn. Meanwhile, the ALLL relative to total loans 

has declined in recent years. This article provides information on trends in the ALLL over time and by loan 

type and discusses the factors analysts consider when 

evaluating the adequacy of the ALLL. Special attention 

is given to issues related to the volatility of loan losses 

and the composition of the loan portfolio. 

Historical Perspective on the Allowance 

for Loan and Lease Losses 

The nation is currently witnessing one of the longest 

economic expansions since World War II. It is to be 

expected that some institutions will reduce their ALLL 

CHART 1 

coverage during periods of improved economic conditions. However, in the current environment—in which 

loan availability is abundant, growth is strong, and competition is fierce—some industry leaders and regulators 

have expressed concern about the loosening of underwriting standards and greater risk in bank loan portfolios. At the same time, the ALLL relative to total loans 

for commercial banks has declined to the lowest point in 

a decade (see Chart 1). This allowance ratio has diminished because commercial banks’ loan loss provisions 

have not kept pace with new loan growth. In some 

cases, banks have determined that their allowances are 

higher than necessary and have taken negative loan loss 

provisions, which are credited back to income. 

This decline in reserve coverage has been broad based, 

with the exception of credit card specialists. Commercial banks with concentrations in commercial lending 

and large multinational banks have significantly 

reduced the level of reserves to total loans in recent 

years. Table 1 (next page) shows that since 1993, ALLL 

ratios at both commercial lending banks and multinational banks have declined 31 percent. Moreover, commercial lending banks with assets exceeding $10 billion 

have reduced ALLL ratios by slightly over 37 percent, 

or 98 basis points, over the same period. 

The low level of nonperforming and charged-off loans, 

coupled with prevailing favorable economic conditions, 

is doubtless a significant factor in the reduction of 

New York Regional Outlook 11 Second Quarter 1998 

Commercial Bank Reserves at Lowest Point in a Decade 

Source: FDIC Historical Statistics on Banking, National Bureau of Economic Research, Inc. 

1965 1967 1969 1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 

0.0 

0.5 

1.0 

1.5 

2.0 

2.5 

3.0 

% of Loans

Current 

Expansion 

Recessionary 

periods 
In Focus This Quarter
 

TABLE 1 

Commercial Bank Allowance for Loan and Lease Losses to 

Total Loans by Lender Type 

TYPE OF LENDER 

NUMBER OF 

BANKS 

ASSETS 

($BILLIONS) 1997 1996 1995 1994 1993 

MULTINATIONAL 

COMMERCIAL 

CREDIT CARD 

MORTGAGE 

AGRICULTURAL 

11 

3,207 

67 

286 

2,373 

$1,383 

$1,915 

$202 

$120 

$120 

2.14 

1.63 

4.21 

1.26 

1.53 

2.25 

1.71 

3.48 

1.45 

1.66 

2.55 

1.90 

3.21 

1.45 

1.69 

2.83 

2.16 

2.89 

1.69 

1.75 

3.10 

2.37 

3.35 

1.87 

1.83 

Definitions for lender types by order of priority: Multinational—assets >$10 billion and foreign assets >25% of 

assets; Commercial—C&I plus CRE loans >50% of assets; Credit Card—credit card loans >50% of assets; Mortgage— 

1- to 4-family mortgages and mortgage-backed securities >50% of assets; Agricultural—agricultural production and 

agricultural real-estate loans >25% of total loans. 

Source: Bank Call Reports 

ALLL levels. Asset quality indicators such as nonperforming loans and loan loss rates are at historically 

favorable levels. At year-end 1997, the banking industry’s nonperforming loans were just under 1 percent of 

total loans, the lowest in 13 years. The industry’s loan 

charge-off rates (with the exception of consumer loans) 

are also at historical lows. (See the Regional Outlook, 

first quarter 1997, for a detailed discussion of consumer 

loan losses.) However, even with the problems in consumer lending, the banking industry’s aggregate loan 

loss rate is down significantly from levels in the early 

1990s (see Chart 2). 

As the economic expansion reaches an advanced age, 

an important question for insured institutions is 

whether their ALLLs adequately reflect the risks assoCHART 2 

Source: Bank Call Reports 

Asset Quality Indicators Are at Historically 

Favorable Levels 

0.0% 

0.5% 

1.0% 

1.5% 

2.0% 

1985 1987 1989 1991 1993 1995 1997

0.0 

0.5 

1.0 

1.5 

2.0 

2.5 

3.0 

3.5 

4.0 

Charge-off 

Rates 

Nonperforming 

Loan Rates 

% of Total Loans 

ciated with changing industry practices. Insured institutions could experience strains on profitability and capital if allowance levels are inadequate. Given changing 

underwriting trends and loan delinquency patterns, a 

related question is whether reliance on past loss experience in setting the allowance will be an adequate measure for current losses. 

Trends in Underwriting Prompt 

Regulatory Cautions 

Over the past year, various underwriting and lending 

practices surveys by the FDIC, the Office of the Comptroller of the Currency (OCC), and the Federal Reserve 

have noted easing of terms and weakening underwriting 

standards on loans, especially in commercial loan portfolios. It is important to note that, in 1997, nearly twothirds of the commercial banking industry’s loan growth 

was centered in the commercial real estate (CRE) and 

commercial and industrial (C&I) loan categories 

(Chart 3). 

In the FDIC’s Report on Underwriting Practices for 

April 1997 through September 1997, examiners noted 

“above-average” risk in current underwriting practices 

for new loans at almost 10 percent of the 1,233 FDICsupervised institutions examined. Of the institutions 

with above-average risk, 12 percent did not adjust pricing for loan risk. Examiners noted that several of the 

852 institutions examined that were making business 

loans had poor underwriting standards, including lack 

of documentation of the borrower’s financial strength 

New York Regional Outlook 12 Second Quarter 1998 
In Focus This Quarter
 

(21 percent) and poor and unpredictable loan repayment 

sources (14 percent). Also, of the 571 institutions 

specifically involved in asset-based business lending, 

20 percent often failed to monitor collateral. Furthermore, 20 percent of the 398 institutions examined that 

were actively engaged in construction lending repeatedly failed to consider alternative repayment sources, and 

29 percent often funded speculative projects. In contrast, just one year earlier, in the Report on Underwriting Practices for April 1996 through September 1996, 

examiners reported that only 11 percent of the institutions examined that were actively engaged in construction lending often funded speculative projects. 

The Federal Reserve’s Senior Loan Officer Opinion 

Survey for November 1997 and February 1998 both 

indicated some easing of commercial business lending 

terms and standards. Also, the OCC’s 1997 Survey of 

Credit Underwriting Practices stated that the level of 

inherent credit risk continues to increase for components of both commercial and consumer loan portfolios. 

These underwriting trends have resulted in increased 

risk profiles for some insured institutions, while ALLL 

ratios at some institutions continue to decline. 

In August 1997, the OCC issued an Advisory Letter 

voicing its concern about declining allowance levels in 

commercial banks. The OCC cited as primary concerns 

the apparent increases in credit risk reported by examiners, such as weakening underwriting trends in the syndicated loan market, easing of other commercial 

underwriting standards, and consumer lending delinquency and charge-off trends. Moreover, the OCC 

found that some banks were using flawed reserve 

CHART 3 

Loan Growth in 1997 Centered in
 

Commercial Loans
 

% of Total Loan Growth 

–30 

–20 

–10 

0 

10 

20 

30 

40 

50 

60 

70 

80 

Commercial

Consumer

Residential

Mortgages

CRE 

C&I 

Other 

Note: Percent of all loan growth for commercial banks in 1997 

Source: Bank Call Reports 

methodologies for estimating loan loss rates, including 

an overreliance on historical loss rates. 

Factors Affecting Adequacy 

of the ALLL 

In using offsite data to assess allowance adequacy, analysts consider financial ratios such as the allowance to 

total loans, reserve coverage (allowance to nonperforming loans), loan loss provisions to charge-offs, and loan 

delinquency levels. These ratios are evaluated against 

historical benchmarks. At the same time, however, analysts supplement the analysis with consideration of the 

potential effects of current industry trends. For example, the banking industry is currently witnessing higher 

than normal losses in consumer lending spurred by 

increased bankruptcy filings and the migration of loans 

from current to charged off without intervening delinquencies. An institution that has a sizable consumer 

loan portfolio may therefore need to attach more weight 

to recent loan loss data in setting the allowance, since 

historical trends may not adequately reflect reserving 

needs. 

Insured institutions exhibit different management and 

portfolio characteristics that significantly influence the 

level of the allowance. These characteristics include the 

diversification of a loan portfolio (diversification by 

borrower, loan type, geography, or industry), the history and recent trends of credit losses, management’s 

practices in the recognition of losses, trends in past-due 

and nonperforming loans, underwriting practices, and 

economic conditions. 

New techniques continue to be developed to improve 

the reliability of allowance estimates. Management 

information systems, which enable the collection of 

more refined historical data, coupled with the application of statistical techniques, are helping some institutions formulate more statistically reasoned allowance 

estimates. Loan management tools such as credit scoring systems, risk rating systems, and consideration of 

economic cycles in the review of historical loss and 

delinquency data all are aiding bankers in the reserving 

process. While these new techniques provide more analytically defensible estimates, they do not diminish the 

role of judgment in assessing ALLL adequacy. 

The role of judgment in setting the ALLL is underscored by the volatility of loan losses over time. 

New York Regional Outlook 13 Second Quarter 1998 
In Focus This Quarter
 

CHART 4 

Historically, Commercial Loan Loss Rates Have Been Higher and More Volatile 

than Mortgage Loss Rates 

Source: Bank Call Reports 

0.0 

0.2 

0.4 

0.6 

0.8 

1.0 

1.2 

1.4 

1.6 

1991 1992 1993 1994 1995 1996 1997 

Loan Loss Rates (%)

Commercial Real Estate Loans 

Commercial & Industrial Loans 

Residential Mortgages 

“Volatility” in this context refers to the degree to which 

loan losses have diverged or might diverge from the 

long-run averages. Volatility in loan losses can result 

from changes in the business cycle, local economic 

events, and major one-time events. For example, a bank 

relying on a historic average loan loss calculation to 

derive its reserve level could find itself underreserved if 

it does not adjust its historical loss rates for deteriorating economic conditions and suddenly incurs greater 

loan losses than it had anticipated simply on the basis of 

past performance. 

Generally, different types of loans experience varying 

loan loss rates because of the inherently different risks 

and varying levels of volatility within each type. Chart 

4 shows that commercial loans, such as commercial and 

industrial loans and commercial real estate, historically 

have had greater losses than residential loans. Furthermore, the loss rates on commercial loans have not only 

been higher, they have been more volatile over the 

years, while average losses on mortgage loans have varied little. 

Volatility in loan losses is determined not only by economic events but also by banks’ willingness to take risk. 

Banks that adopt more liberal underwriting policies and 

high loan growth objectives may experience greater 

loan default risk and greater volatility in loan loss rates 

than suggested by their own past experience. For example, Chart 4 shows that mortgage lending has had low 

and stable loss rates on average. The recent growth in 

subprime and high loan-to-value mortgage lending, 

however, may result in increased volatility and losses 

for some lenders going forward. 

All of these factors suggest that ALLLs would be 

expected to vary considerably both over time and across 

loan types. Table 2 shows that this has been the case. 

The ALLL is reported as a single line item on the Call 

Report. This makes it difficult to estimate how much of 

the ALLL is attributable to a particular loan type or to 

compare allowance levels for banks with significantly 

different loan portfolios. Table 2 shows the results of a 

statistical regression estimation of commercial bank 

allowance allocations across the various loan types for 

TABLE 2 

ALLL Allocations Have Varied over Time and by Loan Type 

(Commercial Banks under $1 Billion)* 

LOAN TYPE 1997 (%) 1996 (%) 1995 (%) 1994 (%) 1993 (%) 1992 (%) 1991 (%) 

C&I 

CRE 

MORTGAGES 

CREDIT CARDS 

1.71 

1.44 

0.92 

4.47 

1.85 

1.54 

1.00 

4.42 

1.87 

1.77 

1.05 

3.32 

2.06 

1.83 

1.19 

3.11 

2.14 

1.97 

1.22 

3.20 

2.29 

2.02 

1.07 

3.29 

2.45 

1.99 

0.91 

3.59 

* Estimated regression results 

Source: Bank Call Reports 

New York Regional Outlook 14 Second Quarter 1998 
In Focus This Quarter
 

1991 through 1997 for commercial banks with under $1 

billion in assets. Not surprisingly, CRE and C&I loans 

received relatively higher allowance allocations than 

residential mortgage loans, indicating that banks saw 

greater risk in these loan types. Also, credit card loans 

consistently received higher allocations than the other 

loan categories, and the allocations have increased in 

recent years owing to the increased delinquencies and 

charge-offs in this area. 

Conclusions 

The adequacy of the ALLL is measured not only relative to historical loan loss experience but also relative to 

current conditions that may cause losses to differ from 

past experience. Increased losses could result from 

adverse economic developments, from changes in 

banks’ appetite for taking risk, or 

both. In this regard, reported weakening in underwriting standards is 

increasing some banks’ risk exposure to an economic downturn. 

Institutions with high concentrations in riskier loans, significant 

growth in riskier loans, or weaknesses in underwriting may be most at risk. Especially 

for such institutions, the adequacy of the ALLL and its 

methodologies merits close scrutiny. 

Andrea Bazemore, Banking Analyst 

New York Regional Outlook 15 Second Quarter 1998 
Regular Features	 Regional Economy
 

New York Region: Economy Strengthening,
 

but Falling Interest Rates Pose Challenges
 

•	 Strong economic growth, flattening yield curves, and lower mortgage rates are stimulating home purchases 

and a surge of refinancings in the Region. 

•	 Banks in the Region may face tightening margins because of the large volume of refinancings in the 

pipeline. 

•	 Demographic trends in the Region may dampen housing market activity over the long term. 

Economy Remains Strong as Inflation 

and Interest Rates Fall 

The nation continues to experience exceptionally robust 

economic growth. The gross domestic product, the 

broadest measure of economic activity, rose 3.8 percent 

in 1997—the fastest pace of economic expansion since 

the late 1980s. In addition, measures of inflation remain 

extremely low. The consumer price index, for example, 

advanced only 2.3 percent in 1997, the fifth consecutive 

year of less than 3 percent growth. This combination of 

fast economic growth in a low inflationary environment 

has spawned jobs and lowered unemployment across the 

nation and the Region. In some parts of the Region, personnel shortages have become severe as labor markets 

have tightened. Fixed-rate mortgage interest rates have 

fallen to their lowest point since 1993, and the spread 

between fixed and adjustable-rate mortgages has narrowed considerably (see Chart 1). 

In addition, as long-term interest rates have dropped 

faster than short-term rates, the yield curve has flattened considerably (see Chart 2). The difference 

between the ten-year Treasury bill and the six-month 

bill, for example, dropped from 90 basis points in January 1997 to 30 basis points at the end of January 1998. 

A flatter yield curve provides substantial incentive for 

borrowers of adjustable-rate mortgages (ARMs) to refinance into fixed-rate loans, particularly since borrowers 

tend to prefer the certainty of fixed-rate loans. The combination of lower interest rates and a flattening yield 

curve has produced a wave of mortgage refinancings 

(see Current Regional Banking Issues). 

Large Numbers of Mortgage Refinancings 

Are in the Pipeline 

In 1993, mortgage interest rates were slightly lower than 

they are today. A February 1998 report by Merrill 

Lynch found that 75 percent of existing mortgages were 

refinanced between 1992 and 1993, when mortgage 

rates declined. In recent months, declining mortgage 

rates again have stimulated a surge in demand for mortCHART 1	 CHART 2 

Source: Federal Home Loan Bank. 1998 represents first quarter only. 

The Spread between Fixed and Adjustable-Rate 

Mortgages Has Narrowed 

5 

6 

7 

8 

9 

10 

’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 

Interest Rate (%) 

Fixed 

Adjustable 

Source: Bloomberg 

3 

4 

5 

6 

7 

8 

October 1993 

December 1992 

January 1998 

3 Month 1 Year 

Percent 

20 Year 30 Year 

A Flatter Yield Curve Reduces Demand for ARMs 

New York Regional Outlook 16	 Second Quarter 1998 
Regular Features Regional Economy
 

gage refinancings. The Mortgage Bankers Association’s (MBA) market index, which measures mortgage 

loan applications, recently jumped to between 600 and 

700, up from around 200 one year ago. A separate MBA 

refinancing index that tracks refinancings moved from 

about 700 in October 1997 to over 3000, an increase of 

over 400 percent, before falling back in late January 

1998 (see Chart 3). 

In January 1998, both indices were higher than their 

1993 peaks, and the percentage change in these indices 

from their December levels suggested a tripling of refinancing rates in early 1998. Such growth would imply 

prepayment speeds far in excess of those experienced in 

1993. Back then, some mortgages could not be refinanced because depressed housing prices in the early 

1990s meant that many homeowners lacked sufficient 

equity in their property to refinance. With home prices 

rising, many owners now have greater equity, enabling 

easier refinancing. A large number of prepayments 

could significantly compress bank margins and squeeze 

profitability (see Current Regional Banking Issues). 

The magnitude of increases in prepayment volume may, 

however, be somewhat less than suggested by the MBA 

refinancing index. Solomon, Smith Barney uses a title 

search index, developed by Dow Jones, to forecast prepayments. This index paints a somewhat more muted 

picture of the number of refinancings. The title search 

index avoids two of the major problems of the MBA 

refinancing index, which Solomon believes contains an 

upward bias. First, multiple title searches on the same 

property are screened out. Mortgage brokers indicate 

that it is fairly common for people to file multiple applications during periods of heightened refinance activity 

CHART 3 

Source: Mortgage Bankers Association 

Mortgage Refinancings Surge 

0 

500 

1000 

1500 

2000 

2500 

3000 

3500 

3 Oct 97

17 Oct 9731 Oct 97

14 Nov 9728 Nov 97

12 Dec 9724 Dec 97

9 Jan 98

23 Jan 98

6 Feb 98

20 Feb 98 

Index Value 

in order to obtain the best deal. Second, title searches 

for mortgage applications of new homes are excluded. 

Solomon, Smith Barney believes that the title search 

index is a more reliable indicator of prepayment levels. 

Even so, the title search index indicates that a surge in 

refinancings is well on the way, although perhaps not to 

the extent seen in 1992 to 1993. Merrill Lynch also 

believes that there will be fewer refinancings than suggested by the MBA index. Merrill Lynch indicates that 

the pace of refinancings cannot be sustained at the 1993 

level. In 1993, refinancings were high because mortgage rates had been so much higher prior to that year. 

During the past several years, mortgage rates have been 

lower. 

A January 1998 report by PaineWebber notes that the 

economy between 1992 and 1993 was different than it is 

today and refinancings may not reach the share of new 

loan originations they hit in 1992 to 1993. Presently, 

new home sales and housing starts in the nation remain 

relatively strong. The current refinancing boom follows 

six years of economic expansion in which the housing 

industry has been stronger than expected. The trend 

continued into 1998. According to the National Association of Realtors (NAR), sales of existing homes 

surged 8.7 percent in February 1998 over January, the 

highest rate compiled in 30 years of record-keeping by 

the NAR. By contrast, in 1992 to 1993, the refinancing 

surge followed a recession. Unit sales between 1991 and 

1993 averaged only about 3.5 million units. Because of 

the high volume of sales, the 1997 to 1998 wave of refinancings may be a lower percentage of total mortgage 

originations than it was in the earlier period. 

Lower Interest Rates Stimulate the Region’s 

Real Estate Markets 

Even though the flatter yield curve may put pressure on 

margins, the Region’s banks could benefit from the low 

interest rates. Lower interest rates historically have been 

associated with stronger economic activity. In the present strong-economic low-inflation environment, lower 

interest rates already have been stimulating the residential real estate market. For example, using mortgage 

recording and real property transfer tax collections to 

reflect originations and property transactions, there has 

been a huge surge in the volume of mortgages and property transfers in New York City (see Chart 4, next 

page). Projections by the city’s Office of Management 

and Budget for the rest of 1998 forecast continued 

strong growth. In addition, existing home sales for 

New York Regional Outlook 17 Second Quarter 1998 
Regular Features Regional Economy
 

CHART 4 CHART 5 

Source: NYC Office of Management and Budget. 1998 figures are projections. 

New York City Sees Record Mortgage and 

Transfer Tax Collections 

100 

150 

200 

250 

300 

’92 ’93 ’94 ’95 ’96 ’97 ’98 

$Millions Real Property 

Mortgage Transfer Tax 

Recording Tax 

Source: U.S. Census Bureau 

The 25- to 34-Year-Old Cohort 

Is Declining Sharply 

90 

95 

100 

105 

110 

115 

120 

’80 ’82 ’84 ’86 ’88 ’90 ’92 ’94 ’96 

Nation 

Region 

Index Value 

single-family homes, condos, and co-ops were up 

between 4 and 6 percent in New York and Pennsylvania between the fourth quarter of 1996 and the fourth 

quarter of 1997. In Maryland, existing home sales were 

up almost 19 percent. Reports from New Jersey and 

Delaware also indicate strong growth in home sales. 

Moreover, home prices are also rising: Data compiled 

by the Office of Federal Housing Enterprise Oversight 

show that prices are now at all-time highs in the Region. 

Not only are more mortgages being originated, but 

lower interest rates are contributing to a stronger economy in the Region. The result is more jobs and higher 

incomes, and financial institutions are helped by these 

improved economic conditions. Refinancings may provide consumers with extra cash to purchase automobiles, make home improvements, and take vacations. 

Other consumers may see refinancing as a way to 

restructure or consolidate other forms of debt, such as 

credit cards and home equity lines of credit. 

Regional Demographics Are Less Favorable 

for Future Housing Activity 

Despite the lower mortgage rates and the more favorable economy, the housing market may remain constrained over the next few years because of fundamental 

demographic trends in the nation and the Region. 

According to the U.S. Census, the age cohort of 25 to 34 

represents the bracket in which household formation 

usually begins. However, the number of 25- to 34-yearolds is declining nationwide; it is falling even more 

quickly in the Region (see Chart 5). The situation is 

most noticeable in New York and Pennsylvania, where 

rates of new household formation have been less than 

half the national rate (see Chart 6). 

Housing indicators may be reflecting this demographic 

trend. Compared to a surge in new permits elsewhere in 

the nation, new permits for multifamily homes in the 

Region have risen only modestly, and permits for 

single-family homes have stayed flat for several years. 

The somewhat higher permit activity for the two- to 

five-unit homes reflects construction of multifamily 

homes, which have become more popular in the Region 

as the cost of new construction has soared. Only New 

Jersey has seen a rise in development of new singlefamily homes. Nevertheless, growth in both permit categories remains well below their late 1980s levels. 

CHART 6 

Source: U.S. Census Bureau 

Household Formation in the Region 

Is Relatively Low 

0 

0.5 

1.0 

1.5 

2.0 

2.5 

Delaware 

Maryland 

New Jersey 

New York 

Pennsylvania 

United States 

Year-over-Year Change in Number of Households (%) 

1995 1996 

New York Regional Outlook 18 Second Quarter 1998 
Regular Features Regional Economy
 

Implications: Over the long run, these demographic 

trends may reduce future demand not only in the starter 

home market, but also in the housing market as a whole. 

Reduced household formation may limit the ability of 

older households to sell their current homes and trade 

up. Banks may find a slow-growing pool of potential 

young homeowners in the Region, which could limit 

future originations. 

Norman Gertner, Regional Economist 

For More Information 

Bond Market Roundup: Strategy. Solomon, Smith 

Barney, January 23 and January 30, 1998. 

Disinflation: What It Means for Mortgage Companies. PaineWebber, January 26, 1998. 

Economic and Financial Update Report. Merrill 

Lynch, February 1998. 

New York Regional Outlook 19 Second Quarter 1998 
Regular Features	 Regional Banking
 

Current Regional Banking Issues
 

• The New York Region’s financial institutions remain healthy despite credit card weakness. Money center 

banks’ earnings are affected by the Southeast Asian economic crisis. 

•	 Financial institutions are facing a wave of refinancing activity as interest rates remain low, the yield curve 

flattens, and competition intensifies. 

•	 Small financial institutions and savings institutions have the heaviest dependence on residential real estate 

mortgages and may therefore face the most interest rate risk. 

• Financial institutions face a variety of potential risks associated with the current interest rate environment, 

including thinning margins, reinvestment risk, and pressure on underwriting standards. 

Solid Performance Reported in 1997 Despite 

Weakness in Credit Cards and Asian Crisis 

The Region’s banks and thrifts reported healthy financial conditions in 1997 (see Table 1). Insured institutions 

in the New York Region reported an average return on 

assets (ROA) near its all-time high despite a continued 

decline in net interest margins (NIM), primarily because 

of lower noninterest expenses. The Region’s average 

leverage capital ratio fell slightly from 1996 levels but 

continues to be strong. Overall past-due ratios continue 

to decline, reflecting improvement in commercial real 

estate loan portfolios. Credit card loan portfolios are 

still showing signs of weakness, however. Nonperforming credit card loans as a percentage of credit card loans 

are about the same as in 1996, but charge-offs rose quite 

significantly in 1997. Further, although credit card 

charge-offs fell in January 1998, delinquencies remain 

high. This situation evidences a prolonged weakness in 

TABLE 1 

the sector and may portend further high levels of chargeoffs later in the year, since delinquencies have been a 

leading indicator of charge-offs. 

New York’s money center banks reported that earnings 

were hurt by the Southeast Asian economic crisis in the 

fourth quarter of 1997, primarily because of trading 

losses and increased loan loss provisions. Nonetheless, 

most of them reported increases in net income for the 

fourth quarter of 1997 over the same quarter in 1996. 

Industry analysts indicate that a slowdown in underwriting and advisory business in Southeast Asia could 

translate into dampened earnings throughout 1998, 

especially for multinational players with substantial feegenerating businesses in that region. Analysts also contend, however, that these banks, having learned their 

lesson from the Latin American debt crisis of the 1980s, 

have comparatively little credit exposure to Southeast 

Asian countries. 

New York Region Institutions Continue to Show Strength 

FINANCIAL INDICATORS 12/31/97 12/31/96 12/31/95 

RETURN ON ASSETS 1.09 1.04 .99 

NET INTEREST MARGIN 3.52 3.66 3.80 

RETURN ON EQUITY 14.45 13.66 13.09 

TIER 1 LEVERAGE 7.09 7.14 7.30 

NONPERFORMING ASSETS/TOTAL ASSETS 0.82 0.92 1.12 

PAST-DUE LOANS (%) 2.60 2.69 3.02 

NONPERFORMING CREDIT CARD LOANS (%) 5.07 5.08 4.51 

CREDIT CARD CHARGE-OFFS (%) 5.95 4.82 4.13 

Source: Bank and Thrift Call Reports 

New York Regional Outlook 20	 Second Quarter 1998 
Regular Features Regional Banking
 

Mortgage Refinancing Activity Heats Up TABLE 2

The current interest rate environment is very favorable 

to consumers looking to refinance mortgages. Many 

financial institutions are lowering refinancing costs in 

order to keep customers or attract new business, making 

it more economical to refinance. Financial institutions 

in general are more willing to waive fees for applications, appraisals, and legal services or to roll these 

fees into the new mortgage (“zero-cost” mortgages). 

Technological advances have eased the application 

process and boosted lending efficiency by shortening 

the amount of time required to make a loan. 

As a result, various sources estimate that in February 

1998, between 55 and 65 percent of mortgage applications were for refinancings, almost double the percentage of a year earlier. There are reports of consumers 

refinancing to save as little as 1/2 percent or refinancing several times in the past year. Consumers are refinancing to lower payments, lock in low rates, and 

increasingly, to consolidate nonmortgage debt. Adjustable rate mortgage (ARM) borrowers are particularly 

active. The Federal Home Loan Mortgage Corporation 

(Freddie Mac) estimates that 90 percent of conventional ARM borrowers can refinance into a fixed-rate mortgage at a net savings. Earnings at many of the Region’s 

insured institutions may be pressured if this environment persists. From a long-term perspective, bankers 

may face the challenge of operating on thinner margins 

while incurring more interest rate risk, particularly if 

the yield curve remains relatively flat for an extended 

period. 

Institutions with Higher Concentrations in 

Mortgage Loans May Be More Affected 

Residential real estate lending is one of the primary 

business lines of most of the Region’s insured institutions, particularly smaller institutions, as well as savings 

banks and thrift institutions. As of December 31, 1997, 

for institutions with under $1 billion in total assets, residential real estate loans comprise more than 52 percent 

of total loans, compared to just 30 percent for institutions with more than $10 billion in assets. The concentration is even higher among banks with total assets 

under $100 million (see Table 2). 

Savings banks and thrifts, by nature consumer oriented, 

have significant concentrations in residential real estate 

loans (see Table 3). Almost 83 percent of thrifts’ loan 

Residential Real Estate Loans Are 

Predominant in Smaller Institutions 

RESIDENTIAL 

REAL ESTATE LOANS 

AS PERCENTAGE OF 

TOTAL ASSETS TOTAL LOANS* 

OVER $10 BILLION 30.1 

$1–$10 BILLION 40.8 

$100 MILLION TO
 

$1 BILLION
 52.3 

UNDER $100 MILLION 61.7 

* As of 12/31/97
 

Source: Bank and Thrift Call Reports
 

portfolios are residential real estate loans. Put another 

way, the Region has 197 (out of 949) financial institutions with 50 percent or more of total assets in residential real estate loans. Of the 197, all but 15 are savings 

banks or savings and loan associations. Further, 

although these institutions comprise about 20 percent of 

all institutions in the Region, they hold only 5 percent of 

the assets in the Region, reflecting their generally smaller size. 

Institutions with a concentration of ARMs are particularly vulnerable in a low-interest-rate, flattened-yieldcurve environment. According to Freddie Mac, ARMs 

make up approximately 30 to 40 percent of all residential mortgages for commercial banks. However, thrift 

portfolios traditionally are dominated by ARMs. Thrifts 

therefore may be more susceptible to the risks associatTABLE 3 

Savings Institutions Have Most 

Residential Real Estate Loans 

RESIDENTIAL 

REAL ESTATE LOANS 

AS PERCENTAGE OF 

TYPE OF INSTITUTION TOTAL LOANS* 

SAVINGS AND LOANS 83.0 

MUTUAL INSTITUTIONS 78.0 

SAVINGS BANKS 72.5 

NATIONAL BANKS 41.4 

STATE MEMBER BANKS 35.8 

STATE NONMEMBER 

BANKS 34.5 

* As of 12/31/97 

Source: Bank and Thrift Call Reports 

New York Regional Outlook 21 Second Quarter 1998 
Regular Features Regional Banking
 

ed with such an environment, which are discussed 

below. 

The Flat Yield Curve Is Spurring a Shift into 

Long-Term, Fixed-Rate Mortgages... 

In March 1998, Freddie Mac’s Primary Mortgage Market Survey indicated that the average interest rate for 

30-year fixed-rate mortgages declined to 7.08 percent, 

compared to 7.94 percent one year earlier. In contrast, 

the average rate of ARMs fell very slightly to 5.67 percent, compared to 5.71 percent one year earlier, evidencing the narrowing spreads between short- and 

long-term rates (see Regional Economy). With shortterm rates high relative to long-term rates, holders of 

ARMs have a strong incentive to refinance into fixedrate instruments. As of March 1998, a fully indexed 

ARM was likely to have a coupon rate in excess of fixed 

rates. Additionally, there is very little difference 

between current rates for long-term, fixed-rate mortgages and those on five- and seven-year balloon mortgages, making the latter less attractive to borrowers. 

Further, new mortgage originations are more likely to 

be fixed-rate loans, as new homeowners have a natural 

inclination to lock in low rates. 

During the earlier refinancing waves between 1991 and 

1993, the short-term end of the yield curve was relatively low, so that ARMs and balloon mortgages still 

had rates that were attractive to consumers. ARM teaser rates approximating 3 percent were common at a time 

when long-term rates were above 6 percent, creating a 

wide spread. Inside Mortgage Finance recently published data made available by Freddie Mac indicating 

that during the earlier refinancing waves, approximately 15 percent of fixed-rate loans actually were refinanced into ARMs or balloons. For ARMs, 30 to 40 

percent of refinancings went back into the shorter duration mortgages, and for balloon mortgages, over 70 percent did so. These refinancings provided an ample 

supply of shorter duration mortgages for insured institutions seeking to replace runoff and expand their loan 

portfolios. Today’s flatter yield curve will not provide 

the same opportunities. Data from Freddie Mac for the 

fourth quarter of 1997 show that 87 percent of ARMs 

being refinanced today switch to 15- or 30-year fixedrate mortgages. Also, through November 1997, only 18 

percent of new mortgages carried adjustable-rate features, down from 33 percent a year earlier. 

...Which Exposes Financial Institutions to 

Interest Rate Risk and Thinning Margins 

The implication of these trends is that financial institutions will have more low-yielding, fixed-rate residential 

mortgages on their books, potentially squeezing future 

margins and increasing interest rate risk. There is evidence that other asset yields may decline as well, especially if current conditions persist. For example, as 

commercial real estate markets improve throughout the 

Region, commercial borrowers are also seeking to refinance existing debt. Banks’ and thrifts’ funding structures are primarily short term, in the form of deposits, 

which usually means that funding costs are well below 

yields earned on longer term assets. The flatter yield 

curve means that these funding costs are not declining 

in line with earning asset 

yields, which puts downward 

pressure on net interest margins. With earnings at historically high levels, narrowing 

margins alone do not warrant 

great concern. However, with a 

high proportion of low-yielding, fixed-rate assets on their 

balance sheets, financial institutions may be more vulnerable to interest rate fluctuations. At the very least, 

institutions will have to look hard at their hedging 

strategies to ensure flexibility in their asset and liability 

management. 

Other Risks Lurk as Well 

There are other risks associated with the current refinancing boom. Mortgage-backed securities (MBS), 

which lose value as prepayments rise because of lost 

income potential, have become very volatile. Financial 

institutions investing in MBS could face valuation 

writedowns and reinvestment dilemmas. As of December 31, 1997, MBS comprised 11 percent of the total 

assets of the Region’s financial institutions. Additionally, in the past few years, insured institutions have shifted non-MBS portions of investment portfolios from 

U.S. Treasury securities toward U.S. agency debt 

(another 10 percent of total assets). A large portion of 

this debt, particularly that issued in the past three years, 

is callable, which creates reinvestment risk. In addition, 

institutions holding mortgage servicing rights may see 

declines in noninterest income or writedowns of mortgage servicing assets because of accelerated prepayments in those mortgage portfolios. 

New York Regional Outlook 22 Second Quarter 1998 
Regular Features Regional Banking
 

Intense competition raises concerns that institutions 

may compromise underwriting standards in an effort to 

retain customers or book new business. Banks and other 

financial services companies are aggressively marketing refinancing opportunities and low-cost loans. Such 

competition and demand for loans has already resulted 

in declining spreads relative to U.S. Treasury securities. 

Alan Greenspan, Federal Reserve Board chairman, was 

recently quoted in the American Banker as saying to 

Congress, “We must be concerned about becoming too 

complacent about evaluating repayment risk. Bad loans 

are made when you experience low yield spreads.” He 

further stated that spreads are historically thin because 

“banks are accepting only ‘modest’ compensation for 

the risks they are incurring.” With margins already considered “razor thin,” the easing of other terms and conditions that could affect overall credit quality may be on 

the rise and warrants close scrutiny. 

Will the Refinancing Wave Last? 

There is much debate as to how long this refinancing 

wave will last and how big it will be. The flatter yield 

curve and the intense competition among financial 

institutions make refinancing viable for more consumers than during the last refinancing wave in 1993. 

Also, since home prices in the Region have been on the 

rise over the past several years, consumers have additional home equity that they may tap to consolidate 

higher interest rate debt such as credit cards and floating-rate home equity lines of credit. If short-term rates 

decline, returning the spread between short- and longterm rates closer to its historical average, further refinancings could result as ARMs become more attractive 

again. Conversely, if rates rise, the primary incentive to 

refinance would disappear. Also, the refinancing waves 

in 1991 through 1993 followed an 11-year period when 

30-year fixed-rate mortgages averaged in excess of 10 

percent. According to Bloomberg, as of December 31, 

1997, only 11 percent of all securitized Fannie Mae/ 

Freddie Mac 30-year mortgage pools bore coupons in 

excess of 8 percent. With the rate differential between 

outstanding mortgages and current rates much narrower than in the early 1990s, prepayment activity may lose 

steam fairly quickly. 

Karen A. Wigder, Financial Analyst 

For More Information 

“Cut Your Mortgage Down to Size.” Money Magazine, March 1998. 

Disinflation: What It Means for Mortgage Companies. PaineWebber, January 26, 1998. 

“More Refi Borrowers Opting for 30-Year Mortgages.” Inside Mortgage Finance, January 9, 1998. 

Primary Mortgage Market Survey. Federal Home 

Loan Mortgage Corporation, March 1998. 

New York Regional Outlook 23 Second Quarter 1998 
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