Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION THIRD QUARTER 1997 

FDIC
 

Kansas City
 

Region
 

Division of
 

Insurance
 

Craig A. Rice,
 

Senior Regional
 

Analyst
 

Jeffrey W. Walser,
 

Regional Economist
 

John M. Anderlik,
 

Financial Analyst
 

In Focus This Quarter 

◆ Subprime Lending: A Time for Caution—The extent of subprime lending is increasing as strong competition for high-quality borrowers has 

some lenders moving down the credit quality spectrum. Subprime lending requires 

a commitment of resources and expertise beyond that required in more conservative lending, and the consequences of deficiencies in underwriting, servicing, and 

collection can be severe. See page 3. 

By Kathy R. Kalser, Debra L. Novak 

◆ Retail Shakeout: Causes and Implications for Lenders— 

Despite favorable economic conditions, the retail industry is experiencing slow revenue growth in a highly competitive environment. The confluence of rapid change 

in store formats and slow revenue growth has led to an ongoing shakeout among 

both large and small retail chains, and this shakeout may adversely affect credit 

quality at some insured institutions. See page 6. 

By Richard A. Brown, Diane Ellis 

Regular Features 

◆ Regional Economy—Flooding in the Red River Valley affected a significant portion of North Dakota’s economy . . . the aircraft industry is driving a 

boom in Wichita . . . cattle ranching is poised for improved profitability in 1997 . . . 

small independent hog farmers face stiff competition from larger operations. 

See page 11. 

By Craig A. Rice, Jeffrey W. Walser 

◆ Financial Markets—Securitization of home equity loans is growing 

rapidly . . . consumer debt consolidation loans may be driving this growth . . . signs 

of relaxed underwriting have appeared . . . the arrival of FASITs could increase the 

appetite of community banks to enter the ABS market. See page 16. 

By Allen Puwalski 

◆ Regional Banking—Banks in the Red River Valley may experience 

some credit quality problems . . . the Region’s banks turn to alternatives to core 

deposits to fund loan growth . . . the year 2000 problem cannot be ignored. 

See page 20. 

By John M. Anderlik, Craig A. Rice 

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 Kansas City Region’s Regional 

Outlook, please call Craig Rice at (816) 234-8034 or send an e-mail to crice@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 Paul C. Bishop 

Richard A. Brown 

Steven K. Burton 

Diane Ellis 

Kathy R. Kalser 

Ronald L. Spieker 

Publications Manager Teresa J. Franks 
In Focus This Quarter
 

Subprime Lending: A Time for Caution
 

•	 Subprime lenders specialize in lending to borrowers with blemished or limited credit histories. 

•	 The consequences of deficiencies in underwriting, 

servicing, and collection can be severe with subprime lending. Lenders that fail to dedicate the 

necessary resources in these areas likely will have 

trouble succeeding in the increasingly competitive 

market for subprime loans. 

•	 Some institutions insured by the FDIC have failed 

to properly assess and control the risks associated 

with their subprime lending programs. 

What Are Subprime Loans? 

Faced with strong competition and shrinking margins 

on loans to high-quality borrowers, some lenders are 

moving down the credit quality spectrum. The strategy 

to extend loans to borrowers perceived as less creditworthy is referred to as “subprime” lending. Subprime 

lending is most commonly associated with auto, home 

equity, mortgage, and secured credit card loans to borrowers who have blemished or limited credit histories. 

Generally, the characteristics of a subprime borrower 

include a history of paying debts late, personal bankruptcy filings, or an insufficient credit record. 

Subprime loans also are referred to as marginal, nonprime, or below “A” quality loans. There are no established guidelines for determining the degree to which a 

borrower is considered subprime, so one lender’s “B” 

customer could be another lender’s “C” customer. 

Definitional variations aside, some general market 

parameters on ranking loans are presented in Table 1. 

TABLE 1 

Criteria for Loan Rankings 

GRADE PAYMENTS LATE BANKRUPTCY 

30 DAYS FILING
 

PRIME
 NONE NONE
 

A­ LESS THAN 2 NONE IN 5 YEARS 

B LESS THAN 4 NONE IN 3 YEARS 

LESS THAN 6 NONE IN 2 YEARS 

D CONSTANTLY LATE NONE IN 1 YEAR 

Sources: Duff & Phelps, Standard & Poor’s, Mortgage 

Market Information Services 

How Big Is the Market? 

The lack of a standard definition for a subprime loan 

makes it difficult to accurately determine the extent of 

the market. However, some industry experts estimated 

that during 1996, subprime loans secured by residences, 

including both home equity and mortgage loans, 

amounted to between $100 billion and $150 billion compared to the estimated $800 billion in originations of 

conventional mortgages. Subprime auto loans have been 

estimated to range between $75 billion and $100 billion, 

or about 20 percent of total auto loans outstanding. 

Who Makes Subprime Loans? 

In the past, subprime lending was primarily the domain 

of a limited number of finance companies. These firms 

specialized in making high-priced loans to borrowers 

with limited access to credit. 

The number of subprime lenders, however, has surged 

in recent years as more companies have been attracted 

by the significantly higher rates and fees earned on subprime loans. In some cases, yields on these higher risk 

assets have been as high as 15 percent to 30 percent. 

The new subprime participants include finance companies that traditionally served prime borrowers, new specialized subprime lenders, and banks. 

The increase in the number of subprime lenders has 

been fueled by strong demand from investors for assetbacked securities (ABS). This method of funding 

enables the lender to effectively raise cash at a lower 

rate to fund loan growth. In addition, the subprime ABS 

market has attracted lenders that previously refrained 

from making subprime loans because they did not want 

to maintain these high-risk loans or the associated 

reserves on their balance sheet. By issuing securities 

backed by subprime loans, lenders now have the ability 

to originate subprime loans and sell them to ABS 

investors. 

Favorable stock market conditions also helped to fund 

the growth of subprime lenders. Approximately 30 subprime lenders raised nearly $3 billion from stock offerings from January 1995 through April 1997, according 

to market watchers. This financing avenue may become 

less accessible, as investors’ concerns over financial 

Regional Outlook	 3 Third Quarter 1997 

C 
In Focus This Quarter
 

problems of several major market participants have 

caused stock prices of subprime lenders to decline significantly during the first part of 1997. 

Financial Difficulties of Some Subprime 

Lenders 

Market participants have observed that, as in credit card 

lending, increasing competition may be compelling some 

subprime lenders to compromise underwriting standards 

and lower pricing in order 

to protect market share. Financial 

difficulties reported by major subprime auto lenders Jayhawk 

Acceptance Corporation and 

Mercury Finance Company highlight these concerns. 

Problems in subprime lending are not limited to auto 

loans. Lenders that specialize in subprime home equity 

loans and mortgages also are showing signs of stress. In 

April 1997, Moody’s Investors Service lowered the rating on subordinated debt issued by a leading originator 

of subprime mortgage and home equity loans. The reason was concern over the increasing level of delinquencies in the issuer’s loan portfolio and the highly 

competitive environment for subprime home equity 

loans (see Financial Markets). 

Differences between Prime and Subprime 

Lending 

There are key differences between the underwriting, servicing, and collection methods used for prime and subprime lending programs. The goal of the subprime 

underwriting process is to differentiate those subprime 

borrowers whose past credit problems were due to such 

temporary events as illness or job loss from the habitually bad credits. Subprime lenders often supplement a 

prospective borrower’s credit bureau report with such 

additional information as income, employment history, 

and the nature of prior credit problems. This process 

allows the lender to better determine the credit risk or 

“grade” of the borrower. If this determination is successful, the lender can better establish the price at which 

the loan will be profitable. 

Servicing and collection of subprime loans tends to be 

more labor intensive and costly than in prime lending. 

Subprime lenders tend to monitor payments more closely than prime lenders. Some purportedly call their borrowers regularly to remind them when a payment is due. 

In addition, while prime lenders may be willing to work 

with late borrowers by adjusting minimum amounts or 

payment schedules, subprime lenders generally pursue 

collections more aggressively and repossess collateral 

more quickly. 

Insured Institutions and the Subprime Market 

Bank involvement in subprime lending is difficult to 

quantify because subprime loans are not delineated in 

bank and thrift Call Reports. However, both large and 

small banks reportedly are participating in credit card, 

auto, home equity, and mortgage subprime lending. 

Insured institutions have used various strategies to 

establish a presence in the subprime market. Some 

have: 

•	 acquired or formed joint ventures with companies 

specializing in subprime lending; 

•	 built subprime lending programs internally, using 

existing resources; and 

•	 tapped a network of loan brokers with access to subprime borrowers. Smaller banks entering the market 

for subprime mortgages may use this method more 

commonly. 

Through these strategies, insured institutions have: 

•	 extended loans directly to subprime borrowers or 

purchased subprime loans from loan brokers; 

•	 lent to subprime specialty lenders in the form of loan 

participations, warehouse lines, liquidity facilities, 

or dealer lines; and 

•	 serviced subprime loans or invested in asset-backed 

securities secured by subprime loans. 

Risks Associated with Subprime Lending Need 

to Be Considered Carefully 

According to a Financial Institutions Letter (FIL), FIL 

44-97 issued by the FDIC’s Division of Supervision, 

recent examinations revealed that a number of financial 

institutions involved in subprime lending have failed to 

properly assess and control the risks associated with 

subprime lending. Because of the relatively high default 

rates on such loans, the FIL indicates that this type of 

lending warrants particular caution and management 

attention. 

Regional Outlook	 4 Third Quarter 1997 
In Focus This Quarter
 

Institutions need to be thoroughly aware of the 

increased risks and costs associated with lending to 

higher risk borrowers. Some of these risks include: 

•	 Delinquencies and defaults tend to be more frequent 

and occur sooner on lower quality loans (see Chart 1). 

•	 Loan loss reserves that would have been adequate for 

prime lending may not properly cover higher loss 

rates associated with subprime loans. 

•	 Strains on underwriting and collection resources 

may emerge. 

•	 Because selling collateral is more frequently the 

source of repayment on subprime loans, failure to 

accurately estimate recovery values could severely 

affect the profitability of subprime lenders. For 

example, several subprime auto lenders recently 

reported lower profits when the supply of better 

quality cars coming off leases depressed the prices 

they received on repossessed cars. 

Insured institutions that rapidly increase subprime 

exposures also may need to reevaluate delinquency 

measurement methodologies. Rapid loan growth can 

make it more difficult to accurately track delinquency 

and default trends. Generally loans do not default 

immediately, but “season” or reach peak loss rates over 

a period of time. Delinquency and default rates can be 

CHART 1 

0% 

10% 

20% 

30% 

40% 

50% 

1 4 7 10 13 16 19 22 25 28 31 34 

Months since Origination 

"C" Auto Loans 

"A/B" Auto Loans 

"D" Auto Loans 

Source: Fitch Investors Service, L.P. 

Default Rate 

Defaults Are More Frequent and Occur 

Sooner on Lower Quality Auto Loans 

deceptively low if the proportion of new loans exceeds 

the proportion of seasoned loans in a lender’s portfolio. 

Calculating default rates over time for loans originated 

in a particular period or lending program, instead of as 

a percentage of total outstanding loan balances, helps 

reduce the distortion caused by rapid loan growth. This 

method of computing delinquency and default rates, 

known as “static pool” or “vintage analysis,” is a common measurement tool among investment analysts. 

Banks involved in subprime lending also should realize 

that the recent increase in subprime lending has 

occurred during relatively healthy economic conditions. 

The repayment capacity of subprime borrowers may be 

more susceptible to downturns in the economy, which 

could further exacerbate the already high level of delinquencies and defaults typically recorded on subprime 

loans. 

In addition, banks that lend to subprime specialty 

lenders, who rely heavily on securitization, should evaluate the accounting treatment of securitization and the 

effect securitization may have on earnings (see 

Financial Markets). 

Conclusion 

The extent of involvement by insured institutions in 

subprime lending is difficult to quantify. To be successful in subprime lending requires a commitment of 

resources and expertise. Conversely, deficiencies in 

assessing and controlling the risks of subprime lending 

can have serious consequences. Such deficiencies have 

surfaced at a number of FDIC-insured institutions. 

Striking an appropriate balance between the risks and 

rewards of subprime lending is a challenge for bankers 

and merits the continued attention of bank supervisors. 

Kathy R. Kalser, Chief 

Financial Sector Analysis Section 

Debra L. Novak, 

Division of Resolutions and Receiverships 

Regional Outlook	 5 Third Quarter 1997 
In Focus This Quarter
 

Retail Shakeout: Causes and Implications for Lenders
 

•	 Changes in the marketplace, technology, and 

finance are transforming retailing. 

•	 These trends have given rise to rapid growth in 

the new “big box” store format. 

•	 Consolidation in retailing is evident in mergers, 

acquisitions, and bankruptcies. 

•	 The potential for overbuilding in retail real estate 

markets may pose a risk for insured depository 

institutions. 

For the past two decades, construction of retail space 

has outstripped many indicators of demand such as 

growth in retail sales, population, and income. The 

broadest measure of the industry’s health is sales per 

square foot, and, for shopping centers, it has fallen by 

around 35 percent in real terms since 1972. Chart 1 

shows how growth in leasable shopping center space 

has exceeded growth in shopping centers’ sales since 

1972. 

Based on signs of “overstoring,” a number of retail 

industry analysts have concluded that too many stores 

are chasing too few consumer dollars, indicating an 

emerging shakeout in the retail sector. To the extent that 

insured depository institutions provide financing to 

retailers or for retail real estate, they are exposed to 

heightened credit risk as the shakeout unfolds. 

New Forces Are Reshaping the Retail Landscape 

A combination of demographic and economic forces 

has reduced growth in demand for retail goods from the 

boom days of the 1970s and mid-1980s. Meanwhile, 

technology is reconfiguring the way retail goods are 

marketed and delivered, and a low cost of capital has 

stimulated investment in new retail space and new 

retailing concepts. 

A retail industry boom began roughly in 1970 when 

baby boomers and women began entering the work 

force in record numbers. At the same time, proliferation 

in general-purpose credit cards facilitated an extension 

in consumer borrowing power. As a result, there was a 

CHART 1 

100 

150 

200 

250 

300 

350 

’72 ’76 ’80 ’84 ’87 ’89 ’91 ’93 ’95 

Leasable 

Space* 

Inflation-adjusted 

Sales * 

* Does not include non-shopping center space. 

Source: International Council of Shopping Centers 

1972=100 

Construction of Shopping Center Space Has 

Outstripped Sales Growth 

98 percent increase in inflation-adjusted retail sales 

from 1967 to 1994. 

To meet this demand and serve expanding suburban 

communities, developers built shopping centers at a 

rapid pace. The number of shopping centers, from small 

neighborhood strip centers to huge regional malls, grew 

from about 13,000 in 1972 to over 41,000 in 1995. 

Despite economic conditions that seem favorable for 

the retail sector, revenue growth has been painfully 

slow in the 1990s. Payrolls have seen net growth of 13.4 

million jobs since mid-1991, while real disposable personal incomes and consumer confidence have risen 

commensurately. An optimistic household sector has 

shown a willingness to take on debt under these favorable conditions and has done so with the benefit of 

lower interest rates compared to the 1980s. 

Even with generally positive economic conditions, 

retail demand has grown slowly in the 1990s (see Chart 

2, next page). Annual rates of increase in real expenditures on many durable and, especially, nondurable goods 

have lagged behind rates of the previous two decades. 

Slow growth in retail revenues can be explained in part 

by the fact that retail goods overall have risen in price at 

only around two-thirds of the general rate of inflation 

during the 1990s, while the appliance, electronics, and 

personal computer sector has seen actual price deflation. 

Regional Outlook	 6 Third Quarter 1997 
In Focus This Quarter
 

An aging consumer base is another factor holding down 

retail sales growth. The total number of households 

headed by persons age 20 to 35—the age at which families are getting established and acquiring household 

durable goods—is the same now as it was in 1980. The 

lack of growth in this key demographic group has limited growth in retail demand and should continue to do 

so for the foreseeable future. The total population in the 

20 to 35 age bracket is projected to decline slightly by 

2007. 

Other broad trends have contributed to slower retail 

sales growth. Retail sales as a percentage of personal 

income fell from 46 percent to 38 percent between 1967 

to 1996 as consumers shifted more of their disposable 

income to the purchase of personal services, housing, 

education, travel, and entertainment. A Standard and 

Poor’s Industry Survey reports that consumers have 

reduced their number of trips to shopping malls by 35 

percent since 1980, while total shopping hours are down 

70 percent. 

Looking ahead, mail-order retailing through electronic media, 

including cable television and the 

Internet, may be poised to gain 

significant market share at the 

expense of shopping centers. 

“Virtual shopping malls” such as 

Amazon.com, an Internet bookseller, have made headlines with their initial successes,
 

although analysts caution that widespread adoption of
 

high-tech shopping may be some years down the road. 


Technology has become a key to distribution and marketing. Faced with slower revenue growth, retailers have 

been investing in technology to cut their expenses and 

boost their bottom lines. For example, point-of-sale 

scanning delivers a vast amount of information that can 

be used to target marketing efforts and manage and control inventories—providing a distinct competitive 

advantage for large retail chains with vast marketing 

and distribution networks. 

A low cost of capital has fueled investment. Low interest rates and a booming stock market have made market 

financing plentiful and cheap. This environment has 

allowed retailers to overhaul retail strategies and invest 

heavily in technology, inventory, and retail space— 

investments that might otherwise have been infeasible. 

Since 1991, around 1.13 billion square feet of new retail 

space has been added nationwide representing an 

increase of about 12 percent to the total stock of retail 

real estate over five years. Net additions to retail inventories since 1991 have totaled almost $33 billion in 

inflation-adjusted dollars, an increase of over 18 percent. No figures are available on investments made in 

information systems, although they are known to be 

sizeable. 

Growth of the “Big Box” Format 

Leading retailers have responded to these forces with 

aggressive expansion in the “big box” store format. Big 

box retailers are typically discount stores and superstores, such as Circuit City, PetSmart, and The Home 

Depot, Inc., which tend to cluster in large strip malls 

called “power centers.” In many towns and cities, the 

arrival of big box stores has left smaller, local retail 

establishments with only a small fraction of their former 

share of the local market. 

The big box format has a number of advantages. Among 

the most important is the ability to offer a large, diverse 

on-shelf selection. This approach enables a single location to dominate that retail category in the local market, 

which is why the big box chains are often referred to as 

“category killers.” Large retail chains also have more 

leverage over suppliers. They can negotiate more favorable prices and demand cooperative advertising from 

manufacturers. Large retailers typically have the financial resources to invest in the latest distribution methods 

and technology. Finally, unlike smaller traditional retailers, these large chains can obtain financing through the 

capital markets. 

CHART 2 

Inflation-Adjusted Retail Sales Have Grown 

Slowly in the 1990s 

Real Growth in Retail Sales*, 

Compound Annual Rate 

3.0% 

2.5% 

2.0% 

1.5% 

1.0% 

0.5% 

0.0% 

1970s 1980s 1990s 

* Retail sales excluding autos, deflated by the consumer price index. 

Source: Bureau of the Census and Bureau of Labor Statistics 

Regional Outlook 7 Third Quarter 1997 
In Focus This Quarter
 

Industry Consolidation to Continue 

Rapid expansion among the large retail chains has contributed to a highly competitive retail sector marked by 

intense battles for domination of the major retail categories. The result of this competition, analysts say, will 

be consolidation in the industry as weaker chains give 

way to market leaders. 

One sign of this consolidation is in multibillion dollar 

acquisitions, such as Federated Department Stores’ 

acquisition of R.H. Macy. The five largest department 

store chains (JC Penney, Federated, May, Dillard, and 

Nordstrom) now account for 87 percent of department 

store sales nationwide. The top three discount department store chains (Wal-Mart, K-Mart, and Target) 

account for 87 percent of full-line discount department 

store sales. 

Intensely competitive conditions also are reflected by 

retail bankruptcies and restructurings. Both Woolworth 

Corp. and K-Mart Corp. recently closed a number of 

stores in restructurings that reflect the loss of market 

share to Wal-Mart. Smaller companies that have fewer 

restructuring options are more likely to be forced into 

bankruptcy. Dun & Bradstreet reports that domestic 

business failures among retail establishments rose in 

1995 by 2.8 percent to 12,952. While most of these failures were individual stores and small chains, a number 

of larger chains also filed for bankruptcy during 1995, 

including Barney’s, Bradlees Inc., Caldor, The 

Clothestime Inc., Edison Brothers Stores, ElderBeerman, Herman’s Sporting Goods, Jamesway, and 

Today’s Man. 

As the retail shakeout moves forward, any credit losses 

on commercial and industrial loans to retailers are more 

likely to arise from bankruptcies and restructurings than 

from mergers and acquisitions. Unfortunately, it is difficult to say in advance exactly how consolidation in the 

industry is likely to take place. 

Overbuilding Is a Risk for Retail Real Estate 

Retail industry analysts are particularly concerned 

about the potential for overbuilding of retail space. 

Because of this concern, lenders and examiners should 

be alert to possible credit quality problems with commercial real estate loans secured by retail properties. 

CHART 3 

0 

20 

40 

60 

80 

100 

120 

140 

160 

’88 ’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 

0% 

2% 

4% 

6% 

8% 

10% 

12% 

New Supply Has Recently Outpaced 

Absorption of Retail Space 

Source: FDIC, The Real Estate Report (Summary for 58 major markets) 

Vacancy 

Rate 

Net New Supply Absorption 

Millions of 

Square Feet 

Although a vacancy rate of 7.7 percent does not suggest 

that the U.S. retail market is vastly overbuilt at present, 

there are warning signs. One is that the U.S. aggregate 

vacancy rate has begun to tick upward since 1995 as net 

completions of new retail space have caught up to and 

surpassed the absorption of that space by retailers (see 

Chart 3). Another frequently cited indicator of overbuilding is a falling ratio of sales per square foot in the 

industry, reflecting the fact that additions to retail space 

have outpaced sales growth for some time. In any case, 

local market conditions may be somewhat more volatile 

than the national figures would suggest, particularly in 

areas where a great deal of construction activity has 

recently taken place (see inset, Retail Vacancy Rates 

Continue below the National Average). 

Besides market conditions, underwriting is the other 

major determinant of credit quality in retail real estate 

lending. Market analysts report that many of the problems resulting from local market downturns have been 

on loans with 1980s-vintage underwriting, particularly 

those with high loan-to-value ratios. Analysts also voice 

concern that the rapid expansion of space may be 

putting downward pressure on lease rates. In light of an 

ample supply of space and a number of large chains 

continuing to add space, any valuations that assume 

future growth in lease rates should be closely reviewed. 

The viability of rapid expansion on the part of the large 

retail chains would undergo a particularly severe test in 

the event of a recession. 

Richard A. Brown, Chief, Economic Analysis Section 

Diane Ellis, Senior Financial Analyst 

Regional Outlook 8 Third Quarter 1997 
In Focus This Quarter
 

Retail Vacancy Rates Continue CHART 4 

below the National Average Vacancy Rate Begins to Rise in Kansas City 

after Sustained Decline 

2.5 12% 

Vacancy Rate Net New (right scale) Supply 

Absorption 

’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 

According to F. W. Dodge Real Estate Analysis and 

Planning Service, the vacancy rates for retail real 

estate in the Region’s three major markets have been 

declining in the 1990s. As shown in Table 1, the 

vacancy rates in all three markets in 1995 and 1996 

were below the average of the 58 major markets surveyed. 

Millions of Square Feet 2.0 10%

8% 

1.5 

6% 

4% 

1.0 

0.5 2% 

0.0 0% In the Kansas City metropolitan area, retail vacancy 

rates have been declining since 1990 and have been Source: FDIC, The Real Estate Report 

The Twin Cities retail market continues to boom, with 

1.5 million square feet of new development in 1996 

and a number of major redevelopments. Chart 5, next 

page, shows that the Minneapolis/St. Paul area has 

experienced a steady tightening of retail vacancies 

since 1993. While industry experts expect some retail 

shakeout to occur among the older retail centers, this 

year’s biggest new retail development, Tamarack 

Village in the Woodbury suburb of St. Paul, is proving to be a success. The Dayton Hudson Corporation 

also has agreed to enter two area regional malls by 

building Dayton’s department stores there. 

In St. Louis, there continue to be a number of major 

redevelopments at existing shopping centers, as well 

as new development in the outlying suburbs. 

However, the number of successful retailers in the 

area has dwindled. An example of the large retailers 

below the average of 58 major markets since 1991 

(see Chart 4). Much of the growth in demand for retail 

space has occurred south of the city, especially 

Johnson County, Kansas. However, as shown in 

Table 1, vacancy rates increased in 1996, from 4.4 

percent to 5.3 percent. In apparent response to the historically low vacancy rates of the previous year, newly 

built retail space outpaced absorption for the first 

time in six years (see Chart 4). 

While the Kansas City market’s vacancy was still 

below the 58 major market average of 7.7 percent in 

1996, large projects planned for 1997 have the potential to push the vacancy rate higher. Construction of 

the Great Mall of the Great Plains began in Olathe, 

Kansas, in January. The outlet-based mall will have 1 

million square feet of gross leasable space. In addition, a 648,000-square foot shopping center, including 

a 30-screen movie theater, is scheduled to open in 

suburban Kansas City in fall 1997. 

TABLE 1 

Retail Vacancy Rates in KC Region Are below the 

National Average 

1993 1994 1995 1996 

KANSAS CITY MSA* 7.4 5.4 4.4 5.3 

MINNEAPOLIS MSA 9.0 8.1 6.9 6.8 

ST. LOUIS MSA 8.8 8.4 7.3 7.6 

AVERAGE OF 58 

MAJOR U.S. MARKETS 9.0 7.6 7.4 7.7 

*MSA = Metropolitan Statistical Area 

Source: F. W. Dodge 

Regional Outlook 9 Third Quarter 1997 
In Focus This Quarter
 

CHART 5 CHART 6 

-1.5 

-1.0 

-0.5 

0.0 

0.5 

1.0 

1.5 

2.0 

’89 ’90 ’91 ’92 ’93 ’95 ’96 

Millions of Square Feet 

0% 

2% 

4% 

6% 

8% 

10% 

Demand for St. Louis Retail Space Has Been 

Up and Down in Recent Years 

Source: FDIC, The Real Estate Report 

Vacancy 

Rate 

(right scale) 

Net New Supply 

Absorption 

’94 

-1 

0 

1 

2 

3 

4 

5 

’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 

Millions of Square Feet 

0% 

2% 

4% 

6% 

8% 

10% 

12% 

Minneapolis Retail Vacancy Rate 

Declines for Fourth Straight Year 

Source: FDIC, The Real Estate Report 

Net New 

Supply 

Absorption 

Vacancy Rate 

(right scale) 

leaving the market is the Central Hardware chain, replace those leaving, as indicated in Chart 6 by a 

which vacated a dozen large retail spaces varying in recent rise in the St. Louis retail vacancy rate. 

size from 50,000 square feet to 150,000 square feet in 

1996. New retailers have been somewhat slow to Jeffrey W. Walser, Regional Economist 

Regional Outlook 10 Third Quarter 1997 
Regular Features	 Regional Economy
 

Kansas City Region: North Dakota Suffers 


from Spring Flooding
 

•	 Flooding in the Red River Valley devastated private and public property and will strain North Dakota’s 

resources. 

•	 Wichita’s booming aircraft industry should propel the city’s economy in the near term but may increase the 

city’s already heavy reliance on the industry. 

•	 Declining inventories in 1997 should push up cattle prices, helping the Region’s cattle ranchers. 

•	 The hog industry continues to consolidate in the Region, but small operators in Iowa resist the trend. 

April Flood Hit North Dakota Hardest 

Severe winter storms dumped record amounts of snow 

over parts of North Dakota and western Minnesota. 

The resultant spring thaw and flood may have serious 

consequences for the economy in the area known as the 

Red River Valley, especially for North Dakota. The Red 

River flows northward and forms the border between 

Minnesota and North Dakota. The Red River Valley, a 

very flat area, is the most fertile land in North Dakota 

and home to 35 percent of North Dakota’s population. 

Table 1 shows the importance of the Red River Valley to 

North Dakota. 

The Federal Reserve Bank of Minneapolis has made 

preliminary estimates of property damage, based on 

publicly available information, at $1.2 billion to $1.8 

billion, with the greatest destruction in the Grand 

Forks and East Grand Forks area. Damage to residenTABLE 1 

Counties on the Red River Make Up 

Much of North Dakota’s Economy 

HOUSE­

% OF HOLD % OF 

POPULA- STATE INCOME STATE 

COUNTY TION TOTAL ($ MIL) TOTAL 

CASS 102,874 16.1% 1,085 19.0% 

GRAND FORKS 70,683 11.1% 640 11.2% 

RICHLAND 18,148 2.8% 159 2.8% 

WALSH 13,840 2.2% 116 2.0% 

PEMBINA 9,238 1.4% 83 1.5% 

TRAILL 8,752 1.4% 74 1.3% 

SIX-COUNTY 

TOTALS 223,535 35.0% 2,157 37.8% 

Source: 1990 U.S. Census 

tial and commercial buildings in that area may range 

from $600 million to $800 million, and damage to property in the buildings may range from $375 million to 

$525 million. State officials estimate that less than 10 

percent of this damage to private property is covered by 

insurance. The Federal Reserve Bank also estimated 

that losses of net worth to independent businesses could 

range from $150 million to $400 million. A Grand 

Forks county commissioner estimated that the county 

had lost 30 percent of its tax base. Losses of public 

buildings, roads, and bridges may be in the range of 

$120 million to $200 million. These estimates represent 

only part of the total negative economic impact, as they 

do not include foregone output or employment income 

or costs incurred while building dikes, stacking sandbags, and evacuating residents. 

At the height of the flood, 1.7 million acres of cropland 

were underwater, but the losses associated with this 

flooding should be less than previously estimated. 

When the water receded, farmers were able to plant in 

affected areas more quickly than they had expected. 

Because the flood occurred early enough in the season, 

planting was still possible in time to achieve reasonable 

crop maturities. Livestock producers were hard hit by 

the cold, snowy winter and the April snowstorm that 

occurred during the calving season. State officials estimate that more than 160,000 cattle died during the winter, two to three times the usual death rate. While 

individual ranchers suffered severe losses, the effects of 

the cattle deaths are expected to be short-term at worst. 

Congress appropriated some $500 million in federal aid 

to residents of the Red River Valley in June. While most 

such aid is in the form of low-interest loans, it should 

provide some businesses the means to reopen and some 

families assistance to rebuild their homes. The federal 

Regional Outlook	 11 Third Quarter 1997 
Regular Features	 Regional Economy
 

assistance will fall far short of repairing all the flood 

damage, however. The flood damage is very large compared to the size of North Dakota’s economy. As a point 

of comparison, North Dakota’s 1995 to 1997 biannual 

general revenue budget was only $1.4 billion. 

Implications: The flooding could have the following 

effects: 

•	 Taxpayers could pay significantly higher taxes to 

replace damaged infrastructure. 

•	 The direct victims of the flood could require many 

years to pay off the debts incurred after the flooding. 

•	 Many residents of North Dakota who lost much of 

what they had might move elsewhere. The city tax 

assessor of Grand Forks, as quoted in the New York 

Times, estimated that “as many as 7,500 people may 

leave town.” 

•	 As discussed in Regional Banking Conditions, 53 

banks in the Red River Valley, with total assets of 

more than $2.8 billion, face risks from flood-damaged real estate and agricultural losses. 

The Aircraft Industry Is Booming in Wichita 

Because of the concentration of aircraft manufacturing 

in Wichita, the area has been vulnerable to changes in 

the health of the industry. For example, over the past 

two decades, Boeing’s 

fortunes have been subject to booms and busts 

caused by fluctuating 

demand in the commercial and military markets. In fact, Boeing laid off more 

than one-third of its Wichita employees in the early 

1990s as sales lagged expectations. Another example is 

Cessna, which halted production of small piston-engine 

planes by 1986 because of soaring product liability 

costs. It decided to reenter that segment of the business 

after Congress passed the General Aviation 

Revitalization Act of 1994, which limited manufacturers’ liability in airplane accidents. 

The aircraft industry in Wichita sustained strong growth 

in 1996, with Boeing Wichita, Cessna Aircraft, 

Raytheon Aircraft, and Learjet adding more than 5,300 

jobs. The four manufacturers had a substantial economTABLE 2 

The Aircraft Industry Has Fueled the 

Manufacturing Boom in Wichita 

COMPANY 

1995 

EMPLOYMENT 

1996 

EMPLOYMENT INCREASE 

BOEING 14,800 18,000 3,200 

CESSNA 6,740 7,600 860 

RAYTHEON 

AIRCRAFT 6,500 7,500 1,000 

LEARJET 2,836 3,084 248 

AIRCRAFT 

TOTAL 30,876 36,184 5,308 

TOTAL WICHITA 

MSA MFG. 

EMPLOYMENT 57,100 62,100 5,000 

AIRCRAFT AS % 

OF TOTAL MFG. 54% 58% — 

Source: Wichita Eagle and Bureau of Labor Statistics 

ic presence in the area in 1996, as reported in Table 2. 

In 1996, Boeing began advertising for positions such as 

draftsmen, engineers, numerical control programmers, 

and manufacturing analysts. Boeing recalled some of 

the nearly 9,000 employees it downsized earlier in the 

decade. Cessna opened a new plant to build pistonengine planes in mid-1996, using $40 million in Kansas 

industrial revenue bonds. The plant is expected employ 

more than 1,000 workers by the end of 1997. 

As Table 2 shows, all of Wichita’s net increase in manufacturing employment in 1996 was due to the aircraft 

industry. As a result of increased hiring by the aircraft 

producers, Wichita was second among U.S. cities in 

manufacturing employment growth from October 1995 

to October 1996, with an 8.1 percent increase. 

According to local business analysts, the industry 

expansion has exerted direct pressure on the market for 

skilled labor and pushed up wages throughout the local 

economy. Due to the shortage of skilled workers, it has 

been reported that Cessna has recruited inexperienced 

workers with good work records to train in its manufacturing process. Boeing has resorted to hiring away experienced workers from some of its own vendors and 

subcontractors. 

Implications: In the near term, indicators point to 

Wichita’s continued economic health as the industry 

expands. One industry analyst estimates that recent 

Regional Outlook	 12 Third Quarter 1997 
Regular Features Regional Economy
 

investment and hiring by the aircraft industry will result 

in three to five years of sustained growth in Wichita. 

However, this growth will increase the demand for 

labor, possibly restraining growth in service and small 

manufacturing businesses not related to the aircraft 

industry. Higher wages paid in aircraft plants should 

eventually pull up other wages in the local market, as 

workers at each level of skill and experience migrate to 

higher paying jobs. Smaller businesses usually struggle 

to find and retain productive workers, and the rising 

wages could make their task more difficult. At the same 

time, however, higher wages and income growth may 

result in a general increase in demand for the goods and 

services they provide. 

In the longer term, since more than 58 percent of its 

manufacturing jobs are in the aircraft industry, Wichita’s 

fortunes will continue to be dependent on the health of 

that industry, which has been subject to significant variability. Manufacturing accounts for 23.4 percent of total 

employment in Wichita compared with 15.4 percent 

nationwide, according to the Bureau of Labor 

Statistics. 

The upswing in manufacturing employment in Wichita 

has led to increased sales of new and existing homes 

and startups of businesses supplying the aircraft industry and its workers. Demand for mortgage and business 

loans is strong and growing in the current environment, 

but observers of the Wichita economy are mindful of the 

risks that the heavy concentration of the aircraft industry implies. 

Cattle Cycle Turns and Ranchers’ Prospects 

Improve 

As discussed in the second quarter 1997 Regional 

Outlook, the Region’s cattle ranchers have experienced 

several difficult years. However, recent results from a 

government estimate of the U.S. cattle population suggest that ranchers’ chances for profitability will improve 

in 1997 and 1998. 

The semiannual Cattle report, released by the U.S. 

Department of Agriculture (USDA) in January, indicated a population of 101.21 million head of cattle and 

calves nationwide as of January 1, 1997. This inventory 

is 2.2 percent less than the January 1, 1996, number, 

and represents the largest annual decline since 1988. 

The report also indicated 34.28 million beef cows (the 

mothers of feeder cattle) at the beginning of 1997, or 

2.7 percent less than the prior year’s number. The total 

number of calves born in 1996 was reported at 39.59 

million head, or 1.6 percent below the 1995 level. Chart 

1 shows the cyclical pattern of cattle inventories and 

returns to ranchers over the current cattle cycle. 

The cyclical pattern of cattle inventories occurs as 

ranchers respond to the market price of feeder cattle. 

Ranchers maintain herds of cows to produce calves, 

which they grow for about one year and then sell to 

feedlots, where they are fed grain intensively and sold to 

slaughterhouses after about another six months. The 

young cattle sold by the ranchers are known as feeder 

cattle, while the finished cattle sold to slaughterhouses 

are known as fed cattle. 

The price of feeder cattle is affected on the demand side 

by the price of fed cattle. When feedlot operators are 

receiving high prices for their fed cattle, they are willing to bid higher for feeder cattle to fill their feedlots. 

On the supply side, the price of feeder cattle is affected 

by the population of young cattle, which is in turn determined by the population of cows. 

The cattle cycle occurs because of significant lags as 

ranchers adjust their inventories to market prices. 

Small-scale ranchers predominate in the industry, with 

80 percent of the ranches in the United States having 

fewer than 50 cows. Because cattle raising is a secondary source of income for these ranchers and requires 

only modest cash outlays, ranchers are typically slow to 

respond to downturns in market prices. 

The biology of the cattle also causes lags, as the time 

from the conception of a calf until it is ready for market 

is typically 21 months. 

CHART 1 

85 

90 

95 

100 

105 

110 

115 

120 

’82 ’84 ’86 ’88 ’90 ’92 ’94 ’96 

-150 

-100 

-50 

0 

50 

Ranchers’ Returns 100

$ per cow 

Cattle Inventory 

Source: U.S. Department of Agriculture 

Millions of head 

Cattle Cycle Peaks in 1996 

Regional Outlook 13 Third Quarter 1997 
Regular Features Regional Economy
 

In 1995, for example, enough ranchers had been earning negative returns for more than one year that many of 

them sent some of their cows to slaughter, rather than 

breeding them to produce more calves. Continued 

slaughter of cows in 1996 slowed the growth of the cow 

herd, ultimately leading to a reduction in cattle inventory in 1997. 

In 1997, prices of feeder cattle have increased substantially. The price of a 600- to 

650-pound feeder steer in the 

Oklahoma City market has 

increased from $61 per hundred pounds in late October 

1996 to more than $85 in mid-June 1997. This is the 

price ranchers, also known as cow-calf operators, 

receive when they sell young cattle to feedlots for finishing. Chart 2 shows the paths of feeder cattle prices 

and fed cattle prices in 1996 and 1997. The relative 

prices of fed and feeder cattle were unusual in 1996, 

with feeder cattle prices lower than fed cattle prices 

most of the year. 

Implications: Cattle industry analysts expect that 

ranchers in the Kansas City Region, who have 28 percent of the nation’s beef cows, can look forward to 

improved returns in 1997 and 1998. 

The Hog Sector Continues to Consolidate While 

Iowa Producers Battle for Turf 

The seven states of the Kansas City Region are home to 

a significant share of the U.S. swine industry. According 

to the March 27, 1997, Hogs and Pigs report, 47.7 percent of the nation’s hogs are located in the Region. Iowa 

CHART 2 

50 

55 

60 

65 

70 

75 

80 

85 

90 

Fed Cattle 

Feeder Cattle 

Source: Texas-Oklahoma cash markets, weekly data 

$ per 100 lbs. 

Feeder Cattle Prices Recover in 1997 

Jan-96

Feb-96

Apr-96

Jun-96

Aug-96

Oct-96

Dec-96

Jan-97

Mar-97

May-97 

has been the nation’s leading hog-producing state since 

early in the century, and currently controls more than 21 

percent of the national inventory. Minnesota, Missouri, 

Kansas, and Nebraska also rank among the top ten 

hog-producing states. 

Over the past three decades, the hog industry has been 

continuing a trend of consolidation. The number of hogproducing operations nationwide has declined from 

871,000 in 1970 to 157,000 in 1996. By the late 1970s, 

larger hog operations were able to achieve lower average costs of production with investments in specialized 

facilities such as confined hoghouses. Many small or 

part-time growers became unable to compete and exited 

the industry. The trend of consolidation has accelerated 

in the 1990s because new techniques in hog raising have 

required even larger investments in physical and human 

capital. The smaller operator does not produce enough 

hogs to justify large fixed expenditures for the facilities 

and training needed to remain competitive. Table 3 presents the decline in the number hog operations in the 

states of the Kansas City Region. 

While the number of hog operations has declined by 

almost one-half in Iowa, the state still has the largest 

number of hog farmers in the nation. Thanks to their 

numbers and associated political clout, smaller Iowa 

hog farmers have been largely successful in discouraging investment by large hog operators from outside the 

state. 

TABLE 3 

The Region’s Pig Farms Have 

Consolidated Significantly since 1988 

1996 

AS % OF 

1988 1992 1996 1988 

IOWA 41 35 21 51% 

KANSAS 7 6 4 63% 

MINNESOTA 17 14 11 67% 

MISSOURI 17 13 7 41% 

NEBRASKA 13 12 8 64% 

NORTH DAKOTA 3 2 1 29% 

SOUTH DAKOTA 8 7 4 44% 

KC REGION 

TOTALS 104 89 56 54% 

UNITED STATES 323 240 157 49% 

Note: Figures are in thousands of farms 

Source: U.S. Department of Agriculture 

Regional Outlook 14 Third Quarter 1997 
Regular Features Regional Economy
 

In the mid-1990s, alliances of environmental activists 

and family farm organizations used court injunctions to 

stop a number of planned pork production projects from 

locating in Iowa. In 1996, the Iowa legislature passed a 

law that exempted livestock farmers from such lawsuits, 

provided they met environmental standards. This law 

has not entirely stopped litigation between large and 

small hog operators, however. 

There are signs that Iowa’s hog industry is in a long-run 

decline. Two large hog packers downsized some of their 

Iowa operations in February 

and March 1997. The companies cited difficulties in obtaining the hogs needed to 

slaughter at capacity levels. 

According to Glen Grimes, 

agricultural economist at the University of Missouri, in 

an interview in Feedstuffs magazine, the Midwest packing sector will suffer permanent erosion as midwestern 

packing plants are replaced by those in the South and 

the Southwest. Dr. Grimes noted, “Hogs usually move 

first, and the packing plants follow.” 

Implications: Iowa’s political leaders continue to look 

for solutions to the conflict, but the persistence of the 

small hog farmers and their allies will not be denied in 

the short run. In a year such as 1997, when strong hog 

prices and moderate feed costs are expected, many 

smaller operators will be able to enjoy profits. For the 

longer term, however, the number of small producers 

should continue to decline. 

The industry’s consolidation has potential effects on the 

banking industry. Loans to smaller hog producers may 

begin to pose additional risks as such operations 

become less competitive with larger, more technologically sophisticated producers. In addition, community 

banks could face additional competition as larger hog 

producers begin to seek alternative sources of financing 

from larger banks or investors. 

Corn and Soybeans in 1997: Stocks to Be 

Replenished 

The USDA, in its June 1997 World Agricultural 

Demand and Supply Estimates, forecasted corn production of 9.84 billion bushels for this fall harvest, an 

increase of 5.9 percent over the 1996 harvest. If the 

forecast is realized, it will be the second largest harvest 

in U.S. history. Larger planted acreage for corn and soybeans is the result of the above-average prices that have 

prevailed over the past two years. Corn planted acreage 

also has likely been affected by the 1996 Federal 

Agriculture Improvement and Reform Act, which 

decoupled payments to farmers from specific production requirements. The USDA forecast implies that preharvest stocks will increase from 426 million bushels in 

August 1997 to 909 million bushels in August 1998, as 

domestic and export demand will not grow as much as 

supply. The USDA projects that prices paid for the corn 

crop just being planted will be 5 to 20 percent lower 

than for this year’s crop. 

The World Agricultural Demand and Supply Estimates 

forecasts a similar story for soybean production, with a 

record 2.6 billion bushels, an increase of 9.2 percent 

over last year. Ending stocks would more than double to 

260 million bushels. Given production and stocks 

buildup, the USDA projects next year’s soybean prices 

to be 10 to 30 percent lower than this year’s prices. 

Implications: The USDA forecasts farm cash receipts 

from corn and soybeans to be lower in 1997, implying 

lower incomes for farmers who market these crops. 

Craig A. Rice, Senior Regional Analyst
 

Jeffrey W. Walser, Regional Economist
 

Regional Outlook 15 Third Quarter 1997 
Regular Features	 Financial Markets
 

Financial Markets
 

•	 Deteriorating credit quality trends in the rapidly growing home-equity backed securities market could portend trends in bank residential mortgage lending. 

•	 Financial asset securitization investment trusts, known as FASITs, promise to change the asset-backed securities market significantly and could make securitization more accessible to community banks. 

•	 The Treasury yield curve is steeper and higher than it was at year-end 1996. 

•	 During the first quarter of 1997, the Kansas City Regional Bank Index outperformed the S&P 500 but not 

the S&P Composite Bank Index. 

Trends in the Home-Equity Asset-Backed 

Market Are Important to Banks 

The home-equity loan (HEL) asset-backed securities 

(ABS) market has grown by over $20 billion or 251 percent since 1993, with total issuance of HEL ABS topping $27 billion in 1996 (see Chart 1). The rapid growth 

of the market, which has been driven largely by consumer debt consolidation lending, has been accompanied by abnormally early and high levels of 

delinquencies. Banks that are investing in HEL ABS, 

considering securitizing HELs, or lending significantly 

for debt consolidation should be aware of credit quality 

developments in the HEL ABS market. 

The distinction between HELs and first-lien residential 

mortgages is eroding in the HEL ABS market. The refinancing boom spurred by the decline in rates during 

1993 and early 1994 resulted in a change in the makeup 

of the HEL ABS market, causing much higher percentages of the securities to be backed by first-lien HELs 

than previously had been the case. First-lien home-equity lending, know as cash-out refinancing, grew substantially when home-equity borrowers were motivated by 

lower rates to refinance their first mortgages for 

amounts greater than the remaining principal balance 

instead of adding a second mortgage. 

Debt consolidation is the primary reason for homeequity borrowing. Nonbanks that expanded their mortgage lending capacity during 1993 have been 

aggressively marketing to an increasing number of borrowers who desire to consolidate their growing debt 

burdens. According to the Consumer Bankers 

Association 1997 Home-Equity Loan Study, debt consolidation accounted for 36 percent of home-equity 

lines of credit and 40 percent of closed-end loans. Prior 

to 1992, home improvement was the primary reason for 

home-equity borrowing. This trend toward debt consolidation as the reason for home-equity borrowing has 

significant risk implications because, unlike funds lent 

for home improvement, the proceeds of a debt consolidation loan do not enhance the lender’s collateral value. 

The rapid growth of the HEL securitization market has 

been attended by signs of relaxed underwriting. 

Adverse credit quality trends have been particularly 

prominent for loans that were originated in 1995. Chart 

2 (next page) shows the total delinquency rates for 

closed-end loan pools originated in 1995 versus 1994. 

The sharp upward path of delinquency rates for loan 

pools originated in 1995 raises concern that aggressive 

competition for volume, and apparently relaxed underwriting standards, could lead to unprecedented default 

levels. Furthermore, HEL originations in 1996 more 

than doubled 1995 levels, causing market observers to 

suspect that underwriting standards continued to lapse. 

CHART 1 

1993 1994 1995 1996

0 

5 

10 

15 

20 

25 

1993 1994 1995 1996

Securitization of Home Equity 

Loans Has Risen Substantially 

Lines of Credit 

Closed End 

Source: Moody’s Investors Service 

$ Billion 

Regional Outlook	 16 Third Quarter 1997 
Regular Features Financial Markets
 

The trends in the HEL ABS market may portend credit 

quality trends in nonsecuritized cash-out refinancing. If 

similar unfavorable trends exist in bank-originated 

cash-out refinancing, evidence of these trends would be 

obscured by banks’ larger and less risky portfolios of 

purchase mortgage loans. The trends would be obscured 

because banks report all first mortgage lending on 1 to 

4 family residential properties without distinguishing 

between purchase mortgages and cash-out refinancings. 

The unfavorable trends in the HEL ABS market suggest 

that banks that engage in significant cash-out refinancing and other forms of home-equity lending should be 

able to monitor trends in the credit quality of these loans 

separate from purchase mortgage loans. 

A Combination of Several Factors Could Induce 

More Banks to Securitize HELs 

Although the present volume of bank-originated HEL 

securitizations is relatively small, banks have recently 

entered this finance company-dominated market, and a 

combination of several factors is likely to cause more to 

follow. First, home equity lines of credit are currently 

growing at rates exceeding total consumer lending, and, 

by and large, the deposit growth to fund this lending is 

less than robust. In addition, according to Moody’s 

Investors Service, investor demand is high for bankoriginated home-equity line of credit securitizations 

because bank-originated lines are perceived to have 

lower credit risk. The funding benefits and profitability 

of securitizing bank-originated home-equity lines of 

credit could entice more banks into the securitization 

market. Finally, the combination of these factors with 

the potential cost savings provided by using the new 

financial asset securitization investment trust (FASIT) 

CHART 2 

0 

2 

4 

6 

8 

10 

1 3 5 7 9 11 13 15 17 19 21 23 

Months since Origination 

1995-Originated Loans 

Source: Moody’s Investors Service 

Percent 

Higher Delinquency Rates Are Occurring 

Earlier in More Recently Originated Loan Pools 

1994-Originated Loans 

Closed-end Loans 

structure (see discussion below) could produce momentum that will result in banks, large and small, securitizing home equity loans in significantly increased 

amounts. 

Securitizing HELs can change the balance sheet and 

income statement of the securitizer significantly, resulting in significant servicing assets and gains on 

sale. Beginning in 1997, 

when a company sells 

loans, it must comply 

with the requirements of 

Financial Accounting 

Standard (FAS) 125. If 

the company retains servicing rights on the assets sold, FAS 125 requires the 

seller to book an asset related to the gain on sale that 

represents the future income derived from servicing the 

loans. This asset is similar to mortgage servicing rights 

in that it represents the present value of future expected 

cash flows derived from loan servicing. One major 

home-equity securitizer, which indicated that FAS 125 

would not materially affect its financial statements, 

reported servicing assets at almost 90 percent of equity, 

and gains associated with the sale of serviced assets at 

71 percent of total revenue. 

The value of servicing assets is based on management’s 

assumptions about the future cash flows to be generated by the assets. Because these assumptions are based 

largely on historical performance, unexpected deterioration, like that associated with 1995- and possibly 

1996-originated loans, that results in charge-offs or 

early repayment through foreclosure of serviced assets, 

could require the adjustment of the valuation assumptions and the write-down of the servicing assets. 

FASITs Promise to Change the ABS Market 

The Small Business Job Protection Act of 1996 created 

two new sections of the Internal Revenue Code that create and govern FASITs. The FASIT provisions, patterned in part on the real estate mortgage investment 

conduit (REMIC) rules issued in 1986, are intended to 

provide tax certainty for ABS issuers and purchasers 

and enhance the flexibility of asset securitizations. The 

FASIT provisions take effect on September 1, 1997. 

The advent of the FASIT is likely to change the ABS 

market in important ways. First, the FASIT will clarify 

Regional Outlook 17 Third Quarter 1997 
Regular Features Financial Markets
 

the tax treatment of securitizations. Because of the current tax ambiguity, designing ABS structures to avoid 

taxation is administratively costly, and it restricts the 

forms that securitizations can take. The higher administrative cost associated with current securitization techniques establishes a practical minimum size for asset 

pools that can be feasibly securitized. With FASITs and 

the reduced costs associated with tax clarity, the economically feasible pool size may be significantly smaller. The lowering of this threshold could result in more 

community banks entering the securitization market. 

ABS issuers believe that the market for their product 

has been hampered by the restrictive nature of current 

asset-backed tax ambiguity, which prevents them from 

responding to investor 

preferences for varying 

maturities, coupon 

types, and prepayment 

and credit risk profiles. 

FASITs allow sponsors 

the flexibility to create 

multiple-class securities 

that satisfy these preferences with the certainty 

that the securities will count as debt and that the FASIT 

will not be treated as a taxable corporation. This combination of flexibility and tax certainty could lead to the 

kind of innovations in ABS structures that followed the 

1986 REMIC legislation, which brought analogous benefits to the mortgage-backed market. 

FASITs will bring to the ABS market the ability to add 

and remove assets throughout the life of a securitization. This feature could be applied by securitizing 

revolving construction loans and then replacing the 

revolving loans with permanent financing when construction is completed. A FASIT also will be able to 

contain a mixed pool of assets such as real estate, nonreal estate assets, and unsecured credit, allowing exposures to very different markets from the same security. 

Finally, a FASIT can hold swaps and other hedging 

instruments. Using this feature, an issuer could combine 

a mortgage passthrough security with a hedging instrument that is designed to offset mortgage prepayment 

risk, such as a reverse-index amortizing swap. 

The increased flexibility that the FASIT promises to 

bring the ABS market comes with the potential for 

greatly increased complexity and risk. Banks that invest 

in FASIT securities will need to understand fully not 

only the risk characteristics existing at the outset of 

security but also the risk that could arise throughout the 

security’s life if assets are to be removed and replaced. 

Changes in Interest Rates and Bond Values 

The Treasury yield curve (see Chart 3) rose following 

March 25, 1997, when the Federal Open Market 

Committee (FOMC) met and raised the target federal 

funds rate 25 basis points to 5.50 percent. The yield on 

the 30-year Treasury bond rose above 7 percent on the 

Thursday following the meeting and remained there for 

the next 23 days. The FOMC met again on May 20, 

1997, and left the target rate unchanged. 

The model portfolio responded to the rise in rates, but 

only modestly (see Table 1). The relatively short weighted average maturity of the portfolio served to moderate 

the effect of the 54 basis point rise in the five-year 

Treasury between December 31, 1996, and March 31, 

1997. As discussed in Regional Outlook, Second 

Quarter 1997, changes in the value of the model portfolio correlate more with changes in the five-year 

Treasury rate than with the 30-year bond rate. 

The yields along the April 30, 1997, yield curve imply 

that the market expects the curve to continue to flatten 

through the remainder of the year with short rates rising 

somewhat. In order to gauge what affect a 25 basis point 

rise in the yield curve could have on bank fixed-income 

portfolios, the model portfolio has been “shocked” to 

simulate the effect of an instantaneous 25 basis point 

shift in the yield curve on May 28, 1997. 

CHART 3 

The Treasury Yield Curve Is Steeper 

and Higher since Year-end 1996 

5.0 

5.5 

6.0 

6.5 

7.0 

7.5 

3­

month 

2­

year 

7­

year 

30­

year 

Source: Bloomberg 

Percent 

3/31/97 

4/30/97 

12/31/96 

Regional Outlook 18 Third Quarter 1997 
Regular Features Financial Markets
 

TABLE 1 

Type of Security Par Value Percent Maturity Percent Change Reof or Change sulting from 

Portfolio WAL from a 25 bp Rate 

as of 12/31/96 Increase on 

12/31/96 to 5/28/97 

3/31/97 

U.S. TREASURY 5.6% 2,000 20% 1 YR –0.30% –0.16% 

FNMA AGENCY 5.8% CALLABLE 1,200 12% 2 YR –0.50% –0.38% 

STATE COUNTY MUNICIPAL GO 4.8% 800 8% 11 YR –2.05% –2.03% 

FNMA MORTGAGE PASSTHROUGH 7.5% 3,000 30% 8 YR –1.78% –1.44% 

FNMA (REMIC) 8.0% PAC 2,000 20% 2.5 YR –1.27% –0.50% 

CREDIT CARD ASSET-BACKED SECURITY 1,000 10% 5 YR –0.09% 0.00% 

TOTAL 10,000 100% 4.85 YR –1.08% –0.77% 

Note: Portfolio composition based on estimates derived from aggregated Bank Call Report information. 

Again, the interest rate risk benefits of maintaining a 

portfolio of relatively short weighted average life are 

apparent. The U.S. Treasury and the agency, the shortest 

lived instruments, and the floating-rate ABS demonstrate the least price sensitivity. The municipal bond is 

the most sensitive to rate changes owing to its longer 

maturity. The mortgage passthrough security also is 

more sensitive to rising rates because its weighted-average life (WAL) extends as rising rates discourage the 

underlying mortgage holders from prepaying their 

loans. The decline in prepayment rates results in extending the maturity of the security while rates are rising, a 

combination unfavorable to the security’s value. 

CHART 4 

The Kansas City Regional Bank Index 

Outperformed the S&P 500, but Not the S&P 

Composite Bank Index during the First Quarter 

of 1997 

Both the S&P Composite Bank Index and the Kansas 

City Regional Bank Index have been subject to similar 

performance swings this year (see Chart 4). The S&P 

Composite Bank Index, with an almost 13 percent gain 

by May 2, 1997, was still short of its year-to-date high 

on March 7, 1997, at which time it was up almost 20 

percent on the year. The Kansas City Regional Bank 

Index was up almost 11 percent through May 2, 1997. 

Allen Puwalski, Banking Analyst 

-1% 

4% 

9% 

14% 

19% 

S&P 500 

Regional Bank Index S&P Bank Index 

Source: Bloomberg, American Banker 

Change from 12/31/96 

The Kansas City Region’s Bank Index Outperforms the S&P 500 but not the S&P Bank Index 10-Jan 24-Jan 7-Feb 7-Mar 4-Apr

2-May

31-Dec

21-Feb

21-Mar

18-Apr 

Regional Outlook 19 Third Quarter 1997 
Regular Features	 Regional Banking
 

Regional Banking Conditions
 

• The harsh winter and subsequent flooding in the Red River Valley may have a detrimental effect on the loan 

portfolios of some banks. 

•	 Large institutions are increasingly turning to borrowed funds to support loan growth. Community institutions also appear to be steadily increasing their reliance on less traditional deposit funding in the form of 

large-denomination time deposits (CDs). 

• Viewed by many as an inconsequential issue, the year 2000 problem deserves close attention by the Region’s 

banks and thrifts. 

Red River Valley Banks and Thrifts Are Sure to 

Feel the Effects of the Spring Flooding 

Flood-related damages and losses sustained by bank 

customers who are property owners and farmers may 

result in increased loan delinquencies and possible 

charge-offs. Smaller community banks and thrifts with 

offices only in the Red River Valley may be particularly affected, since their entire lending area may have 

been hit by the flood. 

The majority of damage caused by the flood was felt by 

real estate owners, most of whom carried no flood 

insurance on these properties (see Kansas City 

Region—North Dakota Suffers from Spring 

Flooding). In Grand Forks, for example, fewer than 

1,000 flood insurance polices were in force, while nearly 10,000 properties sustained damages. Lenders may 

be at risk in cases where borrowers lack the means or 

the motive to rebuild or repair mortgaged properties. 

While many lenders have granted loan payment deferrals to assist distressed borrowers with their difficult 

TABLE 1 

situations, loan performance problems may surface 

once these grace periods are lifted. 

In addition to credit risk, some mortgage lenders may be 

exposed to liability to the extent that they failed to fulfill their obligations as required by federal law for properties mortgaged in the floodplain. For example, if a 

lender failed to require flood insurance when such 

insurance was mandated, or failed to provide necessary 

flood hazard notifications, that lender could be exposed 

to some liability from customers whose property sustained flood damage. 

As shown in Table 1, 53 small community banks and 

thrifts with combined assets of almost $3 billion are 

headquartered in the Red River Valley. These institutions have $940 million in loans secured by real estate. 

More than two-thirds of this figure represents loans 

secured by 1 to 4 family residences. Table 1 provides 

further information on the real estate exposure of these 

insured institutions relative to equity capital. 

Community Banks and Savings and Loans in the Red River Valley Are Heavily 

Exposed to Real Estate and Agriculture 

(As of December 31, 1996) 

# OF INSTITUTIONS # OF INSTITUTIONS WITH 

WITH REAL ESTATE LOANS AGRICULTURAL LOANS 

AS A % OF EQUITY AS A % OF EQUITY 

STATE 

# OF 

INST. 

TOTAL ASSETS 

(000S) 

GREATER 

THAN 300% 

100% TO 

299% 

GREATER 

THAN 300% 

100% TO 

299% 

MN 

ND 

29 

24 

1,079,000 

1,797,000 

7 

4 

13 

16 

2 

5 

21 

12 

TOTAL 53 $2,876,000 11 29 7 33 

Source: Bank and Thrift Call Reports 

Regional Outlook	 20 Third Quarter 1997 
Regular Features	 Regional Banking
 

Although flood-damaged real estate poses the greatest 

risk to lenders, agricultural loan portfolios also may 

show some deterioration caused by the combined 

effects of a harsh winter and spring flooding. Farm 

lenders most likely will see an increase in borrowing by 

their customers to repair and replace equipment and 

buildings damaged by the flood. Since these new loans 

will increase the volume of debt serviced for a number 

of borrowers, cash flows may become strained, particularly for highly leveraged customers. Reduced crop 

yields also may result in carryover debt, which will further constrain future cash flow. 

The institutions profiled in Table 1 hold over $300 million in loans to farm producers. Of these 53 institutions, 

40 have significant concentrations of credit to farm borrowers relative to equity capital. Those institutions having the highest concentrations of farm loans (more than 

300 percent of equity) have remained profitable during 

the past three years, and levels of nonperforming assets 

reported on December 31, 1996, remained manageable. 

The Midwest flood of 1993 may provide some insight 

into what can be expected for banks and thrifts in the 

Red River Valley. The 1993 flood caused an estimated 

$10 billion in damage, primarily to farmers. However, no 

banks failed as a result of that flood, and in the aggregate, most indicators of bank performance exhibited little deviation from trends existing just prior to the flood. 

It appears that banks did increase loan loss reserves in 

anticipation of loan quality problems, but overall earnings did not seem to be significantly affected. 

While some lessons can be learned from the experiences of the 1993 flood, there are several major differences that make it difficult to project how institutions 

may be affected by the Red River flood. Among the differences are: 

•	 The majority of the damages in the 1993 flood 

were incurred by farmers 

who were at least partially 

indemnified by crop insurance. The most significant 

damage from the Red 

River Valley flood appears to be centered in the real 

estate of uninsured homeowners and businesses. 

•	 The 1993 flood caused a significant increase in 

prices for commodities such as corn and soybeans. 

While yields were reduced, farmers in 1993 mitigated losses by selling salvaged crops at higher prices. 

Currently, however, there has been no significant 

increase in commodity prices to help Red River 

Valley farmers with their projected decrease in crop 

yields. 

•	 Unlike the 1993 flood, the devastation in the Red 

River Valley is geographically highly concentrated. 

Thus, community banks in the Red River Valley will 

probably have few loan customers who were not 

adversely affected by the flood. 

There are several factors that could lessen the financial 

suffering by loan customers and consequently reduce 

the negative implications for 

insured institutions. For 

example, the federal government, through a number of 

programs, provides low-cost 

loans to individuals and businesses to encourage the 

replacement and repair of 

damaged properties. In addition, some properties in frequently flooded areas may be purchased at preflood fair 

market values by programs administered by the federal 

government and the state of Minnesota. Farmers may 

be partially indemnified by crop insurance and could 

find some relief in several emergency low-cost loan 

programs administered by the U.S. Department of 

Agriculture. Few individuals or businesses, however, 

are likely to be immune to the financial consequences 

of the flood. 

Funding Strategies Are Changing to Meet 

Continued Loan Demand 

During the national economic expansion, now into its 

seventh year, loan demand has been vigorous in the 

Region. Not unexpectedly, this demand has put some 

strain on insured institutions’ liquid funds. Since 1992, 

the aggregate loan-to-deposit ratio for the Region’s 

insured institutions increased from 68.4 percent at yearend 1992 to 83.2 percent at year-end 1996. 

The trend in this key liquidity ratio is widespread: By 

year-end 1996, one-third of the institutions had loan-todeposit ratios exceeding 75 percent, and almost threequarters of those were community institutions (those 

with under $100 million in total assets). In contrast, 

only one-eighth of the Region’s institutions had loan-toRegional Outlook	 21 Third Quarter 1997 
Regular Features Regional Banking
 

deposit ratios exceeding 75 percent in 1992. While the 

increase is significant, examiners have identified only a 

few isolated instances of liquidity problems in the 

Region. 

More important is how institutions have funded the 

recent loan growth. Traditionally, institutions have funded loan growth with core deposits (defined in the User’s 

Guide for the Uniform Bank Performance Report as 

savings, checking, and money market accounts, as well 

as CDs under $100,000) because of the stability and 

cost-effectiveness of these instruments compared to 

other funding sources. However, since 1992, the 

Region’s loan growth has far outstripped core deposit 

growth, as illustrated in Chart 1. 

Weak core deposit growth appears to be due, in part, to 

stiff competition from other types of financial service 

companies. These entities have made numerous alternative products, such as mutual funds, available to consumers who traditionally invested in insured deposits. In 

addition, credit unions actively compete for consumer 

deposits and generally offer higher interest rates than 

banks. As a result of these competitive factors, the 

Region’s institutions appear to have altered their funding strategies. 

Large institutions (those with over $1 billion in assets) 

have turned to nondeposit sources of funds. Large institutions have the Region’s highest aggregate loan-todeposit ratio, at 96.3 percent as of year-end 1996, up 

from 77.5 percent in 1991. More important, large institutions have experienced the most significant shift in 

funding. As shown in Chart 2, from 1992 to 1995, large 

CHART 1 

1993 1994 1995 1996 

Core Deposits 

Loans 

Source: Bank and Thrift Call Reports 

Loan Growth in the Region 

during This Economic Expansion 

-2% 

0% 

2% 

4% 

6% 

8% 

10% 

1991 1992 

Growth Rate 

Has Outstripped Core Deposit Growth 

CHART 2 

50% 

55% 

60% 

65% 

70% 

1991 1992 1993 1994 1995 1996 

Core Deposits to Assets 

0% 

5% 

10% 

15% 

20% 

Borrowed 

Funds 

Core 

Deposits 

Source: Bank and Thrift Call Reports 

Large Banks Have Replaced Lost Core 

Deposits with Other Borrowed Funds 

Other 

Other Borrowings to Assets 

institutions’ ratio of core deposits to total assets dropped 

from 66.8 percent to 57.6 percent. Over the same period, these institutions increased their use of borrowed 

funds from 6.2 percent of assets to 15.4 percent of 

assets. Greater bank participation in the Federal Home 

Loan Bank System, which offers member institutions 

relatively stable term funding on a cost-effective basis, 

accounts, at least in part, for much of this growth. 

Unlike large institutions, which have expanded their use 

of other borrowings, community institutions have 

increased noncore deposit accounts, mainly through the 

issuance of large-denomination (over $100,000) 

Certificates of Deposit (CDs). Because many of these 

institutions are located in rural areas that have traditionally had relatively fewer competitors, their core deposit 

bases have tended to be quite stable. However, these 

institutions also have experienced a shift in funding 

composition as large banks and nonbank entities continue to expand into rural areas, thereby providing 

increased competition for consumer deposits. 

Chart 3 (next page), which illustrates funding trends of 

core deposits and large CDs relative to total assets, 

shows a steady increase in the proportion of community institution assets funded by large CDs since 1992. 

Over the same period, core deposits decreased relative 

to assets. 

Implications: Although loan-to-deposit ratios have 

risen with the economic cycle, FDIC examiners report 

only isolated liquidity problems at small institutions. In 

the long term, however, reliance on large CDs by community banks has two potential adverse consequences. 

First, liquidity risk increases because these funds are 

Regional Outlook 22 Third Quarter 1997 
Regular Features Regional Banking
 

CHART 3 

75% 

77% 

79% 

81% 

83% 

85% 

1991 1992 1993 1994 1995 1996 

Core Deposits to Assets 

0% 

2% 

4% 

6% 

8% 

10% 

Large CDs to Assets 

Core Deposits 

Large CDs 

Source: Bank and Thrift Call Reports 

Community Banks in the Region Have Replaced 

Lost Core Deposits with Large CDs 

more interest-rate sensitive, and therefore less stable, 

than core deposits. Second, large CDs are usually more 

costly than core deposits. Increased reliance on such 

funds could ultimately affect community banks’ net 

interest margins and overall profitability. 

The Year 2000 Problem Cannot Be Ignored 

Significant concern has been registered over the potential impact of the year 2000 on computer systems. This 

concern primarily relates to the fact that the year portion 

of dates in many computer systems is represented by 

just two digits (i.e., 96 for 1996). Therefore, some systems may interpret the date 01/01/00 as January 1, 

1900, rather than January 1, 2000. 

The year 2000 effect on financial institutions may be 

especially significant because of their heavy use of 

computer systems. For example, deposit records, loan 

records, and management reports may be inaccurate if 

this flaw is not corrected. In addition, bank customers 

may experience similar problems that have the potential 

to disrupt their ability to conduct business or repay their 

debt. For financial institutions, the potential problems 

may reside with in-house systems and with the systems 

of their servicers. 

Fixing the problem is a relatively straightforward task but 

could involve an enormous 

amount of computer programmer time reviewing voluminous lines of computer code. 

Other approaches to fixing the 

problem could include replacing computer software and 

hardware. While these costs may be significant, lack of 

attention to this issue may be much more costly in terms 

of business disruption, potential computer systems failures, and degradation of financial control systems. 

A recent survey of community bankers by Grant 

Thornton, an accounting and management consulting 

firm, found that most community banks consider the 

year 2000 problem a nonissue. According to the survey, 

only 7 percent of respondents indicated that it is a major 

concern. When asked what steps they have taken to fix 

the problem, 26 percent said they did not have a problem. While indeed many institutions may not have the 

problem, prudent bankers will have a plan to thoroughly audit their systems and the systems of their servicers 

to ensure that they are in fact year 2000 compliant. 

The FDIC’s Division of Supervision recently issued 

Year 2000 Workprogram Procedures to assist examiners 

in raising the awareness of insured institutions to the 

potential problems surrounding this issue. 

John M. Anderlik, Financial Analyst 

Craig A. Rice, Senior Regional Analyst 

Regional Outlook 23 Third Quarter 1997 
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