Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION THIRD QUARTER 2002 

FDIC
 

Boston
 

Region
 

Division of
 

Insurance
 

and Research
 

Paul M. Driscoll,
 

Regional Manager
 

Norman Williams,
 

Regional Economist
 

Cameron Tabor,
 

Senior Financial
 

Analyst
 

Andrea Plante,
 

Economic Analyst
 

Regional Perspectives 

◆ The Region’s six state economies have performed differently through this 

business cycle than during the early 1990s recession—when most experienced 

significant deterioration relative to the nation. The divergence in performance 

among the Region’s states during this downturn may be due to varying degrees of 

dependence on technology employment and the equity market wealth effect. 

◆ Past-due loan levels have remained in check among the Region’s insured 

institutions—but the full effect of the recent recession may not yet have appeared 

in loan performance data. Thus, credit quality could deteriorate further this year. 

Also, with weakening consumer lending conditions and generally sluggish demand 

for business credit in recent quarters, insured institutions may find it harder to 

increase revenues until the economy returns to a stronger footing. Over the near 

term, these trends may be particularly evident in states such as Vermont or Massachusetts, where economic growth is expected to remain sluggish. See page 3. 

By the Boston Region Staff 

In Focus This Quarter 

◆ The Road to Recovery for Commercial Credit Quality: Not without a Few 

Hurdles Ahead—The recession that began in March 2001 has been especially 

hard on the corporate sector. Banks that made loans to affected firms felt the 

immediate effects of the recession through rising problem commercial loans. 

Large banks took the brunt of this commercial credit deterioration, as indicated 

by a somewhat larger uptick in problem commercial loans among large banks 

compared with smaller banks. This credit deterioration was more apparent at 

banks that participated in loan syndications, one of the financing vehicles available primarily to large corporate customers. Various indicators pointing toward 

economic recovery, as well as an apparent decline in rating downgrades and 

default rates among corporate bond issuers in recent weeks, suggest that 

improvement in commercial credit quality may be just ahead. This recovery, however, faces a few hurdles, including continued high leverage, weak earnings, and 

prospects for a more difficult funding environment, particularly for speculativegrade corporations with maturing debt. See page 8. 

By Cecilia Lee Barry, Senior Financial Analyst 

A Publication of the Division of Insurance and Research 
The Regional Outlook is published quarterly by the Division of Insurance and Research of the 

Federal Deposit Insurance Corporation as an information source on banking and economic issues 

for insured financial institutions and financial institution regulators. It is produced for the following eight geographic regions: 

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

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

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

Dallas Region (CO, NM, OK, TX)
 

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

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

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

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

The first and third quarter issues of the Regional Outlook feature in-depth coverage of the economy and the banking industry in each Region and consist of a national edition and eight regional editions. The second and fourth quarter issues are a single national edition that provides an overview 

of economic and banking risks and discusses how these risks relate to insured institutions in each 

FDIC Region. These issues tell the national story and, at the same time, alert the reader to specific 

trends and developments at the regional level. 

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

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

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

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

Outlook, please call Paul Driscoll at (781) 794-5502 or send an e-mail to pdriscoll@fdic.gov. 

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

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

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

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

the Federal Deposit Insurance Corporation. 

Chairman Donald E. Powell 

Director, Division of Insurance Arthur J. Murton 

and Research 

Executive Editor George E. French 

Writer/Editor Kim E. Lowry 

Editors Lynn A. Nejezchleb 

Maureen E. Sweeney 

Richard A. Brown 

Ronald L. Spieker 

Publications Manager Teresa J. Franks 
Regional Perspectives
 

Regional Perspectives
 

•	 Economic performance has varied widely among the New England states during this recession. 

•	 Massachusetts and Vermont have been hardest hit, while Rhode Island and Maine have been spared the 

worst of the recession’s effects. 

•	 The Region’s insured institutions have performed well through the recession; loan growth rates differed 

by state, likely a reflection of individual state economic performance. 

The Effects of the Recession Varied Widely across New England,
 

with the Region’s Insured Institutions Remaining Healthy
 

but Showing Elevated Credit and Earnings Risk
 

Individual State Performance 

Has Varied during This Recession 

The fallout from the most recent economic downturn in 

New England should prove mild compared to the 

effects on the national economy and to the severity of 

the recession (both absolute and relative to the nation) 

during the early 1990s. The Region’s six state 

economies have performed differently through this 

business cycle than during the early 1990s recession, 

when all the states experienced at least one annual 

decline in gross state product and two consecutive 

annual declines in per capita income. The difference 

this time is that the national recession’s adverse impact 

was amplified only in some states—those more 

dependent on technology employment, national business investment, and spending linked to stock market 

wealth effects. 

labor statistics until late summer. In addition to the 

number of “down” months, Massachusetts led the 

Region, followed closely by Vermont, in the magnitude 

of the peak-to-trough percentage job loss during this 

business cycle. Although Connecticut and New Hampshire also experienced a fair number of down months, 

as well as meaningful peak-to-trough declines in jobs, 

these two states have shown renewed job growth since 

year-end 2001 (see Chart 1). 

Unemployment rates also confirm the relative economic performance of the Region’s states. Except in Rhode 

Island (and, to a lesser degree, Maine), unemployment 

rates across the Region entered this recession at very 

low levels and rose sharply. After holding at or above 

the national average for four years in the early 1990s, 

Massachusetts (along with Connecticut) went on to post 

CHART 1 

Massachusetts and Vermont Economies 

Face the Greatest Challenges 

Trends in nonfarm payrolls illustrate how the recent 

downturn differed among the Region’s states. Between 

January 2001 and June 2002, Massachusetts and Vermont experienced the greatest number of monthly 

declines in payrolls as well as the longest consecutive 

runs of falling employment (17 months in the case of 

Massachusetts). Further, labor markets in these two 

states appear likely to continue deteriorating, while 

employment in the other four states apparently stabilized during the first half of 2002. For example, recently announced sizable layoffs at IBM, Vermont’s largest 

employer, are not expected to show up in that state’s 

Massachusetts and Vermont, Hit Hardest by the 

Recession, Will Lag in Job Growth This Year 

* Minimum seasonally adjusted monthly employment recorded after 

January 2001 versus maximum monthly employment 2000–2001 

** 2002 forecast from the New England Economic Project 

Source: Bureau of Labor Statistics and New England Economic Project 

–3 –2 –1 0 1 2 3 

Change in Nonfarm Employment (%) 

loss from peak* 

Dec ’01 to Jun ’02 

(annualized) 

2002** 

MA 

VT 

CT 

NH 

RI 

ME 

Boston Regional Outlook 3	 Third Quarter 2002 
Regional Perspectives
 

one of the lowest unemployment rates in the country by 

2000. Although unemployment rates across the Region 

have risen from the 2000 lows, rates are not expected to 

exceed the national average by much, if at all, in any of 

the Region’s states—this was not the case during the 

early 1990s. However, unemployment rates have risen 

further in some states since 2000 (see Chart 2). As a 

result of this recent divergence in performance, the 

states’ relative unemployment rate rankings may shift 

noticeably this year from 2000. For instance, Massachusetts, which had the Region’s second lowest rate in 

2000, is expected by the New England Economic Project to post the Region’s worst rate this year. Connecticut, which boasted the lowest unemployment rate in 

New England during 2000, is forecast to rise to the middle of the pack in 2002. 

Massachusetts benefited greatly from the strong stock 

market and information technology (IT) investment 

boom during the late 1990s because of the state’s significant concentrations of employment in IT and financial services firms, as well as in ancillary businesses. 

Robust economic growth in Massachusetts in the late 

1990s was strongly influenced by the boom, and the 

absence of these economic catalysts now has further 

amplified the state’s economic decline. In addition, with 

a continued malaise in the national economy a distinct 

possibility, the recent weakness in the IT and financial 

services sectors seems likely to linger and impede the 

state’s economic growth this year. 

Unlike the swing in the Massachusetts economy from 

boom to bust, the relative severity of the economic 

weakness in Vermont, for the most part, does not reflect 

a hangover effect from the late 1990s IT and stock market booms. The state’s largest employer, IBM, has been 

affected negatively by the downturn in IT, and ongoing 

layoffs are expected to accelerate as the year continues, 

but Vermont has experienced other problems as well. 

For example, overall business investment, high-end 

retailing, and tourism—key drivers of business and 

consumer sales in the Vermont economy—also were 

affected adversely during this recession. 

Maine and Rhode Island: No Booms, 

but No Busts, Either 

In contrast, Maine and Rhode Island appear to have 

escaped the adverse effects of the recession because 

they do not have significant concentrations in IT 

and financial services employment, nor are they charCHART 2 

Recession Most Affected Unemployment Rates 

in Massachusetts, Vermont, and Connecticut 

* May 2002 forecast from the New England Economic Project 

VT does not include IBM layoffs announced in June 

Source: Bureau of Labor Statistics and New England Economic Project 

0 

1 

2 

3 

4 

5 

6 

7 

US Region MA CT VT NH ME RI 

2000 2001 2002*

Unemployment Rate (%) 

acterized by sizable concentrations of high-worth 

households. The overall economic effect of these concentrations shows clearly in relative income growth 

trends. Real income growth in Maine and Rhode Island 

during the late 1990s boom was far less than that in 

Massachusetts—a state that exemplified the surge in 

IT and capital gains–driven income (see Chart 3). In 

fact, from 1997 through 1999, Maine and Rhode Island 

reported the Region’s slowest average rates of real 

income growth, while Massachusetts (and New Hampshire) led the Region. 

While IT-dependent states such as Massachusetts saw 

income growth decelerate sharply in 2001 as the effects 

of a weak stock market and an abrupt halt in business 

investment took hold, Maine and Rhode avoided such 

wide swings. Furthermore, Massachusetts is likely to 

post its first loss in real per capita income since the 

early 1990s, while Maine and Rhode Island are expected to experience continued, though somewhat slower, 

income growth this year (see Chart 4). 

Unlike the Region’s other states during the 1990s, 

Rhode Island’s average unemployment rate matched or 

exceeded the national average every year except 1996. 

During 2000, just prior to the recent recession, the 

state’s unemployment rate was the highest in the 

Region. Rhode Island’s more recession-sensitive factory 

sector was already in a prolonged period of contraction, 

and the state’s economic growth in recent years has 

lacked any boom-like qualities. As a result, the recent 

recession’s cyclical impact was limited. 

The downturn’s cyclical effects also were muted in 

Maine, where the recession-sensitive manufacturing 

Boston Regional Outlook 4 Third Quarter 2002 
8 

6 

4 

2 

0 

Regional Perspectives
 

CHART 3 CHART 4 

Growth in Real Per Capita Personal Income 2002 Real Per Capita Income Is Not Expected 

during the Late 1990s Was More Subdued to Decline in Maine and Rhode Island 

in Some States 1 

Change on Year Ago (%) 

–2 

Rhode Island 

Massachusetts 

Maine 

Expected Change on Year Ago (%)

–4 

–3 

–2 

–1 

0 

Nation 

–5 –4 

’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00 ’01 

Source: Bureau of Economic Affairs 

sector had already retrenched somewhat during the 

1990s. Maine’s reliance on factory employment is less 

than that of most other states in the Region but historically has centered on the production of less cyclical nondurable goods, such as pulp and paper, shoes, and textiles. 

Further, the state’s nonfarm job growth benefited little 

from the booming IT sector late in the past decade. 

Insured Institutions Weathered the Recent 

Recession, but Credit and Earnings Risks Remain 

The recent economic downturn appears to have had limited effects on the Region’s insured institutions thus far. 

For example, the boost in net interest margins late in 

2001 and early 2002 from cheaper funding sources 

helped insured institutions remain profitable. However, 

other measures of banking performance—particularly 

loan growth rates—reflect the recent economic slowdown and, in some cases, track the relative economic 

performance of individual states. Table 1 presents median profitability and loan growth rates for the nation, the 

Boston Region, and the New England states. Medians 

are useful as an approximation for trends at “typical” 

small to midsize banks, whose performance likely is 

tied most closely to local economic trends. 

Consumer loan growth (excluding credit card loans) 

decelerated sharply at the end of 2000, ultimately turning negative for insured institutions in those New England states first affected by the recent recession, such as 

Connecticut and Massachusetts (see Table 1). Banks and 

thrifts in other states (such as New Hampshire) that have 

been hit harder by the recent downturn in IT employment continued to post respectable consumer loan 

Region MA CT VT RI ME NH 

Source: New England Economic Project 

growth until late last year; however, loan growth also 

has turned negative for insured institutions in these 

states. Meanwhile, the milder effects of the recession on 

the Maine economy are clear as loan growth continued 

through mid-2001, with only modest deterioration in 

consumer lending since then. Although Rhode Island’s 

economy has also been spared the worst of this recession, consumer loan trends indicate some recent sharp 

declines. These declines may be due, in part, to the fact 

that many of the state’s residents commute to jobs in the 

struggling Greater Boston area, where IT industries 

have come under increasing pressure in recent months 

to reduce pay and bonuses and cut staffing levels. 

In recent years, many of the Region’s insured institutions 

have begun to target increased concentrations of higheryielding, traditionally higher-risk commercial loans.1 

Despite this fact, (aggregate) median commercial loan 

growth has decelerated in recent quarters, which could 

reflect increasing head winds from a slumping economy. 

However, unlike consumer lending, state-level commercial loan trends appear less closely linked to local economic trends. For example, commercial loan growth has 

not faltered significantly in Connecticut, though this 

state’s economy has been one of the Region’s poorest 

performers. Also, commercial lending has turned negative in Rhode Island during a time when that state’s economy has performed relatively well. Part of the disconnect 

may be due to the fact that local commercial credit 

demand has not been driven by the firms that have weakened most during this downturn. For instance, many of 

the Region’s struggling IT firms were not big users of 

1 For a discussion of this trend, see Boston Regional Perspectives, First 

Quarter 2001. 

Boston Regional Outlook 5 Third Quarter 2002 
Regional Perspectives
 

TABLE 1 

New England Insured Institutions Have Reported 

Varying Loan Growth Trends during the Past Two Years 

MEDIAN RETURN ON ASSETS 

MAR-02 DEC-01 SEP-01 JUN-01 MAR-01 DEC-00 SEP-00 JUN-00 MAR-00 

NATION* 

BOSTON REGION 

CONNECTICUT 

MAINE 

MASSACHUSETTS 

NEW HAMPSHIRE 

RHODE ISLAND 

VERMONT 

1.06 

0.84 

0.84 

0.78 

0.81 

0.97 

0.80 

1.02 

0.94 

0.90 

0.86 

0.86 

0.90 

0.95 

0.84 

1.01 

1.04 

0.88 

0.85 

0.89 

0.84 

0.97 

1.35 

1.05 

1.03 

0.81 

0.73 

0.75 

0.77 

0.93 

0.84 

1.09 

1.01 

0.81 

0.80 

0.82 

0.78 

0.84 

0.71 

0.99 

0.94 

0.91 

0.89 

0.78 

0.89 

1.03 

1.26 

1.04 

1.11 

0.93 

0.90 

0.94 

0.89 

1.03 

1.29 

1.09 

1.14 

0.91 

0.95 

0.83 

0.91 

0.94 

1.05 

1.05 

1.09 

0.91 

0.98 

0.77 

0.90 

0.98 

1.17 

0.93 

MEDIAN CONSUMER LOAN GROWTH GROWTH 

MAR-02 DEC-01 SEP-01 JUN-01 MAR-01 DEC-00 SEP-00 JUN-00 MAR-00 

NATION* 

BOSTON REGION 

CONNECTICUT 

MAINE 

MASSACHUSETTS 

NEW HAMPSHIRE 

RHODE ISLAND 

VERMONT 

–2.69 

–4.15 

–3.11 

–1.46 

–4.79 

–5.83 

–7.03 

–2.14 

–1.95 

–4.28 

–4.74 

–2.46 

–5.10 

–2.34 

–2.39 

–2.96 

0.07 

–1.64 

–1.63 

–0.16 

–2.27 

1.06 

–2.91 

–0.73 

1.37 

0.90 

–0.65 

2.35 

0.36 

3.76 

–0.30 

2.55 

0.48 

0.99 

0.56 

0.78 

1.16 

2.64 

9.08 

–2.13 

0.27 

1.24 

1.44 

0.58 

1.30 

2.18 

9.04 

0.52 

1.97 

3.30 

2.07 

3.40 

3.59 

3.77 

0.95 

3.73 

2.97 

3.90 

3.59 

4.02 

3.68 

5.34 

2.43 

3.14 

0.67 

1.03 

0.81 

1.11 

1.23 

–1.75 

8.07 

0.01 

MEDIAN COMMERCIAL LOAN GROWTH 

MAR-02 DEC-01 SEP-01 JUN-01 MAR-01 DEC-00 SEP-00 JUN-00 MAR-00 

NATION* 

BOSTON REGION 

CONNECTICUT 

MAINE 

MASSACHUSETTS 

NEW HAMPSHIRE 

RHODE ISLAND 

VERMONT 

0.68 

1.31 

2.39 

2.03 

0.82 

3.22 

–4.95 

1.30 

0.65 

1.45 

5.84 

2.39 

1.99 

–3.26 

–2.82 

0.72 

0.00 

0.54 

2.50 

–0.95 

1.26 

0.82 

–2.05 

–4.04 

2.64 

4.17 

6.81 

7.91 

1.15 

8.20 

4.60 

1.34 

2.53 

3.71 

1.82 

7.90 

0.42 

5.45 

3.63 

0.86 

2.49 

2.79 

4.15 

3.73 

0.35 

0.28 

2.09 

0.34 

1.51 

2.67 

3.33 

–1.06 

0.60 

–1.38 

2.55 

1.97 

4.01 

6.20 

3.86 

11.32 

6.18 

6.65 

1.46 

7.68 

3.57 

4.18 

3.86 

7.30 

4.09 

0.72 

10.38 

5.44 

MEDIAN COMMERCIAL REAL ESTATE, CONSTRUCTION, MULTIFAMILY LOAN GROWTH 

MAR-02 DEC-01 SEP-01 JUN-01 MAR-01 DEC-00 SEP-00 JUN-00 MAR-00 

NATION* 

BOSTON REGION 

CONNECTICUT 

MAINE 

MASSACHUSETTS 

NEW HAMPSHIRE 

RHODE ISLAND 

VERMONT 

2.15 

2.61 

5.21 

4.39 

2.05 

2.38 

–0.52 

1.07 

2.93 

2.84 

3.37 

2.96 

2.91 

2.89 

1.25 

0.83 

3.46 

3.29 

6.52 

3.40 

2.81 

2.53 

2.26 

3.91 

2.99 

3.47 

3.22 

2.60 

4.07 

2.22 

2.58 

0.44 

2.18 

1.81 

2.67 

0.96 

2.38 

1.10 

0.19 

–0.38 

2.48 

2.57 

2.32 

3.21 

2.71 

2.45 

–0.01 

1.09 

3.00 

2.79 

3.52 

1.50 

2.85 

1.99 

1.65 

2.44 

3.49 

3.28 

3.08 

4.74 

3.28 

2.26 

0.96 

4.41 

3.12 

2.57 

3.66 

2.27 

2.57 

1.24 

1.62 

1.64 

* Excludes the Boston Region 

Source: Bank and Thrift Call Reports 

Boston Regional Outlook 6 Third Quarter 2002 
Regional Perspectives
 

local bank credit, seeking funding instead in public equity markets, through bond sales, or from large lenders 

via syndicated credits. Likewise, many of the area’s 

manufacturing operations may be part of larger organizations based outside the Region, also with access to 

public capital markets or nonlocal bank funding. 

Combined construction and development, commercial 

real estate, and multifamily real estate loan portfolios 

have continued to grow modestly among insured institutions in all the Region’s states. Particularly in Massachusetts, this trend does not appear consistent with the 

fact that the state’s dominant Boston office market is 

showing high vacancy rates and sluggish sales activity. 

However, the commercial real estate and construction 

lending trends shown in Table 1 reflect activity by small 

to midsize banks, which are not significantly involved 

in large-scale office projects in the Region’s major 

metro areas. Rather, commercial construction and mortgage lending in these metro areas is likely dominated by 

public capital market vehicles, such as real estate investment trusts (REITs). 

Employment trends may provide a better indication than 

Boston’s office vacancy rate of the health of local 

commercial real estate and construction markets. Construction employment has been one of the few bright 

spots for the Region’s economy through the recent 

recession. June year-to-date job growth in the construction industry continued to outperform the nation, rising 

2.3 percent for the Region while declining 2.2 percent 

for the nation versus a year ago. 

Past-due loan levels among the Region’s insured institutions remained in check during the recent downturn, 

and deterioration in credit quality was not widespread. 

Charge-offs also remain at low levels. While insured 

institutions appear to have come through the recession 

in relatively good shape, challenges remain. Credit 

quality problems often lag the business cycle, so the full 

effect of the recent recession may not yet have appeared 

in loan performance data. Thus, credit quality among 

the Region’s banks and thrifts could deteriorate further 

this year. Also, with weakening consumer lending conditions and generally sluggish demand for business 

credit in recent quarters, insured institutions may find it 

harder to increase revenues until the economy returns to 

a stronger footing. Slower loan growth will also make 

any existing credit quality problems more apparent, as 

new loans typically have lower average loss rates than 

seasoned credits. 

Over the near term, these trends may become particularly evident in states such as Vermont and Massachusetts, where economic growth is expected to remain 

sluggish. In addition, should the recovery be slow or 

should the national economy fall back into recession, 

the regional economy would be expected to falter as 

well. Local insured institutions could find it more difficult to sustain revenue (loan) growth, while delinquencies and charge-offs might worsen appreciably. 

Boston Region Staff 

Boston Regional Outlook 7 Third Quarter 2002 
In Focus This Quarter
 

The Road to Recovery for Commercial Credit Quality:
 

Not without a Few Hurdles Ahead
 

Introduction 

The banking industry as a whole has performed well in 

recent years, despite increasing loan delinquencies, 

notably in commercial credits. Although the extent of 

commercial loan deterioration has not reached levels 

experienced in the early 1990s, it nonetheless warrants 

scrutiny. With a variety of economic indicators pointing 

toward recovery, the volume of problem commercial 

loans held by insured institutions could plateau during 

2002. Many banks tightened business loan underwriting 

standards beginning in early 2000, a trend that should 

contribute to an eventual turnaround in commercial loan 

quality. Nevertheless, several factors could delay this 

improvement. Corporate profitability has yet to recover 

fully, and many firms continue to operate with significant financial leverage. Highly leveraged firms are 

especially vulnerable to declining revenues, which 

reduce the cash flow available to service debt obligations. More significantly, lower investor tolerance for 

risk has created a far less hospitable financing market 

for speculative-grade firms, possibly straining liquidity 

and increasing the likelihood that these companies 

could default as debts mature. 

Commercial Credit Deterioration Should 

Subside with the Economic Recovery 

While the banking industry has fared well through the 

latest recession, it did not escape the effects of the troubled corporate sector. Large banks (those with assets 

greater than $1 billion), in particular, have seen a significant rise in noncurrent commercial and industrial 

(C&I) loan and loss rates.1 While total C&I loans represented 25 percent of all outstanding loans held by all 

insured commercial banks as of March 31, 2002, net 

C&I loan losses comprised 32 percent of all loan 

losses. In first quarter 2002, noncurrent C&I loans 

reached 2.6 percent of outstanding loans (2.8 percent 

for large banks), the highest level since fourth quarter 

1993. The four-quarter moving average C&I loss rate 

also rose among small and large banks; however, the 

rate of increase for large banks was significantly higher, 

as shown in Chart 1. 

1 Noncurrent loans are defined as loans 90 or more days past due or 

on nonaccrual status. 

CHART 1 

Large Banks Experience a Rapid Rise in 

Commercial and Industrial Loan Loss Rates 

Source: Bank Call Reports, FDIC Research Information System 

Large banks 

(> $1 billion in assets)

Four-Quarter Moving Average Commercial

and Industrial Loss Rates (%)

Small banks 

(< $1 billion in assets) 

0.0 

0.2 

0.4 

0.6 

0.8 

1.0 

1.2 

1.4 

1.6 

1.8 

2.0 

2.2 

1Q90 3Q91 1Q93 3Q94 1Q96 3Q97 1Q99 3Q00 1Q02 

Improving economic conditions and tighter underwriting standards suggest that commercial credit quality 

should improve. A range of indicators suggests that economic recovery is under way, albeit more slowly than 

some expected earlier this year. The housing sector 

remains robust, job conditions have stabilized, and real 

gross domestic product (GDP) grew 5.0 percent in first 

quarter 2002. Although GDP grew at a slower pace of 

1.1 percent in second quarter 2002, business equipment 

spending increased 2.9 percent, in contrast to a decrease 

of 2.7 percent in first quarter 2002. Also, the manufacturing sector began to show signs of recovery with the 

Institute for Supply Management (ISM) index for 

manufacturing reaching 56.2 and 50.5 in June and July 

2002, respectively. The ISM index has remained above 

50, which signals an economic expansion, for the six 

consecutive months since February 2002. Also, the 

index of coincident indicators, a gauge of current economic activity, rose 0.3 percent in June 2002. Furthermore, a survey of 50 leading corporate economists by 

Blue Chip Economic Indicators shows that analysts 

expect the U.S. economy to grow at a rate of 3.3 percent 

in third quarter 2002.2 

Recent changes in underwriting standards also bode 

well for credit quality at commercial banks. The Federal 

2 Blue Chip Economic Indicators, July 2002. Also see Regional 

Outlook, Second Quarter 2002, “Back to the Future: How This 

Downturn Compares to Past Recessions.” See http://www.fdic.gov/ 

bank/analytical/regional/ro20022q/na/index.html. 

Boston Regional Outlook 8 Third Quarter 2002 
In Focus This Quarter
 

Reserve Board’s Senior Loan Officer Opinion Survey 

on Bank Lending Practices, which focuses on 

changes in the supply of and demand for bank loans to 

businesses and households over the previous three 

months, has shown consistent tightening of business 

loan standards during the past two years. The April 

2002 survey indicated some further tightening of standards, but the percentage of banks reporting this tightening has declined since the January survey, consistent 

with the anticipation of a continued economic 

rebound.3 Since credit quality typically lags the business cycle, near-term recovery appears more likely, 

provided the economy continues to improve. This 

recovery in commercial credit quality, however, is not 

without a few hurdles ahead. 

High Default Rates, Rating Downgrades, 

and Bankruptcies Persist 

While the U.S. economy is showing signs of recovery 

and underwriting standards have tightened, corporate 

credit quality could continue to be affected by several 

adverse trends. The number of bankruptcies filed by 

public companies this year is on pace to challenge 

the record set in 2001.4 Furthermore, default rates for 

CHART 2 

Current U.S. Corporate Credit Deterioration Is 

U.S. speculative-grade corporate bond issuers remained 

high at 10.3 percent in June 2002, and the high ratio of 

corporate rating downgrades to upgrades indicates continuing weakness in the corporate sector (see Chart 2).5 

The main reasons for rating downgrades have been poor 

profitability and high leverage. 

Corporate Profitability Remains Fragile 

Corporate profitability has been depressed since first 

quarter 2001 (see Chart 3). However, this trend is improving slowly in 2002. U.S. corporate profits rose during 

second quarter 2002 for the first time in five quarters.6 

However, the rate of recovery is not expected to be strong 

in 2002, as some 93 companies in the Standard & Poor’s 

500 have announced that third quarter earnings will be 

less than expected, more than twice the number of companies that have announced they will beat estimates.7 In 

fact, earnings forecasts have been revised downward 

consistently for the past several months, and analysts 

have warned recently that earnings estimates for the 

second half of 2002 are likely to be reduced. The bright 

spot in earnings continues to be the consumer sector, 

with automobile manufacturers and certain retail areas 

posting strong sales. The worst-performing sectors on a 

CHART 3 

Corporate Profits Remained Depressed 

Approaching Early 1990s Levels 

0 

1 

2 

3 

4 

5 

6 

7 

8 

9 

10 

11 

0.0 

0.5 

1.0 

1.5 

2.0 

2.5 

3.0 

3.5 

4.0 

4.5 

5.0 

Percent Ratio 

Bank commercial and 

industrial noncurrent 

rate (left scale) 

U.S. speculative-grade bond 

issuer default rate (left scale) 

U.S. Corporate bond ratings downgrades 

to upgrades (right scale) 

1988 1990 1992 1994 1996 1998 2000 1Q02 

Year-over-year growth in net income from

continuing operations for all S&P 500 firms (%)

35 

25 

15 

5 

–5 

–15 

–25 

through the First Quarter of 2002 

1997 1998 1999 2000 2001 2002 

Sources: Moody’s, Bank Call Reports, FDIC Research Information System 

3 Senior Loan Officer Opinion Survey on Bank Lending Practices, 

The Federal Reserve Board, April 2002. The survey reported that the 

percentage of domestic banks that reported tightened standards on 

C&I loans to large and middle-market firms (annual sales of at least 

$50 million) since the January survey declined to 25 percent from 

45 percent. The percentage of domestic banks that report tightened 

standards on business loans to small firms declined more, from 42 

percent in January to 15 percent in April. 

4 Bankruptcydata.com reports that 257 publicly traded companies 

filed for bankruptcy in 2001, while 114 companies had filed by 

June 30, 2002. 

Source: Standard & Poor’s 

5 In the first half of 2002, Moody’s downgraded 262 companies and 

upgraded 59, producing a downgrades to upgrades ratio of 4.4:1. 

6 On a year-over-year basis, 371 companies in the Standard & Poor’s 

500 Index that reported earnings through July 26, 2002, posted 

profits. 

7 Danielle Sessa, “U.S. Stocks Slide as Johnson & Johnson, Pepsi 

Shares Tumble,” Bloomberg.com, July 19, 2002. 

Boston Regional Outlook 9 Third Quarter 2002 
In Focus This Quarter
 

year-over-year basis appear to be energy, transportation, 

utilities, capital goods, and communications services.8 

The latest recession was driven primarily by the sharp 

decline in the demand for capital goods. With the slow 

economic recovery, businesses have continued to limit 

capital spending. The rate of recovery for corporate profitability will depend in large part on how soon and to 

what extent businesses resume spending. 

The prospect of slow earnings growth could be particularly problematic for many highly leveraged corporations. Debt levels relative to cash flow have been 

rising because of anemic earnings (see Chart 4). Negative earnings news also comes at a time when several 

well-publicized accounting irregularities have shaken 

investors’ confidence in corporate earnings reports. A 

Huron Consulting Group study of financial restatements indicates that during the past five calendar 

years, the number of restated financial statements filed 

by public companies has grown from approximately 

120 in 1997 to 270 in 2001.9 The number of restatements continued to grow in 2001, despite a reduction in 

the number of public companies. That study found that 

CHART 4 

the largest source of restatements relates to how companies recognize revenue. With depressed corporate 

profits and diminishing investor confidence, some 

firms with debts maturing in the near term may have 

difficulty refinancing. 

Firms with Maturing Debts Could Face 

a Critical Period in the Near Term 

Moody’s estimates that $141 billion worth of U.S. 

speculative-grade corporate bonds and rated bank debt 

will come due over the next three years: $27 billion 

(19 percent) in 2002, $54 billion (38 percent) in 2003, 

and $60 billion (43 percent) in 2004.10 To put these 

numbers into perspective, total U.S. corporate bond 

defaults were $115 billion in all of 2001, of which 

95 percent of those defaulting were speculative-grade 

borrowers. Although Moody’s expects the bulk of 

high-yield debt maturing in 2002 to be refinanced 

despite unfavorable market conditions, concern exists 

about the large percentage of issues rated B1 or lower 

that will come due in 2003 and 2004 (see Chart 5).11 

CHART 5 

Corporate Debt Continues to Rise 

Relative to Cash Flows 

Source: Federal Reserve Board Ratio of nonfarm, nonfinancial debt to cash flow 

3.5 

4.0 

4.5 

5.0 

5.5 

6.0 

1975 1978 1981 1984 1987 1990 1993 1996 1999 1Q02 

Forty-Seven Percent of U.S. Speculative-Grade
 

Bonds and Bank Debt Maturing in 2003–2004
 

Are Rated B1 or Lower
 

Ba1 to Ba3 

53% 

B1 to B3 

36% 

Caa1 or lower 

11% 

Source: Moody’s 

8 Charles L. Hill, et al., This Week in Earnings, Thomson First Call, 

July 22, 2002. 

9 A Study of Restatement Matters, for the five years ended December 

31, 2001, Huron Consulting Group, June 2002. This study excluded 

restatements caused by changes in accounting principles and 

nonfinancial-related restatements. 

10 Tom Marshella, et al., “Refunding Risk for U.S. Speculative Grade 

Borrowers, 2002–2004,” Global Credit Research, Moody’s Investors 

Service, December 2001. Figures related to refunding risk presented 

throughout this article are taken from Moody’s refunding risk studies, 

conducted annually since November 1998. 

11 Speculative-grade debt ratings assigned by Moody’s in the order of 

declining credit quality are as follows: Ba, B, Caa, Ca, and C. 

Moody’s also applies numerical modifiers 1, 2, and 3 in each generic 

rating classification. The modifier 1 indicates that the obligation 

ranks in the higher end of its generic rating category, while the 

modifier 3 indicates a ranking in the lower end of that generic rating 

category. 

Boston Regional Outlook 10 Third Quarter 2002 
In Focus This Quarter
 

Credit deterioration of bank loans is similar to the cur- TABLE 1 

rent trend in corporate bonds. Migration of maturing 

loans into lower grade categories has accelerated in 

recent years (see Chart 6). This ratings decay reflects 

the borrowers’ deteriorated financial condition and the 

effects of liberal underwriting conditions from 1996 to 

1998, when speculative-grade originations were more 

common. For example, the 1999 and 2000 refunding 

risk studies conducted by Moody’s noted that 16 percent 

and 17 percent, respectively, of all rated bank loans 

maturing in 2002 were rated B1 or lower. The trend 

worsened significantly in 2001, when the study noted 

that 39 percent of bank loans maturing in 2002 were 

rated B1 or lower. When firms have to refinance lowgrade debts in today’s environment, they may face 

additional pressure on earnings and liquidity. 

Loss Severity Has Increased 

with Higher Default Rates 

Moody’s credit ratings reflect the likelihood of default 

and the severity of loss given default. As a result, the 

migration of maturing bonds and loans into lower 

grades implies a greater risk of default or increased loss 

severity upon default, or perhaps both. Moody’s notes, 

as part of its 15th annual study of global corporate 

defaults and ratings performance, that average recovery 

rates fell for the third straight year in 2001.12 The recovery rate has deteriorated for all levels of security and 

CHART 6 

The Proportion of Maturing Bank Loans Rated
 

B1 or Lower Is Increasing
 30 

Ba 25 

Average Speculative-Grade 

Recovery Rates in 2001 Show a 

Declining Trend in Nearly All Levels 

of Security and Subordination 

AVERAGE
 

RECOVERY
 

PER $100
 

1982– 

SENIORITY/SECURITY 2000 2001 

SENIOR SECURED BANK LOAN $67.06 $54.68 

EQUIPMENT TRUST $64.65 NA 

SENIOR SECURED BONDS $52.09 $58.00 

SENIOR UNSECURED BONDS $43.82 $36.20 

SENIOR SUBORDINATED BONDS $34.59 $19.90 

SUBORDINATED BONDS $31.83 $16.45 

JUNIOR SUBORDINATED BONDS $22.48 NA 

Note: NA=not available 

Source: Moody’s 

subordination except for senior secured bonds (see 

Table 1). 

Higher-Risk Borrowers Pay High Premiums 

A speculative-grade company refinancing debt today 

will face a much higher price, in terms of spreads over 

a cost of funds index or risk-free instruments, compared to several years ago. Yield spreads between 

investment-grade and speculative-grade bonds have 

widened significantly since early 2000 (see Chart 7), in 

part because of lower investor tolerance for risk, rising 

CHART 7 

$ Billions 

20 

15 

10 

5 

0 

B1 or Lower 

2002 2003 2004 

Credit Costs for Higher-Risk Borrowers Rose 

Dramatically in Recent Years 

Sources: Merrill Lynch Bond Global Bond Indices, Federal Reserve Board Basis point spread over ten-year constant-maturity Treasuries

Investment-grade bonds 

High-yield bonds 

0 

100 

200 

300 

400 

500 

600 

700 

800 

900 

1000 

Jun 

’98 

Dec 

’98 

Jun 

’99 

Dec 

’99 

Jun 

’00 

Dec 

’00 

Jun 

’01 

Dec 

’01 

Jun 

’02 

Source: Moody’s 

12 David Hamilton, et al., “Default & Recovery Rates of Corporate 

Bond Issuers: A Statistical Review of Moody’s Ratings Performance 

1970–2001,” Global Credit Research, Moody’s Investors Service, 

February 2002. The recovery rate is defined as the secondary market 

price of the defaulted instrument approximately one month after the 

time of default. 

Boston Regional Outlook 11 Third Quarter 2002 
In Focus This Quarter
 

defaults, and weakening corporate cash flows. After 

narrowing a bit in first quarter 2002, spreads have 

widened again on renewed concerns about accounting 

irregularities and the realization that the economic 

recovery may come at a slower pace than anticipated. 

Lower investor tolerance for risk has affected not only 

speculative-grade borrowers but also some investmentgrade borrowers. For example, the commercial paper 

(CP) market, which many investment-grade borrowers 

have used as a cheap source of funding, is no longer 

readily available to all investment-grade borrowers.13 

Drawn-Down Commercial Paper Back-up Lines 

Heighten Commercial Bank Exposure14 

Since its peak at the end of 2000, the CP market for 

domestic nonfinancial companies has shrunk by almost 

50 percent (see Chart 8). A reduction in the need for 

working capital and heavy refinancing activity have 

contributed to this contraction. However, the record 

number of downgrades among issuers of CP in 2001 

also contributed to this decline. Money market funds 

cannot hold more than 5 percent of assets in CP graded 

less than A1/P1/F1.15 Thus, the recent flux of downgrades effectively squeezed some issuers out of this 

market and forced them to refinance with fixed-rate 

bonds.16 Also, fears of deteriorating credit quality have 

shut some investment-grade companies out of the CP 

market. Since the collapse of Enron, investors have been 

reluctant to hold the debt of certain companies. Some of 

these companies reported accounting irregularities, and 

the restatement of financial statements revealed previously hidden losses. In some cases, issuers that were not 

involved with accounting irregularities were forced to 

draw on bank credit lines when they were unable to roll 

over their CP because of the lack of demand or extreme13 Commercial paper is short-term promissory notes issued by large 

firms, generally maturing in nine months or less. It is an important 

source of short-term funding for corporations that need a steady 

stream of working capital. 

14 A CP back-up line is a commitment to provide a liquidity support 

for a company’s CP program. It is typically a revolving credit, a 

364-day facility. The rationale is that the borrower does not intend 

to use the back-up line, which generally costs more than issuing 

CP, unless the CP cannot be rolled over or repaid. 

15 The CP market can be divided into three tiers: Tier 1 (A1/P1/F1 or 

better), Tier 2 (A2/P2/F2), and Tier 3 (A3/P3/F3). The first two 

groups make up the bulk of the market. The first rating refers to a 

rating assigned by Standard & Poor’s, while the second and third 

reflect ratings assigned by Moody’s and Fitch, respectively. 

16 Moody’s Investors Service, Moody’s Credit Perspectives, December 

31, 2001. Moody’s downgraded 38 commercial paper programs from 

P1 in 2001. 

CHART 8 

Domestic Nonfinancial Commercial Paper 

Outstandings Have Declined amid Investors’ 

Jitters about Credit Quality 

Source: Federal Reserve Board (Haver Analytics) $ Billions 

100 

150 

200 

250 

300 

350 

2Q95 2Q96 2Q97 2Q98 2Q99 2Q00 2Q01 2Q02 

ly high rates demanded by investors. When a CP issuer 

draws down on the back-up line, rating agencies often 

view this as a weakness in the company’s liquidity, and 

a rating downgrade can occur. In turn, lower ratings lead 

to higher funding costs for the borrowers. 

The steepness of the current yield curve also results in 

significantly higher refinancing costs for investmentgrade corporations that no longer have access to shortterm funding through the CP market. As these 

companies are forced to borrow longer term, they face 

higher refinancing costs in the long-term end of the 

current yield curve.17 For example, if a Tier 1 corporation formerly issuing 90-day CP was forced to issue 

ten-year fixed-term debt in mid-July 2002, the cost 

would have been almost 350 basis points higher than 

issuing 90-day CP. 

Using back-up lines of credit when companies cannot 

roll over maturing CP has become expensive for some 

issuers. Bankers are realizing that initial pricing does 

not reflect the risk inherent in drawn-down lines. As a 

result, bankers have started to impose high utilization 

premiums on BBB-rated CP back-up lines. Also, borrowers recently have been seeking term-out options, 

another sign that refunding risk is a concern.18 Recent 

transactions reported by Loan Pricing Corporation 

show that some investment-grade companies are seek17Bloomberg Fair Market Sector Curves, July 5, 2002. The spread
 

between 60-day and five-year Treasury instruments was nearly 300
 

basis points. 


18 Once the back-up line has been drawn down, the borrower again has
 

to repay or roll over the debt. A revolving facility can be “termed out”
 

so that it becomes an installment loan with a much longer maturity,
 

such as three to five years. Such an option, however, can be costly.
 

Boston Regional Outlook 12 Third Quarter 2002 
In Focus This Quarter
 

ing term-out options even at a fee of 200 basis points. 

The higher premiums demanded reflect both the volatility in the market and deteriorating credit quality indicated by high default rates and rating downgrades in 

recent quarters. 

Conclusion 

During the boom times of the late 1990s, corporations 

enjoyed an abundance of liquidity sources and easy 

access to capital. Many corporations used debt to 

finance business expansions, and rolling over maturing 

debt was not a significant concern. Recently, however, 

stock prices have been declining and investors have 

been concerned about the possibility of more corporate 

financial restatements. In this environment, highly 

leveraged borrowers worry about maturing debts and 

refunding risk implications. Lenders are demanding 

higher spreads because of the volatile financial markets 

and the deteriorated financial condition and debt ratings 

of many borrowers. In general, firms seeking to roll 

over maturing debt clearly face a less hospitable financing market today. With corporate profitability not yet 

strong, highly leveraged companies may find it increasingly difficult to meet debt service requirements and 

loan covenants. Despite these hurdles, the economy 

appears to be improving, and more companies are 

beginning to report higher earnings. With an economic 

recovery and tighter underwriting standards, the deterioration in commercial credit quality should stabilize 

and turn around. 

Cecilia Lee Barry, Senior Financial Analyst 

Boston Regional Outlook 13 Third Quarter 2002 


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