A Publication of the Division of Insurance

Regional Outlook

FEDERAL DEPOSIT INSURANCE CORPORATION FOURTH QUARTER 1997

In Focus This Quarter

◆ Bank Earnings: Competitive Pressures and Cyclical

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

underwriting standards and other changes to risk management practices that can

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

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

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

See page 3.

By Ronald Spieker, Steve Linehan, George French

◆ Strong Demand and Financial Innovation Fuel

Rebounding Commercial Real Estate Markets—Commercial real

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

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

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

Securitization vehicles such as commercial mortgage-backed securities and real

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

See page 9.

By Steven Burton, Gary Ternullo

Regular Features

◆ Regional Economy—A review of the San Francisco Region’s largest

metropolitan areas reveals several that are growing extremely rapidly, while a few

others are performing relatively poorly. Banks’ high and rising exposure to highly

cyclical construction lending in several metropolitan areas is becoming an area of

concern. See page 14.

By Gary C. Zimmerman

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

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

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

form of Tier 1 capital. See page 19.

By Kathy R. Kalser

◆ Regional Banking—Favorable performance continues for most banks

and thrifts in the Region...banks and thrifts show that renewed interest in

commercial real estate lending in several areas has occurred as strong economic

growth has reduced vacancy rates and spurred construction of commercial properties...exposure to higher-risk construction and commercial real estate loans is near

record levels in some areas. See page 23.

By Catherine I. Phillips-Olsen, Roger Stephens, Millen L. Simpson 

FDIC

San Francisco

Region

Division of

Insurance

Catherine I.

Phillips-Olsen,

Regional Manager

Gary C. Zimmerman,

Regional Economist

Roger Stephens,

Financial Analyst
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 San Francisco Region’s

Regional Outlook, please call Catherine I. Phillips-Olsen at (415) 974-4247 or send an e-mail to

cphillips-olsen@fdic.gov.

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

reflect official positions of the Federal Deposit Insurance Corporation. Some of the information

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

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

accuracy by the Federal Deposit Insurance Corporation.

Chairman Andrew C. Hove, Jr.

Director, Division of Insurance Arthur J. Murton

Editor George E. French

Managing Editor Stephen Linehan

Associate Editor Maureen E. Sweeney

Assistant Editors Suzannah L. Susser

John D. Weier

Publications Manager Teresa J. Franks
San Francisco Regional Outlook 3 Fourth Quarter 1997

In Focus This Quarter

• Rapid loan growth, record low credit losses,

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

record levels.

• Intense competition to preserve and attract

business can lead to aggressive loan pricing,

relaxed loan underwriting standards, increased

portfolio concentrations, and other changes to

risk-management practices that can reduce

banks’ ability to sustain earnings and capital

through a downturn.

• As this economic expansion approaches an

advanced age, prudent bankers will allow for the

possibility of an adverse change in economic

conditions.

As the U.S. economic expansion continues through its

seventh year, the banking industry continues to run at

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

aggressive expansion of income sources, and vigorous

cost-cutting. Some analysts argue that banking has

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

cycle.

Yet banks face risks that should not be overlooked.

Assertions that bank earnings will be less sensitive to

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

relaxed underwriting standards and easing of loan

terms, or increased focus on business lines whose risks

are difficult to manage. Policies that boost short-term

shareholder returns, including high dividends and stock

repurchase programs, can reduce banks’ capacity to

weather a future downturn. There is evidence that these

things are occurring to varying degrees in banking

today. Accordingly, as this expansion reaches an

advanced age, prudent bankers will give careful regard

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

Credit Quality

Variations in credit quality have been and are likely to

remain for some time the primary source of large

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

the risks of large swings in credit quality by adjusting

underwriting standards and loan terms, by diversifying

loan portfolio exposures, and by supplying adequate

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

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

these factors during the expansion.

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

shown in Chart 2, bank loan growth has exceeded

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

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

loan losses has tended to follow episodes of rapid loan

growth. 

Credit standards are important tools for individual

banks to manage these cyclical fluctuations in credit

quality. According to the Federal Reserve’s August 1997

Bank Earnings: Competitive Pressures

and Cyclical Risks

CHART 1

Earnings Results Are Largely Driven by

Provision Expenses

-1.0%

0.0%

1.0%

2.0%

3.0%

Return on Avg Assets

Provision Exp/Avg Assets

Source: Commercial Bank Call Reports

-2.0%

6-’85

12-’86

6-’88

12-’89

6-’91

12-’92

6-’94

6-’97

12-’95
San Francisco Regional Outlook 4 Fourth Quarter 1997

In Focus This Quarter

Senior Loan Officer Survey, during the preceding three

months, a large percentage of banks had eased terms on

commercial and commercial real estate loans, including

reducing loan interest rates, increasing credit lines, and

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

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

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

any widespread problems with underwriting practices

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

were “frequently or commonly” funding speculative

construction projects. About 18 percent of institutions

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

loans that lack documentation of financial strength.

Maintaining an adequate allowance for loan losses is

another important way for banks to sustain earnings and

capital during downturns. The aggregate allowance held

by commercial banks has decreased from 2.74 percent

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

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

Although in the aggregate these reserve numbers

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

reserve levels ranged from 1.20 percent to 1.74 percent,

the Office of the Comptroller of the Currency (OCC)

recently issued an advisory letter expressing concern

about declining reserve levels and the need to maintain

an adequate allowance. This letter was a response to

weakness in the credit card sector and to trends in the

market for syndicated commercial loans, including

increasing leverage, declining spreads, and a weakening

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

Diversifying loan portfolios is another way for banks to

help reduce susceptibility to economic downturns. It

has often been noted that the trend toward interstate

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

retain high concentrations of credit exposure to specific

economic sectors. For example, commercial real estate

lending and construction lending has been a source of

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

Strong Demand and Financial Innovation Fuel

Rebounding Commercial Real Estate Markets, banks

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

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

real estate and construction exposures1 exceeding 200

percent of equity and reserves. Concentrations and

rapid growth do not necessarily portend difficulties, but

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

sound underwriting policies and standards and the

maintenance of adequate loss reserves.

The most immediate concerns about credit quality have

been expressed regarding credit cards and some other

CHART 2

-15%

-10%

-5%

0%

5%

10%

15%

20%

1980

GDP Growth

Loan Growth

Average Loan Growth Has Recently

Outpaced Nominal GDP Growth

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

199219941996

CHART 3

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

Net Loan Loss Growth (%)

Loan Losses and Loan Growth Are Correlated

-15

-10

-5

0

5

10

15

-90

-60

-30

0

30

60

90

Loan Growth

Net Loan Loss Growth

198019831986198919921995

1 Includes loans secured by multifamily dwellings and nonfarm nonresidential structures, as well as construction loans.
San Francisco Regional Outlook 5 Fourth Quarter 1997

In Focus This Quarter

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

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

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

accompanied the recession of 1990 to 1991. Noncurrent

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

percent, and some examiners are commenting that these

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

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

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

grew their home equity lines by more than 30 percent

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

Except for credit cards and some other consumer loans,

loan losses are at historically low levels. Nevertheless,

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

this far into the expansion. Institutions that maintain

strong underwriting standards, an adequate allowance

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

Net Interest Margin

Net interest margin (NIM) is another primary driver of

bank earnings. Indeed, a sharp improvement in NIM

helped lead the banking industry’s dramatic recovery

from the last recession (see Chart 4). Commercial

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

4.23 percent still remains near the top of the range

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

next page).

The banking industry’s rapid loan growth in recent

years has been one of the factors supporting the current

high NIM. (Since loans generally yield more than

securities, a higher proportion of loans generally

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

rapid loan growth indefinitely, however. Accordingly, a

TOTAL LOANS AND LEASES 11 13 24

CONSTRUCTION LOANS 4 36 40

COMMERCIAL REAL ESTATE LOANS 9 27 37

TOTAL CRE 10 28 38

1-4 FAMILY RESIDENTIAL LOANS 11 17 29

HOME EQUITY LINES 4 25 29

TOTAL RESIDENTIAL 12 18 29

CREDIT CARD LOANS AND RELATED PLANS 4 17 21

OTHER CONSUMER LOANS 9 18 27

TOTAL CONSUMER LOANS 9 18 27

COMMERCIAL LOANS 9 26 35

Source: Bank & Thrift Call Reports

TABLE 1

Rapid Loan Growth Is

Occurring at a Significant

Number of Institutions

(4 qtrs growth ending 6/97)

CHART 4

Rebound in ROA Since 1990 Fueled

by Improved NIM and Asset Quality

0.0%

0.5%

1.0%

1.5%

2.0%

1984 1986 1988 1990 1992 1994 1996

2.5%

3.0%

3.5%

4.0%

4.5%

5.0%

ROA

Net charge-off ratio

NIM

Source: Commercial Bank Call Reports

R

OA, Net Charge-Off Ratio

NIM (%)

Percentage of Institutions with Loan

Category Growth Approximating

20% to 30% 30% or

More

Total

Over 20%
San Francisco Regional Outlook 6 Fourth Quarter 1997

In Focus This Quarter

risk in the current environment is that in the effort to

support their NIM by generating new lending, banks

may make compromises in loan underwriting, pricing,

and portfolio diversification.

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

the liability side, over the past six years, commercial

banks’ average annual deposit growth rate of 3.2 percent

has been outpaced by the 4.9 percent average annual

growth rate of earning assets. As a result, nondeposit

borrowings have increased significantly in importance,

rising from about 12.6 percent of earning assets in 1991

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

nondeposit borrowings has exceeded the average cost of

deposits over the period by an average of 135 basis

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

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

available to small savers; its effect is that bank funding

is becoming more expensive and more interest-rate

sensitive.

On the asset side, pricing pressures also are frequently

cited as contributing to sluggish NIM. For example, in

the aforementioned syndicated lending market, average

interest spreads charged to noninvestment-grade large

customers have dropped more than 63 basis points

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

are being done at minimal or no risk-adjusted spreads

simply to preserve lending relationships. Increased

securitization of various asset types has also had effects

on pricing. By increasing the depth and liquidity of the

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

competitive pressures on institutions not able to achieve

the volumes necessary to efficiently utilize this new

funding vehicle.

The thin spreads available from high-quality lending

may tempt some institutions to finance higher yielding,

riskier credits in an effort to preserve or boost profit

margins. For example, recent forays by some banks into

subprime lending (see Subprime Lending: A Time for

Caution, Third Quarter 1997) may be one indication of

how competitive pressures on NIMs are affecting bank

behavior. Over the long term, institutions that manage

their NIMs with a prudent regard for how their newly

booked business may fare during a cyclical downturn

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

Growth in Noninterest Income

Industry analysts often cite the increasing contribution

of fees and other sources of noninterest income as

evidence of the evolution of the banking industry. As

Chart 5 (next page) illustrates, for commercial banks

with over $1 billion in assets, noninterest income now

averages over 40 percent of net revenue (net interest

income plus noninterest income). In contrast, banks

1997 Commercial Bank Performance Compared with Historical Averages

INDUSTRY AVERAGES

6/30/97 1984-1996

ANNUALIZED LOW HIGH

(%) (%) (%)

NET INTEREST INCOME/AVERAGE EARNING ASSETS 4.23 3.89 4.36

X AVERAGE EARNING ASSETS/AVERAGE ASSETS 86.50 86.21 88.42

= NET INTEREST INCOME/AVERAGE ASSETS 3.66 3.36 3.89

+ NONINTEREST INCOME/AVERAGE ASSETS 2.13 1.10 2.13

− NONINTEREST EXPENSE/AVERAGE ASSETS 3.50 3.05 3.90

− PROVISION EXPENSE/AVERAGE ASSETS 0.40 0.28 1.28

+ OTHER ITEMS/AVERAGE ASSETS 0.03 −0.02 0.15

− TAXES/AVERAGE ASSETS 0.68 0.18 0.64

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

Source: Bank & Thrift Call Reports

TABLE 2
San Francisco Regional Outlook 7 Fourth Quarter 1997

In Focus This Quarter

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

traditional banking activities, with only 25 percent of

revenue from these noninterest sources.

Noninterest income growth is being driven both by new

business lines and higher deposit-related fees.

Examples include fees from sales of mutual funds and

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

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

affected the growth in reported noninterest income.

With the exception of trading revenue, noninterest

income has historically shown a growth trend that has

not been especially sensitive to economic cycles.

However, newer fee-based businesses such as mortgage

banking, mutual funds, and securities underwriting may

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

reduce banks’ historical exposure to economic cycles.

The Effect of Expense Control 

on Earnings Performance

Cost-cutting efforts in banking continue to show their

effects. Since 1991, commercial banks’ efficiency

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

Other measures of productivity have shown similar

improvement. For example, commercial banking assets

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

between 1984 and 1997.

Growth in overhead expense has been contained largely

through consolidation, technological advances, and low

levels of problem assets. Mergers have resulted in the

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

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

products and services. Favorable economic conditions

have reduced costs associated with loan collection and

asset workouts. 

Whether the downward trend in overhead expenses will

continue is an open question. Should problem loans

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

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

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

Tower Group Survey of Information Technology

Services in Banking noted that the banking industry is

“faced with an aging IT infrastructure.” The survey

suggests that most technology-related expenses could

increase at a 5.6 percent compounded growth rate until

the year 2000 and that expenses for outside services

could increase 11 percent over the same period. The

ability to generate future revenue gains may depend on

additional bank investment not only in technology but

also in the development of new products and services.

CHART 5

Noninterest Revenue to Net Revenue*

Banks Over $1 Billion

Banks Under $1 Billion

Source: Commercial Bank Call Reports

* Net Revenue = Net interest income plus noninterest income

10

20

30

40

50

6-’85

Net Revenue (%)

6-’876-’896-’916-’936-’956-’97

CHART 6

Commercial Banks’ Efficiency Ratio*

Is Steadily Improving

70%

1984

Source: Commercial Bank Call Reports

68%

66%

64%

62%

60%

58%

56%

198619881990199219941996

* Noninterest expense/(net interest income + noninterest income) 2 The efficiency ratio is normally defined as noninterest expense

divided by the sum of net interest revenue and noninterest revenue.
San Francisco Regional Outlook 8 Fourth Quarter 1997

In Focus This Quarter

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

example, reductions in personnel, or excessive reliance

on automated underwriting procedures (see Will Credit

Scoring Transform the Market for Small-Business

Lending? Second Quarter 1997), may raise concerns

about the effectiveness of internal administration and

control processes. Cost-cutting that cuts too deeply into

customer service can erode franchise value. Mergers

can reduce redundant expense, but at some point there

may be diseconomies to managing a large organization. 

The Role of Capital in the Management 

of Earnings

Management, shareholders, and analysts often evaluate

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

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

continue to grow ROE and EPS; these objectives have

been made progressively more difficult to attain by the

significant level of capital that has built up over the past

five years.

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

recent rash of mergers and acquisitions, high dividend

payout ratios, increased stock repurchases, and the

development of alternative types of hybrid capital such

as trust preferred stock (see Financial Markets). For

example, during 1995 and 1996, major merger and

acquisition deals included some $835 billion in bank

and thrift assets. During 1996, commercial banks with

over $1 billion in assets had an average dividend payout

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

assets averaged 55 percent for 1996 and 52 percent for

1994. In addition, banks and bank holding companies

have issued some $21 billion in trust preferred stock

during the last nine months, some of which has been

used to fund the almost $42 billion in share repurchase

programs announced by large banks during 1996 and

early 1997.3

While the book value of equity and other capital ratios

has increased at the aggregate industry level, a number

of banks are reporting declines in equity capital and

leverage capital ratios despite positive earnings (see

Chart 7). For all institutions, the ability to actively manage capital accounts going forward will depend largely

on having earnings available above the levels needed to

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

and examiners will need to carefully review strategies

that increase bank leverage or increase business risk

without considering the potential effects of a downturn

in credit quality or other weakening in the economy. 

Summary

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

time when banks’ traditional business lines are coming

under greater competitive pressure than ever. While the

industry as a whole is adapting well to these competitive

pressures, there may be a tendency for some insured

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

The nature of banking is to profit by taking calculated

risks, and naturally more profits will be made during the

expansionary phase of a cycle than during a downturn.

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

will be those that allow for the possibility of an adverse

change in business conditions, and prudently balance

the levels of risk taken with the expected returns. 

Ronald Spieker, Chief, Depository Institutions Section

Steve Linehan, Assistant Director, Analysis Branch

George French, Deputy Director

3 Salomon Brothers.

CHART 7

An Increasing Number of Profitable Banks Are

Reducing Tier 1 Capital*

Source: Commercial Bank Call Reports

* Both Tier 1 dollar amount and ratio

0

200

400

600

800

1992 1993 1994 1995 1996

Number of Banks
San Francisco Regional Outlook 9 Fourth Quarter 1997

In Focus This Quarter

• Commercial banks are leading a resurgence in

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

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

• New funds directed toward commercial real estate

are being increasingly supported by commercial

mortgage-backed securities and real estate investment trusts.

• Some analysts have expressed concern that these

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

loan pricing.

In the wake of declining values and the large losses of

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

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

involves the major changes taking place in how real

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

banks—who is financing this expanding activity.

Commercial Banks Show Renewed Interest 

in Commercial Real Estate

Strong evidence of commercial real estate’s rebound

can be seen in its renewed attractiveness to lenders.

Federal Reserve figures show that nearly $58 billion of

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

lending pales in comparison with that of the late

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

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

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

billion net increase in mortgage lending during 1995

and 1996.

Perhaps the most convincing evidence of commercial

real estate’s recovery comes from the market itself.

Rising prices and tightening supplies of space in most

major markets and for most property types suggest a

growing demand for new commercial property stock.

Numerous indices and market studies support this

notion:

• As measured by Koll/NREI national composites,

prices and rents turned up sharply after 1993, with

rents surpassing their 1988 to 1989 levels by 1995

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

rates saw increases exceeding 20 percent in 1996.1

Strong Demand and Financial Innovation Fuel

Rebounding Commercial Real Estate Markets

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

1991 1992 1993 1994 1995 1996

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

COMMERCIAL BANKS 3.1 −8.4 −4.3 7.5 18.0 18.7

CMBSS 1.3 8.7 10.3 11.3 10.6 16.1

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

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

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

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

REIT EQUITY OFFERINGS 1.6 2.0 13.2 11.1 8.2 13.0

PENSION FUNDS −4.8 −4.3 −0.7 9.6 13.8 14.3

ALL OTHER SOURCES 8.1 5.4 5.0 0.9 −0.5 3.0

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

Investment Research

TABLE 1

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

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

Diego.
San Francisco Regional Outlook 10 Fourth Quarter 1997

In Focus This Quarter

• Property capitalization rates, which measure the

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

These falling rates indicate that investors are paying

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

not yet caught up with rents, which now exceed their

previous highs in some markets, suggesting that the

current recovery is not yet peaking. 

• Declining vacancy rates reflect strong demand for

office properties, which Grubb & Ellis cast as the

hottest sector in its 1997 forecast. Nationwide, office

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

3). Moreover, Torto-Wheaton Research estimates

that 21 of the 56 metropolitan areas it tracks had

single-digit vacancy rates at the end of first quarter

1997. Not surprisingly, many of the tightest markets

are those with the greatest rent inflation. 

While the unrestrained commercial development of the

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

shadow is fading as declining vacancy rates and rising

rental rates for existing properties fuel optimism

among lenders and investors and strengthen the case

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

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

projections rather than solely on the basis of competitive pressures.

Borrowers’ Financing Options Expanding

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

broader and more competitive financing market has

emerged. In this market, financing often bypasses

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

debt or the properties themselves, parceling them into

smaller, more standardized, and thus more liquid pieces

that are attractive to institutional and individual

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

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

trusts (REITs) have played in funding commercial real

estate over the past five years. This increase in public

CHART 1

Prices and Rents on Upswing Nationwide

0.80

0.90

1.00

1.10

1.20

1.30

1990 1991 1992 1993 1994 1995 1996

Rents

Prices

Index (1986 = 1.00)

Source: Koll National Real Estate Index

CHART 2

Property Capitalization Rates Dropping

8.0

8.5

9.0

9.5

10.0

10.5

11.0

11.5

1990 1991 1992 1993 1994 1995 1996 1997

Overall Cap Rates (%)

Office

Retail

Apartment

Source: Donaldson, Lufkin & Jenrette

CHART 3

National Downtown and Suburban

Class A Vacancy Rates Falling

8

13

18

23

1988

Source: CB Commercial / Torto-Wheaton Research

Downtown

Suburban

1989 1990 1991 1992 1993 1994 1995 1996

Vacancy Rates (%)
San Francisco Regional Outlook 11 Fourth Quarter 1997

In Focus This Quarter

financing left financial institutions in 1996 with

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

a decade before.

From a lender’s perspective, CMBSs offer several

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

production and servicing activities while avoiding the

excessive concentrations of credit risk that plagued

lenders during the last real estate downturn.2 According

to Commercial Mortgage Alert, outstanding CMBSs

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

new issuance. While outstanding volume is still dwarfed

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

has been remarkable considering that such securities

were virtually nonexistent prior to 1991.

At present, most commercial banks are not active in

issuing CMBSs, accounting for only $2.6 billion of

CMBS issuance in 1996, according to E&Y Kenneth

Leventhal Real Estate Group. Rather, the primary

source of these securities is investment banks, which

generate substantial fees by converting existing loans

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

to originate mortgage loans for distribution to investors

in the secondary market. Nomura Securities

International estimates that such conduits accounted

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

double the volume of 1995. Only a handful of the

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

1996. Aside from this relatively small number of bank

competitors, investment banks are among the largest

and most active conduit issuers. 

There is no fundamental reason why banks cannot take

greater part in the rapidly growing CMBS market. In

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

to facilitating loan demand, evaluating repayment risk,

servicing loans, and monitoring a project’s development. Obstacles of scale may preclude smaller institutions from directly issuing CMBSs ($500 million in volume is often cited as a minimum for efficiently assembling a deal). However, if the CMBS market develops

like that for MBSs, standardized underwriting may

enable small institutions to remain competitive either by

cooperatively forming their own conduits or by selling

their loans to existing conduits. 

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

assets raises a number of efficiency issues for direct

lenders. Securitization provides property developers and

owners access to a much larger pool of potential funding

sources and a wider array of funding options. Moreover,

the costs of public financing reflect efficiencies born of

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

securitized debt more easily than could be done with

whole loans. While improved efficiencies are a positive

aspect of the growth in securitized investments, these

efficiencies threaten to dictate bank pricing, thereby

potentially reducing margins or driving institutions to

lend on less economically feasible projects in an effort to

preserve margins and market share. 

REITs:An Alternative to Traditional 

Capital Sources

Commercial real estate financing is evolving in other

ways. REITs have become major players in the industry

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

estate through purchases of equity in the REIT. The

REIT itself holds title to the underlying properties and,

provided it meets certain requirements, can directly pass

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

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

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

Accompanying this rise in capitalization has been an

equally dramatic rise in bank lending to REITs.

According to Loan Pricing Corporation, bank lending

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

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

a tenfold increase over the period 1990 to 1992. 

The rise in REIT capitalization can be attributed in part

to pent-up institutional demand for real estate. REITs

2 While securitization of loans purports to shift credit risk to investors,

many analysts and rating agencies have recently expressed concern

over recourse arrangements, both contractual and voluntary, whereby

the seller/servicer effectively assumes all or most of losses experienced by the security.
San Francisco Regional Outlook 12 Fourth Quarter 1997

In Focus This Quarter

have a particular appeal to fund managers since they

offer the benefits of investment diversification without

the dual headaches of property management and asset

illiquidity. Aside from the direct credit risk posed by

lending to REITs, their rising popularity confronts banks

with an indirect threat as well—the threat that banks

could be crowded out of lending opportunities if

investors find REIT funding structures more attractive

from a cost and control standpoint. The degree to which

this crowding out may occur is unclear, for according to

Nomura Research, REITs historically have borrowed 40

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

over half of this borrowing takes place through public

offerings of secured and unsecured debt, leaving only a

small portion to be financed by banks and other private

lenders. Because REITs tend to focus on the highest

quality projects, their increasing presence also creates

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

Many analysts have also expressed unease over the rapid

rise in the valuations of REITs, some of whose shares

are priced at a considerable premium to the properties

themselves. Anecdotal evidence suggests that premiums

as high as 40 percent over market value have been paid

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

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

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

fairly nominal amount of overall real estate holdings,

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

Commercial Real Estate Securitization:

Some Broader Implications

Maturing CMBS markets could eventually improve the

overall stability of commercial real estate markets not

only by improving market liquidity but also by enabling

investors to diversify and share their credit exposures

among a greater number of participants. In addition,

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

more uniform and prudent underwriting standards.

However, concern naturally arises because CMBSs are

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

downturn. This situation leads to questions concerning

the impact they will have on property values and market

liquidity and whether today’s underwriting terms, driven

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

standardized structures underlying these securities offer

enough flexibility to borrowers to renegotiate loan

terms—a critical workout tool during times of financial

stress. The answers to these questions will ultimately

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

There are also questions about how REITs will affect

commercial real estate markets. One argument is that

the appetite for REIT investments, combined with the

premiums that the trusts can pay for properties, will

push the price of commercial space beyond sustainable

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

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

estate values. The contrary view holds that REITs will

improve market efficiency by providing continuous

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

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

cycles.

As an investment, commercial real estate is quickly

regaining the broad favor it lost during the last market

downturn. But the channels through which a lender or

investor can participate in this market are expanding

even more dramatically. Investment exposures to real

estate are no longer effectively limited to private equity

or debt. The choices are multiplying, with liquid public

markets for both debt and equity providing the foundation for existing and future commercial real estateCHART 4

REIT Capitalization Soaring

0

10

20

30

40

50

60

70

80

 1994

$ Billions

0

400

Source: National Association of Real Estate Investment Trusts

 1986 1987 1988 1989 1990 1991 1992 1993 1995 1996

50

100

150

200

250

300

350

Market Capitalization (Left Scale)

Number of REITs (Right Scale)
San Francisco Regional Outlook 13 Fourth Quarter 1997

In Focus This Quarter

based instruments—instruments such as swaps, options,

and property derivatives—that will permit the tailoring,

hedging, and even creation of synthetic real estate

investment positions. Although financial institutions are

participating in this revival, it is clearly a different world

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

how best to compete against—or participate in—these

new real estate financing strategies.

Steven Burton, Senior Banking Analyst

sburton@fdic.gov

Gary Ternullo, Senior Financial Analyst

gternullo@fdic.gov

Economic expansion in the Region has increased the

demand for commercial real estate and stimulated

commercial real estate and construction lending in

many markets. While three of the Region’s larger

commercial real estate markets—Honolulu, Los

Angeles, and Riverside—remain identified problems, strong economic growth has reduced vacancy

rates and increased valuations to near replacement

cost in most other markets. Consequently, commercial

real estate construction activity has been brisk, especially in the Region’s faster-growing areas. However,

two other areas—Fresno and Las Vegas—deserve

attention because of rising vacancy rates or deteriorating economic conditions or both (see San

Francisco Region’s Large Metropolitan Areas

Experience a Wide Range of Conditions and Risks).

Lenders in the San Francisco Region have taken

advantage of the rebound in commercial real estate

and have significantly increased their concentrations

in construction and commercial real estate loans over

the past three years. As of June 1997, exposure to both

construction and commercial real estate loans at community banks—institutions with total assets less than

$1 billion that are not primarily credit card banks—

has increased to levels not seen since the early 1990s

(see Regional Banking Conditions). The concentration of construction and commercial real estate loans

found in the San Francisco Region community banks

is disproportionately high relative to the rest of the

nation. Furthermore, not only have community banks

increased their construction and commercial real

estate loans outstanding, but they also have sharply

increased construction and commercial real estate

loan commitments. For these reasons, the regional

and local real estate markets in areas with high real

estate concentrations should be closely monitored.

Catherine I. Phillips-Olsen, Regional Manager

Commercial Real Estate in the San Francisco Region Rebounds
San Francisco Regional Outlook 14 Fourth Quarter 1997

Regular Features Regional Economy

San Francisco Region Includes Both Fast- and

Slow-Growing Large Metropolitan Areas

While the San Francisco Region leads the nation in economic growth and includes some of the nation’s fastestgrowing metropolitan areas, it also includes several

underperforming areas. However, as the Region’s

economies differ, so do the economic and banking risks

these areas face. Both groups of large metropolitan

areas are subject to national economic risks, such as

recessions. Other risks are regional. In some fastergrowing areas, the economic risks center on demographics, specifically slower population growth that

might dampen their booming real estate markets and

economies. The group of weaker economies risks being

left out of a sustained period of national economic

growth. Moreover, some metropolitan areas in each

group may be emerging as areas of special interest

because of their heavy bank exposure to commercial

real estate and construction lending (see Regional

Banking Conditions). 

Of particular interest are the metropolitan statistical

areas (MSAs) within each group where the local economy is very dependent on highly cyclical construction

activity and where the local banks have a heavy exposure to construction and commercial real estate lending. Two faster-growing areas, Las Vegas and Portland,

and one slower-growing area, Tucson, fall into this category. Fresno also may bear closer examination even

though its economy is not highly dependent on construction. The overall weakness in Fresno’s economy

and real estate markets, coupled with its banks’ heavy

construction lending exposure, should be carefully

observed.

Large Metropolitan Areas outside California

Continue Their Robust Growth

The four fastest-growing large MSAs (those with

employment greater than 250,000) in the Region are

Las Vegas, Phoenix, Seattle, and Portland. These MSAs

continue to be among the fastest growing in the nation,

and all are reporting strength in services and construction. Each of these MSAs reported robust growth over

the 12 months ending in July 1997 (see Chart 1). These

MSAs added jobs at a 4.3 percent pace or better, comSan Francisco Region’s Large Metropolitan Areas

Experience a Wide Range of Conditions and Risks

• The Region has several large metropolitan areas—Las Vegas, Phoenix, Seattle, and Portland—where

employment is growing at almost twice the national rate or faster.

• Some of these metropolitan areas have experienced a moderation in both population growth and construction activity since 1996, and most face risks associated with their heavy exposure to the cyclical

construction industry.

• Three other large metropolitan areas in the Region—Fresno,Tucson, and Honolulu—are performing much

worse than the Region and face risks ranging from real estate slowdowns to recessions.

• In several metropolitan areas, community banks’ exposure to construction lending is approaching that

found at the peak in 1990 at southern California community banks, just before real estate markets in that

area collapsed.

CHART 1

Employment Growth in Rapidly Growing MSAs

Is Much Faster Than for the Nation

Source: Bureau of Labor Statistics

Annual % Change

0 2 4 6 8 10

Las Vegas

Phoenix

Seattle

Portland

San Francisco

Region

Nation

July 1997

July 1996
San Francisco Regional Outlook 15 Fourth Quarter 1997

Regular Features Regional Economy

pared with 3.1 percent and 2.3 percent, respectively, for

the Region and the nation. 

The service sector, which accounts for three of every

ten jobs in the Region, continues to set the pace for

expansion in the fast-growing MSAs. Each of these

MSAs reported growth rates in service jobs equaled or

exceeded the Region’s 4.4 percent rate over the 12

months ending in July. All four also reported very

strong growth in manufacturing jobs, well above the

Region’s 3 percent rate. With the exception of Seattle,

each of the MSAs also added construction jobs at robust

rates of 7.3 percent or better.

Despite the continued strong growth in these fast-growing MSAs, three grew at a slower pace in 1997 than in

1996. Seattle, which is experiencing an aerospace

boom, was the only one of the four MSAs where

employment growth accelerated over the past 12

months. However, Chart 1 also illustrates that the rapid

growth of these MSAs over the past two years continues

to easily outpace the Region, even with their slightly

slower rate of growth in 1997.

Demographic Forces May Slow Growth

The Region’s four fast-growing large MSAs are all

located outside California and could be subject to

demographic shifts within the Region. Such shifts might

slow population growth and adversely affect both real

estate markets and financial institutions in those MSAs

with heavy commercial real estate and construction loan

exposures.

The influx of new residents, many arriving from

California, was a strong factor in the expansion of the

Region outside of California during the 1990s. States

and metropolitan areas with strong economies and more

favorable employment market conditions generally

experienced accelerated population growth, while

California suffered large job losses, high levels of

unemployment, and an unprecedented net outflow of

residents.

Recent population figures, however, suggest that the

outflow from California may be slowing or even reversing as the state’s overall economy picks up and job

opportunities improve. Chart 2 shows that California’s

population growth was higher in 1996, compared with

the prior three-year period. In contrast, population

growth rates for all of the other states in the Region

were slower in 1996 compared to the earlier period. 

Rapid population growth in the 1990s spurred the construction sector in these metropolitan areas and most of

them became much more dependent on construction

sector jobs than the Region as a whole. For example, as

of July 1997 construction accounted for only 4.9 percent of all nonfarm jobs in the nation and 5.1 percent in

the Region. Nevertheless, as is shown in Chart 3, as of

July 1997 construction accounted for 10.3 percent of all

jobs in Las Vegas, 7.1 percent in Phoenix, and 6.2 percent in Portland. 

The dependence of these MSAs on construction activity is reflected in the June 1997 banking industry statistics. Community banks (those with less than $1 billion

in total assets, excluding specialty credit card banks) in

CHART 2

% Employment Growth Rate

Source: Census Bureau

In 1996 Only California’s Population Growth

Surpassed Its Prior 3-Year Average Growth Rate

0 1 2 3 4 5

Nevada

Arizona

Oregon

Washington

California

San Francisco

Region

1996

Prior 3 Years

CHART 3

Source: Bureau of Labor Statistics

% of Employment

Most Fast-Growing MSAs in the San Francisco

Region Are Dependent on Construction Jobs

0 2 4 6 8 10 12

Las Vegas

Phoenix

Portland

Seattle

San Francisco

 Region

Nation

As of July 1997
San Francisco Regional Outlook 16 Fourth Quarter 1997

Regular Features Regional Economy

three of these MSAs have a much larger share of their

loan portfolio in construction loans than banks of similar size elsewhere in the Region. In Las Vegas, construction loans made up 17.3 percent of total loans,

while Portland and Seattle report 15.9 percent and 14

percent, respectively. The comparable figures for their

peers in the Region and for all community banks in the

nation are only 8.2 percent and 4.8 percent, respectively. Finally, to give some historical perspective to the

degree of exposure for community banks in these

MSAs, at year end 1990, before the Los Angeles real

estate markets tumbled, construction loans at Los

Angeles–area community banks accounted for 15.4 percent of total loans.

Dependence on the Construction Industry

Exposes These Areas to Weakness in the 

Event of a Slowdown

Amid a background of renewed strength in the real

estate sector nationally, several fast-growing MSAs are

reporting potential signs of softening in some real estate

and construction indicators. Moreover, some softening

is consistent with the slowdown in migration to these

MSAs. Second quarter 1997 metropolitan office vacancy rates for Las Vegas rose to 3.6 percentage points

above the third quarter 1996 vacancy rate as the supply

of new facilities has outstripped demand. The area’s

vacancy rate of 13.2 percent is noticeably above the

national average of 11.2 percent. In the first and second

quarters of 1997, industrial vacancy rates rose slightly

in Portland. Finally, nonresidential construction contracts fell modestly in both Portland and Seattle in 1996,

and more recently Las Vegas, Phoenix, and Seattle all

reported declines in the first quarter of 1997 compared

with the same period in 1996. 

Residential real estate markets in much of the Region

outside of California also appear to be showing signs of

cooling off, such as smaller price increases. At midyear

1997, total single-family residential building permits

for the Region were down slightly relative to the same

period a year earlier. Except for Seattle, where real

estate markets are picking up with the economy, the

other three fast-growing areas all are reporting noteworthy declines in 1997 compared with 1996 for both single-family and multifamily permits. Total permits,

usually an indicator of future residential construction

activity, are below last year’s pace in Phoenix (−10 percent), Portland (−9 percent), and Las Vegas (−7 percent). Conversely, California, where housing sales and

prices are exhibiting renewed strength, especially in the

Bay Area, is showing a sizable increase in 1997 permits

authorized.

The simultaneous softening of many real estate market

indicators in these fast-growing MSAs, following the

slowdown in migration to these areas, may be an early

warning of deteriorating real estate market conditions

and reduced construction activity. This is important,

since the construction industry is one of the most

volatile sectors of the economy and its boom and bust

periods often lead the overall business cycle. Chart 4

shows the extent of these wide swings in construction

for the fast-growing MSAs. The annual growth rate of

construction-sector employment varied about four times

as much over the past 20 years as the growth rate of total

employment excluding construction jobs. 

Implications: While the outlook for the fast-growing

MSAs is positive, the effects of potential demographic

changes on their booming real-estate-based sectors and

the heavy exposure of real estate lenders in the construction and commercial real estate areas should be

carefully monitored. Most economists expect these

areas to continue to expand rapidly, although probably

at somewhat reduced growth rates. For example,

DRI/McGraw-Hill recently projected that Las Vegas

(ranked first), Phoenix (seventh), and Portland (twelfth)

would be among the top 20 large MSAs in the nation in

employment growth over the five-year period ending in

2002. In spite of this optimism, slower growth and

reduced immigration could have adverse impacts on

these areas. Las Vegas in particular has been singled out

CHART 4

Source: Bureau of Labor Statistics

Construction Has Wider Cyclical Swings Than

Does Other Employment in Fast-Growing MSAs*

*Includes Las Vegas, Phoenix, and Portland MSAs.

−20

−10

0

10

20

30

Percent

Construction Other

Employment

−30

Dec-74 Dec-78 Dec-82 Dec-86 Dec-90 Dec-94
San Francisco Regional Outlook 17 Fourth Quarter 1997

Regular Features Regional Economy

for concern by some economists because of its heavy

dependence on the robust performance of its highly

cyclical construction industry.

Warning Signs in Fresno and Tucson

The strength of the four metropolitan areas described

above contrasts sharply with the performance of the

three slowest-growing large metropolitan areas in the

Region. These areas fall into two groups. The first

includes Honolulu, which remains an established area

of concern because of its lingering recession. The second group includes MSAs that are still expanding but

also are experiencing signs of deterioration, such as a

slowdown in employment growth or softening real

estate markets. Fresno, in California’s Central Valley,

has recorded job growth of less than 1.5 percent for the

past two years, and its unemployment rate of 12.1 percent is almost twice the rate for the state. Tucson’s economy also has slowed noticeably from just two years ago,

when it was one of the Region’s fastest-growing MSAs.

Fresno’s Economy Is Slow Compared with the

Region, and Its Real Estate Markets Are

Softening

Fresno is emerging as an area of concern because of its

slow economy, erratic growth pattern, and softening

real estate market conditions. The Fresno area reported

only 1.4 percent growth in employment over the 12

months ending in July 1997, less than half the growth

rate for the Region. Many sectors of the economy,

including construction, finance, and wholesale and

retail trade, are weak. Demographics also may be playing a role in the Fresno market. A sharp downturn in

residential real estate markets may reflect a reduced

inflow of residents from the Los Angeles Basin as the

southern California economy improves. The weak economy and high and rising metropolitan office vacancy

rates (14.4 percent for the second quarter of 1997) are

important because community banks in the Fresno area

have a relatively heavy exposure to both construction

(16.1 percent of total loans) and commercial real estate

loans (24.9 percent). This concern is underscored by a

significant increase over the past year in the ratio of

past-due and nonaccrual construction loans to total

loans. For construction loans, the ratio soared from

5.6 percent to 10.7 percent (see Regional Banking

Conditions). 

Tucson’s Economy Has Slipped over 

the Past Two Years

In recent months, Tucson’s economy has grown slowly

compared with the Region. It also has experienced some

signs of deterioration in real estate markets. Despite the

slowdown over the past year, Tucson remains at full

employment. In July 1997, Tucson’s 3.3 percent unemployment rate was well below the national average of

4.8 percent. 

Tucson’s reported employment growth rate dropped

below 1 percent over the 12 months ended in July 1997;

a year earlier it added jobs at twice that rate. Two key

reasons for the slower growth

were a loss of government jobs

and a loss of construction jobs. In

addition, there was a sharp slowdown in job creation by the service sector in general and

business services in particular.

While health care services picked

up somewhat, the change was not

enough to offset weakness elsewhere in the service sector.

Despite the apparent weakness in Tucson’s local economy, activities more dependent on the health of the

national economy, such as tourist-related services and

manufacturing, continue to do well.

The decline in Tucson’s construction employment is

consistent with the signs of weakness in some sectors of

the area’s real estate markets. The softness is important

because construction accounts for 6.4 percent of

Tucson’s jobs, well above the 5.1 percent share for the

Region. Weakness is most evident in vacancy rates for

industrial properties, where the second quarter 1997

vacancy rate of 13.1 percent is 5 percentage points higher than the national average. Tucson’s metropolitan

office vacancy rate rose from 8.5 percent in the first

quarter to 9.0 percent in the second quarter. Within the

Tucson area, however, while the downtown office

vacancy rate remains very high (almost 22 percent),

suburban office markets are very tight and vacancy

rates are under 5 percent. 

Not only have some segments of the commercial real

estate market softened, but residential housing permits

for the Tucson metropolitan area for June 1997 also fell

almost 8 percent from a year earlier. The decline was

most dramatic in multifamily housing permits, but
San Francisco Regional Outlook 18 Fourth Quarter 1997

Regular Features Regional Economy

single-family permits also fell. The weakness also could

be influenced by slower in-migration. These twin developments, a slowing in the economy and signs of deterioration in some real estate indicators, are of particular

interest in Tucson. Banks in Tucson, especially larger

institutions, are heavily engaged in real estate lending.

Commercial real estate loans make up almost 27 percent of total loans at banks in Tucson; construction

loans account for another 15 percent of total loans.

Exposure to both loan types is high relative to other

metropolitan areas in the Region.

Lingering Risks

Finally, Honolulu continues to suffer from a lingering

recession, and current indicators do not foretell a quick

turnaround. Commercial office vacancy rates remained

close to 15 percent in the second

quarter of 1997, among the highest in the nation. Housing prices

continue on a steep decline, and

building permits are far below

pre-recession levels. International

forces have buffeted real estate

investment and tourism; the soft

Japanese economy and the

stronger dollar have caused many foreign visitors to

reduce their spending or shorten their visits. 

Implications: Weak economic conditions in these three

MSAs warrant additional monitoring, although the risks

vary somewhat across these MSAs. For example, while

the Tucson area has slowed recently, its long-term

prospects are generally considered sound.

DRI/McGraw-Hill recently ranked Tucson fifteenth

among the top 20 MSAs in expected growth over the

next five years. Still, community banks in the Fresno

area and larger banks in the Tucson area have relatively

high exposures to both commercial real estate and construction lending. Because of their high degree of exposure in these loan categories, which have created

problems for the banking industry following slowdowns

in other parts of the Region, the slower growth rate of

these communities bears closer monitoring.

Gary C. Zimmerman, Regional Economist

For More Information

Gabriel, Stuart A., and Joe P. Mattey. “The Slowing

Exodus from California.” Economic Letter, Federal

Reserve Bank of San Francisco, Number 96-38;

December 27, 1996.

Zimmerman, Gary C. “California’s Community Banks

in the 1990s.” Economic Letter, Federal Reserve Bank

of San Francisco, Number 96-04; January 26, 1996.

$
San Francisco Regional Outlook 19 Fourth Quarter 1997

Regular Features Financial Markets

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

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

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

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

institutions moved quickly to issue trust preferred stock.

Trust preferred stock can be a less expensive form of

Tier 1 capital for bank holding companies because of

the tax deductibility of the dividend payments paid on

this type of preferred stock. 

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

1996 through June 1997.1 The dollar amount of trust

preferred stock issued represented almost 95 percent of

the incremental amount of Tier 1 capital added by those

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

to fund stock buyback programs. As an example of the

relative importance of these stock buyback programs,

one large bank holding company’s Tier 1 capital ratio

would be 7.25 percent excluding the trust preferred

shares, and 8.34 percent including the shares.

Rating agencies and investment analysts have argued

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

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

and the ability of investors to accelerate their claims

against the bank holding company. Institutions contemplating issuing trust preferred stock should be aware of

the concerns expressed by rating agencies and of the

possibility that excessive reliance on debt-like capital

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

Trust Preferred Structure

Provides a Tax-Advantaged

Capital Funding Alternative

Trust preferred shares, also

known as capital securities, are

traded under different names

depending on the underwriter, payment terms, and

maturity. Some of the more common acronyms include

TOPRS (Trust Originated Preferred Shares), QUIPS

(Quarterly Income Preferred Shares), and MIPS

(Monthly Income Preferred Shares).

Although trust preferreds are issued under different

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

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

the bank holding company is formed. The trust issues

two classes of stock: common and preferred shares. The

common stock of the trust subsidiary is owned by the

bank holding company, and the trust preferred stock is

sold to investors. The trust upstreams the proceeds from

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

note with terms identical to the trust preferred shares.

(The subordinated note must be the sole asset of the

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

On a consolidated basis, the trust preferred stock is

treated as a minority interest of the bank holding company, and the subordinated note is eliminated as interFinancial Markets

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

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

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

preferred dividends.

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

1 The amount of trust preferred stock outstanding is not delineated in

Call Reports. 2 Trust preferred dividends, unlike dividends on traditional preferred

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

company level and as taxable income by investors of the trust preferred shares.
San Francisco Regional Outlook 20 Fourth Quarter 1997

Regular Features Financial Markets

CHART 1

How Is Trust Preferred Stock Structured

to Count as Tier 1 Capital?

Trust Preferred

Proceeds

Trust Preferred Shares

Dividend Payments—funded by interest

received on subordinated note

Investors in Trust

Preferred Shares

Trust Subsidiary

Issues trust preferred shares

(structured as a non-taxpaying entity)

Trust Preferred Proceeds

(Trust preferred shares treated as

minority interest by BHC and

counted toward Tier 1 capital)

Subordinated Note—same coupon

and payment terms as trust preferred

shares, booked as intercompany debt

and eliminated upon consolidation

Interest Payments—paid with

before-tax dollars by the BHC

Bank Holding Company

(BHC)

(BHC owns common stock of

trust subsidiary)
San Francisco Regional Outlook 21 Fourth Quarter 1997

Regular Features Financial Markets

company debt. The interest paid by the bank holding

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

fund the dividends on the trust preferred shares. In

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

the investors in the trust preferred shares.

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

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

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

accelerate the claim against the bank holding company.

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

stockholders of the bank holding company. 

Trust preferred shares typically have maturities of 30

years or more and contain call options and redemption

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

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

Banks are not permitted to count trust preferred stock

toward Tier 1 capital because of the cumulative feature

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

1 capital as cumulative preferred stock, including trust

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

Risk-Based Capital Standards set by the Basle Accord.

Bank Holding Companies of All Sizes 

Have Issued Trust Preferred Stock

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

federal budget. Bank holding companies rushed to take

advantage of a potentially short-lived tax loophole,

while investors were attracted by the opportunity to

earn higher rates than on similarly rated bank debt.

Bank holding companies have used proceeds from trust

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

subsidiaries, to finance acquisitions, and to buy back

common stock. 

As the tax advantage of the trust preferred stock

remained intact through the budget negotiations, the

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

under $2.5 billion in the second quarter. Trust preferred

issuance by larger banks declined as some approached

their limit on Tier 1 trust preferred, while more smaller

banks took advantage of the market for trust preferred

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

banks in various size categories that have issued trust

preferred stock in recent quarters.) Investment bankers

are reportedly working on new structures that may make

it easier and more cost effective for smaller institutions

to issue these capital securities, perhaps through some

pooling arrangement. 

REIT Preferred Stock—Another Type 

of Tax-Advantaged Tier 1 Capital

Prior to the Federal Reserve’s announcement last

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

institutions to issue tax-advantaged preferred shares.

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

In an REIT preferred structure, the issuer establishes a

corporation that elects REIT tax status. Proceeds from

the preferred shares that are sold to investors are used to

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

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

CHART 2

More Small Institutions Issue Trust

Preferred Stock

Source: Keefe, Bruyette & Woods

0

5

10

15

20

25

30

4Q96 1Q97 2Q97

Number of

Banks

Bank Size

$10-100 billion

$100+ billion

< $10 billion
San Francisco Regional Outlook 22 Fourth Quarter 1997

Regular Features Financial Markets

operating costs and preferred dividends. As long as the

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

are tax deductible by the holding company. 

Will the Tax-Advantaged Status of Trust

Preferred Stock Continue?

Although the tax-advantaged status of trust preferred

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

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

that eliminated the tax-advantaged status of a specific

type of preferred stock known as Step-Down preferred

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

means of raising tax advantaged Tier 1 capital.

Issues and Concerns

A number of bank holding companies have embarked

on stock buyback programs financed by trust preferred

stock issuance, thereby boosting earnings per share by

reducing the number of common shares outstanding,

while maintaining Tier 1 regulatory capital ratios.

Rating agencies and investment analysts, however,

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

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

holding companies with trust preferred stock in excess

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

some analysts that trust preferred stock is a weaker

form of Tier 1 capital than other forms of capital such

as common and perpetual preferred stock, because of

its limited life and treatment upon a liquidation of the

trust.

A recent regulatory interpretation has underscored the

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

the Comptroller of the Currency (OCC) has determined

that investments by banks in trust preferred stock

should be treated as investments in debt securities.4 The

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

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

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

Banking organizations should be aware of the views of

rating agencies and bank analysts toward trust preferred

stock. In times of economic stress, excessive reliance on

debt-like capital instruments could result in increased

financial fragility of the overall organization, a higher

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

service the obligations (explicit or implicit) of the

holding company could attract the attention of bank

regulators.

Kathy R. Kalser, Chief

Financial Sector Analysis Section

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

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

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

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

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

to shareholders.

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

preferred stock would be treated as Type III investments under 12

CFR Section 2 1.2 (k).
San Francisco Regional Outlook 23 Fourth Quarter 1997

Regular Features Regional Banking

Second-Quarter Reports Reflect Overall Good

Earnings, Capital, and Asset Quality

With the exception of a few slower-growing metropolitan areas in California, the Region’s banks and thrifts

overall continue to report relatively strong financial

conditions. For the quarter ended June 30, 1997, insured

institutions in the San Francisco Region reported:

• a return on assets (ROA) of 1.13 percent, down

slightly from first quarter’s ROA of 1.17 percent

because of a slight decline in the net interest margin

at the Region’s banks and thrifts;

• an average leverage capital ratio that continued to

improve, climbing from 7.48 percent during the

quarter to 7.54 percent; and

• a decline in past-due loans to 2.09 percent of total

loans from 2.38 percent in the first quarter of 1997,

primarily due to improvement in the real estate and

commercial loan portfolios.

Fewer institutions reported losses during the second

quarter of 1997 than during the second quarter of 1996.

Eighty-one insured institutions, with combined assets of

$25 billion (2.5 percent of the Region’s total assets),

reported net losses in the second quarter of 1997.

Together, these institutions lost a total of $89.6 million.

These statistics compare favorably with those from the

second quarter of 1996, when 92 insured institutions

with combined assets of $30.5 billion reported a $151.1

million loss.

Large and Small Banks Take Divergent

Approaches to Deposit Service Charges

One reason for the improved financial condition of

insured institutions in the San Francisco Region is the

increasing effort banks and thrifts are making to generate more noninterest income and diversify their revenue

streams. In many cases, traditional sources of noninterest income, such as service charges on deposit accounts

and surcharges on automated teller machine (ATM)

transactions, are being reevaluated and repriced.

In the San Francisco Region, service charges on deposit

accounts have become a more important source of

income. Since 1990, service charges on domestic

deposits have climbed from 4.4 percent of gross operating income to 6.2 percent for the first half of 1997.

However, Chart 1 reveals that in the San Francisco

Regional Banking Conditions

• Favorable performance continues in 1997 for most banks and thrifts in the San Francisco Region.

• Deposit service charges are becoming a more important source of revenue at the Region’s large banks,

widening the disparity between them and their community bank counterparts.

• The Region’s community banks have significantly more equity capital exposed to commercial real estate,

construction loans, and other real estate owned than do community banks nationwide.

• Exposure to higher-risk real estate lending warrants monitoring.

CHART 1

 Note: Deposit service charges collected per hundred dollars on deposit

 Source: Bank Call Reports * annualized

Service Charge

Large Banks Widen the Gap on Deposit

Service Charges

$0.40

$0.47

$0.54

$0.61

$0.68

$0.75

$0.82

$0.89

1990 1991 1992 1993 1994 1995 1996 2Q97*

 Banks with Assets over $1 Billion

Banks with Assets under $1 Billion
San Francisco Regional Outlook 24 Fourth Quarter 1997

Regular Features Regional Banking

Region, large banks, those with assets greater than $1.0

billion that are not credit card banks, generate significantly more income per dollar of deposits from service

charges on deposit accounts than do community banks

(institutions with assets under $1 billion).

The service charge disparity has arisen in part because

several of the Region’s larger banks made efforts to

expand revenues by charging nontraditional service

fees. In addition to the traditional minimum-balance

maintenance charges, withdrawal penalties, stop-payment orders, and returned-check fees, these institutions

also now are charging for such services as telephone

access, personal teller service, home-based electronic

banking, and ATM use for both bank customers and

other users.

ATM charges for noncustomers started after

MasterCard and Visa—the owners of the Cirrus and

Plus ATM networks—lifted their ban on surcharges on

April 1, 1996. The new noncustomer ATM surcharge

has become popular with ATM owners across the

nation. According to a nationwide survey conducted by

Carmody and Bloom, Inc., the share of ATM owners

imposing surcharges on noncustomers grew from 40

percent to 65 percent in the six months ending February

1997. The same study found that in the West, noncustomers paid a surcharge at 87 percent of the ATMs

owned by the banks that were surveyed. Large financial

institutions own an overwhelming majority of these

machines.

In contrast to the large banks that implemented surcharges, many of the Region’s community banks (those

with assets less than $1.0 billion, excluding credit card

banks) are not imposing ATM surcharges, in a strategic

attempt to retain, and possibly gain, market share.

According to a 1997 Grant Thornton survey, community banks recognize that ATM surcharges and other

deposit fees could provide a means of paying for

expanded ATM services. However, they also recognize

“free” ATM access as a potential customer drawing

card. These factors may in part explain why in 1997

deposit service charges collected per hundred dollars of

domestic deposits at small banks continued to decline to

less than half the amount collected by larger banks.

Implications: In light of the increased use of fees at

some large banks and the reluctance of many small

banks to raise fees, the disparity in deposit service

charge income between the large and small banks in the

Region may widen. However, as noted by Atlanta consultant George Albright, over the long term, higher

profits from ATMs may result in an increased supply of

these machines and, eventually, downward pressure on

fees.

Institutions in Several Areas of the Region 

Have Increased Their Risk Profiles

The Region’s economic expansion over the past several

years not only has revived several of the Region’s real

estate markets but also has resulted in significant asset

and loan growth and improved profitability at many

banks and thrifts. However, during this period of prosperity some institutions may have assumed additional

risk in their loan portfolios by increasing their exposure

to higher-risk types of loans, such as construction and

commercial real estate loans. This exposure warrants

monitoring, particularly in metropolitan statistical areas

(MSAs) such as Fresno and Las Vegas, where the real

estate markets appear to be softening and the economies

are, in the case of Fresno, beginning to show signs of

weakness (see San Francisco Region’s Large

Metropolitan Areas Experience a Wide Range of

Conditions and Risks).

The Region’s high level of exposure to commercial real

estate and construction lending is most evident at community banks—defined here as institutions with total

assets less than $1 billion that are not primarily credit

card banks. Chart 2 reveals that community banks in the

San Francisco Region have significantly more equity

capital exposed to commercial real estate and construction loans, direct real estate investments, and other real

estate owned than do community banks nationwide. The

CHART 2

Region’s Community Banks Increase Equity

Exposure* to Higher-Risk Real Estate Assets

Source: Bank Call Reports

*Exposure = (commercial real estate loans+construction loans+ORE)/equity

**Banks with assets less than $1.0 billion

100

150

200

1990 1991 1992 1993 1994 1995 1996 Jun-97

% of Equity

250

300

Nation**

Region**
San Francisco Regional Outlook 25 Fourth Quarter 1997

Regular Features Regional Banking

chart also shows that the Region’s community bank

exposure to these higher-risk real estate assets, at 235

percent of equity capital, not only is well above the

national average of 147 percent but also has been trending upward since 1995.

Renewed interest in commercial real estate lending in

many areas of the San Francisco Region over the past

three years has occurred because strong economic

growth has reduced vacancy rates and spurred construction of commercial properties. As discussed in Strong

Demand and Financial Innovation Fuel Rebounding

Commercial Real Estate Markets, the Region’s

renewed interest in commercial real estate parallels

national trends. In a recent national report on commercial real estate, Donaldson, Lufkin, & Jenrette (DLJ)

identified Las Vegas and Salt Lake City as the two most

active smaller-area office construction markets in the

nation. They also cited Portland, Phoenix, and Seattle as

larger areas with booming office construction sectors.

Note, however, that DLJ’s ranking of these markets as

leaders in commercial real estate is based on the area’s

high level of construction activity, not the viability of the

projects or overall market conditions.

Because the resurgence in the commercial real estate

market has not been uniform throughout the Region, the

Region’s community banks’ exposure to real estate

lending has a geographic component that also is not uniform across the Region. Chart 3 shows that during the

second quarter of 1997, community banks in several

MSAs reported combined commercial real estate and

construction loans approaching 30 percent of assets,

which is in excess of exposure of 23 percent and 15 percent, respectively, for the Region and the nation. MSAs

with exposures exceeding 30 percent of assets include

Reno, Nevada; Eugene, Oregon; and Santa Rosa,

Riverside–San Bernardino, Sacramento, San Diego, and

San Jose, California. Furthermore, many institutions in

these areas also are disclosing significant unfunded

commercial real estate and construction commitments.

The combined exposure to commercial real estate and

construction loans in these areas is noteworthy because

it has risen to levels not seen since the commercial real

estate downturn in the early 1990s.

In addition to variances in risk exposure between metropolitan areas, profit and problem loan levels at community banks with concentrations in higher-risk real

estate assets also differ significantly among the

Region’s MSAs. Table 1 (next page) lists seven MSAs,

most with robust economies, where community banks

significantly outperformed the Region. In each of these

MSAs, the banks, as a group, reported an ROA exceeding 1.5 percent during the second quarter of 1997, with

most well above the 1.3 percent earned by peer banks in

the Region. Community banks in Utah’s two largest

metropolitan areas, Salt Lake City and Provo, lead the

Region, with ROAs of 2.6 percent and 2.3 percent,

respectively. Two Oregon MSAs also have community

banks that, as a group, reported ROAs of more than 2.1

percent. Such high ROAs may be an indicator that these

banks are accepting an above-average level of risk.

The Region also has several MSAs where community

banks are underperforming relative to the Region and

the nation. Five of these moderate- to slow-growing

MSAs—Napa, Stockton, Riverside, Fresno, and

Honolulu—also are highlighted in Table 1. Not only did

institutions in these MSAs report ROAs of less than 0.75

CHART 3

Community Banks in Several MSAs Have Increased Their Concentrations in

Commercial Real Estate and Construction Loans since 1993

Source: Bank Call Reports

0

10

20

30

40

Riverside San Diego Reno Sacramento Santa Rosa Eugene San Jose Fresno Las Vegas San Francisco

 Region

Nation

% of Total Assets

34.34%

35.79%

23.91%

34.20%

14.11%

33.81%

24.25%

33.37%

22.41%

31.39%

22.26%

31.08%

12.85%

30.94%

21.17%

28.37%

22.02%

27.39%

19.89%

23.37%

12.19%

14.54%

Dec-93

Jun-97
San Francisco Regional Outlook 26 Fourth Quarter 1997

Regular Features Regional Banking

percent, typically due to abnormally high provisions for

loan losses, but most also had above-average exposure to

high-risk assets and higher levels of nonperforming

assets relative to both the Region and the nation.

Although profits at most of the Region’s banks and

thrifts are at record levels and nonperforming assets are

declining, changing economic conditions within individual MSAs can adversely affect the performance of

an area’s insured financial institutions. Table 2 reveals

five major markets in the Region where office vacancy

rates, a key economic indicator, are trending upward.

Table 2 also shows that a total of eight markets continue

to have vacancy rates in excess of the national average.

Four of the Region’s eight underperforming real estate

markets—Riverside, Bakersfield, Los Angeles, and

Honolulu—remain well-identified problem commercial

real estate markets, with office vacancy rates much

higher than the rest of the Region and the nation. In contrast, Fresno and Las Vegas may be considered to pose

risks either because of rising vacancy rates or, in the

case of Fresno, generally weak economic conditions

(see San Francisco Region’s Large Metropolitan Areas

Experience a Wide Range of Conditions and Risks).

In Fresno, where the economy is showing signs of weakness and the construction market has softened, community banks already are recording deterioration in asset

quality. For example, as the Fresno economy has slowed

over the last year, the past-due ratio (loans 30 days or

more past due plus nonaccrual loans divided by total

loans of this type) for construction loans climbed from

5.6 percent in June 1996 to 10.7 percent in June 1997. In

contrast, the comparable ratio for the Region fell to 2.9

percent in June 1997 from 3.2 percent a year earlier.

Although office employment and construction growth

in the Las Vegas area remain robust, the area’s office

vacancy rates have been trending upward since 1994

and are currently 2 percentage points above the national level. Moreover, Chart 4 reveals that, in spite of the

steadily increasing vacancies, Las Vegas–area community banks continue to increase their concentration in

commercial real estate and construction loans, which is

already well above both the Region’s and the nation’s

peer levels.

Implications: The Region’s MSAs with very high concentrations of lending in construction and commercial

real estate may warrant additional monitoring, even

Performance Varies across MSAs with Higher-Risk Real Estate Exposure

% EQUITY % EQUITY

PAST PAST

MSA HIGHER- CON- DUE MSA HIGHER- CON- DUE

ASSETS RISK STRUC- COM’L ASSETS RISK STRUC- COM’L

> $500 RE TION RE & > $500 RE TION RE &

MSAS MILLION CONST. ROA MSAS MILLION CONST. ROA

(1) (2) (3) (4) (1) (2) (3) (4)

MORE PROFITABLE... LESS PROFITABLE...

SALT LAKE, UT $3,504 111% 44% 1.7% 2.6% NAPA, CA $1,007 308% 51% 4.6% 0.7%

PROVO, UT $656 212% 102% 0.7% 2.3% STOCKTON, CA $2,533 178% 33% 5.0% 0.7%

SALEM, OR $605 251% 68% 0.7% 2.1% RIVERSIDE, CA $1,485 444% 70% 2.3% 0.7%

EUGENE, OR $821 312% 125% 2.5% 2.1% HONOLULU, HI $2,254 183% 31% 6.5% 0.6%

MONTEREY, CA $972 327% 45% 1.1% 1.7% FRESNO, CA $724 316% 115% 5.6% 0.6%

BILLINGS, MT $755 173% 16% 2.2% 1.7% REGION (5) $99,723 235% 51% 2.2% 1.3%

PHOENIX, AZ $2,933 196% 60% 1.1% 1.5% NATION (6) $984,362 147% 29% 1.9% 1.3%

Source: June 30, 1997, Bank Call Reports

(1) MSAs where Community Bank assets (5) in the aggregate sum to more than $500 million, amounts shown in millions.

(2) Higher-Risk Real Estate: (construction + commercial real estate loans + other real estate owned + real estate 

investments)/equity.

(3) More than 30 days past due plus nonaccrual commercial real estate and construction loans as a percentage of total 

commercial real estate and construction loans.

(4) Annualized earnings as of June 30, 1997, as a percentage of average assets.

(5) Community banks are defined as banks with assets less than $1.0 billion, excluding credit card banks.

(6) Community banks are defined as banks with assets less than $1.0 billion.

TABLE 1
San Francisco Regional Outlook 27 Fourth Quarter 1997

Regular Features Regional Banking

though profitability in many of them remains high. In

some of these areas, community banks in the aggregate

have more than 30 percent of their assets and 100 percent of equity capital exposed to these higher-risk loan

categories, with some individual banks reporting higher

exposures. A significant deterioration in real estate markets or construction activity in these MSAs could have

a disproportionate impact on their asset quality and

profitability. This is particularly true in Las Vegas and

Fresno, where some real estate market indicators are

already showing signs of deterioration (see San

Francisco Region’s Large Metropolitan Areas

Experience a Wide Range of Conditions and Risks).

Catherine I. Phillips-Olsen, Regional Manager

Roger Stephens, Financial Analyst

Millen L. Simpson, Examiner, Division of Supervision

TABLE 2

Metropolitan Office Vacancy Rates

Edge Up in Five MSAs

VACANCY RATES

MSA 2Q93 2Q94 2Q95 2Q96 2Q97

RIVERSIDE* 21.3% 20.8% 22.6% 23.5% 24.3%

LOS ANGELES 21.6% 20.3% 19.9% 18.8% 18.0%

BAKERSFIELD 19.1% 15.1% 14.4% 14.1% 17.6%

HONOLULU 9.6% 11.9% 12.7% 15.5% 14.8%

FRESNO 18.0% 17.2% 12.5% 12.3% 14.4%

LAS VEGAS 11.7% 7.2% 8.9% 11.9% 13.2%

ORANGE COUNTY 17.2% 16.7% 15.8% 14.7% 12.9%

SAN DIEGO 21.9% 18.7% 17.7% 15.4% 12.2%

NATION 18.0% 16.3% 14.7% 13.1% 11.2%

SACRAMENTO 17.2% 12.9% 12.7% 9.9% 10.4%

PHOENIX 20.6% 17.7% 13.3% 10.4% 9.7%

TUCSON 21.2% 17.1% 11.4% 11.2% 9.0%

SEATTLE 13.2% 13.1% 10.3% 8.8% 7.5%

SAN FRANCISCO 12.4% 10.0% 9.9% 6.5% 6.7%

PORTLAND 13.1% 9.6% 9.8% 7.8% 5.8%

SALT LAKE 15.1% 8.8% 6.4% 5.5% 5.6%

SAN JOSE 1.3% 1.4% 1.4% 7.7% 2.6%

Source: CB Commercial Office Vacancy Index of United

States

* Vacancy rates for 1993 and 1994 reflect year-end rates

CHART 4

Las Vegas Community Banks’ Higher-Risk

Real Estate Exposure Increases Despite

Rising Office Vacancies

Source: Bank Call Reports, CB Commercial Office Vacancy Index

* Commercial Real Estate and Construction

10

15

20

25

30

35

1993 1994 1995 2Q96 2Q97 5

8

11

14

% of Assets

(line)

Office Vacancy %

(bar)

Commitments*

Loans*
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