Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION FIRST QUARTER 2002 

FDIC
 

Kansas City
 

Region
 

Division of
 

Insurance
 

John M. Anderlik,
 

Regional Manager
 

Jeff W. Walser,
 

Regional Economist
 

Richard D. Cofer,
 

Jr.,
 

Senior Financial
 

Analyst
 

Regional Perspectives 

◆ In the aftermath of the September 11, 2001, attacks, layoffs in the aircraft manufacturing industry, the major employer in the Wichita metropolitan area, have seriously 

hurt the local economy. 

◆ In the aggregate, during the past three years insured institutions headquartered in 

the Wichita area have increased concentrations in construction and development, nonresidential commercial property, and business lending, traditionally higher-risk loan 

types. 

◆ Commercial real estate submarkets—office, industrial, retail, multifamily, and 

hotel—are showing signs of weakening in the Region’s three major metropolitan 

areas, Minneapolis-St. Paul, St. Louis, and Kansas City. As this weakening has 

occurred, however, insured institutions have continued to increase commercial real 

estate concentrations. See page 3. 

By Richard D. Cofer, Jr., Senior Financial Analyst 

In Focus This Quarter 

◆ Housing Market Has Held Up Well in This Recession, but Some Issues Raise 

Concern—Recent trends in mortgage underwriting are of particular interest, as an 

estimated $2 trillion in mortgage debt, approximately one-third of the total outstanding, 

was underwritten during 2001. Nonconstruction residential mortgages traditionally 

have represented one of the better-performing loan classes during prior downturns. The 

level of credit risk, however, may be higher this time around because the mortgage lending business has changed since the last downturn. This article examines these changes, 

including increased involvement by insured institutions in the higher-risk subprime 

credit market, the acceptance of higher initial leverage on home purchases, and greater 

use of automated underwriting and collateral valuation processes, which have not been 

recession-tested. 

◆ Home price softening could have an adverse effect on residential construction and 

development (C&D) and mortgage portfolios. In the aggregate, the level of risk appears 

modest. However, insured institutions with significant C&D loan exposures in markets 

that experienced ongoing residential construction during 2001, despite slowing local 

economies, are at higher risk. Weakening home prices could hurt loan quality in selected markets. The San Francisco Bay area stands out as a place to watch in this regard. 

See page 11. 

By Scott Hughes, Regional Economist 

Judy Plock, Senior Financial Analyst 

Joan Schneider, Regional Economist 

Norm Williams, Regional Economist 

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

Insurance Corporation as an information source on banking and economic issues for insured 

financial institutions and financial institution regulators. It is produced for the following eight 

geographic regions: 

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

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

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

Dallas Region (CO, NM, OK, TX)
 

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

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

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

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

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

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

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

trends and developments at the regional level. 

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

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

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

For more information or to provide comments or suggestions about the Kansas City Region’s 

Regional Outlook, please call John Anderlik at (816) 234-8198 or send an e-mail to 

janderlik@fdic.gov. 

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

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

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

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

the Federal Deposit Insurance Corporation. 

Chairman Donald E. Powell 

Director, Division of Insurance Arthur J. Murton 

Executive Editor George E. French 

Writer/Editor Kim E. Lowry 

Editors Lynn A. Nejezchleb 

Maureen E. Sweeney 

Richard A. Brown 

Ronald L. Spieker 

Publications Manager Teresa J. Franks 
Regional Perspectives
 

Regional Perspectives
 

•	 The Wichita, Kansas, economy relies heavily on the aircraft manufacturing sector. Its economy is expected to be 

more adversely affected than other areas of the Region by the aftermath of the September 11, 2001, attacks, as 

declining demand for domestic air travel has contributed to significant layoffs. 

•	 The Region’s three largest metropolitan areas, Kansas City, Minneapolis-St. Paul, and St. Louis, are experiencing some 

weakening in the commercial real estate sector because of the slowing regional economy. At the same time, insured 

institutions in these three markets have significantly increased concentrations in commercial real estate lending. 

The Kansas City Region Has Been Adversely Affected by the 


September 11, 2001, Attacks and the Slowing Economy
 

The nation’s economy slowed significantly in 2001, as 

considerable retrenchment in business capital and information technology spending contributed to weakness in 

the manufacturing sector. In addition, the attacks on 

September 11, 2001, negatively affected consumer confidence and willingness to purchase goods and services. 

Officially, the nation’s economy entered a recession in 

March 2001,1 and most analysts do not expect recovery 

until spring or summer 2002. 

The Region’s economy has not been immune to these 

problems; the economies of Missouri and Minnesota 

are in recession, and the economies of the other five 

states are near recessionary levels.2 However, in some 

cases the effects have been less severe than for the 

nation as a whole. For example, heavy layoffs in 2001, 

particularly in the manufacturing sector, have contributed to a significant increase in unemployment levels. Unemployment nationwide rose from 4.0 percent at 

year-end 2000 to 5.8 percent by December 2001. 

Increases in the Region’s unemployment rate have been 

more muted, which is not surprising considering that the 

labor markets in the Region’s seven states were among 

the tightest in the nation heading into the economic 

slowdown. As of December 2001, unemployment rates 

in the Region ranged from North Dakota’s still-low 2.8 

percent to Missouri’s 4.4 percent. 

However, the effects of the manufacturing slowdown 

have begun to manifest themselves in the Region (see 

Chart 1). This chart shows the results of a monthly 

1 According to the National Bureau of Economic Research (NBER). 2 Economy.com, in a conference call to subscribers, December 12, 

2001. 

survey of purchasing managers by the Institute for 

Supply Management. The Purchasing Managers Index 

is an important gauge of future manufacturing activity 

because it reflects purchasing managers’ intentions over 

the next six months. If the index exceeds 50, the manufacturing sector is expected to expand; if it falls below 

50, a contraction in the sector is expected. Chart 1 

shows that the nation’s economy experienced manufacturing problems before the Region’s did; however, as of 

November 2001, the Region’s index, at 42.6, is slightly 

worse than the nation’s, at 44.5. 

This article examines two areas that are showing particular weakness. The first is the Wichita economy, which 

has been affected directly by the aftermath of the terrorist 

attacks. The second is commercial real estate, which has 

been affected adversely by the slumping national economy but not necessarily by the events of September 11. 

CHART 1 

Purchasing Managers’ Expectations 

Continued to Fall in the 4th Quarter 

Sources: National Association of Purchasing Managers, Creighton University 

Feb

 ’00 

Nov

 ’00 

May

 ’00 

May

 ’01 

Aug

 ’01 

Feb 

’01 

Aug

 ’00 

Nov

 ’01 

35 

40 

45 

50 

55 

60 

65 

Kansas City Region 

United States 

Value < 50 Indicates 

Expected Contraction 

Kansas City Regional Outlook 3	 First Quarter 2002 
Regional Perspectives
 

Wichita Could Be Most Affected by the 

Aftermath of the Terrorist Attacks 

After posting gains between 4 percent and 8 percent 

during much of 1999 and 2000, demand for domestic air 

travel declined significantly through the first half of 

2001 as businesses cut travel expenses to cope with 

declining profitability.3 Immediately following September 11, demand for airline travel dropped more than 30 

percent from the year-ago period and remained about 25 

percent below year-ago levels through the last week of 

October 2001.4 The travel industry—and companies that 

manufacture components, such as aircraft, for the industry—has been hardest hit by the slowdown. 

The Wichita economy is driven primarily by the aircraft 

manufacturing industry. Manufacturing represents 26 

percent of the metropolitan area’s employment, and 70 

percent of the payroll in this sector is in the aerospace 

industry.5 In fact, Wichita’s top four employers, in number of employees, are aerospace companies: Boeing 

(17,300), Cessna Aircraft (11,165), Raytheon Aircraft 

(9,200), and Bombardier Aerospace (3,900).6 The health 

of Wichita’s economy is tied strongly to the aircraft 

manufacturing sector because of the concentration of 

employment in this industry. 

Following the terrorist attacks, a sudden downturn in 

demand resulted in excess capacity, and the airlines 

immediately curtailed orders for new commercial jets. 

As a result, the top four aircraft manufacturing employers in Wichita have announced significant layoffs or 

other employment changes. Boeing has announced 

plans to cut up to 30,000 jobs in 2001 and 2002 nationwide in its commercial jet division, including approximately 5,000 layoffs at its plant in Wichita (Boeing 

Wichita7). Raytheon and Bombardier together plan to 

eliminate more than 2,000 jobs in Wichita by the end of 

2001. Cessna, while not yet laying off employees, is 

delaying plans to add 550 new jobs at its Wichita facilities. Wichita’s unemployment rate could rise by as much 

as 1.6 percent in 2002 from the aircraft manufacturers’ 

3 Figures are based on the year-over-year percentage change of the threemonth moving average of domestic airline passenger revenue miles. 

Economy.com, Inc., Metro 2001, www.economy.com, October 2001. 4 Economy.com, Inc., Industry Outlook conference call presented by 

Dr. Mark Zandi and Economy.com research staff, November 14, 2001. 5 Center for Economic Development and Business Research, W. Frank 

Barton School of Business, Wichita State University, Wichita’s 

Economic Outlook 2001 Review and 2002 Forecast, 2001. 6 Economy.com, Inc., Metro 2001, October 2001. 7 The Boeing Company, Boeing Commercial Airplanes Group, 

Wichita, Kansas. 

layoffs, and the overall impact could be much more 

severe as the effects of lost salaries ripple through the 

economy.8 

The announced job cuts could contribute to a slowing in 

personal income growth and rising unemployment in the 

Wichita area, as was the case with past layoffs. Boeing 

Wichita trimmed about 12 percent of its workforce in 

1999 and early 2000 because of soft international 

demand and internal reorganization;9 however, at that 

time, the area’s economy was strong. Riding a crest of 

increasing gross domestic product, the Wichita economy entered 1999 with an unemployment rate of 3.3 

percent and ended 1998 with 7.1 percent growth in personal income (personal income growth had exceeded 5 

percent annually since 1995).10 Following the layoffs at 

the Boeing Wichita plant, personal income growth 

declined to 2.4 percent in 1999, and Wichita’s unemployment rate reached 4.2 percent in 2000. The repercussions, however, could have been worse had other 

employers—other aircraft manufacturers, industrial 

manufacturers, construction companies, and services 

companies—not been able to absorb many of Boeing’s 

displaced workers. 

The outlook is not as favorable in the aftermath of September 11. Given its significant reliance on the aircraft 

manufacturing industry, the timing of Wichita’s rebound 

will track the aircraft manufacturing sector’s rebound, 

which could take several years. Current estimates do not 

show any new orders for Boeing until at least 2004, and 

aircraft deliveries are expected to decline 40 percent 

between 2001 and 2004.11 Additionally, unlike in 1999, 

the other major aircraft manufacturers are also stressed, 

in large part because of the fallout from the terrorist 

attacks. Instead of representing a source of strength, 

these and other companies are also laying off workers. 

In addition to increasing unemployment and declining 

personal income growth as a result of the September 11 

attacks, housing markets could suffer if workers are not 

willing or able to purchase or upgrade their housing. 

During Boeing’s last labor force contraction, in 1999 

and 2000, the decline in employment and personal 

income growth soon affected Wichita’s housing sector. 

The median sales price of existing homes had increased 

annually, from $62,400 in 1990 to $91,500 in 1999. In 

2000 the fallout from the Boeing layoffs contributed to 

8 See footnote 5. 

9 See footnote 5. 

10 See footnote 6. 

11 See footnote 4. 

Kansas City Regional Outlook 4 First Quarter 2002 
Regional Perspectives
 

a drop in the median sales price for the first time in a 

decade—to $90,800. 

Wichita’s economic woes can be expected to affect 

insured institution loan portfolios in the area. Reported 

aggregate loan data as of September 30, 2001, show 

that banks and thrifts increased loan portfolios by 

4.7 percent from year-ago levels after posting 7.8 and 

7.4 percent growth rates the preceding two years.12 

The majority of this growth is centered in construction 

and development, nonresidential commercial property, 

and business lending, traditionally higher-risk forms of 

lending. As a result, these loan segments now represent 

35 percent of aggregate total assets, up from 31.4 percent two years ago. With the unfavorable economic 

outlook facing Wichita in the near term, business customers could experience strained cash flows that could 

contribute to rising delinquency rates. In addition, 

should vacancy rates rise, loan portfolios secured by 

commercial real estate could experience some weakening in credit quality. 

Fortunately, Wichita’s insured institutions currently are 

reporting solid financial conditions. The aggregate 

leverage capital ratio was 8.4 percent at September 30, 

2001, the highest reported third-quarter figure in five 

years. Additionally, asset quality indicators such as 

delinquency, noncurrent loan ratios, and net charge-off 

rates remain low compared with historical figures. 

Moreover, the number of problem banks and those with 

troubled asset portfolios is small by historical standards. 

Although the economic scenario for Wichita looks poor 

in the short term, the U.S. war on terrorism could ultimately benefit the city. For example, the Department of 

Defense Appropriations Act, 2002, signed into law on 

January 10, 2002, includes funds for a program that permits the Air Force to lease 100 modified Boeing 767 

commercial jets over the next ten years for an estimated 

$20 billion. Much of the modification work likely would 

be performed at the Boeing Wichita facility. 

The Region’s Commercial Real Estate Markets 

Are Experiencing the Brunt of the Recession 

Coinciding with the nation’s first recession in ten 

years, metropolitan markets across the nation are seeing softening commercial real estate (CRE) markets. 

12 FDIC-insured financial institutions with total assets under $1 billion. 

Reported data are merger adjusted. 

Data suggest that all CRE segments—office, industrial, 

retail, multifamily, and hotel—are experiencing problems to varying degrees across a wide range of 

metropolitan areas. The results of a Moody’s analysis 

indicate national weakness in all these markets (see 

Table 1).13 

The Kansas City Region’s three major metropolitan 

areas—Minneapolis-St. Paul (Minneapolis), St. Louis, 

and Kansas City—have also been affected, to varying 

degrees, by softening in the CRE sector. According to 

TABLE 1 

Commercial Real Estate Markets 

Weakened in 2001 

MOODY’S PROPERTY MARKET
 

EQUILIBRIUM STOPLIGHT
 

STOPLIGHT GREEN YELLOW 

STL 

NATION 

KC 

STL 

RED 

COLOR NOT 

MEANING: STRESSED FRAGILE STRESSED 

OFFICE NATION 

KC 

MNP 

STL 

INDUSTRIAL NATION 

KC 

MNP 

STL 

RETAIL NATION 

KC 

MNP 

MULTIFAMILY 

MNP 

HOTEL* NATION 

MNP 

STL 

KC–Kansas City, MNP–Minneapolis-St. Paul, STL–St. Louis 

Entries show the market’s placement in the fourth 

quarter 2001 report. Arrows show the market’s 

fourth quarter 2000 placement if different from 

current placement. 

*No data provided on the Kansas City market. 

Source: Sally Gordon, “CMBS: Red-Yellow-Green 

Update, Fourth Quarter 2001 Quarterly Assessment 

of U.S. Property Markets,” www.moodys.com, Moody’s 

Investors Service, January 12, 2001, and January 4, 

2002. 

13 Gordon, Sally, CMBS: Red-Yellow-Green Update, Fourth Quarter 

2000 and Fourth Quarter 2001 Quarterly Assessment of U.S. Property 

Markets. Moody’s Investors Service, January 12, 2001, and January 4, 

2002. 

Kansas City Regional Outlook 5 First Quarter 2002 
 

Regional Perspectives
 

Moody’s (see Table 1, page 5), at least one CRE segment 

in each of these metropolitan markets is showing fragility or weakness. In addition, at least one segment of the 

CRE market in each of these metropolitan statistical 

areas (MSAs) has been downgraded by Moody’s since 

fourth-quarter 2000. 

As documented in History of the Eighties, CRE market 

deterioration historically has been a significant source 

of distress and has contributed to failures of FDICinsured institutions.14 The following section examines 

all segments of the CRE market in each of the Region’s 

major MSAs and assesses the level of vulnerability in 

each segment. 

Office Markets 

The weakening economy has affected the office market 

profoundly, particularly in areas with substantial concentrations of high-tech employment. According to 

Torto Wheaton Research (TWR), 51 of 53 major metropolitan office markets experienced increasing vacancy rates in the first three quarters of 2001. The national 

vacancy rate increased from a 19-year year-end low of 

8.3 percent in December 2000 to 12.3 percent at yearend 2001 (see Chart 2). Property & Portfolio Research, 

Inc. (PP&R), a real estate sector research firm, projects 

that the national vacancy rate will peak at 13.9 percent 

in 2002. 

CHART 2 

The situation is similar for the Region’s three major 

metropolitan markets. TWR data show that the office 

vacancy rate for Kansas City has exceeded the national 

rate significantly since year-end 2000. Vacancy rates for 

the Minneapolis and St. Louis markets are now in line 

with the national rate (see Chart 2). The results of the 

Moody’s analysis (see Table 1, page 5) corroborate these 

figures; all three markets are designated as falling in the 

“yellow” (fragile) or “red” (stressed) categories. 

When analyzing office markets, it is important to examine the differences between prime Class A space and 

Class B and C space and to distinguish between suburban and downtown markets in a metropolitan area. As 

illustrated in Table 2, the Kansas City, Minneapolis, and 

St. Louis office markets are somewhat dissimilar. All 

office markets in the Minneapolis MSA—both suburban and downtown areas—are exhibiting similar vacancy rates. The same can be said in St. Louis, although 

Class B/C space is showing higher delinquency levels 

than Class A space. 

However, the Kansas City office market shows wide 

variations in vacancies between the downtown and suburban submarkets and Class A and B/C space. These 

distinctions are important, especially for lenders, as 

CRE loan portfolios may exhibit strengths or substantial 

weaknesses based on the location of the loans. 

TABLE 2 

The Region’s Office Markets Weakened in 2001 Vacancy Rate (percent) 

Nation is the aggregate ratio of 53 metropolitan statistical areas reported by 

Torto Wheaton Research. 

Source: Torto Wheaton Research 

4Q97 4Q98 4Q99 4Q00 4Q01 

18 

16 

14 

12 

10 

8 

6 

4 

2 

0 

Kansas City 

St. Louis Minneapolis Nation 

A Market’s Aggregate Office 

Vacancy Rate Can Vary Greatly 

from Its Metropolitan Submarkets 

VACANCY RATES OF CLASS A AND CLASS B/C SPACE 

METROPOLITAN 

MARKET 

METROPOLITAN STATISTICAL AREA 

KANSAS ST. 

CITY MINNEAPOLIS LOUIS 

DOWNTOWN MARKET 

CLASS A 

CLASS B/C 

SUBURBAN MARKET 

CLASS A 

CLASS B/C 

3.3% 8.8% 11.0% 

24.4% 10.3% 15.9% 

20.7% 9.8% 9.3% 

14.1% 13.1% 7.8% 

Source: Torto Wheaton Research, Second Quarter 2001 Data 

14 Federal Deposit Insurance Corporation. 1997. History of the 

Eighties—Lessons for the Future. Vol. I: An Examination of the 

Banking Crises of the 1980s and Early 1990s, Chapters 9 and 10 

(http://www.fdic.gov/bank/historical/history/index.html). 

Kansas City Regional Outlook 6 First Quarter 2002 
 

Regional Perspectives
 

Industrial Space 

As business output slowed in 2000 and 2001, demand 

for industrial space for manufacturing, warehousing and 

distribution, and research and development (R&D) also 

declined. Chart 3 shows that the national industrialspace vacancy rate increased significantly from a longterm low of 6.7 percent in fourth-quarter 2000 to 9.0 

percent at year-end 2001.15 This increase can be attributed to the fact that demand was relatively low, as indicated by negative absorption rates in the first three 

quarters of 2001. In addition, new construction is estimated to top 220 million square feet in 2001, the highest level in more than a decade.16 

Although Chart 3 shows the Minneapolis, Kansas City, 

and St. Louis industrial markets currently faring better 

than the national average, these markets continue to 

experience rising vacancy rates because of contraction 

in the manufacturing sector. Minneapolis appears to be 

the most vulnerable of the three markets, largely 

because of the higher concentration in R&D industrial 

space during a period of contraction in the high-tech 

sector. R&D space accounts for 11 percent of the Minneapolis industrial market, compared with 2 percent for 

Kansas City and 1 percent for St. Louis.17 The Kansas 

City industrial vacancy rate is low by historical standards and compared with national trends and is not 

expected to increase much beyond the current level. The 

results of the Moody’s analysis indicates the same findCHART 3 

ings, with Minneapolis receiving a “yellow” rating and 

Kansas City and St. Louis receiving “green” ratings. 

Retail Space 

Vacancy rates for retail space have risen in Kansas City, 

Minneapolis, and St. Louis since posting historically 

low rates of 5.9, 5.5, and 8.6 percent, respectively, in 

first-quarter 2000. However, while vacancy rates in 

these markets are expected to continue to rise through 

much of 2002 (see Chart 4), rates are not expected to 

reach levels that may cause concern. Moody’s “red” rating for Minneapolis (see Table 1) reflects strong supply 

in the pipeline at the same time retail sales growth is 

declining, a situation that could result in oversupply. 

Multifamily Housing 

The Minneapolis apartment market remains extremely 

tight (see Chart 5, next page). Vacancies are rising 

slightly; however, the long-term outlook for the area 

remains favorable because of strong population growth 

and household income trends. By contrast, the multifamily housing market in St. Louis and Kansas City is 

not faring well. Moody’s cautionary “yellow” ratings for 

St. Louis and Kansas City retail are attributed to significant new supply coupled with sagging demand because 

of weak employment and income growth. This situation 

is most pronounced in Kansas City, where numerous 

apartment construction projects are in progress, exacerbating the current supply/demand imbalance. 

CHART 4 

The Region’s Industrial Markets Are Faring 

Better than Rest of the Nation 

Vacancy Rate (percent) 

Nation is the aggregate ratio of 53 metropolitan statistical areas reported 

by Torto Wheaton Research. 

Source: Torto Wheaton Research 

10 

9 

8 

7 

6 

5 

4 

3 

2 

1 

0 

4Q97 4Q98 4Q99 4Q00 4Q01 

Kansas 

City 

St. Louis 

Minneapolis 

Nation 

Retail Vacancy Rates Are Expected to
 

Continue Rising through 2002
 

Nation 

Vacancy Rate (percent) 

’96 ’97 ’98 ’99 ’00 ’01F ’02F ’03F 

Note: F = forecast. “Nation” is the aggregate ratio of 54 metropolitan statistical 

areas reported by PPR. 

Source: PPR Fundamentals by Property and Portfolio Research, Inc. 

18 

16 

14 

12 

10 

8 

6 

4 

2 

0 

St. Louis 

Kansas City 

Minneapolis 

15 Torto Wheaton Research.
 16 See “Slowing Economy Reduces Demand for U.S. Office Space,”
 

Regional Outlook, Third Quarter 2001.
 17 Torto Wheaton Research.
 

Kansas City Regional Outlook 7 First Quarter 2002 
Regional Perspectives
 

Hotels 

The hotel situation changed dramatically after September 11. Hotel room occupancy had been declining 

before the terrorist attacks as businesses cut travel budgets and consumers scaled back travel plans in response 

to the slowing economy (see Chart 6). However, according to Moody’s, the hotel room occupancy rate in Minneapolis and St. Louis remained strong (the Moody’s 

hotel sector analysis did not include Kansas City). The 

dramatic reduction of travel that followed the attacks 

resulted in Moody’s downgrading most markets. 

CHART 5 

Kansas City’s Apartment Vacancy Rate Is 

Expected to Rise Significantly through 2002 

10 Kansas 

9 

Moody’s rates St. Louis, Minneapolis, and the nation as 

“red,” indicating significant weakness (see Table 1). All 

three had been “green” one year earlier. 

Insured Institution Exposure to Commercial 

Real Estate in the Kansas City Region Stands 

at the Highest Level in a Decade 

While CRE markets are showing varying degrees of 

deterioration in the Region’s three major MSAs, insured 

institutions are reporting relatively high exposures to 

CRE.18 As shown in Chart 7, emphasis on CRE lending 

has increased significantly among insured institutions 

in these three markets and the nation since 1998.19 In the 

past year (October 1, 2000, through September 30, 

2001), insured institutions in the Kansas City, Minneapolis, and St. Louis MSAs increased CRE loans as a 

share of total assets by 2.4, 2.1, and 1.6 percent, respec6 

City 

St. Louis 

Nation 

institutions are now holding a higher level of new, or 5

Vacancy Rate (percent) 

8 tively. This growth occurred as the property markets in 

7 these MSAs began to weaken and suggests that insured 

“unseasoned,” CRE loans than at any other time in the 4 

than seasoned loans during times of economic stress. 2
 

1
 Minneapolis
 

0
 CRE lending by insured institutions in the Kansas City ’96 ’97 ’98 ’99 ’00 ’01F ’02F ’03F 

Note: F = forecast. “Nation” is the aggregate ratio of 54 metropolitan statistical market was flat during the first half of the 1990s, as 

past decade. Unseasoned loans typically perform worse 3 

areas reported by PPR. many institutions unraveled CRE loan problems that Source: PPR Fundamentals by Property and Portfolio Research, Inc. 

surfaced early in the decade. The ratio of aggregate 

CHART 6 CHART 7 

Like the Rest of the Nation, the Region Has Seen Insured Institutions Have Significantly Increased 

a Significant Drop in Hotel Room Occupancy CRE Loan Concentrations since 1998 

35

Commercial Real Estate Loans

to Total Assets (percent) 

72 

Minneapolis 70 

Kansas City 

Nation

Rooms Occupied (percent)

Kansas 

City 

St. Louis 

Nation 

30 

25 

20 

15 

68 

66 

64 

62 

60 

58 

56 St. Louis 

54 Minneapolis

10 52 

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

Note: F = forecast. “Nation” is the aggregate ratio of 54 metropolitan statistical Note: Nation is the aggregate ratio of financial institutions present in 

areas reported by PPR. 53 metropolitan statistical areas tracked by Torto Wheaton Research. 

Source: PPR Fundamentals by Property and Portfolio Research, Inc. Source: Bank Call Reports. 

’96 ’97 ’98 ’99 ’00 ’01F ’02F ’03F 

18 “Insured institutions” in this section refers to banks and thrifts that 

hold assets of less than $1 billion and greater than 10 percent of total 

assets in CRE loans. 

19 CRE lending includes real estate construction and development 

loans, loans secured by multifamily properties, and loans secured by 

other nonresidential properties. 

Kansas City Regional Outlook 8 First Quarter 2002 
Regional Perspectives
 

CRE loans to total assets hovered between 22.2 and 

23.3 percent from 1990 to 1995. However, after dipping 

slightly to a decade-low 19.9 percent in 1998, the ratio 

surged to a Region-high 30.6 percent in 2001. 

Insured institutions lending in the Kansas City market 

also exhibit a significantly higher concentration in construction and development (C&D) lending than the 

other markets; C&D lending as a proportion of total 

assets has consistently been higher than the national 

average. Insured institutions in the St. Louis and Minneapolis markets hold C&D loan portfolios that mirror 

national levels. C&D loans are typically more vulnerable than other loan categories to changes in property 

market conditions. As a result, the higher exposure to 

C&D loans among insured institutions in the Kansas 

City market suggests that the level of credit risk could 

exceed that for institutions lending in the Minneapolis 

and St. Louis markets. 

Although insured institutions lending in the St. Louis 

market have fewer assets invested in CRE than institutions lending in the Kansas City and Minneapolis markets, their capital bases are also lower. As of September 

30, 2001, CRE loans among insured institutions operating in the St. Louis market represented 349 percent of 

Tier 1 capital, compared with 312 percent in Kansas 

City and 300 percent in Minneapolis. 

Overall, insured institutions lending in the Minneapolis 

market exhibit a less risky CRE loan profile. Banks 

and thrifts in this area experienced the most sizable 

change in CRE loan volume relative to total assets 

during the past decade, more than doubling from a low 

12.4 percent of total assets in 1991 to 25.2 percent in 

2001. However, because the CRE loan-to-asset ratio 

was well below that of institutions lending in the 

Kansas City and St. Louis markets ten years ago, the 

25.2 percent ratio remains lower than that of the other 

markets. Additionally, banks and thrifts in Minneapolis 

reported the least amount of C&D lending of the three 

markets, posting relatively low and flat C&D loan 

volume relative to assets. 

Although insured institutions in the Region’s major 

markets recently have increased CRE loan exposures 

significantly, current levels remain at or below the 

aggregate national level shown in Chart 7. Additionally, although the CRE markets in Kansas City, 

Minneapolis, and St. Louis have weakened somewhat, 

they are not among the weakest in the country. Therefore, while insured institutions in the three MSAs now 

face greater challenges from the CRE sector than 

they did two years ago, banks and thrifts in other 

metropolitan areas are experiencing greater deterioration in CRE portfolios. 

In addition, reported asset quality remains strong. As of 

September 30, 2001, St. Louis’s insured institutions 

reported the highest delinquent and noncurrent loan 

ratio of the three MSAs, at 2.1 percent, and institutions 

in Kansas City reported the highest net charge-off rate, 

at 0.2 percent, although both ratios are low compared 

with national levels and historical levels. It is important 

to note that there are no other indications of significant, 

widespread credit quality deterioration among insured 

institutions in these markets, and the number of problem 

institutions and those with troubled asset portfolios 

remains low by historical standards. 

Insured institutions are faced with weakening in certain 

of the Region’s CRE markets for the first time in a 

decade. Bankers should ensure that credit risk management practices and procedures are in place to ride out a 

more challenging economic environment. 

Richard D. Cofer, Jr. 

Senior Financial Analyst 

Kansas City Regional Outlook 9 First Quarter 2002 

In Focus This Quarter
 

Housing Market Has Held Up Well in This 


Recession, but Some Issues Raise Concern
 

Trends in housing markets are important performance 

drivers for many FDIC-insured institutions. The health of 

residential markets can affect the credit quality of residential mortgage loans, home equity loans, and loans to 

finance residential construction and is linked indirectly to 

the performance of other types of consumer and smallbusiness debt. Further, an estimated $2 trillion in mortgage debt, approximately one-third of the mortgage 

market, was underwritten during 2001, with 56 percent of 

this activity in refinancing transactions.1 This activity 

makes recent trends in underwriting of particular interest. 

An ancillary issue for many mortgage lenders, interest 

rate risk, is not addressed in this article.2 

The U.S. economy entered a recession in March 2001, 

and the question arises as to how consumer creditworthiness, housing values, and recent mortgage-lending 

practices will fare during this downturn. Developments 

contributing to increased credit risk include higher consumer debt burdens, looser mortgage loan underwriting 

standards, and the emergence of subprime mortgage 

lending as a significant line of business for some banks. 

Mitigating this risk has been the steady appreciation of 

home prices, which have shown signs of softening in 

some markets but not to the extent seen at a comparable 

stage in previous recessions. 

Home price weakness may be more pronounced in 2002 

as the effects of the recession take hold, but in the 

authors’ judgment, systemic weakness in home prices is 

unlikely, absent a deep and long recession. Adverse mortgage lending trends are not expected to threaten the capital or earnings of the vast majority of insured 

institutions. Nonconstruction residential mortgages, even 

during the most pronounced periods of stress in the 1980s 

and early 1990s, remained the best-performing loan 

class, especially for lenders specializing in residential 

real estate; and, historically, these mortgages have been 

1 Mortgage Market Forecast, www.mbaa.org/marketdata/forecasts/,
 

January 2002.
 

2 For a discussion of this issue, see “Regional Perspectives,” Boston
 

and Chicago Regions, Regional Outlook, First Quarter 2002.
 

one of the lowest credit-risk loan types for all manner of 

insured institutions.3 

That said, however, there are pockets of risk for 

insured institutions. There is evidence that borrowers 

with weak credit may be experiencing greater repayment difficulties, elevating the risks faced by subprime 

mortgage lenders. Further, a slump in residential real 

estate markets could be especially detrimental to 

insured institutions with significant exposures to 

housing construction because projects might not sell at 

projected asking prices or as quickly as anticipated. 

Finally, in specific markets where housing prices may 

have achieved unsustainable levels, some increase in 

housing-related credit quality problems can be expected, and in this regard, the San Francisco Bay area 

stands out as a place to watch. 

The Recession Thus Far Has Had 

a Minimal Impact on Mortgage 

Delinquencies at Insured Institutions 

Despite three quarters of recession, most housing indicators remained quite healthy this past year relative to 

trends seen in past recessions. For example, new and 

existing home sales both set records during the year, 

while new home construction failed to decline, an 

occurrence not seen in the past six recessions. Another indicator, year-over-year growth in existing home 

prices—as measured by either the Office of Federal 

Housing Enterprise Oversight (OFHEO) repeat sales 

price index or the National Association of Realtors 

(NAR) median single-family price statistic—showed 

deceleration but remained well above trends seen at 

similar points in past recessions. This behavior partly 

reflected the early robustness of household income in 

the face of recession and relatively low fixed mortgage 

rates during 2001, which helped to counter some of the 

3 See “Region’s Insured Institutions Exhibit Lower Risk Profile than 

the Nation’s, Appendix: Risk-Weighting Methodology,” Table A in 

Boston Region, Regional Outlook, First-Quarter 2000. 

Kansas City Regional Outlook 11 First Quarter 2002 
In Focus This Quarter
 

CHART 1 CHART 2 

Through September 2001, Mortgage-


Related Delinquencies Remained Modest
 

Although the Much Larger Market for 

Existing Homes Has Held Up, New Home 

Prices Are Under Pressure 

Percentage Change from

Prior Year 

Sources: Census (new), National Association of Realtors (Existing) 

Existing 

New 

–10 

–5 

0 

5 

10 

15 

20 

,

79 ,81 ,83 ,85 ,87 ,89 ,91 ,93 ,95 ,97 ,99 ,

01 

Percentage 

30+ Days Past Due 

0 

2 

4 

6 

8 

10 

12 

,

91 ,93 ,95 ,97 ,99 Sep ,

01 

0 

1 

2 

3 

4 

5 

6 

Percentage 

30+ Days Past Due 

95th Percentiles (R) 

mortgages equity lines 

75th Percentiles (L) 

NOTE: Sample consists of banks with at least $1 million in equity lines 

or mortgages that are also at least 5 percent of bank's Tier 1 capital. 

Source: Bank and Thrift Call Reports 

initial adverse effects of the recession on housing 

demand. 

One sign of potential weakness appeared late in 2001 

in the modest year-over-year decline in median prices 

of new single-family homes (see Chart 1). Because 

existing home sales outnumber new home sales roughly fivefold, price trends in the latter are generally not 

predictive of prices for the much larger existing home 

market.4 However, as discussed later in this article, 

adverse pricing trends in the new home segment do 

raise concerns for residential developers and insured 

institutions that finance residential construction. 

The steady increase in prices of existing homes depicted in Chart 1 masks considerable regional variation. 

As detailed later in this article, home price growth 

began to weaken in 2001 in a number of metropolitan 

statistical areas (MSAs). While there is no clear common denominator among the markets in which this 

occurred, a number of these markets had both extremely rapid home price growth in the recent past and significant slowdowns in employment growth or outright 

contractions in employment last year. 

Credit quality indicators for insured institutions’ mortgage loans have shown only preliminary signs of 

weakness thus far. Through the first nine months of 

2001, insured institutions showed negligible advances 

in median past-due ratios for mortgages and equity 

4 Existing home prices are also more reflective than new home prices 

of trends in broader economic indicators, such as aggregate per capita personal income. 

lines of credit, although continued strong mortgage 

origination activity in 2001 may have masked (in the 

aggregate) developing credit problems for more seasoned mortgage loans. For institutions that held at 

least $1 million in residential mortgages or home equity lines of credit and whose exposures comprised at 

least 5 percent of Tier 1 capital, some modest deterioration is evident in the worst-performing mortgages 

and home equity lines since 1999, as seen in Chart 2.5 

Even if this recession lingers, worsens, or both, residential mortgage lending (nonconstruction and development-related) likely poses only modest risk to most 

insured institutions’ earnings and capital, since it has 

held up better in prior recessions than other loan types. 

What Are the Risks Facing Housing 

Lenders in 2002 and Beyond? 

In an environment of significantly slower economic 

growth than prevailed during the 1990s, can the 

strength of housing prices and the relatively benign 

credit quality environment for housing lenders be 

expected to continue? The answer will depend on the 

interplay of economic conditions and lenders’ risk profiles. In the remainder of this article, we discuss the 

gradual increase in the risk profile for insured mortgage lenders that appears to have occurred during the 

5 It is interesting to examine the (adverse) tail of the credit quality distribution when looking at residential mortgage trends, as average and 

median past-due ratios move little and are typically very low—thus, 

only the highest 25th and 5th percentiles of past-due ratios are presented in Chart 2. 

Kansas City Regional Outlook 12 First Quarter 2002 
, UT

Miami– 

y, NY

Phoenix, AZ

, NV–AZ 

, MO–IL 

Tucson, AZ

Oklahoma City

, NY

, OK 

Kansas City

Tulsa, OK

, MO–KS

, NC–SC 

mingham, AL

, TN-AR–MS

Honolulu, HI

, SC 

Entire Nation

, FL

e City

alo

ville

 Lauderdale

Alban

Buff

 Louis

Green

egas

lotte

Salt Lak

Memphis

Las V

Char

St.

Bir

Ft.

In Focus This Quarter
 

1990s, as well as some cyclical risks to their performance that may exist as the recession plays out. 

Evolving Lending Practices Have Increased 

the Risk Profile for Mortgage Lenders 

Although history suggests that residential mortgage 

defaults will be relatively low even in a recession, 

changes in the mortgage market since the 1990–1991 

recession could affect mortgage performance during the 

present downturn. Many underwriting changes over the 

past decade have been driven in part by the growing 

importance of the secondary market for mortgage debt, 

and of Fannie Mae and Freddie Mac in particular. In 

1980, federal and related agencies had direct or indirect 

interests in approximately 17 percent of all mortgage 

debt.6 By 2000, their share of the mortgage market had 

increased to roughly 41 percent. Insured bank and thrift 

mortgage exposures grew over the same period, but, as 

a share of direct mortgage debt, bank and thrift mortgage holdings decreased from 59 to 35 percent. These 

trends notwithstanding, insured institutions still provide 

substantial funding, directly or indirectly, to the housing 

market: as of September 30, 2001, 1 to 4 family mortgage loans and mortgage-backed securities held by 

insured institutions aggregated $2.3 trillion, up 37 percent from five years earlier. 

Although an active secondary mortgage market has 

broadened homeownership, improved mortgage loan liquidity, and allowed insured institutions to allay credit 

risk, it has also heightened market competition and transformed the lending process. In presecondary market 

CHART 3 

1993 2000 

days, lenders largely had to retain originated mortgages 

in their own portfolios. Consequently, only lenders with 

ready funding sources (such as banks, thrifts, and insurance and finance companies) were able to compete in the 

mortgage markets. The advent of the secondary market 

enlarged the pool of available funding and permitted both 

insured institutions and other originators to transfer their 

mortgage business readily into entities such as mortgage 

pools and trusts. Consequently, many new players, 

including on-line and brick-and-mortar mortgage brokers, have entered the mortgage origination market. 

The resulting robust mortgage loan competition, combined with Internet-based consumer research tools, has 

led to considerable commodification of the mortgage 

market. Rather than competing on the basis of traditional 

relationships, lenders’ market shares are increasingly 

driven by price. For smaller savings institutions that focus 

heavily on residential mortgage underwriting, this issue 

has likely elevated business risk. Heightened competition 

has caused some loosening of mortgage underwriting 

standards and pushed lenders to use technology to expedite and streamline the underwriting process. Consequently, credit-scoring mechanisms and automated 

valuation techniques currently in place have not been 

tested through a full credit cycle. Because pricing competition has pressured margins, some mortgage lenders 

have pursued subprime or high loan-to-value (HLTV) 

mortgages. The ability of insured institutions to mitigate 

subprime losses through an economic downturn is untested to a large extent as well—finance companies dominated the high-risk mortgage market in past recessions. 

High Loan-to-Purchase Price Ratios Are Increasingly Common in Some Metro Areas 

Percentage of Mortgages with Loan-toPurchase Price Ratios Exceeding 90 Percent 

60 

40 

20 

0 

Source: Federal Housing Finance Board 

6 These interests include residential, commercial, and farm real estate debts held directly by, or held in mortgage pools or trusts issued by, federal 

and related agencies. Source: Table 1186, Statistical Abstract of the United States: 2001, page 733. 

Kansas City Regional Outlook 13 First Quarter 2002 
In Focus This Quarter
 

In general, mortgage underwriting standards have loosened industrywide over the past decade. For instance, 

lenders have increasingly accepted higher loan-topurchase price (LTPP) ratios for purchase money mortgages.7 According to the Federal Housing Finance 

Board, LTPP ratios are high and have risen in several 

metropolitan areas over the past seven years (see Chart 3). 

Between 1993 and 2000, the Honolulu, Tulsa, and Tucson markets exhibited the largest increases in mortgages 

with LTPP ratios exceeding 90 percent. 

Although lenders often mitigate the risk of loss associated with low downpayments by requiring private mortgage 

insurance (PMI), recently the mortgage industry has 

allowed borrowers to avoid purchasing PMI. In particular, 

“piggyback” financing has made homeownership 

increasingly possible for households that cannot afford 

the traditional 20 percent down payment or do not wish to 

pay for PMI. With piggyback financing, the borrower 

often arranges a conforming 80 percent LTPP first mortgage and finances a portion of the remaining 20 percent 

with a concurrent second mortgage on the property (e.g., 

“80-10-10”). This type of transaction has become popular 

because interest paid on the (albeit more expensive) second mortgage is tax-deductible, whereas PMI premiums 

are not. Thus, piggyback financing is probably most 

attractive to individuals in higher-cost/tax areas or higher 

tax brackets, such as those in the Northeast and California. This trend effectively shifts the first loss position 

on all low down payment loans to the lender that 

retains the junior position. These institutions are, of 

course, compensated for some of this risk with the 

higher interest rates charged on the piggyback portion 

of these mortgages. 

Competitive factors have prompted the industry to 

enhance underwriting automation. As part of the push, 

credit scoring has become a routine part of the credit 

analysis process, and, increasingly, lenders are using 

automated valuation models (AVMs) to determine collateral coverage. However, credit scoring and collateral valuation models have been in popular use only 

since the 1990–1991 recession; consequently, their 

predictive ability in a downturn is uncertain. Although 

some have touted AVMs as the answer to appraisal 

fraud, the ability of statistical models to simulate the 

qualitative judgments considered critical to traditional 

appraisals is unknown. Paper appraisals reportedly 

7 Purchase money mortgages are loans extended solely for the initial 

purchase of a home. Statistics on loan-to-value ratios for supplemental home equity loans/lines (e.g., piggyback or “80-10-10” financing), as well as refinanced mortgages, are not readily available. 

continue to dominate the industry; however, recently, 

the two largest government-sponsored enterprises have 

begun accepting AVMs in lieu of standard appraisals 

for loans under $275,000.8 For lenders that specialize 

in HLTV mortgages, there is less room for error with 

AVMs. 

Cyclical Weakness Is Already Apparent 

in Subprime Mortgage Lending 

Historically, certain insured institutions have made 

mortgage loans with narrow collateral margins or to 

borrowers with limited or blemished credit histories. 

However, significant entry by FDIC-insured institutions into mortgage lending to borrowers with weak or 

marginal credit, as a targeted line of business, generally has occurred only since the early 1990s. These 

“subprime” mortgages are neither defined nor reported on Bank Call Reports. As a result, gauging the 

extent of bank involvement in subprime lending at any 

point in time is difficult. However, the FDIC estimates 

that fewer than 1 percent of all insured institutions 

have significant subprime residential mortgage exposures. Nevertheless, according to some measures, subprime mortgages as a share of total mortgage 

originations peaked at 13 percent in early 2000, before 

moderating somewhat during the first three quarters of 

last year.9 Thus, a much larger number of institutions 

probably have some limited involvement in subprime 

mortgage lending. A survey by the Minneapolis Federal Reserve Bank found that 29 percent of banks in 

the Minneapolis District offered loans to low-credit 

quality consumer borrowers in 1999.10 

Subprime mortgage loan performance appears to have 

deteriorated notably during 2001. One source of support for this observation comes from delinquency 

trends on Federal Housing Agency (FHA)-insured 

mortgages, which are often granted to first-time homebuyers with troubled credit histories and borrowers 

with low down payments. The Mortgage Bankers 

Association reports that while the national delinquency rate on conventional mortgages rose 58 basis points 

in the year ending third-quarter 2001, the delinquency 

rate on FHA mortgages shot up by 234 basis points, to 

11.4 percent (see Chart 4). This growing gap between 

8 “Automated Appraisals Require Caution by Lenders,” American 

Banker, October 10, 2001. 9 Based on dollar volumes, data from Inside Mortgage Finance Publications, Bethesda, MD. 

10 Ron Feldman and Jason Schmidt, “Why All Concerns About Subprime Lending Are Not Created Equal,” Fedgazette, Minneapolis 

Federal Reserve, July 1999. 

Kansas City Regional Outlook 14 First Quarter 2002 
In Focus This Quarter
 

CHART 4 

Recent Mortgage Delinquencies for HigherRisk Loans Reached All-Time Highs 

Percentage of Mortgages

30+ Days Past Due

FHA 

Conventional 

,

79 ,81 ,83 ,85 ,87 ,89 ,91 ,93 ,95 ,97 ,99 ,01 

0 

2 

4 

6 

8 

10 

12 

Source: Mortgage Bankers Association 

delinquency rates on conventional and governmentinsured mortgages suggests that marginal and subprime borrowers are facing growing repayment 

difficulties. 

A database of more than 6.5 million subprime loans 

tracked by Loan Performance Corporation (formerly 

Mortgage Information Corporation) reported similar 

trends. The nationwide third quarter 2001 ratio of seriously delinquent subprime mortgages was 7.3 percent, up 

from 5.5 percent one year earlier.11 Moreover, subprime 

delinquencies significantly exceeded those found among 

prime mortgages, as just under 0.5 percent of conventional prime mortgages were seriously delinquent.12 Also 

of possible concern are vintage data trends, which show 

how pools of primary and junior-lien subprime mortgages perform over time. Mortgages originated in 2000 

are performing poorly in relation to previous years’ vintages.13 This simply could reflect the impact of the current 

recession. Alternatively, Loan Performance Corporation 

analysts have suggested that the 2001 refinancing boom 

might have created some adverse selection in mortgage 

pools originated during the relatively higher interest rate 

environment of late 1999 and early 2000.14 Because high11 The Market Pulse, Loan Performance Corporation (formerly Mortgage Information Corporation), Winter 2001 and Fall 2001. 

12 The Market Pulse, Loan Performance Corporation, Fall 2001. 13 Per Loan Performance Corporation delinquency data, subprime primary mortgages originated in 2000 displayed higher delinquency 

ratios for their age compared with similarly seasoned subprime loans 

originated in 1996, 1997, 1998, or 1999. Moody’s second-quarter 

2001 Home Equity Index Update found the same to be true of subprime home equity loans. 

14 “Another Look at the 2000 Book,” The Market Pulse, Loan Performance Corporation (formerly Mortgage Information Corporation), 

Winter 2001. 

er-coupon and variable-rate loans comprised a significant 

share of mortgage originations during that period, overall 

prepayment rates on the 2000 vintage might have been 

unusually high during 2001. Consequently, the best-quality loans in the 2000 pool might have refinanced, leaving 

loans of lesser credit quality behind and elevating the 

residual delinquency experience in that pool. 

Given these trends, an important issue for subprime 

lenders is their ability to anticipate and plan for the 

impact of an economic slump on their operations. Some 

institutions clearly adopt subprime lending as part of an 

overall business strategy, setting up monitoring and collection departments geared to dealing with such loans. 

Among large, national lenders, for example, one institution that makes 5 to 10 percent of its loans to subprime 

borrowers recently provided additional resources to its 

loan services and default management departments. This 

action followed a period when one-third of its increase in 

nonperforming single-family mortgage loans was associated with loans to subprime borrowers.15 

C&D Lending Risks May Be Elevated in MSAs 

with Potential Supply/Demand Imbalances 

Historically, lending to finance housing construction is 

riskier than mortgage lending on existing structures. 

Insured institutions report construction and development 

(C&D) lending in a single category that includes both 

commercial and residential construction. While it is thus 

impossible to ascertain from quarterly call reports the 

extent of bank involvement in financing housing construction, anecdotal evidence suggests that, although 

smaller insured institutions engage to some degree in 

commercial property development, their C&D lending 

largely finances single-family construction. If markets 

with an oversupply of housing see weaker economic performance, insured institutions engaged in financing residential real estate development may be at risk. This could 

result in an increase in C&D loan delinquencies, losses, 

and other-real-estate-owned (OREO). 

Demand for housing can be affected by two distinct 

trends: secular, or longer term; and cyclical, or shorter 

term. Over the long term, demographic trends, such as 

population growth rates and concentrations of households by age cohort, can affect overall demand for housing, as well as the types of homes demanded. Demand in 

local housing markets also can be affected by more cyclical factors such as recent changes in economic 

15 Calmetta Coleman, “Default Worries on Home Loans Escalate as 

Lenders Report Delinquency,” Wall Street Journal, October 29, 2001. 

Kansas City Regional Outlook 15 First Quarter 2002 
In Focus This Quarter
 

conditions, including interest rates. New supply of homes 

in local housing markets is produced in response to perceived or estimated future demand. Correct interpretation 

of market and economic signals is critical to the success 

of builders in metropolitan areas; however, this activity is complicated by the lags associated with developing, permitting, and constructing properties. The effect 

of overestimating future demand could be multiplied if 

several builders inaccurately gauge changes in 

demand. Consequently, a construction market with 

numerous smaller developers, such as Atlanta, may 

see amplified swings in construction activity and may 

experience excess supply during certain periods. 

Although conceptually straightforward, measuring the 

balance between housing demand and supply is challenging, particularly at lower geographic levels. Shortcomings in data availability, quality, and timeliness 

can limit the effectiveness of this type of analysis. As 

already mentioned, some insight about current housing 

market conditions in specific metropolitan areas may 

be gained by analyzing both secular and cyclical 

trends. However, given the onset of recession last year, 

the role of cyclical factors is of prime concern at this 

time. 

To measure the cyclical aspect of the relationship 

between a market’s supply and demand, some analysts 

rely heavily on the concept of employment-driven 

demand.16 Such analysis involves tracking a demand/ 

supply ratio based on employment growth and permit 

issuance. Areas where permitting activity continues to 

accelerate while employment levels decrease may produce an increasing imbalance in the local housing 

market.17 

Using a simplified version of employment-driven 

demand, we identified a number of metropolitan areas 

as being at risk for a rising imbalance in their housing 

markets (see Chart 5), the largest of which are Chicago, Greensboro (NC), Minneapolis, Phoenix, Portland (OR-WA), St. Louis, and, most notably, Atlanta. 

These markets are displaying signs that residential 

16 For example, see www.myersgroup.com. 17 This approach, although more reflective of recent economic events 

than perhaps more secular measures, is not without its drawbacks. For 

example, employment data from the Bureau of Labor Statistics’ establishment survey are frequently revised, and, consequently, employment-driven demand may need to be reexamined. 

CHART 5 

–120 

–100 

–80 

–60 

–40 

–20 

20 

40 

60 

(5,000) (2,500) 2,500 5,000 

December 2001 Year-to-Date Permits 

(Year-Ago Change) 

December 2001 Employment

(Year-Ago Change, Thousands) 

Sources: Bureau of Labor Statistics, U.S. Census Bureau (Haver Analytics) 

Some Larger MSAs Continued to See 

Permit Growth during 2001, despite 

Declining Employment 

0 

Greensboro, 

Minneapolis, 

& St. Louis 

Chicago 

Atlanta 

Portland, OR–WA 

Phoenix 

construction activity may not be responding in kind to 

local economies that have started to contract during 

this recession. Further, Phoenix, Portland, and Atlanta 

were identified previously as banking markets exhibiting elevated risk profiles.18 

Chart 6 displays the level (y axis) and trend (x axis) in 

C&D lending exposures for the top 25 MSAs by median C&D concentration as a share of assets.19 It is 

apparent that some markets identified in Chart 5 as 

having significant banking exposure to C&D lending 

also may have a cyclical imbalance in home building. 

Atlanta, for example, demonstrates one of the highest 

exposures, with a ratio of median C&D to total assets 

of 17 percent in third-quarter 2001, a roughly 100­

basis-point increase from year-end 2000. In other 

words, while employment-driven demand has softened 

in the metropolitan area, single-family construction 

activity has continued, and community bank lenders 

may have increased their level of residential financing 

commitments. 

Cyclical Risks May Be Developing 

with Respect to Home Prices 

Popular comparisons have been made recently 

between the healthy run-up in housing prices during 

18 See “In Focus This Quarter,” Regional Outlook, Fourth-Quarter 

2001. 

19 We considered only MSAs that had at least six locally headquartered community banks that engaged in C&D lending activity and 

then charted the top 25 MSAs ranked by September 2001 median 

C&D/assets. 

Kansas City Regional Outlook 16 First Quarter 2002 
In Focus This Quarter
 

CHART 6 

Some Banking Markets Are Seeing Rising Construction and Development (C&D) 

Exposure Coupled with Potentially Growing Supply/Demand Imbalances 

Sources: Bank Call Reports, Bureau of Labor Statistics, U.S. Census Bureau (Haver Analytics) Median C&D Loans-to-Assets (Third-Quarter 2001, %) 

0 

5 

10 

15 

20 

25 

30 

Change in Median C&D Loans-to-Assets 

(Percentage Point Change, from Fourth-Quarter 2000 to Third-Quarter 2001) 

–2 0 2 4 6 8 10 

Salt Lake City 

Atlanta Provo-Orem, UT 

Stockton, CA 

Greensboro 

Portland, OR–WA 

Phoenix 

MSAs with declining employment

 but rising permitting during 2001 

the past several years and the technology stock-fed 

speculative “bubble” in equity prices that persisted 

through early 2000. The subsequent bursting of this 

bubble and the resulting economic distress have raised 

concerns of a sequel featuring housing prices. 

According to the OFHEO repeat sales price index, 

there has never been an instance of outright declines in 

aggregate U.S. existing home prices.20 However, home 

prices do exhibit strong cyclical tendencies, with the 

rate of appreciation slowing during national recessions. In addition, there have been some decidedly 

CHART 7 

negative episodes during the past few decades in various metropolitan markets. At the national level, existing-home price growth historically has followed trends 

in population-adjusted personal income growth,21 and 

some have pointed to a growing imbalance between 

the two as a sign that home prices may weaken as the 

effects of the recession take hold (see Chart 7). 

Given that home price bubbles have occurred in the 

past, most notably in Texas, California, and the Northeast during the 1980s, and that their ultimate deflation 

MAP 1 

Change on Year Ago (%) Note: E=estimate 

Sources: OFHEO, U.S. Census Bureau 

The Widening Gap between Home Price and 

Income Growth Has Raised Some Concern 

Per Capita Income 

Home Price Index 

’85 ’87 ’91 ’93 ’97 ’01E ’89 ’95 ’99 

0 

2 

4 

6 

8 

10 

Drops in Affordability since the Mid-1990s
 

Are Most Prevalent in California 


and the Northeast
 

Top 10 percent of
 

MSAs ranked by decline
 

in affordability index, 1996
 

to 2001 (through June)
 

NOTE: Anchorage, AK, is included, but not shown. 

Source: Economy.com 

20 According to the National Association of Realtors’ U.S. median price, a few episodes of price declines (on a quarterly, year-ago basis) are present in the time series—specifically first- and second-quarter 1989; fourth-quarter 1990; and first-quarter 1993—only the 1990 episode occurred
 

during a recession. Also, as shown in Chart 1, U.S. median new home prices have experienced meaningful declines.
 21 This relationship is generally true at the metropolitan level as well.
 

Kansas City Regional Outlook 17 First Quarter 2002 
In Focus This Quarter
 

resulted in significant negative fallout for these areas’ 

economies and insured institutions, it is useful to look 

at these historical examples as a potential “worst-case” 

scenario (with very low probability) for residential 

real estate markets during the current recession. It is 

unlikely that significant, systemic risks from home 

price bubbles have arisen yet for residential lenders. 

Of course, this situation could change if the current 

recession deepens or is protracted, or if growth during 

the subsequent recovery is anemic. Further, national 

trends can obscure dramatic variations in local markets, and a handful of MSAs today are coming off several years of rapid home price growth and falling 

affordability. These markets, and the residential lenders 

targeting them, may be more at risk as local economic 

growth falters. 

Map 1 shows markets that have seen the most significant reductions in affordability (sharp price gains) 

during the past several years. Not surprisingly, many 

of them—namely larger cities in California and the 

Northeast—are those that historically have seen the 

biggest swings in prices and a penchant for speculative 

excess. 

In markets with rapidly declining affordability, credit 

risk arises from the increasing likelihood that new 

borrowers will commit a greater share of household 

financial resources to meet monthly payments. Credit 

problems could become more readily apparent given 

any subsequent disruptions to employment or income 

in these markets—especially among households with 

limited wealth or that require multiple job holders to 

meet mortgage payments. These risks may be amplified by the increased underwriting of HLTV and subprime mortgages during the past decade. 

Disruptions to aggregate household liquidity from lost 

employment or decreased income can result in rising 

mortgage delinquencies. With respect to foreclosures, 

however, some research has suggested that the decline 

in prices relative to the balance owed on the mortgage 

(rising loan-to-value ratio) is the most significant factor.22 Even in instances of prolonged job/income loss, 

owners with positive equity are likely able to sell their 

22 For instance, “Mortgage Default Risk and Real Estate Prices: The 

Use of Index-Based Futures and Options in Real Estate,” Case, 

Shiller, & Weiss, NBER Working Paper #5078, NBER, April 1995, 

finds this to be the case, while citing past work that identified the link 

between rising LTVs and foreclosure rates. 

CHART 8 

Rising Foreclosure Rates Followed Falling 

Home Prices in New England a Decade Ago 

Sources: OFHEO (prices), Mortgage Bankers Association (foreclosures) 

Annual Home Price Change (%) 

’79 ’84 ’89 ’94 ’99 

Inverse 

Price (R) 

Foreclosure (L) 

–20 

–10 

0 

10 

20 

30 

Foreclosure Started

(% of Existing Loans) 

0.00 

0.10 

0.20 

0.30 

0.40 

0.50 

homes profitably, thus avoiding foreclosure. Chart 8 

shows the strong relationship between declining home 

prices and increasing foreclosure rates in New England a decade ago (the chart plots the inverse price 

change in order to emphasize the relationship).23 

The data available through late 2001 were mixed with 

respect to home resale price trends at the MSA level. 

On the one hand, while existing home prices as measured by the OFHEO home price index showed no 

markets with year-over-year price declines in fourthquarter 2001, NAR’s median resale price metric did 

show about a dozen markets with year-over-year 

declines, none exceeding four percent. A deceleration 

in year-over-year home price growth was evident for 

many markets (and the nation) using either measure. It 

should be noted that the OFHEO data do not include 

sales of high-priced homes and are less influenced by 

changes in the mix of homes sold than are average and 

median prices;24 this issue is more meaningful in the 

nation’s most expensive markets, such as MSAs in the 

23 In states where dominant metro areas have seen large price declines 

in past years, such as Massachusetts, this relationship is more pronounced than in larger states or the nation as a whole. For example, 

the two-decade correlation between foreclosures started and price 

change is –78 percent in Massachusetts versus roughly –60 percent in 

both California and the nation. 

24 Data are obtained from aggregating repeat sales or refinancings of 

the same properties over time and using statistical methods to calculate an overall rate of home price appreciation for each market. Sampled properties are confined to those whose mortgages are 

“conventional” and do not exceed a conforming loan limit (set at 

$275,000 in 2001) required for securitization through Fannie Mae and 

Freddie Mac. For more information, see www.ofheo.gov/house/. 

Kansas City Regional Outlook 18 First Quarter 2002 
In Focus This Quarter
 

TABLE 1 

As Recession Evolved, Home Price Appreciation Waned through 2001 

...Further Deceleration in Growth (or Declines) May Be Possible in 2002 

ANNUAL PERCENT CHANGES 

MSAS RANKED 

BY DECELERATION 

IN HOME PRICE INDEX 

FROM 1Q01 TO 4Q01 

OFHEO HOME PRICE INDEX 

NONFARM 

EMPLOYMENT 

1998– 

2000 1Q01 2Q01 3Q01 4Q01 

1998– 

2000 2001 

UNITED STATES 6.3 9.6 9.1 8.8 6.9 2.4 0.3 

SAN JOSE CA PMSA 17.7 24.4 16.9 8.4 0.6 3.4 –0.4 

SANTA CRUZ-WATSONVILLE CA 

PMSA 16.8 25.7 17.3 11.9 5.9 N/A N/A 

SAN FRANCISCO CA PMSA 16.5 19.4 13.9 9.1 3.5 3.3 1.3 

SALINAS CA MSA 13.7 24.3 22.4 19.0 9.4 3.3 0.9 

SANTA ROSA CA PMSA 14.8 22.7 19.6 13.6 8.6 4.1 1.6 

OAKLAND CA PMSA 14.7 22.3 18.0 14.1 8.2 3.4 2.0 

AUSTIN-SAN MARCOS TX MSA 9.4 15.2 12.1 7.7 5.0 5.9 2.1 

MERCED CA MSA 6.4 24.6 21.8 17.3 15.7 N/A N/A 

JAMESTOWN NY MSA 4.9 9.9 0.8 7.4 1.6 N/A N/A 

STOCKTON-LODI CA MSA 9.0 22.8 25.2 20.6 14.9 3.7 3.0 

WHEELING WV-OH MSA 4.1 10.8 7.7 11.7 3.7 1.1 –0.5 

GOLDSBORO NC MSA 4.0 7.9 3.2 1.6 0.9 N/A N/A 

CUMBERLAND MD-WV MSA 2.7 8.6 8.4 8.1 1.8 N/A N/A 

LEWISTON-AUBURN ME NECMA 4.2 14.0 8.6 10.1 7.1 4.4 –0.4 

BANGOR ME NECMA 3.7 13.2 7.4 9.3 6.5 N/A N/A 

FARGO-MOORHEAD ND-MN MSA 4.0 11.1 6.5 5.4 4.6 2.1 –0.3 

BARNSTABLE-YARMOUTH MA 

NECMA 12.8 17.6 14.5 14.6 12.5 3.9 1.3 

PINE BLUFF AR MSA 2.2 6.6 9.7 5.0 0.3 0.8 –1.7 

DUBUQUE IA MSA 3.9 8.8 6.0 6.9 2.5 1.1 –0.6 

BOULDER-LONGMONT CO PMSA 10.9 14.6 11.7 11.7 8.3 5.1 3.2 

DENVER CO PMSA 11.1 13.7 11.8 10.9 7.9 3.8 2.3 

UTICA-ROME NY MSA 3.5 14.6 9.5 8.4 9.1 2.4 0.1 

VALLEJO-FAIRFIELD-NAPA CA PMSA 11.8 20.0 19.1 16.6 14.7 4.7 2.8 

BRYAN-COLLEGE STATION TX MSA 4.8 11.1 2.1 5.6 5.8 4.0 0.7 

SAN DIEGO CA MSA 11.8 15.6 13.8 12.9 10.4 4.3 2.7 

SAN LUIS OBISPO-ATASCADERO­ PASO ROBLES CA MSA 11.4 19.2 18.0 17.8 14.2 N/A N/A 

TUCSON AZ MSA 3.3 8.6 8.0 6.8 3.6 3.5 0.8 

JERSEY CITY NJ PMSA 8.0 11.1 17.6 13.7 6.2 2.1 2.7 

CLARKSVILLE-HOPKINSVILLE TNKY MSA 3.3 9.1 4.2 6.5 4.2 N/A N/A 

RAPID CITY SD MSA 6.2 8.9 9.3 7.7 4.1 3.1 0.1 

LA CROSSE WI-MN MSA 5.7 7.4 5.8 5.1 2.6 2.3 1.0 

ST. CLOUD MN MSA 6.9 10.4 8.5 9.4 5.7 3.8 1.4 

Sources: Office of Federal Housing Enterprise Oversight (OFHEO), Bureau of Labor Statistics 

Kansas City Regional Outlook 19 First Quarter 2002 
 

In Focus This Quarter
 

San Francisco Bay Area25 and parts of the Northeast, 

since prices for high-end homes (typically financed by 

jumbo mortgages) may be more volatile over the economic cycle. 

Table 1 lists markets whose 2001 deceleration in home 

price growth was in the top 10 percent of the more 

than 300 metro areas for which the OFHEO statistic is 

available. The table also provides (where available) 

each MSA’s recent employment trend as an indicator 

of overall economic conditions. These markets may yet 

see even more pronounced deceleration in home price 

growth or even declines in home prices this year (as 

may others not shown). This possibility will be determined for the most part by the performance of each market’s local economy. 

The metro areas in the table are 

ordered by the magnitude of their 

deceleration in home price growth 

over the initial quarters of this recession. As a result, the marked deceleration in year-over-year price 

growth in the recently overheated 

San Francisco Bay Area puts many of its MSAs near the 

top of the list. In the table, San Jose, San Francisco, 

Oakland, Denver, and San Diego also previously were 

identified as banking markets with elevated risk profiles.26 For some of the smaller MSAs in Table 1 with 

more volatile appreciation rates, such as Utica and 

Fargo, comparisons of recent price trends are more 

appropriate using the 1998–2000 average as a benchmark, as these markets experienced pronounced spikes in 

year-ago price growth during first-quarter 2001. 

It is hard to generalize about which markets will see the 

most pronounced home price weakness as the recession 

continues. However, certain markets have shown a tendency in the past to be driven to a greater degree by speculative, rather than fundamental, factors. These markets 

are more likely to see significant downward corrections 

in price when economic activity falls for a prolonged 

period or by a sufficient magnitude. One study from the 

mid-1990s found, in comparing 14 cities in the Northeast and West with 16 inland cities, that while both 

groups tended to respond similarly to local and national 

25 As considered here, this includes the following MSAs: San Jose,
 

Santa Cruz-Watsonville, San Francisco, Santa Rosa, Oakland, Salinas, and Vallejo-Fairfield-Napa.
 

26 See “In Focus This Quarter,” Regional Outlook, Fourth Quarter
 

2001.
 

economic forces (fundamental, or “equilibrium,” price 

drivers), prices in the former group tended to be influenced to a greater degree by speculative, or “disequilibrium,” variables, including recent trends in price 

appreciation.27 Cities along the nation’s coasts also have 

tended to see the most significant price swings over the 

past 20 years. 

History also provides some insights into the nature and 

extent of any price declines in markets where economic 

conditions deteriorate. A study of two significant examples, Boston and Los Angeles in the 1980s and early 

1990s, concluded that declines differed by property type 

(i.e., condos versus single-family) and price class (i.e., 

high-end versus entry-level).28 This dispersion in price 

declines arose from differing rates of appreciation (properties that experienced the greatest inflation during the 

boom saw the largest deflation) and from the nature of 

each city’s economic decline, which differed according to 

concentrations of job losses by industry and wage type, 

underlying demographic factors, and housing supply 

trends. 

Looking at recent developments, it seems that the greatest near-term risk of a significant downward adjustment 

in housing prices is in the San Francisco Bay area. In 

recent years, this area witnessed double-digit home price 

appreciation that exceeded growth in per capita income 

by a wide margin. A recent analysis from the University 

of California-Berkeley’s Haas School of Business forecast that prices in the Bay Area housing market will 

decline by 15 percent overall (and by 30 percent for luxury homes) by the time the local economy’s recession 

ends late this year.29 Meanwhile, the larger MSAs in 

Southern California have not seen as significant a disparity between home price appreciation and personal 

income growth during this cycle as during the 1980s. 

Also in contrast to the 1980s, New England (and the 

Northeast generally) has seen little speculative purchase 

or construction activity in recent years, which should 

help to mitigate any price weakness through the current 

recession in these markets.30 

27 Jesse M. Abraham and Patric H. Hendershott, “Bubbles in Metropolitan Housing Markets,” Working Paper #4774, NBER, June 1994. 

28 Karl E. Case and Robert J. Shiller, “A Decade of Boom and Bust in 

the Prices of Single-Family Homes: Boston and Los Angeles, 1983 to 

1993,” New England Economic Review, March/April 1994. 29 David Goll, “Bay Area Housing Market Will Remain Slow,” East 

Bay Business Times, January 23, 2002. 30 “Regional Perspectives,” Boston Region, Regional Outlook, First 

Quarter 2002. 

Kansas City Regional Outlook 20 First Quarter 2002 
In Focus This Quarter
 

Conclusion 

Home prices are holding up in most markets, and, generally, permanent residential mortgages have fared 

well in prior recessions. However, history might 

understate credit risks for insured institutions during 

this cycle because the mortgage lending business has 

changed since the last recession. Chief among these 

changes are robust mortgage market competition, 

which has contributed to narrower collateral margins; 

increased reliance on underwriting automation; and 

expanded involvement in the subprime credit market. 

In addition, residential C&D lenders in certain markets might be particularly vulnerable, since C&D credits typically undergo higher loss rates and some areas 

are experiencing continued construction despite a 

cyclical slowdown (as measured by employment 

trends). Permanent mortgage lenders in certain areas, 

such as the San Francisco Bay area, could also face 

higher loss rates and foreclosures going forward, as the 

current economic weakness places downward pressure 

on home prices and dampens the ability of households 

to meet mortgage payments. 

Scott Hughes, Regional Economist 

Judy Plock, Senior Financial Analyst 

Joan Schneider, Regional Economist 

Norm Williams, Regional Economist 

Kansas City Regional Outlook 21 First Quarter 2002 


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