Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION FIRST QUARTER 2000 

FDIC
 

Memphis
 

Region
 

Division of
 

Insurance
 

Gary L. Beasley,
 

Regional Manager
 

Harry W. John,
 

Regional Economist
 

Robert L. Burns,
 

Senior Financial
 

Analyst
 

F. Miguel Hasty,
 

Financial Analyst
 

In Focus This Quarter 

◆ Recent Trends Raise Concerns about the Future of Business Credit 

Quality—Commercial and industrial (C&I) lending is one of the largest and 

fastest-growing lending lines at insured institutions. Recent growth in C&I lending 

can be attributed to a strong U.S. economy, increased industrial merger activity, and 

a willingness of lenders to extend credit. While C&I credit quality remains relatively strong, signs of deterioration have recently begun appearing in C&I portfolios 

and in corporate bond defaults. These signs of weakness in commercial credit quality raise concerns because they are appearing during a period of economic strength. 

Business credit quality could deteriorate further in the event of an economic slowdown, higher interest rates, or a loosening of underwriting practices. See page 3. 

By Arlinda Sothoron, Alan Deaton 

◆ Local Industries in the Global Economy—The contribution of international trade to overall U.S. economic activity has been increasing for a number of 

years. Although the United States trades with many nations, most activity is concentrated in a few markets—Canada, Japan, and Mexico. Across a collection of 

industries, there is, however, considerable variation in both the level of exposure to 

export markets and the intensity of import competition.A number of industries are 

highly exposed to international markets, suggesting that economic conditions 

abroad are particularly important in any assessment of future revenue growth or 

profitability. See page 11. 

By Paul C. Bishop 

Regional Perspectives 

◆ Economic and Banking Conditions—Although the regional economy is 

healthy, employment growth is slowing because of tight labor markets, slowing 

export levels, and weaknesses in the manufacturing and agricultural sectors. Overall banking conditions remain favorable, although net interest margins have compressed. See page 19. 

◆ Changing Loan Portfolio Composition Increases Inherent Credit 

Risk—Recent loan growth has occurred in traditionally higher-risk commercial 

and commercial real estate loans. While traditional asset quality measures remain 

favorable, weaknesses in some borrowers and examination findings indicate that 

levels of credit risk could rise. See page 21. 

◆ Longer Asset Maturities May Be Increasing Market Sensitivity—The 

complexity of managing interest rate risk is increasing as asset maturities and 

repricing frequencies extend. Banks may be more vulnerable to economic losses 

resulting from higher interest rates if funding strategies or interest rate risk management practices do not adequately compensate for these changes. See page 24. 

By the Memphis Region Staff 

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)
 

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 Memphis Region’s Regional 

Outlook, please call Gary Beasley at (901) 821-5234 or send an e-mail to gbeasley@fdic.gov. 

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

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

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

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

the Federal Deposit Insurance Corporation. 

Chairman Donna Tanoue 

Director, Division of Insurance Arthur J. Murton 

Executive Editor George E. French 

Writer/Editor Kim E. Lowry 

Editors Lynn A. Nejezchleb 

Maureen E. Sweeney 

Richard A. Brown 

Steven E. Cunningham 

Ronald L. Spieker 

Publications Manager Teresa J. Franks 
In Focus This Quarter
 

Recent Trends Raise Concerns about the Future of
 

Business Credit Quality
 

•	 C&I loan portfolios have been growing rapidly 

during this economic expansion. 

•	 Indicators of weakening corporate credit quality 

have begun to appear, including higher C&I loan 

losses and rising corporate bond defaults. 

•	 The future of business credit quality will depend 

on the economy and on underwriting practices. 

Commercial and industrial (C&I) lending is one of the 

largest and fastest-growing segments of lending at 

insured institutions. As of the third quarter of 1999, 

C&I loans comprised 24 percent of total loans and 

leases held by FDIC-insured institutions, up from 21 

percent at the end of 1995. C&I loan portfolios have 

grown primarily because of strong loan demand driven 

by a long economic expansion during which the indebtedness on corporate balance sheets has expanded rapidly. Even as the economic expansion continues, C&I loan 

charge-offs have begun to trend upward, albeit from historically low levels. By some measures, banks and the 

financial markets appear to be assuming increased levels of risk that could lead to greater C&I loan losses 

when the economy eventually weakens. 

High rates of growth in commercial lending and weakening indicators of C&I credit quality raise concerns 

about the future of credit quality at insured institutions. 

This article examines the factors that have contributed 

to high C&I loan growth rates and discusses the drivers 

that will determine the direction of C&I credit quality in 

the future. While loan performance at insured institutions is relatively good at the present time, signs of deterioration and stress have begun to appear despite the 

continued strength of the domestic economy. The future 

of C&I credit quality will ultimately be determined by 

trends in underwriting and corporate debt levels, along 

with the performance of the U.S. economy. 

C&I Loan Growth Has Accelerated 

C&I loans held by FDIC-insured banks and thrifts grew 

by almost 9 percent during the 12 months ending in 

September 1999, down somewhat from a 13.4 percent 

rate of growth in 1998 (see Chart 1). By contrast, total 

CHART 1 

Commercial and Industrial (C&I) 

Loans Are Growing at a Faster Rate 

than Total Loans and Leases 

Loan Growth 

Rate (%) C&I Loans 

15 

10 

5 

0 

–5 

–10 

Note: 1999 data are annualized based on 3Q99 data. 

Source: FDIC Research Information System 

Total Loans 

and Leases 

’86 ’88 ’90 ’92 ’94 ’96 ’98 

loans and leases at insured institutions grew by only 7 

percent in the 12 months ending in September 1999. 

C&I loans accounted for approximately 29 percent of 

all net new loans booked during the 12 months ending 

in September 1999, while unfunded C&I loan commitments grew by approximately 17 percent to $1.6 trillion. 

Syndicated lending played a major role in C&I loan 

growth during the 1990s. As intense competition and a 

narrowing of financial institutions’ net interest margins 

have encouraged lenders to seek additional sources of 

revenue, larger institutions have become increasingly 

active as loan syndicators and as purchasers of syndicated credits. Syndicated loan volume reached its peak 

in 1997, when originations totaled some $1.1 trillion 

(see Chart 2, next page).1 After falling off in 1998, originations of syndicated loans rose by 17 percent in 1999 

to just over $1.0 trillion. Leveraged loans, in which the 

borrower’s debt-to-equity ratio is significantly higher 

than the industry average, served as a catalyst for syndicated lending growth in 1999, accounting for 32 percent of total syndicated loan originations. Leveraged 

lending is very attractive to lending institutions because 

of the generous fee income associated with leveraged 

originations. Leveraged loan originations grew to $320 

billion in 1999, partly because of the continued rapid 

pace of corporate mergers in 1999.2 

1 LPC Gold Sheets, Vol. XIV, No. 1. Loan Pricing Corporation.
 

January 10, 2000.
 

2 According to Houlihan Lokey’s Mergerstat, total M&A activity set
 

a new record of $1.4 trillion in merger deal value in 1999.
 

Memphis Regional Outlook 3	 First Quarter 2000 
In Focus This Quarter
 

Most of the C&I loan growth among insured institutions 

since 1997 has been concentrated in loans to domestic 

borrowers. C&I loans held in foreign offices declined 

following the Asian economic crisis and the Russian 

government bond default in 1997 and 1998, respectively, while domestic C&I lending was growing at doubledigit rates. During the 12 months ending in September 

1999, C&I loans held in domestic offices grew 12.2 

percent while C&I loans held in foreign offices 

declined by almost 6 percent. 

Is This Rapid Loan Growth a Cause 

for Concern? 

The effect of rapid loan growth on subsequent credit 

quality has been the subject of a number of articles. A 

recent study by the Federal Reserve Bank of Kansas 

City found that high rates of loan growth in the early 

1980s and early 1990s appeared to be positively correlated with future higher loss rates.3 The study also noted, 

however, that relatively high loan growth rates in the 

late 1980s did not result in sharply higher loss rates. 

Another study by the Federal Deposit Insurance Corporation found that banks that failed during the banking 

crisis of the 1980s were generally more likely to have 

grown their loan portfolios aggressively than banks that 

did not fail.4 But it remains to be seen whether the high 

C&I loan growth rates of today will necessarily contribute to higher losses for insured institutions in the 

future. The future course of industry loan losses 

depends on many factors, including the condition of the 

economy, the interest rate environment, and underwriting standards used in originating C&I credits. 

The Condition of the Economy 

Is an Important Driver of C&I Loan Growth 

Recent economic conditions have been particularly 

conducive to rapid growth in domestic C&I lending. 

Business investment has expanded at double-digit 

annual rates as firms have invested in new technologies 

to raise productivity and keep costs down. These productivity gains have been instrumental in allowing the 

3 William R. Keeton. “Does Faster Loan Growth Lead to Higher Loan
 

Losses?” Economic Review. Federal Reserve Bank of Kansas City.
 

Second quarter 1999. 


4 Federal Deposit Insurance Corporation, Division of Research and
 

Statistics. History of the Eighties: Lessons for the Future. Vol. 1, An
 

Examination of the Banking Crises of the 1980s and Early 1990s.
 

1997. http://www.fdic.gov/bank/historical/history/contents.html.
 

CHART 2 

Syndicated Loan Originations Rebounded 

in 1999 after Falling from Record Levels 

Source: Loan Pricing Corporation 

Syndicated Loan Originations

 ($ Billions) 

0 

200 

400 

600 

800 

1,000 

1,200 

’95 ’96 ’97 ’98 ’99 

economy to grow at a relatively rapid pace with low 

inflation. Strong growth in real wages has helped boost 

the consumer confidence index to an all-time high of 

144 in January 2000. Robust consumer demand for 

goods and services has kept business profits growing, 

further spurring business borrowing to finance inventories, new construction, and fixed assets such as computer networks. Amid all of these favorable trends, C&I 

loan charge-off rates have remained at record lows of 

less than 0.5 percent since 1994. Recently, however, 

despite a continuation of generally favorable conditions 

in the economy and the financial markets, signs of credit quality deterioration have begun to appear in C&I 

loan portfolios. 

Evidence from Financial Institutions Points 

to a Weakening in Business Credit Quality 

Despite strong business conditions and generally good 

asset quality, signs of deterioration in C&I credit quality have begun to appear in bank portfolios. While problem C&I loan levels remain low by historical standards, 

net C&I loan charge-offs during the 12 months ending 

in September 1999 were 63 percent higher than during 

the previous 12-month period. The net C&I loan chargeoff rate rose in the 12 months ending in September 1999 

to 0.5 percent, up from 0.3 percent one year earlier. 

Similarly, noncurrent C&I loans as of September 1999 

rose to $11.2 billion, or 1.2 percent of total C&I loans.5 

In dollar terms, this level of noncurrent loans is 30 percent higher than one year earlier. 

5 Noncurrent C&I loans include C&I loans past-due over 90 days and 

all C&I loans in nonaccrual status. 

Memphis Regional Outlook 4 First Quarter 2000 
In Focus This Quarter
 

Despite these increases in C&I charge-offs and noncurrent C&I loans, the current industry ratios for these measures remain well below the 1.9 percent and 4.5 percent 

ratios reported during the recession in 1991 for net C&I 

charge-offs and noncurrent C&I loans, respectively. 

Interagency Loan Review Reveals Increases 

in Problem Credits from Previously Low Levels 

The results of the 1999 Shared National Credit (SNC) 

review provide another indication of slipping credit 

quality at large commercial banks.6 According to the 

Federal Reserve Board of Governors, adversely classified syndicated loans rose to $37.4 billion in the 1999 

review, a level approximately 70 percent higher than that 

reported in 1998. This figure represents 2 percent of the 

$1.8 trillion in drawn and undrawn loan commitments 

reviewed in 1999. By contrast, adversely classified 

assets identified in the 1998 SNC review totaled only 

$22 billion, or 1.3 percent of loans reviewed in 1998.7 

While the level of adversely classified syndicated loans 

remains low, 14 percent of the loans adversely classified 

during the 1999 review were loans made to new borrowers since the 1998 SNC review. In reference to this 

finding, Office of the Comptroller of the Currency 

(OCC) First Senior Deputy Comptroller and Chief 

Counsel Julie Williams has noted that “Banks are booking new loans that are weak at their inception.”8 The 

high rate of adversely classified new loans could be 

attributable to the continued effects of loan originations 

made toward the end of a period of loosened underwriting standards in 1997 and early 1998. Alternatively, it 

could indicate a higher-risk credit mix in current C&I 

loan portfolios. 

Signs of corporate stress that may weaken credit quality at insured institutions are also reflected in recent 

Banc of America Securities analysis of publicly available bank loan amendments.9 This study shows a significant increase in the number of loan amendments 

6 The annual interagency process reviews commercial loans over 

$20 million that are shared by three or more participants. 

7 Federal Reserve Board Press Release. November 10, 1999. 

8 “OCC’s Williams Warns of Credit Risk in the Banking System; Calls 

for Bankers to Scrutinize Loan Portfolios More Closely.” OCC Press 

Release. October 5, 1999. 

9 “Leveraged Loans: The Plot Thickens.” Banc of America Securities 

Syndicated Finance Research. November 15, 1999. This loan amendment analysis was completed using only publicly available information 

from Loan Pricing Corporation and Banc of America Securities LLC. 

generated because of covenant relief requests, from 22 

percent of all loan amendments during the last six 

months of 1998 to 45 percent during the first ten 

months of 1999. 

Corporate Bond Defaults Soared in 1999 

Trends in corporate bond defaults also indicate increasing levels of stress in the corporate sector. During 1999, 

147 issuers defaulted on $44.6 billion in long-term debt. 

Default rates as a percentage of volumes outstanding (or 

dollar default rates) have trended upward each year 

since 1996, reaching 2.2 percent for all corporate issues 

at year-end 1999. Much of the increase can be attributed 

to a rising dollar default rate for speculative-grade 

issues, which peaked in November 1999 at 8.2 percent. 

Measured as a percentage of all issuers, the default rate 

for speculative-grade issues rose to a post-1991 high of 

6 percent in September 1999 (see Chart 3). According 

to Moody’s, year-end 1999 default rates improved marginally but are expected to remain high through mid2000.10 In addition, domestic speculative-grade issuers 

reported twice as many issuer downgrades as upgrades 

during the fourth quarter of 1999, although the dollar 

volume of upgrades exceeded the dollar volume of 

downgrades by 55 percent.11 

10 “Corporate Bond Default Rates Highest Since 1991.” Moody’s
 

Investors Service. October 13, 1999.
 

11 “Moody’s Default Rate Pendulum.” Moody’s October 1999 Commentary. Moody’s Investors Service. October 18, 1999.
 

CHART 3 

The Default Rate on Corporate Bonds Has
 

Been Driven by Defaults on Speculative Issues
 

Issuer-Weighted 

Default Rate (%) 

15 All Corporate Issues 

10 

5 

0 

Speculative Issues 

Dec ’89 Dec ’91 Dec ’93 Dec ’95 Dec ’97 Dec ’99 

Source: Moody’s Investors Service 

Memphis Regional Outlook 5 First Quarter 2000 
In Focus This Quarter
 

Why Are C&I Loan Losses Increasing 

Amid Strong Economic Growth? 

Several factors have contributed to the current signs of 

deterioration of C&I credit quality in an environment of 

favorable business conditions. These factors include 

global competition and deflationary pressures, an 

increase in corporate debt levels, loosened underwriting 

standards, and a greater appetite for risk. 

Global competition and deflationary pressures 

have squeezed revenues. An era of low inflation and 

intense global price competition has contributed to low 

or negative revenue growth in a number of domestic 

industry sectors, particularly commodities and manufacturing.12 The result has been an increase in loan 

losses and corporate bond defaults in these sectors. 

Moody’s noted that the industrial sector, weakened by 

low commodity prices, accounted for 64 percent of all 

defaults in 1999, with the oil and gas, steel, and shipping industries being especially hard-hit.13 For example, 

Standard & Poor’s (S&P) reports that third-quarter 

1999 earnings for the iron and steel sector declined 80 

percent from one year earlier after five consecutive 

quarters of negative year-over-year earnings growth. 

Initially, commodity price declines and the international economic turmoil in 1997 and 1998 resulted in 

slowed foreign C&I lending and increased net losses of 

C&I loans held in foreign offices. These losses accounted for the majority of net C&I loan losses in 1997 and 

1998. However, this adverse trend reversed itself in 

1999, when C&I loans held in domestic offices 

accounted for the majority of losses. 

Corporations are increasingly reliant on debt markets. Increasing levels of debt on corporate balance 

sheets have helped to foster C&I loan growth. The 

growth in corporate debt is partially a result of actions 

taken by firms to improve operating efficiency, including increasing merger and acquisition (M&A) activity 

and rising spending on fixed investments. Capital 

expenditures on fixed investments by businesses have 

increased at a steady rate since the 1990–91 recession, 

as evidenced by Chart 4. Cash flow has also been 

increasing, but at a slower rate, resulting in a growing 

“financing gap” that reached an annualized level of 

12 See also Richard A. Brown and Alan Deaton. “Falling Prices in
 

Commodities and Manufacturing Pose Continuing Risks to Credit
 

Quality.” Regional Outlook, third quarter 1999. http://www.fdic.gov/
 

bank/analytical/regional/ro19993q/na/t3q1999.pdf.
 

13 “Historical Default Rates of Corporate Bond Issuers, 1920–1999.”
 

Moody’s Investors Service, January 2000.
 

CHART 4 

The Financing Gap Has Widened

 for Nonfinancial Corporations 

$ Billions “Financing Gap” 

900 

700 

500 

300 

100 

Capital Expenditures Cash Flow 

’80 ’82 ’84 ’86 ’88 ’90 ’92 ’94 ’96 ’98 

Note: 1999 data are annualized based on 3Q99 data. 

Source: Federal Reserve Board (Haver Analytics) 

$142 billion in the third quarter of 1999. Where cash 

flow has not been available to finance investment, firms 

have turned primarily to debt financing as opposed to 

equity financing. Net new corporate equity issues by 

nonfarm nonfinancial corporations have been negative 

in each year since 1993, while net new corporate bond 

issuance has increased from $75 billion in 1993 to $219 

billion in 1998. 

Loosened underwriting standards in 1997 and early 

1998 are contributing to current losses. Signs of 

stress in C&I loan portfolios can be partially attributed 

to loosened underwriting standards in 1997 and early 

1998. During 1997 and early 1998, loan underwriting 

standards loosened, accompanied by reduced spreads 

and pricing. In May 1998, the Federal Reserve Board 

Senior Loan Officer Opinion Survey on Bank Lending Practices reported that domestic banks were “generally eager to make loans to businesses” and that 

during early 1998 “a large percentage cut their spreads 

on such loans.” Moody’s describes the second half of the 

1990s as a “mini credit cycle.” The cycle began in 1995, 

when the strong economy, accompanied by falling interest rates and low loan losses and default rates, encouraged investor demand for high-yield bonds and loans.14 

A record number of first-time speculative-grade deals 

were also brought to market during 1997 and early 

1998. The increase in the volume of issuance was itself 

enough to push the default rate lower, which in turn may 

have fueled investor demand for additional high-risk 

bonds. However, the Asian crisis during 1997 and the 

Russian debt default during the second half of 1998 

14 “Default Rate Pendulum.” October 18, 1999. 

Memphis Regional Outlook 6 First Quarter 2000 
In Focus This Quarter
 

caused new issuance of speculative-grade bonds to slow 

significantly while defaults rose sharply, to a rate of 6 

percent by issuer in September 1999. While speculativegrade bond issuance declined, banks stepped in to fill 

the void by raising originations of highly leveraged 

loans between second-quarter 1998 and fourth-quarter 

1999.15 

Financial markets have evidenced greater risk 

appetite. While the ratio of speculative-grade bond 

issues to total corporate bond issues has remained fairly stable at approximately 40 percent during the past 

decade, the composition of borrowings has shifted substantially. Moody’s reports a shift in the distribution of 

bond issue ratings within the speculative-grade category toward the lower end of the ratings scale (see Chart 

5).16 Evidence of this shift is demonstrated by the fact 

that bonds rated B3 or lower currently comprise approximately 35 percent of all speculative-grade issues, a 

record high and up from 24 percent in 1995.17 Furthermore, almost 50 percent of the issuers that defaulted 

during the year ending September 1999 were rated for 

three years or less.18 This change in the composition of 

ratings has contributed to the current increase in speculative-grade defaults and could affect the future volatility and liquidity of the market. The current high volume 

of corporate bond defaults reflects the looser standards 

in 1997 and 1998 for corporate debt issued by low-rated 

first-time issuers, who accounted for 40 percent of rated 

15 LPC Gold Sheets. January 10, 2000.
 16 Moody’s January 2000 Commentary. January 18, 2000.
 

17 “Refunding Risk for Speculative Grade Borrowers.” Moody’s Special Comment. Moody’s Investors Service. December 15, 1999.
 

18 “Default Rate Pendulum.” October 18, 1999.
 

CHART 5 

bond defaults in 1999.19 This relationship is analogous 

to the current increase in net C&I charge-offs partially 

attributable to weakened underwriting standards in 

1997 and early 1998. 

The Increase in Leveraged Lending Could 

Result in a Riskier Mix in C&I Loan Portfolios 

Leveraged lending comprises an important part of the 

syndicated lending market and generates considerable 

fee income for financial institutions. Leveraged loans 

have grown from 12 percent of total syndicated loan 

originations in 1995 to 32 percent in 1999 (see Chart 6, 

next page). Leveraged syndicated loan originations grew 

19 percent to $320 billion in 1999, as investors were 

seeking higher risk-adjusted returns and lenders were 

seeking higher fees. Paine Webber analysts estimate that 

leveraged lending accounts for over 80 percent of syndicated loan fees and profits earned by loan underwriters.20 

Highly leveraged lending increased to a new record of 

$190 billion in 1999.21 This growth in loan originations 

reflects the current high corporate demand for loans, and 

by definition these loans are being made to borrowers 

with higher-than-normal levels of financial leverage and 

risk. In return for their higher risk profile, leveraged borrowers must compensate financial institutions through 

higher pricing and higher fees. 

19 Moody’s January 2000 Commentary. January 18, 2000.
 

20 “The Biggest Secret of Wall Street.” Paine Webber Equity Research.
 

May 14, 1999.
 

21 Loan Pricing Corporation defines highly leveraged loans as those
 

for which pricing exceeds 250 basis points over LIBOR and generally involves sub-investment-grade credits.
 

The Composition of the Rated Bond Market Has Shifted

 toward the Lower Part of the Speculative-Grade Issues 

Distribution of Issuer Ratings 

as a Percentage of Total Issuers 

Note: Unrated issues of corporate debt fall below the speculative-grade “C” rating. 

Source: Moody's Investors Service 

Aaa Aa1 Aa2 Aa3 A1 A2 A3 Baa1 Baa2 Baa3 Ba1 Ba2 Ba3 B1 B2 B3 Caa1 Caa2 Caa3 Ca C 

Moody’s Bond Ratings 

January 1998 January 2000 

Investment-Grade Ratings Speculative-Grade Ratings 

0 

2 

4 

6 

8 

10 

12 

Memphis Regional Outlook 7 First Quarter 2000 
In Focus This Quarter
 

CHART 6 

$ Billions As a Percentage of 

Total Syndicated Loans 

Loans to Leveraged Companies Represent 

a Greater Portion of Syndicated Loans 

Originations of Syndicated Loans to Leveraged Companies 

Note: 1999 data are annualized based on 3Q99 data. 

Source: Loan Pricing Corporation 

’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 

400 

0 

100 

200 

300 

40 

0 

10 

20 

30 

Leveraged lending volumes have recently been partially 

driven by M&A lending, which comprised over 30 percent of the total syndicated loan market in 1999. M&A 

activity approached $1.4 trillion in total volume during 

1999, increasing the demand for capital and driving corporations to the loan market.22 Approximately 22 percent of leveraged loans originated in 1998 were to the 

media and telecommunications industries, which have 

experienced significant levels of M&A activity.23 Leveraged buyout activity contributed an additional 15 percent to leveraged lending volumes, surpassing 1998 

levels in quantity. 

Where Is Business Credit Quality Heading? 

The future direction of business credit quality will be 

influenced by several factors, including the condition of 

the economy, growth in the indebtedness of corporate 

borrowers, exposure to vulnerable industry sectors, the 

interest rate environment, the development of emerging 

markets, and underwriting standards. 

Economic growth will remain an important determinant of credit quality. Should economic growth slow 

and corporate profits decline, the demand for C&I loans 

is likely to fall, and problem asset levels are likely to 

rise. A recent S&P survey of global credit conditions 

noted that excessive credit, attributable to unsustainable 

corporate indebtedness and falling asset values, has 

weakened the financial systems of 20 nations. As for 

credit expansion in the United States, the survey noted 

22 Houlihan Lokey’s Mergerstat. www.mergerstat.com. 23 “The Biggest Secret of Wall Street.” May 14, 1999. 

that the ratio of private sector loans outstanding to gross 

domestic product rose from 101 percent in 1995 to 142 

percent in 1999. S&P also noted evidence that banks’ 

C&I loan portfolios may be relying too heavily on loan 

repayments based on projections that are realizable only 

if the current economic expansion continues. S&P estimates that 5 to 15 percent of bank loans could default 

should the United States experience a significant downturn in the stock market leading to a hard landing for the 

domestic economy.24 

Continued growth in corporate indebtedness could 

contribute to increased losses and defaults. The 

growth rate of corporate debt has surpassed the growth 

rate of the economy in each year since 1994. A widening financing gap and increasing debt levels could pose 

problems if there are adverse changes in the interest rate 

environment or if corporate revenue growth slows. Rising rates will increase the costs of servicing debt, while 

a slowdown in revenue growth would reduce the cash 

flow available to service outstanding debt. Under such a 

scenario, business bankruptcies and failures are likely 

to rise, causing increased loan losses and bond defaults. 

Lending to some industries involves high-risk exposures. Despite the strength of the U.S. economy, some 

domestic industries are continuing to experience stress. 

Exposures to weakened industry sectors, such as health 

care and oil and gas, could negatively affect C&I credit 

quality at insured institutions. One way to evaluate the 

relative riskiness of firms operating in a given industry 

is through KMV Corporation’s® Expected Default FrequencyTM (EDFTM) analysis. KMV Corporation® has 

developed a proprietary method of measuring the 

degree of credit risk inherent in corporate borrowers by 

calculating an EDFTM score to estimate the probability 

that a firm will default on its obligations within one 

year.25 Chart 7 diagrams syndicated loan exposures 

along with December 1999 EDFTM scores and the direction of change since December 1998. This chart illustrates one measure of the risk associated with the 10 

industry sectors having the highest expected default 

24 “Global Financial System Stress: The Weak, the Vulnerable, and 

Those Limping Toward Recovery.” Standard & Poor’s. December 17, 

1999. 

25 KMV’s® proprietary calculation for EDFTM is based on (1) the current market value of the firm, (2) the structure of the firm’s current 

obligations, and (3) the vulnerability of the firm to large changes in 

market value. Multiplying industry originations by median industry 

EDFTM scores provides an estimate of expected default volumes. This 

figure provides a more meaningful measure of aggregate lending risk 

exposure than pure origination volumes alone and can be used to rank 

industry exposures. 

Memphis Regional Outlook 8 First Quarter 2000 
 

In Focus This Quarter
 

volume based on the volume of 1999 syndicated loan 

originations. In 1999, loans originated to mortgage 

lenders (including subprime lenders), communications 

firms, oil and gas firms, health care firms, and retail 

trade organizations generated the five highest expected 

default volumes among 50 broad industry sector classifications. 

The interest rate environment and refunding risk 

affect the demand for and availability of credit. 

Declining interest yield spreads from 1996 to 1998 

benefited borrowers. As spreads declined, the rate of 

syndicated loan growth increased and refinancing 

activity was high. Increases in spreads since 1998, 

along with higher interest rates, have caused refinancing activity to slow significantly. However, rising rates 

have not significantly affected origination volumes, as 

new debt continues to come into the market. Rising 

interest rates and refunding risk particularly affect 

speculative-grade borrowers. Higher interest rates 

would raise businesses’ cost of borrowing, potentially 

decreasing the demand for business credit and impairing borrowers’ ability to repay their debts. Once a corporation’s debt service ability is compromised, access 

to new capital markets can become limited. A sharp 

rise in interest rates would particularly impair the ability of highly leveraged firms to repay floating-rate debt 

obligations. 

Refunding risk continues to be a concern for speculative-grade borrowers as they face potential problems 

refinancing the maturing portions of long-term debt. 

The current tightening of terms in the C&I market and 

increasing default rates heighten refunding risk to borrowers. Rising interest rates or limited access to secondary markets could also increase refunding risk. This 

situation could continue to be problematic, since a rising volume of speculative-grade borrowings, consisting 

largely of unsecured bank debt, matures in 2001 and 

2002. Specifically, $64 billion in speculative-grade debt 

matures in 2001 and 2002, and approximately 63 percent of the debt is unsecured.26 

Potential growth in new markets presents both 

opportunities and challenges. The Internet and European syndicated loan markets represent both future 

potential growth areas and possible sources of credit 

risk for C&I lenders. The Internet has introduced large 

new markets to the loan and bond markets and has 

26 “Refunding Risk for Speculative Grade Borrowers.” December 15, 

1999. 

CHART 7 

Lending to Some Industries May 

Involve Higher Risk Exposures 

Change in Expected Default FrequencyTM (EDFTM) 

for the 12 Months Ending in December 1999 

6 

8 

–2 0 2 4 6 8 10 12 14 16 18 20

 EDFTM as of December 1999 

1 

2 4 5

3 

6 

7 

9 

10 

4 

2 

0 

–2 

Industry Name and Origination Dollars in Billions:

 1. Communication Services - $234.6

 2. Motor Vehicles and Parts - $133.1

 3. Chemicals and Drugs - $96.1

 4. Retail Trade - $92.1

 5. Wholesale Trade - $46.5

 6. Health Care Services - $42.3

 7. Oil & Gas Extraction - $41.8

 8. Entertainment - $33.5

 9. Mortgage Lenders and Mortage-Backed Securities - $20.2 

10. Hotels & Lodging Services - $20.2 

Note: Data and bubble size represent total syndicated loan originations
 

for the year ending 1999.
 

Sources: Securities Data Corporation; KMV Credit Monitor®
 

increased market efficiency. The “Internet economy” 

grew 68 percent from the first quarter of 1998 to the 

first quarter of 1999, with annual revenue expected to 

exceed $500 billion in 1999.27 Internet technology has 

improved the efficiency of the syndicated loan markets, 

with recent changes including the development of public price reporting, credit ratings, and Internet sites for 

online trading.28 Increased levels of credit risk could 

result from the volatility of Internet stock prices and the 

competitive disadvantage faced by firms that do not 

have an Internet presence but must compete against 

firms that do. 

While the majority of syndicated loan financing currently occurs in the United States, analysts predict that 

syndicated lending activity in Europe will accelerate 

significantly because of increased cross-border competition generated by the introduction of the euro and new 

financing needs. In addition, the European high-yield 

bond market is still developing but produced $6.8 billion of volume in the third quarter of 1999, or 61 per27 “Internet Indicators.” The Center for Research in Electronic Commerce at the University of Texas Graduate School of Business. October 27, 1999. 

28 “Syndicated Loan Market Soars as Efficiency Increases.” The Wall 

Street Journal. December 6, 1999. 

Memphis Regional Outlook 9 First Quarter 2000 
In Focus This Quarter
 

cent of the total market.29 Domestic lenders have begun 

to compete for this market but face credit risks because 

the European markets also pose sovereign and foreign 

exchange risk. 

Underwriting Remains the Key to Assessing 

C&I Credit Quality 

The August 1999 OCC Survey of Credit Underwriting 

Practices reported some tightening of commercial loan 

underwriting standards. However, loan officers also 

reported increased embedded risks in commercial loan 

portfolios for the fifth consecutive year. Survey respondents attributed the increased risks to weakened underwriting standards in previous years. The November 

1999 Federal Reserve Board Senior Loan Officer 

Opinion Survey on Bank Lending Practices found that 

30 percent of domestic banks reported increasing risk 

premiums, credit line costs, and loan spreads during the 

preceding three months. Loan 

officers cited an uncertain or 

unfavorable economic outlook, 

an expected worsening of industry-specific problems, and a 

reduced tolerance for risk as reasons for tightening C&I lending 

standards. 

Despite signs of tightening underwriting standards, the 

mix of credits appears to be riskier than in recent times. 

The OCC issued an advisory to banks in May 1999 

warning of potential problems with leveraged lending. 

The OCC stated that highly leveraged corporations 

could be particularly vulnerable to economic weakness 

and may not be able to compete effectively in a rising 

29 LPC Gold Sheets, Vol. XII, No. 44. Loan Pricing Corporation. 

November 15, 1999. 

interest rate environment. The OCC also addressed 

reliance on enterprise value loans, which are often used 

to support leveraged lending. Enterprise values are calculations based on projections of the future income of a 

firm. If such estimates are overly optimistic, or if the 

company fails to meet the assumptions underlying these 

estimates, the lender may be subject to considerable 

credit risk. The last interagency SNC review also noted 

instances of inadequate documentation and support for 

enterprise loans.30 

Summary 

C&I lending is one of the largest and fastest growing 

lending lines at insured institutions. Recent growth in 

C&I lending can be attributed to a number of factors, 

including a favorable economy, merger and acquisition 

activity, and other sources of high loan demand, strong 

asset quality, aggressive pricing, and attractive fee 

income. While indicators of C&I loan performance 

remain generally strong, signs of deterioration in commercial credit quality have begun to surface. These 

signs are cause for some concern because they are surfacing during a period of remarkable economic 

strength. Increasing corporate indebtedness, signs of 

corporate stress, and adverse trends in corporate bond 

defaults suggest that an economic downturn could result 

in a much more challenging environment for business 

credit quality. 

By Arlinda Sothoron, Senior Financial Analyst 

Alan Deaton, Economic Analyst 

30 Remarks by OCC First Senior Deputy Comptroller and Chief Counsel Julie L. Williams before the Robert Morris Associates Conference 

on Lending and Credit Risk Management, October 5, 1999. 

Memphis Regional Outlook 10 First Quarter 2000 
In Focus This Quarter
 

Local Industries in the Global Economy
 

•	 The contribution of international trade to U.S. 

economic activity has risen rapidly during the 

past decade. The U.S. economy has been increasingly influenced by conditions abroad, such as the 

recent financial market turmoil in several emerging markets. 

•	 Canada, Japan, and Mexico are the largest U.S. 

trading partners, accounting for approximately 

40 percent of U.S. trade. Western Europe and Asia 

(excluding Japan) also account for a large share 

of U.S. trade. 

•	 The importance of trade at the industry level 

varies widely. The industries most dependent on 

trade, including machinery and transportation 

equipment, also account for a large share of U.S. 

trade. 

The value of goods and services traded on international 

markets has more than doubled during the past decade. 

More goods and services than ever are being shipped 

abroad and imported from all parts of the globe. Consequently, U.S. economic activity is increasingly influenced by the flow of goods, services, and capital across 

national borders. 

The increasing importance of international trade is 

reflected in different types and levels of exposure to 

international markets. First, total exports and imports 

compared with overall economic activity confirm the 

increasing contribution of trade to the economy as a 

whole. Second, the amount of U.S. trade with foreign 

markets, although widely varied, is concentrated in a 

small number of countries, namely Canada, Japan, and 

Mexico. Consequently, economic conditions in these 

countries are particularly important in assessing the 

influence of global economic conditions on U.S. trade. 

Third, the level of exposure to international trade across 

industry sectors varies considerably. Some industries are 

not influenced greatly by activity in international markets, while for other, more trade-dependent industries, 

conditions in the world economy are an important factor 

in determining the level of sales and profit. The exposure 

to international markets, either through reliance on trade 

with particular countries or via industries with a significant exposure to international markets, is an important 

consideration for lenders seeking to determine a firm’s 

future profitability and financial condition. 

International Trade Is of Growing Importance 

Over the past 30 years, international trade has grown 

more quickly than the economy as a whole. Exports, 

which include both merchandise and services, have 

risen from less than 5 percent of U.S. gross domestic 

product (GDP) in 1970 to approximately 12 percent 

today. The merchandise component accounts for about 

73 percent of exports and includes manufactured goods, 

agricultural products, and raw materials such as metals 

and oil. The services component of exports, accounting 

for about 28 percent of total exports, includes travel services, passenger fares, royalties, freight and port services, and a number of smaller sectors such as financial 

and educational services. 

Imports also account for a growing share of U.S. consumption of goods and services, exceeding 15 percent 

of U.S. GDP in 1999, up from 6 percent in 1970. Merchandise is the largest component of imports, accounting for 83 percent, while services account for 17 percent 

(see Table 1, next page). 

Although trade in services has grown quickly for many 

years, merchandise still accounts for the majority of all 

trade. The dominance of merchandise is attributable, in 

part, to the difficulty of trading many types of services. 

With few exceptions, services are generally produced 

and consumed within a local market because they cannot be transported easily and are subject to language 

and cultural barriers. Hospitals, dry cleaners, and movie 

theaters, for example, serve well-defined local markets 

and produce products that cannot be traded competitively on international markets. Although trade in services such as travel continues to grow, the remainder of 

this article focuses primarily on the dominant merchandise component. 

U.S. Trade Activity Has Reflected Recent 

Global Economic Turmoil 

Over time, conditions in the international economy have 

become an increasingly important influence on U.S. 

growth, since a rising share of all domestically produced goods and services is sold abroad. Similarly, an 

increasing volume of imported goods and services 

implies a higher level of competition for domestic producers that compete directly with imports. 

Memphis Regional Outlook 11	 First Quarter 2000 
In Focus This Quarter
 

TABLE 1 

Merchandise Is the Largest Component of Trade 

DOLLAR VALUE* PERCENT 1999 

(1998, $ MILLIONS) OF TOTAL GROWTH** 

Exports $ 933,910 100.0% 1.8% 

MERCHANDISE 682,138 73.0% 0.8% 

AGRICULTURE AND 

RELATED COMMODITIES 26,603 2.8% –1.8% 

MINERAL COMMODITIES 6,644 0.7% –17.4% 

MANUFACTURED GOODS 593,297 63.5% –0.1% 

OTHER MERCHANDISE 55,593 6.0% 39.5% 

SERVICES 263,662 28.2% 4.3% 

TRAVEL 71,250 7.6% 3.0% 

PASSENGER FARES 19,996 2.1% 2.7% 

ROYALTIES AND LICENSE FEES 36,807 3.9% 4.1% 

FREIGHT AND PORT SERVICES 25,520 2.7% 6.4% 

OTHER SERVICES 110,089 11.8% 5.0% 

ADJUSTMENTS*** (11,890) 

Imports $ 1,098,193 100.0% 10.3% 

MERCHANDISE 907,647 82.6% 10.4% 

AGRICULTURE AND 

RELATED COMMODITIES 22,859 2.1% –2.2% 

MINERAL COMMODITIES 38,619 3.5% 5.6% 

MANUFACTURED GOODS 803,384 73.2% 11.6% 

OTHER MERCHANDISE 42,786 3.9% –0.6% 

SERVICES 181,015 16.5% 9.6% 

TRAVEL 56,105 5.1% 7.2% 

PASSENGER FARES 19,797 1.8% 8.3% 

ROYALTIES AND LICENSE FEES 11,293 1.0% 11.0% 

FREIGHT AND PORT SERVICES 30,460 2.8% 11.4% 

OTHER SERVICES 63,360 5.8% 10.9% 

ADJUSTMENTS*** 9,531 

* Sum of components may not equal total due to rounding.
 

** First three quarters of 1999 versus first three quarters of 1998.
 

*** Because of different methods of estimating the merchandise and services components of trade, an adjustment
 

term is necessary. Consequently, percentages may not sum to 100.
 

Sources: Bureau of Economic Analysis; Bureau of Census
 

Memphis Regional Outlook 12 First Quarter 2000 
In Focus This Quarter
 

During the past two and a half years, for example, the 

international economy has been buffeted by a series of 

crises that resulted in steep exchange rate depreciations 

for a number of countries and a marked slowdown in 

economic growth in many emerging markets. Although 

the U.S. economy remained surprisingly strong during 

the worst of the emerging markets crises, the fallout 

was evident in the diverging performance of U.S. 

exports and imports over the period. 

From mid-1997 through mid-1999, U.S. exports were 

generally flat, reflecting the sluggish pace of growth in 

several important U.S. export markets. Export prices 

fell by 4 percent over the period in response to weak 

demand for U.S. exports. In particular, exporters of 

agricultural products, basic manufactured goods, and 

commodities faced rapidly deteriorating conditions in 

several important overseas markets. For example, the 

value of merchandise exports to the Pacific Rim fell by 

15 percent during the first six months of 1999 compared with the same period in 1997 because of the 

recent financial market turmoil in the region. 

U.S. imports continued to grow during the period, 

however, reflecting both strong demand for imported 

goods and falling prices. In fact, average import prices 

fell by 5 percent between 1997 and 1999. At the same 

time, competition from imports limited the pricing 

power of domestic producers that compete with goods 

produced abroad. Although producers that compete 

with cheaper imports experienced adverse effects on 

profitability, consumers and firms that purchased 

goods from abroad generally benefited from falling 

import prices.1 

The slowdown in U.S. export activity and the acceleration of import growth have resulted in an increasing 

trade imbalance (see Chart 1). The U.S. trade deficit, 

which reached a record $26.5 billion in November, has 

raised concerns among analysts about the vulnerability 

of the dollar. Faster growth abroad or a slowdown in 

U.S. growth could convince foreign investors to 

increase purchases of assets outside the United States, 

resulting in a sell-off of the dollar. Depending on the 

severity and speed of a sell-off, heightened financial 

market volatility and rising U.S. import prices could 

result. Although potentially many forces are at work in 

1 Weak import prices are a factor cited by analysts to explain the 

benign performance of U.S. inflation during the past few years. 

CHART 1 

U.S. Import Growth Has Accelerated 

while Exports Remain Flat 

$ Billions 

350 

300 

250 

200 

150 

100 

Imports 

Exports 

1992 1993 1994 1995 1996 1997 1998 1999 

Source: Bureau of Economic Analysis 

such a scenario, rising inflation or a falling dollar may 

ultimately result in higher interest rates and slower U.S. 

growth. The extent to which U.S. trade would be affected by such a scenario is difficult to assess, since 

changes in the prices of either imports or exports would 

result in both positive and negative effects on firms’ 

costs, revenue, and profitability.2 

Most U.S. Trade Is Concentrated 

in a Few Foreign Markets 

Because the United States trades with most nations, 

economic conditions abroad are one of the critical 

factors that determine the growth of U.S. trade. Foreign demand for U.S. goods and services depends on 

the strength of the markets to which exporters ship 

their goods. Consequently, economic weakness 

abroad often results in slower U.S. export growth. 

Economic conditions abroad also influence the level 

of import competition that U.S. firms experience. 

Foreign firms facing slack demand in their own 

domestic markets, much like manufacturers in Southeast Asia during the recent market turmoil, may 

2 During the early 1980s, the dollar rose by roughly 50 percent, as 

measured against a trade-weighted basket of currencies. The 

increase in the value of the dollar made U.S. exports much more 

costly on world markets and contributed to financial stress among 

export-dependent manufacturers and agriculture producers. Beginning in mid-1985 the dollar fell sharply, back to its pre-appreciation 

level. The resulting improvement in U.S. competitiveness contributed to robust growth in U.S. exports that lasted during the rest 

of the 1980s. 

Memphis Regional Outlook 13 First Quarter 2000 
In Focus This Quarter
 

reduce prices of their U.S.-bound goods to compete 

more effectively with U.S. producers.3 

Although the U.S. trades with many nations, a large 

share of U.S. trade is concentrated among a small number of countries. Canada, Mexico, and Japan account 

for more than 40 percent of merchandise exports and 

imports. Asia (excluding Japan) and Western Europe 

each account for just over 20 percent of U.S. exports 

and a broadly similar share of imports. Central and 

South America, despite proximity to the United States, 

account for less than 10 percent of exports and only 

5 percent of imports (see Chart 2). 

The United States has routinely run a trade deficit with 

its largest trading partners. The trade deficit with 

Canada was $22.8 billion through the first three quarters of 1999. The trade deficit with Mexico topped 

$18.8 billion during the same period. The trade 

deficits with Japan and China, by far the two largest at 

$53.4 billion and $49.4 billion, respectively, accounted for approximately 40 percent of the total U.S. merchandise trade deficit through the first three quarters 

of 1999. 

The Importance of Trade Varies 

among Industries 

The level of export activity or the intensity of import 

competition also varies across industries. Besides the 

overall dollar volume of exports, industries differ in the 

proportion of total production that is exported. 

Although some industries, such as leather products, 

account for a relatively small share of total U.S. 

exports, exports from this industry make up a large 

share of all U.S. leather goods production. In cases 

such as this, conditions in export markets are important 

for producers even if total export sales from a particular industry are small. 

Industries also differ in the share of total spending 

devoted to imports. Imports account for a relatively 

3 From the perspective of a foreign exporter, increased sales of goods 

abroad, even at reduced prices, may be a preferred strategy to offset 

lower sales within its own weaker domestic market. A foreign steel 

mill facing weak sales in its home market may choose to sell its output below cost on the world market if it can still cover its fixed costs 

of operation. There also may be an incentive to maintain or even 

expand market share and recoup current losses in the future when 

prices rebound. 

CHART 2 

Canada Is the Largest U.S. Trading Partner 

(1Q99 through 3Q99, ranked by exports) 

Eastern Europe 

Africa 

Central/South America 

Japan 

Mexico 

Asia (excluding Japan) 

Western Europe 

Canada 

Source: Bureau of Census 

–250 

$ Billions 

–150 –50 50 150 250 

Imports Exports 

small portion of all domestic spending on farm products such as grains and livestock, for example, while 

imports account for a relatively large share of all U.S. 

oil consumption. These differences expose U.S. industries to varying levels of competition from abroad. In 

industries characterized by high levels of import competition, import prices may largely shape the domestic 

pricing environment and, by extension, the revenue and 

profit growth of domestic firms. 

For the purposes of this article, industries can be 

assigned to one of three broad categories depending on 

their exposure to international markets either through 

exports or through the intensity of import competition. 

Firms in Less Exposed Industries are not directly influenced by conditions in the global markets. Export markets are not a particularly important source of revenue, 

and imports are a negligible share of all domestic consumption of goods produced by these industries. In 

contrast, some industries are highly exposed through 

their reliance on export markets, through competition 

from imports, or in some cases, through both. For firms 

in these Highly Exposed Industries, conditions in international markets are clearly one of the important factors influencing current and prospective financial 

performance. Industries not part of either group, or 

Moderately Exposed Industries, face some competition 

from abroad and may earn a relatively small amount of 

revenue from export markets. 

To gauge these differences more fully, a measure 

of exposure to international markets was calculated for 

a set of 26 industries (20 manufacturing industries, 

4 mining industries, and 2 agriculture sectors). Table 2 

Memphis Regional Outlook 14 First Quarter 2000 
In Focus This Quarter
 

TABLE 2 

Industry Exposure to International Trade 

IMPORT SHARE OF U.S. CONSUMPTION 

LOW MEDIUM HIGH 

EXPORT 

SHARE OF U.S. PRODUCTION 

LOW 

PRINTING AND PUBLISHING 

FOOD PRODUCTS 

LUMBER AND WOOD 

PRODUCTS 

PETROLEUM AND COAL 

PRODUCTS 

AGRICULTURAL SERVICES, 

FORESTRY, AND FISHING 

FURNITURE AND FIXTURES 

OIL AND GAS EXTRACTION 

MEDIUM 

COAL MINING 

TOBACCO PRODUCTS 

NONMETALLIC MINERALS, 

EXCEPT FUELS 

FABRICATED METAL 

PRODUCTS 

METAL MINING 

PAPER AND ALLIED 

PRODUCTS 

TEXTILE MILL PRODUCTS 

STONE, CLAY, AND 

GLASS PRODUCTS 

RUBBER AND PLASTIC 

PRODUCTS 

PRIMARY METAL INDUSTRIES 

MISCELLANEOUS MANUFACTURING INDUSTRIES 

APPAREL PRODUCTS 

HIGH 

FARM PRODUCTS CHEMICALS AND ALLIED 

PRODUCTS 

INSTRUMENTS AND 

RELATED PRODUCTS 

TRANSPORTATION 

EQUIPMENT 

INDUSTRIAL MACHINERY 

AND EQUIPMENT 

ELECTRONIC EQUIPMENT 

LEATHER AND LEATHER 

PRODUCTS 

Highly Exposed Industries 

Moderately Exposed Industries 

Less Exposed Industries 

summarizes the results of the assessment.4 Each row 

shows industries that have high, medium, or low 

reliance on export markets, defined as the share of U.S. 

production in a particular industry that is exported. 

Each industry was ranked by this measure, with the 7 

highest industries placed in the High category, the 7 

lowest in the Low category, and the remaining 12 in the 

4 Export share of production (rows in Table 2) was calculated as the 

ratio of inflation-adjusted exports at the industry level divided by 

inflation-adjusted production in that industry (Gross Output by Industry from the Bureau of Economic Analysis was used as a measure of 

industry production). The import share of consumption (columns in 

Table 2) was calculated as the share of inflation-adjusted industry 

imports divided by inflation-adjusted domestic production less 

exports plus imports. All calculations were based on 1997 data, the 

latest industry-level production data available. 

Medium category.5 Table 2 shows, for example, that a 

relatively low proportion of production in the printing 

and publishing, lumber and wood products, and oil and 

gas extraction industries is exported. In contrast, a relatively high percentage of production in the farm products sector, chemicals, and transportation equipment 

industries is exported. 

5 This allocation, while completely arbitrary, roughly corresponds to a 

distribution where 50 percent of the industries are assigned to the 

Medium category, with the remaining 50 percent evenly allocated 

between the High and Low categories. Breakpoints for the distribution of industries by export share of production were as follows: Low: 

less than 7 percent; High: greater than 13 percent. 

Memphis Regional Outlook 15 First Quarter 2000 
In Focus This Quarter
 

The industries in each column are categorized by the 

share of U.S. consumption expenditures in a particular 

industry that are satisfied by imports. Again, the Low 

and High categories each include 7 industries, and the 

Medium category includes the remaining 12 industries.6 

On the basis of this analysis, for example, a relatively 

low share of U.S. consumption of food, fabricated metals, and farm products is imported. In contrast, a large 

share of U.S. consumption of oil, apparel, and electronic equipment is imported.7 

As shown in the lower right cell of the table, four industries are highly exposed to both export markets and 

import competition. These industries—transportation 

equipment, industrial machinery, electronic equipment, 

and leather products—account for slightly less than half 

of total U.S. exports and a similar percentage of total 

U.S. imports. Not only are these industries more closely tied to international markets than most other industries examined, but they also account for a large share of 

U.S. international trade. 

Using the terminology introduced above, Highly 

Exposed Industries are defined as those assigned to 

either of the High categories; industries in this group 

either are very reliant on export markets or face high 

levels of import competition. Less Exposed Industries 

are defined as those that have little exposure to either 

export markets or import competition; they are shown 

in the upper left cell in the Low classification. The 

remaining industries are defined as Moderately 

Exposed Industries. 

Chart 3 illustrates the distribution of establishments in 

each of the three categories by Region.8 Among the 

6 Breakpoints for the distribution of industries by import share of 

consumption were as follows: Low: less than 9 percent; High: greater 

than 25 percent. 

7 Although not directly included in the analysis, most domestically 

produced services also have minimal reliance on export markets and 

face little import competition. Retail trade, construction, local transportation services, and government, for example, all operate in relatively sheltered markets and are dependent on the health of the local 

economy. Particular firms may engage in high levels of international activity in tradable services such as travel, but manufacturing, 

mining, and agriculture account for the majority of imports and 

exports. 

8 An establishment is defined as a single physical location at which 

business is conducted or services or industrial operations are performed. It is not necessarily identical with a company or enterprise, 

which may consist of one or more establishments. Data are from 

County Business Patterns (Bureau of Census, 1997). 

CHART 3 

Atlanta Boston Chicago Dallas Kansas Memphis New San 

City York Francisco 

Number of Establishments* Classified by 

International Trade Exposure by Region 

0 

10,000 

20,000 

30,000 

40,000 

50,000 

60,000 

FDIC Region 

Source: Bureau of Census, 1997 County Business Patterns Database 

*An establishment is a single physical location at which business is conducted. 

Highly Exposed Industries 

Moderately Exposed 

Industries 

Less Exposed Industries 

group of industries analyzed, most are in the Moderately Exposed Industries category. Of the FDIC Regions, 

Atlanta, Chicago, and San Francisco have the greatest 

number of establishments in this category. The Chicago 

and San Francisco Regions lead in the number of establishments in the Highly Exposed Industries group, followed by the New York and Dallas Regions.9 Less 

Exposed Industries account for a relatively small number of establishments. As suggested above, however, 

most service-sector, construction, and government 

enterprises, while not part of this analysis, could be 

classified as Less Exposed.10 

Although this analysis highlights the varying level of 

direct exposure to international markets, industries also 

may be exposed through a less direct secondary channel. 

Several industries, although not highly exposed themselves, are suppliers to Highly Exposed Industries. For 

example, the rubber and plastics industry produces 

goods that are used in the manufacture and assembly of 

transportation equipment, a Highly Exposed Industry. 

9 An alternative way of analyzing the establishment data is to calculate the percentage of all establishments across the 25 industries that 

are in Highly Exposed Industries. On the basis of this calculation, the 

Dallas Region ranks highest at 42 percent because of the large number of establishments engaged in oil and gas extraction. For the 

remaining Regions, the percentages vary between 25 percent and 35 

percent. Across all industries (including services and other sectors not 

part of this analysis), the percentage of Highly Exposed Industries in 

each Region ranges from 1.7 percent (Atlanta Region) to 3.4 percent 

(Boston Region) of total establishments. 

10 These data do not include a count of establishments in the farm 

products sector (Standard Industrial Code (SIC) 01 and SIC 02). 

Therefore, 25 industries are represented in the establishment data, and 

not 26 as in Table 2. 

Memphis Regional Outlook 16 First Quarter 2000 
In Focus This Quarter
 

Consequently, conditions in export markets for transportation equipment are of particular interest for manufacturers of certain types of rubber and plastic products. 

These supplier industries are also vulnerable to import 

competition through this secondary exposure to international markets. A transportation equipment manufacturer, in response to heightened competition in international 

markets for its products, may switch from a domestic 

supplier of rubber products to a cheaper foreign supplier 

if a favorable price differential emerges. Therefore, 

assessing the exposure of industries to either exports or 

imports requires consideration of any secondary linkages 

between suppliers and purchasers of industry products. 

Summary 

The contribution of international trade to overall U.S. 

economic activity has been increasing for a number of 

years. The growing significance of trade has been highlighted by the recent series of economic and financial 

crises across the globe. One result of recent global economic turmoil has been a slowdown in U.S. export 

growth resulting from both slumping international 

demand for U.S. goods and services and weak prices. 

Import growth has continued unabated, largely because 

of strong U.S. growth, leading to a rapidly widening 

trade deficit. The effects of import and export growth 

on particular industries vary because of differing levels 

of reliance on export markets and the extent of import 

competition. This analysis suggests that several industries are highly exposed to changing global economic 

conditions. Lenders should be aware that for firms in 

these industries, changes in global economic conditions, including demand for U.S. exports and prices of 

both imports and exports, largely determine pricing, 

revenue growth, and profitability. 

Paul C. Bishop 

Senior Financial Economist 

Memphis Regional Outlook 17 First Quarter 2000 
Regional Perspectives
 

Memphis Region’s Exports Decline 

Although the Memphis Region is less dependent on 

exports than the nation, the share of the Region’s gross 

state products represented by export activity rose during 

much of the 1990s. However, the value of regional 

exports started to fall after the third quarter of 1997, 

primarily because of economic and financial troubles in 

emerging markets coupled with a stronger U.S. dollar. 

The reduction in the value of exports has been more 

pronounced in certain sectors and states as indicated by 

the export growth figures in Table 1.1 

TABLE 1 

Memphis Regional Export Values 

Have Declined in Recent Years 

(Year-over-Year Percent Change) 

3Q97 3Q98 3Q99 

ARKANSAS 27.3 –28.1 –3.4 

KENTUCKY 20.0 6.5 9.7 

LOUISIANA –9.0 1.2 –15.7 

MISSISSIPPI 13.0 2.8 1.6 

TENNESSEE 15.7 –0.7 –2.5 

Region 12.4 –0.9 –1.0 

Source: Massachusetts Institute for Social and 

Economic Research 

The Region’s agricultural and manufacturing sectors 

have experienced the greatest volatility in export activity. Export values declined significantly for agricultural 

products, such as oil seeds, processed foods, poultry, 

lumber, and wood products. Moderate declines in 

exports also occurred in manufacturing sectors, including chemicals, electronics, industrial machinery, and 

primary metals, beginning in the third quarter of 1998 

and continuing through the third quarter of 1999. The 

declines in manufacturing exports were most pronounced in Louisiana; however, declines have also 

occurred in Arkansas and Mississippi. The influence 

that a state’s export performance exerts on the manufacturing and agricultural sectors varies. 

Arkansas and Louisiana showed the greatest volatility 

in export values during recent years. Arkansas, a major 

crops and poultry exporter, experienced a decline in 

export activity in 1998 primarily because of financial 

difficulties in Russia and to a lesser extent Asia. Russia 

was a major importer of the state’s poultry products during the 1990s. Worldwide low commodity prices for 

much of 1998 and 1999 hampered both states’ agricultural exports. The decline in export value results from 

currency appreciation (price) and reduced shipping vol1 Exporter location series allocates exports according to the physical 

location of exporters. 

umes. However, currency appreciation, which results in 

products becoming more expensive for foreign customers, has exerted the most pronounced effect. 

According to the U.S. Department of Agriculture, about 

80 percent of the drop in commodity export values 

nationally can be attributed to price fluctuation. 

Reduced tonnage accounted for only 20 percent of the 

decline. 

Louisiana’s worldwide exports declined 6 percent to 

$12.5 billion during the first nine months of 1999, 

compared with the same period in 1998. (Note, export 

figures attributed to Louisiana include products that 

are produced outside the state and shipped through 

the ports of Louisiana, particularly agricultural 

products produced in the Midwest.) Exports of 

processed foods and chemicals experienced declines 

during the first nine months of 1999. The processed 

foods sector experienced the largest decline at 29 percent. Processed foods have traditionally been a strong 

export sector, especially prepackaged mixes and 

spices, and seasonings. 

Kentucky’s ability to generate significant positive 

export growth during the past few years distinguishes it 

from other states in the Region. This performance can 

be attributed largely to strong demand for auto and 

related component parts. In addition, the state’s largest 

trade partner, Canada, has encountered less economic 

volatility than has been experienced by the state’s other 

trading partners. 

Increasing global competition is also resulting in job 

losses for the Region. Low-cost foreign labor and cheap 

foreign currencies, relative to the dollar, are motivating 

manufacturers to relocate production of some goods 

and related jobs out of the Region. For example, during 

1998 approximately 8,000 jobs in Tennessee’s apparel 

industry were lost, primarily as a result of production 

being moved to overseas locations. Job losses have been 

concentrated in rural areas and in low-skilled positions. 

The outlook for export growth among states in the 

Region is encouraging, as international economies 

recover. The Organization for Economic Cooperation 

and Development projects the world economy to grow 

at an annual 3.5 percent in 2000. Sectors in the Region 

with the greatest potential to benefit from export 

growth are the ones hurt most recently by weakened 

trade conditions, including agriculture, electronics, 

chemicals, and industrial machinery. One indication of 

an improving outlook for the Region’s export activity is 

the planned $1 billion Millennium Port in Plaquemines 

Parish, Louisiana, which will handle container trade 

activity between North America and Latin America. 

Port-related activity in the state currently generates 

approximately 51,000 jobs, and about $1 billion in 

earnings. 

Memphis Regional Outlook 18 First Quarter 2000 
-

Regional Perspectives
 

Regional Perspectives
 

•	 Although the Region’s economy is healthy, employment growth is slowing. Continued weakness in agriculture is affecting some lenders. Overall banking conditions, however, remain favorable. 

•	 Many insured institutions may be accepting greater inherent asset risk in exchange for improved yields. 

•	 Recent loan growth has occurred in traditionally higher-risk commercial and industrial (C&I) and commercial real estate loans. While asset quality remains favorable, weaknesses in some borrower sectors and 

examination findings point to the potential for increased levels of credit risk. 

•	 The complexity of managing interest rate risk is increasing as asset maturities and repricing frequencies 

extend. Both loan and investment portfolios appear more sensitive to market conditions. 

Region’s Economic and Banking Conditions 

Growth in the Memphis Region 

Lags the Nation 

The Memphis Region’s economy, as measured by payroll 

employment growth, underperformed the nation’s in third 

quarter 1999 (see Table 1). After peaking in the mid1990s, payroll employment growth consistently has 

lagged the nation; in fact, the gap between national and 

regional growth widened during the first nine months of 

1999 (see Chart 1). Among sectors, employment growth 

in services and retail trade remains encouraging for the 

Region, except in Mississippi, where previously vigorous 

growth in casino-related service employment is slowing. 

Job gains in the retail sector are attributable to continued 

strong consumer confidence as personal expenditures 

bolster economic activity. The overall slowing in the job 

creation rate results from tight labor markets, a second 

consecutive year of declining exports, and weaknesses in 

the manufacturing and agricultural sectors. 

The Region’s generally healthy economy is evidenced 

by an unemployment rate of 4.4 percent in the third 

quarter of 1999. While this rate is slightly higher than 

the 4.2 percent reported nationally, labor markets in 

many of the Region’s metropolitan statistical areas 

(MSAs) are extremely tight. Louisiana MSAs reported 

the highest unemployment rates, affected by layoffs in 

the oil and gas sector. Most other major MSAs reported 

unemployment rates between 3.0 and 3.5 percent. 

Nashville, Tennessee, and Lexington, Kentucky, 

reported extremely low unemployment rates at 2.5 and 

2.1 percent, respectively. Firms in these areas face considerable difficulty recruiting qualified workers. 

Weak conditions persist in the manufacturing sector. 

Manufacturing firms have been shedding jobs in recent 

CHART 1 

TABLE 1 

Employment Growth Slows 

(YEAR OVER-YEAR, % 

3Q98 3Q99 

ARKANSAS 1.66 1.48 

KENTUCKY 2.72 1.84 

LOUISIANA 2.71 0.65 

MISSISSIPPI 2.51 0.01 

TENNESSEE 2.41 1.12 

Region 2.45 1.06 

United States 2.73 1.85 

Source: Bureau of Labor Statistics Source: Bureau of Labor Statistics 

Regional Payroll Growth Trails the Nation’s 

Year-over-Year Growth (%) 

–2.0 

–1.0 

0.0 

1.0 

2.0 

3.0 

4.0 

5.0 

Region 

Nation 

’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 

Third Quarter 

Memphis Regional Outlook 19	 First Quarter 2000 
Regional Perspectives
 

years, especially in textile and apparel. These two industries have been shrinking nationwide because of international competition and lower overseas labor costs. 

Tennessee, with the largest employment base in textiles 

and apparel in the Region, reported that 70 manufacturing firms in the sector ceased operations in the past two 

years.1 

Weaknesses in exports also contributed to slowing economic growth. The dollar value of the Region’s exports 

declined by 1.0 percent in third quarter 1999 from one 

year ago, the second annual decline since robust 12.4 

percent growth was reported in third quarter 1997. 

Weakness in trade contributed to the Region’s slowing 

overall employment growth and led to layoffs and some 

plant closures, especially in low-skilled manufacturing 

plants. For more detail on the national and regional 

trade situation, see the “Local Industries in the Global 

Economy,” In Focus article in this issue. 

In the agricultural sector, weaker exports and falling 

commodity prices led to disappointing farm earnings 

for much of the 1999 season. Although net farm income 

in 1999 is expected to increase 8.8 percent from 1998, 

the change is largely attributable to increased government subsidies and emergency funding. During 1999, 

direct government payments to farmers are expected to 

represent nearly 48 percent of net farm income, up from 

27.7 percent in 1998 and 15.4 percent in 1997. While 

the additional government funding should enable most 

farmers to meet debt obligations, crop prices remain 

low with little improvement expected in 2000, barring 

any supply shocks. As a result, farmers will likely continue to struggle financially. 

Asset quality among agricultural lenders2 is being 

adversely affected by conditions in the sector. Regionally, the ratio of median agricultural past-due and nonac1 Middle Tennessee State University, Global Commerce: Tennessee
 

and the International Economy, 1999.
 2 Agricultural lenders are institutions reporting 25 percent or more of
 

total loans in agricultural loans.
 

crual loans to total loans increased to 1.04 percent in 

the third quarter of 1999 from 0.66 percent one year 

ago. Furthermore, the ratio of net loan losses to total 

loans jumped from 0.09 percent of average agricultural loans in the third quarter of 1998 to 0.16 percent one 

year later. Anecdotal evidence suggests that carryover 

debt is increasing. Forty-two percent of the FDICsupervised agricultural lenders in the nation showed a 

sharp or moderate increase in the level of carryover 

debt from August 1998 through September 1999, up 

from 29 percent for the previous six-month period.3 

Banking Conditions Remain Favorable, 

although Earnings Performance Declines 

Banks and thrifts reported generally favorable financial 

conditions in the third quarter of 1999. Median leverage 

capital ratios remained virtually unchanged from one 

year ago at 9.7 percent. Asset quality indicators generally improved except among agricultural lenders, as 

previously noted. The ratio of median total past-due 

loans to total loans was 2.17 percent, down 21 basis 

points from the previous year. 

In contrast, earnings performance declined during the 

same period. The median return on assets was 1.15 percent, down 9 basis points from the third quarter of 

1998. Lower earnings are attributed to the continuing 

slide in net interest margins (NIMs). The median NIM 

was 4.23 percent, a 14-basis-point drop from one year 

ago; increasing competition for loans and funding is 

the primary factor contributing to this decline. In an 

effort to bolster slumping margins, many insured financial institutions are changing asset compositions to 

improve earning asset yields. In the process, they may 

be accepting increased credit risk and greater market 

sensitivity. 

3 FDIC, Report on Underwriting Practices, for the period ended September 1999. 

Memphis Regional Outlook 20 First Quarter 2000 
Regional Perspectives
 

Inherent Credit Risk Rises
 

Since the early 1990s, banks’ asset composition has 

shifted from securities into loan portfolios. Average 

loan-to-asset ratios at established institutions rose from 

just over 50 percent at year-end 1992 to 62 percent as of 

September 30, 1999. Loans typically offer higher available yields than securities, but also usually represent 

higher credit risk. 

Recent growth has been concentrated in traditionally 

higher risk loan types, such as C&I and commercial real 

estate (CRE) loans (see Chart 2). Although C&I and 

CRE loans accounted for less than one-third of aggregate loans at established community banks in the 

Region4 on September 30, 1997, these two loan types 

comprised almost half of net loan growth during the 

subsequent two years. As a result, bank concentrations 

in these loan types are growing (see Table 2). 

Strong Commercial Loan Demand Has 

Facilitated the Shift in Portfolio Composition 

In the nation and the Region, businesses are turning 

more frequently to financial institutions for C&I lending. Businesses’ capital expenditures have increased 

sharply since the last recession. In the initial phases of 

the expansion, cash flow rose in close correlation with 

capital expenditures. More recently, increases in cash 

flow have not kept pace, creating a widening financing 

4 Established community banks are banks with less than $1 billion in 

total assets that have been in operation for three or more years. 

CHART 2 

gap for businesses (see “Recent Trends Raise Concerns 

about the Future of Business Credit Quality,” In Focus). 

This gap is being met, at least in part, by increased lending from insured financial institutions. 

Demand for CRE loans also is strong. In the Region’s 

metropolitan areas, CRE loan growth has been driven 

by active commercial development. Although commercial construction activity is slowing in response to 

growing supply-and-demand imbalances in some markets, many metropolitan banks and thrifts are adding 

aggressively to CRE loan totals. Outside metropolitan 

areas, CRE loans often represent financing of business 

TABLE 2 

Rapid C&I and CRE Loan Growth 

Increases Exposure 

AVERAGE 

PERCENT OF ANNUAL 

TOTAL LOANS GROWTH 

Loan Types Sep 97 Sep 98 Over Period 

COMMERCIAL 12.9 13.4 12.6 

CRE* 16.5 18.9 18.2 

CONSTRUCTION 5.0 5.8 19.3 

RESIDENTIAL 39.2 37.0 7.3 

CONSUMER 17.0 15.6 5.6 

AGRICULTURE 7.9 7.4 6.7 

OTHER 1.6 2.0 23.7 

C&I = commercial and industrial; CRE = commercial real 

estate 

* Excludes construction 

Source: Bank and Thrift Call Reports 

Loan Portfolio Composition Share of Net Loan Growth 

as of September 30, 1997 from September 30, 1997 to September 30, 1999 

Agricultural & Agricultural &
 

Other
 

C&I & CRE 

29.4% 

Residential & 

Consumer 

56.1% 

Other
 

9.5%
 8.8% 

Construction 

5.0% 

C&I = commercial and industrial 

CRE = commercial real estate 

Residential & 

Consumer 

36.1% 

C&I & CRE 

45.5% 

Construction 

Source: Bank and Thrift Call Reports 9.6% 

Memphis Regional Outlook 21 First Quarter 2000 
Regional Perspectives
 

firms’ capital expenditures with repayment expected 

from the continuing operations of the business rather 

than from income produced by the property securing the 

loan. The growth in loans secured by real estate, 

whether in metropolitan or rural areas, is likely being 

driven by many of the same factors driving C&I loan 

growth. 

Traditional Asset Quality Measures 

Remain Favorable 

Despite the rapid growth in C&I and CRE loans, and 

perhaps even partially because of this growth, past-due 

loan ratios and loan loss rates at most insured institutions remain low. Aggregate C&I past-due loans at community banks were reported at 2.73 percent of total C&I 

loans as of September 30, 1999, down from 3.09 percent the prior year. C&I loan loss rates rose slightly in 

1998, reaching 0.84 percent of average C&I loans. An 

aggregate C&I loan loss rate of 0.67 percent through the 

first nine months of 1999 was similar to the rate reported in the first nine months of 1998.5 Past-due ratios for 

CRE loans declined in recent years and CRE loan loss 

rates remain stable. 

Improvement in asset quality indicators also is evident for banks 

with high exposure to commercial 

lending.6 Only among the Region’s 

largest banks with concentrations 

in commercial lending (those with 

total assets of $1 billion or more) were past-due loan 

ratios higher in the third quarter of 1999 than in the previous year. Smaller commercial lenders reported a 

decline in both past-due loan ratios and loan loss rates 

through the first nine months of 1999. They also reported considerably faster loan growth than other community banks in the Region. C&I and CRE loans among 

smaller commercial lenders grew at an average of 19.2 

percent and 26.3 percent, respectively, over the 12 

months ended September 30, 1999. 

The rapid growth in C&I and CRE loans, particularly 

among active commercial lenders, may mask to some 

extent changes in past-due ratios and loss rates for these 

5 Calendar-year annual loss rates are typically higher than annualized 

loan loss for any partial-year period as many community banks and 

thrifts recognize a higher volume of loan losses at year-end. 

6 Commercial lenders are defined as institutions with C&I and CRE 

loans comprising 25 percent or more of total assets. 

loan types. As newly originated loans are unlikely to fail 

to perform initially, the large volume of new loans in 

portfolios would tend to lower reported past-due loan 

ratios and loss rates. As a result, these ratios likely 

understate credit quality concerns to some degree 

among institutions reporting rapid growth. 

Although reported credit quality measures at insured 

institutions remain strong, credit concerns with some 

borrower sectors are rising, as discussed in “Recent 

Trends Raise Concerns about the Future of Business 

Credit Quality,” In Focus. Overall, business conditions 

remain generally favorable; however, some industries 

face narrowing profit margins, declining cash flow, and 

rising leverage. These conditions contribute to a higher 

risk of companies defaulting on debt obligations. 

The declining financial condition of certain borrower 

sectors could result in increased levels of credit risk. A 

Federal Reserve Board survey of senior lending officers conducted in mid-19997 noted concern for commercial loan portfolios in the event of an economic 

downturn. One-third of the banks surveyed stated that 

C&I loan portfolios have become more sensitive to periods of economic weakness. This sensitivity was most 

often attributed to borrowers’ increased financial leverage, borrowers’ narrowing profit margins, and previous 

easing of credit standards. 

Regulatory Examinations Indicate Increased 

Concerns with Asset Quality 

One potential indicator of future credit concerns is the 

increasing number of regulatory examination rating 

downgrades. Examination ratings are assigned to every 

institution to quantify supervisory concern. In determining a rating, regulatory agencies consider each institution’s risk management practices, as well as 

performance and condition, during on-site examinations. Composite ratings range from 1, indicating the 

least supervisory concern, to 5, indicating the highest 

degree of supervisory concern. In 1998, the number of 

institutions receiving examination rating downgrades in 

the Region exceeded those receiving upgrades for the 

first time since 1990. This trend continued through the 

first nine months of 1999, with almost twice as many 

downgrades as upgrades. 

7 Federal Reserve Board, Senior Loan Officer Opinion Survey on 

Bank Lending Practices, August 1999. 

Memphis Regional Outlook 22 First Quarter 2000 
Regional Perspectives
 

The steep decline in the number of upgrades, however, 

is reasonable given the large number of financial institutions already rated as 1 and therefore not eligible to be 

upgraded. However, trends suggest rising supervisory 

concern even if institutions ineligible for either an 

upgrade or a downgrade are excluded from the analysis.8 After fluctuating within a relatively narrow range 

throughout the mid-1990s, rating downgrades as a percentage of institutions eligible for downgrades 

increased sharply in 1998 (see Chart 3). By September 

30, 1999, this ratio reached the highest level reported 

since 1991. Similarly, the ratio of rating upgrades to 

institutions eligible for upgrades has declined in recent 

years and is at its lowest level since 1990. 

The majority of recent downgrades represent a change 

from a 1 to a 2 composite rating. While both ratings represent lower levels of supervisory concern, the shift 

indicates that examiners are encountering new or rising 

risk in these institutions. Also, the number of institutions that represent heightened supervisory concern9 is 

rising, although remaining well below levels reported in 

the early 1990s. 

The composite rating reflects banks’ overall condition 

and encompasses several component factors; asset quality is but one of these factors. However, asset component downgrades have been typical among institutions 

with composite rating downgrades in recent years. 

8 Because a 1-rated institution cannot receive a higher rating, these
 

institutions are considered ineligible for an upgrade in this analysis.
 

Likewise, a 5-rated institution is considered ineligible for an examination rating downgrade.
 

9 Institutions representing heightened supervisory concern are those
 

with a composite rating of 3, 4, or 5.
 

CHART 3 

Since 1997, asset quality component rating downgrades 

occurred in slightly more than two-thirds of examinations involving a composite rating downgrade. Also, 

asset quality component rating downgrades occurred at 

a higher rate than composite rating downgrades, with 

one in five asset component ratings eligible for downgrade being downgraded in 1998. These trends suggest 

that although aggregate loan loss rates and past-due 

loan ratios remain relatively low, examiners are increasingly concerned with how institutions are managing 

credit risk, the strength of loan underwriting practices, 

and the potential for future credit problems. Anecdotal 

evidence suggests that these concerns result largely 

from banks’ efforts to maintain or increase loan volume 

in the current competitive environment. 

Allowance Levels Lag Rapid Loan Growth 

Insured institutions generally have not tempered growing C&I and CRE exposure with larger cushions for loan 

losses. Allowances for loan and lease losses have fallen 

in relation to both total loans and noncurrent loans in the 

Region, particularly among commercial lenders. The 

average allowance for loan and lease losses at commercial lenders with less than $1 billion in total assets 

declined to 1.29 percent of total loans, compared with 

1.38 percent among other community banks. 

The lower allowance level reported by commercial 

lenders appears somewhat inconsistent with the generally higher volatility in asset quality measures reported by these institutions since the mid-1980s (see Chart 

4). While commercial lenders have made provisions 

for loan losses adequate to absorb actual loan losses in 

CHART 4 

Examination Ratings Suggest Risks Are Rising Commercial Lenders Report Greater Volatility 

35 3-, 4-, & 5-Rated Upgrades/Institutions Banks/All Banks 

30 Eligible for Upgrade 

in Asset Quality than Other Banks 

8 Loan Past-Due Ratios 

25 

Commercial Lenders* 

6 

Percent 20 

Downgrades/Institutions 15 Eligible for Downgrade 

10 

Percent 

Other Banks 4 

2 Loan Loss Rates 

5 

0 

’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99* 

* Through September 30, 1999 

Source: FDIC Research Information System 

0 

’84 ’85 ’86 ’87 ’88 ’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 

* 25 percent or more of total assets in commercial and industrial or commercial 

real estate loans 

Source: Bank Call Reports 

Memphis Regional Outlook 23 First Quarter 2000 
Regional Perspectives
 

recent years, provisions have not been sufficient to mercial lenders may wish to revisit how well current 

grow allowance levels commensurate with loan port- allowance levels provide a cushion for future potential 

folio growth. With greater historical variability in credit losses. 

asset quality and recent rapid loan growth, some comMarket Sensitivity Rises
 

Rising risk from asset composition changes may not be 

confined to credit quality concerns, as many banks in 

the Region appear increasingly vulnerable to changes in 

interest rates.10 Banks historically have been funded 

with short-term liabilities supporting longer-term 

assets. As a result, bank liabilities reprice more quickly 

with changes in interest rates. Recently, a shift in asset 

composition toward longer maturities has increased this 

liability sensitivity at the Region’s banks. The volume of 

assets with maturities in excess of five years has grown 

steadily since 1995 and is at its highest level this 

decade. Without a corresponding extension of funding 

sources, the lengthening of asset repricing opportunities 

(see Chart 5) may expose banks to greater risk of economic loss as interest rates rise. At a minimum, the 

lengthening of asset repricing opportunities highlights 

the need for strong interest rate risk management practices. Banks have appeared willing to accept increased 

market sensitivity in exchange for additional yield and 

improved near-term earnings performance. 

10 This analysis is based on aggregate balance-sheet data for community banks. The market sensitivity of individual banks is largely determined by banks’ asset/liability management practices, which may 

mitigate rising asset or liability sensitivity. 

CHART 5 

Asset Maturities Are Extending 

at Community Banks 70 

60 

50 

40 

30 

20 

10 

0 

15.3 

20.5 

6.3 

48.5 51.9 

27.0 

18.6 

22.8 

7.7 

61.0 

52.7 

37.7 

September 30, 1997 

September 30, 1999

Percent of Assets with Maturity or

Repricing Date Exceeding Five Years*

All Residential Other Mortgage Mortgage- Other 

assets mortgages loans pass- derivative debt 

through securities securities 

securities 

* Mortgage derivatives with average life of three years or more are shown as 

having a maturity exceeding five years. 

Source: Bank Call Reports 

Efforts to improve earnings performance by accepting 

additional market sensitivity, however, may lead to a 

compression of NIMs following recent increases in 

interest rates. As assets and liabilities reprice to the new 

interest rate environment, funding costs are likely to rise 

faster than asset yields. Changes in interest rates in the 

second half of 1999 also have involved a widening of 

spreads between short- and long-term interest rates, 

although these spreads remain below ten-year averages. 

While the widening of the spread should benefit bank 

earnings, such gains likely will be more than offset by 

the adverse effects of rising interest rates on liabilitysensitive balance sheets. 

Residential Lenders’ Earnings Could Fall 

The earnings performance of residential lenders may be 

adversely affected by rising interest rates. Residential 

lending grew as a percentage of total loans among the 

Region’s financial institutions throughout the early and 

mid-1990s, but residential loan exposure declined 

slightly in more recent years as banks and thrifts shifted 

into C&I and CRE loans. Although the relative share of 

residential mortgages is declining, market sensitivity of 

mortgage loan portfolios may have increased as institutions shifted to longer maturities or repricing opportunities on such loans. As shown in Chart 5, residential 

loans maturing or repricing in over five years increased 

slightly to 22.8 percent of total residential loans from 

September 1997 to September 1999. 

Changes in residential loan portfolios are more pronounced than indicated by the increase in longermaturity loan volume. Among loans maturing in less 

than five years, a shift has occurred from loans maturing and repricing within three years to those maturing in 

three to five years (see Chart 6). While this extension of 

maturities into intermediate-term time periods does not 

heighten asset sensitivity to the degree of risk presented 

by longer-term maturities, it may increase earnings 

volatility. 

Memphis Regional Outlook 24 First Quarter 2000 
Regional Perspectives
 

CHART 6	 from this source should decline. Institutions with significant residential lending may reduce pricing or weak- Residential Loan Portfolio Maturities Extend en underwriting standards to maintain mortgage Over 4.8 5.4	 origination volumes. Alternatively, some institutions 15 Years 

42.4 

21.0 

16.2 

15.7 17.4 5 to
 may emphasize or enter business lines with increased 15 Years
 

Percent of Residential Loans

credit risk or with which they have limited experience. 

19.4 

20.2	 

Not all changes in mortgage activity will increase mar­ 1 to 

3 to
 

5 Years
 

3 Years ket sensitivity among residential lenders. Institutions 

may be able to reduce risk through the use of adjustablerate mortgages (ARMs). In recent years, customers 

have preferred fixed-rate loans to ARMs because of the 

flatness of the yield curve and historically low interest 

Less Than 37.6

1 Year 

September 1997 September 1999
 

Source: Bank Call Reports
 

Although interest rates remain relatively low, recent 

increases are dampening mortgage activity. Mortgage 

interest rates are near their highest levels in two years, 

with the monthly average commitment rate for a 30­

year fixed-rate mortgage up over 100 basis points from 

levels reported one year ago. The increase in mortgage 

rates is translating into a slowdown in originations. The 

Mortgage Bankers Association estimates that mortgage 

originations nationally will fall 14.8 percent in 1999 

and drop another 23.8 percent in 2000. While slowing 

housing starts are a factor, the primary cause for lower 

expected originations is reduced refinancing activity, 

projected to decline 75 percent in 2000. 

Some of the Region’s residential lenders may see a 

greater decline in mortgage activity, as housing starts in 

certain areas are expected to fall more dramatically than 

at the national level. Although some MSAs experienced 

moderate growth in housing permits in 1999, permits in 

most major MSAs, with the exception of Lexington, are 

projected by Regional Financial Associates to drop 

substantially in 2000. Housing permits in Jackson, 

Louisville, Memphis, Nashville, and New Orleans are 

projected to fall a minimum of 20 percent in 2000; permits for Biloxi and Little Rock are projected to decline 

rate levels. With the increase in rates and some widening of spreads between short- and long-term rates, customers may migrate toward adjustable-rate products. 

The Mortgage Bankers Association projects ARM volume to rise from 12 percent of total originations in 1998 

to 31 percent in 2000. Institutions may find any repositioning of mortgage portfolios a slow process, however, 

because of the sharp decline in total originations. 

Market Sensitivity in Investment 

Portfolios Has Increased 

Many insured institution investment portfolios exhibit 

considerable maturity extension. As shown in Chart 5, 

maturities and repricing opportunities on securities 

lengthened considerably among community banks during the previous two years. Investment portfolio maturities likely were extended in an effort to stem falling 

yields on investment securities (see Chart 7) and 

improve earnings performance. While short-term profitability may have benefited from the extension, bank 

CHART 7 

As Investment Portfolio Yields Fell in 1997, 

Many Banks Extended Investment Maturities 

8 Long-Term Securities/Total Securities 

7 40 

Securities Portfolio Yield 

nearly 40 percent in 2000. 

Residential lenders’ earnings could also be hurt by 

lower mortgage activity. Institutions of all asset sizes 

have become increasingly reliant on mortgage origination fee income, from both loans retained by the institution and those sold into the secondary market. With 

Securities Portfolio Yield

Long-Term Securities 

6 

5 

4 

fewer residential mortgage originations, fee income11 

3 

Sep Dec Mar Jun Sep Dec Mar Jun Sep 11 Mortgage origination fee income is reported as additional loan yield ’97 ’97 ’98 ’98 ’98 ’98 ’99 ’99 ’99 

for loans held in institution portfolios and is reported as noninterest Source: Bank and Thrift Call Reports 

income for loans sold into the secondary market. 

Memphis Regional Outlook 25	 First Quarter 2000 

45 

35 

30 

25 

20 
Regional Perspectives
 

earnings may be more sensitive to changes in interest 

rates in the longer term. 

With increases in interest rates, the market value of 

bank investment portfolios has declined sharply.12 As of 

September 30, 1998, community banks in the Region 

reported net appreciation equivalent to 3.7 percent of 

total equity capital. One year later, community banks 

reported net depreciation equivalent to 3.9 percent of 

total equity. This reversal was widespread among financial institutions, with 92 percent of community banks 

reporting depreciation or unrealized loss in their investment portfolios as of September 1999 compared with 

only 4 percent one year ago. 

The number of banks reporting high levels of unrealized 

losses and depreciation is up sharply from previous 

years. Among the Region’s almost 900 community 

banks, 80 reported unrealized losses or depreciation 

equivalent to 10 percent or more of total equity capital 

on September 30, 1999. One year earlier, only one bank 

reported this high level. 

Aggressive lengthening in reinvestment horizons and 

heavy weighting in mortgage-related debt instruments 

were common among institutions reporting high depreciation levels. The effects of rising interest rates can be 

particularly pronounced for mortgage-backed and mortgage-derivative securities. Higher interest rates usually 

translate into slower prepayments on fixed-rate mortgage loans. As prepayments on the mortgage loans that 

comprise the source of cash flow for mortgage-related 

securities slow, these securities often experience a 

lengthening of their effective maturities. As a result, 

investors must wait longer to reinvest these funds at the 

new higher interest rates available on alternative investments, raising interest rate risk. 

Efforts to Alter Funding Strategies 

Have Met with Limited Success 

Sensitivity to market risk is not merely a function of 

asset selection, but also encompasses funding strategies 

and risk management. Increasing competition for 

deposits has somewhat limited the ability of banks to 

adjust funding strategies. With weak core deposit 

growth, many institutions now rely more heavily on 

alternative funding sources such as brokered deposits 

and Federal Home Loan Bank advances. In many cases, 

these alternative funds can be used to offset greater 

market sensitivity in assets. For example, community 

banks appear to have used an increasing volume of 

other longer-term borrowing sources, primarily Federal 

Home Loan Bank borrowings, to match longer-term 

assets, such as residential loans (see Chart 8). For additional details on changing funding strategies in the 

Region, see the Memphis Regional Outlook, Third 

Quarter 1999. 

Although growing, the use of other borrowing sources 

remains limited as certificates of deposit (CDs) continue to be the primary source of funding for community 

banks. In this category, depositor preferences play a significant role in determining maturity and repricing frequency. In recent years, depositors have appeared 

unwilling to place their funds in longer maturities and 

the level of short-term CDs has increased. As a result, 

community bank funding remains short term. 

CHART 8 

Although Long-Term Borrowings Rise, ShortTerm CDs Remain Primary Funding Source 

80 

Borrowings 

Percent Maturing in

over One Year 

70 

60 

50 

40 

30 

20 

10 

0 

Sept 

’97 Sept 

’99 

20.5 18.2 

68.2 

59.4 

CDs 

CD = certificate of deposit represents the present-value recognition of future expected earnings Source: Bank Call Reports 

losses resulting from the debt instrument being below market yield. 

12 The decline in market value includes both depreciation in securities 

designated as held to maturity and unrealized losses on securities designated as held for sale. In either case, the decline in market value 

CDs as Percentage of Borrowings as 

Total Liabilities Percentage of Total 

Sept ’97 51.1 2.5 

Sept ’99 50.0 3.9 

Memphis Regional Outlook 26 First Quarter 2000 
Regional Perspectives
 

The Importance of Risk Management Rises
 

Recent changes in asset composition affecting credit 

risk and market sensitivity are prompting institution 

management to review their institutions’ balance sheet 

positions in line with their own risk preferences. With 

the current favorable economic and banking environment, now may be an opportune time to perform some 

level of strategic risk assessment. As a part of this 

strategic review, managers may wish to consider the 

strength of internal risk management systems and the 

adequacy of earnings, allowances for loan losses, and 

capital positions as a cushion against potential risk. 

Going forward, managers will need to continue to balance the desire for current period earnings against the 

need for strong financial condition and performance in 

the future. 

Memphis Region Staff 

Memphis Regional Outlook 27 First Quarter 2000 
✁
 

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Street Address __________________________________________________________________________ 

City, State, Zip Code __________________________________________________________________________ 

Please fax or mail this order form to:	 FDIC Public Information Center 

801 17th Street, N.W., Room 100 

Washington, D.C. 20434 

Fax Number (202) 416-2076 

Please indicate below each Region’s issue you wish to receive: 

Atlanta _________ Dallas _________ New York _________ National _________ 

Boston _________ Kansas City _________ San Francisco _________ All _________ 

Chicago _________ Memphis _________ 

Federal Deposit Insurance Corporation 

Washington, DC 20429-9990 

OFFICIAL BUSINESS 

PENALTY FOR PRIVATE USE, $300 

BULK RATE
 

MAIL
 

Postage &
 

Fees Paid
 

FDIC
 

Permit No. G-36