Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION FIRST QUARTER 2002 

FDIC
 

New York
 

Region
 

Division of
 

Insurance
 

Kathy R. Kalser,
 

Regional Manager
 

Robert M. DiChiara,
 

Senior Financial
 

Analyst
 

Norman Gertner,
 

Regional Economist
 

Alexander J.G.
 

Gilchrist,
 

Economic Analyst
 

Regional Perspectives 

◆ The Region’s economy has weakened in the aftermath of September 11—Prior 

to the terrorist attacks, the Region’s economy, although slowing primarily because of 

deterioration in the manufacturing sector, was stronger than the nation’s. However, the 

aftermath of September 11, 2001, contributed to weakening in the financial services, 

airline, and tourism industries. Commercial real estate markets also have exhibited 

some deterioration, particularly in areas most affected by the attacks. See page 3. 

◆ Banks are better positioned now than during the last recession, but challenges 

remain—Capital and reserves to total assets have increased since the early 1990s, and 

credit quality measures are more favorable than a decade ago. Nevertheless, the 

Region’s banks reported weakening credit quality in third-quarter 2001. Also, after 

declining to ten-year lows, net interest margins benefited from a steeper yield curve in 

2001; however, margins may not improve as much as in past cycles, and record mortgage 

refinancing activity could challenge interest rate risk management. See page 6. 

By the New York Region Staff 

In Focus This Quarter 

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

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

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

was underwritten during 2001. Nonconstruction residential mortgages traditionally 

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

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

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

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

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

recession-tested. 

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

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

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

that experienced ongoing residential construction during 2001, despite slowing local 

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

See page 11. 

By Scott Hughes, Regional Economist 

Judy Plock, Senior Financial Analyst 

Joan Schneider, Regional Economist 

Norm Williams, Regional Economist 

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

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

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

geographic regions: 

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

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

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

Dallas Region (CO, NM, OK, TX)
 

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

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

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

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

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

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

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

trends and developments at the regional level. 

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

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

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

For more information or to provide comments or suggestions about the New York Region’s 

Regional Outlook, please call Kathy Kalser at (917) 320-2650 or send an e-mail to kkalser@fdic.gov. 

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

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

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

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

the Federal Deposit Insurance Corporation. 

Chairman Donald E. Powell 

Director, Division of Insurance Arthur J. Murton 

Executive Editor George E. French 

Writer/Editor Kim E. Lowry 

Editors Lynn A. Nejezchleb 

Maureen E. Sweeney 

Richard A. Brown 

Ronald L. Spieker 

Publications Manager Teresa J. Franks 
Regional Perspectives
 

Regional Perspectives
 

• The aftermath of the September 11 attacks contributed to weakening in key sectors of the regional economy, including financial and business services and tourism. 

•	 During the current recession, the Region’s rate of job loss may exceed the nation’s but may not reach levels 

experienced during the 1990–1991 recession. 

•	 The Region’s insured institutions appear better positioned to weather a recession than they were a decade 

ago; however, credit quality weakness has become more widespread among the Region’s banks and across 

lending lines. 

•	 The Region’s banks benefited from a steeper yield curve in 2001; however, changes in the level and shape of 

the yield curve likely will affect banks’ asset/liability maturity structures and interest rate risk management 

strategies. 

The events of September 11, 2001, significantly altered 

the Region’s economic outlook. Prior to the terrorist 

attacks, the Region’s economy, although slowing primarily because of weakness in the manufacturing sector, 

was stronger than the nation’s. However, the aftermath 

of September 11 contributed to weakening in key sectors of the Region’s economy, including the financial 

services, airline, and tourism industries. Furthermore, 

the weakness in the national economy following the 

attacks undoubtedly contributed to additional job losses 

in the Region’s manufacturing sector. 

September 11 Weakens New York City 

and Surrounding Economies 

The September 11 attacks caused unprecedented psychological and physical damage to New York City. The 

effects of the national recession and the fallout in the 

financial services sector, the foundation of Manhattan’s 

economy, have stunted the near-term prospects for economic growth in the New York City metropolitan area. 

New York City now faces the possibility of a more prolonged economic downturn than the nation, as it begins 

the long process of repairing its infrastructure, including 

transportation and communications systems, and replacing destroyed office space. In fact, according to a recent 

study, the New York City area ranked first in the nation 

in the number of jobs potentially lost in the aftermath of 

September 11 and third in percentage of jobs lost.1 Furthermore, while the median Blue Chip forecasts estimate that the nation’s economy will expand by a modest 

1 Milken Institute, Metropolitan Economies in the Wake of 9/11, January 11, 2002. 

1.5 percent in 2002, the New York City Comptroller’s 

Office forecasts that the city’s economy will contract by 

3.1 percent this year.2 Longer-term ramifications of September 11 include increased security costs to be borne 

by the local government and the possibility that some 

businesses and residents will relocate permanently outside of New York City, weakening the city’s economic 

base. 

The less favorable economic outlook for New York City 

compared with the nation reflects weakened financial, 

business services, and tourism sectors, which together 

represent a substantial portion of the city’s economy. New 

York City’s financial services sector has been affected 

adversely by declining levels of employment and personal income. The city’s share of employment in the securities industry is approximately ten times that of the nation. 

Following September 11, many financial services firms 

announced significant layoffs and moved some operations out of the city. Many of the layoffs included higherpaying Wall Street jobs. In addition to increased layoffs, 

financial services firms, which had experienced lower 

earnings prior to September 11 because of sluggish trading and lower underwriting revenues, announced sharply 

reduced bonuses. The New York State Comptroller’s 

Office estimated that financial services sector bonuses, 

which can account for a significant portion of personal 

income, declined 35 percent from 2000 to 2001.3 In 

2 New York City Forecast: New York City Comptroller’s Office, The 

Comptroller’s Comments on the December Financial Plan for Fiscal 

Years 2002 to 2005, December 2001. National Forecast: Blue Chip 

Economic Indicators, February 10, 2002. 3 New York State Comptroller’s Office, Review of the Four-Year 

Financial Plan for Fiscal Years 2002 Through 2005, December 2001. 

New York Regional Outlook 3	 First Quarter 2002 
Regional Perspectives
 

addition, Manhattan’s business services sector, which 

includes advertising and personnel supply firms that are 

sensitive to declines in business activity, is vulnerable to 

significant declines in revenues and increased layoffs. 

Public apprehension about airline safety has depressed 

tourism in New York City significantly. The city’s hotels 

reported lower occupancy rates and revenues following 

the attacks, which compounded declines related to softening economic conditions in the first half of 2001. 

After declining by as much as 50 percent immediately 

after September 11, revenue per available room for New 

York City hotels was down an average of 22 percent in 

December 2001 compared with a year ago,4 an indication of the continuing weakening of the city’s economy 

during the winter season. 

The Region’s vulnerability to economic weakness following September 11 has not been limited to New York 

City. Other parts of the Region rely to varying degrees 

on industries affected by the attacks (see Map 1). A high 

concentration5 of securities jobs increases the vulnerability of the northern New Jersey economy because of 

the significantly reduced compensation in the securities 

industry. Even though the number of securities jobs in 

that area has increased since September 11 because of 

relocation of firms from Manhattan, the influx of securities jobs into New Jersey may not compensate for the 

decline in disposable income. A negative income effect 

could cause ripples throughout northern and central 

New Jersey, an area that has been hurt by retrenchment 

in the telecom industry. Northern New Jersey also is 

vulnerable to weakness in air transportation related to 

Newark International Airport. 

The Region’s economies that rely on tourism and travelrelated jobs face increased weakness, as air travel has 

not yet returned to pre-September 11 levels. A greater 

reliance on drive-in traffic, however, has buffered 

some areas, such as Atlantic City and parts of upstate 

New York and Pennsylvania. While Atlantic City has 

one of the highest concentrations of tourism-related 

jobs in the nation, it is significantly less dependent on 

air traffic than some other tourist destinations, such as 

4 Bear Stearns, eBearcall, January 4, 2002. 5 Concentrations at the county level were measured with Location 

Quotients (LQs). A higher concentration than the nation is reflected 

by an LQ greater than one. This analysis examined counties with LQs 

greater than 1.5 in five vulnerable industries: securities and commodity brokers, hotels and tourism, aircraft and parts, air transportation 

and transportation services, and business services. 

MAP 1 

Sources: WEFA, Bureau of Labor Statistics 

Region’s Exposure to 9/11 Effect Is Limited 

Counties with a Location Quotient > 1.5 in: 

Two Vulnerable Industries 

One Vulnerable Industry 

No Vulnerable Industries 

Orlando and Las Vegas. The economies of Washington, D.C., Baltimore, and Philadelphia also have traditionally benefited from a robust tourism sector and 

convention activity and, as a result, are also susceptible 

to economic weakness following the attacks. 

The Region’s Office Markets Have 

Weakened, Particularly in Manhattan 

and Northern New Jersey 

The Region’s office market conditions have weakened 

along with the economy, and softening has been greatest in the areas that were most adversely affected by 

the September 11 attacks. Office vacancy rates rose in 

the Region’s major cities during 2001, consistent with 

national trends. Despite the recent rise, office vacancy 

rates for many of the Region’s large metropolitan areas 

were below or close to the national average, in part a 

reflection of the modest amount of new office construction in the Region. A decade ago, the Region’s 

office market problems were supply driven. The current rise in vacancy rates, by contrast, results predominantly from a drop in demand. Layoffs and optimistic 

estimates of space requirements, particularly by hightech companies that have closed their doors, resulted in 

an unprecedented level of leased office space returning 

to the market. 

New York Regional Outlook 4 First Quarter 2002 
Regional Perspectives
 

Office market conditions in New York City significantly weakened last year. After remaining well below 

the national average because of strong demand and 

limited supply, the downtown Manhattan office vacancy rate nearly tripled to 10.6 percent during 2001, 

compared with last year.6 The September 11 attacks 

damaged 17.8 million square feet of office space and 

destroyed another 13.4 million square feet, roughly 16 

percent of the city’s downtown office market. Many 

analysts speculated that Manhattan’s office vacancy 

rates would not increase because of the loss of office 

space. Instead, office vacancy rates sharply rose as 

downtown tenants flooded the market with sublet 

space. Over 10 million square feet of leased space was 

returned to market in fourth quarter 2001, nearly 

equivalent to the amount of space destroyed.7 A number of factors contributed to the increase in sublet 

space, including the desire of companies to leave lower 

Manhattan, office consolidations resulting from layoffs, and fiscal tightening because of weaker economic conditions.8 

Despite the migration of businesses from lower Manhattan, vacancy rates have increased in midtown Manhattan and northern and central New Jersey office 

markets because of the influx of sublet space. The 

amount of sublet space in northern and central New Jersey office markets increased by 170 percent during the 

past year, representing almost 40 percent of the total 

available office space.9 According to a Moody’s 

Investors Service report, the outlook for the northern 

New Jersey office markets is less favorable than for the 

New York City market. Both office markets have experienced reduced demand reflecting economic weakness, 

and in the case of New York City, some relocation out of 

Manhattan. Unlike Manhattan, however, which has had 

minimal office construction in the past ten years, northern New Jersey is facing softening demand for office 

6 C.B. Richard Ellis. 

7 Grubb & Ellis Research, New York City’s Office Market—A Post 9­

space at the same time that a moderate amount of new 

office construction is reaching completion.10 

Path of Region’s Recession during This 

Decade Differs from the 1990s Path 

The path of the current regional economic downturn differs from that of the recession a decade ago. The 

Region’s rate of employment growth during the current 

recession closely approximates the nation’s (see Chart 

1); this contrasts with 1990–1991, when the Region’s 

rate of employment growth declined precipitously at the 

start of the recession. The difference in rate of job loss 

is a reflection, in part, of the fact that the banking and 

real estate sectors are in better condition now than they 

were before the last recession. 

The dynamics of the post-September 11 economy, 

however, may result in more layoffs in the Region than 

in the nation, particularly in areas that depend more on 

industries adversely affected by the attacks. Furthermore, the Region’s rate of employment growth, while 

keeping pace with the nation’s prior to September 11, 

may lag the national average in the postattacks period 

because of the economic weight of the New York City 

metropolitan area. Nevertheless, while the Region’s 

economic recovery may not match the nation’s in timing or strength, neither is it likely to be as prolonged or 

CHART 1 

Region’s Rate of Job Loss Is Similar
 

to That of the Nation,
 

Unlike during the Last Recession
 

Employment Change (y/y, %)

U.S. ’90–’91 

NYR ’90–’91 

U.S. Current 

NYR Current 

–4.0 

–3.0 

–2.0 

–1.0 

0.0 

1.0 

2.0 

3.0 

11 Update, December 2001. According to the report, 5.6 million 

square feet of office space damaged on September 11 had been 

reopened by the end of 2001. 

8 John Holusha, January 6, 2002, “In Office Market, a Time of Uncertainty,” New York Times. 9 Grubb & Ellis Research, Office Market Trends: A Survey of the 

Nation’s Office Markets, Winter 2001. New Jersey Office Market 

Trends: The Scramble for Space Following the WTC Attacks, Third 

Quarter 2001. 

–12 –10 –8 –6 –4 –2 0 2 4 6 8 10 12 

Months from Start of Recession 

Sources: Bureau of Labor Statistics, Haver Analytics 

10 Sally Gordon, January 4, 2002, “CMBS: Red-Yellow-Green Update 

Fourth Quarter 2001 Quarterly Assessment of U.S. Property Markets,” Moody’s Investors Service. 

New York Regional Outlook 5 First Quarter 2002 
Regional Perspectives
 

painful as it was in the early 1990s. The pace and vitality of any recovery are likely to depend on several factors, including the industrial mix of local economies 

and the “pull” effect from the national economy. 

Banks Are Better Positioned Now 

than During the 1990–1991 Recession, 

but Challenges Remain 

The Region’s insured institutions appear better positioned to weather this recession than they were the 

1990–1991 downturn. Capital and reserves to total 

assets for the Region’s banks approximated 10 percent 

by third quarter 2001, an increase of more than 150 

basis points since the early 1990s, and credit quality 

measures are more favorable than those a decade ago.11 

Nevertheless, challenges lie ahead, as an increasing 

percentage of the Region’s insured institutions reported credit quality deterioration in third quarter 2001. 

Additionally, after declining to ten-year lows, banks’ 

net interest margins benefited from a steeper yield 

curve in 2001; however, margins may not increase to 

the same degree as during past cycles. Moreover, 

record mortgage refinancing activity in 2001 has 

implications for insured institutions’ interest rate risk 

management strategies. 

CHART 2 

Credit Quality Weakens, Concurrent 

with Economic Decline 

While credit quality ratios reported by the Region’s 

insured institutions are more favorable than those a 

decade ago (see Chart 2), weakness is becoming more 

widespread among the Region’s banks. In third quarter 

2001, one-third of the Region’s institutions reported at 

least a 25-basis-point increase in the past-due ratio 

from the prior quarter, a slightly higher percentage 

than was reported a year earlier. It is important to note 

that credit quality weakness was reported across most 

lending lines. 

The Region’s large banks (total assets over $10 billion) 

reported continued credit quality deterioration, primarily in commercial and industrial (C&I) loan portfolios. 

However, commercial credit quality weakness was not 

limited to bank loan portfolios, as Moody’s Investors 

Service reported that the ratio of corporate bond downgrades to upgrades reached 2.9 in 2001, the highest ratio 

since 1991.12 Large bank past-due and charge-off ratios 

reached an eight-year high of 2.76 percent and 1.06 percent, respectively, in third quarter 2001 but remained 

below levels of a decade ago, when the C&I past-due 

ratio reached 7.01 percent and charge-offs were 2.54 

percent. Increased sales of distressed loans by insured 

institutions in the secondary market during this economic downturn may have partially mitigated the negative effect on large bank C&I credit quality ratios. 

Credit Quality Indicators among Insured Institutions Remain More Favorable than a Decade Ago 

Past-Due Ratio (Percent) 

Large Banks Regional Banks Community Banks 

0 

2 

4 

6 

8 

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

Note: Excludes credit card banks, specialty banks, and institutions in operation three years or less. Large banks—total assets over $10 billion. Regional banks—total assets 

between $1 and $10 billion. Community banks—total assets less than $1 billion. Median figures as of September 30 displayed. 

Source: Bank and Thrift Call Reports 

11 Banking analysis uses median figures as of September 30, 2001, and, unless otherwise noted, excludes specialty banks and institutions in operation for fewer than three years.
 

12 Moody’s Investors Service, “U.S. Corporate Credit Worth Decline in 2001 Steepest Since 1991,” January 8, 2002. 


New York Regional Outlook 6 First Quarter 2002 
Regional Perspectives
 

According to a report, the nation’s banks sold an estimated $5 billion in problem loans last year.13 Large corporate bankruptcies, including Enron and Kmart, and 

credit quality problems related to Argentina could further pressure large bank loan portfolios. In fourth quarter 2001, some of the Region’s large banks announced 

substantial charge-offs related to Enron and Argentina.14 

The Region’s community and regional-sized banks15 

also reported slightly higher delinquency ratios, which 

suggests that commercial credit quality weakness, to a 

lesser extent, has migrated to small- and middle-market 

businesses.16 As is the case with the Region’s large 

banks, however, credit quality ratios remain significantly below peaks reached during the 1990–1991 recession. 

Perhaps reflecting the softening economy, the amount of 

delinquent commercial real estate (CRE) loans reported 

by the Region’s community and regional banks 

increased almost 30 percent over the past year’s, pushing CRE past-due ratios moderately higher. The 

Region’s insured institutions with the highest concentration of CRE loans tend to be located in large metropolitan areas, such as New York City and northern New 

Jersey, which are experiencing softening market conditions. CRE delinquency ratios reported by banks in 

these metropolitan areas increased moderately in 2001 

but remain well below ratios of a decade ago. 

Office market conditions in the Region moderately weakened in 2001, primarily reflecting reduced demand rather 

than excess supply (generally a more severe problem, as 

was the case in the 1990–1991 recession). As discussed 

earlier in this article, part of the problem during the past 

year, particularly after September 11, has been an 

increase in available sublet space. An increase in sublet 

space initially may not affect CRE loan quality because 

typically the tenant remains obligated to pay the lease 

payment. Nevertheless, more sublet space may constrain 

office rental rates.17 Moreover, lenders could experience 

13 Goldman Sachs, “Banks: Regional/Trust & Processing United 

States,” February 6, 2002. 

14 According to a January 16, 2001, press release, JP Morgan Chase 

announced $807 million in credit costs related to Enron and Argentina in fourth quarter 2001. Citigroup’s press release on January 17, 

2001, included a $228 million charge related to Enron and a $470 

million charge related to Argentina for fourth quarter 2001. 

15 Community banks are defined as insured institutions with total 

assets less than $1 billion. Regional banks are defined as insured 

institutions with total assets between $1 billion and $10 billion. 

16 For more information on credit quality and bankruptcy trends, see 

Federal Deposit Insurance Corporation, Bank Trends: Large and Small 

Companies Exhibit Diverging Bankruptcy Trends, January 2002. 17 Torto Wheaton Research, “Why Aren’t Things Worse?” December 

24, 2001. 

some weakening in CRE portfolios, particularly on loans 

made at the height of the business expansion that assume 

peak rental rates and occupancy levels. Markets characterized by new construction and reduced demand could 

face more serious problems. 

Credit quality weakening in consumer portfolios was 

consistent with slowing growth in personal income and 

rising unemployment, as the delinquency rate on credit 

cards and residential mortgage loans slightly increased 

over the past year.18 The Region’s credit card banks,19 

which hold or manage over one-third of the nation’s 

credit card loans and receivables, reported higher loan 

delinquency and charge-off ratios in third quarter 2001, 

approaching levels reached during the 1990–1991 recession. Credit card charge-off rates are forecast to rise in 

2002, consistent with trends in past economic downturns.20 Some credit card lenders reported higher margins in 2001, as increases in net interest margins (NIMs) 

more than offset higher credit costs. Earnings may come 

under more pressure this year, however, as funding costs 

stabilize (or perhaps increase, should interest rates rise) 

while charge-offs continue to climb. Subprime credit 

card lenders likely will experience much greater earnings pressures because charge-offs on subprime loans 

typically exceed levels for prime loans because of the 

subprime borrower’s weaker credit profile. Furthermore, subprime lenders, which rely on higher fees to 

offset charge-offs, may not be able to increase fees to 

levels that will offset elevated credit costs during a slowing economy.21 

Changes in credit quality indicators tend to lag shifts in 

economic conditions; as a result, further weakening in 

credit quality is possible, underscoring the importance 

of strong loan administration practices. Results of the 

September 2001 FDIC Report on Underwriting Practices indicate that the proportion of banks nationally that 

had “medium” or “high” risk associated with loan 

administration rose from 37 percent to 40 percent during the six-month period ending September 30, 2001. 

Should credit quality continue to weaken, bank management may need to allocate greater resources to the loan 

administration function. 

18 See the “In Focus” article for a discussion of national trends in
 

mortgage lending and residential real estate markets.
 

19 Credit card banks are institutions with credit card loans and securitized credit card receivables to total assets greater than 50 percent.
 

20 Credit Suisse First Boston, “Fourth Quarter Earnings Preview,”
 

January 2, 2002. 


21 Wachovia Securities, “Credit Cards 101,” November 27, 2001.
 

New York Regional Outlook 7 First Quarter 2002 
 

Regional Perspectives
 

Changes in the Shape and Level of the Yield 

Curve Have Implications for Margins and 

Interest Rate Risk 

Another challenge faced by the Region’s insured institutions, particularly community banks, is the effect of 

changes in the shape and level of the yield curve on 

bank margins and interest rate risk management. As discussed in New York Regional Outlook, First Quarter 

2001, community bank NIMs historically have followed 

changes in the steepness of the yield curve (see Chart 

3). Community banks typically “fund short and lend 

long”; loans generally have longer maturities or repricing intervals than deposits. Moreover, community banks 

typically generate a greater portion of income from traditional banking revenue (i.e., margin revenue) than do 

larger, diversified insured institutions. In third quarter 

2001, the Region’s community banks generated 88 percent of total revenue from margin or “spread” income; 

margin income represented 68 percent of revenue for 

the Region’s large banks. The greater dependency of 

community banks on margin revenue suggests that the 

profitability of these institutions may be more susceptible to changes in the level and shape of the yield curve. 

The Region’s community banks reported a decline in 

asset yield concurrent with falling long-term interest 

rates. Long-term Treasury rates declined steadily 

between May 2000 and September 2001; the average 

CHART 3 

rate on a 30-year mortgage dropped 170 basis points.22 

The decline in mortgage rates spurred a refinancing 

wave that exceeded levels reached in 1998 as borrowers 

took advantage of lower interest rates and refinanced 

primarily into longer-term mortgages (see Chart 4). The 

refinancing boom has implications for interest rate risk 

management, particularly for banks that focus on residential mortgage lending. Lower market interest rates 

also contributed to a decline in the yield earned on community bank commercial loan and investment portfolios. Reflecting lower yields earned on loans and 

securities, the asset yield reported by the Region’s community banks declined 65 basis points through the first 

nine months of 2001. 

Funding costs for the Region’s community banks also 

fell during 2001, although reductions were more than 

offset by declining yields on earning assets. During the 

first nine months of 2001, the federal funds target rate 

fell by 350 basis points, and short-term U.S. Treasury 

rates declined, on average, 287 basis points.23 During the 

same period, the median cost of funds reported by the 

Region’s community banks dropped 52 basis points, 

less than the decline in the median asset yield. Community bank funding costs did not decline commensurate 

with market rates, in part because of deposit maturity 

and repricing schedules. Rates on time deposits, which 

accounted for 42 percent of community bank liabilities, 

are poised to decline as one-quarter of community bank 

Net Interest Margins Follow the Shape of the Yield Curve 

Note: Includes banks with total assets under $1 billion in operation more than three years, excluding specialty banks; median net interest margin displayed. The 

spread is the difference between the yield on ten-year U.S. Treasury notes and three-month U.S. Treasury bills. 

Sources: Federal Reserve Board (Haver Analytics), Bank and Thrift Call Reports Basis Points

Percent 

Spread 

(left axis) 

Net Interest Margin 

(right axis) 

–100 

0 

100 

200 

300 

400 

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

3.5 

3.7 

3.9 

4.1 

4.3 

4.5 

22 Federal Reserve Board (Haver Analytics).
 23 Short-term U.S. Treasury rates are defined as rates on three-month through two-year U.S. Treasury securities. Federal Reserve Board (Haver
 

Analytics).
 

New York Regional Outlook 8 First Quarter 2002 
Regional Perspectives
 

certificates of deposit (CDs) were scheduled to mature 

or reprice by year-end 2001, and three-quarters mature 

or reprice within one year.24 The extent of the reduction 

in funding costs, however, will depend on the degree of 

pricing power retained by banks in the face of increased 

competition, and on consumers’ preferences for CD 

maturities and alternative investments. 

Benefits of Steeper Yield Curve 

May Be Muted During This Cycle 

While changes in the shape of the yield curve have 

cyclical implications for bank margins, competition is a 

secular challenge faced by the banking industry. Following the 1990–1991 recession, the Region’s community banks experienced increased NIMs as the yield 

curve steepened. During this cycle, bank margins also 

are likely to widen; however, increased competition for 

loans and deposits may constrain the degree of margin 

improvement. Competition for banking products has 

strengthened, as evidenced by the growth of nonbank 

financial services providers and credit union membership. For example, membership in credit unions grew 

from 61.4 million in 1992 to 78.7 million in 2001.25 

Moreover, deposit alternatives such as mutual funds 

play a much larger role than they did a decade ago. As 

a result, banks’ pricing power likely has declined over 

time. Additionally, while deposit growth increased in 

2001, reflecting, in part, weak stock market conditions, 

CHART 4 

depositors may return to the stock market should equity 

prospects improve. 

Refinancing Wave Heightens Importance of 

Interest Rate Risk Management among 

Residential Lenders 

Elevated mortgage refinancing levels may have implications for bank interest rate risk profiles, particularly 

among insured institutions that specialize in residential 

lending and mortgage-related securities. Relative to the 

nation, a larger proportion of the Region’s institutions 

may be affected by the recent refinancing boom because 

one-third of the Region’s banks are residential lenders, 

compared with 10 percent for the rest of the nation.26 

The Region’s residential lenders reported a slight 

increase in loan maturities as of September 30, 2001; 

however, maturities are likely to extend further because 

more homeowners took advantage of historically low 

long-term mortgage rates late last year. For example, 

following the 1998 refinancing wave, the median percentage of 1 to 4 family mortgage loans and mortgagebacked securities reported by the Region’s residential 

lenders that were scheduled to mature or reprice in five 

or more years increased from 57 percent to 67 percent. 

Asset maturity extension may be greater following this 

refinancing wave than it was four years ago because of 

the record amount of mortgage originations last year; 

this possibility is somewhat dependent on the degree to 

Note: Refinancing Index shown through November 2001. 

Sources: Mortgage Bankers Association (MBA), Federal Reserve Board 

10-Year Treasury Bond 

Yield at Constant Maturity 

MBA Refinancing Index: 

Mortgage Loan Applications 

Mortgage Refinancings Boom with Declining Long-Term Interest Rates 

2 

3 

4 

5 

6 

7 

8 

Percent 

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

0 

1000 

2000 

3000 

4000 

5000 

24 Maturity and repricing data was not available for thrift institutions.
 

25 National Credit Union Administration, Mid-Year Statistics for Federally Insured Credit Unions, 2001.
 26 “Residential lenders” refers to institutions holding greater than 50 percent of total assets in one- to four-family mortgage loans and mortgage-


backed securities.
 

New York Regional Outlook 9 First Quarter 2002 
Regional Perspectives
 

which institutions sell mortgage loans in the secondary 

market. In 2001, an estimated $2.0 trillion in mortgages 

were originated, eclipsing the $1.5 trillion of originations in 1998; a substantial proportion is long-term 

fixed-rate mortgages.27 

Investment strategies also may have implications for an 

insured institution’s interest rate risk management. 

Management may try to offset lower loan yields by 

moving out on the yield curve and investing in longerterm securities, further lengthening asset maturities. 

27 Mortgage Bankers Association, “Mortgage Finance Forecasts,” 

December 17, 2001. 

Asset maturity extension may be mitigated by lengthening the maturity of some bank funding sources, as evidenced by a slight shift into longer-term Federal Home 

Loan Bank borrowings by the Region’s residential 

lenders in third quarter 2001. Nevertheless, a higher 

concentration of long-term assets could increase exposure to rising interest rates among the Region’s residential lenders, particularly if the economic recovery is 

stronger than expected. 

Kathy R. Kalser, Regional Manager 

Robert M. DiChiara, Senior Financial Analyst 

Norman Gertner, Regional Economist 

Alexander J.G. Gilchrist, Economic Analyst 

New York Regional Outlook 10 First Quarter 2002 
In Focus This Quarter
 

Housing Market Has Held Up Well in This 


Recession, but Some Issues Raise Concern
 

Trends in housing markets are important performance 

drivers for many FDIC-insured institutions. The health of 

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

finance residential construction and is linked indirectly to 

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

market, was underwritten during 2001, with 56 percent of 

this activity in refinancing transactions.1 This activity 

makes recent trends in underwriting of particular interest. 

An ancillary issue for many mortgage lenders, interest 

rate risk, is not addressed in this article.2 

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

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

practices will fare during this downturn. Developments 

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

standards, and the emergence of subprime mortgage 

lending as a significant line of business for some banks. 

Mitigating this risk has been the steady appreciation of 

home prices, which have shown signs of softening in 

some markets but not to the extent seen at a comparable 

stage in previous recessions. 

Home price weakness may be more pronounced in 2002 

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

authors’ judgment, systemic weakness in home prices is 

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

institutions. Nonconstruction residential mortgages, even 

during the most pronounced periods of stress in the 1980s 

and early 1990s, remained the best-performing loan 

class, especially for lenders specializing in residential 

real estate; and, historically, these mortgages have been 

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

January 2002.
 

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

and Chicago Regions, Regional Outlook, First Quarter 2002.
 

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

insured institutions.3 

That said, however, there are pockets of risk for 

insured institutions. There is evidence that borrowers 

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

mortgage lenders. Further, a slump in residential real 

estate markets could be especially detrimental to 

insured institutions with significant exposures to 

housing construction because projects might not sell at 

projected asking prices or as quickly as anticipated. 

Finally, in specific markets where housing prices may 

have achieved unsustainable levels, some increase in 

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

stands out as a place to watch. 

The Recession Thus Far Has Had 

a Minimal Impact on Mortgage 

Delinquencies at Insured Institutions 

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

trends seen in past recessions. For example, new and 

existing home sales both set records during the year, 

while new home construction failed to decline, an 

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

prices—as measured by either the Office of Federal 

Housing Enterprise Oversight (OFHEO) repeat sales 

price index or the National Association of Realtors 

(NAR) median single-family price statistic—showed 

deceleration but remained well above trends seen at 

similar points in past recessions. This behavior partly 

reflected the early robustness of household income in 

the face of recession and relatively low fixed mortgage 

rates during 2001, which helped to counter some of the 

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

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

Boston Region, Regional Outlook, First-Quarter 2000. 

New York Regional Outlook 11 First Quarter 2002 
In Focus This Quarter
 

CHART 1 CHART 2 

Through September 2001, Mortgage-


Related Delinquencies Remained Modest
 

Although the Much Larger Market for 

Existing Homes Has Held Up, New Home 

Prices Are Under Pressure 

Percentage Change from

Prior Year 

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

Existing 

New 

–10 

–5 

0 

5 

10 

15 

20 

,

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

01 

Percentage 

30+ Days Past Due 

0 

2 

4 

6 

8 

10 

12 

,

91 ,93 ,95 ,97 ,99 Sep ,

01 

0 

1 

2 

3 

4 

5 

6 

Percentage 

30+ Days Past Due 

95th Percentiles (R) 

mortgages equity lines 

75th Percentiles (L) 

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

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

Source: Bank and Thrift Call Reports 

initial adverse effects of the recession on housing 

demand. 

One sign of potential weakness appeared late in 2001 

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

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

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

predictive of prices for the much larger existing home 

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

adverse pricing trends in the new home segment do 

raise concerns for residential developers and insured 

institutions that finance residential construction. 

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

As detailed later in this article, home price growth 

began to weaken in 2001 in a number of metropolitan 

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

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

contractions in employment last year. 

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

weakness thus far. Through the first nine months of 

2001, insured institutions showed negligible advances 

in median past-due ratios for mortgages and equity 

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

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

lines of credit, although continued strong mortgage 

origination activity in 2001 may have masked (in the 

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

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

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

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

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

insured institutions’ earnings and capital, since it has 

held up better in prior recessions than other loan types. 

What Are the Risks Facing Housing 

Lenders in 2002 and Beyond? 

In an environment of significantly slower economic 

growth than prevailed during the 1990s, can the 

strength of housing prices and the relatively benign 

credit quality environment for housing lenders be 

expected to continue? The answer will depend on the 

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

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

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

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

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

New York Regional Outlook 12 First Quarter 2002 
, UT

Miami– 

y, NY

Phoenix, AZ

, NV–AZ 

, MO–IL 

Tucson, AZ

Oklahoma City

, NY

, OK 

Kansas City

Tulsa, OK

, MO–KS

, NC–SC 

mingham, AL

, TN-AR–MS

Honolulu, HI

, SC 

Entire Nation

, FL

e City

alo

ville

 Lauderdale

Alban

Buff

 Louis

Green

egas

lotte

Salt Lak

Memphis

Las V

Char

St.

Bir

Ft.

In Focus This Quarter
 

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

Evolving Lending Practices Have Increased 

the Risk Profile for Mortgage Lenders 

Although history suggests that residential mortgage 

defaults will be relatively low even in a recession, 

changes in the mortgage market since the 1990–1991 

recession could affect mortgage performance during the 

present downturn. Many underwriting changes over the 

past decade have been driven in part by the growing 

importance of the secondary market for mortgage debt, 

and of Fannie Mae and Freddie Mac in particular. In 

1980, federal and related agencies had direct or indirect 

interests in approximately 17 percent of all mortgage 

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

increased to roughly 41 percent. Insured bank and thrift 

mortgage exposures grew over the same period, but, as 

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

trends notwithstanding, insured institutions still provide 

substantial funding, directly or indirectly, to the housing 

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

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

Although an active secondary mortgage market has 

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

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

CHART 3 

1993 2000 

days, lenders largely had to retain originated mortgages 

in their own portfolios. Consequently, only lenders with 

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

mortgage markets. The advent of the secondary market 

enlarged the pool of available funding and permitted both 

insured institutions and other originators to transfer their 

mortgage business readily into entities such as mortgage 

pools and trusts. Consequently, many new players, 

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

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

led to considerable commodification of the mortgage 

market. Rather than competing on the basis of traditional 

relationships, lenders’ market shares are increasingly 

driven by price. For smaller savings institutions that focus 

heavily on residential mortgage underwriting, this issue 

has likely elevated business risk. Heightened competition 

has caused some loosening of mortgage underwriting 

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

valuation techniques currently in place have not been 

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

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

mortgages. The ability of insured institutions to mitigate 

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

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

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

60 

40 

20 

0 

Source: Federal Housing Finance Board 

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

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

New York Regional Outlook 13 First Quarter 2002 
In Focus This Quarter
 

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

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

Board, LTPP ratios are high and have risen in several 

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

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

with LTPP ratios exceeding 90 percent. 

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

insurance (PMI), recently the mortgage industry has 

allowed borrowers to avoid purchasing PMI. In particular, 

“piggyback” financing has made homeownership 

increasingly possible for households that cannot afford 

the traditional 20 percent down payment or do not wish to 

pay for PMI. With piggyback financing, the borrower 

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

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

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

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

are not. Thus, piggyback financing is probably most 

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

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

on all low down payment loans to the lender that 

retains the junior position. These institutions are, of 

course, compensated for some of this risk with the 

higher interest rates charged on the piggyback portion 

of these mortgages. 

Competitive factors have prompted the industry to 

enhance underwriting automation. As part of the push, 

credit scoring has become a routine part of the credit 

analysis process, and, increasingly, lenders are using 

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

since the 1990–1991 recession; consequently, their 

predictive ability in a downturn is uncertain. Although 

some have touted AVMs as the answer to appraisal 

fraud, the ability of statistical models to simulate the 

qualitative judgments considered critical to traditional 

appraisals is unknown. Paper appraisals reportedly 

7 Purchase money mortgages are loans extended solely for the initial 

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

continue to dominate the industry; however, recently, 

the two largest government-sponsored enterprises have 

begun accepting AVMs in lieu of standard appraisals 

for loans under $275,000.8 For lenders that specialize 

in HLTV mortgages, there is less room for error with 

AVMs. 

Cyclical Weakness Is Already Apparent 

in Subprime Mortgage Lending 

Historically, certain insured institutions have made 

mortgage loans with narrow collateral margins or to 

borrowers with limited or blemished credit histories. 

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

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

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

extent of bank involvement in subprime lending at any 

point in time is difficult. However, the FDIC estimates 

that fewer than 1 percent of all insured institutions 

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

originations peaked at 13 percent in early 2000, before 

moderating somewhat during the first three quarters of 

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

probably have some limited involvement in subprime 

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

the Minneapolis District offered loans to low-credit 

quality consumer borrowers in 1999.10 

Subprime mortgage loan performance appears to have 

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

trends on Federal Housing Agency (FHA)-insured 

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

with low down payments. The Mortgage Bankers 

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

in the year ending third-quarter 2001, the delinquency 

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

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

8 “Automated Appraisals Require Caution by Lenders,” American 

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

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

Federal Reserve, July 1999. 

New York Regional Outlook 14 First Quarter 2002 
In Focus This Quarter
 

CHART 4 

Recent Mortgage Delinquencies for HigherRisk Loans Reached All-Time Highs 

Percentage of Mortgages

30+ Days Past Due

FHA 

Conventional 

,

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

0 

2 

4 

6 

8 

10 

12 

Source: Mortgage Bankers Association 

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

difficulties. 

A database of more than 6.5 million subprime loans 

tracked by Loan Performance Corporation (formerly 

Mortgage Information Corporation) reported similar 

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

from 5.5 percent one year earlier.11 Moreover, subprime 

delinquencies significantly exceeded those found among 

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

of possible concern are vintage data trends, which show 

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

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

recession. Alternatively, Loan Performance Corporation 

analysts have suggested that the 2001 refinancing boom 

might have created some adverse selection in mortgage 

pools originated during the relatively higher interest rate 

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

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

ratios for their age compared with similarly seasoned subprime loans 

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

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

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

Winter 2001. 

er-coupon and variable-rate loans comprised a significant 

share of mortgage originations during that period, overall 

prepayment rates on the 2000 vintage might have been 

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

loans of lesser credit quality behind and elevating the 

residual delinquency experience in that pool. 

Given these trends, an important issue for subprime 

lenders is their ability to anticipate and plan for the 

impact of an economic slump on their operations. Some 

institutions clearly adopt subprime lending as part of an 

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

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

borrowers recently provided additional resources to its 

loan services and default management departments. This 

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

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

C&D Lending Risks May Be Elevated in MSAs 

with Potential Supply/Demand Imbalances 

Historically, lending to finance housing construction is 

riskier than mortgage lending on existing structures. 

Insured institutions report construction and development 

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

commercial and residential construction. While it is thus 

impossible to ascertain from quarterly call reports the 

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

smaller insured institutions engage to some degree in 

commercial property development, their C&D lending 

largely finances single-family construction. If markets 

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

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

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

Demand for housing can be affected by two distinct 

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

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

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

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

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

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

New York Regional Outlook 15 First Quarter 2002 
In Focus This Quarter
 

conditions, including interest rates. New supply of homes 

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

of market and economic signals is critical to the success 

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

of overestimating future demand could be multiplied if 

several builders inaccurately gauge changes in 

demand. Consequently, a construction market with 

numerous smaller developers, such as Atlanta, may 

see amplified swings in construction activity and may 

experience excess supply during certain periods. 

Although conceptually straightforward, measuring the 

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

can limit the effectiveness of this type of analysis. As 

already mentioned, some insight about current housing 

market conditions in specific metropolitan areas may 

be gained by analyzing both secular and cyclical 

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

the role of cyclical factors is of prime concern at this 

time. 

To measure the cyclical aspect of the relationship 

between a market’s supply and demand, some analysts 

rely heavily on the concept of employment-driven 

demand.16 Such analysis involves tracking a demand/ 

supply ratio based on employment growth and permit 

issuance. Areas where permitting activity continues to 

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

market.17 

Using a simplified version of employment-driven 

demand, we identified a number of metropolitan areas 

as being at risk for a rising imbalance in their housing 

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

These markets are displaying signs that residential 

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

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

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

CHART 5 

–120 

–100 

–80 

–60 

–40 

–20 

20 

40 

60 

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

December 2001 Year-to-Date Permits 

(Year-Ago Change) 

December 2001 Employment

(Year-Ago Change, Thousands) 

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

Some Larger MSAs Continued to See 

Permit Growth during 2001, despite 

Declining Employment 

0 

Greensboro, 

Minneapolis, 

& St. Louis 

Chicago 

Atlanta 

Portland, OR–WA 

Phoenix 

construction activity may not be responding in kind to 

local economies that have started to contract during 

this recession. Further, Phoenix, Portland, and Atlanta 

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

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

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

apparent that some markets identified in Chart 5 as 

having significant banking exposure to C&D lending 

also may have a cyclical imbalance in home building. 

Atlanta, for example, demonstrates one of the highest 

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

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

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

words, while employment-driven demand has softened 

in the metropolitan area, single-family construction 

activity has continued, and community bank lenders 

may have increased their level of residential financing 

commitments. 

Cyclical Risks May Be Developing 

with Respect to Home Prices 

Popular comparisons have been made recently 

between the healthy run-up in housing prices during 

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

2001. 

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

then charted the top 25 MSAs ranked by September 2001 median 

C&D/assets. 

New York Regional Outlook 16 First Quarter 2002 
In Focus This Quarter
 

CHART 6 

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

Exposure Coupled with Potentially Growing Supply/Demand Imbalances 

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

0 

5 

10 

15 

20 

25 

30 

Change in Median C&D Loans-to-Assets 

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

–2 0 2 4 6 8 10 

Salt Lake City 

Atlanta Provo-Orem, UT 

Stockton, CA 

Greensboro 

Portland, OR–WA 

Phoenix 

MSAs with declining employment

 but rising permitting during 2001 

the past several years and the technology stock-fed 

speculative “bubble” in equity prices that persisted 

through early 2000. The subsequent bursting of this 

bubble and the resulting economic distress have raised 

concerns of a sequel featuring housing prices. 

According to the OFHEO repeat sales price index, 

there has never been an instance of outright declines in 

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

prices do exhibit strong cyclical tendencies, with the 

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

CHART 7 

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

in population-adjusted personal income growth,21 and 

some have pointed to a growing imbalance between 

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

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

Given that home price bubbles have occurred in the 

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

MAP 1 

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

Sources: OFHEO, U.S. Census Bureau 

The Widening Gap between Home Price and 

Income Growth Has Raised Some Concern 

Per Capita Income 

Home Price Index 

’85 ’87 ’91 ’93 ’97 ’01E ’89 ’95 ’99 

0 

2 

4 

6 

8 

10 

Drops in Affordability since the Mid-1990s
 

Are Most Prevalent in California 


and the Northeast
 

Top 10 percent of
 

MSAs ranked by decline
 

in affordability index, 1996
 

to 2001 (through June)
 

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

Source: Economy.com 

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

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

New York Regional Outlook 17 First Quarter 2002 
In Focus This Quarter
 

resulted in significant negative fallout for these areas’ 

economies and insured institutions, it is useful to look 

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

scenario (with very low probability) for residential 

real estate markets during the current recession. It is 

unlikely that significant, systemic risks from home 

price bubbles have arisen yet for residential lenders. 

Of course, this situation could change if the current 

recession deepens or is protracted, or if growth during 

the subsequent recovery is anemic. Further, national 

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

affordability. These markets, and the residential lenders 

targeting them, may be more at risk as local economic 

growth falters. 

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

during the past several years. Not surprisingly, many 

of them—namely larger cities in California and the 

Northeast—are those that historically have seen the 

biggest swings in prices and a penchant for speculative 

excess. 

In markets with rapidly declining affordability, credit 

risk arises from the increasing likelihood that new 

borrowers will commit a greater share of household 

financial resources to meet monthly payments. Credit 

problems could become more readily apparent given 

any subsequent disruptions to employment or income 

in these markets—especially among households with 

limited wealth or that require multiple job holders to 

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

Disruptions to aggregate household liquidity from lost 

employment or decreased income can result in rising 

mortgage delinquencies. With respect to foreclosures, 

however, some research has suggested that the decline 

in prices relative to the balance owed on the mortgage 

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

owners with positive equity are likely able to sell their 

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

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

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

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

between rising LTVs and foreclosure rates. 

CHART 8 

Rising Foreclosure Rates Followed Falling 

Home Prices in New England a Decade Ago 

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

Annual Home Price Change (%) 

’79 ’84 ’89 ’94 ’99 

Inverse 

Price (R) 

Foreclosure (L) 

–20 

–10 

0 

10 

20 

30 

Foreclosure Started

(% of Existing Loans) 

0.00 

0.10 

0.20 

0.30 

0.40 

0.50 

homes profitably, thus avoiding foreclosure. Chart 8 

shows the strong relationship between declining home 

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

change in order to emphasize the relationship).23 

The data available through late 2001 were mixed with 

respect to home resale price trends at the MSA level. 

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

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

show about a dozen markets with year-over-year 

declines, none exceeding four percent. A deceleration 

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

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

should be noted that the OFHEO data do not include 

sales of high-priced homes and are less influenced by 

changes in the mix of homes sold than are average and 

median prices;24 this issue is more meaningful in the 

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

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

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

the two-decade correlation between foreclosures started and price 

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

both California and the nation. 

24 Data are obtained from aggregating repeat sales or refinancings of 

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

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

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

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

New York Regional Outlook 18 First Quarter 2002 
In Focus This Quarter
 

TABLE 1 

As Recession Evolved, Home Price Appreciation Waned through 2001 

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

ANNUAL PERCENT CHANGES 

MSAS RANKED 

BY DECELERATION 

IN HOME PRICE INDEX 

FROM 1Q01 TO 4Q01 

OFHEO HOME PRICE INDEX 

NONFARM 

EMPLOYMENT 

1998– 

2000 1Q01 2Q01 3Q01 4Q01 

1998– 

2000 2001 

UNITED STATES 6.3 9.6 9.1 8.8 6.9 2.4 0.3 

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

SANTA CRUZ-WATSONVILLE CA 

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

SAN FRANCISCO CA PMSA 16.5 19.4 13.9 9.1 3.5 3.3 1.3 

SALINAS CA MSA 13.7 24.3 22.4 19.0 9.4 3.3 0.9 

SANTA ROSA CA PMSA 14.8 22.7 19.6 13.6 8.6 4.1 1.6 

OAKLAND CA PMSA 14.7 22.3 18.0 14.1 8.2 3.4 2.0 

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

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

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

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

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

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

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

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

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

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

BARNSTABLE-YARMOUTH MA 

NECMA 12.8 17.6 14.5 14.6 12.5 3.9 1.3 

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

DUBUQUE IA MSA 3.9 8.8 6.0 6.9 2.5 1.1 –0.6 

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

DENVER CO PMSA 11.1 13.7 11.8 10.9 7.9 3.8 2.3 

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

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

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

SAN DIEGO CA MSA 11.8 15.6 13.8 12.9 10.4 4.3 2.7 

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

TUCSON AZ MSA 3.3 8.6 8.0 6.8 3.6 3.5 0.8 

JERSEY CITY NJ PMSA 8.0 11.1 17.6 13.7 6.2 2.1 2.7 

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

RAPID CITY SD MSA 6.2 8.9 9.3 7.7 4.1 3.1 0.1 

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

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

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

New York Regional Outlook 19 First Quarter 2002 
 

In Focus This Quarter
 

San Francisco Bay Area25 and parts of the Northeast, 

since prices for high-end homes (typically financed by 

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

Table 1 lists markets whose 2001 deceleration in home 

price growth was in the top 10 percent of the more 

than 300 metro areas for which the OFHEO statistic is 

available. The table also provides (where available) 

each MSA’s recent employment trend as an indicator 

of overall economic conditions. These markets may yet 

see even more pronounced deceleration in home price 

growth or even declines in home prices this year (as 

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

The metro areas in the table are 

ordered by the magnitude of their 

deceleration in home price growth 

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

growth in the recently overheated 

San Francisco Bay Area puts many of its MSAs near the 

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

Oakland, Denver, and San Diego also previously were 

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

more volatile appreciation rates, such as Utica and 

Fargo, comparisons of recent price trends are more 

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

year-ago price growth during first-quarter 2001. 

It is hard to generalize about which markets will see the 

most pronounced home price weakness as the recession 

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

are more likely to see significant downward corrections 

in price when economic activity falls for a prolonged 

period or by a sufficient magnitude. One study from the 

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

groups tended to respond similarly to local and national 

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

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

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

2001.
 

economic forces (fundamental, or “equilibrium,” price 

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

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

tended to see the most significant price swings over the 

past 20 years. 

History also provides some insights into the nature and 

extent of any price declines in markets where economic 

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

1990s, concluded that declines differed by property type 

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

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

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

boom saw the largest deflation) and from the nature of 

each city’s economic decline, which differed according to 

concentrations of job losses by industry and wage type, 

underlying demographic factors, and housing supply 

trends. 

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

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

recent years, this area witnessed double-digit home price 

appreciation that exceeded growth in per capita income 

by a wide margin. A recent analysis from the University 

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

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

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

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

income growth during this cycle as during the 1980s. 

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

Northeast generally) has seen little speculative purchase 

or construction activity in recent years, which should 

help to mitigate any price weakness through the current 

recession in these markets.30 

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

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

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

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

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

Quarter 2002. 

New York Regional Outlook 20 First Quarter 2002 
In Focus This Quarter
 

Conclusion 

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

well in prior recessions. However, history might 

understate credit risks for insured institutions during 

this cycle because the mortgage lending business has 

changed since the last recession. Chief among these 

changes are robust mortgage market competition, 

which has contributed to narrower collateral margins; 

increased reliance on underwriting automation; and 

expanded involvement in the subprime credit market. 

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

are experiencing continued construction despite a 

cyclical slowdown (as measured by employment 

trends). Permanent mortgage lenders in certain areas, 

such as the San Francisco Bay area, could also face 

higher loss rates and foreclosures going forward, as the 

current economic weakness places downward pressure 

on home prices and dampens the ability of households 

to meet mortgage payments. 

Scott Hughes, Regional Economist 

Judy Plock, Senior Financial Analyst 

Joan Schneider, Regional Economist 

Norm Williams, Regional Economist 

New York Regional Outlook 21 First Quarter 2002 


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