Outlook
 

SPRING 2004 

In Focus This Quarter 

Housing Bubble Concerns and the Outlook for Mortgage Credit 

Quality—U.S. home prices have risen briskly over the past several years, 

outpacing growth in disposable income. In terms of sales volumes, the 

housing sector had another banner year in 2003. This housing boom has 

raised concerns among some analysts about the possibility of a home price 

bubble and the specter of home prices suddenly collapsing. At the same 

time, rising levels of consumer and mortgage debt, and a decline in the 

quality of that debt, also merit attention. What connects these areas of 

concern is the possibility that household credit quality could decline 

further if home prices were to decline precipitously. This article reviews 

current evidence and expert opinion on the possibility of a national home 

price bubble and considers the overall outlook for mortgage credit quality 

for the remainder of 2004. See page 3. 

By Cynthia Angell, Senior Financial Economist 

The FDIC’s Economic and Banking Outlook in Charts—This new feature provides a graphic executive summary of 

the FDIC’s analytical perspective on current economic and banking issues, but it is not meant to be an exhaustive analysis 

of these issues. Please refer to the FDIC Outlook articles and other FDIC publications for more in-depth analysis 

(www.fdic.gov). We are constantly striving to improve the FDIC Outlook and other publications. Please contact Associate 

Director Rae-Ann Miller at rmiller@fdic.gov with your comments about this new feature or any of our publications. See 

page 11. 

By Risk Analysis Staff and Regional Operations Staff 

Regional Perspectives 

Atlanta—Structural and cyclical forces will affect the perfor- Kansas City—Hydrological drought conditions may begin to 

mance of the manufacturing sector. Areas with significant affect farmers’ ability to irrigate crops, which could hurt yields 

employment in traditional industries that remain under struc- and contribute to greater weakness in agricultural bank credit 

tural pressure may recover more slowly, and insured institution quality. See page 25. 

credit quality could weaken further. See page 13. New York—The housing sector has continued to perform 

Chicago—The regional economy is improving, albeit unevenly strongly in the Northeast. However, higher interest rates and 

among industries and across states. Should interest rates rise moderating appreciation in home prices could challenge many 

further, insured institutions will face continued challenges to of the Region’s insured institutions. See page 29. 

increase revenue while maintaining favorable asset quality. See San Francisco—Despite weak office market fundamentals, page 17. insured institutions in several metro areas report exposures to 

Dallas—Branching activity in the Dallas Region, driven by commercial real estate lending that exceed the national median. 

economic and demographic factors, has significantly exceeded Credit quality remains sound overall; however, continued 

that of the nation during the past decade. The performance of economic weakness could contribute to deterioration in asset 

insured institutions varies in response to specific branching quality. See page 33. 

strategies. See page 21. By Regional Operations Staff 

San 

Francisco 

Kansas 

City 

Dallas Atlanta 

New 

York 

Chicago 

FEDERAL DEPOSIT INSURANCE CORPORATION 
The FDIC Outlook is published quarterly by the Division of Insurance and Research of the Federal Deposit 

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

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

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

Jack M. Phelps, Regional Manager, 678-916-2295 

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David Van Vickle, Regional Manager, 312-382-7551 

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Catherine Phillips-Olsen, Regional Manager, 415-808-8158 

The FDIC Outlook provides an overview of economic and banking risks and discusses how these risks relate 

to insured institutions nationally and in each FDIC region. 

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or to provide comments or suggestions about FDIC Outlook, please call Rae-Ann Miller at 202-898-8523 or 

send an e-mail to rmiller@fdic.gov. 

The views expressed in the FDIC 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 

and Research 

Arthur J. Murton 

Executive Editor Maureen E. Sweeney 

Managing Editor Kim E. Lowry 

Editors Rae-Ann Miller 

Richard A. Brown 

Ronald L. Spieker 

Norman Williams 

Publications Manager Teresa J. Franks 
In Focus This Quarter 

Housing Bubble Concerns and the 

Outlook for Mortgage Credit Quality 

U.S. home prices have risen briskly over the past 

several years, outpacing growth in disposable income. 

In terms of sales volumes, the housing sector had 

another banner year in 2003.1 This housing boom has 

raised concerns among some analysts about the possibility of a home price bubble and the specter of home 

prices suddenly collapsing. Rising levels of consumer 

and mortgage debt, and a decline in the quality of that 

debt, also merit attention. What connects these areas 

of concern is the possibility that household credit quality could decline further if home prices were to fall 

precipitously. This article reviews current evidence and 

expert opinion on the possibility of a national home 

price bubble and considers the overall outlook for mortgage credit quality for the remainder of 2004. 

Some Market Watchers Perceive 

a U.S. Housing Bubble... 

Karl Case and Robert Shiller define a bubble as “a situation in which excessive public expectations for future 

price increases cause prices to be temporarily 

elevated.”2 Under this definition, an asset bubble can 

be said to exist when prices have risen faster than the 

underlying supply and demand fundamentals would 

suggest. The speculative element is a key feature of any 

asset bubble, as expectations of further price gains, 

rather than fundamental factors, begin to drive appreciation. Typically, these episodes are identified only in 

hindsight, when panic selling bursts the bubble. This 

sequence of events has been observed in many historical episodes with assets such as equities, land, and even 

tulip bulbs. There is an important distinction, therefore, between a “boom,” when prices increase at a 

historically rapid pace, and a “bubble,” when unsustainable factors lead to a boom/bust price path. A boom is 

required for a bubble to form, but a boom does not 

necessarily mean that a collapse in prices is imminent. 

1 Sales of existing homes rose to record levels in 2003, surpassing 

previous records set in 2002. Sales of new single-family homes topped 

1 million units, establishing a new record high for the third consecutive year. In addition, according to the National Association of Home 

Builders, new home starts rose in 2003 to 1.85 million, the highest 

number of housing starts since 1978. 

2 Karl E. Case and Robert J. Shiller, Is There a Bubble in the Housing 

Market? An Analysis, Washington, DC: Brookings Institution, 2003. 

Concerns about a nationwide housing bubble arise from 

the very robust activity in the housing sector and mortgage markets in recent years. Mortgage borrowing has 

boomed as low interest rates, together with strong 

demographics, have spurred homeownership and refinancing by existing homeowners looking to liquidate 

home equity gains. In fact, the homeownership rate 

reached an all-time high of 68.6 percent by the fourth 

quarter of 2003. The mortgage market has grown at 

double-digit rates since early 2002, bringing total U.S. 

home mortgage debt to $6.6 trillion by third quarter 

2003. In just the two years ending September 2003, 

total mortgage debt outstanding rose by $1.4 trillion, 

or 26 percent.3 Strong demand for housing, facilitated 

by low interest rates, has pushed home prices to their 

highest rates of appreciation in more than a decade. 

But this sturdy price appreciation has not been accompanied by equally strong personal income growth. Since 

2000, annual home price appreciation has averaged 

roughly 7 percent, while disposable per capita personal 

income gained 4 percent per year, on average (see 

Chart 1, next page). As a result, many observers, still 

smarting from the high-tech stock bubble of 2000, are 

uneasy over the longevity of this housing upturn and its 

seeming disconnect from fundamentals such as income. 

They fear an abrupt end to what they perceive as a 

bubble in the value of U.S. homes. 

...But Housing May Be More Resistant 

to Bubbles than Other Assets 

On the surface, the performance of the housing market 

in recent years appears to be consistent with a burgeoning asset bubble. And because housing typically is a 

leveraged asset, purchasing, or “investing,” in housing 

can be viewed as comparable to buying stocks on margin, 

with similar risk, in that a homeowner can potentially 

go “underwater,” owing more on the asset than it might 

fetch if resold at the prevailing market price. 

However, the analogy to stocks ends there. There are 

several reasons why housing, particularly owneroccupied housing, is less prone to price bubbles than 

3 Federal Reserve Board, Flow of Funds data. 

FDIC OUTLOOK 3 SPRING 2004 
In Focus This Quarter 

Chart 1 

Sources: Office of Federal Housing Enterprise Oversight; U.S. Bureau of the Census. 

Home Prices Have Advanced at a Quicker Pace than After-Tax Incomes during 

the Past Several Years, Raising Concerns of an Asset Bubble in Home Prices 

Paired-sales home price index and disposable 

per capita personal income; percentage change one year ago. 

85 

12 

10 

8 

6 

4 

2 

0 

86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 

Disposable per capita income Home price index

(Four quarter moving average) 

Recessions 

stocks. For example, homeowners cannot short 

their housing asset readily, nor is there a margin call 

demanding additional funds when prices drop below 

the outstanding mortgage balance. Also, the trading 

volume in the housing market is much less than in 

Table 1 

the financial asset markets, since housing turns over 

far less frequently. 

Further underscoring differences in these assets are 

unique characteristics and structural attributes that 

Attributes of the Housing “Asset” That Mitigate Against 

Price Collapse following a Boom, in Contrast to Stocks 

Attribute Mitigating Effect 

Utility Housing provides shelter as well as privacy, choice, and comfort. Homeowners live in their “asset.” 

Stockowners do not. 

High Transaction Costs The costs required to secure and vacate a house are huge with respect to time, fees, effort, and 

household disruption. The high transaction costs for housing generally discourage rapid, repeat 

buying and selling, unlike equity markets, where discount brokerages have pushed trading fees to 

very low levels in recent years. 

Tax Advantages Homeowners enjoy the tax benefit of mortgage interest deductibility, and buyers can usually deduct 

loan points and origination fees. Alternative living arrangements, such as renting or living with one’s 

parents, do not convey similar tax relief. Also, unlike stock sales, gains from home sales are tax 

advantaged in some instances. 

Breadth of Ownership There is no “nationwide” market for housing as there is for other assets, and a large majority of 

single-family homes are owner-occupied.a Stock ownership is more likely than housing to reflect 

trader/investor holdings, which are maintained only as long as they are profitable or provide some 

benefit, such as diversification. Stock prices reflect millions of decisions brought together in a 

single collective marketplace. Stock investors’ buy-sell decisions in response to reported earnings 

can immediately and significantly influence stock price movements. In contrast, housing prices are 

driven by local factors, as most homeowners do not live in homes that are geographically far 

removed from their jobs or family. 

Intangible Benefits Homeownership is thought to convey other important benefits aside from investment returns and 

shelter, contributing to neighborhood stability and social involvement. In addition, there is some 

evidence that homeownership contributes to more positive outcomes for children.b 

a Of total occupied single-family units, 84.6 percent are owner-occupied according to the U.S. Bureau of the Census, American Housing Survey for the United States, 2001. 

b Richard K. Green and Michelle J. White, “Measuring the Benefits of Homeowning: Effects on Children,” Journal of Urban Economics, 41, 1996, pp. 441–461. 

Source: FDIC. 

FDIC OUTLOOK 4 SPRING 2004 
In Focus This Quarter 

make housing less vulnerable than any other asset 

to severe boom and bust price swings (see Table 1). 

Housing’s unique characteristics of utility, transaction 

mechanisms, and financial treatment are not comparable to those of assets such as equities. The confluence 

of these factors mitigates speculative tendencies and 

allays the potential for a price collapse. 

There Is No U.S. Housing Bubble, but Local Volatility 

Has Occurred 

Although reliable price histories do not exist, it is recognized that home prices fell precipitously in many areas of 

the nation during the Great Depression. This drop could 

be likened to a national boom/bust or bubble in housing. 

However, the structure of mortgage finance, which 

played an important role in that episode, has changed 

profoundly since that time. Before the 1930s, mortgage 

Chart 2 

credit typically took the form of short-term, callable, 

nonamortizing loans. As home prices fell, homeowners 

often could not refinance when their loans came due or 

were called by the bank. The result was a wave of real 

estate liquidation that drove prices downward. In 

response, federal mortgage programs established in the 

aftermath of the Depression took the form of long-term, 

noncallable, amortizing notes that created the standard 

of modern U.S. mortgage finance. These institutional 

changes eliminated a major avenue for any systemic 

price collapse in U.S. housing markets resulting from a 

severe nationwide economic shock. 

While some systemic factors, such as mortgage interest 

rates, influence home prices across the country, most 

influences on home prices are local. They include 

supply-side factors, such as the availability of developable land and local construction costs, and demandside factors, including changes in employment, real 

U.S. Price T rends 

Los Angeles: Boom and Bust 

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999 

2000

2001

2002

2003

–15 

–10 

–5 

0 

5 

10 

15 

20 

25 

30 Columbus: Boom and Steady 

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999 

2000

2001

2002

2003

0 

2 

4 

6 

8 

10 

Des Moines: Stable 

–2 

0 

2 

4 

6 

8 

10 

0 

2 

4 

6 

8 

10 

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999 

2000

2001

2002

2003

Note: Y ear -over -year percentage change in home price index. 

Source: Office of Federal Housing Enterprise Oversight. 

Price Trends Vary Widely by City 

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999 

2000

2001

2002

2003

FDIC OUTLOOK 5 SPRING 2004 
In Focus This Quarter 

incomes, population, and taxes.4 Differences in these 

local factors tend to drive differences in home price 

performance across the country (see Chart 2). Markets 

where home price boom/busts have occurred in the 

past few decades have tended to exhibit two common 

features: (1) significant episodes of economic boom 

and bust, affecting demand through large employment 

and population changes, and (2) limited space for new 

development, constraining adjustment in the supply 

of new housing. 

Many areas of the “oil patch” of Texas, Louisiana, and 

Oklahoma experienced large percentage declines in 

home prices during the last half of the 1980s. Major 

markets in New England and California experienced 

smaller price declines between 1989 and 1995. These 

regions shared some of the problems associated with 

the “rolling regional recession” of the 1980s, when 

boom times were followed by job losses, bank failures, 

and, often, significant outmigration. On a national 

scale, however, the U.S. repeat-sales home price index, 

published by the Office of Federal Housing Enterprise 

Oversight (OFHEO), has never shown an annual 

decline in its 27-year history. 

Price declines such as those associated with the rolling 

regional recession of the 1980s typically can be attributed to demand-side factors. However, supply-side 

issues also come into play. While markets typically 

clear by adjustments in price and quantity, markets 

where supply is constrained must clear more through 

price change. Coastal markets or those with strict 

zoning, such as in California and the Northeast, 

historically have shown wider swings in home price 

appreciation, attributable in part to the difficulty of 

expanding supply during a boom (see Map 1). 

Thus, owing to the combination of demand- and 

supply-side factors, markets with both volatile 

demand and constrained supply are likely to see more 

pronounced price swings than markets experiencing 

just one or the other. While a nationwide housing 

bubble appears unlikely at this time, some markets 

are experiencing significant price swings, reflecting 

changing local economic, demographic, or affordability conditions. 

4 Stephen Malpezzi, “Housing Prices, Externalities, and Regulation in 

U.S. Metropolitan Areas,” Journal of Housing Research, Vol. 7, Issue 

2, 1996, pp. 209–241. 

Map 1 

Cities with Widest Price Swings, 1980–2002 

Top 20 percent of Metropolitan Statistical Areas, ranked by difference

in maximum and minimum annual percentage change in home price

index, were clustered along the coasts. Honolulu (not shown) had the 

widest swing. 

Sources: Office of Federal Housing Enterprise Oversight; Freddie Mac (the 26 cities 

plotted are top 20 percent of 130 metropolitan areas with necessary data history). 

The most recent OFHEO data (see Table 2, next page) 

show that markets registering the weakest home price 

growth are, for the most part, cities that have seen 

significant recent economic deterioration as a result of 

the loss of dot-com or telecom jobs or, in the case of 

Salt Lake City and Provo, Utah, a post-Olympics 

slump. The markets with the strongest home price 

growth are mostly cities in California and the Northeast that typically have shown a tendency toward wide 

price swings because of supply constraints. These 

markets generally did not experience a disproportionate level of economic distress during and after the 

2001 recession. 

The history of U.S. home prices suggests a clear potential for home prices to decline in individual markets, 

particularly in cities that have shown wide price swings 

in the past and where prices recently have risen 

dramatically. However, this same history also strongly 

suggests that it is highly unlikely that home prices will 

fall precipitously across the entire country—even if 

rising interest rates raise the cost of mortgage borrowing 

and reduce housing affordability. Further, a significant 

price decline does not inevitably follow a sharp rise in 

local home prices. In many cases, the aftermath of a 

housing boom has been characterized by slower sales 

and price stabilization until the underlying fundamentals have a chance to catch up with market prices. 

Understanding the behavior of both buyers and sellers is 

key to understanding home price dynamics. Were prices 

to fall in certain markets, history and academic research 

suggest that potential sellers would tend to withdraw 

from the marketplace rather than proceed with panic 

sales. In fact, studies show that “household mobility 

FDIC OUTLOOK 6 SPRING 2004 
In Focus This Quarter 

Table 2 

Variations in Home Price Appreciation 

(annual percentage change in home prices, 

third quarter 2003) 

10 Fastest Markets 10 Slowest Markets 

Fresno, CA 16.05% Austin, TX –0.31% 

Fort Pierce, FL 14.70% San Jose, CA 0.43% 

Redding, CA 14.44% Boulder, CO 1.07% 

Chico, CA 13.79% Denver, CO 1.35% 

Riverside, CA 13.34% Springfield, IL 1.57% 

Providence, RI 12.03% Provo, UT 1.62% 

Bakersfield, CA 12.01% Lafayette, IN 1.69% 

San Diego, CA 11.90% Salt Lake City, UT 1.73% 

Ventura, CA 11.81% Fort Collins, CO 1.73% 

Santa Barbara, CA 11.62% Greensboro, NC 1.89% 

Source: Office of Federal Housing Enterprise Oversight. 

[selling] is significantly influenced by nominal loss aversion,” or a willingness to continue to hold the asset and 

take further losses in the hope that the price will go up 

one day.5 Because of homeowners’ loss aversion, homes 

tend to stay on the market longer with asking prices set 

well above selling prices, and many sellers withdraw 

their homes without sale.6 This behavior is typical in all 

but the most economically distressed markets. Unless 

the number of homeowners who must sell because of job 

or income loss is a significant portion of sellers in a 

market, weakness in a local real estate market is more 

likely to result in a slowdown in transactions than a 

plunge in home prices. Although owners may be more 

inclined to sell in a down market if the property is not 

their primary residence, high transaction costs weigh 

against quick “trades” by investors. 

Credit Quality Concerns May Pose Greater Risks 

The previous discussion indicates that concerns over 

an imminent, widespread collapse in home prices are 

somewhat misplaced. Of greater and broader concern 

are rising levels of consumer and mortgage debt and 

the decline in the quality of that debt. The recent 

5 Gary V. Engelhardt, Nominal Loss Aversion, Housing Equity 

Constraints, and Household Mobility: Evidence from the United States, 

CPR Working Paper Series # 42, Syracuse, NY: Center for Policy 

Research, Syracuse University, 2001. 

6 D. Genesove and C.J. Mayer, “Nominal Loss Aversion and Seller 

Behavior: Evidence from the Housing Markets,” Quarterly Journal 

of Economics, 116, 2001, pp. 1233–1260. 

period of historically low mortgage rates has left the 

economy in uncharted territory with respect to household indebtedness. Among the new homeowners who 

have pushed the nation’s ownership rate to record 

levels are those with high leverage, volatile incomes, 

or limited wealth. Many of these buyers realized the 

American dream of home ownership only through lowdown-payment, variable-rate mortgages obtained during 

a time of historically low interest rates. As interest rates 

rise, these homeowners may see their incomes strained 

by rising debt service costs, while slower home price 

appreciation limits their ability to build equity and 

lower their leverage. The remainder of this article 

explores these household credit quality concerns. 

Mortgage credit quality indicators exhibited some 

weakness during the 2001 recession and, in the ensuing 

period, have shown slight improvement. Since peaking 

in the third quarter of 2001 at 4.83 percent, delinquencies on all residential mortgage loans have declined 

to 4.28 percent.7 Similarly, credit quality problems 

in construction and development (C&D) loans have 

moderated somewhat. The ratio of delinquent C&D 

loans to total C&D loans has fallen to 1.8 percent as 

of September 2003 from its recent peak of 2.6 percent 

two years ago.8 However, volatility in home prices 

could contribute to consumer credit quality concerns. 

According to data from LoanPerformance Corporation, 

more than three-quarters of currently outstanding mortgage debt has been originated in the past three years, 

thanks primarily to robust home purchase and refinance 

activity facilitated by record low mortgage rates. With 

these loans underwritten on the basis of recent high 

collateral values, a decline in home values in some 

markets could lead to default activity and losses to 

residential lenders. In particular, high-risk borrowers 

may default in increasing numbers should interest rates 

rise and home prices fall. The number of speculative 

homebuilders also may elevate construction lending 

risk in some markets. 

Mortgage Debt and Consumer Credit Present Risks 

During and after the 2001 recession, persistently low 

interest rates prompted households to add consumer 

debt rather than deleverage. During the year ending 

September 2003, U.S. households added nearly 

7 Mortgage Bankers Association/Haver Analytics. 

8 FDIC Call Report data, September 30, 2003. 

FDIC OUTLOOK 7 SPRING 2004 
In Focus This Quarter 

Chart 3 

Subprime Mortgage Origination Volumes 

Have Grown Sharply but Remain Steady 

as a Share of the Overall Market 

*2003 data are year-to-date through June. 

Sources: Inside B&C Lending; Mortgage Bankers Association of America. 

Subprime Mortgage Originations Subprime Share of Total Originations $ BillionsPercent 

0 

3 

6 

9 

12 

15 

0 

55 

110 

165 

220 

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003* 

$925 billion in debt to their balance sheets, an 

increase of more than 11 percent.9 Households have 

not assumed debt so quickly since the late 1980s. 

The sustained increase in the aggregate financial 

obligations of homeowners is attributable to both 

higher leverage and a higher rate of homeownership, 

especially among borrowers with fewer financial 

resources. The amount of household credit debt is 

not worrisome in itself, but its concentration among 

high-credit-risk households may pose additional risk 

to residential lenders. Nonmortgage consumer lenders 

also may bear some risk if liquidity issues result in a 

reprioritization of debt repayment. Households may 

Chart 4 

make repaying mortgages a higher priority than repaying unsecured consumer credit, such as credit cards. 

Over the past decade, changes in lending standards and 

the introduction of subprime and high loan-to-value 

(HLTV) mortgages have allowed new homeowners to 

qualify for mortgages despite higher overall debt levels 

and lower down payments. Between 1993 and 2001, 

the subprime share of all home purchase mortgage originations in metropolitan areas climbed from 1.3 percent 

to 6.5 percent, while the subprime share of refinance 

loans jumped from 2.1 percent to 10.1 percent (see 

Chart 3).10 

The popularity of subprime loans carries risk, as 

subprime loans historically have exhibited default 

rates on the order of ten times greater than prime 

loans extended to borrowers with solid credit 

records.11 HLTV mortgages also have shown higher 

default rates. In 2002, loans exceeding 80 percent 

of the home purchase price accounted for more than 

35 percent of all purchase mortgages underwritten 

in 40 percent of the nation’s metropolitan areas. 

In some cities, loans exceeding 80 percent of the 

home purchase price accounted for over 50 percent 

of originations during 2002 (see Chart 4).12 

Higher interest rates also could have implications 

for mortgage credit risk. According to the Mortgage 

Bankers Association, during 2003, 20 percent of 

* Loan-to-purchase price data are for conventional purchase money mortgages only. 

Source: Federal Housing Finance Board (2002). 

Low Down Payments in Some Markets Could Elevate Default Risks 

Memphis

Rochester

Oklahoma City

Syracuse

Kansas City

Tulsa

Greenville

Buffalo

Birmingham

Greensboro

Charlotte

Grand Rapids

Dayton

Jacksonville

Omaha

Phoenix

Atlanta

St. Louis

Tucson

Columbus

Indianapolis

Cleveland

Las Vegas 

> 90% loan-to-purchase price* 

80–90% loan-to-purchase price* 

Share of High-Leverage Home Purchase Loans Originated in 2002 

0 

11 

22 

33 

44 

55 

66 

Percent 

9 Susan Burhouse, FYI: Evaluating the Consumer Lending Revolution, 

Washington, DC: Federal Deposit Insurance Corporation, September 

17, 2003. 

10 Joint Center for Housing Studies of Harvard University, The State of 

the Nation’s Housing, Cambridge, MA, 2003. 11 Ibid. 

12 Federal Housing Finance Board. Monthly Interest Rate Survey, 2002. 

FDIC OUTLOOK 8 SPRING 2004 
In Focus This Quarter 

Chart 5 

Home Purchasers in Higher-Priced Markets Opt 

for Adjustable-Rate Mortgages More Frequently 

Note: Data include mortgages originated for home purchases only; exclude refinancings. 

Source: Federal Housing Finance Board. 

Nation 

Washington, DC 

Seattle 

San Francisco 

San Diego 

Salt Lake City 

Portland 

Phoenix 

Philadelphia 

New York 

Minneapolis 

Miami 

Los Angeles Kansas City 

Indianapolis 

Honolulu 

Detroit 

Denver 

Dallas 

Chicago 

Boston 

Atlanta 

0 

10 

20 

30 

40 

50 

60 

140 180 220 260 300 340 380 420 

Average purchase price (1999–2002, $ thousands) 

Average annual share of home purchase mortgages 

with adjustable rates (1999–2002, %) 

conventional mortgages were originated using 

adjustable rate mortgages (ARMs), despite a historically 

low fixed-rate environment. After equalizing for differences in the credit quality of borrowers, ARMs offer 

lower rates than fixed-rate loans during any part of the 

interest-rate cycle. Thus, they improve affordability and 

allow buyers to purchase more expensive homes for any 

given monthly payment. However, these loans also 

expose homeowners to rising interest rates, since the 

debt service cost on ARMs is tied to short-term interest 

rate movements. This feature can increase credit risks 

for lenders when interest rates and monthly mortgage 

payments rise. 

Although the 20 percent figure cited previously seems 

modest, it masks a rising trend during 2003. The share 

of ARMs rose from roughly 14 percent of all conventional mortgages underwritten in January to 32 percent 

by December, even though conventional 30-year fixed 

mortgage rates fell during the year. This trend suggests 

that at least some homebuyers were stretching to keep 

their monthly payments manageable in the face of 

rising home prices. Affordability is a persistent issue 

in the highest-priced U.S. housing markets, such as 

San Francisco, San Diego, Los Angeles, New York, 

Boston, Seattle, and Denver. As a result, borrowers in 

these markets use ARMs more frequently than borrowers elsewhere (see Chart 5).13 Not only do high home 

prices require more borrowers to seek ARMs, but many 

of these cities historically have posted some of the 

widest home price swings (see Map 1). As a result, 

13 Allen Puwalski and Norman Williams, FYI: Economic Conditions and 

Emerging Risks in Banking, Washington, DC: Federal Deposit Insurance Corporation, November 4, 2003. 

homeowners in these markets are potentially exposed 

to both rising monthly mortgage payments and falling 

house prices if interest rates rise. 

Subprime borrowers are another group of homeowners 

with a disproportionate exposure to rising interest rates. 

Based on our estimates, subprime mortgage borrowers 

seemed about twice as likely to hold ARMs as conventional borrowers during 2003.14 The exposure of these 

households to rising interest rates compounds the credit 

risk associated with subprime consumer portfolios. 

Home equity lines of credit (HELOCs) may carry even 

greater credit risk than ARMs when interest rates rise 

or home prices decline. HELOCs, set up as lines of 

credit from which homeowners can draw up to a maximum loan amount based on the equity in the home, 

may extend homeowner leverage well beyond 100 

percent. In addition, with a variable interest rate that 

fluctuates over the life of the loan, HELOCs involve 

greater interest rate risks for homeowners. In contrast 

to primary lien ARMs, most HELOCs do not have 

an adjustment cap to limit the size of any payment 

increase. Furthermore, changes in the prime rate affect 

the rates of HELOCs immediately.15 With HELOC 

debt currently at $254 billion and representing a 

commitment tied to home equity, credit quality in this 

segment could decline when interest rates rise.16 

Although private mortgage insurance (PMI) mitigates 

the risk of collateral losses to lenders, it does not cover 

all risks, specifically those from “piggyback” loans. By 

convention, borrowers are required to supply at least 

20 percent down to avoid paying for PMI. But certain 

loans, typically called 80-10-10 loans, are structured 

14 Our estimates are based on the following: As of the third quarter 

2003, 56 percent of the total mortgage loans (on a dollar basis) in the 

LoanPerformance subprime database were “non-fixed” (ARMs and 

hybrids). Given that over three-quarters of all mortgage loans were 

underwritten in the past three years, we used the share of conventional ARMs underwritten (data from the Mortgage Bankers Association weekly survey, on a dollar basis) during those years as a rough 

approximation for the total outstanding share of conventional mortgages in ARMs. These MBA data indicate that ARMs accounted for 

roughly one-fourth of the value of conventional mortgages underwritten between 2001 and third quarter 2003, or roughly one-half the LoanPerformance subprime figure. 

15 Certain HELOCs have guaranteed fixed introductory rates, but these 

rates typically are binding for only a few months. 

16 The amount of debt tied to HELOCs, as measured by revolving home 

equity loans at domestically chartered commercial banks, jumped 

from $106 billion in the first quarter of 2000 to $254 billion in the third 

quarter of 2003, averaging an almost 35 percent annual increase. 

Source: Federal Reserve Board. 

FDIC OUTLOOK 9 SPRING 2004 
In Focus This Quarter 

to avoid paying for PMI, and thus no insurance is 

obtained. Under an 80-10-10, a homebuyer with a 

10 percent down payment obtains a loan for 80 percent 

of the home’s purchase price at a standard interest rate 

and then gets a second, or piggyback, loan at 10 percent 

of the purchase price, but at a higher interest rate. 

This type of financing adds leverage over the traditional 20 percent down payment loan at the same time 

it avoids PMI, a safeguard for lenders. While lending 

programs such as piggybacks, subprime mortgages, and 

ARMs have allowed greater opportunities for homeownership, they also may present increased credit risks to 

lenders, particularly should interest rates rise or home 

prices fall. 

Residential Construction Lending Is an Additional 

Concern 

Another key component of credit risk associated with 

residential real estate is C&D lending. High levels of 

speculative residential construction would be of particular concern in a softening housing market, as residential developers and their lenders could face losses when 

actual sale prices differed from values assumed at the 

time loans were made. In addition, a recent Federal 

Deposit Insurance Corporation report17 noted that 

thinly capitalized builders and newer institutions seeking to expand market share also represent concerns in 

residential construction lending. 

17 Allen Puwalski and Norman Williams, FYI: Economic Conditions 

and Emerging Risks in Banking, Washington, DC: Federal Deposit 

Insurance Corporation, November 4, 2003. 

Conclusion 

In summary, because home prices have appreciated 

briskly over the past several years and outpaced income 

growth, concerns have been voiced about the possibility of a nationwide home price bubble. However, it is 

unlikely that home prices are poised to plunge nationwide, even when mortgage rates rise. Housing markets 

by nature are local, and significant price declines 

historically have been observed only in markets experiencing serious economic distress. Furthermore, housing 

markets have characteristics not inherent in other 

assets that temper speculative tendencies and generally 

mitigate against price collapse. Because most of the 

factors affecting home prices are local in nature, it is 

highly unlikely that home prices would decline simultaneously and uniformly in different cities as a result of 

some shift such as a rise in interest rates. 

The greater risk to insured institutions is the potential 

for increased credit delinquencies and losses among 

highly leveraged, subprime, and ARM borrowers. These 

high-risk segments of mortgage lending may drive overall mortgage loss rates higher if home prices decline or 

interest rates rise. Credit losses may, in turn, spill over 

to nonmortgage consumer credit products if households 

prioritize debt repayment to give preference to mortgage payment. Residential construction lending in 

markets where there is significant speculative building, 

as well as an abundance of thinly capitalized builders, 

also may be of concern, especially when the current 

housing boom inevitably cools. 

Cynthia Angell, Senior Financial Economist 

FDIC OUTLOOK 10 SPRING 2004 
In Focus This Quarter 

The FDIC’s Economic and Banking 


Outlook in Charts
 

Commercial Bank Exposures to Commercial 

Real Estate (CRE) Are High, but So Are Capital Levels 

Note: Includes multifamily, nonresidential, and construction and development loans. 

Source: Bank Call Reports. Median CRE to Assets (%)

U.S. Median New York Region 

Atlanta Region 

Chicago Region 

Kansas City 

Region 

Dallas Region 

San Francisco Region 

Media Capital to Assets (%) 

0 

5 

10 

15 

20 

25 

30 

35 

9.0 9.2 9.4 9.6 9.8 10.0 

Business Investment Contributed Positively 

to Economic Growth Last Year, after Weighing 

Against It in 2002. The Weaker Dollar Also 

Helped to Make Trade Less of a Negative 

Source: Bureau of Economic Analysis. 

Consumption Business 

Investment 

Housing Trade Government 

Contribution to real gross domestic product growth 

percentage points, 2002 (light blue) and 2003 (dark blue) 

–1.0 

–0.5 

0.0 

0.5 

1.0 

1.5 

2.0 

2.5 

3.0 

Despite Stronger Economic Activity, the Economy Has 

Yet to Generate Substantial Job Growth 

Source: Bureau of Labor Statistics. 

Change in nonfarm payrolls 

(thousands) 

–400 

–200 

0 

200 

400 

600 

1999 2000 2001 2002 2003 2004 

Manufacturing Survey Shows Strongest Surge 

in Output in Over 20 Years and a Net Increase 

in Hiring for the First Time in Over 3 Years 

Source: Institute for Supply Management. 

30 

40 

50 

60 

70 

80 

1990 1992 1994 1996 1998 2000 2002 2004 

ISM Manufacturing Index Subcomponents 

Diffusion index. Readings above 50 indicate net expansion. 

Production 

Hiring 

The Trend in Long-Term Asset Growth Has Been 

Widespread among FDIC-Insured Commercial Banks 

Note: Long-term assets have a next repricing date or ultimate maturity greater than 

five years. 

Source: Bank Call Reports (year-end data for 2000–2002, third quarter data for 2003). 

Median long-term assets to earning 

assets (%) 

0 

5 

10 

15 

20 

25 

30 

35 

United 

States 

Region 

Atlanta 

Region 

Chicago 

Region 

Dallas 

Region 

Kansas 

City 

Region 

New York 

Region 

San 

Francisco 

Region 

2001 2002 2003 

Bank and Thrift Exposure to Consumer Lending 

Has Risen as Personal Bankruptcies 

Hover Near Record Highs 

Note: Consumer loans include permanent residential mortgages, home equity lines, 

credit cards, and all other consumer loans. 

Sources: FDIC Research Information System; Administrative Office of the U.S. Courts 

(Haver Analytics). 

25 

26 

27 

28 

29 

30 

31 

98Q2 99Q2 00Q2 01Q2 02Q2 03Q2 

Average Consumer Loans to Assets (%) Personal Bankruptcy Filings 

(thousands) 

400 

300 

200 

FDIC OUTLOOK 11 SPRING 2004 
In Focus This Quarter 

The U.S. economic expansion accelerated and 

became more balanced in 2003. Consumer spending 

gains continued apace, while business investment 

rebounded, commercial real estate investment was 

less of a drag, and the weaker dollar helped to make 

international trade a positive contributor to growth 

during three of four quarters last year. But job growth 

remains the most obvious missing link to a sustainable, vigorous economic expansion. During the five 

months ended January 2004, nonfarm payroll growth 

averaged only 73,000 per month. Gains at more than 

double that pace are needed to bring unemployment 

down appreciably. The factory sector, which is starting to show signs of improvement in orders and 

output, has been the main drag on overall job growth 

since the recession ended in November 2001. 

Looking forward, real GDP is expected to gain 

about 4.5 percent this year on stronger growth in 

business investment, inventory building, and exports. 

Consumer spending should maintain a moderate pace 

of growth and may be boosted in the short term by 

a favorable tax refund season. Most analysts expect 

inflation and interest rates to remain relatively low. 

The major risk to this favorable outlook remains the 

employment situation. Without stronger job growth, 

consumer income, confidence, and spending could 

weaken, dampening the prospects for economic 

growth beyond midyear. 

During the first nine months of 2003, more than 94 

percent of FDIC-insured institutions were profitable, 

and the industry’s return on assets (ROA) reached a 

record 1.37 percent. The FDIC’s outlook for banking 

in 2004 remains positive, given favorable economic 

trends, improving asset quality, strong earnings, and 

high capital levels. However, the industry does face 

some challenges in the coming year. 

High and increasing levels of long-term assets have 

created some exposure to rising interest rates. Moreover, there is a question regarding whether the 

household sector—the engine for banking growth 

through the 2001 recession and beyond—could 

falter. Sources of concern about households include 

rising indebtedness, the near-record pace of personal 

bankruptcy filings, and the possibility that consumer 

spending could tail off once the effects of the 2003 

tax cut and the 2003 mortgage refinancing boom run 

their course. 

Another challenge for the banking industry is in 

commercial real estate, where lending concentrations 

are high and market fundamentals have been poor. 

Offsetting these challenges is a solid financial picture 

for the industry, where measures of earnings and 

capital are generally at or near record levels. 

Norman Williams, Chief, Economic Analysis Section 

Allen Puwalski, Chief, Financial Institutions 

Analysis Section 

Jack Phelps, CFA, Regional Manager 

Scott Hughes, Regional Economist 

FDIC OUTLOOK 12 SPRING 2004 
Regional Perspectives 

Atlanta Regional Perspectives
 

Manufacturing in the Atlanta Region: A Help

or Hindrance to a Recovery in Employment

Growth? 

Although a rebound in employment 

growth late in 2003 fueled optimism 

about the nation’s economy in 2004, 

the manufacturing sector has 

continued to shed jobs, prompting 

concern about whether this sector 

will be a net asset or liability. 

Manufacturing is a critical economic component 

in several Atlanta Region 

states; shares of employment in the manufacturing sector in Alabama, 

Georgia, and North and 

South Carolina exceed the national 

ing sector’s overall contribution to 

average of 12 percent. The manufactureconomic growth in the Region likely will be 

a function of the type of industry and the extent of 

geographic concentration. This article identifies critical 

manufacturing industries in the Region, examines their 

recent performance and prospects for future growth, 

and assesses implications for local economies and the 

banking industry. 

Perspectives on Industry Performance: Structural 

and Cyclical Considerations 

Manufacturing industry performance is influenced by 

long-term (structural) and short-term (cyclical) trends. 

In the short term, manufacturing closely follows the 

economic cycle, although performance tends to be 

more volatile than in other sectors of the economy. 

If economic growth picks up, the performance of the 

manufacturing industry typically improves. In the long 

term, structural factors can constrain industry performance and potential gains in employment.1 Nationwide, during the past few years, increasing competition 

(and industry relocation) from overseas firms and the 

slow-paced economic recovery have contributed to 

1 Long-term industry trends often include greater automation, cost 

competitiveness (both domestically and internationally), use of parttime or contract workers, and niche or specialized manufacturing. 

significant job losses in the manufacturing sector. 

Locally, the net effect of structural and cyclical forces 

can be magnified by specific industry concentrations. 

Areas with large shares of employment in particular 

industries—those that continue to shed jobs because 

of structural forces—are less likely to participate in 

an economic recovery once cyclical effects moderate. 

The Atlanta Region is home to several critical 

manufacturing industries. 

Although the Atlanta Region is home to a variety of 

manufacturers, our analysis is limited to the relationship between structural and cyclical effects in two types 

of industries—those classified as “traditional” or 

“emerging” based on location quotient analysis.2 Traditional industries are defined as those that are relatively 

more concentrated in the Region than in the nation in 

terms of shares of total employment or, statistically, 

those with a location quotient greater than one in 

2002.3 Emerging industries are classified as those with 

a location quotient that increased between 1992 and 

2002, indicating that these industries have become 

increasingly concentrated in the Atlanta Region. 

Seven industries satisfied the definition of a traditional 

industry (see Table 1, next page), and they can be 

described in a number of ways.4 First, these industries 

continued to represent a large share of the manufacturing sector, accounting for just over 33 percent of all 

employment, compared with 21 percent nationally. The 

textiles subsector, despite decades of erosion, remains 

the Region’s largest industrial employer, with more 

than 300,000 workers, and is characterized by a location quotient that exceeds four. Second, the location 

2 Approximately 30 percent of manufacturing employment in the 

Atlanta Region was not classified as either traditional or emerging 

because these jobs did not meet our criteria. Chemicals, although a 

large employer in the Region, with more than 150,000 workers and 

considered a critical industry in certain local areas, is characterized 

by a location quotient less than one in 2002, down 0.17 points from a 

decade earlier. 

3 A location quotient measures an industry’s share of local employment relative to the corresponding national share. Algebraically, the 

calculation is shown as 

Industry Location Quotient (LQ) = 

[Local Industry Employment/Total Local Employment]/ 

[National Industry Employment/Total National Employment]. 

If the calculated ratio is greater than one, an industry is more 

concentrated locally than nationally. Refer to the Atlanta Regional 

Outlook, Spring 2003, for more information. 4 Textiles, beverage and tobacco products, furniture, wood products, 

apparel, paper products, and nonmetallic mineral products. 

FDIC OUTLOOK 13 SPRING 2004 
Regional Perspectives 

quotient in each traditional industry has declined 

during the past ten years. Third, during the past year, 

national employment in traditional industries has 

declined at a more rapid rate than employment in 

emerging industries. National employment in the 

apparel manufacturing subsector alone fell by more 

than 16 percent. Comparatively weaker performance in 

traditional industries presumably can be attributed in 

part to greater ongoing structural erosion during the 

cyclical downturn. Given the greater number of traditional compared with emerging industry exposures in 

the Atlanta Region, manufacturing employment losses 

have continued to outpace those at the national level. 

In contrast, six critical industries in the Atlanta Region 

are characterized by location quotients that increased 

between 1992 and 2000 and therefore are classified as 

emerging industries.5 Although all industries except 

food processing lost employment during the past year, 

the decline was almost half that experienced by traditional industries. Transportation equipment, namely 

automobile manufacturing, is a good example of this 

type of industry. Manufacturers have relocated or built 

Table 1 

new facilities in recent years to take advantage of the 

Region’s low cost of doing business. Similarly, during 

the high-tech boom, the Region benefited from growth 

in computer and electronics equipment manufacturing. 

If the economic recovery continues to strengthen in 

2004 or cyclical forces moderate, these industries may 

contribute more toward job growth, as they, unlike 

traditional industries, may not be vulnerable to structural employment losses. 

The strength of the economic recovery in certain 

areas of the Atlanta Region may be a function of 

industry exposure. 

The degree of economic diversity varies widely across 

the Atlanta Region, and geographic exposure to either 

traditional or emerging industries may affect an area’s 

economic growth prospects significantly. Some areas 

stand out in our analysis as a result of high exposures to 

a number of traditional industries. The Greensboro and 

rural North Carolina areas, for example, have location 

quotients greater than one for every traditional industry 

identified in our study. Moreover, employment in traditional industries is high, accounting for 11 percent of 

The Atlanta Region’s Industrial Base Reflects Its Diversity 

Atlanta Region Nation 

Industry Location Quotients Industry Employment Year-Ago Job Growth 

(Ranked by 2002 location quotient) 1992 2002 2002 2003 Q3 

Manufacturing 1.03 0.94 2,746,501 –4.3% 

Traditional Industries 

Textiles 4.42 4.11 316,279 –9.8% 

Beverage and Tobacco Products 1.68 1.39 47,945 –5.4% 

Furniture 1.70 1.38 118,925 –5.0% 

Wood Products 1.38 1.32 177,086 –2.9% 

Apparel 1.72 1.16 104,330 –16.1% 

Paper Products 1.13 1.08 117,662 –4.2% 

Nonmetallic Mineral Products 1.11 1.07 104,407 –3.3% 

Emerging Industries 

Food Manufacturing 0.91 0.94 248,947 0.5% 

Primary Metal Manufacturing 0.79 0.81 83,735 –6.6% 

Printing and Publishing 0.78 0.80 196,797 –2.1% 

Transportation Equipment 0.66 0.77 224,696 –3.3% 

Computer and Electronic Manufacturing 0.65 0.67 208,234 –7.5% 

Petroleum and Coal Products 0.23 0.37 8,024 –1.7% 

Sources: Bureau of Labor Statistics/Haver Analytics; Global Insight, Inc. 

5 Food processing, primary metal manufacturing, print and publishing, transportation equipment, computers and electronic manufacturing, and 

petroleum and coal products. 

FDIC OUTLOOK 14 SPRING 2004 
Regional Perspectives 

all jobs in the Greensboro metropolitan statistical area 

(MSA). Although the Greensboro MSA is characterized by a concentration in printing and publishing, 

employment in traditional industries is nearly three 

times as high as employment in this emerging industry. 

The Danville, VA; Florence, SC; and Hickory, NC 

MSAs not only have relatively high concentrations in 

multiple traditional industries but also are characterized 

by greater levels of aggregate employment in traditional 

compared with emerging industries (see Table 2); rural 

areas of Alabama, Georgia, and South Carolina can be 

described similarly. Continued erosion in traditional 

industries, combined with increasing overseas competition and greater use of automation, likely will constrain 

any recovery in economic growth in areas where exposures to traditional industries remain high. 

In contrast to the potential downside risks associated 

with a concentration of traditional industries, relatively 

high exposures to emerging industries may contribute 

to a rebound in economic growth if cyclical pressures 

moderate. Although these industries exist in several 

areas in the Region, our analysis determined that their 

presence frequently was eclipsed by the scale of traditional industry employment. Greenville, SC, for example, boasts a healthy transportation equipment industry 

(automobiles), which is an emerging industry. However, 

this area also is home to high employment concentrations in textiles, apparel, furniture, and nonmetallic 

mineral products (four traditional industries); employment in the aggregate for these traditional industries 

Table 2 

was 50 percent higher than in emerging industries. 

The situation is reversed in other areas, such as the 

Tuscaloosa, Birmingham, Dothan, and Huntsville, 

AL; and Charlottesville, VA, MSAs, which have relatively high exposures to emerging industries and aggregate employment in emerging industries that exceeds 

that for traditional industries. A number of metropolitan areas in Florida have employment exposures to 

single emerging industries, such as computer or transportation equipment manufacturing, and no traditional 

industries; however, employment in emerging industries 

remains low. 

Although equity performance points toward a moderation in cyclical constraints in several traditional and 

emerging industries, total manufacturing job growth 

has yet to recover. Many economists are forecasting 

a pick-up in the manufacturing sector because of a 

decline in the relative trade value of the dollar over 

the past year. Exports showed strength in late 2003, 

and a December survey of purchasing managers indicated the strongest foreign demand for U.S. goods in 

14 years.6 While accelerating export activity is positive 

news, it is uncertain which industries will benefit most. 

What Are the Implications for Banking? 

During the past 12 months, industry employment exposures in the Atlanta Region may have played a role in 

community bank loan performance.7 Overall, credit 

Chart 1 

Several Areas of the Atlanta Region Have 

Multiple Exposures to Traditional Industries 

Traditional Industries1 

Community Banks Based in States Characterized by
 

Relatively Significant Shares of Employment in
 

Traditional Manufacturing Industries Tended to Report
 

Traditional/ 

Number Emerging 

with High2 Employment, Employment 

Area Concentration 2002 Ratio 

Greensboro, NC 7 71,838 2.9 

Rural North Carolina 7 106,270 2.1 

Rural Alabama 6 75,088 2.1 

Danville, VA 6 9,365 3.8 Year-over-Year Basis Point

Change in Total Noncurrent Loans

(September 2002–September

2003) 

Greater Weakening in Credit Quality 

15 

10 

5 

0 

–5 

–10 

–15 

–20 

–25 

–30 

AL 

FL 

GA

NC

SC

VA 

WV 

High

Traditional

Low

Traditional 

Florence, SC 6 3,615 2.2 

Rural Georgia 6 32,026 2.1 

Hickory, NC 6 48,947 4.4 

Rural South Carolina 5 41,766 2.1 

1

Textiles, beverage and tobacco products, furniture, wood products, apparel, paper, and
 

nonmetallic minerals.
 

2

Location quotient greater than one.
 

Source: Global Insight, Inc. 


* High/low traditional manufactures consist of an average change in noncurrent loans
 

across states with the respective industry exposures. Traditional industries consist of
 

textiles, beverage and tobacco products, furniture, wood products, apparel, paper products,
 

and nonmetallic mineral products.
 

Source: Bank Call Reports, September 30.
 

6 James C. Cooper and Kathleen Madigan, “The Economy’s Big Mo 

Is Beating Expectations,” Business Week, January 26, 2004. 

FDIC OUTLOOK 15 SPRING 2004 
Regional Perspectives 

The Region’s Large Banks Report Solid Financial	 11.5 percentage points to 19 percent at September 

30, 2003. Large banks have shifted portfolio empha- Performance 

sis from this traditionally higher-yielding asset class 

into lower-yielding one-to-four family mortgages, Profitability remained solid among large banks which have increased 8 percentage points during headquartered in the Atlanta Region. Median the same period to 33 percent of total loans. A return on assets (ROA) grew for a second straight healthy housing market and an unprecedented year and finished September 30, 2003, at 1.22 level of refinancing activity in 2003 combined percent, up 6 basis points from a year earlier. A with strong consumer demand helped offset weak- drop in net interest income was offset by lower ness in the commercial sector. provision expenses and securities gains, which 

led to the higher ROA figure. After rising in 

third quarter 2002, the median net interest margin Asset quality has continued to improve among the 

(NIM) slid during the most recent 12-month Region’s large banks. The ratio of median past-due 

period, falling 36 basis points to 3.60 percent by and nonaccrual loans as a percentage of total loans 

September 30, 2003. Nevertheless, a steeper yield fell for a second straight 12-month period to finish 

curve during third quarter 2003 may result in an September 30, 2003, at 1.44 percent, down 42 basis 

easing of margin pressures going forward, but a points from September 30, 2002. However, strong 

substantial improvement in the NIM is not likely loan growth, especially in the one-to-four family 

to occur until commercial loan growth improves. mortgage portfolio, may be amplifying the level of 

improvement. 

However, since third quarter 1999, commercial 

loans as a percentage of total loans have fallen 

quality has improved; the average noncurrent loan 

level reported by community banks in the Region 

declined during the year ending September 30, 2003. 

However, community banks based in states characterized by significant exposure to traditional industries 

reported an increase. For example, insured institutions 

based in Virginia, North and South Carolina, and 

Georgia reported an average increase in noncurrent 

loans of 11 basis points between September 30, 2002, 

and September 30, 2003. Community banks based in 

other states in the Region, or in states characterized by 

multiple exposures to emerging industries and where 

employment in emerging industries is greater than in 

traditional sectors, reported an average decline in 

7 Community banks are defined as commercial banks that hold assets 

less than $1 billion and exclude specialty institutions. 

noncurrent loan levels of 15 basis points during the 

same period (see Chart 1, previous page). 

Obviously, a variety of factors affect the performance 

of institutions in these states, and many of these factors 

take time to work through the financial statements of 

individual institutions. It is reasonable to expect that 

weaknesses in traditional industries are among the 

factors leading to differences in noncurrent ratios 

among institutions in states with concentrations in 

traditional industries versus emerging industries. These 

differences could widen if weakness in the manufacturing sector continue. 

Jack Phelps, CFA, Regional Manager 

Scott Hughes, Regional Economist 

Ron Sims, CFA, Senior Financial Analyst 

Pam Stallings, Senior Financial Analyst 

FDIC OUTLOOK 16	 SPRING 2004 
Regional Perspectives 

Chicago Regional Perspectives
 

Signs of Economic Improvement Are Uneven among 

Industry Sectors and States in the Chicago Region 

Certain key developments indicate that the Region’s 

economy is performing better than at any time since 

before the 2001 recession. For example, the Midwest 

Manufacturing Index (MMI) 

rose in third quarter 2003, the 

first gain in four quarters and 

the largest since early 2000. 

This upturn accompanied 

improvement in the Region’s 

labor market, as third-quarter 

job losses slowed to less than an 

annual rate of 0.5 percent (see 

Chart 1). The October MMI reading suggests that, even should no 

additional advance occur in November and December, 

this gauge of manufacturing activity in the Chicago 

Region will post an annual rate of increase of at least 

2.5 percent in fourth quarter 2003. 

To date, however, growth in output has not led to 

net gains in employment in the Region. Several 

sectors, such as leisure and hospitality, education and 

health, and professional and business services, hired 

additional workers even as large layoffs occurred in 

manufacturing and government during third quarter 

2003. Employment conditions among states also are 

uneven. Wisconsin, for example, is the only state 

in the Region to report an increase in employment 

during each of the first three quarters of 2003, while 

Chart 1 Percentage change (at annual rate) 

Sources: Federal Reserve Bank of Chicago; Bureau of Labor Statistics. 

Region’s Economy Improved in Third Quarter 2003: 

Manufacturing Output Rose and Pace 

of Job Loss Slowed 

–12.5 

–7.5 

–2.5 

2.5 

7.5 

12.5 

1Q99 3Q99 1Q00 3Q00 1Q01 3Q01 1Q02 3Q02 1Q03 3Q03 

Midwest Manufacturing Index 

Chicago Region 

job growth 

employment in Michigan fell by 1.3 percent during 

the same time frame. 

Nationally, the length of the workweek and number of 

overtime hours have been rising among factory workers, 

according to the Bureau of Labor Statistics. Longer 

workweeks and additional overtime help boost wages 

and salaries for this group, but manufacturers are not 

likely to hire additional workers until they use their 

existing workforce more fully. Gains in manufacturers’ 

orders in recent quarters suggest that factory output 

should continue increasing as 2004 unfolds, boosting 

capacity utilization rates, reducing job layoffs, and 

perhaps triggering hiring. 

However, until total employment in the Region shows 

sustained and broad-based gains, financial strains 

among some households and repercussions such as high 

personal bankruptcy and mortgage foreclosure rates 

likely will persist. In addition, some retired workers— 

such as those who worked for steel companies that filed 

for bankruptcy—are experiencing financial setbacks 

because of dramatic reductions in their pension and 

health benefits. When the Pension Benefit Guaranty 

Corporation assumes the defined-benefit pension obligations of firms that file for bankruptcy, pensioners’ 

monthly benefits are subject to a maximum amount 

that may be far less than they had been receiving or 

anticipated.1 

Not unexpectedly, signs of consumer repayment problems have emerged, and loan performance has deteriorated fairly quickly among one-to-four family mortgages. 

On September 30, 2003, the percentage of past-due 

or nonaccrual (PDNA) residential mortgages held by 

community institutions in the Region was relatively 

high, at 2.45 percent, and matched the rate for 

consumer loans.2 Putting this figure into perspective, 

during 1997 through 2001, third-quarter PDNA rates 

for one-to-four family mortgages ranged 45 to 60 basis 

1 Details about the Pension Benefit Guaranty Corporation (PBGC) and 

maximum monthly guarantee levels can be found at www.pbgc.gov. 

For information on defined-benefit pension plans and the PBGC, refer 

to “Could a Bull Market Be a Panacea for Defined Benefit Pension 

Plans?” FYI: An Update on Emerging Issues in Banking, January 13, 

2004, at www.fdic.gov/bank/analytical/fyi/2004/011304fyi.html. 2 Community institutions are nonspecialty banks and thrifts that have 

been in existence at least three years and hold assets less than 

$1 billion. 

FDIC OUTLOOK 17 SPRING 2004 
Regional Perspectives 

points lower than for consumer loans; in 1992 through 

1996, the difference was at least 90 basis points. 

Compared with other segments of the loan portfolio, 

the September 2003 PDNA rate for mortgages was 

exceeded only by commercial and industrial (C&I) 

loans (3.24 percent) and construction and development 

loans (2.73 percent). To date, however, the charge-off 

rate for mortgage loans remains relatively low. 

In contrast, the third-quarter PDNA ratio on one-tofour family mortgages held by the Region’s largest institutions (those holding assets of at least $20 billion) was 

3.32 percent, higher than for C&I loans (3.12 percent) 

and for other major loan groups. This relatively high 

PDNA ratio for mortgages could reflect a number of 

factors, including these institutions’ strategic policies 

and greater risk tolerance; geographic exposure beyond 

their local area; greater exposure to subprime, jumbo, 

and nonconforming loans; and use of third-party 

brokers or appraisers. As past-due mortgage rates rose, 

so did the average charge-off rate for mortgage loans 

among large institutions based in the Chicago Region. 

Third-quarter charge-off rates for one-to-four family 

mortgages have been 0.30 percent or higher since 2001, 

about triple the rate in the previous few years. 

In recent years, many homeowners refinanced their 

debt and locked in fixed-rate mortgages at low rates, 

an act that should help shelter them from rising debt 

burdens as interest rates rise. However, refinancing 

activity slumped in recent months as mortgage rates 

rose and the pace of home appreciation in the Region 

slowed. As a result, some households may be less able 

to support spending by taking equity out of their homes 

and lowering debt payment burdens. 

Rising Interest Rates Are Likely to Affect Earnings 

in a Variety of Ways 

Economic growth is improving and becoming more 

broad based across the nation; as a result, interest 

rates are expected to rise. Indeed, although the Federal 

Open Market Committee maintained the target fed 

funds rate at 1 percent at its December 2003 meeting, 

market forces have pushed up yields on intermediateand longer-term Treasury securities since midyear. For 

example, the yield on the five-year constant-maturity 

Treasury note in December was 100 basis points above 

the June low of 2.27 percent. With the exception of a 

brief interval from late 2001 into early 2002, the rise in 

rates during the second half of 2003 for securities with 

a maturity of one year or more reversed the three-year 

trend of falling rates that began early in 2000. 

Looking ahead, the Blue Chip Economic Indicators 

consensus forecast calls for the yield curve to show a 

parallel upward shift during 2004, as yields on threemonth Treasury bills and ten-year Treasury notes are 

expected to rise by 80 basis points.3 A subgroup of this 

forecast’s participants expects not only greater increases 

in interest rates but also a flattening of the yield curve; 

they forecast a 140-basis-point increase during 2004 in 

the three-month Treasury bill rate and a 110-basispoint increase for the ten-year note. 

Improving economic conditions and a shift from a 

sustained period of low interest rates to one of rising 

rates are expected to affect insured institutions based 

in the Chicago Region in a variety of ways. Some of 

the impact to date is illustrated by the following interest-sensitive components of the return on assets (ROA) 

ratio, which posted a modest decline in third quarter 

2003 relative to a year earlier (see Table 1). 

Securities gains: Unrealized gains on securities held 

for sale peaked in third quarter 2002. The decline 

since then reflects the fact that insured institutions not 

only realized some gains by selling securities but also 

lowered securities portfolio valuations as interest rates 

rose after midyear (see Chart 2). In third quarter 2003, 

realized gains from securities sales boosted ROA by 3 

basis points among insured institutions in the Chicago 

Region, noticeably less than the 23-basis-point contribution a year earlier. Given the general expectation 

that interest rates will rise over the next year, the 

contribution to ROA from unrealized securities gains 

likely will shrink or turn negative in coming quarters. 

Net interest income: From September 30, 2002, to 

September 30, 2003, insured institutions headquartered 

in the Chicago Region reported an 18-basis-point 

decline in net interest income as a percentage of average assets. During this period, the yield on earning 

assets fell 83 basis points, while the cost of funding 

earning assets declined to a lesser degree. 

Whether a rising yield curve will enhance net interest 

income in coming quarters depends on insured institu3 Aspen Publishers, Inc., Blue Chip Economic Indicators, Vol. 28, 

No. 12, December 10, 2003. 

FDIC OUTLOOK 18 SPRING 2004 
Regional Perspectives 

Table 1 

Net Income of Chicago Region’s Institutions Changed Little in Past Year 

Income statement contribution (as a percentage of average assets) 

Three months ended Sept. 30 

2002 2003 

Basis point 

change 

Net interest income 

Total noninterest income 

Noninterest expense 

Provision expense 

Security gains (or losses) 

Income taxes 

Net income (return on assets) 

3.33 3.15 

1.87 1.93 

–2.97 –2.88 

–0.55 –0.43 

0.23 0.03 

–0.62 –0.56 

1.29 1.24 

–0.18 

0.06 

0.09 

0.12 

–0.20 

0.06 

–0.05 

Source: Bank and Thrift Call Reports for all institutions in the Chicago Region. 

tions’ interest-rate risk management strategies. A few 

institutions seemingly were caught by surprise when 

interest rates started rising recently, as several took 

charges to unwind funding vehicles with option 

features that started incurring losses as rates rose. 

Banks and thrifts that rely heavily on deposits as a 

source of funding may benefit if the spread between 

the yield on earning assets and deposit rates widens. 

Compression of this spread in recent years likely 

reflected, at least in part, the reluctance of institutions 

to lower rates on deposits in tandem with rates on 

assets, especially after deposit rates fell below the 

psychologically sensitive level of 1 percent. 

Fee income: The upturn in interest rates also is 

expected to dampen fee income, notably among 

insured institutions with significant mortgage origination and refinancing activity. Refinancing of residenChart 2 $ Billions 

Sources: Bank and Thrift Call Reports; Federal Reserve Board. 

Unrealized Securities Gains Tapered Off among 

Chicago Region’s Banks and Thrifts 

Percent (per annum) 

Yield on five-year Treasury note (right axis) 

Net unrealized gain 

or loss on securities (left axis) 

–4 

–3 

–2 

–1 

0 

1 

2 

3 

4 

5 

Sep ‘94

Sep ‘95Sep ‘96Sep ‘97Sep ‘98Sep ‘99Sep ‘00Sep ‘01Sep ‘02Sep ‘03 0 

1 

2 

3 

4 

5 

6 

7 

8 

9 

tial mortgages has plunged since midyear, and growth 

in home purchase applications has slowed considerably. Indeed, such large national mortgage lenders as 

Washington Mutual recently announced planned 

layoffs of thousands of employees in response to the 

drop in mortgage underwriting activity.4 Other institutions are taking similar actions, and nationwide 

employment by credit intermediaries, which includes 

mortgage banking, fell by 22,000 in fourth quarter 

2003, following gains of about a quarter-million over 

the prior three years that largely reflected increased 

mortgage refinancing activity. 

The Brighter Side of Rising Interest Rates 

As insured institutions adjust to some short-term or 

adverse impacts from rising interest rates, rising rates 

may help widen the spread between deposit rates paid 

and yields on earning assets. In addition, other aspects 

of insured institutions’ operations would be expected 

to benefit from improving economic conditions. 

Lower provision expenses already contributed positively to ROA among the Region’s community banks 

in the third quarter. Even though the past-due rate 

on one-to-four family mortgages is relatively high 

compared with other loan types, the 30- to 89-day 

past-due rate on September 30, 2003, for all loans 

held by community institutions was 51 basis points 

lower than two years earlier. The improvement in the 

30- to 89-day past-due rate for all loans suggests that 

the percentage of loans seriously delinquent (i.e., past 

4 Bradley Meacham, “WAMU Cuts Jobs, Profit Outlook as Mortgage 

Business Slows,” The Seattle Times, December 10, 2003. 

FDIC OUTLOOK 19 SPRING 2004 
Regional Perspectives 

due by 90 or more days or on nonaccrual basis) may ease 

in coming quarters. Although the Region’s economic 

recovery has not been vibrant and areas of concern 

remain, the fact that general economic conditions are 

stabilizing suggests that loan quality may not deteriorate 

further. 

In addition, growth in demand for loans typically lags 

upturns in economic growth. Consequently, in coming 

quarters banks and thrifts may be able to expand loan 

portfolios without easing underwriting standards. The 

Federal Reserve’s recent survey of senior loan officers 

indicated that demand for consumer loans strengthened 

in the third and fourth quarters, although demand for 

home mortgage loans declined. In the same period, a 

smaller net percentage of banks reported weaker 

demand for C&I loans. In contrast, demand for 

commercial real estate loans weakened at about the 

same pace as in the third quarter.5 

5 Federal Reserve Board, Senior Loan Officer Opinion Survey on Bank 

Lending Practices, October 2003. 

Looking Ahead 

Although economic growth across the Region at 

year-end 2003 was neither vigorous nor widespread, 

certain conditions and leading indicators suggested 

that momentum was building that could sustain more 

robust and balanced growth in future quarters. In this 

environment, insured institutions will continue to 

face challenges, such as pressure on net interest 

margins and credit quality concerns. Meanwhile, 

business and household demand for nonmortgage 

loans may strengthen, but fee income from mortgage 

origination activity and the contribution to income 

from securities gains may fade quickly. A shift to a 

sustained period of rising interest rates also will 

contrast with conditions of recent years, reinforcing 

the need for insured institutions to monitor and 

manage interest rate risk continually. 

Chicago Staff 

FDIC OUTLOOK 20 SPRING 2004 
Regional Perspectives 

Dallas Regional Perspectives
 

Banking Industry Consolidation 

May Mask Competitive Effects of 

Increased Branching Activity 

Consolidation in the banking industry has been dramatic, with the total 

number of Federal Deposit Insurance Corporation (FDIC)-insured 

institutions declining 29 percent during 

the past decade, from nearly 13,000 to 

approximately 9,200. Over the same period, 

however, the number of physical branch offices 

increased 15 percent nationwide.1 The growth in the 

number of physical branches is all the more striking in 

that it occurred during a period of rapid technological 

advances, including the rise of the Internet and increasing broadband capacity, which enabled customers to 

bank on-line. 

Consumers have been the engine of economic growth 

through the recent recession and period of gradual recovery. The branch has become the most prominent delivery channel in the competition for consumer business; as 

a result, the number of de novo branches has increased. 

However, some observers now believe that banks may 

Table 1 

have overplayed branch expansion, particularly if the 

consumer sector cools.2 

Banking industry consolidation 

in the Dallas Region has been on 

a par with that of the nation, but 

growth in the number of branches, at 

42 percent, is nearly triple that of the 

nation, although it varies significantly 

among states. This article discusses 

trends in consolidation and branching in the Dallas 

Region. It also examines differences in overall performance and risk profiles based on the nature of branching 

activities to determine the effects of certain branching 

strategies. 

Economic and Demographic Conditions Are Driving 

New Branch Activity 

Branching activity has varied among states in the Region 

(see Table 1). Colorado leads the group, as the number 

of branches has more than doubled in that state. Branch 

growth rates in Texas, Oklahoma, and Arkansas also 

significantly outpaced those of the nation, while Mississippi lagged the nation with only 8 percent growth. 

Despite Steady State-Level Declines in the Number of Institutions, 

the Number of Branches Has Increased 

2Q03 Change 2Q03 Change 

Insured in Insured National Branch of Branches National Rank 

State Institutions from 2Q94 % Rank Count from 2Q94 % Change 

Arkansas 174 –37% 7 1,128 55% 6 

Colorado 178 –41% 4 1,167 111% 2 

Louisiana 171 –32% 16 1,340 17% 24 

Mississippi 105 –22% 37 1,008 8% 31 

New Mexico 60 –35% 10 426 20% 23 

Oklahoma 278 –25% 32 945 52% 7 

Tennessee 209 –26% 29 1,820 20% 22 

Texas 707 –33% 13 4,438 60% 4 

Region 1,882 –32% 12,272 42% 

Nation 9,232 –29% 77,712 15% 

Source: Bureau of Labor Statistics, Summary of Deposits. 

1 The Federal Deposit Insurance Corporation collects deposit data at the branch level as of June 30 every year. Data from June 1994 through June
 

2003 were used for this article.
 

2 Greta Sundaramoorthy, “Deposit Drop Looks Like More Than a Blip: Some See Effect on Industry’s Branch-building Binge,” The American
 

Banker, December 22, 2003.
 

FDIC OUTLOOK 21 SPRING 2004 
Regional Perspectives Regional Perspectives 

As shown in Table 2, the variations in branching 

activity by state are generally well correlated with 

economic and demographic trends. Colorado’s heavy 

branching activity occurred at a time when the state 

led the Dallas Region in level of and growth in per 

capita personal income; the state also experienced 

relatively high population and employment growth 

rates. Robust economic and demographic factors over 

the past decade also explain the relatively high level 

of branching activity in Texas. Conversely, states with 

branching activity close to or less than the national 

average (Louisiana, New Mexico, Tennessee, and 

Mississippi) have been characterized by less favorable 

economic or demographic factors during the past 

decade. 

Economic and demographic factors are not the only 

explanations for the level of branching activity. Less 

concentrated markets also have experienced growth as 

competitors opened branches to gain market share. 

For example, as shown in the last column of Table 2, 

the Arkansas market was highly fragmented in 1994, 

with the top five institutions controlling only 18 

percent of the deposit market. Despite poor economic 

Table 2 

fundamentals, including low levels of per capita 

personal income and weak employment growth, the 

number of branches in the state increased 55 percent, 

with the top five institutions controlling 30 percent 

of the market at the end of the decade. 

Some of the increase in branching activity can be 

attributed to changes in state and federal laws, which 

eased restrictions on branching within and across state 

lines. Empirical studies have analyzed the effects of an 

easing in branching restrictions; the results suggest 

that deregulation contributes to greater profit efficiency (during a time when costs have increased and 

spreads have declined) and an increase in the number 

of offices per capita.3 As a result, during the past ten 

years, it is reasonable to assume that branching would 

have been greater in states with previously restrictive 

laws, such as Oklahoma, Texas, and Colorado. 

It is instructive to review branching activity below the 

state level, because branching decisions are typically 

market specific—often at the county level, or in urban 

areas at the ZIP code level or below. For the purposes 

of this article, it is not practical to review the condiThe Variation in State-Level Economic and Demographic Conditions 

Helps to Explain Differences in Branching Levels 

Top 5 Institutions’ 

Control of 

Per Capita Personal Income Population Employment Market Share 

Average Average Average Average
 

Annual National Annual National
 Annual National Annual National 

Level, Level Change, Change Change, Change Growth, Growth 2Q 2Q 

State 1993–2002 Rank 1993–2002 Rank 1993–2002 Rank 1993–2002 Rank 1994 2003 

Arkansas 20,065 48 3.7% 45 3.4% 2 1.8% 26 18% 30% 

Colorado 28,095 8 4.6% 4 2.6% 3 3.2% 4 40% 44% 

Louisiana 21,352 44 4.2% 13 0.4% 45 1.6% 35 37% 57% 

Mississippi 18,976 50 4.3% 7 0.9% 23 1.6% 34 48% 50% 

New Mexico 20,187 47 3.9% 31 1.5% 12 2.5% 9 39% 54% 

Oklahoma 21,478 42 3.7% 43 0.8% 29 2.0% 17 26% 34% 

Tennessee 23,584 34 3.9% 34 1.4% 14 1.7% 28 41% 51% 

Texas 24,362 29 4.1% 19 2.1% 7 2.6% 8 42% 44% 

Region 24,546 4.1% 1.6% 2.3% 17% 26% 

Nation 26,259 3.9% 1.2% 1.8% 

Source: Bureau of Labor Statistics, Summary of Deposits. 

3 A.A. Dick, Nationwide Branching and Its Impact on Market Structure, Quality and Bank Performance, Finance and Economics Discussion Series, 

Washington, DC: Federal Reserve Board, 2003, and R.B. Avery et al., “Changes in the Distribution of Banking Offices,” Federal Reserve Bulletin, 

September 1997, pp. 707–725. 

FDIC OUTLOOK 22 SPRING 2004 
Regional Perspectives 

Map 1 The banking analyses conducted for this article are 

limited to the county level. Analysts researching 

branching issues and trends in banking industry 

competition can access the FDIC’s website at 

www.fdic.gov for data at the ZIP code level, as well 

as state, metro, and county levels. The Industry 

Analysis section provides links to bank data 

(Institution Directory, Summary of Deposits) and 

statistics (Regional Economic Conditions) with 

helpful user guides. 

tions and trends for all 738 counties and 3,509 ZIP 

codes that are home to branches in the Dallas Region. 

However, a comparison of trends in a sample of counties 

that exhibited the most rapid and slowest rates of 

branching activity provides helpful insights. The rapid 

growth group excludes counties that were home to fewer 

than ten branches as of June 30, 2003, and comprises 76 

counties that ranked in the top decile for growth in the 

number of branches. The slow growth group consists of 

76 counties that ranked in the bottom decile for growth 

in the number of branches. It is important to note that 

the number of branches actually declined in 68 counties 

in the latter group during the past ten years. 

Not surprisingly, the rapid growth counties overwhelmingly are in metropolitan areas that experienced generally favorable economic and demographic 

trends during the past decade. Indeed, Austin, Dallas, 

Denver, Fort Worth, Houston, and Oklahoma City 

each added more than 100 branches and together 

accounted for more than a third of all new branches 

in the Region. In contrast, the vast majority of the 

slow growth counties are in rural areas that have been 

characterized by decidedly less favorable trends (see 

Map 1). The median per capita personal income level 

in the rapid growth counties was almost 116 percent 

of that in the slow growth counties during the past 

decade. In addition, median annual population and 

employment growth levels in the rapid growth counties were 5.2 and 4.2 times greater, respectively, than 

in the slow growth counties. 

Performance Varies Markedly Depending on 

Branching Strategy 

There are significant differences in performance and 

risk characteristics based on the existence and nature 

The Proliferation in Branches Is Concentrated 

in Metro Areas of the Dallas Region 

Denver 

Oklahoma City 

Dallas/Fort Worth Austin 

Houston 

Ten-Year Nominal Change in Branches 

10 or more branches (85) 

6 to 9 branches (60) 

1 to 5 branches (365) 

No change in branches (166) 

Negative change (68) 

of branching activities among the 1,943 banks operating in the Dallas Region as of June 30, 2003.4 For 

analytical purposes, insured institutions were categorized in four groups: 

• Group 1 operated branches exclusively in metropolitan statistical areas (MSAs). 

• Group 2 operated branches exclusively outside MSAs. 

• Group 3 operated a combination of MSA- and nonMSA-based branches. 

• Group 4 had no branches. 

Our analysis also identified Subgroup A, which consists 

of banks with headquarters in non-MSAs that have 

attempted to improve performance by branching into 

MSAs. Banks in Subgroup A also fall into Group 1 or 

Group 3. 

Overall, insured institutions that operate branches 

displayed significantly stronger growth rates, higher rates 

of lending, and higher operating profits than those without branches (see Table 3, next page). Banks that operate branches also reported lower average ratios of Tier 1 

risk-based capital to risk-weighted assets, indicating that 

they have greater opportunities to leverage risk. 

4 Included in the 1,943 are 61 banks that operate branches in the 

Dallas Region but are headquartered outside the Region. 

FDIC OUTLOOK 23 SPRING 2004 
Regional Perspectives 

Table 3 

Financial Trends Vary among Those with Branches 

and Contrast Significantly with Those without Branches 

Group Name 

Number of 

Insured 

Institutions 

Deposit 

Growth 

(median, %) 

Core 

Funding 

to Total 

Assets 

(median, %) 

Time 

Deposits 

to Total 

Assets 

(median, %) 

Loanto-Asset 

Ratio 

(median, %) 

Past-Due 

Ratio 

(median, %) 

Return 

on Assets 

Pretax 

(median,%) 

Quarterly 

Net 

Interest 

Margin 

(median, %) 

Tier 1 

Risk-Based 

Capital to 

Risk 

Weighted 

Assets 

Group 1 558 9.3 36.4 33.5 62.8 1.9 1.45 4.36 12.85 

Group 2 494 5.0 27.8 41.0 57.4 2.8 1.50 4.25 15.27 

Group 3 353 7.3 35.4 35.6 64.5 2.0 1.63 4.32 12.22 

Group 4 538 3.7 27.8 40.4 51.9 2.7 1.38 4.05 19.04 

Subgroup A 196 7.0 31.7 40.1 64.1 2.3 1.54 4.39 12.85 

1

Subgroup A banks also appear in Groups 1 and 3. 

2

Core funding includes demand deposit accounts, money market deposit accounts, and savings accounts. 

3

Time deposits include certificates of deposits and time open accounts held in domestic offices. 

Source: Bank and Thrift Call Reports, Summary of Deposits. 

Among those with branches, the groups operating at 

least one branch in an MSA reported the highest 

median asset and deposit growth rates, roughly 2.5 times 

those of institutions without branches. A similar observation applies to median pretax return on assets, with 

the banks in Group 1 and Group 3 realizing an advantage of more than 25 basis points compared with banks 

without branches. The ability of banks operating in 

MSAs to invest significantly greater shares of assets 

in loans likely explains much of their edge in earnings 

performance. Earnings also may benefit from greater 

levels of core funding (demand, savings, and money 

market deposit accounts) and the lower costs typically 

associated with these funding sources. Finally, banks 

that operate branches in MSAs have reported significantly lower median past-due ratios than those without 

branches or those that branch only in rural areas. These 

performance data seem to suggest that banks in 

Subgroup A (banks with headquarters outside MSAs) 

have benefited from branching into more robust 

markets. 

Looking Ahead—Will the Pace of Branch Growth 

Continue? 

The decision to open or acquire a branch or maintain 

an existing branch is based on a determination that 

doing so will provide a net benefit/profit. Only bank 

management can make this determination, as it is 

specific to markets, branch types, and the institution’s 

strategy and business mix. Although growth undoubtedly 

will continue in various markets, one simple measure of 

feasibility—the number of people per branch—suggests 

that overall branch growth may moderate. In fact, the 

number of customers available to support a branch in 

the Dallas Region declined by approximately 20 percent 

during the past decade, falling to an average of 2,422 in 

non-MSAs and 4,562 in MSAs. 

Other trends in retail business conditions also have 

implications for a particular bank’s branching strategy. 

Nationwide, deposit growth varied during the ten years 

ending June 30, 2003 (averaging 5.5 percent), with the 

strongest gains coming after 2000, a trend attributable 

at least in part to the decline in the equity markets. 

However, with the recent rebound in the stock market, 

the third quarter 2003 FDIC Quarterly Banking 

Profile reported the first quarter-over-quarter decline 

in deposits since first quarter 1999. Moreover, while the 

consumer sector has remained strong, management 

must ask whether retail banking will retain its attraction when other types of businesses rebound or when 

interest rates rise. 

Clearly, bank management must consider a number 

of factors related to current business conditions 

when making branching decisions—the increased 

competition arising from a greater number of branches, 

higher land and building costs, the decline in the 

number of people per branch, and challenges facing the 

retail banking business. All these factors together could 

indicate that the time required for a new branch to 

become profitable may increase, if it has not done so 

already in some markets—a key calculation that must 

be factored into an overall branching strategy. 

Memphis Staff 

FDIC OUTLOOK 24 SPRING 2004 
Hydrological Drought Conditions Are 

Expected to Affect Farmers and Their 

Lenders 

In the Winter 2003 FDIC Outlook, the 

Kansas City Regional Perspectives article 

described how drought conditions have 

existed in the Kansas City Region since 

2000. Nebraska, western Kansas, and 

southern South Dakota have been the 

hardest hit, experiencing at least moderate 

levels of “agricultural” drought during 

three of the past four years. This article 

discusses another type of drought that is 

affecting much of the Region and is being aggravated by 

agricultural drought conditions: “hydrological” drought. 

Hydrological Drought Conditions Are Significant and 

Increasing 

Agricultural drought refers to topsoil moisture levels 

that are important for proper crop development. 

Hydrological drought focuses on the longer-term availability of water for all uses, including farming, urban 

uses, manufacturing, and recreation. Specifically, hydrological drought refers to shortages in surface or subsurface water supplies, such as reservoirs, rivers, and 

aquifers. According to the Drought Mitigation Center, 

a research institute at the University of Nebraska, 

precipitation shortfalls typically contribute the most 

to hydrological drought conditions, but factors such as 

increased land development, landscape, and construction of dams may also have a significant effect. Precipitation deficiencies can cause agricultural drought to 

manifest very quickly, but they take longer to cause 

hydrological drought. Hydrological drought can be 

observed in declining lake and reservoir levels, reduced 

stream and river flows, and depleted aquifer levels. 

In the Kansas City Region, the effects of hydrological 

drought on surface water levels have increased in 

severity as a result of lower than normal rainfall and 

snowfall levels during the past few years. As shown 

in Map 1, Kansas and Nebraska are experiencing the 

most severe drought. In Kansas, the river system is 

running quite low; the flows of the Arkansas, Cimarron, Republican, and North and South Platte Rivers 

all have declined during the past decade.1 The 

greatest decrease in flow has been in the 

Arkansas River because of drought and 

upstream water diversion for irrigation 

and recreational purposes. In Nebraska, 

reservoir levels show the greatest impact of 

the drought. The water level in the state’s 

two largest reservoirs, Lake McConaughy 

and Lake Harlan, declined 24 percent 

and 29 percent, respectively, between 

October 30, 2002, and September 30, 

2003. As of September 30, 2003, these 

lakes stood at 25 percent and 36 percent 

of their normal capacities, the lowest 

levels since they were originally filled.2 

As disturbing as surface water levels are, the worst may 

not be over. Climatologists such as Al Dutcher with the 

University of Nebraska predict that it will take several 

years of much higher than normal precipitation, typically in the form of snowfall, to recharge these water 

levels.3 However, a multifederal agency study that 

combines various climatological models predicts that 

the Kansas City Region will continue to see abnormally 

Regional Perspectives 

Kansas City Regional Perspectives 

Map 1 

Agricultural and Hydrological Drought
 

Continue to Plague Much of the Region
 

U.S. Drought Monitor, December 9, 2003 

Drought Intensity: 

DO Abnormally Dry Drought Impact Types:
 

D1 Drought—Moderate
 Delineates dominant impacts D2 Drought—Severe
 

D3 Drought—Extreme A = Agricultural (crops, pastures,
 

D4 Drought—Exceptional grasslands)

H = Hydrological (water) 

(No type = both impacts) 

Note: The Drought Monitor focuses on broad-scale conditions. Local conditions may vary. 

Source: U.S. Drought Monitor, http://drought.unl.edu/dm. 

1 Kansas Geological Survey, Kansas Geological Survey Open File
 

Report 2003-41, p. 12.
 

2 Nebraska Department of Natural Resources, Surface Water
 

Information, 2003, http://waterdata.usgs.gov/ne/nwis/current.
 3 Agweb.com, February 11, 2003, www.agweb.com/news_show_
 

news_article.asp?file=AgNewsArticle_20032111447_5412&articleid=
 

95259&newscat=GN.
 

FDIC OUTLOOK 25 SPRING 2004 
Regional Perspectives 

dry to moderate drought conditions over the next five 

years, which does not bode well for replenishment of 

water supplies.4 

Although the low reservoir and river levels are troubling, they are only a readily apparent, visual indication 

of a much larger problem. The hydrological drought 

has had a profound effect on the Region’s underground 

water system, the largest part of which is the Ogallala 

Aquifer, a vast geologic formation that sprawls below 

eight states from South Dakota to Texas (see Map 2).5 

Map 2 

OGALLALA AQUIFER 

The Ogallala Aquifer Spans 

the Western Half of the Region 

WYOMING SOUTH DAKOTA 

COLORADO KANSAS 

OKLAHOMA 

TEXAS 

NEW MEXICO 

0 50 100 150 MILES 

NEBRAKSA 

Source: High Plains Underground Water Conservation District #1, www.hpwd.com/ 

ogallala/ogallala.asp. 

4 Climate Prediction Center, National Climatic Data Center, and National 

Oceanic and Atmospheric Administration, December 13, 2003, 

www.cpc.ncep.noaa.gov/products/predictions/experimental/edb/ 

lbfinal.gif. 

5 Sometimes the terms “Ogallala Aquifer” and “High Plains Aquifer” are 

used interchangeably; while they are related, they are two separate 

water tables. The High Plains Aquifer is a large (approximately 33,500 

square miles of surface area) body of sands, gravels, silts, and clays. 

In western Kansas it is generally identical with the Ogallala formation, 

and the aquifer system was originally known as the Ogallala Aquifer. 

However, the part of the aquifer extending into south-central Kansas 

(east of Ford County) is now recognized as a hydrologically similar but 

geologically different formation, and the combined aquifer system is 

referred to as the High Plains Aquifer. Kansas Geological Survey Open 

File Report 2000-29, Lawrence: University of Kansas. 

Nebraska, Kansas, and South Dakota are positioned 

over 77 percent of this massive aquifer’s available water. 

Under Nebraska alone, the aquifer contains approximately 2,130 million acre-feet of water, and under 

Kansas it contains 320 million acre-feet. For comparison, the cumulative level of the top 17 reservoirs in 

Kansas, even if filled to capacity, is just 6.7 million 

acre-feet of water. The agricultural drought has affected 

the Ogallala Aquifer in two ways: less precipitation has 

caused the replenishment rate to be far below average, 

and it has also caused farmers to draw more water from 

the system for crop irrigation. In some of the most 

severely affected areas, the water table levels have 

declined by as much as ten feet per year. As a result, 

farmers have incurred higher costs to drill deeper wells 

and have had to pay more in extraction costs to bring 

water up from lower pumping levels. 

Long-term factors also have affected the aquifer system 

adversely. Crop irrigation, which began in earnest in 

the 1940s, has gradually reduced the volume of water 

in the Ogallala Aquifer. According to the University 

of Nebraska Water Center, the aquifer lost 56 million 

acre-feet of water between 1987 and 2002. The greatest 

water level changes occurred in southwest Kansas and 

the southwestern part of the Texas Panhandle, where 

up to 50 percent of the water has been depleted, 

compared with pre-irrigation levels.6 

The Ability to Irrigate Is the Key to Many Farmers’ 

Fortunes 

An estimated 95 percent of the water extracted from 

the Ogallala Aquifer each year is used to irrigate crops. 

In the Region’s western half, some crops, such as corn, 

require more water to produce profitable crop yields 

than precipitation alone can provide. Crops that 

require less water, such as wheat and soybeans, are 

planted in areas where irrigation is not available or 

cannot be utilized fully. However, the returns to farmers 

are typically far less than if they grew irrigated corn, 

which produces much higher yields. During the growing season, the average corn crop requires 25 inches of 

water—from rainfall or irrigation—to reach maximum 

yield potential. In normal precipitation years, rainfall 

accounts for about 13 inches, and farm operators apply 

6 Water-level Changes in the High Plains Aquifer, Predevelopment to 

2001, 1999 to 2000, and 2000 to 2001, Lincoln: University of Nebraska 

Water Center, 2003, http://watercenter.unl.edu/whatsnew/ 

water_levels.htm. 

FDIC OUTLOOK 26 SPRING 2004 
Regional Perspectives 

about 12 inches of irrigation water. By contrast, in Banks in the Region May Feel the Effects severe drought years, such as the Region experienced in 

2002 and 2003, many farm operators had to apply as 

much as 20 inches of water. 

Water shortages have led many water districts in 

Nebraska, Kansas, and South Dakota to limit the 

amount of water that farmers can use for crop irrigation. 

In these areas, water meters have been installed on 

wells, and water allocations typically are provided over 

a five-year period. Because of the severe drought that 

has affected the western half of the Region, examiners 

note that some farmers used more than their yearly 

water allocations to grow irrigated corn in 2002 and 

2003, effectively “borrowing” water from future years. 

If higher than normal rainfall does not occur in upcoming growing seasons, these farmers will be forced to 

make tough decisions. They could reduce water application rates, which will result in lower corn yields, or they 

could substitute lower-earning crops such as wheat or 

soybeans. Either way, farmers’ cash flows are vulnerable 

in the short term. Even farmers who have adequate 

water allocations remaining could face higher pumping 

expenses to bring water up from declining water tables. 

Even more significant than short-term considerations 

are the long-term effects of water shortages. Communities use water supplies not only for crop irrigation but 

also for related agricultural operations, hydroelectric 

power, recreation, and barge traffic. Usage is determined 

politically; urban population growth, a changing 

economic mix (less oil and gas extraction, more light 

industry), and increased environmental concern have 

contributed to a change in priorities in drought-affected 

states. Crop irrigation has represented the primary use of 

water supplies to date, but now priority has begun to be 

assigned to wildlife habitats, recreation, and water quality.7 Governors in Nebraska and Kansas have initiated 

task forces to study the effects of water shortages and 

recommend actions to prevent disruptions. Many foreseeable scenarios involve increased restrictions on crop 

irrigation; in fact, in Nebraska the recent settlement of 

a lawsuit with Kansas regarding use of the Republican 

River has resulted in the installation of water meters 

(to be completed by year-end 2004) and a moratorium 

on new irrigation wells.8 The next logical step will be 

water allocations where none had previously existed. 

7 Managing Water: Policies and Problems, Lincoln: Drought Mitigation
 

Center, University of Nebraska, 2003, www.drought.unl.edu/plan/
 

managewater.htm.
 

8 Information regarding the lawsuit and the settlement can be found
 

at www.accesskansas.org/kda/dwr/Interstate/Republican_River.htm.
 

Hydrological drought could eventually have serious 

consequences for many of the Region’s insured financial 

institutions. Approximately 22 percent of all counties 

in the Region are irrigated significantly and have been 

affected adversely by drought conditions (see Map 3).9 

Most of these counties are in Nebraska and Kansas. 

If hydrological drought conditions result in irrigation 

problems, farmers will face the prospect of lower cash 

flows, as well as the potential for declining land 

values.10 Banks in these counties would be the most 

vulnerable to any resulting weakness in farm income. 

Eighty percent of the 299 banks headquartered in these 

counties are considered farm banks because of their 

Map 3 

Persistent Drought Continues to Have an Adverse
 

Effect on Areas with High Dependence on Irrigation
 

Darker shaded areas indicate drought conditions in 2002
 

and 2003 as well as 2001 and 2000.
 

Lighter shaded areas are counties with at least moderate drought


in the last two years but not in 2000 and 2001.
 

Triangles indicate counties with a high level of irrigated cropland in 2001.
 

Source: U.S. Drought Monitor, http://drought.unl.edu/dm. 

9 Irrigated is defined as greater than 10 percent of cropland in the 

county is irrigated; the median for the Region is approximately 

8 percent. 

10 For example, in Kansas in 2003 an acre of irrigated farmland sold for 

an average of $1,100, while an acre of nonirrigated farmland sold for 

about $650. Agricultural Land Values, p. 1, Kansas Agricultural Statistical Service, 2003. Permanent reductions in water allocations would 

likely case farmland values to drop to somewhere within that range. 

FDIC OUTLOOK 27 SPRING 2004 
Regional Perspectives 

relatively high agricultural lending concentrations.11 

The current agricultural drought conditions already 

have stressed credit quality among these farm banks. 

At September 30, 2003, about one-quarter of the farm 

banks based in these counties reported past-due or 

nonaccrual loans that exceed 5 percent of total loans, 

up from 15 percent of banks a year ago. By contrast, 

only 10 percent of the Region’s farm banks in areas 

that have not experienced multiple years of drought 

reported this level of problem loans. 

11 The Federal Deposit Insurance Corporation defines farm banks 

as institutions with at least 25 percent of loan portfolios in farm 

operating loans or loans secured by farm real estate. 

In conclusion, the hydrological drought could have 

significant adverse effects on farmers and their lenders. 

In the short term, farmers face cash flow difficulties 

from a variety of sources—from reduced crop yields for 

farmers who have used more than their annual water 

allocations to higher water-pumping costs. Over the 

long term, changes in water policy during the next few 

years likely will be incremental, barring the return of 

extreme agricultural drought conditions. However, any 

restrictions on the use of water beyond the status quo 

would hurt farmers and their lenders. 

Shelly M. Yeager, Financial Analyst 

Allen E. McGregor, Supervisory Examiner 

FDIC OUTLOOK 28 SPRING 2004 
Regional Perspectives 

New York Regional Perspectives
 

Housing in the Northeast 

Against the backdrop of an overall weak national economy—at least until recently—housing has stood out 

as a principal source of economic strength. 

Whether evaluated by construction activity, 

rate of home price appreciation, or residential mortgage credit quality, the 

housing sector has performed strongly 

nationwide, including in the 

Northeast. Nonetheless, concerns 

about future performance of the 

housing industry and sustainability 

of current rates of home price 

appreciation have increased. This 

article examines housing market 

conditions in the Region and the implications of rising 

interest rates and a more tepid housing market on 

insured institutions. 

The Region’s Residential Construction Activity Has 

Increased in Recent Years, but Growth Is Less than 

the Nation’s 

While the number of housing permits in the nation has 

increased significantly in recent years, the increase in 

the Northeast has been more modest. This situation is 

due largely to factors such as lower birth rates, unfavorable migration patterns, and less land on which to 

build. However, economic developments also have 

played a part. For example, during the 1980s, the housChart 1 

Number of Units (000s) 

Note: Data exclude Washington, DC; Puerto Rico; and the U.S. Virgin Islands. 

Source: Bureau of the Census. 

Construction Permits in the New York Region, 

unlike the Nation, Have Not Reached 

the Highs of the 1980s 

0 

500 

1000 

1500 

2000 

’82 ’84 ’86 ’88 

0 

100 

200 

300 

United States (L) 400

New York Region (R) 

Number of Units (000s) 

’80 ’90 ’92 ’94 ’96 ’98 ’00 ’02 

ing boom in the Northeast coincided 

with an economic revival in the 

Region. That boom and the 

accompanying revival did not 

last. The economic recovery 

began to falter by the end of the 

1980s, and rising interest rates on the 

heels of speculative overbuilding of real 

estate sealed the fate of the housing 

sector. In recent years, new home 

construction in the Northeast has 

increased but has not reached previous peaks 

(see Chart 1). Consequently, housing prices in the 

Region have surged, far outstripping home price 

appreciation nationwide. 

Many of the Nation’s Top Housing Markets Are in 

the New York Region 

The rate of home price appreciation had begun to ease 

in most of the Region’s metropolitan statistical areas 

(MSAs) through third quarter 2003, although some 

markets continued to report strong price growth. Of 

the 50 housing markets with the highest rate of price 

appreciation as of third quarter 2003, 20 are in the New 

York Region.1 Areas that warrant monitoring because 

of rapid and potentially unsustainable rates of home 

price appreciation generally are clustered around the 

Region’s larger, higher-priced housing markets, which 

include Providence, RI; New Bedford, MA; and 

Monmouth-Ocean, Atlantic-Cape May, and Jersey 

City, NJ. Housing markets in many parts of New 

Jersey have benefited from favorable employment 

and immigration trends and constraints on the supply 

of single-family housing. The Providence and New 

Bedford markets recently have become attractive as 

alternatives to the very expensive Boston market. The 

housing markets that have experienced more significant 

easing in the rate of home price appreciation in third 

1 Source: Office of Federal Housing Enterprise Oversight. Home price 

appreciation rate measured as the difference in the home price index 

between third quarter 2002 and 2003. These markets include New 

Bedford, MA; Jersey City, NJ; Providence-Fall River-Warwick, RI; 

Atlantic City-Cape May, NJ; Brockton, MA; Monmouth-Ocean, NJ; 

Newburgh, NY; Fitchburg-Leominster, MA; Barnstable-Yarmouth, MA; 

New London-Norwich, CT; Nassau-Suffolk, NY; Albany-SchenectadyTroy, NY; New Haven, CT; Baltimore, MD; Glens Falls, NY; Washington, 

DC; Bridgeport, CT; Portland, ME; Vineland-Millville-Bridgeton, NJ; 

and Hagerstown, MD. 

FDIC OUTLOOK 29 SPRING 2004 
Regional Perspectives 

quarter 2003 include Lowell, Lawrence, and Boston, 

MA; Nashua, NH; and New York, NY, reflecting, in 

part, localized softening in these economies following 

rapid increases in housing prices.2 

Home prices have not appreciated to the same extent 

in all of the Region’s markets. Communities throughout 

much of Pennsylvania, upstate New York, and parts 

of New England that have weaker, typically manufacturing-based economies have lower rates of home price 

appreciation than those of the nation. Unlike some of 

the Region’s more vibrant housing markets, population 

in some of these areas has declined, constraining the 

demand for housing. Nonetheless, according to third 

quarter 2003 data from the Office of Federal Housing 

Enterprise Oversight, although rates of home price 

appreciation generally have eased, none of the Region’s 

housing markets experienced a decline in the median 

home price during the past year. 

Rates of Home Price Appreciation: Too Much Too 

Fast? 

Strong home price appreciation in some of the Region’s 

housing markets has prompted concern about sustainability. Professors Karl Case and Robert Schiller 

addressed this possibility in a paper prepared for the 

Brookings Institution.

3 For the most part, the paper 

supports a soft, rather than hard, landing for housing 

prices. It cites favorable levels of affordability owing to 

historically low mortgage rates as a key positive factor. 

Other data also support the potential for a soft landing. 

Unlike during the 1980s, new housing supply has 

moved with, not ahead of, rising demand. Inventories 

of unsold existing homes compared with sales during 

this past year were only slightly elevated, unlike the 

record lows of previous years. Also, the share of sales 

of completed houses compared with sales of houses not 

started or under construction has been near the lowest 

recorded level and well below levels in the 1970s and 

1980s.4 This proxy for supply-demand for single-family 

The Region’s Community Banks Report Favorable 

Credit Quality and Strong Growth in HousingRelated Assets 

Overall, insured institutions in the New York Region 

and nationwide have reported favorable residential 

loan quality in recent years. While parts of the Region, 

predominantly metropolitan areas in upstate New York 

and western Pennsylvania, report residential delinquency rates above the national measure, the Region’s 

median residential mortgage loan past-due rate declined 

steadily throughout the most recent recession, and at 

1.0 percent is considerably below the 1.7 percent level 

in the rest of the nation (see Chart 2). 

The Region’s community banks are active in residential 

real estate lending; approximately one-third specialize 

in residential lending, compared with 10 percent for the 

rest of the nation.5 In addition, weak commercial and 

industrial (C&I) loan demand during this economic 

downturn likely has contributed to strong growth in 

mortgage-related assets among the Region’s community 

banks (see box for detail on the Region’s large banks). 

Since the beginning of the 2001 recession, community 

bank portfolios of residential mortgages, home equity 

lines of credit (HELOCs), and mortgage-backed securities (MBSs) have grown from $229 billion to $285 

billion, a 24 percent increase, compared with a modest 

decline in C&I loans (see Chart 3, next page). The 

Chart 2 

The Region’s Community Banks Report 

Lower Past-Due Residential Loan Ratios 

than the Nation 

Percentage of Loans Past Due

0.0 

0.5 

1.0 

1.5 

2.0 

2.5 

3Q99 1Q00 3Q00 1Q01 3Q01 1Q02 3Q02 1Q03 3Q03 

Rest of the Nation 

New York Region 

housing suggests that speculative construction and 

lending activity remain in check. 

2 The rate of home price appreciation between third quarters 2002 and 

2003 was compared with the average annual rate of appreciation 

between third quarters 1998 and 2002. 

3 Karl Case and Robert Schiller, Is There a Bubble in the Housing 

Market? An Analysis, Washington, DC: Brookings Institution, 2003. 4 Bureau of the Census, Housing Vacancy Survey and New Homes 

Sold and for Sale by Stage of Construction, Washington, DC. 

Note: Excludes banks less than three years old and credit card banks. Past-due loans
 

are those at least 30 days past due.
 

Source: Bank and Thrift Call Reports.
 

5 Community banks are defined as insured institutions holding less 

than $10 billion in assets. Residential specialists are community banks 

that hold at least 50 percent of assets in one-to-four family residential 

loans or mortgage-backed securities. These definitions exclude institutions less than three years old. 

FDIC OUTLOOK 30 SPRING 2004 
Regional Perspectives 

Chart 3 

The Region’s Community Banks Have Increased
 

Holdings of Mortgage-Related Assets
 

since the Start of the 2001 Downturn
 

75 

55 

35 

15 

–5 Total HELOCs MBSs First Commercial 

Mortgage- and Second Mortgage and 

Related Mortgages Loans Industrial 

Loans Assets 

Note: Growth rates are adjusted for mergers. HELOCs = Home Equity Lines of Credit.
 

MBSs = Mortgage-Backed Securities.
 

Source: Bank and Thrift Call Reports.
 Growth Rate from First Quarter 2001 through Third Quarter 2003 (percentage) 

comparatively high growth rate in MBSs is largely the 

result of the increased size of, and banks’ participation 

in, the secondary mortgage market. The significant 

growth in HELOCs is primarily the result of the 

increased popularity of these loans among consumers, 

a trend that has been aided by appreciating home 

values. Contributing to the more modest growth rate 

of first mortgage loans is the large size of the portfolio 

of first mortgages (making high percentage growth 

rates more difficult to attain), banks’ selling of first 

mortgages in the secondary market, and the fact that 

a large proportion of first mortgage underwriting 

activity has been refinancing of existing debt. 

What Lies Ahead? 

An expanding economy would be expected to enhance 

insured institution performance. However, rising interest rates and potentially lower demand for residential 

mortgages have less favorable implications. First, fees 

from record volumes of mortgage originations and 

refinancings have been an important source of income 

during this housing boom. A scaled-back level of mortgage activity likely would translate into a decline in 

mortgage-related fee income. According to estimates by 

the Mortgage Bankers Association, the dollar amount 

of mortgage origination volume is forecast to decline 

by approximately 47 percent in 2004, from a record 

$3.8 trillion in 2003.6 

6 Mortgage Bankers Association, Macroeconomic and Housing 

Finance Outlook for 2004–2006, Washington, DC: 2004. 

Second, during the 2003 refinancing wave many 

homeowners opted for long-term, fixed-rate mortgages. Such mortgages could expose banks that hold 

these loans to extension risk should rates continue to 

rise, thereby heightening the importance of interest 

rate risk management.7 

Finally, rising interest rates may increase debt service 

requirements for some borrowers. Growth in home 

equity loans, which typically carry adjustable rates, 

has been strong in recent years, and interest rates on 

HELOCs likely would reprice upward if interest rates 

rise. In addition, demand for adjustable rate mortgages (ARMs) increased nationwide in the second 

half of 2003 as rates on fixed-rate mortgages rose.8 

The Region’s community banks held a much lower 

proportion of residential mortgage loan portfolios 

in ARMs (25 percent) than in fixed-rate mortgages 

(75 percent) through third quarter 2003, and a lower 

percentage than community banks nationally. Going 

forward, however, the ARM percentage may increase 

if consumer demand continues to shift to ARMs. 

The typically lower initial rate on ARMs compared 

with fixed-rate loans may temporarily facilitate lower 

debt service payments for borrowers. However, rising 

interest rates likely would cause ARMs to reprice 

upward and debt service payments to climb, potentially straining borrowers’ repayment capacity. 

While experts are not calling for a decline in home 

prices in the Region similar to that of the 1980s, 

rates of appreciation are likely to continue to slow. 

In addition, consumers’ level of mortgage debt has 

grown in recent years, and the potential for rising 

interest rates to pressure borrowers’ debt service 

capability has increased. These trends highlight the 

importance of taking into account the potential 

effect of rising interest rates on loan portfolio quality. 

7 For more information on extension risk among the Region’s insured 

institutions, see New York Regional Perspectives, Winter 2003. 8 Month-end averages for the percentage of loans originated as 

ARMs increased from 26 percent in July 2003 to 42 percent in 

December 2003, according to the Mortgage Bankers Association 

and Haver Analytics. 

FDIC OUTLOOK 31 SPRING 2004 
Regional Perspectives 

The Region’s Large Banks Report Strong	 (NIMs). The Region’s large banks reported a fifth 

consecutive quarterly decline in the median NIM in Residential Mortgage Demand and Favorable third quarter 2003. In the face of shrinking NIMs, Credit Quality, but Margins Continue to profitability for most of the Region’s large banks was Compress boosted in third quarter 2003 by declines in provisions 

for loan losses, a rebound in capital markets activities, The Region’s large institutions have experienced and securities gains. However, securities gains were 

strong demand for residential mortgages against the lower than in the prior quarter, largely because of the 

backdrop of overall healthy housing markets and the dramatic rise in interest rates in the third quarter. 

unprecedented refinancing wave of 2003.9 Strong While securities gains likely will continue to moderate, 

demand from the consumer sector has offset weak margins may widen following the steepening of the 

demand for C&I loans. The Region’s large banks yield curve in the second half of 2003. 

reported growth in one-to-four family mortgage Most of the Region’s large banks reported favorable loans of 22 percent during the past 12 months, credit quality in third quarter 2003; 64 percent compared with a decline in C&I loans of 9 percent. reported a lower past-due ratio than in the same 

However, the drop in long-term interest rates to 50- period a year ago. The C&I loan delinquency and 

year lows in June 2003 has pushed asset yields down charge-off rates declined in the quarter, and resiand contributed to decline in net interest margins dential mortgage loan quality remained favorable. 

Although the median past-due residential loan 

delinquency rate for the Region’s large banks is 

9 low at 1.1 percent, the increase in interest rates Large institutions are defined as insured institutions that hold
 

$10 billion or more in assets. This definition does not include in the second half of 2003 may affect borrowers’
 

credit card banks. debt service performance negatively.
 

New York Staff 

FDIC OUTLOOK 32	 SPRING 2004 
Regional Perspectives 

San Francisco Regional Perspectives
 

The Recovery of Office Markets 

Lags in Certain High-TechDependent MSAs 

The significant loss 

of office-occupying 

employment following 

the high-tech downturn 

and subsequent “jobless” 

recovery from the 2001 recession has kept office absorption 

rates low, causing vacancy rates 

to escalate in several previously 

“hot” office commercial real estate (CRE) markets in 

the San Francisco Region.1 This article identifies the 

metropolitan statistical areas (MSAs) in the Region 

that are characterized by some of the highest levels of 

job losses since the recession and analyzes the fundamentals of office properties in these markets.2 The 

article also evaluates levels of community bank exposure to CRE lending in these markets to identify areas 

where prolonged weak economic growth could result 

in asset-quality deterioration. 

Table 1 

High-Tech Job Losses Challenge CRE Conditions 

in Some of the Region’s Markets 

Although the San Francisco Region narrowly outperformed the nation with a 0.1 percent year-over-year 

employment growth rate in November 2003, several 

high-tech-dependent MSAs continued to experience 

annual job losses. Between February 2001 and November 

2003, net job losses in the San Jose and San Francisco 

MSAs topped 20 percent, far exceeding job losses across 

the Region or elsewhere in the nation. Other major 

MSAs with office-related employment below prerecession levels are the Portland, Oakland, Seattle, and Salt 

Lake City MSAs, where employment was 3.5 to 5.6 

percent lower in November 2003 than in February 2001. 

The high-tech-dependent MSAs that experienced 

significant job losses and added substantial office space 

generally experienced the most significant jump in 

vacancy rates. Among the 16 major markets in the 

Region, increases in the office vacancy rate since 2000 

were notable in the San Jose, San Francisco, Oakland, 

Portland, Seattle, and Salt Lake City MSAs (see 

Table 1).3 By third quarter 2003, vacancy rates in each 

Declines in Office-Occupying Jobs Pushed Up 

Vacancy Rates in Several of the Region’s Office Markets 

Change in Office-Occupying Third Quarter 2003 

Employment (%) Office Vacancy Rates (%) 

Metropolitan Year-over- Post- Increase 

Statistical Area Year1 Recession2 Total since 20003 Class A Class B/C 

San Jose –3.7 –27.9 18.9 17.7 23.5 15.2 

San Francisco –2.9 –20.6 20.3 16.9 20.6 19.6 

Oakland –0.9 –5.4 16.1 13.5 17.2 14.3 

Portland –0.9 –5.6 18.9 11.8 17.3 20.8 

Salt Lake City –0.8 –3.5 21.1 11.1 21.5 20.9 

Seattle 1.7 –3.9 15.3 11.9 16.0 14.4 

Nation4 0.1 –2.0 16.9 8.7 17.0 16.8 

1

Year-over-year employment change compares November 2003 to November 2002.
 

2

Post-recession employment change from February 2001 to November 2003.
 

3

Increase since 2000 measures the percentage point change in total office vacancy rate from third quarter 2000 to third quarter 2003.
 

4

National vacancy figures are based on a survey of 54 metropolitan markets in the United States.
 

Sources: Torto Wheaton Research; Bureau of Labor Statistics.
 

1 Office-occupying employment includes jobs in the information, financial activities, and professional and business services sectors.
 2 Office fundamentals include absorption, completion, rental, and vacancy rates.
 

3 This analysis was limited to the 16 office markets in the Region that are tracked by Torto Wheaton Research, the source of office market data
 

used throughout this article.
 

FDIC OUTLOOK 33 SPRING 2004 
Regional Perspectives 

of these markets topped 15 percent. The rise in vacancy Chart 1 

rates was also driven by construction, which increased 

21 percent during the five years ending third quarter 

2003. Class A buildings represented 81 percent of 

new office space across the Region. While there is 

no standard definition for Class A space, its office 

properties, compared with B/C-class spaces, are larger, 

more expensive, and characterized by more recent 

construction, more attractive locations, and more 

efficient tenant layouts.4 

Unique economic characteristics in each of the six 

MSAs drive the performance of office CRE. However, 

it is useful to track the performance of the office space 

classes, as they perform differently in business cycles. 

Class A properties typically react sharply to declining Source: Torto Wheaton Research. 

Rents in San Francisco and San Jose Office Markets 

Declined More than 50 Percent from 2000 Levels 

Percentage Change

Third Quarter 2000 to Third Quarter 2003 

–80 

–70 

–60 

–50 

–40 

–30 

–20 

–10 

0 

10 

San 

Francisco 

San 

Jose 

Seattle Oakland Portland Salt Lake 

City 

Class 

A 

Class 

B/C 

market conditions but rebound swiftly as the economy 

recovers.5 Class B/C properties generally exhibit slower 

deterioration in vacancy and rental rates but also 

recover more slowly as market fundamentals improve. 

The slow recovery rate results, in part, from Class A 

property owners offering rental or other concessions 

during periods of high vacancy to fill empty space, 

often luring existing Class B/C office tenants away 

from those properties. Therefore, while Class A space 

tends to recover more quickly, the recovery usually 

comes at the expense of lower rental income driven 

by the influx of B/C renters. 

Highlights of CRE Fundamentals in Six of the 

Region’s Markets 

San Francisco, San Jose, and Oakland MSAs (Bay 

Area): Job losses in these MSAs following the recession were some of the highest in the nation. Office 

vacancy rates in the Bay Area climbed to near tenyear highs as of September 2003. Rents plummeted 

after climbing to record levels three years before 

(see Chart 1). Vacancy rates were affected adversely 

by a 17 percent increase in new office space in the 

five years ending September 2003. This new construction was spurred by the robust high-tech job market 

in the late 1990s; Class A space represented more 

than 85 percent of the total construction. Despite 

4 For more information about the characteristics of different classes
 

of office space, see www.tortowheatonresearch.com/pdfs/
 

TWR%20Office%20Methodology.pdf, p. 3.
 

5 Sally Gordon, “CMBS: The Dynamics of Class A and B Office
 

Markets—Class B Plays the Tortoise, and Class A, the Hare,”
 

Moody’s Investors Service, June 2001.
 

the recent recovery in some high-tech fundamentals, 

analysts contend it will take years of employment 

gains to fuel substantial absorption and drop vacancy 

rates into the single digits.6 

Portland MSA: A prolonged weakness in the area’s 

key microchip industry, combined with a 20 percent 

increase in office space, contributed to a tripling of the 

office vacancy rate during the five years ended third 

quarter 2003. Vacancy rates among Class B/C properties continued to increase through third quarter 2003, 

surpassing the Class A vacancy rate for the second 

quarter in a row. Weak demand has resulted in a 

dampening of rental rates and has caused tenants to 

leave Class B/C space for Class A space. 

Salt Lake City MSA: Office vacancy rates in the Salt 

Lake City MSA were the highest in the Region during 

third quarter 2003 at almost 21 percent for both Class A 

and B/C properties, double the level three years ago. 

Higher vacancy rates are attributed primarily to a 25 

percent increase in new office completions during the 

five years ending September 2003, which significantly 

outpaced demand. Although the Torto Wheaton 

Research (TWR) 2003 forecast for the Salt Lake City 

MSA projects negative net absorption in B/C properties, 

TWR also estimates a slight improvement in vacancy 

rates in 2004, because of minimal additions to stock. 

6 Colliers International, Third Quarter 2003 Snapshot, Colliers International Office Market Report, San Francisco, September 2003. 

www.colliersmn.com/prod/ccgrd.nsf/f68f8adce56d721e8825666b0071b 

a37/0db70548a776f8f788256dc6006294d0/$FILE/Q3_2003.pdf. 

FDIC OUTLOOK 34 SPRING 2004 
Regional Perspectives 

Seattle: Office vacancy rates in the Seattle MSA 

more than quadrupled during the three years ending 

September 2003, as employment contracted in response 

to the downturn in the high-tech sector and Boeing laid 

off workers. At the same time, new office space was 

added to the market. During the five years ended third 

quarter 2003, office supply, most of which was in Class 

A properties, increased more than 30 percent. As a 

result, Class A vacancy rates increased significantly, and 

rental rates declined 35 percent. Although the pace of 

new office supply is expected to slow in 2004, TWR 

does not project single-digit vacancy rates until 2007. 

Continued Weakness in the Office Market May 

Challenge Asset Quality 

CRE lenders across the Region performed fairly well 

through this cycle. However, insured institutions based 

in these six MSAs reported somewhat elevated exposures to CRE credits in third quarter 2003, which could 

heighten their vulnerability to sustained office market 

weakness. The median CRE-to-Tier 1 capital ratio 

among established community institutions headquartered in these markets exceeded 200 percent as of third 

quarter 2003, higher than the 174 percent median 

reported by MSA-based community banks elsewhere 

in the nation.7 

Despite persistent weakness in these office markets, 

established community institutions based in five of the 

7 Established community institutions include insured institutions in 

operation at least three years that report less than $5 billion in total 

assets, consumer loan-to-Tier 1 loan ratios of less than 300 percent, 

total assets in excess of unfunded commitments, and average loanto-average asset ratios of at least 25 percent. The definition also 

excludes industrial loan companies. These data restrictions were 

used to minimize distortions caused by high proportions of specialty 

or large institutions that may not make loans primarily within the 

headquarters’ MSA. 

six markets reported past-due CRE ratios below the 

nation’s 0.59 percent as of third quarter 2003.8 

Although declining somewhat, the median past-due 

ratio remains high (1.84 percent) among banks based 

in the Salt Lake City market. This situation can be 

attributed, at least in part, to the fact that office 

vacancy rates in this MSA have been increasing during 

the past six years, a longer period of stress than the 

Region’s other high-tech-dependent markets experienced. A prolonged period of low interest rates, underwriting improvements brought about by regulatory 

changes and lessons learned from the CRE problems of 

the 1980s and early 1990s, and increased transparency 

and public ownership of CRE transactions may have 

mitigated the effects of deteriorating market conditions 

on asset quality among insured institutions in these six 

markets. In particular, lower rates may have reduced 

debt service burdens among borrowers enough to offset 

lower cash flows resulting from declining rents. 

Office market fundamentals in the six MSAs could 

remain weak for some time. Torto Wheaton Research 

forecasts that office vacancy rates in these areas will 

remain above 10 percent until at least 2007. The 

Federal Deposit Insurance Corporation (FDIC) monitors market conditions closely and periodically covers 

them and CRE risks in FDIC publications. It also 

considers these conditions and risks during the supervisory process. Currently, the FDIC’s San Francisco 

Regional Office is conducting offsite reviews that evaluate bank policies and board reporting of portfolio-wide 

CRE concentration risk. These reviews will strengthen 

examination processes and facilitate the identification 

of best practices for risk management systems. 

Robert Basinger, Senior Financial Analyst 

John Roberts, Regional Economist 

8 For purposes of this article, commercial real estate loans refer 

exclusively to nonfarm, nonresidential credits. 

FDIC OUTLOOK 35 SPRING 2004 
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