Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION THIRD QUARTER 1997 

FDIC Chicago
 

Region
 

Division of
 

Insurance
 

John D. Weier,
 

Senior Regional
 

Analyst
 

Joan D. Schneider,
 

Regional Economist
 

Michael J. Feeney,
 

Financial Analyst
 

In Focus This Quarter 

◆ Subprime Lending: A Time for Caution—The extent of subprime lending is increasing as strong competition for high-quality borrowers has 

some lenders moving down the credit quality spectrum. Subprime lending requires 

a commitment of resources and expertise beyond that required in more conservative lending, and the consequences of deficiencies in underwriting, servicing, and 

collection can be severe. See page 3. 

By Kathy R. Kalser, Debra L. Novak 

◆ Retail Shakeout: Causes and Implications for Lenders— 

Despite favorable economic conditions, the retail industry is experiencing slow revenue growth in a highly competitive environment. The confluence of rapid change 

in store formats and slow revenue growth has led to an ongoing shakeout among 

both large and small retail chains, and this shakeout may adversely affect credit 

quality at some insured institutions. See page 6. 

By Richard A. Brown, Diane Ellis 

Regular Features 

◆ Regional Economy—Brisk industrial activity and tight labor markets 

characterize the Chicago Region . . . the advanced age of the current cyclical expansion suggests a cautious outlook . . . multifamily housing may be overbuilt in some 

markets . . . agricultural banks face challenges. See page 10. 

By Joan D. Schneider 

◆ Financial Markets—Securitization of home equity loans is growing 

rapidly . . . consumer debt consolidation loans may be driving this growth . . . signs 

of relaxed underwriting have appeared . . . the arrival of FASITs could increase the 

appetite of community banks to enter the ABS market. See page 14. 

By Allen Puwalski 

◆ Regional Banking—Rising interest rates earlier this year and new examination ratings reinforce the need for prudent interest-rate risk management . . . 

actions to diversify revenue streams create new opportunities and risks . . . interstate 

branching becomes a reality. See page 18. 

By John D. Weier, Elise A. Flynn 

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

Insurance Corporation for the following eight geographic regions: 

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

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

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

Dallas Region (CO, NM, OK, TX)
 

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

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

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

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

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

form found on the back cover to the FDIC Public Information Center. Contact the Public 

Information Center for current pricing on bulk orders. 

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

more information or to provide comments or suggestions about the Chicago Region’s Regional 

Outlook, please call John Weier at (312) 382-7512 or send an e-mail to jweier@fdic.gov. 

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

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

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

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

accuracy by the Federal Deposit Insurance Corporation. 

Chairman Andrew C. Hove, Jr. 

Director, Division of Insurance Arthur J. Murton 

Editor George E. French 

Managing Editor Stephen Linehan 

Associate Editor Maureen E. Sweeney 

Assistant Editors Paul C. Bishop 

Richard A. Brown 

Steven K. Burton 

Diane Ellis 

Kathy R. Kalser 

Ronald L. Spieker 

Publications Manager Teresa J. Franks 
In Focus This Quarter
 

Subprime Lending: A Time for Caution
 

•	 Subprime lenders specialize in lending to borrowers with blemished or limited credit histories. 

•	 The consequences of deficiencies in underwriting, 

servicing, and collection can be severe with subprime lending. Lenders that fail to dedicate the 

necessary resources in these areas likely will have 

trouble succeeding in the increasingly competitive 

market for subprime loans. 

•	 Some institutions insured by the FDIC have failed 

to properly assess and control the risks associated 

with their subprime lending programs. 

What Are Subprime Loans? 

Faced with strong competition and shrinking margins 

on loans to high-quality borrowers, some lenders are 

moving down the credit quality spectrum. The strategy 

to extend loans to borrowers perceived as less creditworthy is referred to as “subprime” lending. Subprime 

lending is most commonly associated with auto, home 

equity, mortgage, and secured credit card loans to borrowers who have blemished or limited credit histories. 

Generally, the characteristics of a subprime borrower 

include a history of paying debts late, personal bankruptcy filings, or an insufficient credit record. 

Subprime loans also are referred to as marginal, nonprime, or below “A” quality loans. There are no established guidelines for determining the degree to which a 

borrower is considered subprime, so one lender’s “B” 

customer could be another lender’s “C” customer. 

Definitional variations aside, some general market 

parameters on ranking loans are presented in Table 1. 

TABLE 1 

Criteria for Loan Rankings 

GRADE PAYMENTS LATE BANKRUPTCY 

30 DAYS FILING
 

PRIME
 NONE NONE
 

A­ LESS THAN 2 NONE IN 5 YEARS 

B LESS THAN 4 NONE IN 3 YEARS 

LESS THAN 6 NONE IN 2 YEARS 

D CONSTANTLY LATE NONE IN 1 YEAR 

Sources: Duff & Phelps, Standard & Poor’s, Mortgage 

Market Information Services 

How Big Is the Market? 

The lack of a standard definition for a subprime loan 

makes it difficult to accurately determine the extent of 

the market. However, some industry experts estimated 

that during 1996, subprime loans secured by residences, 

including both home equity and mortgage loans, 

amounted to between $100 billion and $150 billion compared to the estimated $800 billion in originations of 

conventional mortgages. Subprime auto loans have been 

estimated to range between $75 billion and $100 billion, 

or about 20 percent of total auto loans outstanding. 

Who Makes Subprime Loans? 

In the past, subprime lending was primarily the domain 

of a limited number of finance companies. These firms 

specialized in making high-priced loans to borrowers 

with limited access to credit. 

The number of subprime lenders, however, has surged 

in recent years as more companies have been attracted 

by the significantly higher rates and fees earned on subprime loans. In some cases, yields on these higher risk 

assets have been as high as 15 percent to 30 percent. 

The new subprime participants include finance companies that traditionally served prime borrowers, new specialized subprime lenders, and banks. 

The increase in the number of subprime lenders has 

been fueled by strong demand from investors for assetbacked securities (ABS). This method of funding 

enables the lender to effectively raise cash at a lower 

rate to fund loan growth. In addition, the subprime ABS 

market has attracted lenders that previously refrained 

from making subprime loans because they did not want 

to maintain these high-risk loans or the associated 

reserves on their balance sheet. By issuing securities 

backed by subprime loans, lenders now have the ability 

to originate subprime loans and sell them to ABS 

investors. 

Favorable stock market conditions also helped to fund 

the growth of subprime lenders. Approximately 30 subprime lenders raised nearly $3 billion from stock offerings from January 1995 through April 1997, according 

to market watchers. This financing avenue may become 

less accessible, as investors’ concerns over financial 

Regional Outlook	 3 Third Quarter 1997 

C 
In Focus This Quarter
 

problems of several major market participants have 

caused stock prices of subprime lenders to decline significantly during the first part of 1997. 

Financial Difficulties of Some Subprime 

Lenders 

Market participants have observed that, as in credit card 

lending, increasing competition may be compelling some 

subprime lenders to compromise 

underwriting standards and lower 

pricing in order to protect market 

share. Financial difficulties reported by major subprime auto lenders 

Jayhawk Acceptance Corporation 

and Mercury Finance Company 

highlight these concerns. 

Problems in subprime lending are not limited to auto 

loans. Lenders that specialize in subprime home equity 

loans and mortgages also are showing signs of stress. In 

April 1997, Moody’s Investors Service lowered the rating on subordinated debt issued by a leading originator 

of subprime mortgage and home equity loans. The reason was concern over the increasing level of delinquencies in the issuer’s loan portfolio and the highly 

competitive environment for subprime home equity 

loans (see Financial Markets). 

Differences between Prime and Subprime 

Lending 

There are key differences between the underwriting, servicing, and collection methods used for prime and subprime lending programs. The goal of the subprime 

underwriting process is to differentiate those subprime 

borrowers whose past credit problems were due to such 

temporary events as illness or job loss from the habitually bad credits. Subprime lenders often supplement a 

prospective borrower’s credit bureau report with such 

additional information as income, employment history, 

and the nature of prior credit problems. This process 

allows the lender to better determine the credit risk or 

“grade” of the borrower. If this determination is successful, the lender can better establish the price at which 

the loan will be profitable. 

Servicing and collection of subprime loans tends to be 

more labor intensive and costly than in prime lending. 

Subprime lenders tend to monitor payments more closely than prime lenders. Some purportedly call their borrowers regularly to remind them when a payment is due. 

In addition, while prime lenders may be willing to work 

with late borrowers by adjusting minimum amounts or 

payment schedules, subprime lenders generally pursue 

collections more aggressively and repossess collateral 

more quickly. 

Insured Institutions and the Subprime Market 

Bank involvement in subprime lending is difficult to 

quantify because subprime loans are not delineated in 

bank and thrift Call Reports. However, both large and 

small banks reportedly are participating in credit card, 

auto, home equity, and mortgage subprime lending. 

Insured institutions have used various strategies to 

establish a presence in the subprime market. Some 

have: 

•	 acquired or formed joint ventures with companies 

specializing in subprime lending; 

•	 built subprime lending programs internally, using 

existing resources; and 

•	 tapped a network of loan brokers with access to subprime borrowers. Smaller banks entering the market 

for subprime mortgages may use this method more 

commonly. 

Through these strategies, insured institutions have: 

•	 extended loans directly to subprime borrowers or 

purchased subprime loans from loan brokers; 

•	 lent to subprime specialty lenders in the form of loan 

participations, warehouse lines, liquidity facilities, 

or dealer lines; and 

•	 serviced subprime loans or invested in asset-backed 

securities secured by subprime loans. 

Risks Associated with Subprime Lending Need 

to Be Considered Carefully 

According to a Financial Institutions Letter (FIL), FIL 

44-97 issued by the FDIC’s Division of Supervision, 

recent examinations revealed that a number of financial 

institutions involved in subprime lending have failed to 

properly assess and control the risks associated with 

subprime lending. Because of the relatively high default 

rates on such loans, the FIL indicates that this type of 

lending warrants particular caution and management 

attention. 

Regional Outlook	 4 Third Quarter 1997 
In Focus This Quarter
 

Institutions need to be thoroughly aware of the 

increased risks and costs associated with lending to 

higher risk borrowers. Some of these risks include: 

•	 Delinquencies and defaults tend to be more frequent 

and occur sooner on lower quality loans (see Chart 1). 

•	 Loan loss reserves that would have been adequate for 

prime lending may not properly cover higher loss 

rates associated with subprime loans. 

•	 Strains on underwriting and collection resources 

may emerge. 

•	 Because selling collateral is more frequently the 

source of repayment on subprime loans, failure to 

accurately estimate recovery values could severely 

affect the profitability of subprime lenders. For 

example, several subprime auto lenders recently 

reported lower profits when the supply of better 

quality cars coming off leases depressed the prices 

they received on repossessed cars. 

Insured institutions that rapidly increase subprime 

exposures also may need to reevaluate delinquency 

measurement methodologies. Rapid loan growth can 

make it more difficult to accurately track delinquency 

and default trends. Generally loans do not default 

immediately, but “season” or reach peak loss rates over 

CHART 1 

0% 

10% 

20% 

30% 

40% 

50% 

1 4 7 10 13 16 19 22 25 28 31 34 

Months since Origination 

"C" Auto Loans 

"A/B" Auto Loans 

"D" Auto Loans 

Source: Fitch Investors Service, L.P. 

Default Rate 

Defaults Are More Frequent and Occur 

Sooner on Lower Quality Auto Loans 

a period of time. Delinquency and default rates can be 

deceptively low if the proportion of new loans exceeds 

the proportion of seasoned loans in a lender’s portfolio. 

Calculating default rates over time for loans originated 

in a particular period or lending program, instead of as 

a percentage of total outstanding loan balances, helps 

reduce the distortion caused by rapid loan growth. This 

method of computing delinquency and default rates, 

known as “static pool” or “vintage analysis,” is a common measurement tool among investment analysts. 

Banks involved in subprime lending also should realize 

that the recent increase in subprime lending has 

occurred during relatively healthy economic conditions. 

The repayment capacity of subprime borrowers may be 

more susceptible to downturns in the economy, which 

could further exacerbate the already high level of delinquencies and defaults typically recorded on subprime 

loans. 

In addition, banks that lend to subprime specialty 

lenders, who rely heavily on securitization, should evaluate the accounting treatment of securitization and the 

effect securitization may have on earnings (see 

Financial Markets). 

Conclusion 

The extent of involvement by insured institutions in 

subprime lending is difficult to quantify. To be successful in subprime lending requires a commitment of 

resources and expertise. Conversely, deficiencies in 

assessing and controlling the risks of subprime lending 

can have serious consequences. Such deficiencies have 

surfaced at a number of FDIC-insured institutions. 

Striking an appropriate balance between the risks and 

rewards of subprime lending is a challenge for bankers 

and merits the continued attention of bank supervisors. 

Kathy R. Kalser, Chief 

Financial Sector Analysis Section 

Debra L. Novak, 

Division of Resolutions and Receiverships 

Regional Outlook	 5 Third Quarter 1997 
In Focus This Quarter
 

Retail Shakeout: Causes and Implications for Lenders
 

•	 Changes in the marketplace, technology, and 

finance are transforming retailing. 

•	 These trends have given rise to rapid growth in 

the new “big box” store format. 

•	 Consolidation in retailing is evident in mergers, 

acquisitions, and bankruptcies. 

•	 The potential for overbuilding in retail real estate 

markets may pose a risk for insured depository 

institutions. 

For the past two decades, construction of retail space 

has outstripped many indicators of demand such as 

growth in retail sales, population, and income. The 

broadest measure of the industry’s health is sales per 

square foot, and, for shopping centers, it has fallen by 

around 35 percent in real terms since 1972. Chart 1 

shows how growth in leasable shopping center space 

has exceeded growth in shopping centers’ sales since 

1972. 

Based on signs of “overstoring,” a number of retail 

industry analysts have concluded that too many stores 

are chasing too few consumer dollars, indicating an 

emerging shakeout in the retail sector. To the extent that 

insured depository institutions provide financing to 

retailers or for retail real estate, they are exposed to 

heightened credit risk as the shakeout unfolds. 

New Forces Are Reshaping the Retail Landscape 

A combination of demographic and economic forces 

has reduced growth in demand for retail goods from the 

boom days of the 1970s and mid-1980s. Meanwhile, 

technology is reconfiguring the way retail goods are 

marketed and delivered, and a low cost of capital has 

stimulated investment in new retail space and new 

retailing concepts. 

A retail industry boom began roughly in 1970 when 

baby boomers and women began entering the work 

force in record numbers. At the same time, proliferation 

in general-purpose credit cards facilitated an extension 

in consumer borrowing power. As a result, there was a 

CHART 1 

100 

150 

200 

250 

300 

350 

’72 ’76 ’80 ’84 ’87 ’89 ’91 ’93 ’95 

Leasable 

Space* 

Inflation-adjusted 

Sales * 

* Does not include non-shopping center space. 

Source: International Council of Shopping Centers 

1972=100 

Construction of Shopping Center Space Has 

Outstripped Sales Growth 

98 percent increase in inflation-adjusted retail sales 

from 1967 to 1994. 

To meet this demand and serve expanding suburban 

communities, developers built shopping centers at a 

rapid pace. The number of shopping centers, from small 

neighborhood strip centers to huge regional malls, grew 

from about 13,000 in 1972 to over 41,000 in 1995. 

Despite economic conditions that seem favorable for 

the retail sector, revenue growth has been painfully 

slow in the 1990s. Payrolls have seen net growth of 13.4 

million jobs since mid-1991, while real disposable personal incomes and consumer confidence have risen 

commensurately. An optimistic household sector has 

shown a willingness to take on debt under these favorable conditions and has done so with the benefit of 

lower interest rates compared to the 1980s. 

Even with generally positive economic conditions, 

retail demand has grown slowly in the 1990s (see Chart 

2, next page). Annual rates of increase in real expenditures on many durable and, especially, nondurable goods 

have lagged behind rates of the previous two decades. 

Slow growth in retail revenues can be explained in part 

by the fact that retail goods overall have risen in price at 

only around two-thirds of the general rate of inflation 

during the 1990s, while the appliance, electronics, and 

personal computer sector has seen actual price deflation. 

Regional Outlook	 6 Third Quarter 1997 
In Focus This Quarter
 

An aging consumer base is another factor holding down 

retail sales growth. The total number of households 

headed by persons age 20 to 35—the age at which families are getting established and acquiring household 

durable goods—is the same now as it was in 1980. The 

lack of growth in this key demographic group has limited growth in retail demand and should continue to do 

so for the foreseeable future. The total population in the 

20 to 35 age bracket is projected to decline slightly by 

2007. 

Other broad trends have contributed to slower retail 

sales growth. Retail sales as a percentage of personal 

income fell from 46 percent to 38 percent between 1967 

to 1996 as consumers shifted more of their disposable 

income to the purchase of personal services, housing, 

education, travel, and entertainment. A Standard and 

Poor’s Industry Survey reports that consumers have 

reduced their number of trips to shopping malls by 35 

percent since 1980, while total shopping hours are down 

70 percent. 

Looking ahead, mail-order retailing through electronic media, 

including cable television and the 

Internet, may be poised to gain 

significant market share at the 

expense of shopping centers. 

“Virtual shopping malls” such as 

Amazon.com, an Internet bookseller, have made headlines with their initial successes,
 

although analysts caution that widespread adoption of
 

high-tech shopping may be some years down the road. 


Technology has become a key to distribution and marketing. Faced with slower revenue growth, retailers have 

been investing in technology to cut their expenses and 

boost their bottom lines. For example, point-of-sale 

scanning delivers a vast amount of information that can 

be used to target marketing efforts and manage and control inventories—providing a distinct competitive 

advantage for large retail chains with vast marketing 

and distribution networks. 

A low cost of capital has fueled investment. Low interest rates and a booming stock market have made market 

financing plentiful and cheap. This environment has 

allowed retailers to overhaul retail strategies and invest 

heavily in technology, inventory, and retail space— 

investments that might otherwise have been infeasible. 

Since 1991, around 1.13 billion square feet of new retail 

space has been added nationwide representing an 

increase of about 12 percent to the total stock of retail 

real estate over five years. Net additions to retail inventories since 1991 have totaled almost $33 billion in 

inflation-adjusted dollars, an increase of over 18 percent. No figures are available on investments made in 

information systems, although they are known to be 

sizeable. 

Growth of the “Big Box” Format 

Leading retailers have responded to these forces with 

aggressive expansion in the “big box” store format. Big 

box retailers are typically discount stores and superstores, such as Circuit City, PetSmart, and The Home 

Depot, Inc., which tend to cluster in large strip malls 

called “power centers.” In many towns and cities, the 

arrival of big box stores has left smaller, local retail 

establishments with only a small fraction of their former 

share of the local market. 

The big box format has a number of advantages. Among 

the most important is the ability to offer a large, diverse 

on-shelf selection. This approach enables a single location to dominate that retail category in the local market, 

which is why the big box chains are often referred to as 

“category killers.” Large retail chains also have more 

leverage over suppliers. They can negotiate more favorable prices and demand cooperative advertising from 

manufacturers. Large retailers typically have the financial resources to invest in the latest distribution methods 

and technology. Finally, unlike smaller traditional retailers, these large chains can obtain financing through the 

capital markets. 

CHART 2 

Inflation-Adjusted Retail Sales Have Grown 

Slowly in the 1990s 

Real Growth in Retail Sales*, 

Compound Annual Rate 

3.0% 

2.5% 

2.0% 

1.5% 

1.0% 

0.5% 

0.0% 

1970s 1980s 1990s 

* Retail sales excluding autos, deflated by the consumer price index. 

Source: Bureau of the Census and Bureau of Labor Statistics 

Regional Outlook 7 Third Quarter 1997 
In Focus This Quarter
 

Industry Consolidation to Continue 

Rapid expansion among the large retail chains has contributed to a highly competitive retail sector marked by 

intense battles for domination of the major retail categories. The result of this competition, analysts say, will 

be consolidation in the industry as weaker chains give 

way to market leaders. 

One sign of this consolidation is in multibillion dollar 

acquisitions, such as Federated Department Stores’ 

acquisition of R.H. Macy. The five largest department 

store chains (JC Penney, Federated, May, Dillard, and 

Nordstrom) now account for 87 percent of department 

store sales nationwide. The top three discount department store chains (Wal-Mart, K-Mart, and Target) 

account for 87 percent of full-line discount department 

store sales. 

Intensely competitive conditions also are reflected by 

retail bankruptcies and restructurings. Both Woolworth 

Corp. and K-Mart Corp. recently closed a number of 

stores in restructurings that reflect the loss of market 

share to Wal-Mart. Smaller companies that have fewer 

restructuring options are more likely to be forced into 

bankruptcy. Dun & Bradstreet reports that domestic 

business failures among retail establishments rose in 

1995 by 2.8 percent to 12,952. While most of these failures were individual stores and small chains, a number 

of larger chains also filed for bankruptcy during 1995, 

including Barney’s, Bradlees Inc., Caldor, The 

Clothestime Inc., Edison Brothers Stores, ElderBeerman, Herman’s Sporting Goods, Jamesway, and 

Today’s Man. 

As the retail shakeout moves forward, any credit losses 

on commercial and industrial loans to retailers are more 

likely to arise from bankruptcies and restructurings than 

from mergers and acquisitions. Unfortunately, it is difficult to say in advance exactly how consolidation in the 

industry is likely to take place. 

Overbuilding Is a Risk for Retail Real Estate 

Retail industry analysts are particularly concerned 

about the potential for overbuilding of retail space. 

Because of this concern, lenders and examiners should 

be alert to possible credit quality problems with commercial real estate loans secured by retail properties. 

CHART 3 

0 

20 

40 

60 

80 

100 

120 

140 

160 

’88 ’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 

0% 

2% 

4% 

6% 

8% 

10% 

12% 

New Supply Has Recently Outpaced 

Absorption of Retail Space 

Source: FDIC, The Real Estate Report (Summary for 58 major markets) 

Vacancy 

Rate 

Net New Supply Absorption 

Millions of 

Square Feet 

Although a vacancy rate of 7.7 percent does not suggest 

that the U.S. retail market is vastly overbuilt at present, 

there are warning signs. One is that the U.S. aggregate 

vacancy rate has begun to tick upward since 1995 as net 

completions of new retail space have caught up to and 

surpassed the absorption of that space by retailers (see 

Chart 3). Another frequently cited indicator of overbuilding is a falling ratio of sales per square foot in the 

industry, reflecting the fact that additions to retail space 

have outpaced sales growth for some time. In any case, 

local market conditions may be somewhat more volatile 

than the national figures would suggest, particularly in 

areas where a great deal of construction activity has 

recently taken place (see inset, Retail Vacancy Rates 

Climb Slightly in the Chicago Region). 

Besides market conditions, underwriting is the other 

major determinant of credit quality in retail real estate 

lending. Market analysts report that many of the problems resulting from local market downturns have been 

on loans with 1980s-vintage underwriting, particularly 

those with high loan-to-value ratios. Analysts also voice 

concern that the rapid expansion of space may be 

putting downward pressure on lease rates. In light of an 

ample supply of space and a number of large chains 

continuing to add space, any valuations that assume 

future growth in lease rates should be closely reviewed. 

The viability of rapid expansion on the part of the large 

retail chains would undergo a particularly severe test in 

the event of a recession. 

Richard A. Brown, Chief, Economic Analysis Section 

Diane Ellis, Senior Financial Analyst 

Regional Outlook 8 Third Quarter 1997 
In Focus This Quarter
 

Retail Vacancy Rates Climb Slightly CHART 4

in the Chicago Region 

Reports from around the Chicago Region indicate that 

the supply of new retail space is beginning to outstrip 

the demand for that space in many metropolitan 

areas. Net new supply of retail space slightly exceeded demand in many of the Region’s major metropolitan areas recently. Thus, most vacancy rates in this 

Region at year-end 1996 were several tenths of a percentage point higher than year-earlier levels, according to the latest edition of the FDIC’s The Real Estate 

Report (see Table 1). 

Two metropolitan areas are exhibiting signs of potential overbuilding. In Indianapolis, cumulative net 

new supply over the past three years has exceeded 

absorption by more than 2 million square feet (see 

Chart 4). Consequently, the vacancy rate rose by 

about 1 percentage point in each of the past two years, 

reaching 8.9 percent late in 1996. Planned retail projects for the Indianapolis area call for an additional 

2.9 million square feet of space. However, over 90 

percent of this space is in the early planning stage and 

therefore subject to postponement or cancellation 

until more of the currently available space is 

absorbed. 

Cleveland’s vacancy rate has risen more slowly than 

the rate in the Indianapolis market. Nevertheless, it is 

TABLE 1 

-1000 

0 

1000 

2000 

3000 

4000 

0% 

2% 

4% 

6% 

8% 

10% 

New Supply of Retail Space Outpaces 

Demand in Indianapolis 

Vacancy 

Rate 

(right 

scale) 

Net New Absorption Supply 

198819891990199119921993199419951996 

Thousands of Square Feet 

Source: FDIC, The Real Estate Report 

the highest since the late 1980s, with the exception of 

1992. This increase has developed despite relatively 

limited new supply in recent years (see Chart 5). The 

opening of the SouthPark Center, the first new mall 

built in Northeast Ohio in the past 18 years, accounted for some of last year’s spurt in new space built. The 

customer traffic it experienced, however, reportedly 

drew heavily from several existing malls. At the same 

time the new mall was opening, the area’s first mall, 

constructed in 1963, was being demolished to make 

room for a big box store and a strip center. 

Joan D. Schneider, Regional Economist 

CHART 5 

Vacancy Rates in Chicago Region’s 

Retail Real Estate Markets 

1993 1994 1995 1996 

CHICAGO PMSA* 8.3 7.7 6.9 6.6 

CINCINNATI PMSA 

(OH-KY-IN) 10.8 8.2 7.4 7.7 

CLEVELAND PMSA 6.3 6.7 7.5 8.0 

COLUMBUS MSA* 6.8 5.6 4.7 5.1 

DETROIT PMSA 8.0 5.1 4.6 4.8 

INDIANAPOLIS MSA 6.7 6.9 7.8 8.9 

MILWAUKEE PMSA 8.8 8.7 8.7 9.2 

*MSA = Metropolitan Statistical Area; 

PMSA = Primary Metropolitan Statistical Area 

Source: FDIC, The Real Estate Report 

-2500 

-1500 

-500 

500 

1500 

2500 

3500 

4500 

2% 

3% 

4% 

5% 

6% 

7% 

8% 

9% 

Source: FDIC, The Real Estate Report 

Vacancy Rate Rises in Cleveland 

Net New 

Supply 

Absorption 

Thousands of Square Feet 

198819891990199119921993199419951996 

Vacancy 

Rate 

(right 

scale) 

Regional Outlook 9
 Third Quarter 1997 
Regular Features	 Regional Economy
 

Chicago Region’s Economy: Checking Its Pulse
 

•	 Continuing healthy auto and truck sales and low inventory stocks suggest that the motor-vehicle and related industries will continue operating at high levels in the near term. A significant rise in interest rates is 

among the possible risks that would be detrimental to the Region’s industrial economy. 

•	 Multifamily residential construction outpaced demand recently, pushing the Midwest’s rental vacancy rate 

to its highest level in a decade. 

•	 Agricultural banks are facing increased competition at a time when volatile output prices and changes 

brought about by the 1996 Farm Bill may challenge traditional underwriting practices. 

•	 The extended cyclical expansion has contributed to the Region’s current economic vigor. Even so, the expansion’s longevity and the recent, policy-induced rise in interest rates suggest that institutions should review 

the economic assumptions used for their product pricing and strategic planning. 

Steady Pulse: Motor-Vehicle Sector 

Healthy demand from households and businesses continues to support national car and truck sales at a high 

level (see Chart 1). Although interest rates have edged 

up recently (see Chart 3 in Financial Markets article), 

the near-term effect on demand for vehicles is expected 

to be marginal. An industry rule of thumb is that a 25 

basis-point increase in the federal funds rate trims vehicle sales by only 100,000 to 150,000 units at an annual 

rate. In order to offset this projected loss, however, 

some automakers and dealers are sweetening incentives 

or subsidizing their financing terms. 

Auto inventories were already lean before recent labor 

strikes, which trimmed inventories even further (see 

Chart 1). The currently wide gap between sales and 

inventories suggests that there will be some short-term 

rebound in production both to rebuild inventories and 

meet demand. Because over half of the nation’s auto 

assembly plants are located in this Region, the vehicle 

industry’s current health is exerting a pervasive influence. Another rule of thumb suggests that for every one 

job in auto and truck plants, there are about two and 

one-half jobs in ancillary industries. High levels of 

activity in this and many other industries helped reduce 

the Region’s unemployment rate to 4.5 percent in the 

first quarter, the lowest in more than two decades. 

Despite the strength of vehicle sales, competition and 

changes in financing options have trimmed the share of 

consumer auto loans held by banks. Nationwide, banks 

currently hold 40.4 percent of auto credits, according to 

the Federal Reserve’s consumer credit data. This share 

is more than 3 percentage points lower than in 1994 (see 

Chart 2, next page), reflecting gains among such other 

lenders as credit unions and savings institutions as well 

as the development of the auto asset-backed securities 

(ABS) market. 

To some extent, banks are transforming how they participate in the auto financing market but not necessarily 

yielding earning power. For example, commercial 

banks’ issuance jumped to 28 percent of the auto ABS 

market in 1995 after three years of subdued participation. It rose further in 1996, to 34 percent. The rise in 

banks’ share reflects not only their increasing participation but also the fact that the captive auto finance companies (e.g., GMAC, Chrysler Financial, Ford Motor 

Credit) have shifted their funding strategies away from 

this market to asset-backed commercial paper and other 

alternatives. 

CHART 1 

 Inventories Are Low as Sales Remain High 

Millions of Vehicles Millions of Units, Annual Rate 

Light Vehicle Sales 

(right scale) 

Domestic 

Auto 

Inventories (left scale) 

16 

1.8 15 

1.6 14 

1.3 13 

1.1 12 

0.8 11 May-90 May-91 May-92 May-93 May-94 May-95 May-96 May-97 

Source: U.S. Department of Commerce 

Regional Outlook	 10 Third Quarter 1997 
Regular Features Regional Economy
 

CHART 2 

Shifting Shares in Auto Credit Market 

50% 

40% 

30% 

20% 

10% 

0% 

Source: Federal Reserve Board of Governors 

Commercial Banks 

Pools of 

Securitized 

Assets 

Finance 

Companies 

Other 

Jan-85Jan-87Jan-89Jan-91Jan-93Jan-95Jan-97 

Implications: To date, the recent rise in interest rates 

appears to be having little impact on the Region’s 

motor-vehicle and other major industries, from either 

the demand or supply side. If interest rates rise significantly or labor shortages intensify, however, the manufacturing sector will have difficulty sustaining recent 

levels of activity. In that event, income growth for both 

the household and business sectors will be negatively 

affected, which could lower loan demand and possibly 

cause credit quality problems. While many banks in the 

Chicago Region retain auto loans in their portfolios, a 

few are participating in the auto ABS market. 

TABLE 1 

Quickening Pulse: Multifamily Construction 

An upswing in residential construction has been under 

way since 1991. The expansion reflects both favorable 

economic conditions and a sharp rebound in the 

Midwest’s homeownership rate to a 20-year high. The 

Midwest, which covers states in the FDIC’s Chicago 

and Kansas City Regions, historically has the highest 

rate in the nation. In the first quarter of 1997, the homeownership rate was 70.6 percent in the Midwest, solidly 

above the national rate of 65.4 percent. 

Since 1991, single-family home starts in the Midwest 

have risen at a 5.8 percent average annual rate. Rising 

considerably faster were units started in multifamily 

buildings. These starts averaged 10.2 percent annual 

growth but soared by as much as 35 percent in 1994. 

Behind this vigor, however, was considerable variation 

among cities in the Chicago Region, as shown in 

Table 1. 

Signs are appearing that the supply of new apartments 

is outpacing demand in some markets. First, the rental 

vacancy rate for the Midwest climbed to 8.5 percent in 

the first quarter of 1997 (see Chart 3, next page). This 

rate is not only considerably above its range during the 

past decade but also now exceeds the national rate, 

which has not seen a similar increase. 

Permits for New 5+ Unit Buildings 

Market Number of Units % Change 

1995 1996 1995 1996 

AKRON PMSA 309 815 –48% 164% 

BLOOMINGTON IN 259 181 –17% –30% 

CHICAGO PMSA 5259 6768 7% 29% 

CINCINNATI OH-KY-IN PMSA 2513 1734 4% –31% 

CLEVELAND-LORAIN-ELYRIA 1437 858 126% –40% 

COLUMBUS 2587 3291 7% 27% 

DAYTON-SPRINGFIELD 371 1319 –62% 256% 

DETROIT PMSA 2826 3414 –7% 21% 

GRAND RAPIDS-MUSKEGON-HOLLAND 1109 1320 5% 19% 

INDIANAPOLIS 2558 2439 64% –5% 

MADISON 1394 568 –3% –59% 

MILWAUKEE-WAUKESHA PMSA 2143 2232 8% 4% 

TOLEDO 531 117 59% –78% 

Source: Census Bureau 

Regional Outlook 11 Third Quarter 1997 
Regular Features	 Regional Economy
 

CHART 3 

4% 

5% 

6% 

7% 

8% 

9% 

Midwest 

United States 

Midwest’s Rental Vacancy Rate Takes Off 

Source: U.S. Department of Commerce Q1-76 Q1-79 Q1-82 Q1-85

Q1-88

Q1-91

Q1-94

Q1-97 

Second, a number of apartment projects, ranging from 

new construction to conversion of former industrial and 

office structures, are in the pipeline and will add to 

supply in coming quarters. Third, there are anecdotal 

reports of investor funds seeking projects owing to an 

upswing in activity by capital-rich real estate investment 

trusts, insurance companies, and others looking for 

longer term investment opportunities. 

Implications: Rental vacancy rates in Dayton and 

Columbus have risen noticeably in the past two years, 

increasing by more than 3.5 percentage points (see 

Chart 4). It remains to be seen whether demand this year 

will significantly lower these rates, as happened in the 

Indianapolis market after 1993. If a substantial number 

of apartments are still in the construction pipelines in 

these cities, then the near-term outlook may involve 

weakness in rental rates and cash flows. Troubled profitability, in turn, could erode developers’ ability to 

CHART 4 

3% 

4% 

5% 

6% 

7% 

8% 

9% 

10% 

11% 

12% 

198619881990199219941996 

Several Rental Vacancy Rates Climb 

Indianapolis 

Columbus 

Dayton 

Source: FDIC, The Real Estate Report 

maintain loan repayment schedules or obtain permanent 

financing. 

Agriculture Banks Face Challenges Despite 

Robust Crop Forecasts 

Soybean and corn plantings progressed at a near-record 

pace through mid-May. Early estimates from the U.S. 

Department of Agriculture (USDA) suggest that U.S. 

farmers may harvest a record 2.6 billion bushels of soybeans and a near-record 9.8 billion bushels of corn. 

Since the Chicago Region grows about one-third of the 

nation’s corn and soybeans, good harvests should benefit the Region in various ways: 

•	 The USDA estimates that crop revenues nationally 

will fall by about 4 percent this year—partly because 

of lower corn prices—yet remain above $100 billion 

after posting a record high last year. 

•	 Rebuilding of corn and soybean stockpiles would 

occur after a season when reserves were the lowest in 

20 years or longer. 

•	 Profits for livestock producers should be enhanced 

by an easing of feed costs for cattle and hogs. 

•	 Food companies could avoid repeating last year’s 

shutdowns of processing and milling operations 

owing to raw material shortages. 

Despite the favorable planting reports, soybean prices 

currently are quite high (see Chart 5, next page). LateMay cash prices in central Illinois were roughly 25 percent higher than at the start of the year, partly because 

strong domestic and foreign demand suggests additional shrinkage of reserves until the harvest starts at the 

end of this summer. 

Agricultural banks face other challenges beyond the 

impact of gyrating product prices on their customers 

and localities. Increased competition from several 

fronts slightly trimmed banks’ share of farm debt to 

39.4 percent in 1996, according to the USDA. This drop 

was the first since the 1980s. Among the contributing 

factors are: 

•	 Equipment manufacturers, seed companies, and 

other agricultural vendors are more active in offering 

credit to farmers. John Deere Credit, for example, 

Regional Outlook	 12 Third Quarter 1997 
Regular Features	 Regional Economy
 

CHART 5	 CHART 6 

 Central Illinois Soybean Prices Reflect
 

Currently Strong Demand and Low Stocks
 

$ per bushel 

$4 

$5 

$6 

$7 

$8 

$9

Jan-90Jan-91Jan-92Jan-93Jan-94Jan-95Jan-96Jan-97 

Sources: Wall Street Journal, Doane’s Agricultural Report 

Percentage of Ag Loans 

0% 

20% 

40% 

60% 

80% 

100%

 Banks’ Agricultural Lending in Region 

Dominated by Small and Midsize Institutions 

Source: Bank and Thrift Call Reports 

Over $1 

Billion 

$100 Million 

to $1 Billion 

Under $100 

Million 

Asset Size 

MI

IN

IL

WI

OH

Region 

reportedly had $3.6 billion in its agricultural retail 

note program last year. PHI Financial Services, the 

financing arm of the nation’s largest seed supplier, 

has started offering operating lines of credit in addition to its traditional short-term financing for seeds. 

•	 Leasing of equipment through manufacturers, another substitute for traditional credit, is being used by 

about 20 percent of crop farmers. 

•	 The Farm Credit System has recently become more 

active. Its share of agricultural lending rose to 25.6 

percent in 1996 from 24.4 percent in 1994. The 

USDA estimates that it will rise by another percentage point this year. 

In addition, small institutions face increasing competition from within the industry. Several large banks that 

operate nationwide are seeking to grow their share of 

farm lending. Beyond funding large, commercial-sized 

farms, some of these institutions are encroaching on the 

traditional customer base of smaller banks. 

Implications: Early 1997 agricultural production projections appear bright, which should be a plus for 

insured institutions with credit concentrations to this 

sector. Even so: 

•	 Lenders need to ensure that the potential volatility of 

prices, such as seen recently for soybeans, is incorporated into their underwriting decisions. 

•	 Small and midsized banks, which currently provide 

84.5 percent of agricultural loans made by insured 

institutions in this Region (see Chart 6), are facing 

increased competition from larger banks as well as 

nonbank lenders. 

•	 The potential impact of the 1996 Farm Bill deserves 

watching. Lenders need to assess the potential 

impact on borrowers whose crops are affected by the 

planned phase-out of farm subsidies. 

Joan D. Schneider, Regional Economist 

Regional Outlook	 13 Third Quarter 1997 
Regular Features	 Financial Markets
 

Financial Markets
 

•	 Deteriorating credit quality trends in the rapidly growing home-equity backed securities market could portend trends in bank residential mortgage lending. 

•	 Financial asset securitization investment trusts, known as FASITs, promise to change the asset-backed securities market significantly and could make securitization more accessible to community banks. 

•	 The Treasury yield curve is steeper and higher than it was at year-end 1996. 

•	 Community bank stocks in the Chicago Region performed smoothly despite turmoil in the broad market. 

Trends in the Home-Equity Asset-Backed 

Market Are Important to Banks 

The home-equity loan (HEL) asset-backed securities 

(ABS) market has grown by over $20 billion or 251 percent since 1993, with total issuance of HEL ABS topping $27 billion in 1996 (see Chart 1). The rapid growth 

of the market, which has been driven largely by consumer debt consolidation lending, has been accompanied by abnormally early and high levels of 

delinquencies. Banks that are investing in HEL ABS, 

considering securitizing HELs, or lending significantly 

for debt consolidation should be aware of credit quality 

developments in the HEL ABS market. 

The distinction between HELs and first-lien residential 

mortgages is eroding in the HEL ABS market. The refinancing boom spurred by the decline in rates during 

1993 and early 1994 resulted in a change in the makeup 

of the HEL ABS market, causing much higher percentages of the securities to be backed by first-lien HELs 

than previously had been the case. First-lien home-equity lending, know as cash-out refinancing, grew substantially when home-equity borrowers were motivated by 

lower rates to refinance their first mortgages for 

amounts greater than the remaining principal balance 

instead of adding a second mortgage. 

Debt consolidation is the primary reason for homeequity borrowing. Nonbanks that expanded their mortgage lending capacity during 1993 have been 

aggressively marketing to an increasing number of borrowers who desire to consolidate their growing debt 

burdens. According to the Consumer Bankers 

Association 1997 Home-Equity Loan Study, debt consolidation accounted for 36 percent of home-equity 

lines of credit and 40 percent of closed-end loans. Prior 

to 1992, home improvement was the primary reason for 

home-equity borrowing. This trend toward debt consolidation as the reason for home-equity borrowing has 

significant risk implications because, unlike funds lent 

for home improvement, the proceeds of a debt consolidation loan do not enhance the lender’s collateral value. 

The rapid growth of the HEL securitization market has 

been attended by signs of relaxed underwriting. 

Adverse credit quality trends have been particularly 

prominent for loans that were originated in 1995. Chart 

2 (next page) shows the total delinquency rates for 

closed-end loan pools originated in 1995 versus 1994. 

The sharp upward path of delinquency rates for loan 

pools originated in 1995 raises concern that aggressive 

competition for volume, and apparently relaxed underwriting standards, could lead to unprecedented default 

levels. Furthermore, HEL originations in 1996 more 

than doubled 1995 levels, causing market observers to 

suspect that underwriting standards continued to lapse. 

CHART 1 

1993 1994 1995 1996

0 

5 

10 

15 

20 

25 

1993 1994 1995 1996

Securitization of Home Equity 

Loans Has Risen Substantially 

Lines of Credit 

Closed End 

Source: Moody’s Investors Service 

$ Billion 

Regional Outlook	 14 Third Quarter 1997 
Regular Features Financial Markets
 

The trends in the HEL ABS market may portend credit 

quality trends in nonsecuritized cash-out refinancing. If 

similar unfavorable trends exist in bank-originated 

cash-out refinancing, evidence of these trends would be 

obscured by banks’ larger and less risky portfolios of 

purchase mortgage loans. The trends would be obscured 

because banks report all first mortgage lending on 1 to 

4 family residential properties without distinguishing 

between purchase mortgages and cash-out refinancings. 

The unfavorable trends in the HEL ABS market suggest 

that banks that engage in significant cash-out refinancing and other forms of home-equity lending should be 

able to monitor trends in the credit quality of these loans 

separate from purchase mortgage loans. 

A Combination of Several Factors Could Induce 

More Banks to Securitize HELs 

Although the present volume of bank-originated HEL 

securitizations is relatively small, banks have recently 

entered this finance company-dominated market, and a 

combination of several factors is likely to cause more to 

follow. First, home equity lines of credit are currently 

growing at rates exceeding total consumer lending, and, 

by and large, the deposit growth to fund this lending is 

less than robust. In addition, according to Moody’s 

Investors Service, investor demand is high for bankoriginated home-equity line of credit securitizations 

because bank-originated lines are perceived to have 

lower credit risk. The funding benefits and profitability 

of securitizing bank-originated home-equity lines of 

credit could entice more banks into the securitization 

market. Finally, the combination of these factors with 

the potential cost savings provided by using the new 

financial asset securitization investment trust (FASIT) 

CHART 2 

0 

2 

4 

6 

8 

10 

1 3 5 7 9 11 13 15 17 19 21 23 

Months since Origination 

1995-Originated Loans 

Source: Moody’s Investors Service 

Percent 

Higher Delinquency Rates Are Occurring 

Earlier in More Recently Originated Loan Pools 

1994-Originated Loans 

Closed-end Loans 

structure (see discussion below) could produce momentum that will result in banks, large and small, securitizing home equity loans in significantly increased 

amounts. 

Securitizing HELs can change the balance sheet and 

income statement of the securitizer significantly, resulting in significant servicing assets and gains on sale. 

Beginning in 1997, when a 

company sells loans, it 

must comply with the 

requirements of Financial 

Accounting Standard 

(FAS) 125. If the company 

retains servicing rights on 

the assets sold, FAS 125 

requires the seller to book 

an asset related to the gain on sale that represents the 

future income derived from servicing the loans. This 

asset is similar to mortgage servicing rights in that it 

represents the present value of future expected cash 

flows derived from loan servicing. One major homeequity securitizer, which indicated that FAS 125 would 

not materially affect its financial statements, reported 

servicing assets at almost 90 percent of equity, and 

gains associated with the sale of serviced assets at 71 

percent of total revenue. 

The value of servicing assets is based on management’s 

assumptions about the future cash flows to be generated by the assets. Because these assumptions are based 

largely on historical performance, unexpected deterioration, like that associated with 1995- and possibly 

1996-originated loans, that results in charge-offs or 

early repayment through foreclosure of serviced assets, 

could require the adjustment of the valuation assumptions and the write-down of the servicing assets. 

FASITs Promise to Change the ABS Market 

The Small Business Job Protection Act of 1996 created 

two new sections of the Internal Revenue Code that create and govern FASITs. The FASIT provisions, patterned in part on the real estate mortgage investment 

conduit (REMIC) rules issued in 1986, are intended to 

provide tax certainty for ABS issuers and purchasers 

and enhance the flexibility of asset securitizations. The 

FASIT provisions take effect on September 1, 1997. 

The advent of the FASIT is likely to change the ABS 

market in important ways. First, the FASIT will clarify 

Regional Outlook 15 Third Quarter 1997 
Regular Features Financial Markets
 

the tax treatment of securitizations. Because of the current tax ambiguity, designing ABS structures to avoid 

taxation is administratively costly, and it restricts the 

forms that securitizations can take. The higher administrative cost associated with current securitization techniques establishes a practical minimum size for asset 

pools that can be feasibly securitized. With FASITs and 

the reduced costs associated with tax clarity, the economically feasible pool size may be significantly smaller. The lowering of this threshold could result in more 

community banks entering the securitization market. 

ABS issuers believe that the market for their product 

has been hampered by the restrictive nature of current 

asset-backed tax ambiguity, which prevents them from 

responding to investor 

preferences for varying 

maturities, coupon types, 

and prepayment and credit risk profiles. FASITs 

allow sponsors the flexibility to create multipleclass securities that 

satisfy these preferences 

with the certainty that the 

securities will count as debt and that the FASIT will not 

be treated as a taxable corporation. This combination of 

flexibility and tax certainty could lead to the kind of 

innovations in ABS structures that followed the 1986 

REMIC legislation, which brought analogous benefits 

to the mortgage-backed market. 

FASITs will bring to the ABS market the ability to add 

and remove assets throughout the life of a securitization. This feature could be applied by securitizing 

revolving construction loans and then replacing the 

revolving loans with permanent financing when construction is completed. A FASIT also will be able to 

contain a mixed pool of assets such as real estate, nonreal estate assets, and unsecured credit, allowing exposures to very different markets from the same security. 

Finally, a FASIT can hold swaps and other hedging 

instruments. Using this feature, an issuer could combine 

a mortgage passthrough security with a hedging instrument that is designed to offset mortgage prepayment 

risk, such as a reverse-index amortizing swap. 

The increased flexibility that the FASIT promises to 

bring the ABS market comes with the potential for 

greatly increased complexity and risk. Banks that invest 

in FASIT securities will need to understand fully not 

only the risk characteristics existing at the outset of 

security but also the risk that could arise throughout the 

security’s life if assets are to be removed and replaced. 

Changes in Interest Rates and Bond Values 

The Treasury yield curve (see Chart 3) rose following 

March 25, 1997, when the Federal Open Market 

Committee (FOMC) met and raised the target federal 

funds rate 25 basis points to 5.50 percent. The yield on 

the 30-year Treasury bond rose above 7 percent on the 

Thursday following the meeting and remained there for 

the next 23 days. The FOMC met again on May 20, 

1997, and left the target rate unchanged. 

The model portfolio responded to the rise in rates, but 

only modestly (see Table 1). The relatively short weighted average maturity of the portfolio served to moderate 

the effect of the 54 basis point rise in the five-year 

Treasury between December 31, 1996, and March 31, 

1997. As discussed in Regional Outlook, second quarter 1997, changes in the value of the model portfolio 

correlate more with changes in the five-year Treasury 

rate than with the 30-year bond rate. 

The yields along the April 30, 1997, yield curve imply 

that the market expects the curve to continue to flatten 

through the remainder of the year with short rates rising 

somewhat. In order to gauge what affect a 25 basis point 

rise in the yield curve could have on bank fixed-income 

portfolios, the model portfolio has been “shocked” to 

simulate the effect of an instantaneous 25 basis point 

shift in the yield curve on May 28, 1997. 

CHART 3 

The Treasury Yield Curve Is Steeper 

and Higher since Year-end 1996 

5.0 

5.5 

6.0 

6.5 

7.0 

7.5 

3­

month 

2­

year 

7­

year 

30­

year 

Source: Bloomberg 

Percent 

3/31/97 

4/30/97 

12/31/96 

Regional Outlook 16 Third Quarter 1997 
Regular Features Financial Markets
 

TABLE 1 

Type of Security Par Value Percent Maturity Percent Change Reof or Change sulting from 

Portfolio WAL from a 25 bp Rate 

as of 12/31/96 Increase on 

12/31/96 to 5/28/97 

3/31/97 

U.S. TREASURY 5.6% 2,000 20% 1 YR –0.30% –0.16% 

FNMA AGENCY 5.8% CALLABLE 1,200 12% 2 YR –0.50% –0.38% 

STATE COUNTY MUNICIPAL GO 4.8% 800 8% 11 YR –2.05% –2.03% 

FNMA MORTGAGE PASSTHROUGH 7.5% 3,000 30% 8 YR –1.78% –1.44% 

FNMA (REMIC) 8.0% PAC 2,000 20% 2.5 YR –1.27% –0.50% 

CREDIT CARD ASSET-BACKED SECURITY 1,000 10% 5 YR –0.09% 0.00% 

TOTAL 10,000 100% 4.85 YR –1.08% –0.77% 

Note: Portfolio composition based on estimates derived from aggregated Bank Call Report information. 

Again, the interest rate risk benefits of maintaining a 

portfolio of relatively short weighted average life are 

apparent. The U.S. Treasury and the agency, the shortest 

lived instruments, and the floating-rate ABS demonstrate the least price sensitivity. The municipal bond is 

the most sensitive to rate changes owing to its longer 

maturity. The mortgage passthrough security also is 

more sensitive to rising rates because its weighted-average life (WAL) extends as rising rates discourage the 

underlying mortgage holders from prepaying their 

loans. The decline in prepayment rates results in extending the maturity of the security while rates are rising, a 

combination unfavorable to the security’s value. 

CHART 4 

Community Bank Stocks in the Chicago Region 

Performed Smoothly Despite Turmoil in the 

Broad Market 

Both the S&P Composite Bank Index and the Chicago 

Regional Bank Index have been subject to similar performance swings this year (Chart 4). The S&P 

Composite Bank Index, with an almost 13 percent gain 

by May 2, 1997, was still short of its year-to-date high 

on March 7, 1997, at which time it was up almost 20 

percent on the year. The Chicago Region’s Community 

Bank Index was spared much of the influence of a 

gyrating market, rising in value steadily to a 12.72 percent gain through May 2, 1997, just 5 basis points shy 

of the S&P Composite Bank Index’s gain. 

Allen Puwalski, Banking Analyst 

-1% 

4% 

9% 

14% 

19% 

S&P 500 

Chicago Regional Bank Index 

S&P Bank Index

 Source: Bloomberg, American Banker 

Change from 12/31/96 

Region’s Community Bank Index 

The Chicago Region’s Community Bank Index Performs Smoothly through a Rough Market 31-Dec 3-Jan 10-Jan 17-Jan 24-Jan 31-Jan 7-Feb 14-Feb 21-Feb 28-Feb 7-Mar 14-Mar 21-Mar 28-Mar 4-Apr 11-Apr 18-Apr 25-Apr

2-May 

Regional Outlook 17 Third Quarter 1997 
Regular Features	 Regional Banking
 

Chicago Region Banks and Thrifts Manage Interest
 

Rate Changes and Expand Revenue Sources 


•	 The overall condition of the Region’s insured institutions remains sound, with strong capital and earnings 

providing significant financial flexibility. 

•	 Recent interest rate changes and implementation of the new “Sensitivity to Market Risk” examination component rating reinforce the need for interest rate risk controls. 

•	 Noninterest income has become more important to institutions large and small, creating new opportunities 

and risks. 

•	 Interstate branching has become a reality, with states in the Chicago Region setting different conditions for 

branch network acquisitions and de novo branches. 

Overview 

In the aggregate, the Region’s banks and thrifts continue to be positively influenced by good economic conditions (see Chicago Region’s Economy: Checking Its 

Pulse). These conditions have helped to maintain traditional measures of profitability and capital adequacy at 

high levels. In addition, they have assisted in keeping 

the amounts of nonperforming assets low (see Chart 1). 

During the first quarter of 1997, the Chicago Region’s 

institutions: 

•	 increased aggrgate leverage capital to over 8 percent 

of average assets; 

•	 improved their aggregate return on assets to 1.22 

percent; and 

CHART 1 

Chicago Region Institutions Continue 

to Show Financial Strength 

9
 

8
 

7
 1995 1996 

6 

5 

4 

3 

2 

1 

0 

Return on Net 

Assets Interest 

Margin 

Source: Bank and Thrift Call Reports 

1Q97 

NPA* to Tier 1 

Assets Leverage 

*Nonperforming Assets 

•	 except for consumer loan portfolios, continued to 

report low nonperforming and past due asset levels. 

Banks and thrifts also continue to adapt to changes in 

different economic and business sectors by altering balance sheet structures and earnings strategies. Last quarter, this section of the Regional Outlook focused on 

some of the ongoing balance sheet changes and discussed how the Region’s institutions altered: 

•	 lending practices and strategies—decreasing growth 

in consumer lending and more actively participating 

in construction lending, home equity lending, and 

lease financings; and 

•	 funding patterns—relying more heavily on alternatives to core deposits to fund their operations. 

This quarter, the focus shifts to selected components of 

the revenue stream and a brief discussion of interstate 

branching as it relates to the Chicago Region. 

Net Interest Income Remains the Primary 

Source of Revenue 

Net interest income has declined slightly as a percentage of net revenues over the past several years, but it 

remains the primary source of income for insured institutions (see Table 1, next page). Because of its importance, prudent management and control of net interest 

income remains a primary goal of many managers. 

While many factors affect net interest income and margin performance, the effect of rising and falling market 

Percent 

Regional Outlook	 18 Third Quarter 1997 
Regular Features Regional Banking
 

TABLE 1 

Net Interest Income Is the Primary 

Component of Net Revenue 

1Q97 1Q92 

NET INTEREST INCOME 71% 74% 

NONINTEREST INCOME 28% 24% 

SECURITIES GAINS 

AND LOSSES 1% 2% 

Source: Bank and Thrift Call Reports 

interest rates has been one of the more significant factors for this Region. Changes in interest income earned 

and expense paid by insured institutions have generally 

followed market interest rates. However, on an aggregate basis, changes in each of these components have 

substantially offset one another. As a result, the Region’s 

aggregate quarterly net interest margin has been maintained within a 47 basis point range (highest quarter to 

lowest quarter) over the past five years, or about 11 

percent of the highest quarter’s performance. The 

aggregate net interest margin for banks under $100 million in total assets has been more stable, varying by only 

38 basis points, or about 8 percent of the highest quarter’s performance. This range of movement, though 

slightly more than that of the nation as a whole, appears 

manageable and is considerably less than the 300 basis 

point range within which the quarterly average federal 

funds rate has fluctuated during the same period (see 

Chart 2). 

While aggregate performance has been relatively stable, 

margin fluctuations at individual institutions have been 

much more volatile. In fact, the range of change in the 

quarterly net interest margin for about 27 percent of 

individual banks and thrifts in this Region exceeded 150 

basis points over the past five years (see Chart 3, next 

page). In some cases, the effects and management of 

rising and falling market interest rates played a significant role. In others, factors such as growth realized by 

new banks, timing of interest accruals, and problem 

asset levels are primary drivers of net interest margin 

changes. 

Implications: Concern over controlling rate risk is 

heightened when interest rates are volatile or market 

participants are uncertain in which direction rates are 

headed. While interest rates have not been extremely 

volatile of late, recent actions by the Federal Reserve— 

first to raise interest rates in March (see Financial 

Markets), then to hold them steady in May—have left 

some analysts uncertain over where short- and intermediate-term rates may be headed. 

In the past, banks and thrifts have implemented various 

strategies to manage interest rate margins as well as 

market values of their asset, liability, and off-balancesheet positions. These strategies include altering balance sheet structures and actively managing loan and 

deposit pricing. One of their more important advantages 

has been significant price flexibility on nonmaturity 

deposits. For example, many banks and thrifts have 

demonstrated the ability to increase rates on money 

market and NOW accounts at a much slower rate than 

changes in short-term market rates might otherwise 

dictate. 

In recognition of the importance of managing risk in 

this area, bank and thrift regulators recently added a 

sixth examination rating component to the former 

CAMEL rating called “Sensitivity to Market Risk” (or 

“S” rating). This rating was designed to address the 

degree to which changes in interest rates, foreign 

exchange rates, commodity prices, or equity prices can 

adversely affect an institution’s earnings or capital. 

(Interest rate risk, which is the prevailing market risk for 

most of the banks and thrifts in this Region, had primarily been reflected in the Earnings component rating 

in the past.) The new component also focuses on an 

institution’s ability to monitor and manage risk in these 

areas. Since its inception earlier this year, examiners 

have assigned a “1” or “2” rating for this component in 

over 90 percent of the Region’s institutions where an 

“S” rating has been assigned. 

CHART 2 Fed Fund Rate

% of Avg. Earning Assets 

0 

1 

2 

3 

4 

5 

6 

7 

0 

1 

2 

3 

4 

5 

6 

7 

All Institution NIM* 

Fed Funds Rate 

Source: Bank and Thrift Call 

Aggregate Net Interest Margin Is Fairly 

Stable Despite Changing Market Rates... 

Small Bank NIM* 

*Net Interest Margin 

1Q921Q931Q941Q951Q961Q97 

Regional Outlook 19 Third Quarter 1997 
39% 33%

34% 37%

Regular Features Regional Banking
 

CHART 3 

27% 30%

0% 

20% 

40% 

60% 

80% 

100% 

Small 

Institutions 

All 

Institutions 

Source: Bank and Thrift Call Reports 

150+ 

100 - 150 

Below 100 

Basis Point 

Change* 

*Change from Highest to 

Lowest Quarter 1Q92 to 1Q97 

...But Individual Institutions’ Net 

Interest Margins Fluctuate over a 

Wider Range 

Percent of Institutions 

Noninterest Income Growing in Importance 

In an attempt to mitigate the effect of interest rate risk 

on total revenues, as well as to diversify revenue 

streams, insured institutions have focused on increasing 

noninterest income. As a result, noninterest income has 

trended upward and, while somewhat volatile, represented about 28 percent of net revenues for the Chicago 

Region on an aggregate basis during the first quarter of 

1997 (see Chart 4). 

In many cases, traditional sources of noninterest 

income, such as service charges on deposit accounts 

and trust fees, are being reviewed by banks. Some institutions have initiated fees for previously free services, 

such as conducting business with tellers. Others have 

changed the fee structure on returned checks and ATM 

usage. 

In addition, institutions are expanding their sources of 

revenue through the sales of items such as: 

• mutual funds; 

• annuities; and 

• insurance. 

Though large and midsize institutions in the Region 

generate significantly more fees for these products than 

do banks under $100 million in total assets, the latter 

also have participated in the trend toward additional revenue sources. For example, over 500 institutions in this 

Region, or about 23 percent of the Region’s total, 

recorded annuity sales during the first quarter of this 

year, with over 100 smaller institutions participating. 

Additionally, over 575 institutions, 150 of them small 

banks and thrifts, posted mutual fund sales. 

Implications: Many of the recent initiatives to raise fee 

revenues have some risks attached. For example, some 

banks with large ATM networks in the Region recently 

began charging noncustomers a fee for use of their ATM 

equipment. These banks have had to balance the added 

fee income against a considerable amount of negative 

publicity from consumer groups that claim the fees are 

unfair. Some of the newer fee-related business lines, 

such as mutual funds and annuities, also have unique 

risks. Increased revenues from these sources must be 

balanced against potential contingent liability and reputation risk arising from the sale. For example, banks 

may create some contingent liability if they fail to make 

appropriate disclosures regarding the noninsured status 

of annuities they sell. 

Regulators have reacted to changing risk profiles, especially in the area of nondeposit investment products. 

During May of this year, the FDIC’s Division of 

Supervision issued new examination guidance concerning nondeposit investment products and provided this 

information to insured institutions through Financial 

Institution Letter #48-97. 

Interstate Branching Becomes a Reality 

Beginning June 1, 1997, Title I of the Riegle-Neal Act 

provides “authority for banking organizations to acquire 

banks across state lines and for the acquisition or establishment of interstate branches.” It significantly eases 

CHART 4 

10% 

13% 

16% 

19% 

22% 

25% 

28% 

31% 

Source: Bank and Thrift Call Reports 

Noninterest Income Share of 

Quarterly Net Revenue Increases 

All 

Banks under 

$100 Million 

1Q87 1Q881Q891Q901Q911Q921Q931Q941Q951Q961Q97

Regional Outlook 20 Third Quarter 1997 
Regular Features Regional Banking
 

restrictions on the interstate acquisition of banks by 

bank holding companies. Banks in different states may 

merge and operate the resulting institution as a bank 

with interstate branches. 

TABLE 2 

Rules for Interstate Branching 

Vary across States 

State Allow Only a De Novo 

Portion of a Interstate 

Branch Network Branches? 

to Be Acquired? 

ILLINOIS NO NO 

INDIANA YES YES, ONLY ON
 

A RECIPROCAL
 

BASIS
 

MICHIGAN YES YES, ONLY ON
 

A RECIPROCAL
 

BASIS
 

OHIO YES YES 

WISCONSIN YES, AS LONG AS HOME NO 

AND HOST STATE 

REGULATORS APPROVE 

Source: Conference of State Bank Supervisors, 

Washington, D.C. 

All states within the Region now allow some form of 

interstate branching, though there are differences (see 

Table 2). For example, Illinois has limited the ability of 

a purchaser to branch into that state unless the purchaser acquires all the branches of the target bank in that 

state. Thus, an acquirer would need to purchase all ten 

branches of a ten-branch bank rather than only one or 

two. In addition, Illinois and Wisconsin require that 

branches and banks acquired must have been in operation for five years or more. 

Implications: The national trend toward fewer insured 

institutions is being experienced by all states in the 

Region, which has seen a net reduction of over 20 percent of independently chartered banks and thrifts since 

the end of 1990. Much of this reduction is due to acquisitions and mergers, trends that interstate branching 

may accelerate. Interstate branching also may cause 

changes in the competitive landscape, as some existing 

institutions compete against larger, nonlocal banking 

organizations. 

John D. Weier, Senior Regional Analyst 

Elise A. Flynn, Examiner, Division of Supervision 

Regional Outlook 21 Third Quarter 1997 


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