Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION SECOND QUARTER 1998 

FDIC
 

Memphis
 

Region
 

Division of
 

Insurance
 

Gary L. Beasley,
 

Regional Manager
 

David T. Griffiths,
 

Regional Economist
 

Robert L. Burns,
 

Financial Analyst
 

In Focus This Quarter 

◆ Gain-on-Sale Accounting Can Result in Unstable Capital Ratios and Volatile Earnings—The accounting for transferring and servicing financial assets causes asset sellers, particularly high-growth lenders, to recognize significant noncash income related to retained economic interests in the sold 

assets. This is true whether a company securitizes its own assets or sells its assets as 

a conduit to another securitizer. Values are often driven by management assumptions about future performance of the sold assets. Major writedowns of gain-on-sale 

assets by some finance and mortgage companies underscore the importance of careful scrutiny of these assumptions by banks and their supervisors. See page 3. 

By Allen Puwalski 

◆ How Will the Expansion End?—Analysts are now focusing on when 

and how the current expansion will end. Although no one can accurately predict 

when a recession will begin, two possible scenarios have emerged. Each scenario has 

important implications for lenders as they prepare for the possibility of slower economic growth or recession. See page 7. 

By Paul C. Bishop 

◆ Trends Affecting the Allowance for Loan and Lease Losses— 

In today’s environment, in which loan availability is abundant, growth is strong, and 

competition is fierce, some industry leaders and regulators have expressed concern 

about the loosening of underwriting standards and greater risk in bank loan portfolios. At the same time, the allowance for loan and lease losses (ALLL) relative to 

total loans at many insured institutions is declining. As the economic expansion 

reaches an advanced age, an important question for insured institutions is whether 

their ALLLs adequately reflect the risks associated with changing industry practices. See page 11. 

By Andrea Bazemore 

Regular Features 

◆ Regional Economy—Revised employment data show growth in the Memphis Region to be stronger than previously reported in 1997, with the states performing more uniformly...the agricultural price outlook is weaker for 1998 as a 

result of the downturn in Asia and large Latin American harvests...Louisiana’s 

exposure to oil prices is lower than in the early 1980s but is still significant...technology has reduced the price at which oil-related activity can remain profitable, but 

companies may move quickly if this threshold is breached. See page 16. 

By David T. Griffiths, Gary L. Beasley 

◆ Regional Banking—Banks and thrifts reported strong performance in 

1997...a flattening yield curve may place downward pressure on margins and 

earnings this year...agricultural lenders posted strong performance as farmers 

completed a second year under FAIR, although this year may pose new challenges 

from lower projected commodity prices...banks in oil- and gas-producing areas 

appear well positioned to withstand fluctuating energy prices. See page 20. 

By Gary L. Beasley, Robert L. Burns 

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, AS, AZ, CA, FM, GU, HI, ID, MT, NV, OR, UT, WA, WY)
 

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

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

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

publish/regout. For more information or to provide comments or suggestions about the Memphis 

Region’s Regional Outlook, please call Gary Beasley at (901) 821-5234 or send an e-mail to 

gbeasley@fdic.gov. 

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

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

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

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

the Federal Deposit Insurance Corporation. 

Chairman Donna Tanoue 

Director, Division of Insurance Arthur J. Murton 

Editor George E. French 

Assistant Editors Gary L. Beasley 

Jack M.W. Phelps 

Publications Manager Teresa J. Franks 
In Focus This Quarter
 

Gain-on-Sale Accounting Can Result in Unstable
 

Capital Ratios and Volatile Earnings 


•	 Gains generated from asset sales under SFAS 125 

rely on management assumptions about the lifetime performance of the assets sold and may not 

materialize in cash if the assumptions prove 

incorrect. 

•	 Gain-on-sale accounting has been most significant to securitizers, but nonsecuritizers can and 

do retain economic interests that give rise to significant gain-on-sale assets. 

•	 Finance companies seeking to shift attention from 

gain-on-sale assumptions may find willing bank 

correspondents. 

•	 The rating services have modified capital and 

earnings analysis in order to lessen what they consider distortions caused by SFAS 125. 

Statement of Financial Accounting Standards No. 125 

(SFAS 125),Accounting for Transfers and Servicing of 

Financial Assets and Extinguishing of Liabilities, 

causes asset sellers, particularly high-growth lenders, to 

recognize significant noncash income. Applying SFAS 

125, which became effective on January 1, 1997, can 

give rise to significant noncash gains and related assets 

if an economic interest is retained in assets sold. The 

value of retained interests in assets sold is quantified on 

the basis of management’s assumptions about future 

charge-off rates, repayment rates, and the rate used to 

discount the expected cash flows from the loans sold. 

Because the value of these assets changes when actual 

performance deviates from the assumptions, the quality 

of earnings, capital, and liquidity for a lender that relies 

significantly on gains on sale must be considered carefully. 

The recent writedowns of interest-only (IO) assets by a 

few major finance companies have led to a higher level 

of scrutiny of companies whose financial statements are 

influenced significantly by gain-on-sale accounting. 

The Securities and Exchange Commission has recently 

increased its scrutiny of publicly traded companies that 

use gain-on-sale accounting, and it may soon require 

assumptions regarding defaults, prepayments, and discount rates to be disclosed in financial statements. The 

same companies that enjoyed soaring stock performance thanks to high earnings growth caused by gainon-sale accounting have seen their stock values tumble 

as they have had to write down their gain-on-salerelated assets. 

Several major credit rating companies have recognized 

the significant effect of gain-on-sale accounting under 

SFAS 125 on interpreting financial statements. These 

companies have issued comments or reports dealing 

with SFAS 125’s effect on the quality of earnings and 

capital of the companies they rate and how they adjust 

their analysis as a result. The consensus of these papers 

is that gain-on-sale accounting for companies that securitize often results in significantly higher reported earnings and equity compared to balance sheet 

lenders—without, in many cases, materially changing 

the underlying economics or credit risk to the originator 

of the assets.1 Generally, the rating services have modified capital and earnings analysis in order to lessen 

what they consider distortions caused by SFAS 125. 

There Are Risks Associated with Gain-on-Sale 

Accounting 

The asset booked in connection with an SFAS 125 loan 

sale is an IO strip that represents the present value of 

future excess spread cash flows generated by the transferred assets. Generally, asset-backed securitizations, 

including some classified as mortgage-backed securities, are structured so that each month the expected cash 

flows from the underlying assets will be sufficient to 

pay the investor coupon, the trust expenses, the servicing fee, and net charge-offs. The cash flow that the 

underlying assets will generate each month cannot be 

known with certainty because the underlying asset may 

allow for variable principal payments (e.g., credit card 

accounts), or the borrowers may default. Securitizations 

are structured so that there is enough cushion between 

the expected cash flows and the required payments and 

1 Duff & Phelps Credit Rating Company, “Securitization and Corporate Credit Risk.” Special Report Financial Services Industry, July 

1997; T. E. Foley and M. R. Foley. “Alternative Financial Ratios for 

the Effects of Securitization Tools for Analysis.” Moody’s Special 

Comment, September 1997; H. L. Moehlman, R. W. Merrit, and N. E. 

Stroker. “Capital Implications of Securitization and Effect of SFAS 

125.” Fitch Research, September 16, 1997. 

Memphis Regional Outlook 3	 Second Quarter 1998 
In Focus This Quarter
 

expected charge-offs to absorb fluctuations in actual 

cash flows and actual charge-offs. This cushion is 

excess spread. As actual cash flows vary from projections, so does the excess spread generated. 

According to SFAS 125, when a company sells assets 

and retains the right to future excess spread cash flows, 

the calculation of the gain on the sale includes the capitalization of this right. In many transactions, the gain 

on sale consists entirely of the fair value of the IO strip 

that represents this right—none of which is necessarily 

received in cash. In addition, with many transactions, 

cash receipt is further delayed while cash flows go to 

fund the spread account, which is analogous to an internal loan loss reserve. 

SFAS 125 states that quoted market prices in active 

markets are the best evidence of fair value and should 

be used whenever available. Although there have been 

some sales of these IO strips, the number of sales is not 

yet sufficient to constitute an active market. When market prices are not available, SFAS 125 states that the 

estimate of fair value should be based on the best information available. In practice, fair value of the excess 

spread is determined by present valuing the expected 

cash flows using a discounted cash flow model. 

The value of the right to future cash flows is determined 

on the basis of management’s assumptions about the 

charge-off rate, the average life of loans, and the rate 

used to discount the cash flows. These input assumptions drive the model results and, therefore, the magnitude of the gain. The stability of the value of the IO will 

depend greatly on the extent to which the input assumptions accurately describe the pool performance over the 

life of the transferred assets. Changes in economic or 

market conditions that were not anticipated in the initial 

cash-flow assumptions will likely cause the pool of 

loans to perform differently than initially projected. 

Gain-on-sale accounting is significant to securitizers. 

To illustrate the significance of the IO account to a 

securitizer’s reported income, consider one major subprime lender. During fiscal year 1997, this company’s 

IO asset grew by over $141 million. Despite a $28 million writedown of the IO asset, the net growth of the 

asset constituted over half of total revenue and over 

eight times net income. The revaluation of the IO was 

necessitated by higher-than-expected prepayment rates. 

Current market conditions were not anticipated by 

many companies that benefited from high earnings 

related to gain-on-sale accounting. Several other major 

securitizers have reduced the carrying value of their IO 

assets in the face of either rising charge-off rates or 

higher prepayment rates. Writing down an IO strip 

largely represents a company’s admission that it will not 

generate on a cash basis income that was booked previously. 

Chart 1 displays the cumulative charge-off rates by vintage for Moody’s index of home equity loan securitizations. The index consists mostly of prime mortgages, so 

the loss rates are still low. However, the rising trend in 

losses is noteworthy and reflects the growing influence 

of subprime securitizations on the index and the related 

decline in underwriting standards as competition has 

increased in this market. Loans originated in 1995 and 

1996 are causing progressively larger and earlier losses. 

After 21 months of seasoning, the cumulative loss rate 

on loans originated in 1996 is .17 percent—almost six 

times the loss rate experienced by the 1994-originated 

cohort at the same age. Despite the continued low loss 

rates for the home equity market in general, subprime 

lenders are experiencing accelerated loss rates that are 

eroding the value of their interests in excess spreads. 

There may be a tendency for management to base 

assumptions about expected loss rates on loans sold 

solely on past experience with similar loans. Such an 

approach may not capture changes in market conditions 

and trends. For example, the Moody’s data demonstrate 

that loss rates on home equity loans, including first 

liens, have been trending upward rapidly. This trend 

implies that when estimating loss rates, management 

should consider the potential for changes in market conCHART 1 

Vintage Analysis of Home Equity Loan 

Securitizations 

Source: Moody’s Investor Services 

0.00 

0.05 

0.10 

0.15 

0.20 

1 3 5 7 9 11 13 15 17 19 21 

Cumulative 

Loss (%) 

1994 

1995 

1996 

Months 

Memphis Regional Outlook 4 Second Quarter 1998 
In Focus This Quarter
 

ditions over the life of the sold assets as well as the past 

performance of similar assets. 

Like loss rates, prepayment rates have risen substantially in the subprime mortgage market. Several factors 

have contributed to the rise. One factor is the trend 

toward higher loan-to-value (LTV) loans in the mortgage market, which has allowed borrowers to obtain 

additional cash from their homes without waiting to pay 

down principal. Mortgage bankers report the tendency 

of some subprime borrowers, often debt consolidators, 

to maintain outstanding balances at the highest possible 

LTV. With maximum LTV ceilings rising, debt consolidators can refinance home equity loans without having 

to amortize existing debt. 

Another important factor contributing to rising prepayment rates is competition among lenders for volume 

growth. To continue to grow volume, lenders have been 

sacrificing margins on loans to offer a better rate to borrowers. When estimating prepayment rates for subprime 

borrowers, it has been normal to expect that they would 

need to improve their credit rating, or “credit cure,” 

before they would find it economical to refinance. Stiff 

competition for volume has allowed borrowers to find 

better rates without credit curing and has stimulated 

them to refinance prior to the time estimated at origination. Falling interest rates and a relatively flat yield 

curve are likely to increase prepayment rates. 

In standard finance theory, uncertainty about the future 

level of losses and prepayment rates is compensated for 

by discounting the cash flows at a higher rate. Some 

analysts advocate using a discount rate similar to the 

required rate of return for equity investments. Faced 

with changing conditions, one large finance company 

that specializes in high LTV lending announced in 

December 1997 that it was increasing the discount rate 

it uses to value new IO strips from 12.5 percent to 33 

percent. 

The IO Strip Asset Is Growing at Insured 

Depository Institutions 

As of December 31, 1997, only 30 institutions reported 

this IO asset at more than 5 percent of tier 1 capital. 

However, some institutions have booked gains that 

should have given rise to a call-reportable IO strip but 

did not properly report the assets. Therefore, the current 

reporting may understate the prevalence of the asset. 

Furthermore, the recent attention to gain-on-sale 

accounting from the public equity markets has at least a 

few large finance and mortgage companies seeking 

business strategies that shed IO strip-related volatility 

from their financial statements. One such strategy 

already in use is to leave the economic interest in excess 

spread with the correspondents that originate the loans. 

This is done as follows: The correspondent originates 

loans for purchase by a finance company. The finance 

company pays par for the loans, and instead of being 

paid an origination fee or a premium for the loans, the 

seller retains the right to excess spread generated over 

the life of the loan. The seller books a gain and an IO 

asset that capitalizes this right to receive future cash 

flows. The nature of the IO asset is exactly the same 

whether it arises directly from a securitization or from a 

sale of loans to a securitizer. If this strategy is used 

widely by finance and mortgage companies, then IO 

strips are likely to grow among institutions that originate loans for sale to these companies (see Chart 2). 

For insured depository institutions, the capital effects of 

SFAS 125 need to be evaluated carefully. Analysis of the 

financial statements and leverage ratios of insured institutions should consider fully issues related to the quality of earnings and the stability of capital posed by the 

volatility of the IO strip. Insured institutions that engage 

in significant asset sales while retaining economic interests that give rise to SFAS 125–related assets are subject 

to distortions similar to those of nonbank financial 

companies. 

The activity of originating and selling loans and booking associated gains can lead to capital ratios that 

CHART 2 

IO Strip Is Growing at Insured Institutions 

Source: Bank & Thrift Call Reports 

0.00 

0.50 

1.00 

1.50 

2.00 

2.50 

3.00 

1Q97 2Q97 3Q97 4Q97 

$Billion 

120 

130 

140 

150 

160 

Number of Institutions 

Number of Institutions 

IO Strip 

Memphis Regional Outlook 5 Second Quarter 1998 
In Focus This Quarter
 

appear high by traditional bank standards. For several 

reasons, the leverage ratio can appear particularly high. 

First, although the asset may be more volatile than 

mortgage serving rights, there is no limit to the amount 

of IO strip that a bank can include in tier 1 capital. Second, the amount of IO strip booked increases capital by 

a gain on the net of the tax effect. The extent to which 

the amount remains in capital depends, of course, on the 

institution’s dividend policy. Third, the denominator of 

the leverage ratio is reduced by the sale because the 

loans are no longer assets of the bank. The cumulative 

result can be a significant boost to the leverage ratio. 

Several insured institutions report an IO strip at greater 

than 25 percent of tier 1 capital. For an institution whose 

primary line of business is originating and selling subprime mortgages, the asset can quickly reach a level 

exceeding tier 1 capital. In a little more than a year of 

originating and selling subprime mortgages to a major 

securitizer, one institution has amassed IO assets that it 

has valued at more than 150 percent of tier 1 capital. 

The institutions that have concentrations of 25 percent 

or more of tier 1 capital in IO assets have a median 

leverage ratio of about 11 percent. In contrast, the median equity capital ratio for nonbank mortgage securitizers tracked by SNL DataSource is about 30 percent. 

Public debt markets or banks that lend to these finance 

companies appear to require significantly higher capital 

levels than regulatory minimums required for banks. 

The potential for growth of the IO 

strip asset at insured institutions 

seems strong. In some circumstances, minimum capital standards for banks may require 

significantly less capital for IO 

asset exposure than the public 

equity markets. Perhaps more 

important, the quick rise of the significance of gain-onsale accounting to the mortgage and consumer credit 

markets exemplifies the speed with which exposure to 

risk can be acquired through the securitization market. 

Strong demand for asset-backed securities coupled with 

changing accounting emphases, which in this case favor 

asset sellers, can lead quickly to substantial exposures. 

Allen Puwalski, Senior Financial Analyst 

Risk-Based Capital (RBC) Treatment of the Gain-on-Sale–Related IO Asset 

If the IO asset derives from excess spread that absorbs tions does not necessarily preclude subprime mortcharge-offs from the sold assets, then the IO strip con- gages in general from receiving the reduced risk 

stitutes recourse from the sold assets for RBC pur- weighting. Although the capital standards require that 

poses. RBC standards require capital to be held mortgages be prudently underwritten to qualify for 

against this exposure. In general, the capital require- the 50 percent risk weighting, it is not entirely clear 

ment for this exposure is the amount of capital that how the term “prudently underwritten” applies to subwould have been required for the assets had they not prime mortgages. A higher expected loss rate alone 

been sold. If the sold assets are one- to four-family may be insufficient cause for presuming that the 

residential mortgages, they may receive a 50 percent mortgages are not prudently underwritten. 

risk weighting. Subprime mortgages are not necessarily precluded from receiving this weighting. The rationale for reducing the capital requirement for 

traditional one- to four-family mortgage lending is 

In order to apply the 50 percent risk weighting, the related to the maturity of the market and consistently 

capital standards require that one- to four-family res- low loss rates. As noted above, the subprime mortgage 

idential mortgages be fully secured and prudently market is changing rapidly, and loss rates can be much 

underwritten. The “fully secured” requirement pre- higher than in traditional mortgage lending. Accordcludes high-LTV loans with LTV ratios of greater ingly, bank managements need to be aware of the 

than 100 percent from receiving reduced capital potential volatility and risks associated with gain-onrequirements, but the language of the RBC regula- sale assets associated with subprime mortgages. 

Memphis Regional Outlook 6 Second Quarter 1998 
In Focus This Quarter
 

How Will the Expansion End?
 

•	 Despite a very low unemployment rate and high 

industry capacity utilization, inflation has been 

unusually subdued during this expansion, with 

price declines in some sectors. 

•	 After seven years of expansion, most analysts 

expect the economy’s growth to slow in the coming 

months. 

•	 The last seven expansions have ended with an 

inflation-driven increase in short-term interest 

rates; in contrast, some analysts believe that the 

next recession will be caused by a period of falling 

prices for commodities, finished goods, and perhaps wages. 

•	 Insured institutions that base lending and strategic decisions on assumptions of continued robust 

economic growth should scrutinize and test those 

decisions against possible adverse change in economic conditions. 

The current economic expansion is the third longest on 

record since World War II. Since mid-1991, when the 

expansion began, more than 15 million new jobs have 

been created and inflation-adjusted gross domestic 

product (GDP) has increased by nearly 20 percent. In 

fact, the unemployment rate reached a 24-year low 

when it fell to 4.6 percent in November 1997 and again 

in February 1998. At the same time, inflation has 

remained unusually low, at only 2.3 percent during 

1997. 

Analysts are now focusing on when and under what circumstances the current expansion will end. While no 

one can accurately predict when the expansion will end, 

two related but competing theories about how it will end 

have emerged in recent months. The first and more 

familiar scenario occurs when the Federal Reserve 

increases short-term interest rates to prevent a rapid 

increase in inflation caused by an overheating economy. 

The second scenario, a deflation-induced contraction, is 

less familiar in the context of recent recessions. This 

scenario posits a period of falling prices for commodities, finished goods, and, under the most severe circumstances, even wages. 

Whatever the cause of the next downturn, its effects are 

likely to be important for the performance of lenders. 

During the 1990–91 recession, for example, the widespread deterioration of economic conditions was 

reflected in a number of indicators: Inflation-adjusted 

GDP fell by 2 percent; the number of business failures 

rose by nearly 40 percent; unemployment increased by 

more than 40 percent to 9.8 million; the unemployment 

rate peaked at more than 7 percent; single-family housing starts fell by almost 22 percent; and the bank card 

delinquency rate increased from 2.4 percent to 3.3 percent. This experience suggests that no matter what triggers the next downturn, dramatic adverse changes in the 

drivers of bank performance will likely result. 

How Have Economic Expansions 

Usually Ended? 

Although to some extent each business cycle is unique, 

virtually all of the post–World War II expansions have 

shown a similar characteristic: Toward the end of the 

expansion, inflation has accelerated. As the economy 

expands, the prices of inputs, including the wages of 

workers, are bid up as firms compete for resources to 

meet demand. The overall inflation rate will rise if 

prices increase across a large number of industries. Left 

unchecked, an increase in the overall price level may 

itself feed back into the labor market through demands 

for higher wages. 

By raising short-term interest rates, the Federal Reserve 

can limit what might otherwise lead to a rapid increase 

in both wages and prices. Higher interest rates will 

reduce sales of capital goods, housing, and consumer 

durables, the demand for which is very sensitive to the 

level of interest rates. One reflection of this sensitivity 

is the changing pattern of loan growth over the business 

cycle. During periods of expansion, the demand for 

loans grows rapidly as businesses and households borrow to finance purchases of capital goods and consumer 

durables. If short-term interest rates are increased in 

response to inflationary pressures, loan growth will 

slow as businesses and consumers reduce their demand 

for loans. If interest rates continue to increase, loan 

growth may decline as it has done before and during 

each recession. The cyclical movement of loan growth 

(with vertical bars indicating periods of recession) is 

shown in Chart 1 (next page). 

Looking more closely at short-term interest rates, Chart 

2 (next page) illustrates the federal funds rate during the 

Memphis Regional Outlook 7	 Second Quarter 1998 
In Focus This Quarter
 

CHART 1	 expansion began. During the expansion between 1975 

and 1980, for example, the inflation rate was nearly 12 Commercial Bank Loan Growth percent at the start of the expansion but fell to just over during the Business Cycle 6 percent after four quarters. Inflation remained at 

approximately 6 percent until the twelfth quarter of the 

–5 

0 

5 

10 

15 

20 

25 

1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 

Percent Change—Year Ago 

expansion, after which it accelerated to more than 12 

percent by the end of the 20-quarter expansion. 

The current inflation trend differs from previous expansions in two ways. First, by the later stages of previous 

expansions, inflation was accelerating (see Chart 3). In 

contrast, there are few signs of accelerating consumer 

price inflation during the current expansion. In fact, it 

appears that the rate of inflation is declining; the United 

States has experienced disinflation.1 Second, among 

Source: Federal Reserve 

last seven business cycles. While an increase in shortterm interest rates has preceded each recession, it 

should be noted that an increase in rates is not sufficient 

to induce a recession. An increase in rates in 1984 was 

followed by a period of rapid growth that lasted until 

1990. More recently, the increase in rates during 1994 

was accompanied by a slowdown in the economy, but 

not a recession. 

What Is Different about Inflation 

during This Expansion? 

With history as a guide, one would expect inflation to 

rise as the current expansion matures. Chart 3 illustrates 

consumer price inflation during the four longest postwar expansions, including the current one. The chart 

shows the inflation rate at various points after the 

CHART 2 

expansions that have lasted more than 20 quarters, the 

current rate of inflation is one of the lowest since World 

War II. Consumer inflation is both decreasing and low 

by historical standards. 

What Are the Two Views about 

Future Inflation? 

Two views have developed about how the current 

expansion will end. The debate, couched in terms of the 

expected rate of future inflation, is of more than academic concern. The Federal Reserve’s decision about 

1 In popular discussions of inflation rates and the price level, terminology is sometimes used loosely. To clarify, a declining rate of inflation, properly described as disinflation, means that prices are 

increasing at a progressively slower rate over time. Deflation is 

defined as a generally falling price level or, equivalently, a negative 

inflation rate. 

CHART 3 

Federal Funds Rate and Recent 

Recessions 

0 

5 

10 

15 

20 

1955 1959 1963 1967 1971 1975 1979 1983 1987 1991 1995 

Federal Funds Rate (percent) 

Source: Federal Reserve 

Consumer Price Inflation during Four Longest 

Postwar Expansions 

0 

2 

4 

6 

8 

10 

12 

14 

0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 32 34 

Quarters after Start of Expansion 

Percent 

1975–1980 

1982–1990 

1961–1969 

1991–present 

Note: Prices exclude food and energy 

Source: Bureau of Labor Statistics 

Memphis Regional Outlook 8	 Second Quarter 1998 
In Focus This Quarter
 

whether to change short-term interest rates may be 

influenced by arguments on either side of the debate. 

The Traditional View 

Although inflation has been tame during this expansion, 

adherents of the traditional view believe that impending 

inflation still poses a danger to the longevity of the 

expansion. Evidence cited to support this view includes 

a very low unemployment rate and rising inflationadjusted wages. The reasons for the low inflation rate 

include low energy prices, inexpensive imports, and 

brisk domestic and international competition. These 

factors have delayed the onset of inflationary pressures, 

but they will not remain favorable indefinitely. The 

underlying dynamics have not changed significantly 

from those that led to rising inflation during every other 

recent economic expansion. This is also the view of the 

Federal Reserve Open Market Committee, as stated in 

the minutes of its November 12, 1997, meeting: 

The reasons for the relative quiescence of inflation 

were not fully understood, but they undoubtedly 

included a number of special factors...the risks 

remained in the direction of rising price inflation 

though the extent and timing of that outcome were 

subject to considerable debate. 

—Federal Reserve Bulletin, February 1998, p. 104 

The Deflation View 

Alternatively, some analysts suggest that a recession 

may be brought about by a period of deflation. Advocates of this scenario base their view on the unusually 

low and falling inflation rate in the United States, even 

after seven years of economic expansion. They also suggest that the national economy of the 1990s is markedly different from that of the 1970s and 1980s. Intense 

global competition is now the norm and not the exception. Worker productivity growth is believed to be higher than the official data show, meaning that wage 

growth will not translate as readily as before into price 

increases. The U.S. economy is more prone to a period 

of falling prices than at any time in the recent past, especially in view of decreasing rates of inflation and deflationary forces originating from the ongoing Asian 

financial crisis. 

What Does the Evidence Show? 

Because determining economic policy is necessarily a 

forward-looking process, policymakers look at many 

indicators to determine the likely future course of inflation. A brief review of some of the more popular indicators reveals contradictory readings that can support 

either the inflation or deflation scenario. 

Wage Growth 

The national unemployment rate is currently very low, 

signaling that labor markets are near capacity in terms 

of their ability to create new jobs. The nation’s unemployment rate was below 5 percent for nine months during 1997. This rate has been well below what many 

analysts thought possible without a sharp rise in inflation. As labor market conditions have tightened, wage 

growth has increased. Since 1993 the rate of growth has 

been on a steady upward trend, from a low of just over 

2 percent to about 4 percent in the first quarter of 1998. 

Capacity Utilization 

Capacity utilization, the percentage of industrial capacity that is currently in use, has risen since early 1997. 

Utilization has been around 83 percent since mid-1997, 

a threshold rate that has traditionally signaled impending inflationary pressures at factories, mines, and utilities. 

Commodity Prices 

Many commodities, such as metals, crude oil, and 

unprocessed food products, have exhibited weak prices 

during the past several months. Between mid-1996 and 

early 1998, the Knight-Ridder Commodity Research 

Board Price Index fell by more than 15 percent. Key to 

the decline was a 35 percent decrease in crude oil 

prices. 

Finished Goods Prices 

Since the data show that both labor and physical capital 

are at high rates of utilization, the traditional inflation 

scenario suggests that there will be increasing price 

pressures. In the manufacturing sector, such price pressures would likely show up first in the prices of goods 

as they leave the factory. The price of finished goods 

rose by only 0.4 percent during 1997, however. On a 

monthly basis, prices declined during eight months in 

1997. 

Service Sector Prices 

The service sector accounts for a growing portion of all 

output and employment in the U.S. economy. Labor 

costs generally account for a much higher percentage of 

input costs in the service sector than in the manufacturMemphis Regional Outlook 9 Second Quarter 1998 
In Focus This Quarter
 

ing industries. Additionally, many service industries 

operate in local markets and are insulated from national or global competition. Consequently, inflation rates 

in the service sector are generally higher than in the 

goods sector. Service sector inflation has, however, 

been on a downward trend, falling from 5.5 percent in 

1990 to 3.1 percent in 1997. 

Import Prices 

Since early 1996, import prices have fallen precipitously. The decline is due in part to the rising value of the 

dollar, which has reduced the cost of imports. Nonpetroleum import prices have fallen by 5 percent since 

early 1996. Within that group, capital goods prices have 

decreased by 12 percent over the same period. 

One factor that will continue to put downward pressure 

on prices is the turmoil in Asian markets. Asian 

exporters are now much more competitive with the rest 

of the world, following the drop in the value of their currencies. Consequently, U.S. firms that compete with 

Asian producers will be under greater pressure to cut 

prices. At the same time, reduced Asian demand for 

U.S. exports could lead to a ballooning trade deficit and 

a softening of export prices. In January 1998, for example, the United States reported a record-breaking trade 

deficit of $12 billion, caused in part by slower export 

growth. 

From this brief review, it is apparent that signs of 

impending inflation are at best mixed. Clearly, U.S. 

labor markets are at or near full effective capacity, and 

the utilization of factories and physical capital is also 

very high. There is little evidence that these factors are 

causing an increase in prices at either the producer or 

consumer levels. 

How Will the Expansion End? 

Although no one can accurately determine when the 

expansion will end, most analysts are predicting slower 

economic growth in the second half of 1998. Indicators 

such as the unemployment rate suggest that growth will 

be limited by the availability of labor needed to produce 

an increasing supply of goods and services. Weak or 

declining output prices in some sectors could act as a 

further constraint on economic growth. 

Among economists, the traditional view that the expansion will end following a rise in inflation and an 

increase in short-term interest rates appears to be the 

more prevalent view. Nevertheless, the possibility that 

the next economic downturn might be triggered by the 

ripple effects of declining output prices should not be 

dismissed, especially in light of the potentially adverse 

and less familiar risks associated with deflation. What is 

clear for insured institutions is that at this stage of the 

economic expansion, lending and strategic decisions 

predicated on an assumption of continued robust economic growth should be carefully scrutinized and considered in light of a possible deterioration of economic 

conditions. 

Paul C. Bishop, Economist 

Why Might Deflation 


Be a Concern?
 

The most significant difference between the inflation and deflation scenarios is reflected in the 

response of financial markets. One of the consequences of inflation is that a dollar in the future is 

of less value than today’s dollar. In a deflationary 

environment, the opposite is true—a dollar in the 

future will buy more goods and services than a dollar today. 

In a deflation scenario, debtors would see the real 

value of their financial obligations rise and might 

therefore be hesitant to borrow. A fixed monthly 

mortgage payment, for example, would be paid 

back with increasingly valuable dollars over time. 

Asset values could fall, especially since the purchase of an asset, such as a house, would require 

inflation-adjusted debt repayments that increase 

through time. Likewise, consumer credit debt obligations, such as payments on outstanding credit 

card balances, would become increasingly onerous. 

For households already experiencing credit problems, the prospect of a period of sustained deflation 

would worsen their financial position. At the very 

least, deterioration in credit quality would be 

expected, along with an increase in the number of 

business and personal bankruptcies. 

Memphis Regional Outlook 10 Second Quarter 1998 
In Focus This Quarter
 

Trends Affecting the Allowance for
 

Loan and Lease Losses
 

•	 Allowance for loan and lease loss (ALLL) levels 

are declining relative to total loans. 

•	 Some industry leaders and regulators have 

expressed concern about the loosening of underwriting standards and greater risk in bank loan 

portfolios. 

•	 Significant growth in riskier loan types calls 

attention to the need to scrutinize closely the adequacy of the allowance. 

Weakening underwriting standards and significant 

growth in riskier loan types have increased the risk 

exposures of some insured institutions to an economic 

downturn. Meanwhile, the ALLL relative to total loans 

has declined in recent years. This article provides information on trends in the ALLL over time and by loan 

type and discusses the factors analysts consider when 

evaluating the adequacy of the ALLL. Special attention 

is given to issues related to the volatility of loan losses 

and the composition of the loan portfolio. 

Historical Perspective on the Allowance 

for Loan and Lease Losses 

The nation is currently witnessing one of the longest 

economic expansions since World War II. It is to be 

expected that some institutions will reduce their ALLL 

CHART 1 

coverage during periods of improved economic conditions. However, in the current environment—in which 

loan availability is abundant, growth is strong, and competition is fierce—some industry leaders and regulators 

have expressed concern about the loosening of underwriting standards and greater risk in bank loan portfolios. At the same time, the ALLL relative to total loans 

for commercial banks has declined to the lowest point in 

a decade (see Chart 1). This allowance ratio has diminished because commercial banks’ loan loss provisions 

have not kept pace with new loan growth. In some 

cases, banks have determined that their allowances are 

higher than necessary and have taken negative loan loss 

provisions, which are credited back to income. 

This decline in reserve coverage has been broad based, 

with the exception of credit card specialists. Commercial banks with concentrations in commercial lending 

and large multinational banks have significantly 

reduced the level of reserves to total loans in recent 

years. Table 1 (next page) shows that since 1993, ALLL 

ratios at both commercial lending banks and multinational banks have declined 31 percent. Moreover, commercial lending banks with assets exceeding $10 billion 

have reduced ALLL ratios by slightly over 37 percent, 

or 98 basis points, over the same period. 

The low level of nonperforming and charged-off loans, 

coupled with prevailing favorable economic conditions, 

is doubtless a significant factor in the reduction of 

Memphis Regional Outlook 11 Second Quarter 1998 

Commercial Bank Reserves at Lowest Point in a Decade 

Source: FDIC Historical Statistics on Banking, National Bureau of Economic Research, Inc. 

1965 1967 1969 1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 

0.0 

0.5 

1.0 

1.5 

2.0 

2.5 

3.0 

% of Loans

Current 

Expansion 

Recessionary 

periods 
In Focus This Quarter
 

TABLE 1 

Commercial Bank Allowance for Loan and Lease Losses to 

Total Loans by Lender Type 

TYPE OF LENDER 

NUMBER OF 

BANKS 

ASSETS 

($BILLIONS) 1997 1996 1995 1994 1993 

MULTINATIONAL 

COMMERCIAL 

CREDIT CARD 

MORTGAGE 

AGRICULTURAL 

11 

3,207 

67 

286 

2,373 

$1,383 

$1,915 

$202 

$120 

$120 

2.14 

1.63 

4.21 

1.26 

1.53 

2.25 

1.71 

3.48 

1.45 

1.66 

2.55 

1.90 

3.21 

1.45 

1.69 

2.83 

2.16 

2.89 

1.69 

1.75 

3.10 

2.37 

3.35 

1.87 

1.83 

Definitions for lender types by order of priority: Multinational—assets >$10 billion and foreign assets >25% of 

assets; Commercial—C&I plus CRE loans >50% of assets; Credit Card—credit card loans >50% of assets; Mortgage— 

1- to 4-family mortgages and mortgage-backed securities >50% of assets; Agricultural—agricultural production and 

agricultural real-estate loans >25% of total loans. 

Source: Bank Call Reports 

ALLL levels. Asset quality indicators such as nonperforming loans and loan loss rates are at historically 

favorable levels. At year-end 1997, the banking industry’s nonperforming loans were just under 1 percent of 

total loans, the lowest in 13 years. The industry’s loan 

charge-off rates (with the exception of consumer loans) 

are also at historical lows. (See the Regional Outlook, 

first quarter 1997, for a detailed discussion of consumer 

loan losses.) However, even with the problems in consumer lending, the banking industry’s aggregate loan 

loss rate is down significantly from levels in the early 

1990s (see Chart 2). 

As the economic expansion reaches an advanced age, 

an important question for insured institutions is 

whether their ALLLs adequately reflect the risks assoCHART 2 

Source: Bank Call Reports 

Asset Quality Indicators Are at Historically 

Favorable Levels 

0.0% 

0.5% 

1.0% 

1.5% 

2.0% 

1985 1987 1989 1991 1993 1995 1997

0.0 

0.5 

1.0 

1.5 

2.0 

2.5 

3.0 

3.5 

4.0 

Charge-off 

Rates 

Nonperforming 

Loan Rates 

% of Total Loans 

ciated with changing industry practices. Insured institutions could experience strains on profitability and capital if allowance levels are inadequate. Given changing 

underwriting trends and loan delinquency patterns, a 

related question is whether reliance on past loss experience in setting the allowance will be an adequate measure for current losses. 

Trends in Underwriting Prompt 

Regulatory Cautions 

Over the past year, various underwriting and lending 

practices surveys by the FDIC, the Office of the Comptroller of the Currency (OCC), and the Federal Reserve 

have noted easing of terms and weakening underwriting 

standards on loans, especially in commercial loan portfolios. It is important to note that, in 1997, nearly twothirds of the commercial banking industry’s loan growth 

was centered in the commercial real estate (CRE) and 

commercial and industrial (C&I) loan categories 

(Chart 3). 

In the FDIC’s Report on Underwriting Practices for 

April 1997 through September 1997, examiners noted 

“above-average” risk in current underwriting practices 

for new loans at almost 10 percent of the 1,233 FDICsupervised institutions examined. Of the institutions 

with above-average risk, 12 percent did not adjust pricing for loan risk. Examiners noted that several of the 

852 institutions examined that were making business 

loans had poor underwriting standards, including lack 

of documentation of the borrower’s financial strength 

Memphis Regional Outlook 12 Second Quarter 1998 
In Focus This Quarter
 

(21 percent) and poor and unpredictable loan repayment 

sources (14 percent). Also, of the 571 institutions 

specifically involved in asset-based business lending, 

20 percent often failed to monitor collateral. Furthermore, 20 percent of the 398 institutions examined that 

were actively engaged in construction lending repeatedly failed to consider alternative repayment sources, and 

29 percent often funded speculative projects. In contrast, just one year earlier, in the Report on Underwriting Practices for April 1996 through September 1996, 

examiners reported that only 11 percent of the institutions examined that were actively engaged in construction lending often funded speculative projects. 

The Federal Reserve’s Senior Loan Officer Opinion 

Survey for November 1997 and February 1998 both 

indicated some easing of commercial business lending 

terms and standards. Also, the OCC’s 1997 Survey of 

Credit Underwriting Practices stated that the level of 

inherent credit risk continues to increase for components of both commercial and consumer loan portfolios. 

These underwriting trends have resulted in increased 

risk profiles for some insured institutions, while ALLL 

ratios at some institutions continue to decline. 

In August 1997, the OCC issued an Advisory Letter 

voicing its concern about declining allowance levels in 

commercial banks. The OCC cited as primary concerns 

the apparent increases in credit risk reported by examiners, such as weakening underwriting trends in the syndicated loan market, easing of other commercial 

underwriting standards, and consumer lending delinquency and charge-off trends. Moreover, the OCC 

found that some banks were using flawed reserve 

CHART 3 

Loan Growth in 1997 Centered in
 

Commercial Loans
 

% of Total Loan Growth 

–30 

–20 

–10 

0 

10 

20 

30 

40 

50 

60 

70 

80 

Commercial

Consumer

Residential

Mortgages

CRE 

C&I 

Other 

Note: Percent of all loan growth for commercial banks in 1997 

Source: Bank Call Reports 

methodologies for estimating loan loss rates, including 

an overreliance on historical loss rates. 

Factors Affecting Adequacy 

of the ALLL 

In using offsite data to assess allowance adequacy, analysts consider financial ratios such as the allowance to 

total loans, reserve coverage (allowance to nonperforming loans), loan loss provisions to charge-offs, and loan 

delinquency levels. These ratios are evaluated against 

historical benchmarks. At the same time, however, analysts supplement the analysis with consideration of the 

potential effects of current industry trends. For example, the banking industry is currently witnessing higher 

than normal losses in consumer lending spurred by 

increased bankruptcy filings and the migration of loans 

from current to charged off without intervening delinquencies. An institution that has a sizable consumer 

loan portfolio may therefore need to attach more weight 

to recent loan loss data in setting the allowance, since 

historical trends may not adequately reflect reserving 

needs. 

Insured institutions exhibit different management and 

portfolio characteristics that significantly influence the 

level of the allowance. These characteristics include the 

diversification of a loan portfolio (diversification by 

borrower, loan type, geography, or industry), the history and recent trends of credit losses, management’s 

practices in the recognition of losses, trends in past-due 

and nonperforming loans, underwriting practices, and 

economic conditions. 

New techniques continue to be developed to improve 

the reliability of allowance estimates. Management 

information systems, which enable the collection of 

more refined historical data, coupled with the application of statistical techniques, are helping some institutions formulate more statistically reasoned allowance 

estimates. Loan management tools such as credit scoring systems, risk rating systems, and consideration of 

economic cycles in the review of historical loss and 

delinquency data all are aiding bankers in the reserving 

process. While these new techniques provide more analytically defensible estimates, they do not diminish the 

role of judgment in assessing ALLL adequacy. 

The role of judgment in setting the ALLL is underscored by the volatility of loan losses over time. 

Memphis Regional Outlook 13 Second Quarter 1998 
In Focus This Quarter
 

CHART 4 

Historically, Commercial Loan Loss Rates Have Been Higher and More Volatile 

than Mortgage Loss Rates 

Source: Bank Call Reports 

0.0 

0.2 

0.4 

0.6 

0.8 

1.0 

1.2 

1.4 

1.6 

1991 1992 1993 1994 1995 1996 1997 

Loan Loss Rates (%)

Commercial Real Estate Loans 

Commercial & Industrial Loans 

Residential Mortgages 

“Volatility” in this context refers to the degree to which 

loan losses have diverged or might diverge from the 

long-run averages. Volatility in loan losses can result 

from changes in the business cycle, local economic 

events, and major one-time events. For example, a bank 

relying on a historic average loan loss calculation to 

derive its reserve level could find itself underreserved if 

it does not adjust its historical loss rates for deteriorating economic conditions and suddenly incurs greater 

loan losses than it had anticipated simply on the basis of 

past performance. 

Generally, different types of loans experience varying 

loan loss rates because of the inherently different risks 

and varying levels of volatility within each type. Chart 

4 shows that commercial loans, such as commercial and 

industrial loans and commercial real estate, historically 

have had greater losses than residential loans. Furthermore, the loss rates on commercial loans have not only 

been higher, they have been more volatile over the 

years, while average losses on mortgage loans have varied little. 

Volatility in loan losses is determined not only by economic events but also by banks’ willingness to take risk. 

Banks that adopt more liberal underwriting policies and 

high loan growth objectives may experience greater 

loan default risk and greater volatility in loan loss rates 

than suggested by their own past experience. For example, Chart 4 shows that mortgage lending has had low 

and stable loss rates on average. The recent growth in 

subprime and high loan-to-value mortgage lending, 

however, may result in increased volatility and losses 

for some lenders going forward. 

All of these factors suggest that ALLLs would be 

expected to vary considerably both over time and across 

loan types. Table 2 shows that this has been the case. 

The ALLL is reported as a single line item on the Call 

Report. This makes it difficult to estimate how much of 

the ALLL is attributable to a particular loan type or to 

compare allowance levels for banks with significantly 

different loan portfolios. Table 2 shows the results of a 

statistical regression estimation of commercial bank 

allowance allocations across the various loan types for 

TABLE 2 

ALLL Allocations Have Varied over Time and by Loan Type 

(Commercial Banks under $1 Billion)* 

LOAN TYPE 1997 (%) 1996 (%) 1995 (%) 1994 (%) 1993 (%) 1992 (%) 1991 (%) 

C&I 

CRE 

MORTGAGES 

CREDIT CARDS 

1.71 

1.44 

0.92 

4.47 

1.85 

1.54 

1.00 

4.42 

1.87 

1.77 

1.05 

3.32 

2.06 

1.83 

1.19 

3.11 

2.14 

1.97 

1.22 

3.20 

2.29 

2.02 

1.07 

3.29 

2.45 

1.99 

0.91 

3.59 

* Estimated regression results 

Source: Bank Call Reports 

Memphis Regional Outlook 14 Second Quarter 1998 
In Focus This Quarter
 

1991 through 1997 for commercial banks with under $1 

billion in assets. Not surprisingly, CRE and C&I loans 

received relatively higher allowance allocations than 

residential mortgage loans, indicating that banks saw 

greater risk in these loan types. Also, credit card loans 

consistently received higher allocations than the other 

loan categories, and the allocations have increased in 

recent years owing to the increased delinquencies and 

charge-offs in this area. 

Conclusions 

The adequacy of the ALLL is measured not only relative to historical loan loss experience but also relative to 

current conditions that may cause losses to differ from 

past experience. Increased losses could result from 

adverse economic developments, from changes in 

banks’ appetite for taking risk, or 

both. In this regard, reported weakening in underwriting standards is 

increasing some banks’ risk exposure to an economic downturn. 

Institutions with high concentrations in riskier loans, significant 

growth in riskier loans, or weaknesses in underwriting may be most at risk. Especially 

for such institutions, the adequacy of the ALLL and its 

methodologies merits close scrutiny. 

Andrea Bazemore, Banking Analyst 

Memphis Regional Outlook 15 Second Quarter 1998 
Regular Features	 Regional Economy
 

Memphis Region’s Growth Recovers
 

but Lags the Nation
 

•	 Growth in the Memphis Region, driven by oil-related activity, picked up in the fourth quarter of 1997. 

•	 The importance of the oil and gas industry to the Region has declined but remains highly concentrated in 

Louisiana. 

•	 Areas with joint dependence on oil and agriculture are more at risk this year from commodity price 

movements. 

Last year, the Memphis Region’s employment growth 

reflected the national trend, increasing over the prior 

year despite tight labor markets and slowing population 

growth. While most analysts project growth, the high 

concentration of mining (which includes oil and gas 

extraction) and agricultural production links the 

Region’s economy to the risks associated with commodity prices. 

Regional Roundup 

Growth in the Memphis region accelerated in 1997 but 

remains below the national rate (see Chart 1). Payroll 

employment grew 2.0 percent in 1997, up from the previous year but still below the 2.6 percent recorded for 

the nation. Strength in construction, mining, and services was offset by weakness in durable manufacturing, 

which includes textiles. 

CHART 1 

Region’s Job Growth Recovers Slightly 

− 2 

− 1 

0 

1 

2 

3 

4 

5 

1991 1992 1993 1994 1995 1996 1997 

Percent 

Source: Department of Commerce, Bureau of Labor Statistics 

Region 

U.S. 

Of the Region’s 436 counties, 90 had unemployment 

rates in excess of 7.5 percent, reflecting a difference in 

performance between urban and rural areas (see 

Chart 2, next page). The Region’s employment reports 

have been unusually volatile relative to the nation, particularly with regard to construction jobs and housing 

starts. 

Weaker Agricultural Conditions 

Anticipated in 1998 

The agricultural outlook for the Region is being affected by both short- and long-term factors. In the short 

term, the combined impacts of weaker Asian demand 

and competition from strong harvests in South America 

have weakened prices of some commodities this year 

(e.g., soybeans). Moreover, agricultural exports projected at $56 billion this year are down 2 percent from 1997, 

and this is the second year of decline since the record 

level set in 1996.1 As a result, cash receipts to U.S. farmers are projected at $198 billion in 1998, down from 

$201.5 billion in 1997. The decline would have been 

bigger if USDA had not provided $2.1 billion in export 

credit guarantees for the distressed Asian countries. 

In the longer term, the phaseout of agricultural price 

supports by 2002 mandated by the Federal Agriculture 

Improvement and Reform Act (FAIR) of 1996 may 

increase the volatility of agricultural prices and change 

the allocation of crops planted. 

1 All agricultural projections are from the U.S. Department of Agriculture (USDA), Agricultural Outlook Forum held February 1998 in 

Washington, D.C. 

Memphis Regional Outlook 16	 Second Quarter 1998 
Regular Features 

CHART 2 

High Unemployment Is Concentrated in 

Rural Agricultural and Mining Regions 

Unemployment Rate 

(not seasonally adjusted) 

2.49% or Less (13 counties) 

2.5% to 4.99% (166 counties) 

5.0% to 7.49% (167 counties) 

7.5% and Higher (90 counties) 

Source: Department of Commerce, Bureau of Labor Statistics 

Crops Affected 

This is the third year of decline in cotton acreage and, 

because current market prices are less than the breakeven point of $.70 per pound for many producers, most 

mid-south cotton farmers are planting only their best 

fields this spring. (In Mississippi, last year was the first 

time in 13 years that growers did not plant more than a 

million acres of cotton.) This situation is compounded 

by FAIR, which reduces subsidies and allows more flexibility in planting. 

More fields are likely to be planted with corn as a consequence of greater planting flexibility. As a result, 

USDA expects further softening of corn prices. Soybean prices are projected by USDA to decline 10 to 15 

percent compared with year-ago levels, while stocks 

may double as a result of increased competition from 

South America. 

In Kentucky, there is concern among burley tobacco 

farmers about eventual tobacco legislation. FAIR 

excluded tobacco, but Congress may end the federal 

program that imposes quotas on tobacco producers and 

creates a floor price. Kentucky farmers produce 71 percent of the Region’s burley tobacco crop, and tobacco is 

by far the most profitable use of their land. Legislation 

would add pressure to an industry that has been experiencing a 2 percent annual decline in U.S. tobacco conRegional Economy 

sumption since 1981 and would likely result in a significant reduction in the number of farmers, most of whom 

harvest five or fewer acres of tobacco in addition to 

other crops. 

Livestock Affected 

Livestock is less important to the Region than to the 

nation as a whole. However, the impact of expected hog 

price reductions of as much as 23 percent and broiler 

price reductions of 5 percent likely will contribute to 

lower farm cash receipts. 

Areas Most Affected 

By state, agriculture accounted for 4 percent of gross 

state product (GSP) in Arkansas in 1994 (the most 

recent comprehensive data), making Arkansas by far the 

most agriculture-dependent state in the Region. In 

1997, the state crop harvest was valued at $2.53 billion, 

with rice, cotton, soybeans, and wheat accounting for 87 

percent of the total value of state production. 

By agricultural region, the area along the Mississippi 

and central western Arkansas have the heaviest concentrations of agriculture. An index that calculates farm 

cash receipts as a proportion of wages and salaries for 

the region is shown in Chart 3. The impact of the 

CHART 3 

Agriculturally Dependent Counties Dominate
 

Western Arkansas and the Area along
 

the Mississippi River
 

Index of Dependence 

14.99 or Less (241 counties) 

15 to 29.99 (103 counties) 

30 and Higher (92 counties) 

Source: Department of Commerce, Bureau of Economic Analysis 

Memphis Regional Outlook 17 Second Quarter 1998 
Regular Features	 Regional Economy
 

increased flexibility in crop selection on farm income 

will be felt by many businesses, particularly those in 

areas with the highest reliance on agriculture. 

Implications: FAIR ends transition payments in 2002, 

and although flexibility in planting may tend in the 

longer run to smooth some short-term price volatility, 

there still may be more price risk associated with agriculture. According to Farm Futures Magazine, only 10 

to 15 percent of grain farmers use futures strategies. The 

incentives to use these strategies are likely to increase as 

farmers become more exposed to market prices, and 

sellers of hedging devices may find a novice audience 

for their products. Moreover, any government compensation for the loss in value of tobacco quotas would be 

a one-time payment, not reflected in the capitalized 

value of the land used in growing once the payment is 

made. This situation may pose some additional risk to 

farm loans, as the value of land used as collateral may 

be compromised. 

Oil Remains a Highly Significant but Declining 

Influence on the Region’s Economy 

Oil price weakness in the first quarter of 1998 is a 

reminder of the Region’s dependence on international 

markets, and in particular on the ability of the Organization of Petroleum Exporting Countries (OPEC) to 

affect prices through production quotas. The recent 

weakness in oil prices has been attributed to a combination of the following: 

•	 The Asian crisis—about half the recent growth in 

world oil demand has been from Asia. 

•	 Iraq’s resumption of crude oil exports (the United 

Nations oil for food program). 

most of it offshore. As depicted in Chart 4, the number 

of oil and gas workers peaked at 113.7 thousand in 1981 

before falling below 60 thousand in 1995. There were 

61.7 thousand employed in 1997. The 1981 peak represented 5.4 percent of employment and 34 percent of 

GSP. In 1994 (the most recent value data available), it 

accounted for only 12.7 percent of GSP. 

Nevertheless, oil and gas remain an important component of the Louisiana economy. In fact, jobs in this sector tend to have an above-average multiplier effect on 

the local economy, because weekly wages exceed the 

average manufacturing wage. Refining jobs, for example, pay 63 percent more than the average manufacturing job. Moreover, the oil and gas industry pays over 

$840 million in direct taxes, fees, and royalties to the 

state, accounting for 14 percent of state revenues. Parish 

severance taxes were $389.5 million in 1996–97, up 

13.1 percent from the previous year. In terms of sensitivity, it has been estimated that a $1 drop in the price 

costs the state of Louisiana about $22 million in lower 

tax payments. 

Refining Capacity Far Exceeds Local Production 

The 19 Louisiana oil refineries rank second in national 

refining capacity and account for 15 percent of the 

national total refined output. There is significant capacity in excess of local production: If restricted to 

Louisiana crude, the refineries could operate for only 

two months of the year. Employment in this sector, 

which accounts for about one-sixth of the state’s energy 

jobs, is less variable than drilling, because of flexibility 

to purchase supplies from many sources. Activity is 

concentrated in Calcasieu, East Baton Rouge, St. John 

the Baptist, and Orleans parishes. 

CHART 4 

Oil Price and Louisiana Oil 

Industry Jobs Are Correlated 

• Milder than usual winter temperatures in the United 

States, limiting demand for heating oil. 

• Overproduction by the 11-nation OPEC cartel. (In 

December 1997, OPEC increased its quotas 10 percent to 27.5 billion barrels a day, just as the news of 

the Asian crisis was breaking.) 

The Memphis Region accounts for 7 percent of national crude oil production. The bulk (5.7 percent) is pro0 

20 

40 

60 

80 

100 

120

Dollars per Barrel, Jobs (thousands)

1973

1975

1977

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997 

Refining and Extraction Jobs Wellhead Price (1997$) duced in Louisiana, which ranks fifth nationally. The Source: Department of Energy, Monthly Energy Review state ranks second nationally in natural gas production,
 

Memphis Regional Outlook 18 Second Quarter 1998
 
Regular Features Regional Economy
 

Production Is Concentrated in the South 

State crude oil production is split into three reporting 

areas: north (17 percent), south onshore (60 percent), 

and south offshore (23 percent). In addition, condensate 

(liquid hydrocarbons recovered by surface separators 

from natural gas) and natural gas production are concentrated in the south Louisiana onshore area. Because 

of stable production, condensate and natural gas are rising in relative importance as crude declines. An indication of the level of activity for the parishes in Louisiana 

can be obtained from the severance tax receipts derived 

from oil and gas, as shown in Chart 5. The tax on oil is 

12.5 percent of value; the tax on natural gas (adjusted 

annually) was recently 10.1 cents per thousand cubic 

feet. 

At least 54 of Louisiana’s 64 parishes have energy-related jobs; Lafayette Parish has over 11,000 workers 

employed in the energy sector. Significant income in 

Jefferson and Lafayette parishes derives from offshore 

operations beyond the three-mile limit (not subject to 

severance and royalty payments). Statewide, vendors 

that support these operations account for 4.3 percent of 

all Louisiana business establishments. 

Technology Reduces the Incidence of Dry Wells 

Technology has reduced the number of exploration 

wells needed in the Gulf of Mexico. Only one in ten 

drillings used to be productive, but this number, according to industry sources, has increased. Also, better 

horizontal drilling methods mean that fewer wells are 

required to exploit a productive zone. Moreover, 

because the major drilling companies have concentrated 

on bigger finds in the Gulf and overseas and sold their 

seismic records from the 1960s and 1970s, opportunities exist for smaller companies to use new computer 

technology to enhance and exploit those records. 

Outlook 

Most independent oil companies have a break-even 

point in the $14- to $16-per-barrel range. The larger, 

better financed companies may operate longer at a loss, 

provided they cover a portion of their variable costs of 

production. It is important to note that the peak in 

employment and drilling activity occurred more than a 

year after oil prices declined in 1982. By 1986, the oneyear lag between crude prices and oil-rig count and 

employment had disappeared. 

This fact leads to the inference that drilling response to 

crude prices may now be reduced to a matter of months. 

The shorter response time is likely to ripple through to 

CHART 5 

Oil and Gas Extraction
 

Dominates the Southern Parishes
 

Severance Tax Revenues 

Oil and Gas (in millions) 

0.99 or Less (23 counties) 

1 to 4.99 (24 counties) 

5 to 14.99 (10 counties) 

15 and Higher (7 counties) 

Source: State of Louisiana, Department of Revenue and Taxation 

businesses, including insured institutions, in the form of 

quick changes in the demand for goods, services, and 

loans, as well as changes in the financial capacity of 

customers. 

In the 1973 to 1997 period, domestic wellhead prices 

had a median value of $20.08 a barrel in 1997 dollars, 

meaning that prices have exceeded this level only half 

of the time. If this period is a guide (price controls over 

much of this period muddy the view), persistence of the 

current mid-teen-per-barrel prices could lead to an 

uncertain future for companies that have structured their 

operations around prices averaging $20 a barrel. 

Implications: Today, a smaller proportion of the economy would be affected by significant reversals in the oil 

industry than in 1981. However, the extractive sector is 

still a large portion of the economy and remains highly 

concentrated in the coastal parishes. In addition, the 

dependence of parish finances on oil and gas severance 

tax payments is still significant. Combining the information on oil, gas, and agriculture indicates that the risk 

outlook for parishes that depend on these industries is 

significant. Moreover, insured institutions may have 

both direct lending exposure to these sectors and indirect exposure arising from the ripple effects these sectors have on local economies. As indicated in Current 

Regional Banking Conditions, this issue, there is some 

evidence that banks with significant ties to oil-dependent parishes have tended to have a more defensive posture in the form of higher reserve ratios than typical 

institutions in Louisiana. 

David T. Griffiths, Regional Economist 

Gary L. Beasley, Regional Manager 

Memphis Regional Outlook 19 Second Quarter 1998 
Regular Features	 Regional Banking
 

Current Regional Banking Conditions
 

•	 Banks and thrifts in the Memphis Region reported strong aggregate results for 1997. 

•	 Lower rates and a flat yield curve could complicate interest rate risk management and pressure net interest margins, particularly for mortgage lenders. 

•	 The Region’s agricultural lenders are generally well positioned to deal with potential declines in crop prices 

in 1998. 

•	 Insured institutions in oil- and gas-producing areas could see local economic slowdowns if low oil prices 

persist. 

Overview for 1997 

In aggregate, Memphis Region bank and thrifts continued to be favorably influenced by the generally positive 

economic conditions in the Region during 1997, as 

described in Memphis Region’s Growth Recovers but 

Lags the Nation, in this issue. While the Region’s economy lagged the nation in some areas, overall conditions 

helped maintain strong financial performance in the 

banking industry. During the year, Memphis Region 

institutions: 

•	 increased aggregate leverage capital to 8.9 percent 

of average assets; 

•	 maintained low levels of nonperforming assets; 

•	 improved the aggregate return on assets to 1.29 percent; and 

•	 increased the aggregate net interest margin to 4.40 

agricultural conditions contributed to its failure. The 

financial condition of other banks specializing in agriculture remains strong. The performance of the 

Region’s agricultural lenders and current lending trends 

are discussed later in this article. 

Interest Rate Changes May Affect 

Mortgage Lenders 

The term structure of U.S. Treasury security yields, 

commonly referred to as the yield curve, flattened during 1997. As shown in Chart 1, rates pivoted at approximately the 2-year maturity, with longer maturity rates 

falling and shorter ones rising. The spread between the 

3-month U.S. Treasury bill and 30-year U.S. Treasury 

bond compressed from 151 basis points at year-end 

1996 to 69 basis points by year-end 1997. In addition to 

important economic implications, lower long-term rates 

CHART 1 

percent. 

While the aggregate net interest margin improved, this 

increase was primarily driven by the results of larger 

institutions. The average net interest margin for the 

Region’s banks and thrifts was unchanged for the year 

at 4.47 percent. One possible reason for the apparent 

flatness in average bank and thrift net interest margins 

is the changing shape of the yield curve discussed 

below. 

One bank in Louisiana failed during the fourth quarter 

of 1997, the first failure in the Region since 1992 and 

the first in the nation since August 1996. While this 

bank was an agricultural lender, factors other than local 

The Treasury Yield Curve Flattened in 1997 

4.5 

5.0 

5.5 

6.0 

6.5 

7.0 

Interest Rate (%)

December 31, 1996 

December 31, 1997 

Up 26 

Down 

56 bps 

Constant Maturity Rates 

bps = basis points 

Source: Federal Reserve Board 3 Month 6 Month 1 Year

2 Year

3 Year

5 Year

7 Year

10 Year

20 Year

30 Year 

Memphis Regional Outlook 20	 Second Quarter 1998 
Regular Features Regional Banking
 

CHART 2 CHART 3 

Average Net Interest Margin Does Not Show a 

Clear Relationship with Changing Interest Rates... 

Source: Bank and Thrift Call Reports; Federal Reserve Board 

0 

1 

2 

3 

4 

5 

6 

7 

4.0 

4.2 

4.4 

4.6 

4.8 

5.0 

Net Interest Margin 

Federal Funds Rate 

Federal Funds Rate

Net Interest Margin 

Mar 92

Dec 92Sep 93

Jun 94

Mar 95

Dec 95

Sep 96

Jun 97 

...but Does Exhibit Some Correlation 

with Rate Spreads 

* Net interest margin shown with a one-quarter lag 

Source: Bank and Thrift Call Reports; Federal Reserve Board 

0 

1 

2 

3 

4 

5 

4.0 

4.2 

4.4 

4.6 

4.8 

5.0 

Net Interest Margin* 

Spread between 3-Month and 

30-Year U.S. Treasury Securities 

Net Interest Margin

Interest Rate Spread 

Mar 92

Dec 92Sep 93

Jun 94

Mar 95

Dec 95

Sep 96

Jun 97 

and a flat yield curve may have more direct consequences for banks and thrifts. 

While declining interest rates are generally viewed as 

having a positive effect on bank and thrift industry earnings, many institutions may feel pressure on their net 

interest margins in the current rate environment. 

Adverse consequences of the current rate environment 

could range from reinvesting assets at lower yields, such 

as refinanced mortgage loans or callable securities, to 

replacing entire segments of the balance sheet, such as 

adjustable rate mortgages (ARMs) should demand for 

the product continue to decline. 

Institutions most likely to experience these consequences are those with substantial mortgage-related 

assets.1 The decline in long-term interest rates has led to 

increased prepayments on outstanding mortgages. 

Banks with substantial mortgage-related assets may see 

a flood of prepayments, which they will reinvest at 

lower rates of return, assuming they reinvest in similar 

product types. Also, the few banks and thrifts in the 

Region that service mortgage loans have seen the value 

of their servicing rights erode as prepayments have 

accelerated. 

The level of exposure of Regional banks to prepayment 

risks is little changed in recent years. While banks have 

seen considerable growth in residential lending, 

decreases in mortgage-backed securities have largely 

offset this growth. The average ratio of mortgage-relat1 For purposes of this article, mortgage-related assets are considered 

to be first-lien one- to four-family residential real estate loans, mortgage-backed securities, and mortgage servicing rights. 

ed assets to total assets for the Region’s banks has 

increased modestly from 24.3 percent in 1995 to 25 percent at year-end 1997. Traditionally, bank and thrift residential loan portfolios have been perceived to exhibit a 

lower level of prepayment volatility than most mortgage-backed security products, since institution portfolios often include a high proportion of short-term 

balloon notes and adjustable rate loans. As discussed 

below, the perceived lower volatility associated with 

balloon notes and ARMs may be somewhat misleading 

in the current rate environment. 

In addition to any potential effects from a general 

decline in interest rates, a flattening of the yield curve 

generally is not considered conducive to financial intermediaries as the spread between short-maturity liabilities, often the primary funding sources for institutions, 

and longer-maturity loans and securities is reduced. 

Also, the shape of the curve may have a pronounced 

effect on certain investment products such as structured 

notes and mismatched floating-rate mortgage derivatives or on customer demand for certain types of products such as ARMs. 

As shown in Charts 2 and 3, average net interest margins for the Region’s banks and thrifts do not seem to be 

as closely related to the level of interest rates (represented in Chart 2 by the Federal Funds rate) as to the 

spread between short- and long-term rates.2 If the pattern shown in Chart 3 continues, net interest margins 

would be expected to contract in response to the sharp 

2 The interest rate spread shown in Chart 2 is the difference between 

rates on the 30-year U.S. Treasury bond and the three-month U.S. 

Treasury bill. 

Memphis Regional Outlook 21 Second Quarter 1998 
Regular Features Regional Banking
 

declines in spreads in the second half of 1997. In addition to interest rate changes, many other factors affected bank and thrift net interest margins during the period 

shown, including increased capital levels, higher volumes of earning assets, an asset mix with heavier 

weighting in loans, and increased competitive pressures. 

Beyond the potential impact of narrowing interest rate 

spreads on net interest margins, the flatness of the yield 

curve could have an additional effect on institution risk 

profiles. With the current low level of interest rates and 

flat yield curve, fewer new and existing borrowers are 

choosing ARMs and balloon mortgages. Federal Home 

Loan Mortgage Corporation data show that 92 percent 

of former ARM holders refinanced their conventional 

mortgages with long-term fixed-rate mortgages during 

the fourth quarter of 1997, compared with 57 percent 

during the refinancing wave in 1993. Similarly, the 

share of former balloon mortgage holders transitioning 

into long-term fixed-rate loans is up dramatically. 

Many banks and thrifts have traditionally relied on 

ARMs and balloon notes as a way to participate in the 

residential loan market while limiting timing mismatches between loans and deposits. As the Region’s loan 

portfolios have grown in recent years, so have residential loan volumes and ARMs. As of December 31, 1997, 

adjustable mortgages represented an average of 11.9 

percent of total loans at Memphis Region banks. By 

comparison, the average share of ARM loans among 

banks nationwide was 8.3 percent. As shown in Table 1, 

Kentucky and Tennessee banks reported significantly 

higher ARM holdings than the rest of the Region and 

most of the nation. 

TABLE 1 

Average Adjustable Rate 

Mortgage Holdings of Banks 

Vary by State in the Region 

% OF 

STATE TOTAL LOANS STATE RANK 

ARKANSAS 7.2 24 

KENTUCKY 19.9 6 

LOUISIANA 6.5 28 

MISSISSIPPI 5.7 34 

TENNESSEE 13.7 13 

Source: Bank Call Reports 

ARM balances averaged almost 12 percent of total 

loans among Memphis Region banks, but many institutions reported significantly higher levels. At year-end 

1997, 174 banks (slightly less than 18 percent of banks 

in the Region) held ARM loans equivalent to 25 percent 

or more of total loans. Total assets in the group were in 

excess of $21 billion (9 percent of total banking assets 

in the Region) as of December 31, 1997. These banks 

are heavily concentrated in Kentucky (95 banks, or 35 

percent of banks in the state) and Tennessee (45 banks, 

or 19 percent of banks in the state). Other geographic 

pockets of banks with high ARM levels were reported in 

northwest Arkansas and south central Louisiana. 

Although the mortgage industry nationwide has already 

begun to see considerable reductions in the demand for 

ARMs, Memphis Region banks have seen only a limited reduction in this loan type compared with overall 

residential lending. The aggregate share of ARMs to 

first-lien, one- to four-family residential real estate 

loans was down slightly, from 35.0 percent on June 30, 

1997, to 34.6 percent on December 31, 1997. 

Implications: While certain types of refinanced mortgages may be replaced by new product origination, 

banks and thrifts could see ARM portfolios shrink as 

rising prepayments overwhelm limited current production. Soon, institutions could face the prospect of 

replacing ARMs with commercial or consumer loans, 

which traditionally have involved higher credit risk, or 

longer term fixed-rate residential loans, which have 

greater interest rate risk. 

Bankers and examiners should consider the significance 

of an institution’s ARM and balloon note holdings and 

the potential for such mortgages to be refinanced. This 

potential may be affected by numerous factors, including the age and coupon rates of the mortgages, the 

sophistication of the borrowers, and the competition in 

the area. Also, funding strategies may need to be 

reviewed to ensure that any potential structural changes 

related to increased asset prepayment levels are considered adequately. 

One major determinant of risks posed by the current 

interest rate environment will be its duration. The longer 

low and flat interest rates persist, the more assets will 

reset to lower rates and the more borrowers will shift out 

of adjustable rate products. The potential for more serious margin contraction during any subsequent period of 

rising interest rates increases with the duration of the 

current environment. Even if the flatness of the curve is 

Memphis Regional Outlook 22 Second Quarter 1998 
Regular Features Regional Banking
 

TABLE 2 

Agricultural Loan Totals in Memphis Region Are Rising, 

but Concentrations Are Down 

SEP-95 SEP-96 SEP-97 

ALL BANKS 

AG LOANS (BILLIONS) $5.7 $5.9 $6.6 

% OF TOTAL LOANS 4.7 4.3 4.1 

BANKS WITH AG CONCENTRATIONS 

NUMBER OF BANKS 173 148 135 

AG LOANS AS % OF TOTAL LOANS 38.7 37.7 36.8 

Source: Bank Call Reports 

of short duration, bankers and examiners could take the 

opportunity to consider the effectiveness of policies, 

procedures, and planning in addressing risks posed by 

nonparallel interest rate changes. 

Mixed Signals Are Present in Agricultural 

Lending 

The Region’s agricultural lenders have performed well 

since the passage of the 1996 Federal Agricultural 

Improvement and Reform Act (FAIR). While the share 

of agricultural loans to total loans has declined during 

this time, many rural economies and banks remain highly dependent on the sector. With lower commodity 

prices projected and weather always uncertain, midsouth farmers and agricultural lenders could face a 

tougher year in 1998 than in the two previous years. 

The volume of agricultural loans has continued to 

increase among banks headquartered in the Memphis 

Region, rising from $5.7 billion as of September 30, 

1995, to $6.6 billion as of September 30, 1997. (Thirdquarter loan totals rather than year-end totals were used, 

since this reporting period more closely corresponds to 

peak seasonal borrowings.) Despite the increased loan 

volume, the agricultural sector’s share of total loans in 

the Region has declined, as shown in Table 2. 

The number of banks with loan concentrations in agriculture3 and the level of agricultural loan holdings in 

these banks have declined as well. The declining concentrations in agricultural credits can be attributed to 

3 Agricultural concentration is defined in this article as 25 percent of 

total loans in agricultural production and agricultural real estate 

loans. 

overall growth in other loan categories, competition for 

loans with equipment financing companies and the 

Farm Credit System, and the acquisition of agriculturally dependent banks by more diversified institutions. 

Between September 1995 and September 1997, 14 of 

the original 173 banks with a concentration in agriculture were acquired by other institutions. Total assets of 

banks in the group were $8.7 billion, or 3.7 percent of 

the Region’s total banking assets, as of December 31, 

1997. 

Banks with direct concentrations in agricultural lending 

as of September 30, 1997, are clustered along the Mississippi River. Agricultural credits of banks in these 

areas are predominately crop production and farm 

equipment loans. In other areas, such as Kentucky, 

loans on farmland make up a larger share of the agriculture portfolio. 

For the Region, loans on farmland grew faster than production and equipment loans over the past two years and 

made up the largest share of agricultural loans in 1997. 

One factor in this shift in loan type has been the relatively strong performance of many farmers in the 

Region. Crop producers have needed less annual funding thanks to higher cash receipts from strong production levels and high prices. 

However, among banks showing agricultural loan concentrations, production and equipment loans are still 

predominant and growing at 61 percent of total agricultural loans. By comparison, banks actively making agricultural loans, but with less than 25 percent of total 

loans in such credits, report farmland loans as a dominant and increasing share. This pattern may indicate 

that crop production lending is becoming even more 

specialized. 

Memphis Regional Outlook 23 Second Quarter 1998 
Regular Features Regional Banking
 

Since the passage of FAIR, the overall financial condition of agricultural lenders has become somewhat 

stronger, as shown in Table 3. In 1997, almost twothirds of the group had returns on assets (ROAs) above 

the Region’s aggregate ROA, and three-fourths of the 

group had leverage capital ratios above the Region’s 

aggregate level. Only three banks in the group reported 

losses in 1997. 

The generally positive performance of agricultural-concentrated lenders is not surprising, given the favorable 

conditions affecting most of the Region’s farmers over 

the past two years. During this time, many crop producers benefited from high crop prices, strong production, 

and increased government payments. 

FAIR eliminated the traditional system of deficiency 

payments targeted to minimum price levels and provided for a system of fixed transition payments, which are 

reduced annually and expire in 2002. These transition 

payments were decoupled from current production to 

encourage farmers to become more responsive to market conditions. The recent shift by many of the Region’s 

farmers from planting cotton to more profitable crops 

such as soybeans provides an example of this increased 

responsiveness to prices. 

FDIC Reports on Underwriting Practices prepared 

during 1997 cited examiner concern over transition payments more often than any other issue. However, only a 

limited number of respondents in the Memphis Region 

reported any direct underwriting concerns. A few 

respondents in each state reported concern over loans 

based on unrealistic cash flows. Only Louisiana and 

Tennessee had any responses exhibiting concern over 

unrealistic or escalating land values, and the number of 

such responses was limited. 

TABLE 3 

Implications: The strong performance by farmers and 

agricultural lenders over the past two years may have 

given a false picture of how well producers have adjusted to FAIR’s provisions. Short-term risks resulting from 

increased worldwide production of many crops coupled 

with reduced Asian demand, as well as long-term competitive risks facing the agricultural sector, point to 

lower prices for many of the Region’s commodities in 

1998. Farmers’ performance under a scenario of lower 

commodity prices could provide better insight into the 

change in agricultural lending risks resulting from 

FAIR. 

Banks Operating in Oil and Gas Areas 

Low prices for crude oil in the fourth quarter of 1997 

and first quarter of 1998 raise some concern for the oil 

and gas sector in Louisiana. While the degree of direct 

lending by area banks to oil and gas producers may be 

limited, many local economies depend on the oil and 

gas sector, and any employment downturn in the sector 

could affect financial institutions adversely. Some 

banks in south-central Louisiana already are experiencing distressed local economic conditions resulting from 

textile industry job losses, although the effects have 

been somewhat muted by previously strong energy sector and construction employment growth in the area. 

Banks headquartered in major oil- and gas-producing 

areas of Louisiana4 have shown generally strong performance in recent years. There are 46 banks in these 

areas, with total assets of $6.9 billion, or 2.9 percent of 

the Region’s total banking assets as of December 31, 

4 Major producing areas are defined here as parishes with severance 

tax revenue of $5 million or more in 1996. 

Memphis Region Banks with Agricultural Concentrations Generally Exhibit 

Strong Financial Condition (as of December 31 Each Year) 

1995 1996 1997 

LEVERAGE CAPITAL 10.78 10.98 11.40 

RETURN ON ASSETS 1.23 1.27 1.23 

ALLOWANCE/TOTAL LOANS 1.76 1.79 1.66 

NONCURRENT AG LOANS/AG LOANS 0.61 0.68 0.40 

AG LOANS LOSSES/LOANS 0.24 0.40 0.30 

Source: Bank Call Reports 

Memphis Regional Outlook 24 Second Quarter 1998 
Regular Features Regional Banking
 

1997. The group posted earnings in line with the state 

and Region, with a 1.24 percent ROA in 1997, and 

maintained high leverage capital and allowance for loan 

loss levels at 11.6 and 1.9 percent, respectively, as of 

December 31, 1997. These higher capital and allowance 

levels appear appropriate, given the higher employment 

variability shown in Chart 2 of Memphis Region’s 

Growth Recovers but Lags the Nation. While these 

banks have shown positive trends in noncurrent loan 

levels and loan loss rates in recent years, they still report 

higher levels for both asset quality indicators than state 

or Regional aggregate levels. 

Gary L. Beasley, Regional Manager 

Robert L. Burns, Financial Analyst 

Memphis Regional Outlook 25 Second Quarter 1998 
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