Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION FOURTH QUARTER 1999 

FDIC
 

Boston
 

Region
 

Division of
 

Insurance
 

Daniel Frye,
 

Regional Manager
 

Norman Williams,
 

Regional Economist
 

Cameron Tabor,
 

Senior Financial
 

Analyst
 

Andrea Plante,
 

Economic Analyst
 

In Focus This Quarter 

◆ Economic Conditions and Emerging Risks in Banking—This article provides an 

overview of economic conditions and banking industry trends, with a primary focus on 

potential risks to insured depository institutions. 

● Indicators of Industry Performance—The reported financial condition of insured banks 

and thrifts is strong. However, despite projected growth in earnings, bank and thrift 

stocks underperformed the broader market through October 1999. See page 3. 

● Economic Conditions—The economy remains generally strong, and the outlook calls 

for continued growth. Growth is likely to slow, however, in order to correct financial 

imbalances that have developed as a result of a rapid creation of household and commercial credit and borrowing from abroad. There is a threat that the adjustment process 

could be a volatile one. See page 4. 

● Emerging Risks in Banking—Rising indebtedness on the part of businesses and households raises concerns about future loan performance. Industry responses to intense competition have created greater credit, market, and operational risks. See page 8. 

Consumer Lending—Banks and thrifts are becoming increasingly involved in subprime
 

consumer lending, which has raised some supervisory concerns. See page 8.
 

Commercial and Industrial Lending—Signs of deterioration in corporate credit quality
 

can be found in rising loss rates, slower profit growth, and rising corporate bond defaults.
 

At the same time, banks are expanding their lending to heavily indebted companies in
 

the syndicated loan market. See page 11.
 

Commercial Real Estate and Construction Lending—Loans for real estate construction
 

and development are growing rapidly. Despite an uptick in commercial vacancy rates,
 

loan losses remain low. See page 12.
 

Agricultural Lending—Low commodity prices are hurting farm operating incomes, but
 

widespread effects on farm banks have yet to materialize. See page 13.
 

Funding and Interest Rate Risk—Lagging deposit growth has led to a greater reliance
 

on more volatile, market-based funding, and some institutions are taking on greater
 

interest rate risk to maintain loan growth. See page 14.
 

By the Analysis Branch Staff 

Regional Perspectives 

◆ Economic and Banking Conditions—The Boston Region had a more marked deceleration in job growth than the nation did during the first eight months of 1999; manufacturing continued to shed jobs at a faster pace than the nation...Insured institutions 

performed well, but some measures of credit quality and profitability showed a modest 

decline. See page 18. 

◆ Commercial Real Estate Trends—Commercial real estate office markets remained 

healthy in the Region with declining vacancy rates, while retail and industrial markets 

showed mixed results during the first half of 1999...Total construction starts fell in the 

Region, weighed down by declining office starts. Retail and industrial markets experienced 

increased activity. See page 21. 

◆ Commercial and Small-Business Lending—Commercial lending has increased in the 

Region, but this could reflect greater loan demand more than an easing in underwriting 

standards or pricing...Small-business lending is growing faster than in previous years at the 

Region’s small institutions. The Region’s large institutions are increasingly using credit 

scoring. See page 23. 

By the Boston Region Staff 

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

Insurance Corporation institutions and financial institution regulators. It is produced for the following eight geographic regions: 

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

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

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

Dallas Region (CO, NM, OK, TX)
 

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

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

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

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

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

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

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

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

Outlook, please call Daniel Frye at (781) 794-5678 or send an e-mail to dfrye@fdic.gov. 

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

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

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

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

the Federal Deposit Insurance Corporation. 

Chairman Donna Tanoue 

Director, Division of Insurance Arthur J. Murton 

Executive Editor George E. French 

Editors Lynn A. Nejezchleb 

Maureen E. Sweeney 

Ronald L. Spieker 

Publications Manager Teresa J. Franks 

Writer/Editor Kim E. Lowry 
In Focus This Quarter
 

Economic Conditions and 


Emerging Risks in Banking
 

The Division of Insurance periodically assesses conditions in the economy and the banking industry to identify and 

evaluate trends that could adversely affect the performance of insured depository institutions. Overall, conditions in 

the economy and banking industry are favorable at this time. However, signs point to vulnerability in the economy 

and in the banking industry that may make the years ahead much more challenging. Three broad themes emerge from 

this assessment: 

•	 Households’ and businesses’ debt levels are on the rise. Spending by households and businesses is growing faster 

than cash income, resulting in rapidly increasing indebtedness. Consumer spending has been driven, in part, by 

large increases in the net worth associated with stock holdings and home equity. Businesses are restructuring and 

investing in new technologies to raise productivity and cut costs. Both consumer and business spending has been 

assisted by ready access to financing. Rising interest rates or slower economic growth could make debt service 

more difficult for borrowers. 

•	 Intense competition in banking is driving business strategies. Competitive pressures have affected nearly every 

facet of the banking business. These pressures are evident in net interest margins, which have suffered from tighter 

loan pricing and higher funding costs. To maintain profits, some institutions are lending to less creditworthy borrowers, expanding into new or higher-yielding activities, creating more complex balance sheet structures, or cutting costs. These strategies may lead to greater credit, market, and operational risks. 

•	 The currently benign economic environment is vulnerable to rapid deterioration in the event of financial market 

instability. During the 1990s, we have witnessed recurring, and perhaps more frequent, episodes of financial market turbulence. Recent episodes have arisen mainly overseas and have had little adverse effect on U.S. economic 

activity. However, the current economic expansion is closely tied to the ready availability of market-based financing for households and businesses and to wealth generated with the help of rising stock prices and falling interest 

rates. For this reason, the currently strong economic outlook may be subject to sudden deterioration in the event 

of market shocks that sharply raise interest rates or lower stock prices. 

The analysis that follows explores these themes in more detail in the following sections: 1) indicators of industry performance, 2) economic conditions, and 3) emerging risks in banking. 

Indicators of Industry Performance 

Industry Financial Performance Is Strong and a decline in provision expense. However, the majority of the decline in net earnings resulted from a $1.5 

According to reported financial information, the bank- billion loss posted by one large bank. 

ing and thrift industries are performing well. As summarized in the FDIC Quarterly Banking Profile, The low overall level of net loan losses has been a key 

second quarter 1999, both the commercial banking and contributor to strong industry performance. Chart 1 

thrift industries report near-record earnings, strong cap- (next page) shows that the average net loan loss ratio for 

ital levels, and manageable volumes of problem assets the industry has been low and stable in recent years. 

and loan losses. Return on assets (ROA) for all insured Similarly, the range between the worst and best 5 perinstitutions in the second quarter was 1.21 percent and cent of net loan loss ratios has narrowed considerably 

return on equity (ROE) was 14.07 percent. ROA and since the early 1990s. More than 95 percent of insured 

ROE were down slightly from the first quarter despite institutions reported a net loan loss ratio of less than 1 

improvement in the industry net interest margin (NIM) percent in 1998, continuing a five-year trend. 

Boston Regional Outlook 3	 Fourth Quarter 1999 
In Focus This Quarter
 

CHART 1 

Overview 

ings per share is projected to be 16.9 percent for pubBank Stocks Underperform Despite 

Projected Earnings Growth 

Analysts expect continued earnings growth for banks 

and thrifts in 1999 and 2000. Median growth in earnThe Range of Loan Losses for FDIC-Insured 

Institutions Has Been Stable Recently 

* For institutions with at least 10 percent of assets invested in loans. 

Source: FDIC Bank and Thrift Call Reports (Research Information System) 

–1.0 

0.0 

1.0 

2.0 

3.0 

4.0 

5.0 

6.0 

’84 ’86 ’88 ’90 ’92 ’94 ’96 ’98 

Net Loan Loss Ratio (percent)* 

95th Percentile 

Mean 5th Percentile 

licly traded banks and 19.4 percent for publicly traded 

thrifts for 1999.1 Ratings agencies also view the industry positively. The ratio of upgrades to downgrades for 

ratings issued by Moody’s Investors Service improved 

in the second quarter, with nine companies receiving 

upgrades versus four receiving downgrades. 

Nonetheless, bank and thrift stocks have underperformed the broader market in the first three quarters of 

1999. The SNL Securities Bank Stock Index, which 

tracks more than 450 publicly traded commercial banks, 

declined 6.7 percent between January 1 and September 

30, 1999. The SNL Securities Thrift Stock Index, 

which tracks the performance of about 350 publicly 

traded thrifts, fell 13.7 percent during the same period. 

By contrast, the Standard & Poor’s (S&P) 500 index 

gained 4.6 percent. Analysts cite rising interest rates, 

concerns about problems with corporate credit quality, 

and a decline in bank merger activity as reasons for the 

recent performance of bank and thrift stocks. 

Economic Conditions
 

The U.S. economy has remained generally strong during 

1999, the ninth year of the current economic expansion. 

If growth continues through February 2000—as most 

analysts expect—this expansion will become the 

longest in U.S. history. What is also remarkable about 

this business cycle expansion is the fact that the highest 

rates of growth have occurred during the past two years, 

1997 and 1998. Even as growth has accelerated with 

unemployment declining to 4.2 percent, wage and price 

inflation has remained unusually subdued. While low 

inflation has helped prolong the expansion, it has 

imposed intense price competition on a wide range of 

industries. The currently positive economic outlook is 

subject to possible sudden deterioration in the event of 

financial market shocks that could raise financing costs, 

reduce the availability of financing, or destroy investor 

wealth. 

Commodity Industries Have 

Faced Pricing Pressures 

One disadvantage of low inflation during this expansion 

has been that firms in certain commodity industries 

have suffered from falling prices. Profit margins have 

declined in agriculture, mining, and some manufacturing sectors because of weak or negative revenue growth 

during 1997 and 1998.2 Firms operating in these industries have aggressively cut costs to preserve profit 

margins. Nonetheless, profit growth has been flat or 

negative for a large proportion of S&P 500 firms in the 

mining, textiles, chemicals, iron and steel, and oil and 

gas sectors since 1997. In response, some firms in these 

industries have chosen to consolidate through mergers. 

According to Mergerstat, the dollar volume of merger 

and acquisition transactions involving U.S. firms was a 

record $1.2 trillion in 1998, more than 80 percent above 

1997 levels. 

Business Investment Is Outpacing Cash Flow 

Analysts recently have become concerned about 

increasing levels of debt on corporate balance sheets. 

1 Based on estimates as of November 4, 1999, for 98 commercial 

banks and 33 thrifts that have at least five analyst estimates. 

2 Richard A. Brown and Alan Deaton, “Falling Prices in Commodities 

and Manufacturing Pose Continuing Risks to Credit Quality,” 

Regional Outlook, Third Quarter 1999 (http://www.fdic.gov/bank/ 

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

Boston Regional Outlook 4 Fourth Quarter 1999 
In Focus This Quarter
 

Chart 2 tracks the steady growth of fixed investment by 

U.S. corporations during the current expansion. It also 

shows, however, that growth in cash flow available to 

finance investment has slowed in recent years. This 

“financing gap” has grown steadily, reaching a record 

$86 billion in 1998. 

As a result, corporations must finance an increasing 

portion of investment spending by issuing either net 

new equity or net new debt. In recent years, firms have 

overwhelmingly chosen debt financing. Net issuance of 

corporate debt was $219 billion in 1998, while corporations repurchased equity shares on net for the sixth 

straight year. Corporate borrowing has also continued 

at a brisk pace; domestic commercial and industrial 

(C&I) lending rose by 12.5 percent in the year ending 

June 1999. 

A widening financing gap and increasing debt levels 

could pose future problems if there are adverse 

changes in the financial environment. For example, a 

sharp rise in interest rates would increase the debt burden of businesses, hurt their profitability, and impair 

their creditworthiness. Under such a scenario, firms 

might decide to curtail their capital expenditures, 

which would tend to reduce the rate of growth in the 

rest of the economy. 

Consumer Spending 

Continues to Grow 

Strong growth in consumer spending continues to propel the economic expansion. Spending has accelerated 

in recent quarters, in contrast to previous expansions 

when the strongest growth in consumer spending 

occurred early in the recovery. One factor supporting 

the robust pace of spending is housing activity. Singlefamily housing starts rose to an annualized rate of 

more than 1.3 million units in fourth quarter 1998 and 

have remained near that level through third quarter 

1999. Existing home sales also have maintained a 

record pace of 5.3 million units on an annualized basis 

during the second and third quarters. Low mortgage 

interest rates and real income gains have combined to 

push housing affordability to its highest level in many 

years.3 

3 The housing affordability index published by the National Association of Realtors equals 100 when the median family income qualifies 

for an 80 percent mortgage on a median-priced existing singlefamily home. The value of the index as of the third quarter of 1999 

was 127.1. 

CHART 2 

The Financing Gap Has Widened 

for Nonfinancial Corporations 

Source: Federal Reserve Board (Haver Analytics) 

100 

200 

300 

400 

500 

600 

700 

800 

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

Billions of Dollars 

Capital Expenditures 

“Financing Gap” 

Cash Flow 

Rapid growth in consumer spending also warrants 

attention. Despite the highest rates of real income 

growth in nine years, consumer spending has grown 

more quickly than disposable personal income. The 

divergence in growth has resulted in a falling personal 

savings rate, which reached a record low in 1999.4 The 

recent decline in the personal savings rate continues a 

trend that has been under way for more than a decade 

(see Chart 3, next page).5 

Analysts cannot fully explain the reasons for the falling 

savings rate, although the “wealth effect” associated 

with the accumulation of capital gains by households is 

believed to be a significant factor. Since 1995, the total 

value of equities, mutual funds, and pension funds 

owned by households has risen by $6.8 trillion, while 

the value of owner-occupied housing net of mortgage 

debt has increased by $812 billion. This accumulation 

of wealth apparently has emboldened consumers to 

spend, as evidenced by data that show aggregate spend4 Personal savings is calculated as the difference between disposable 

personal income (DPI, or total income net of taxes) and consumption 

expenditures. The personal savings rate is equal to personal savings 

divided by DPI. It should be noted that capital gains, even when realized, are not included as income in this calculation, although taxes 

paid on capital gains are deducted from DPI. Consequently, largescale realization of capital gains by households will tend to push 

down the personal savings rate. 

5 The Bureau of Economic Analysis, which tabulates the personal 

savings rate, has recently revised its methodology, leading to a large 

revision in the savings rate data. Earlier estimates reported the personal savings rate to be around negative 1 percent, suggesting that 

households were spending more than their disposable (after-tax) 

income. Revised estimates show that the savings rate for the third 

quarter of 1999 was 2.1 percent. Although higher than previously 

reported, the revised personal savings rate data continue to show a 

downward trend similar to earlier savings rate estimates. 

Boston Regional Outlook 5 Fourth Quarter 1999 
In Focus This Quarter
 

CHART 3 

Strong Consumer Spending Has Been 

Accompanied by a Falling Personal Savings Rate 

Source: Bureau of Economic Analysis (Haver Analytics) 

0.0 

2.0 

4.0 

6.0 

8.0 

1Q92 1Q93 1Q94 1Q95 1Q96 1Q97 1Q98 

0.0 

2.0 

4.0 

6.0 

8.0 

10.0 

Personal Savings Rate 

(Percent) 

Personal Consumption Spending 

(Percent change from year ago) 

1Q99 

ing growth exceeding income growth. For the most part, 

when consumers have chosen to convert capital gains to 

spendable cash, they have done so by borrowing—often 

against the equity in their homes or their 401(k) 

accounts. 

The increasing indebtedness of consumers could substantially raise the costs of debt service relative to 

income, especially if interest rates rise or income 

growth slows. Moreover, analysts express concerns 

about a reversal of the wealth effect if there is a significant and sustained decline in equity prices. Any resulting decline in consumer confidence could substantially 

slow the pace of consumer spending, leading to a 

reduced pace of economic growth. 

CHART 4 

The Growing Private Deficit Raises Concerns 

Taken together, the sum of annual net borrowing by 

businesses and households has been referred to as the 

“private deficit.” During the late 1990s, as the combined 

budget of federal, state, and local governments moved 

from deficit to surplus, the private deficit rose sharply; 

between 1996 and 1998, it nearly doubled from $550 

billion to $1.02 trillion (see Chart 4). 

The private deficit was financed from three sources in 

1998. One source was the $73 billion surplus in the 

government sector, the first surplus in 28 years. The 

largest portion of the 1998 private deficit was financed 

by the creation of credit by the domestic financial sector and by an inflow of foreign capital. The rapid creation of credit raises concerns about credit quality, an 

issue that is explored in more detail under Emerging 

Risks in Banking, below. Dependence on foreign capital 

raises questions about what might happen if the foreign 

sector becomes less willing to export capital to the 

United States. 

Recovery Abroad Is Changing 

the Terms of Trade 

During the past three years, the U.S. economy has experienced consistently strong growth with low inflation, 

while the economies of some of its major trading partners have grown more slowly or not at all. Japan was 

mired in its worst recession in decades, while a number 

of countries in Asia, Latin America, and Eastern Europe 

Net Borrowing by Businesses and Households Represents a Growing “Private Deficit” 

Flow of Net Sectoral Lending (lending less borrowing), 

in Billions of Dollars 

Note: “Nonfinancial business” includes farm and nonfarm, corporate and noncorporate businesses. 

Source: Federal Reserve Board (Haver Analytics) 

–1200 

–600 

0 

600 

1200 

’80 ’81 ’82 ’83 ’84 ’85 ’86 ’87 ’88 ’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 

Foreign Sector 

Domestic Financial Sector 

Nonfinancial Business 

Households 

Government 

Boston Regional Outlook 6 Fourth Quarter 1999 
In Focus This Quarter
 

have experienced the harsh fallout resulting from financial market and exchange rate crises. The euro-zone 

economies, Germany and France in particular, have 

grown slowly following the imposition of tight fiscal 

and monetary policies in advance of the introduction of 

the euro on January 1, 1999. 

The net effect of this disparity in growth rates has been 

a growing U.S. trade deficit. The deficit rose by 57 percent in 1998 to $164.3 billion, reflecting a small decline 

in exports and a 5 percent increase in imports. The 

adverse effects of the trade deficit on the U.S. economy 

have been felt primarily by the commodity industries— 

farming, mining, and basic manufacturing. In addition, 

the large trade deficit has resulted in the transfer of billions of dollars to foreign investors. During 1997 and 

1998, many foreign investors used their excess dollars 

to purchase dollar-denominated stocks and bonds. This 

inflow of capital helped keep U.S. equity and bond 

prices high, while pushing up the value of the dollar. 

A global economic recovery during the first three quarters of 1999 has led to higher demand for investment 

capital outside the United States. The International 

Monetary Fund estimates that growth in the global 

economy will increase from 2.5 percent in 1998 to 3.0 

percent in 1999 and 3.5 percent in 2000.6 Foreign 

investors, in anticipation of stronger growth and greater 

investment opportunities abroad, have started to convert 

excess dollar holdings to other currencies, including the 

yen and euro. This change in investment strategy has put 

downward pressure on the value of the dollar. Between 

July and September 1999, the dollar lost approximately 

10 percent of its value against the yen. 

A falling dollar will likely contribute to a recovery of 

U.S. exports in coming months. The index of export 

orders compiled by the National Association of Purchasing Managers points to future growth in shipments 

abroad. The index has signaled growing export orders 

for nine months through October 1999. As Chart 5 

shows, increasing export orders tend to lead the actual 

rise in exports by several months. 

A lower dollar could also place upward pressure on U.S. 

inflation and interest rates. A steady decline in the dollar would make foreign goods more expensive, while 

higher export demand would raise manufacturing output at a time when U.S. labor markets are very tight. The 

prices of several important industrial commodities have 

6 International Monetary Fund, World Economic Outlook, October 

1999. 

CHART 5 

U.S. Exports Fell in 1998, but Rising 

Orders Point to Growth in 1999 

Source: Bureau of the Census; National Association of Purchasing Managers 

(NAPM) (Haver Analytics) 

–10 

–5 

0 

5 

10 

15 

20 

’93 ’94 ’95 ’96 ’97 ’98 ’99 

40 

45 

50 

55 

60 

65 

70 

U.S. Export Growth 

(Percent change from year ago) 

NAPM Export Orders Diffusion Index 

(Greater than 50 signals expansion) 

risen in dollar terms during 1999, led by a doubling in 

the price of oil during the first nine months of 1999. 

Domestically, the producer price index has risen by 

approximately 4 percent since the beginning of the year 

following a two-year decline, reflecting an increase in 

oil and intermediate goods prices. 

Interest rates have risen in step with renewed concerns 

about inflation. The constant maturity yield on 10-year 

Treasury bonds increased by approximately 140 basis 

points in the year ending October 1999, while the Federal Reserve instituted two 25-basis point increases in 

short-term rates during the summer of 1999. 

The Economic Outlook Calls 

for Continued Growth 

One scenario for the year ahead is that the U.S. economy will continue to grow at much the same rate as it 

has during the past few years. As discussed above, 

however, continued rapid growth would lead to even 

greater imbalances in the domestic economy and in the 

foreign sector. For this reason, most economists do not 

believe that rapid growth can continue indefinitely. 

Instead, analysts suggest two possible scenarios for the 

economy. 

The Blue Chip Economic Indicators consensus outlook for the U.S. economy calls for a “soft landing.” 

Gross domestic product is projected to grow at a rate of 

3.8 percent in 1999 with somewhat slower growth of 2.8 

percent in 2000.7 Rising wage pressures, reflecting tight 

7 Blue Chip Economic Indicators, Aspen Publishing, October 10, 

1999. 

Boston Regional Outlook 7 Fourth Quarter 1999 
In Focus This Quarter
 

labor markets across the nation, and economic recovery 

abroad are expected to increase the risks of higher U.S. 

inflation. Improving growth prospects in the global 

economy may also lead to a stabilization of commodity 

prices, reversing a trend of falling prices that has until 

recently contributed to lower U.S. inflation. In response 

to expectations of higher inflation, medium-term interest rates are also expected to rise modestly. Slower U.S. 

growth and faster expansion abroad would result in a 

rebalancing of global growth that should narrow the 

U.S. trade deficit and reduce downward pressure on the 

dollar. 

Although the consensus forecast calls for continued 

expansion, an alternative scenario suggests the possibility of a steep decline in economic growth leading to a 

“hard landing.” Sharply higher interest rates, in 

response to a weak dollar and an unexpected acceleration of U.S. inflation, could lead to declining capital 

investment and reduced consumer spending. Rising 

interest rates would increase the debt burden for households and businesses even as measures of indebtedness 

are rising. A significant and sustained decline in equity 

prices may occur if investors become pessimistic as the 

economy slows. The response of the world economy to 

a U.S. recession is difficult to assess. As the past several months have shown, growth in the U.S. economy has 

been an important factor in supporting growth abroad. 

If the U.S. economy were to enter a recession, overall 

global growth could also slow, depending on the extent 

to which recoveries in Europe, Asia, and Latin America 

offset any shortfall in U.S. growth. 

Emerging Risks in Banking
 

Overview 

Favorable economic conditions continue to support 

strong loan growth and healthy loan performance 

among insured institutions. Net loss rates remain low 

relative to the early 1990s for almost every major loan 

category except consumer loans. Loss rates in domestic 

commercial loans, previously at low levels, rose modestly during the first half of 1999. Agricultural loan loss 

rates appear likely to rise in the future due to the effects 

of weak commodity prices on farm incomes. Strong 

loan growth and low loan losses have helped banks 

achieve record and near-record high quarterly profits. 

However, rising indebtedness on the part of businesses 

and households raises concerns about future loan performance, particularly if economic conditions were to 

deteriorate or if interest rates were to rise. 

Strategic responses to competitive pressures point to 

greater credit, market, and operational risks for the 

industry. Intense competition has pressured NIMs and 

has encouraged many lenders to seek higher returns by 

lending to less creditworthy borrowers. In order to 

maintain and grow profits, some insured institutions are 

expanding into activities such as subprime consumer 

lending, high loan-to-value mortgage lending, and lending with minimal or no documentation requirements. 

Rapid growth in syndicated lending to leveraged companies also indicates that large commercial lenders have 

increased their tolerance for risk. Competition has made 

funding with deposits more difficult. As a result, some 

institutions are relying increasingly on securitizations 

and more expensive, market-based sources of funds, 

which can alter an institution’s liquidity position, interest rate risk profile, and operational needs. Institutions 

have also responded to competitive pressures by cutting 

costs or merging in an attempt to achieve greater efficiencies. In some cases, deep reductions in operating 

costs support profits at the expense of less effective 

operational controls. 

Consumer Lending 

Household Borrowing Is on the Rise 

Household borrowing is growing rapidly, consistent 

with high reported levels of consumer confidence and 

strong consumer spending. Mortgage debt, which grew 

by 10.4 percent in the second quarter from year-ago 

levels, is the fastest-growing segment of household 

debt (see Chart 6). Mortgage loan growth has been particularly strong, in part because of rising homeownership, the availability of more low-down-payment loans, 

and the use of mortgage loans to consolidate revolving 

debt balances. Nonrevolving debt grew by 7.3 percent 

in the year ending June 1999, largely because of strong 

sales of new cars. In contrast, credit card and other 

revolving debt increased by only 5.7 percent during the 

same period—a much slower rate of growth than during the mid-1990s. 

Boston Regional Outlook 8 Fourth Quarter 1999 
In Focus This Quarter
 

CHART 6 

Household Borrowing Is on the Rise, 

Led by Increases in Mortgage Debt 

Source: Federal Reserve Board (Haver Analytics) 

–10 

–5 

0 

5 

10 

15 

20 

25 

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

Percent Change from Year Ago 

Nonrevolving 

Home 

Mortgages Revolving 

A Mortgage Refinancing Boom Has Helped 

Consumers Consolidate Debt 

A key component of the recent shift by consumers from 

credit card debt to mortgage debt has been a surge in 

mortgage refinancing in 1998 and early 1999. The 

Mortgage Bankers Association’s Refinancing Index 

peaked at over 4,300 in October 1998, compared with 

an average monthly index value of 527 during 1997.8 

Many households have refinanced their mortgages to 

obtain cash to pay down credit card and other high-cost 

consumer debt, thereby lowering their monthly financial obligations. According to a Freddie Mac survey of 

1998 refinancing transactions, more than 3 million 

homeowners, or 51 percent of all mortgage-refinance 

borrowers, generated net cash proceeds when they refinanced their loans.9 On average, these borrowers cashed 

out 11 percent of the equity in their homes. On the basis 

of this survey, Bank One Corporation estimated that 

cash out refinancing added about $60 billion in cash 

flow to consumer pocketbooks last year. This extra cash 

flow could help explain recent quarterly declines in personal bankruptcy filings, mortgage delinquencies, and 

consumer credit charge-offs.10 Rising interest rates 

appear to have ended this mortgage refinancing boom. 

The lower volume of mortgage refinancings raises ques8 Index is seasonally adjusted where the week of March 16, 1990 =
 

100.
 

9 Survey cited in a study by the Joint Center for Housing Studies at
 

Harvard University, “The State of the Nation’s Housing: 1999.”
 

10 Tristan Mabry, “This Boom, Some Say, Is on the House,” The Wall
 

Street Journal, July 6, 1999.
 

tions about whether consumers again will increase their 

use of credit cards to finance purchases. If so, there may 

be negative consequences for future consumer debt service burdens and consumer credit quality. 

Credit Card Lenders Face Declining Returns 

After several years of rapid growth in the mid-1990s, 

the credit card industry has become characterized by 

overcapacity and declining margins. At the same time, 

the high level of mortgage refinancings and rising 

household incomes have reduced the dependence of 

consumers on credit card debt. Consequently, credit 

card lenders are struggling to maintain volume as consumers pay off their credit card balances more quickly. 

Overcapacity and declining margins have led lenders to 

search aggressively for new ways to increase revenues. 

One method they have adopted is to charge new fees 

that are triggered by cardholder behavior. Lenders are 

now charging fees for inactive accounts, fees to close 

accounts, and even customer service fees. In addition, 

they are reducing grace periods, curtailing leniency 

periods, and imposing higher penalty interest rates. 

According to RAM Research, banks’ income from 

credit card fees has grown 79 percent over the past two 

years, while card interest income rose only 10 percent.11 

Shrinking margins have also prompted consolidation in 

the credit card industry. Today, the top five issuers control about 60 percent of the total managed assets in the 

credit card sector, up from just 35 percent in 1990.12 

Amid this changing competitive 

landscape, credit quality has 

improved. Credit card charge-off 

levels at insured commercial banks 

hit an all-time high of 5.5 percent 

in the third quarter of 1997 but 

have declined steadily to a level of 

4.1 percent in the second quarter of 

1999. This decline has been attributed to tighter underwriting standards, more aggressive collection efforts, 

and extra household cash flow generated through mortgage refinancings. 

11 Miriam Kreinan Souccar, “Consumer Groups Up in Arms Over
 

Card Penalties,” American Banker, February 26, 1999.
 12 James C. Allen, “Tarnished Platinum,” SNL Securities Bank Mergers & Acquisitions, June 1999.
 

Boston Regional Outlook 9 Fourth Quarter 1999 
In Focus This Quarter
 

Subprime Lenders Have Riskier 

Characteristics than the Industry 

Subprime lending to consumers has grown dramatically in recent years. Subprime mortgage originations 

have grown from 5 percent of the total mortgage market in 1994 to 15 percent in 1997.13 The percentage of 

originations fell somewhat in 1998 to 10 percent—not 

because the volume of subprime mortgage originations 

fell but because the volume of prime mortgage originations was at a record high. In fact, in terms of dollars, 

subprime originations grew by 20 percent from 1997 to 

1998, to $150 billion. That figure is up significantly 

from the $35 billion in subprime originations in 1994. 

Estimates of the size of the subprime automobile loan 

market vary somewhere between $50 billion and $75 

billion, but one source estimates that subprime automobile originations jumped 

from about 8 percent of all 

automobile loan originations 

in 1990 to over 18 percent in 

1998.14 Analysts also have indicated that the subprime 

credit card market is the fastest-growing segment of 

credit card lending today. According to RAM 

Research, subprime receivables are growing 45 percent 

annually, compared with 16 percent or less for other 

segments of credit card lending.15 

Intense competitive pressure has contributed to the 

expansion of bank and thrift participation in subprime 

consumer lending. These loan programs offer higher 

margins than prime consumer lending products and 

have become an attractive alternative for banks and 

thrifts that have experienced shrinking margins in credit cards, mortgage lending, and other consumer product 

types. Moreover, the shakeout in the subprime specialty 

finance industry has provided new opportunities for 

insured depository institutions seeking to enter the subprime lending market. In 1999, several insured depository institutions acquired, or announced plans to 

acquire, a subprime specialty finance company. Bank 

and thrift involvement in subprime lending is expected 

to increase. In fact, some industry analysts predict that 

insured depository institutions with subprime affiliates 

13 The Mortgage Market Statistical Annual for 1999, Inside Mortgage Finance Publications, 1999. 

14 Ron Feldman, An Introduction to Subprime Auto Lending for 

Examiners, Federal Reserve Bank of Minneapolis, April 1998, and 

data supplied by CNW Marketing and Research. 

15 Lisa Fickenscher, “Credit Card Issuers Panning for Gold Among 

Tarnished Credit Histories,” American Banker, October 22, 1998. 

will overtake finance companies as leaders in the subprime industry. 

Subprime lending poses entirely new challenges in risk 

management for insured institutions. Not only are 

expected credit losses higher than for prime consumer 

lending, but a number of factors suggest that losses are 

also less predictable: 

•	 Subprime borrowers are more likely to default than 

prime borrowers and may be more vulnerable to 

economic shocks, such as a recession. Borrowers’ 

previous credit problems suggest that they have 

limited financial resources to withstand economic 

difficulties. 

•	 Credit-scoring and pricing models used to underwrite subprime loans are untested in a recession. 

Analysts have noted that credit-scoring models 

are less effective in predicting the likelihood of 

default for subprime borrowers than they are for 

prime borrowers. 

•	 Operational risks are greater in subprime lending. 

Because defaults occur sooner and more often than 

in prime lending, subprime portfolios require a 

greater investment in servicing and collections 

resources. Subprime lenders run a greater risk that 

these resources could become severely strained if the 

level of defaults is not correctly anticipated. 

•	 Liquidity risks are greater in subprime lending. 

Some large-volume subprime lenders heavily depend 

on the ability to securitize and sell loans to the secondary market. But investor demand for paper 

backed by subprime loans may be volatile, as was 

demonstrated during the financial market turmoil of 

late 1998. A number of nonbank subprime lenders 

experienced a liquidity crunch as a result of that market turmoil, and several opted for—or were forced 

into—bankruptcy.16 

•	 Reputation, legal, and compliance risks also are 

important for subprime lenders. Subprime lenders 

generally run a greater risk of violating, or being 

accused of violating, consumer protection laws or 

regulations. The public perception of subprime 

16 Dominic DiNapoli and Ron Greenspan, “The Next Industry Crisis 

Could Be Even Bigger,” American Banker, June 15, 1999. 

Boston Regional Outlook 10	 Fourth Quarter 1999 
In Focus This Quarter
 

lenders could be tarnished if a recession were to 

result in substantially higher default rates. 

The growing involvement by insured depository institutions in subprime lending has raised significant concerns for bank and thrift supervisors. To address those 

concerns, FDIC Chairman Donna Tanoue recently 

announced that the FDIC will propose to the other federal financial institution regulators that insured depository institutions with concentrations in subprime 

lending be held to higher minimum capital requirements than the current rules dictate.17 The FDIC proposal includes a common supervisory definition of 

subprime lending and ties capital adequacy to the types 

and levels of risks that individual subprime lenders have 

in their portfolios. This proposal will be shared with 

other federal regulators to refine a final approach. 

Commercial and Industrial Lending 

Commercial and Industrial Loan 

Losses Have Been on the Rise 

Insured institutions continue to accommodate the credit needs of business borrowers. Domestic C&I loans 

grew almost 12.5 percent during the year ending in June 

1999 and accounted for 40 percent of all net new loans 

booked during that period. 

Although commercial loan losses are low, there are 

signs that credit quality in C&I portfolios is deteriorating. Net domestic C&I charge-offs during the first half 

of 1999 more than doubled from 1998 levels, while 

noncurrent domestic C&I loans rose by 26 percent. 

Examiners also have reported increasing problems in 

commercial portfolios. The Office of the Comptroller 

of the Currency recently reported that the dollar volume of classified and special-mention Shared National 

Credits rose 70 percent during a recent annual review.18 

Slower profit growth and rising corporate bond defaults 

also point toward somewhat weaker business credit 

17 FDIC Chairman Donna Tanoue in a speech before America’s Community Bankers, Orlando, Florida, November 2, 1999 (http://www. 

fdic.gov/news/news/speeches/chairman/sp02Nov99.html). 

18 “OCC Says Big Commercial Loans Suffering from Lax Underwriting,” American Banker, October 6, 1999, p. 1. The shared national 

credit program is a cooperative interagency program to review large 

credits held at several institutions. Loans subject to review include 

commitments in excess of $20 million that are shared among three or 

more participating lenders. 

quality. While corporate profits grew by an average of 

15 percent per year between 1993 and 1996, economists 

polled by Blue Chip Economic Indicators project 

growth of 6.7 percent for all of 1999, followed by 

growth of only 3.5 percent in 2000.19 Standard & Poor’s 

reported that 55 rated issuers defaulted on $20.5 billion 

in debt during the first six months of 1999.20 This pace 

of defaults is already nearly double levels experienced 

in the first half of 1998 and does not include more 

recent large defaults such as Iridium and Daewoo 

Group. Approximately 85 percent of the defaults that 

occurred during the first half of 1999 were among 

speculative-grade issuers. According to Moody’s, junk 

bond defaults rose to 5.8 percent of issues outstanding 

during the 12 months ending in September 1999, the 

highest level since 1991. 

Rising Losses May Be Attributable 

to Loose Underwriting 

Analysts attribute the recent deterioration in commercial credit quality to weak underwriting standards in 

the corporate debt markets during 1997 and early 

1998.21 Bank underwriting was reported to be particularly accommodating at that time. The Federal Reserve 

Board reported in its May 1998 Senior Loan Officer 

Opinion Survey on Bank Lending Practices that 

domestic banks were “generally eager to make loans to 

businesses” and that during early 1998 “a large percentage cut their spreads on such loans.” Subsequently, the November 1998 Survey reported a “broad 

tightening of business lending practices” associated 

with the financial market turmoil in progress at that 

time. However, regulators have continued to express 

concern about the assumptions underlying bank lending decisions. A Supervision and Regulation Letter 

sent by the Federal Reserve Board of Governors to its 

examiners in September 1999 noted the recent tightening of standards, but stated that “certain deeper issues 

remain,” which relate mainly to overoptimistic 

assumptions about the future repayment capacity of 

business borrowers.22 

19 Blue Chip Economic Indicators, Aspen Publishing, October 10,
 

1999.
 

20 “Defaults Soar in First Half 1999,” Standard & Poor’s, August 12,
 

1999.
 

21 See, for example, “Under Boom Economy, Strain Over Debt,” The
 

Wall Street Journal, August 18, 1999, Section C, p. 1. 
 22 SR 99-23, September 28, 1999. “Recent Trends in Bank Lending
 

Standards for Commercial Loans” (http://www.federalreserve.gov/
 

boarddocs/SRLETTERS/1999/SR9923.HTM).
 

Boston Regional Outlook 11 Fourth Quarter 1999 
In Focus This Quarter
 

Leveraged Lending Has Been the Predominant 

Type of Syndicated Lending 

Banks appear to be taking on more risk in the syndicated loan market by expanding their lending to heavily indebted companies. During the first half of 1999, 

leveraged lending was the fastest-growing segment of 

syndicated commercial lending.23 While overall syndicated loan volume was down slightly compared with 

the first half of 1998, syndicated lending to leveraged 

companies rose $7 billion, or 5 percent, on the strength 

of a record volume of “highly leveraged loans.”24 As 

shown in Chart 7, loans to leveraged companies are 

making up a growing proportion of syndicated loan 

originations. 

Factors driving growth in leveraged lending include a 

high volume of corporate mergers and acquisitions, 

increasing investor demand for higher-yielding loans, 

and a shift in preference for loans over bonds by highyield issuers.25 While bank syndicators pass a large volume of these loans along to nonbank investors, a 

23 Syndicated loans are credits extended to large or medium-sized corporate borrowers that are originated by a group, or syndicate, of 

lenders. One type of syndicated lending is leveraged lending, in 

which the borrower’s debt-to-equity ratio is significantly higher than 

the industry average. Loan Pricing Corporation defines “leveraged 

loans” as those for which pricing exceeds 125 basis points over 

LIBOR. 

24 Loan Pricing Corporation defines “highly leveraged loans” as those 

for which pricing exceeds 225 basis points over LIBOR. 

25 According to Mergerstat, the value of mergers and acquisitions 

(M&A) was almost $400 billion during second-quarter 1999. According to Loan Pricing Corporation, syndicated loans originated in the 

second quarter to finance M&A activity totaled some $69 billion—a 

43 percent increase over issuance in the first quarter. 

CHART 7 

Loans to Leveraged Companies
 

Are Making Up A Greater Proportion of
 

Syndicated Loan Originations
 

Originations of Syndicated Loans to Leveraged Companies
 

As a Percentage of Total Syndicated Loans Dollars in Billions 

32% 

350 

300 

60 

50 

250 40 

200 

30 150 

20 100 

10 50 

0 

’90 ’92 ’94 ’96 ’98 ’99:1H* 

0 

* First half, annualized 

Source: Loan Pricing Corporation 

substantial portion of these credits remains on bank balance sheets. Loan Pricing Corporation has reported 

that as much as 64 percent of the value of “highly leveraged” loans originated in the first half of 1999 was 

retained by banks.26 

Commercial Real Estate 

and Construction Lending 

Construction Loan Volume Continues to Rise 

Loans for real estate construction and development 

(C&D) represent one of the fastest-growing segments of 

bank balance sheets, increasing 24 percent during the 

year ending June 1999. Compared with construction 

activity in the mid-1990s, spending on new commercial 

construction has shifted somewhat away from the industrial and retail markets and toward office and hotel construction. Residential construction growth was also 

strong during the first half of 1999, with single-family 

completions increasing 17 percent from a year ago. In 

the midst of this growth in loan volume, loss rates and 

past-due ratios for construction and development loans 

remain very low by historical standards, as indicated in 

Chart 8. 

Office Vacancy Rates Are Rising 

in Many Top Markets 

In previously published reports, Division of Insurance 

analysts identified nine metropolitan real estate markets 

where rapid development threatened to produce nearterm oversupply conditions.27 These cities were identified based on the pace of current construction activity, 

commercial space demand indicators, and independent 

market analysts’ projections. Six of the metropolitan 

areas identified—Atlanta, Phoenix, Orlando, Portland, 

Dallas, and Nashville—subsequently experienced large 

increases in office vacancy rates during the first half of 

1999. These areas have also experienced reduced 

employment growth and slowing net in-migration. 

Higher vacancy rates are often accompanied by slower 

26 “Junk Loan Market Is Feeling the Pinch of Oversupply and Rising 

Interest Rates,” The Wall Street Journal, September 13, 1999. 27 Steven K. Burton, “Commercial Developments Still Hot in Many 

Major Markets, but Slower Growth May Be Ahead,” Regional 

Outlook, First Quarter 1999 (http://www.fdic.gov/bank/analytical/ 

regional/ro19991q/na/infocus2.html) and “Ranking the Risk of 

Overbuilding in Commercial Real Estate Markets,” Bank Trends, 

FDIC Division of Insurance, October 1998 (http://www.fdic.gov/ 

bank/analytical/bank/bt9807.html). 

Boston Regional Outlook 12 Fourth Quarter 1999 
In Focus This Quarter
 

CHART 8 

Construction Loan Volume Continues to Rise, 

but Problem Loans Remain Low 

* First half 

Source: FDIC Bank and Thrift Call Reports (Research Information System) 

Construction and Development Loans 

0 

75 

150 

225 

’84 ’87 ’90 ’93 ’96 ’99:1H* 

0 

2 

4 

6 

8 

10 

12 

14 

Percent Nonaccrual Rate 

(Right Scale) 

Loss Rate 

(Right Scale) 

Volume in billions of dollars 

(Left Scale) 

rental-rate growth, which may lead to lower real estate 

values. For example, Atlanta’s vacancy rate rose 1.5 percentage points to 10.3 percent, while growth in rental 

rates slowed noticeably from the pace of the previous 

three years.28 

Surveys Suggest Tighter Standards 

in Commercial Real Estate Lending 

Evaluations of bank loan underwriting suggest a recent 

tightening of lending standards for commercial real 

estate loans. The August 1999 Federal Reserve Board 

Senior Loan Officer Opinion Survey reported a net 

tightening of commercial real estate underwriting standards, continuing a trend begun in late 1998. The 

FDIC’s March 1999 Report on Underwriting Practices 

also found fewer instances of risky lending practices 

with respect to commercial real estate and construction 

lending than in prior reports. The FDIC’s September 

Report showed no significant changes in lending 

standards. 

The FDIC also recently published the findings of a targeted evaluation of the underwriting practices of banks 

operating in three of the fastest-growing metropolitan 

areas in the country—Atlanta, Dallas, and Las Vegas.29 

Results indicated that competition was generally driving 

pricing margins down to very low levels, particularly 

28 Vacancy rates and rental growth rates were obtained from REIS 

Reports. 

29 Steven K. Burton, “Recent Trends in Construction Lending Practices,” Bank Trends, FDIC Division of Insurance, July 1999 (http:// 

www.fdic.gov/bank/analytical/bank/bt9901.pdf). 

compared with the 1980s. In some instances, lenders 

have responded to competitive pressures by making 

structural concessions on loan-to-value, cash equity, 

and recourse terms, particularly for large borrowers. 

However, underwriting standards generally have not 

been as aggressive as practices observed in the 1980s. 

Agricultural Lending 

Low Commodity Prices Stress 

the Agriculture Industry 

Low prices for wheat, corn, hogs, cotton, and oilseeds 

are creating financial difficulties for farmers in the 

nation’s midsection. Several consecutive years of high 

worldwide production have resulted in large inventories 

of grains and oilseeds, which have depressed prices. 

Prices not only have fallen from mid-1990s levels, but 

are also low by historical standards. The United States 

Department of Agriculture (USDA) forecasts for 2000 

show little likelihood of improvement in prices.30 

The financial outlook for significant portions of the 

farm sector has deteriorated. The USDA projects that 

farm income from operations will decline by around 15 

percent in 1999 from year-ago levels. However, total net 

farm income is projected to decline less 

than 1 percent. A projected $16.6 billion in government payments is expected to make up most of the difference 

between operating income and total net 

income.31 Legislation passed in October 

1998 provides for $8.7 billion in emergency aid to affected farmers. 

Farm Banks Continue 

to Perform Well Overall 

Despite the difficulties created by low farm prices, the 

overall financial condition of the 2,250 FDIC-insured 

farm banks continues to be strong.32 Farm banks reported an annualized ROA of 1.21 percent and an equity 

capital-to-assets ratio of 10.5 percent at mid-year 

30 “World Agricultural Supply and Demand Estimates,” USDA, October 10, 1999. 

31 “Potential Impacts of an Agricultural Aid Package,” Agricultural 

Outlook, USDA, September 1999. 32 Farm banks are defined by the FDIC as those with over 25 percent 

of their loans in agricultural production or secured by agricultural real 

estate. 

Boston Regional Outlook 13 Fourth Quarter 1999 
In Focus This Quarter
 

1999.33 Loan loss reserves, which stood at 1.58 percent 

of total loans in June, remain high compared to historical levels. Loan performance at farm banks also appears 

to be strong at this time. Total past-due loans made up 

just 2.66 percent of total loans at farm banks in June, a 

level that is only 9 basis points higher than a year ago. 

Moreover, this increase in past-due loans is attributable 

entirely to nonagricultural loans; the level of past-due 

farm loans has not risen over the past 12 months. At the 

same time, higher-than-average nonperforming loan 

levels have been reported by farm banks in the upper 

Midwest and the South. 

There are reasons to believe, however, that it will take 

time for financial distress among farm producers to 

significantly affect loan performance at farm banks. 

One such reason is the increasing use of carryover debt 

to restructure and extend operating loans that cannot 

be fully retired by borrowers during the current crop 

year. The most recent Survey of Agricultural Credit 

Conditions conducted by the Federal Reserve Bank of 

Kansas City indicated an increase in the use of agricultural carryover debt by Tenth District banks.34 

An increase in carryover debt was also noted in 

the FDIC’s March 1999 Report on Underwriting 

Practices, which indicated that almost one-third 

of FDIC-supervised farm banks experienced at least 

a “moderate” increase in agricultural carryover debt 

during the preceding six-month period.35 Although the 

use of carryover debt is not an uncommon practice in 

agricultural lending, it can be a leading indicator of 

declining loan performance. Chart 9 shows that 

increases in carryover debt by Tenth District farm 

banks in 1995 preceded increased loan losses during 

1996. 

33 Twenty-three percent of insured farm banks have adopted a Subchapter S designation since 1997, when banks were first allowed to 

take advantage of the favorable tax treatment available under this section of the Internal Revenue Service code. Because of the effects of 

this tax treatment on reported profitability, farm bank ROA levels 

may not be comparable with ratios from prior periods. 

34 Survey of Agricultural Credit Conditions, Federal Reserve Bank of 

Kansas City, June 29, 1999 (http://www.kc.frb.org/PUBLICAT/ 

RED/PDF/2q99AgCrPress.pdf). The Tenth District comprises significant agricultural areas in Colorado, Kansas, Nebraska, Oklahoma, 

Wyoming, northern New Mexico, and western Missouri. 

35 John M. Anderlik and Jeffrey W. Walser, “Agricultural Sector 

Under Stress: The 1980s and Today,” Kansas City Regional Outlook, 

Third Quarter 1999 (http://www.fdic.gov/bank/analytical/regional/ 

ro19993q/kc/k3q1999.pdf). 

CHART 9 

Rising Levels of Carryover Debt Suggest Future 

Increases in Loan Losses at Farm Banks 

Reports (Research Information System) 

Source: Federal Reserve Bank of Kansas City; FDIC Bank and Thrift Call 

–30% 

–10% 

10% 

30% 

50% 

1Q89 2Q90 3Q91 4Q92 1Q94 2Q95 3Q96 4Q97 1Q99 

–1.0% 

–0.5% 

0.0% 

0.5% 

1.0% 

1.5% 

Net Percentage Reporting 

Higher Agricultural Loan 

Renewals and Extensions 

Moving 4-quarter 

Charge-Off Rate

 (percent) 

Agricultural Production Loans 

(right scale) 

Funding and Interest Rate Risk 

Lagging Deposit Growth Has Led to Greater 

Reliance on Market-Based Funding 

For most of the 1990s, banking industry asset growth 

has outstripped growth in deposits, creating greater 

reliance on more expensive and less stable marketbased sources of funding. The trend in the loan-todeposit ratio for commercial banks, which reached a 

record high of almost 90 percent at June 30, 1999, 

reflects this shift. Deposit growth has not kept pace with 

asset growth, in part because of a low rate of personal 

savings by households and competition for depositor 

funds from higher-yielding investment alternatives and 

nonbanks. Lagging deposit growth is particularly 

important for community banks because these institutions traditionally rely more heavily on deposits to fund 

assets than do larger banks.36 Greater dependence on 

market-based funding can alter the liquidity and interest 

rate risk positions of institutions and may require 

heightened attention to, and expertise regarding, assetliability policies and procedures. 

Growth in Securitization Affects Underwriting 

and the Structure of Bank Balance Sheets 

Banks, and nonbanks in particular, continue to employ 

the securitization market to fund lending activities. 

36 Allen Puwalski and Brian Kenner, “Shifting Funding Trends Pose 

Challenges for Community Banks,” Regional Outlook, Third Quarter 

1999 (http://www.fdic.gov/bank/analytical/regional/ro19993q/na/ 

t3q1999.pdf). 

Boston Regional Outlook 14 Fourth Quarter 1999 
In Focus This Quarter
 

Issuance of asset-backed securities and commercial 

mortgage-backed securities (CMBS) totaled $223 billion through the first six months of 1999, and is on pace 

for another record year. Including participation through 

credit card companies and CMBS conduit programs, 

bank-related issuance amounted to about 25 percent of 

total issuance in 1998, a decline from 1997 levels. 

Although insured institutions are not dominant players, 

growth in the securitization market can influence loan 

underwriting practices and the structure of bank balance 

sheets. 

The securitization market competes to originate loans 

that could be made by insured institutions. This competition may tend to erode underwriting standards if securitizers ease terms to maintain sufficient volume to 

support lending pipelines. Recent trends indicate that 

this competition has intensified. For example, market 

observers note that the subordination levels in the 

CMBS market have been declining, which allows securitizers to increase lending volume for a given level of 

capital.37 

When banks do securitize, it is not always clear how 

much risk is transferred. The issue of credit risk transference by commonly used securitization structures 

continues to receive attention from the markets and rating agencies. For example, many analysts agree that 

revolving structures, such as those used to securitize 

credit cards, eliminate only the most catastrophic credit 

risks for issuers.38 In addition, assets created by gain-onsale accounting rules when loans are securitized can be 

37 Securitizations are often structured in tranches such that a subordinated security bears the credit risk for a senior piece. The relative 

size of the subordinated piece affects not only funding costs for the 

issuer, but also the amount of effective leverage achievable through 

securitization. 

38 A common feature of a revolving securitization structure is the provision for an “early amortization.” When a triggering event occurs, 

such as a negative three-month average excess spread, all available 

cash flows are used to pay off bondholder principal. This event causes receivables related to the deteriorating accounts to remain on the 

balance sheet of the issuer. Unless the deterioration in account credit 

quality is very rapid and severe, the bondholders will be repaid completely, and the credit risk will be borne by the issuer. 

volatile and can lead to unstable earnings and capital if 

not properly controlled and administered. 

Banks and Thrifts Appear Increasingly 

Vulnerable to Rising Interest Rates 

Potentially volatile liabilities and long-term assets 

have been growing as a percentage of banking assets. 

Consistent with reduced deposit funding by insured 

institutions, more market-based and potentially volatile 

liabilities have been supporting an increasing proportion of banking assets in recent years (see Chart 10).39 

At the same time, the lengthening maturity of insured 

institution mortgage portfolios has increased the percentage of total bank assets with maturities or repricing 

frequencies of greater than five years. This trend in 

mortgage portfolios is primarily responsible for the 

thrift industry’s increasing interest rate sensitivity. 

According to the Office of Thrift Supervision’s Quarterly Review of Interest Rate Risk, interest rate sensitivity for the median thrift rose in the second quarter of 

1999 for the third consecutive quarter. 

39 Volatile liabilities include borrowings, federal funds purchased, 

repurchase agreements, jumbo certificates of deposit, foreign 

deposits, and trading liabilities. 

CHART 10 

Long-Term Assets and Volatile Liabilities
 

Have Been Growing as a Percentage
 

of Total Assets
 

Percentage of 

Total Assets 

35 

30 

25 

20 

15 

10 

Volatile Liabilities 

Long-Term Assets 

2Q92 2Q93 2Q94 2Q95 2Q96 2Q97 2Q98 2Q99 

Note: Long-term assets have a maturity or repricing frequency of greater than
 

five years.
 

Source: FDIC Bank and Thrift Call Reports (Research Information System)
 

Boston Regional Outlook 15 Fourth Quarter 1999 
In Focus This Quarter
 

Operational Risks 

Insured banks and thrifts face numerous business- and 

process-oriented operational risks on a daily basis. At 

the same time, recent industry developments and bank 

failures have highlighted the importance of maintaining 

strong operations. The Basle Committee on Banking 

Supervision reported in late 1998 that “awareness of 

operational risk among bank boards and senior management is increasing.”40 

The competitive environment and shareholder expectations have led many insured institutions to search for 

greater efficiency by cutting costs. In some cases, deep 

cuts in overhead expenses may weaken the effectiveness 

of operating and monitoring systems as well as internal 

controls. Anecdotal evidence from banking regulators 

suggests that internal control and recordkeeping weaknesses are on the rise. Moreover, industry consolidation 

and new business activities are creating bigger, more 

complex, and more decentralized operating environments, especially for the largest institutions. These 

issues are important since operational weaknesses may 

leave institutions more vulnerable to adverse economic 

conditions, insider abuse, or fraud. 

Implications 

This article has summarized the generally favorable current condition of the U.S. economy and banking industry. The economy is in the ninth year of a remarkable 

economic expansion that has been conducive to a high 

level of financial performance on the part of the banking industry. There are, nonetheless, areas of vulnerability that could contribute to a less favorable economic 

environment and less robust financial performance for 

insured institutions in the future. 

One issue raised by this report is rising indebtedness on 

the part of households and businesses, which represents 

a growing private deficit. Rising interest rates could 

40 “Operational Risk Management,” Basle Committee on Banking 

Supervision, September 1998 (http://www.bis.org/publ/bcbs42.pdf). 

increase the debt service burden for consumers and 

businesses, making them more vulnerable to a slowing 

economy. An increasing private deficit is problematic 

also because the two major sources of financing—foreign capital inflows and domestic credit creation—have 

the potential to create problems for the economy and for 

lenders. Dependence on foreign capital makes U.S. 

inflation and interest rates highly subject to changes in 

the decisions of foreign investors and the value of the 

dollar. The rapid pace of credit creation by the financial 

sector threatens to impair credit quality. The intuition 

that loose underwriting standards can lead to credit 

quality problems is supported by recent signs of rising 

credit losses in a strong economy. 

The second issue that cuts across this report is the effect 

that competition is having on banking strategies and 

exposures to credit, market, and operational risks. There 

has been an increase in lending to less creditworthy borrowers, including subprime consumer borrowers and 

leveraged corporate borrowers. There is also evidence 

that institutions are pursuing asset-liability structures 

with higher levels of interest rate risk to maintain loan 

growth and meet funding needs. Finally, some of the 

innovations banks have used to counter competitive 

pressures may introduce new risks associated with complex accounting valuations, weakening internal controls, and the need for more intensive loan servicing. 

The third issue is the increasing potential for financial 

market instability, which leaves the economy and the 

banking system vulnerable to sudden shocks. Events 

from fall 1998 showed some of the more damaging 

aspects of these crises, as market-based financing went 

from abundance to scarcity virtually overnight. The 

financial imbalances associated with the rapid creation 

of credit and borrowing from abroad not only create the 

need for the economy to slow down eventually, but also 

threaten to make that adjustment process a 

volatile one. Financial market shocks 

could quickly alter the confidence of 

consumers and businesses and their 

access to financing. Such instability 

could end the current expansion and 

expose underlying weaknesses in 

bank risk-management practices. 

Boston Regional Outlook 16 Fourth Quarter 1999 
In Focus This Quarter
 

This article was prepared and coordinated by the staff of the Analysis Branch of the Division of Insurance. Contributions and feedback from analysts across the Division were essential to its completion. 

Maureen E. Sweeney, Associate Director 

Paul C. Bishop, Senior Financial Economist 

Richard A. Brown, Chief, Economic and Market Trends Section 

Steven K. Burton, Senior Banking Analyst 

Steven E. Cunningham, Chief, Financial Institutions Section 

Alan Deaton, Economic Analyst 

Diane Ellis, Senior Financial Analyst 

Brian Kenner, Financial Analyst 

Allen Puwalski, Senior Financial Analyst 

Arlinda Sothoron, Senior Financial Analyst 

Jack Taylor, Senior Financial Analyst 

Boston Regional Outlook 17 Fourth Quarter 1999 
Regional Perspectives
 

Regional Perspectives
 

•	 The Boston Region had a more marked deceleration in job growth than the nation did during the first eight 

months of 1999; manufacturing continued to shed jobs at a faster pace than the nation. 

•	 Insured institutions performed well, but some measures of credit quality and profitability showed a modest 

decline. 

•	 Commercial real estate office markets remained healthy in the Region with declining vacancy rates, while 

retail and industrial markets showed mixed results during the first half of 1999. 

•	 Commercial lending has increased in the Region, but this could reflect greater loan demand more than an 

easing in underwriting standards or pricing. 

Economic and Banking Conditions 

Job Growth Slowed and Unemployment 

Rates Declined through August 

The Boston Region’s average, year-to-date nonfarm 

payroll growth slowed to 1.6 percent by August compared with 2.3 percent for the nation.1 All of the New 

England states experienced slower job growth in 1999, 

although Maine’s deceleration was modest. In keeping 

with the 1998 trend, job growth was stronger in the 

northern three states than in Connecticut, Massachusetts, and Rhode Island. Across sectors, only manufacturing payrolls declined during the first eight months, 

off 2.3 percent in New England versus a drop of 1.9 percent nationally. 

laborers among the state’s unemployed rather than to a 

lack of demand. 

Labor markets remain tight, with unemployment rates 

in some substate markets falling below 2 percent. As is 

evident in Table 1, New Hampshire experienced the 

Region’s lowest average unemployment rate2 during the 

first eight months of 1999. In contrast, Maine and 

Rhode Island reported the Region’s highest unemployment rates, but even these rates were considerably 

2 The 1999 rates in Table 1 are January to August 1999 averages divided by the same months in 1998, then multiplied by 1998 full-year 

unemployment rates to calculate an annualized figure. 

The Region’s trade and government sectors posted gains TABLE 1 

on par with their 1998 rates, while growth in all other 

sectors deteriorated during the first eight months of 

1999. Job growth also trailed the nation in all sectors, 

except construction, where the New England states generally saw gains that exceeded the nation. Construction 

employment was pushed higher by a spurt in new home 

building during 1998 that continued at a slower pace 

into 1999, as well as by strong commercial construction 

activity in certain metropolitan markets. Connecticut, 

while posting increases, has fallen short of the national 

pace in construction employment gains. Anecdotal 

reports attribute this slower gain to difficulties in finding sufficient numbers of qualified tradesmen and 

Region’s Labor Markets Continue 

to Tighten (unemployment rates) 

1998 1999* 

MASSACHUSETTS 3.3 3.0 

CONNECTICUT 3.4 3.0 

NEW HAMPSHIRE 2.9 2.6 

MAINE 4.4 3.7 

RHODE ISLAND 4.9 3.7 

VERMONT 3.4 2.9 

REGION 3.5 3.1 

NATION 4.5 4.2 

* Jan-Aug average, annual rate 

Source: Bureau of Labor Statistics 

1 January through August average employment, percent change from 

year ago. 

Boston Regional Outlook 18	 Fourth Quarter 1999 
Regional Perspectives
 

below the national average. Analysts have suggested 

that the Region’s tight labor market, mostly attributed to 

modest population growth that remains at less than half 

the national rate, has resulted in an employment growth 

rate that has lagged the nation’s since the late 1980s. 

This gap in employment growth widened in 1999 to its 

highest level in more than four years. Tight labor markets are likely to constrain the Region’s job growth for 

the remainder of the current economic expansion. 

Home Prices Were Rising, 

but Sales and Building Slowed 

Chart 1 shows the trend of appreciation in home sales 

prices for the nation, Region, and the Region’s most 

populous states. The rise in home sales prices during 

1998 outpaced the nation for the first time since 1987. 

The Region experienced an average price increase of 

6.5 percent in 1998 and a 7.5 percent advance during 

the first half of 1999, compared with year-ago gains of 

5.5 and 5.2 percent, respectively, for the nation.3 Massachusetts, continuing the trend begun in 1995, posted 

the Region’s strongest price appreciation during firsthalf 1999, as prices rose at a nearly 9 percent annual 

rate. Connecticut, while not the slowest in the Region 

(that position was shared by Vermont and Rhode 

Island), saw much more modest appreciation of 4.7 

percent. 

3 Annual home price appreciation ranged between 18 and 22 percent 

in the Region from 1984 to 1987, compared with gains of 3 to 9 percent nationally. Thus, the current gap above national appreciation 

rates of roughly 2 percentage points is historically modest. 

CHART 1 

–4 

–2 

0 

2 

4 

6 

8 

10 

Region Again Outpacing Nation in Price Gains 

* January–June, annual rate 

Source: Office of Federal Housing Enterprise Oversight Percent Change from Year Ago 

’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99* 

Connecticut 

Massachusetts 

Region 

Nation 

New England existing home sales, as reported through 

the National Association of Realtors Multiple Listing 

Service, rose at a 6 percent annual rate during the first 

half of 1999, roughly matching the national rate, but 

down from a 13 percent increase in 1998. This slowing 

was anecdotally attributed to a general lack of suitable 

inventory in certain price ranges, particularly in highdemand housing markets, such as those around greater 

Boston. Maine and Rhode Island were the only two 

states in the Region where 1999 home sales growth 

accelerated from 1998; both states experienced annual 

growth around 20 percent during the first six months of 

1999. Vermont, which posted an increase in 1998 after 

three years of decline, saw sales fall during first-half 

1999. Growth in Massachusetts slipped from 10 percent 

during the past two years to about 1 percent during the 

first six months of 1999, as housing inventory thinned 

in the greater Boston area. Connecticut’s advance 

cooled from 14 percent in 1998 to 5 percent during 

first-half 1999, and, after three years of double-digit 

gains, New Hampshire’s growth slowed to 7 percent 

through June 1999. 

Home building activity through May was described in 

depth in Regional Perspectives, Third Quarter 1999. 

With data available through July, the overall deceleration in building noted in last quarter’s article remained 

the same, although state trends were significantly different in many cases (see Table 2). Nationally, building 

also decelerated compared with last year. 

TABLE 2 

Residential Permit Issuance Surged 

in 1998...1999 Posting Generally 

Slower Growth 

(percent change from year ago) 

JAN–JULY 1991– 

1999 1998 1997* 

NATION 6.1 11.9 7.2 

REGION 1.9 16.8 4.4 

MASSACHUSETTS 5.5 12.0 5.2 

CONNECTICUT –12.7 27.4 3.7 

MAINE 3.8 33.4 4.0 

NEW HAMPSHIRE 8.5 6.8 7.6 

RHODE ISLAND 11.8 –1.1 2.0 

VERMONT 26.0 20.0 –1.6 

* Compound annual rate 

Source: U.S. Bureau of the Census 

Boston Regional Outlook 19 Fourth Quarter 1999 
Regional Perspectives
 

Insured Institutions Continued to Perform Well, 

but Show Some Signs of Weakening 

The Boston Region’s insured institutions4 continued to 

perform well through June 1999, but several key indicators showed signs of deterioration. Asset quality 

remained favorable, with total past-due loans at 1.57 

percent, a slight increase from a year ago. Net chargeoffs are still low but increased slightly between the end 

4 Because of unique business characteristics, credit card institutions 

were excluded for purposes of this analysis. 

TABLE 3 

of second-quarter 1998 and June 30, 1999. Noninterest 

income helped to support earnings as net interest 

income declined. Boston Region banks and thrifts posted a collective return on assets of 1.15 percent and a 

return on equity of 13.61 percent. These profitability 

measures compared favorably with the national averages, but were below prior-year levels. The aggregate 

earnings numbers were driven largely by subsidiaries of 

the Region’s three largest banking organizations, which 

accounted for 52 percent of the Region’s total assets. As 

Table 3 indicates, smaller institutions demonstrated the 

greatest erosion of earnings primarily because of 

declining net interest margins. 

Earnings Are Showing Signs of Decline 

ASSETS ASSETS 

NATION BOSTON REGION BIG THREE > $1 BILLION ≤ $1 BILLION 

JUN 98 JUN 99 JUN 98 JUN 99 JUN 98 JUN 99 JUN 98 JUN 99 JUN 98 JUN 99 

RETURN ON ASSETS 1.17 1.13 1.21 1.15 1.25 1.19 1.16 1.16 1.17 1.04 

RETURN ON EQUITY 14.04 13.42 14.27 13.61 17.22 15.94 13.11 13.81 10.76 9.64 

NET INTEREST 

MARGIN 3.80 3.76 3.84 3.76 3.82 3.76 3.73 3.65 3.99 3.86 

PAST-DUE RATIO 1.96 1.89 1.54 1.57 1.32 1.71 1.54 1.32 1.96 1.59 

NET CHARGE-OFFS/ 

LOANS 0.35 0.34 0.22 0.28 0.29 0.42 0.20 0.22 0.12 0.06 

TIER 1 LEVERAGE 7.54 7.62 7.52 7.41 6.32 6.33 7.57 7.29 10.26 10.15 

Note: Credit card institutions are excluded from the above data.
 

Subsidiaries of the Big Three are excluded from the >$1 billion and ≤$1 billion categories.
 

Source: Bank & Thrift Call Reports
 

Boston Regional Outlook 20 Fourth Quarter 1999 
Regional Perspectives
 

Healthy Real Estate Market Conditions Continue in the Boston Region
 

Office Vacancy Rates Hold Steady 

throughout Most of the Region 

Commercial office markets remained healthy throughout the Region in the first half of 1999. Projects that 

were previously in the pipeline were completed, releasing much needed space into the market. Most office 

markets in the Region experienced positive net absorption. Demand for premium space was high in most markets, and in the downtown Boston market, where 

sustained demand was met with low supply, speculative 

construction began to emerge. Current trends caused 

rents in Boston to increase to some of the highest levels 

in the nation as the “space crunch” continued. 

Office markets performed well throughout the Region 

as vacancy rates continued to fall, particularly in the 

Boston area (see Table 4). Overall vacancy rates in 

Boston’s central business district (CBD) remained 

below 5 percent through the first half of 1999, with 

Class A space in the CBD more limited with a 3.2 percent vacancy rate, according to a report from the real 

estate firm Spaulding & Slye Colliers. As of secondquarter 1999, average Class A rents surpassed rates in 

San Francisco and New York, reaching $48.23 per 

square foot. The report also noted that almost 5 million 

square feet of office space was in demand, up from 3.5 

million square feet in 1998, which will likely push 

rental rates up even farther. According to the firm 

Cushman and Wakefield, office vacancy rates in Stamford, New Haven, and southern New Hampshire fell 

slightly in the first half of 1999, while Hartford’s CBD 

vacancy rate held steady at a high 17.8 percent. However, the Boston suburban market saw office vacancy rates 

increase from 9.9 percent to 10.4 percent in the first half 

TABLE 4 

Office Vacancy Rates Continue 

to Fall (percent of downtown 

office space vacant) 

2Q99 2Q98 

BOSTON, MA 4.9 6.1 

HARTFORD, CT 17.8 18.0 

NEW HAVEN, CT 18.3 22.0 

STAMFORD, CT 11.0 11.8 

SOUTHERN NH 14.9 15.6 

Sources: Cushman & Wakefield, Spaulding & Slye 

Colliers 

of 1999. The real estate firm Grubb & Ellis reported 

that 1.1 million square feet in the suburbs was absorbed 

in the first half of 1999. The report also noted that an 

additional 1.8 million of speculative space, of which 

only 16 percent was preleased, was scheduled to be 

available in the latter half of 1999. The additional space 

may push vacancy rates slightly higher. 

Retail and industrial markets experienced mixed results 

through the first half of 1999. According to F.W. Dodge, 

the industrial vacancy rate in Hartford increased by 2.6 

percent. While the Hartford retail vacancy rate has been 

increasing throughout the decade, the 7.5 percent rate in 

the second quarter was in line with the national average. 

The industrial vacancy rate in the greater Boston area 

(defined roughly as the area within Interstate 495) 

increased slightly as developers continue to turn to 

build-to-suit projects, and companies such as Sun 

Microsystems, Staples, and 3Com vacate market-rate 

space for newly built corporate campuses. However, the 

greater Boston retail market, characterized by strong 

demand, has experienced a decline in the vacancy rate 

to 1.9 percent. 

Office Construction Starts Decline, but Retail 

and Industrial Markets Are Still Active 

Total construction starts in the Region were down 27 

percent in the first quarter of 1999 compared with the 

previous year, led by a decline in office starts (see Chart 

2). Office construction starts were down 59 percent in 

CHART 2 

Regional Office Starts Reverse Trend, 

Weigh on Total Construction Starts 

* Annualized rate based on year-to-date numbers 

Source: F.W. Dodge via FDIC Real Estate Report Millions of Square Feet 

1994 

Office 

Total 

0 

5 

10 

15 

20 

25 

1995 1996 1997 1998 1999* 

Boston Regional Outlook 21 Fourth Quarter 1999 
Regional Perspectives
 

the Region from one year ago, the first decline in six 

years, led by decreases in all states except Maine. Markets appear to be keeping themselves in check. As of the 

second quarter of 1999, more than 2 million square feet 

of new construction was in progress in the Boston CBD, 

but much of the space was preleased. Combined with a 

decline in projects in the completed or bidding stage, 

office vacancy rates should remain low. 

A significant amount of retail and industrial development is in the pipeline compared with recent years. 

Over 5 million square feet was added to the initial planning stage in the Boston; Hartford; Providence; and 

Burlington, Vermont, markets. Compared with one 

year earlier, retail and industrial starts were up a combined 7 percent in the Region as of first quarter 1999. 

Retail starts in Hartford were rising in 1999 following a 

sluggish period of growth in the prior year; however, 

starts remained comparatively low when measured 

against the higher levels attained in the mid-1990s. 

The Hartford retail and 

industrial markets have been 

undergoing a structural 

change over the past few 

years. Many larger companies, such as Lechmere, Caldor, and Home Quarters, 

have filed for bankruptcy, leaving blocks of space 

vacant. New construction activity has been dominated 

by build-to-suit projects because much of the older, 

existing space is not suitable for “big box” retailers and 

national companies. This vacated space could be problematic for lenders that may be left with obsolete properties as potential buyers opt for build-to-suit projects. 

Certain Areas Experience Growth 

in CRE Loans, Exposure 

As of second-quarter 1999, construction and development (C&D) activity in the Region’s institutions with 

less than $25 billion in assets increased 20 percent over 

the prior year. For those institutions, C&D loans made 

in the Portland, Maine; New Haven, Connecticut; New 

London, Connecticut; and Providence, Rhode Island, 

Metropolitan Statistical Areas increased over 40 percent 

in the same time. Healthy economic conditions have 

contributed to strong growth over the past two years 

throughout the Region; however, aggregate concentrations relative to Tier 1 capital remain low at only onefifth the peak levels reached in the late 1980s. 

The strong economy and real estate markets have contributed to increased non-C&D commercial real estate 

(CRE) loan activity in certain groups of institutions in 

the Region. Institutions with assets of less than $1 billion have grown CRE loans by an average of 10 percent for the past four years, with an increase of 13 

percent realized for the 12 months ending June 30, 

1999. CRE loans now represent over 11 percent of 

these 385 institutions’ total assets, the highest level in 

recent history. The higher growth and concentration 

levels are being attributed, in large part, to decreased 

competition for CRE loans from the Region’s larger 

institutions rather than “heated” real estate market 

conditions. The larger institutions have actually 

reduced investment in CRE loans over the past four 

years, which has resulted in aggregate CRE loan 

growth for the Region of under 4 percent per year during that period. The smaller institutions have filled 

some of the void left by the larger institutions; however, exposures remain modest relative to the strong 

Tier 1 capital levels of smaller institutions. 

Implications for Banks 

Low vacancy rates may be starting to drive speculative 

projects in certain areas of the Region as developers of 

office space look to satisfy demand. An increase in the 

supply could place downward pressure on rents and 

therefore affect valuations on existing structures. In 

addition, smaller institutions with high concentration 

levels, particularly those operating in active real estate 

markets, should ensure that underwriting standards adequately address the inherent risks associated with a 

downturn in real estate. 

Boston Regional Outlook 22 Fourth Quarter 1999 
Regional Perspectives
 

Commercial Lending Showing Strong Gains Nationally and in the Region
 

Certain Factors May Be Driving 

Corporations to Take on More Bank Debt 

Nationally, commercial loan growth began to accelerate 

in early 1992 and, after stabilizing during 1996, accelerated through 1998. Commercial loan volume is driven 

by many factors; however, it is fundamentally attributed 

to interaction between the pricing (including underwriting criteria and other nonpecuniary “costs”) of loans 

relative to other sources of capital for U.S. businesses, 

and firms’ demand for supplemental funding. A close 

correlation is evident between commercial loan growth 

and the “financing gap.” This gap is the shortfall of 

internally generated funds with respect to capital outlays of all nonfarm, nonfinancial corporations in the 

nation.5 As this gap widens, firms’ need for outside 

financing (which includes commercial credit extended 

by insured institutions) grows. Chart 3 shows this relationship since 1988. The commercial loan data in the 

chart include all insured institutions, but if data are broken down by size class, growth has been dominated by 

large institutions with assets over $1 billion. The chart 

also shows how commercial lending growth eased 

recently, even though the financing gap continued to 

grow. Federal Reserve surveys suggested that lenders 

were tightening underwriting standards in mid-1999 

(raising the indirect costs of bank credit). Interest rates 

rose in the latter half of 1999, while at the same time 

increased corporate bond issuance or some flight to 

quality into treasuries placed upward pressure on corporate bond yields. These factors may have affected 

commercial loan growth. Also, to reduce exposure to 

commercial loans, insured institutions may have moved 

some of these loans off-book through securitizations or 

syndications, possibly masking continued strong growth 

in commercial loan production. 

Although overall economic growth has accelerated 

modestly in recent years, giving rise to greater business 

investment, the expanding financing gap may also be 

related to a noncyclical increase in capital outlays by 

5 From the Flow of Funds Accounts of the United States, the financing gap for nonfarm, nonfinancial corporate businesses is defined as 

total capital expenditures (fixed investment in plant and equipment— 

roughly 90 percent of this account—and the net change in inventories) less the sum of U.S. internal funds (profits after taxes and 

dividends plus consumption of fixed capital) and the IVA (inventory 

valuation adjustment, which adjusts corporations’ book-value inventories for differences in accounting methods and for the effects of 

price changes). 

CHART 3 

Rising Financing Gap Has Boosted 

Demand for Commercial Loans 

Sources: Federal Reserve and Bank and Thrift Call Reports % Change from Year Ago

$ Billions Seasonally Adjusted

Annual Rate, 4Q Moving Average 

’88 ’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 

Financing Gap (R) 

Commercial Loans (L) 

–10 

–5 

0 

5 

10 

15 

20 

25 

–40 

–20 

0 

20 

40 

60 

80 

100 

U.S. corporations, particularly in the area of computers 

and information technology. In addition, limits on 

domestic firms’ ability to raise prices significantly in 

recent years (as demonstrated by stable or declining 

gains in broad U.S. price indices) and modestly rising 

unit labor costs have pressured corporate profit margins 

(see Chart 4). 

Greater growth in capital outlays, combined with slower growth in overall revenues and tighter margins, typically cause firms to seek alternate, outside sources of 

investment funding, such as commercial bank loans. No 

data are available to measure the financing gap in subnational markets. However, the recent national growth 

can most likely explain, at least in part, some of the 

acceleration in commercial lending experienced in the 

CHART 4 

* Profits with inventory valuation and capital consumption adjustments/ 

gross domestic product of nonfinancial corporate business 

Source: Bureau of Economic Analysis and Bureau of Labor Statistics 

Nonfinancial Corporate Profit 

Margins Are Beginning to Thin 

Economic Profit Margin* (%) 

’88 ’90 ’92 ’94 ’96 ’98 

8 

9 

10 

11 

12 

13 

14 

7 

Boston Regional Outlook 23 Fourth Quarter 1999 
Regional Perspectives
 

Boston Region, even though this Region’s overall pace 

of economic growth has remained fairly constant in 

recent years. 

Commercial Lending in the Boston Region 

Following the National Trend 

Commercial and industrial (C&I) lending has been 

active in the Region’s insured institutions. C&I loans 

increased about 14 percent per year for each of the past 

three years, the highest growth rate of any loan type 

except credit cards. The median C&I loan growth rate in 

the Region was 15 percent from June 1998 to June 1999 

and was driven by institutions located in southern New 

England (see Chart 5). 

Connecticut’s median C&I loan growth was particularly 

strong at 27 percent, well above the growth rates reported in the Region’s other five states. Recent interstate 

merger activity within what were previously the state’s 

largest banks (Fleet, BankBoston, and First Union) may 

be contributing to this rapid growth. However, rapid 

loan growth, particularly in potentially higher risk sectors, has often been a precursor to loan problems and 

should be undertaken cautiously. 

The Region’s small institutions (assets less than $1 billion) have experienced considerable growth in C&I 

loans over the past few years. Total commercial loans, 

which remain a small percentage of assets (just under 5 

percent), increased at an average annual rate (mergeradjusted) of 11 percent from the lowest level in June 

1993 to June 1999. This growth was the greatest of any 

loan category in the Region’s small institutions. 

CHART 5 

In addition, C&I loans, which represent 20 percent of 

assets in the Region’s large institutions (assets greater 

than or equal to $1 billion), also grew at an average 

annual rate of 11 percent since June 1993. The Region’s 

three largest institutions, representing a little over half 

the Region’s total assets, drove the concentration measure as C&I loans accounted for 26 percent of assets in 

those institutions. The remaining institutions with assets 

greater than $1 billion held 8 percent of assets in C&I 

loans, which have increased at an average rate of 15 percent since 1993. 

Since bottoming out in June 1993, C&I loan concentration levels have been rising toward the high levels 

reached in the mid-1980s. Commercial loans comprised 

16 percent of total assets as of June 30, 1999, the highest concentration level since 1986, and 213 percent of 

Tier 1 capital, which was 81 percent of the maximum 

level reached in 1986. 

Commercial loan delinquencies have been increasing 

modestly for the past two years and were 1.62 percent 

as of June 30, 1999. This level was the highest reported since March 1997 but does not approach the highs 

of over 11 percent earlier in the decade. C&I loan 

delinquencies in the Region’s smaller institutions have 

been decreasing and were below national totals for 

banks with assets of less than $1 billion as of June 30, 

1999. The overall increase in commercial loan delinquencies has been driven by the Region’s large institutions (see Chart 6). Should cash flow weaken or 

interest rates rise, borrowers with high levels of commercial debt will face higher debt-service burdens that 

may result in additional increases in commercial loan 

delinquency levels. 

CHART 6 

Source: Bank and Thrift Call Reports 

Strength in Commercial Loan Growth Is 

Most Pronounced in Southern New England 

Median Growth Rate (%) 

Region CT RI MA ME NH VT 

0 

5 

10 

15 

20 

25 

30 

1998 1999 

Past-Due Commercial Loans 

at Smaller Institutions Are Declining 

Source: Bank and Thrift Call Reports % of Commercial Loans Past-Due by Asset Size 

Jun ’99 

0 

Region <$1billion 

Nation >$1 billion 

Region >$1 billion 

Nation <$1 billion 

1 

2 

3 

4 

5 

Sep. ’96

Dec. ’96

Mar. ’97 

Jun ’97

Sep ’97

Dec ’97

Mar ’98

Jun ’98

Sep ’98

Dec ’98

Mar ’99 

Boston Regional Outlook 24 Fourth Quarter 1999 
Regional Perspectives
 

Small-Business Lending Focus Differs by Institution Size
 

Industry Consolidation Continues 

The consolidation of the banking industry has resulted 

in fewer, but larger, banks in terms of asset size. As 

banks grow in size, how does this affect the smallbusiness lending market? The number of institutions in 

the Boston Region declined 30 percent from 558 in June 

19936 to 428 as of June 1999. In contrast, the average 

asset size almost doubled from $492 million to $933 

million. The presumption in the marketplace has been 

that as banking institutions merge, lending to smallbusiness declines. 

Historically, the banking industry has been the primary 

source of credit for small businesses. As banks grow in 

size, either through marketplace growth or industry 

mergers and acquisitions, these institutions may focus 

more on larger markets, seek a more national business 

scope, or search out larger borrowers. As a result, some 

lines of business, including small-business lending, may 

be less desirable because of decreased profitability 

compared with other business activities that increase 

margins, maximize efficiencies through economies of 

size and scope, and provide greater returns on allocated 

capital. 

What Has Happened to 

Small-Business Lending? 

Small-business loan7 volume in the Region’s insured 

institutions increased by almost 3.5 percent per year 

since 1993. Small-business real estate loans (56 percent 

of all small-business loans) grew by only 2 percent per 

year from 1993 to 1999, while small-business commercial loans (non-real estate secured) grew about 6 percent 

per year. In comparison, total commercial real estate 

and commercial loan growth were 1 percent and 11 percent, respectively. During this period, asset growth averaged about 7 percent per year and total loan growth was 

about 6 percent per year. 

6 June 1993 is used because that was the first period for which small-


business loan information was collected on Call Reports and Thrift
 

Financial Reports.
 

7 Small-business loans are defined as business loans under $1 million.
 

Loans may be secured by nonresidential real estate or unsecured.
 

Loans are reported in three size categories: loans less than $100,000,
 

loans from $100,000 to $250,000, and loans greater than $250,000
 

but less than $1 million. The size of the loan, not the size of the borrower, defines a small-business loan.
 

On the surface, small-business lending does not appear 

to have kept pace with overall asset and loan growth. 

However, accurately measuring small-business loan 

growth is difficult for various reasons. Borrowers obtain 

financing from a variety of sources—nonbanks as well 

as banks headquartered both within and outside the 

Boston Region. Community Reinvestment Act (CRA) 

data provided by the Federal Financial Institutions 

Examination Council 8 for 1998 show that 51 percent of 

the total number of small-business loans representing 

19 percent of the total dollars loaned to borrowers in the 

Region were made by lenders headquartered outside the 

Region. This figure represents a slight decline from 

1997. 

Out-of-Region lenders, most active in the category of 

small-business loans of less than $100,000, account for 

57 percent of the total number of loans made in that category but only 30 percent of the total dollars. These statistics show that out-of-Region lenders are pursuing the 

smallest dollar loans in this category more aggressively. 

Out-of-Region lenders account for about 11 percent of 

both number and dollars of loans in the $100,000 to 

$250,000 category and about 15 percent each in the over 

$250,000 to $1 million category. Other factors to keep in 

mind are that small-business loans are defined by loan 

size, not by the size of the business, and that the loan size 

definition has not been adjusted for inflation. As a result, 

as borrowers’ credit needs grow, borrowers migrate out 

of the small-business loan reporting categories. 

Call Report data for Boston Region institutions with 

assets greater than $1 billion (excluding credit card 

institutions) as of June 30, 1999, show that smallbusiness commercial loans increased about 3 percent 

per year on average since 1993, with the largest singleyear growth of 19 percent occurring in the past year. 

Asset growth in these institutions averaged 6 percent 

per year, and total loans increased about 5 percent per 

year. Nationally, small-business commercial loans grew 

at an average annual rate of 8 percent, slightly above the 

6 percent increase in asset growth and the 7 percent 

8 All insured institutions, with the exception of small institutions, are 

required to file CRA data. A small institution is defined as a bank or 

thrift that, as of December 31 of either of the prior two calendar years, 

had total assets less than $250 million and was independent or was an 

affiliate of a holding company that, as of December 31 of either of the 

prior two calendar years, had total banking and thrift assets of less 

than $1 billion. 

Boston Regional Outlook 25 Fourth Quarter 1999 
Regional Perspectives
 

increase in loan growth. Certain factors may have 

affected the slower regional growth compared with the 

nation. In particular, loan securitizations, sales, and 

acquisition-related divestitures are not reported on Call 

Reports and could lead to an understatement of smallbusiness loan production. 

Small-business loans in the Region’s small institutions 

grew at an average annual rate of 13 percent from 1993 

to 1999 compared with asset and loan growth of about 

7 percent each per year. Small-business loans secured 

by real estate (69 percent of the total small-business 

loans in these institutions) increased at an average annual rate of almost 12 percent, and small-business commercial loans increased about 15 percent per year. 

Demand for small-business loans remains high and is 

expected to increase. A study conducted by Conning & 

Co., an insurance research and investment company, 

using data from Regional Financial Associates, shows that the 

number of New England small 

businesses is expected to increase 

1.2 percent between 1997 and 

2002 after an increase of 0.7 percent between 1992 and 1997. 

Nationally, the number of small 

businesses is expected to increase 1.4 percent between 

1997 and 2002 after increasing 1.1 percent between 

1992 and 1997. 

Technological advancements also have affected smallbusiness lending. Use of credit-scoring models has 

reduced loan processing costs compared with traditional underwriting practices, and scoring models continue 

to be used more frequently by larger institutions and 

nonbanks to assess potential borrowers’ creditworthiness. The Region’s large banks are reporting the most 

significant increase in small-business lending in the 

under $100,000 loan category. Credit-scoring models 

can be applied more easily to loans of this size. 

The large institutions, on a merger-adjusted basis, have 

realized average small-business commercial loan 

growth of 8 percent per year since 1994 in the under 

$100,000 category. This category increased almost 40 

percent between June 1998 and June 1999 as the large 

institutions aggressively targeted the smaller business 

loans. However, small-business loans secured by real 

estate and small-business commercial loans greater than 

$250,000 have not increased in the large institutions. 

This further suggests that these institutions are placing 

greater reliance on credit-scoring models to assess borrowers’ repayment ability on more traditional commercial loans, not on loans that require more costly forms 

of underwriting and collateralization. This trend is consistent with the general trend that shows large banks 

reducing exposure to CRE loans. 

The small institutions experienced average smallbusiness commercial loan growth of about 19 percent 

per year in the $250,000 to $1 million category from 

June 1993 to June 1999. The large category of smallbusiness loans secured by real estate experienced 

14 percent average growth during this same period 

compared with small overall declines in the large institutions. On the basis of this rapid growth, small institutions appear to be more willing to make small-business 

loans secured by real estate and are making larger loans 

as competition intensifies in the less than $100,000 

market. This trend could result in increased levels of 

credit risk in the smaller institutions as portfolios 

become less diverse. However, the smaller institutions 

appear to be more actively seeking collateralized loans 

to help protect against potential loss. As credit scoring 

grows in acceptance and use, particularly by the larger 

institutions, small institutions may see growth potential 

diminish because of increased competition. 

Boston Region Staff 

Boston Regional Outlook 26 Fourth Quarter 1999 
✁
 

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