Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION THIRD QUARTER 1997 

FDIC
 

Boston
 

Region
 

Division of
 

Insurance
 

Daniel Frye,
 

Senior Regional
 

Analyst
 

Norman Williams,
 

Regional Economist
 

Cameron Tabor,
 

Financial Analyst
 

In Focus This Quarter 

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

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

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

collection can be severe. See page 3. 

By Kathy R. Kalser, Debra L. Novak 

◆ Retail Shakeout: Causes and Implications for Lenders— 

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

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

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

quality at some insured institutions. See page 6. 

By Richard A. Brown, Diane Ellis 

Regular Features 

◆ Regional Economy—Job growth in New England gathers steam . . . 

New Hampshire has the Region’s best performing economy, led by high-tech manufacuring . . . ties to the Massachusetts economy affect New Hampshire’s insured 

institutions . . . Maine’s recent slow economic growth can be traced to its concentration in forest products and defense industries. See page 10. 

By Norman Williams 

◆ Financial Markets—Securitization of home equity loans is growing 

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

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

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

By Allen Puwalski 

◆ Regional Banking—Strong performance continues for most insured 

institutions . . . consumer loan problems persist . . . surging loan commitments plus 

lackluster core deposit growth may cause faster loan growth and tighter liquidity 

. . . more institutions are using derivatives to manage market risks. See page 18. 

By Daniel Frye 

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

Insurance Corporation for the following eight geographic regions: 

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

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

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

Dallas Region (CO, NM, OK, TX)
 

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

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

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

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

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

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

Information Center for current pricing on bulk orders. 

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

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

Outlook, please call Daniel Frye at (617) 320-1792 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 Andrew C. Hove, Jr. 

Director, Division of Insurance Arthur J. Murton 

Editor George E. French 

Managing Editor Stephen Linehan 

Associate Editor Maureen E. Sweeney 

Assistant Editors Paul C. Bishop 

Richard A. Brown 

Steven K. Burton 

Diane Ellis 

Kathy R. Kalser 

Ronald L. Spieker 

Publications Manager Teresa J. Franks 
In Focus This Quarter
 

Subprime Lending: A Time for Caution
 

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

•	 The consequences of deficiencies in underwriting, 

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

necessary resources in these areas likely will have 

trouble succeeding in the increasingly competitive 

market for subprime loans. 

•	 Some institutions insured by the FDIC have failed 

to properly assess and control the risks associated 

with their subprime lending programs. 

What Are Subprime Loans? 

Faced with strong competition and shrinking margins 

on loans to high-quality borrowers, some lenders are 

moving down the credit quality spectrum. The strategy 

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

lending is most commonly associated with auto, home 

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

Generally, the characteristics of a subprime borrower 

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

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

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

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

Definitional variations aside, some general market 

parameters on ranking loans are presented in Table 1. 

TABLE 1 

Criteria for Loan Rankings 

GRADE PAYMENTS LATE BANKRUPTCY 

30 DAYS FILING
 

PRIME
 NONE NONE
 

A­ LESS THAN 2 NONE IN 5 YEARS 

B LESS THAN 4 NONE IN 3 YEARS 

LESS THAN 6 NONE IN 2 YEARS 

D CONSTANTLY LATE NONE IN 1 YEAR 

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

Market Information Services 

How Big Is the Market? 

The lack of a standard definition for a subprime loan 

makes it difficult to accurately determine the extent of 

the market. However, some industry experts estimated 

that during 1996, subprime loans secured by residences, 

including both home equity and mortgage loans, 

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

conventional mortgages. Subprime auto loans have been 

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

or about 20 percent of total auto loans outstanding. 

Who Makes Subprime Loans? 

In the past, subprime lending was primarily the domain 

of a limited number of finance companies. These firms 

specialized in making high-priced loans to borrowers 

with limited access to credit. 

The number of subprime lenders, however, has surged 

in recent years as more companies have been attracted 

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

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

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

The increase in the number of subprime lenders has 

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

enables the lender to effectively raise cash at a lower 

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

market has attracted lenders that previously refrained 

from making subprime loans because they did not want 

to maintain these high-risk loans or the associated 

reserves on their balance sheet. By issuing securities 

backed by subprime loans, lenders now have the ability 

to originate subprime loans and sell them to ABS 

investors. 

Favorable stock market conditions also helped to fund 

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

to market watchers. This financing avenue may become 

less accessible, as investors’ concerns over financial 

Regional Outlook	 3 Third Quarter 1997 

C 
In Focus This Quarter
 

problems of several major market participants have 

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

Financial Difficulties of Some Subprime 

Lenders 

Market participants have observed that, as in credit card 

lending, increasing competition may be compelling some 

subprime lenders to compromise underwriting standards 

and lower pricing in order 

to protect market share. Financial 

difficulties reported by major subprime auto lenders Jayhawk 

Acceptance Corporation and 

Mercury Finance Company highlight these concerns. 

Problems in subprime lending are not limited to auto 

loans. Lenders that specialize in subprime home equity 

loans and mortgages also are showing signs of stress. In 

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

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

competitive environment for subprime home equity 

loans (see Financial Markets). 

Differences between Prime and Subprime 

Lending 

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

underwriting process is to differentiate those subprime 

borrowers whose past credit problems were due to such 

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

prospective borrower’s credit bureau report with such 

additional information as income, employment history, 

and the nature of prior credit problems. This process 

allows the lender to better determine the credit risk or 

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

the loan will be profitable. 

Servicing and collection of subprime loans tends to be 

more labor intensive and costly than in prime lending. 

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

In addition, while prime lenders may be willing to work 

with late borrowers by adjusting minimum amounts or 

payment schedules, subprime lenders generally pursue 

collections more aggressively and repossess collateral 

more quickly. 

Insured Institutions and the Subprime Market 

Bank involvement in subprime lending is difficult to 

quantify because subprime loans are not delineated in 

bank and thrift Call Reports. However, both large and 

small banks reportedly are participating in credit card, 

auto, home equity, and mortgage subprime lending. 

Insured institutions have used various strategies to 

establish a presence in the subprime market. Some 

have: 

•	 acquired or formed joint ventures with companies 

specializing in subprime lending; 

•	 built subprime lending programs internally, using 

existing resources; and 

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

for subprime mortgages may use this method more 

commonly. 

Through these strategies, insured institutions have: 

•	 extended loans directly to subprime borrowers or 

purchased subprime loans from loan brokers; 

•	 lent to subprime specialty lenders in the form of loan 

participations, warehouse lines, liquidity facilities, 

or dealer lines; and 

•	 serviced subprime loans or invested in asset-backed 

securities secured by subprime loans. 

Risks Associated with Subprime Lending Need 

to Be Considered Carefully 

According to a Financial Institutions Letter (FIL), FIL 

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

recent examinations revealed that a number of financial 

institutions involved in subprime lending have failed to 

properly assess and control the risks associated with 

subprime lending. Because of the relatively high default 

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

Regional Outlook	 4 Third Quarter 1997 
In Focus This Quarter
 

lending warrants particular caution and management 

attention. 

Institutions need to be thoroughly aware of the 

increased risks and costs associated with lending to 

higher risk borrowers. Some of these risks include: 

•	 Delinquencies and defaults tend to be more frequent 

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

•	 Loan loss reserves that would have been adequate for 

prime lending may not properly cover higher loss 

rates associated with subprime loans. 

•	 Strains on underwriting and collection resources 

may emerge. 

•	 Because selling collateral is more frequently the 

source of repayment on subprime loans, failure to 

accurately estimate recovery values could severely 

affect the profitability of subprime lenders. For 

example, several subprime auto lenders recently 

reported lower profits when the supply of better 

quality cars coming off leases depressed the prices 

they received on repossessed cars. 

Insured institutions that rapidly increase subprime 

exposures also may need to reevaluate delinquency 

measurement methodologies. Rapid loan growth can 

make it more difficult to accurately track delinquency 

and default trends. Generally loans do not default 

CHART 1 

0% 

10% 

20% 

30% 

40% 

50% 

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

Months since Origination 

"C" Auto Loans 

"A/B" Auto Loans 

"D" Auto Loans 

Source: Fitch Investors Service, L.P. 

Default Rate 

Defaults Are More Frequent and Occur 

Sooner on Lower Quality Auto Loans 

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

a period of time. Delinquency and default rates can be 

deceptively low if the proportion of new loans exceeds 

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

Calculating default rates over time for loans originated 

in a particular period or lending program, instead of as 

a percentage of total outstanding loan balances, helps 

reduce the distortion caused by rapid loan growth. This 

method of computing delinquency and default rates, 

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

Banks involved in subprime lending also should realize 

that the recent increase in subprime lending has 

occurred during relatively healthy economic conditions. 

The repayment capacity of subprime borrowers may be 

more susceptible to downturns in the economy, which 

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

loans. 

In addition, banks that lend to subprime specialty 

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

effect securitization may have on earnings (see 

Financial Markets). 

Conclusion 

The extent of involvement by insured institutions in 

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

resources and expertise. Conversely, deficiencies in 

assessing and controlling the risks of subprime lending 

can have serious consequences. Such deficiencies have 

surfaced at a number of FDIC-insured institutions. 

Striking an appropriate balance between the risks and 

rewards of subprime lending is a challenge for bankers 

and merits the continued attention of bank supervisors. 

Kathy R. Kalser, Chief 

Financial Sector Analysis Section 

Debra L. Novak, 

Division of Resolutions and Receiverships 

Regional Outlook	 5 Third Quarter 1997 
In Focus This Quarter
 

Retail Shakeout: Causes and Implications for Lenders
 

•	 Changes in the marketplace, technology, and 

finance are transforming retailing. 

•	 These trends have given rise to rapid growth in 

the new “big box” store format. 

•	 Consolidation in retailing is evident in mergers, 

acquisitions, and bankruptcies. 

•	 The potential for overbuilding in retail real estate 

markets may pose a risk for insured depository 

institutions. 

For the past two decades, construction of retail space 

has outstripped many indicators of demand such as 

growth in retail sales, population, and income. The 

broadest measure of the industry’s health is sales per 

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

around 35 percent in real terms since 1972. Chart 1 

shows how growth in leasable shopping center space 

has exceeded growth in shopping centers’ sales since 

1972. 

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

industry analysts have concluded that too many stores 

are chasing too few consumer dollars, indicating an 

emerging shakeout in the retail sector. To the extent that 

insured depository institutions provide financing to 

retailers or for retail real estate, they are exposed to 

heightened credit risk as the shakeout unfolds. 

New Forces Are Reshaping the Retail Landscape 

A combination of demographic and economic forces 

has reduced growth in demand for retail goods from the 

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

technology is reconfiguring the way retail goods are 

marketed and delivered, and a low cost of capital has 

stimulated investment in new retail space and new 

retailing concepts. 

A retail industry boom began roughly in 1970 when 

baby boomers and women began entering the work 

force in record numbers. At the same time, proliferation 

in general-purpose credit cards facilitated an extension 

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

CHART 1 

100 

150 

200 

250 

300 

350 

’72 ’76 ’80 ’84 ’87 ’89 ’91 ’93 ’95 

Leasable 

Space* 

Inflation-adjusted 

Sales * 

* Does not include non-shopping center space. 

Source: International Council of Shopping Centers 

1972=100 

Construction of Shopping Center Space Has 

Outstripped Sales Growth 

98 percent increase in inflation-adjusted retail sales 

from 1967 to 1994. 

To meet this demand and serve expanding suburban 

communities, developers built shopping centers at a 

rapid pace. The number of shopping centers, from small 

neighborhood strip centers to huge regional malls, grew 

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

Despite economic conditions that seem favorable for 

the retail sector, revenue growth has been painfully 

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

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

commensurately. An optimistic household sector has 

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

lower interest rates compared to the 1980s. 

Even with generally positive economic conditions, 

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

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

have lagged behind rates of the previous two decades. 

Slow growth in retail revenues can be explained in part 

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

only around two-thirds of the general rate of inflation 

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

personal computer sector has seen actual price deflation. 

Regional Outlook	 6 Third Quarter 1997 
In Focus This Quarter
 

An aging consumer base is another factor holding down 

retail sales growth. The total number of households 

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

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

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

so for the foreseeable future. The total population in the 

20 to 35 age bracket is projected to decline slightly by 

2007. 

Other broad trends have contributed to slower retail 

sales growth. Retail sales as a percentage of personal 

income fell from 46 percent to 38 percent between 1967 

to 1996 as consumers shifted more of their disposable 

income to the purchase of personal services, housing, 

education, travel, and entertainment. A Standard and 

Poor’s Industry Survey reports that consumers have 

reduced their number of trips to shopping malls by 35 

percent since 1980, while total shopping hours are down 

70 percent. 

Looking ahead, mail-order retailing through electronic media, 

including cable television and the 

Internet, may be poised to gain 

significant market share at the 

expense of shopping centers. 

“Virtual shopping malls” such as 

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

although analysts caution that widespread adoption of
 

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


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

been investing in technology to cut their expenses and 

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

scanning delivers a vast amount of information that can 

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

advantage for large retail chains with vast marketing 

and distribution networks. 

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

financing plentiful and cheap. This environment has 

allowed retailers to overhaul retail strategies and invest 

heavily in technology, inventory, and retail space— 

investments that might otherwise have been infeasible. 

Since 1991, around 1.13 billion square feet of new retail 

space has been added nationwide representing an 

increase of about 12 percent to the total stock of retail 

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

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

information systems, although they are known to be 

sizeable. 

Growth of the “Big Box” Format 

Leading retailers have responded to these forces with 

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

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

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

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

arrival of big box stores has left smaller, local retail 

establishments with only a small fraction of their former 

share of the local market. 

The big box format has a number of advantages. Among 

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

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

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

“category killers.” Large retail chains also have more 

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

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

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

capital markets. 

CHART 2 

Inflation-Adjusted Retail Sales Have Grown 

Slowly in the 1990s 

Real Growth in Retail Sales*, 

Compound Annual Rate 

3.0% 

2.5% 

2.0% 

1.5% 

1.0% 

0.5% 

0.0% 

1970s 1980s 1990s 

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

Source: Bureau of the Census and Bureau of Labor Statistics 

Regional Outlook 7 Third Quarter 1997 
In Focus This Quarter
 

Industry Consolidation to Continue 

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

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

be consolidation in the industry as weaker chains give 

way to market leaders. 

One sign of this consolidation is in multibillion dollar 

acquisitions, such as Federated Department Stores’ 

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

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

Nordstrom) now account for 87 percent of department 

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

account for 87 percent of full-line discount department 

store sales. 

Intensely competitive conditions also are reflected by 

retail bankruptcies and restructurings. Both Woolworth 

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

stores in restructurings that reflect the loss of market 

share to Wal-Mart. Smaller companies that have fewer 

restructuring options are more likely to be forced into 

bankruptcy. Dun & Bradstreet reports that domestic 

business failures among retail establishments rose in 

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

of larger chains also filed for bankruptcy during 1995, 

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

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

Today’s Man. 

As the retail shakeout moves forward, any credit losses 

on commercial and industrial loans to retailers are more 

likely to arise from bankruptcies and restructurings than 

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

industry is likely to take place. 

Overbuilding Is a Risk for Retail Real Estate 

Retail industry analysts are particularly concerned 

about the potential for overbuilding of retail space. 

Because of this concern, lenders and examiners should 

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

CHART 3 

0 

20 

40 

60 

80 

100 

120 

140 

160 

’88 ’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 

0% 

2% 

4% 

6% 

8% 

10% 

12% 

New Supply Has Recently Outpaced 

Absorption of Retail Space 

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

Vacancy 

Rate 

Net New Supply Absorption 

Millions of 

Square Feet 

Although a vacancy rate of 7.7 percent does not suggest 

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

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

vacancy rate has begun to tick upward since 1995 as net 

completions of new retail space have caught up to and 

surpassed the absorption of that space by retailers (see 

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

industry, reflecting the fact that additions to retail space 

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

local market conditions may be somewhat more volatile 

than the national figures would suggest, particularly in 

areas where a great deal of construction activity has 

recently taken place (see inset, Retail Real Estate 

Markets a Mixed Bag in the Boston Region). 

Besides market conditions, underwriting is the other 

major determinant of credit quality in retail real estate 

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

on loans with 1980s-vintage underwriting, particularly 

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

concern that the rapid expansion of space may be 

putting downward pressure on lease rates. In light of an 

ample supply of space and a number of large chains 

continuing to add space, any valuations that assume 

future growth in lease rates should be closely reviewed. 

The viability of rapid expansion on the part of the large 

retail chains would undergo a particularly severe test in 

the event of a recession. 

Richard A. Brown, Chief, Economic Analysis Section 

Diane Ellis, Senior Financial Analyst 

Regional Outlook 8 Third Quarter 1997 
In Focus This Quarter
 

Retail Real Estate Markets a Mixed across its major metropolitan areas during the past

three years (see Table 1). However, Hartford, which Bag in the Boston Region has suffered longer than most cities in Connecticut 

owing to structural declines in insurance and defense, 

The last recession was preceded by rampant over- reached an all-time high retail vacancy rate in 1996. 

building of commercial real estate properties, partic- This trend is contrary to the modest improvement in 

ularly in eastern Massachusetts and southern New office and industrial vacancy rates seen in that market 

Hampshire. Since that time, retail vacancy rates gen- over the past few years. 

erally have improved across the Boston Region. 

Despite the general trend, Hartford, Connecticut, Chart 4 shows the recent trend in Hartford’s retail real 

may be seeing some overbuilding, as net new supply estate market. Net new supply has been coming 

has consistently outstripped absorption rates in recent onstream far more rapidly than it has been absorbed 

years. by retailers. As a result, the city’s vacancy rate has 

climbed steadily, peaking at 7.5 percent in the fourth 

Table 1 shows the recent trend in vacancy rates for the quarter of 1996 (averaging 6.8 percent for the year). 

three major markets where data were consistently Prior to the last recession, Hartford’s retail vacancy 

available. The 1996 average 2.5 percent vacancy rate rate hovered around 1 percent, but it jumped to about 

for the combined Boston and Brockton markets is the 4 percent in 1991. Rather than declining, as has been 

lowest rate recorded there in over a decade. Continued the case for most other markets across the Region durpositive trends in the eastern Massachusetts economy ing the recent recovery, Hartford’s under-utilization of 

since the last recession have allowed existing space to retail space continued to worsen between 1991 and 

be absorbed, while there has been only limited new 1996. 

construction. As a result, vacancy rates are currently 

well below the peak reached in 1991 and seem likely Norman Williams, Regional Economist 

to remain so for the next several years. 

CHART 4 

Like eastern Massachusetts, southwestern Connecticut Too Much Retail Space in Hartford has seen a general improvement in retail vacancy rates 

Thousands of square feet Percent 

500 Net New 8 TABLE 1 Absorption Supply (left scale) (left scale) Retail Vacancy Rates: 400 

Vacancy Rate 6

Low in Boston, Rising in Hartford (right scale) 300 

1994 1995 1996 LAST PEAK 4 

200 

BOSTON/BROCKTON 3.4 3.1 2.5 7.3 (1991) 

2 HARTFORD, CT 5.2 5.7 6.8 CURRENT 100 

STAMFORD, 

BRIDGEPORT, & 0 0 

NEW HAVEN, CT 6.0 5.7 5.5 7.2 (1992) 1988 1990 1992 1994 1996

Source: FDIC, The Real Estate Report Source: FDIC, The Real Estate Report 

Regional Outlook 9 Third Quarter 1997 
Regular Features	 Regional Economy
 

Boston Region: Economic Update and Focus on
 

Northern New England
 

•	 The New England economy continues to do well, mirroring trends in the national economy, and the outlook 

for insured institutions remains generally positive. 

•	 New Hampshire is the Region’s best performing economy by many measures. 

•	 Maine has lagged the other northern New England states in part because of the makeup of its manufacturing sector. 

•	 Owing to New Hampshire’s stronger links to the Massachusetts economy, its insured institutions have seen 

more volatile asset growth and earnings than those in the other northern New England states. 

Region’s Economy Remains Healthy, Mirroring 

Nation in Job Growth 

Employment: Nonfarm job growth in New England 

matched the national pace during the first four months 

of 1997 (see Table 1). However, some of the Region’s 

apparent strength in this year-ago comparison can be 

attributed to harsh weather early in the first quarter of 

1996, which suppressed job growth during that period. 

To eliminate the influence of 1996’s weather on yearover-year comparisons inherent in Table 1, it is useful to 

look at the recent month-to-month trend in seasonally 

adjusted employment growth, expressed at an annual 

rate. Using this method, nonfarm job gains in New 

England averaged 1.3 percent during the first four 

months of the year—a much slower rate than the 2.5 

percent at the national level. However, in just the past 

few months the pace of job growth has strengthened in 

New England, averaging 2.2 percent during March and 

April, versus 2.5 percent for the nation. 

Income: As job gains continue in the Region, so does 

growth in income. After exceeding the nation in 1995, 

the advance in New England personal income weakened 

somewhat last year but still rose a respectable 4.9 percent over the prior year (versus 5.4 percent for the 

nation). The strongest gain was in Massachusetts, 

which matched the national rate. Income growth was 

slowest last year in Maine and Rhode Island (both just 

under 4 percent). 

Residential Construction: Home building, which 

helps drive economic activity through increased construction wages and greater consumer spending linked 

to new home sales, also continued to advance in the first 

three months of 1997. Although a year-over-year comparison of residential permits is unduly influenced by 

the harsh winter weather in early 1996, New England’s 

first-quarter activity was the strongest it has been for 

that period in seven years. The volume of residential 

construction remains at about 40 percent of its late 

1980s peak, with applications for multifamily dwellings 

at only 20 percent of the 1988 level (when rampant 

overbuilding of condominiums preceded the last recession). This modest growth should be sustainable in the 

absence of a national recession. 

Implications: Thus far this year, the Region’s economic health remains favorable. Moderate rates of growth in 

employment, income, and spending should allow 

TABLE 1 

New England Job Growth 

Matches U.S. 

NONFARM EMPLOYMENT, NOT SEASONALLY 

ADJUSTED (% CHANGE OVER PRIOR YEAR) 

JAN-APRIL 1997 1996 

UNITED STATES 2.2 2.0 

NEW ENGLAND 2.3 1.7 

CONNECTICUT 1.9 1.4 

MAINE 1.3 0.3 

MASSACHUSETTS 2.7 2.0 

NEW HAMPSHIRE 3.5 3.7 

RHODE ISLAND 1.3 0.4 

VERMONT 1.6 1.8 

Source: Bureau of Labor Statistics 

Regional Outlook	 10 Third Quarter 1997 
Regular Features Regional Economy
 

insured institutions to increase lending and revenue this 

year while limiting the potential for a widespread deterioration in credit quality. 

Focus on Northern New England 

This article focuses on northern New England. Maine 

in particular has generally seen a slower pace of economic growth than either New Hampshire or Vermont. 

Some underlying factors influencing growth, such as 

manufacturing employment trends, are examined, as are 

the implications for insured institutions. 

Population Trends: In New England, the severity of 

the last recession resulted in significant net domestic 

out-migration, which impeded population growth relative to the rest of the nation. This trend continues in the 

Region’s southern states, although the amount of 

domestic out-migration has been declining steadily in 

recent years. Population trends are tied to job and 

income growth and thus directly affect a state’s economic performance. 

Chart 1 points out recent trends in population for the 

northern New England states relative to the rest of the 

Region. Vermont, which had the fewest job losses during the last recession, saw only modest net domestic 

out-migration in 1991 and 1992. As a result, population 

growth was not significantly impeded in that state. 

Although not shown on Chart 1, the national population 

track has closely mirrored Vermont’s since 1986. 

New Hampshire experienced a more pronounced outflow of persons to other states than Vermont (note the 

leveling-off of population in the early 1990s), but 

growth accelerated after 1991. New Hampshire’s lack of 

personal income and sales taxes has helped it to draw 

residents from neighboring New England states, including some 16,000 from Massachusetts between 1992 and 

1994. For employers, New Hampshire’s appeal lies in 

the fact that it is an average-cost state (labor, energy, 

taxes) in a high-cost region. 

Maine began seeing net domestic in-migration in 1996, 

after several years of net departures, but its northern 

rural counties remain susceptible to population outflows. As evident in Chart 1, Maine’s population was 

relatively unchanged between 1991 and 1996 (up 0.6 

percent, similar to southern New England for that period). Meanwhile, New Hampshire’s population grew 5 

CHART 1 

New Hampshire and Vermont Lead Region’s 

Population Growth 

Resident Population 

Index 1986 = 100 Vermont 

115 

110 

105 

100 Southern New England 

New Hampshire 

Maine 

95 

’86 ’87 ’88 ’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 

Source: U.S. Census 

percent during the past five years, and Vermont’s rose 

by almost 4 percent. 

Employment Trends: Strong gains in jobs and income 

have coincided with New Hampshire’s population 

growth, making it the Region’s best performing economy. Between 1992 and 1996, nonfarm payrolls rose an 

average of 3.5 percent per year in New Hampshire, versus a 2.4 percent rate for the nation during that time. In 

Vermont, the average pace of job growth was 2.3 percent annually, while Maine was the weakest northern 

state during this period, with gains averaging only 1.3 

percent. By comparison, growth was about 1.6 percent 

in southern New England. 

Differences in Manufacturing Sectors Help 

Explain Divergent Growth Rates 

Maine’s slower job growth in recent years is partly due 

to the dominance of declining defense and old-line factory industries in its manufacturing sector. By contrast, 

New Hampshire and Vermont have advanced more 

rapidly thanks to the strong presence of high-growth 

technology-related manufacturing industries. 

New Hampshire: Last year New Hampshire’s manufacturing payrolls rose 1.9 percent, placing it fourteenth 

among the 50 states. Almost 19 percent of New 

Hampshire nonfarm jobs are in manufacturing, versus 

about 16 percent nationwide. New Hampshire’s leading 

factory employers are electrical machinery and computers, electronics, and instruments industries, which 

together comprise almost half the factory jobs in the 

state. A recent American Electronics Association study 

Regional Outlook 11 Third Quarter 1997 
Regular Features Regional Economy
 

pointed out that between 1990 and 1995, New 

Hampshire had the largest number of high-tech workers 

per capita of any state. Electronics and machinery 

(including computers) account for about half the value 

of New Hampshire’s annual exports. 

Vermont: Vermont saw factory payrolls rise 1.8 percent 

in 1996, with factory jobs accounting for about 17 percent of the state’s nonfarm employment. Vermont manufacturing is fairly diversified, with one-third of jobs in 

nondurable goods (mostly paper, printing, and food processing) and two-thirds in durable goods industries. 

Still, 30 percent of Vermont’s manufacturing jobs are in 

electrical machinery (including computers) and electronics, owing primarily to IBM’s strong presence in the 

state. In Vermont, output of semiconductors and related 

devices (primarily from IBM) accounts for 82 percent 

of the value of state exports each year. 

Maine: Maine contrasts sharply with New Hampshire 

and Vermont. Maine had the largest percentage decline 

in industrial jobs of all the states in New England last 

year and lost more manufacturing jobs (in percentage terms) 

than all states but Alaska, 

Mississippi, and Delaware. 

Except for a modest rebound in 

1994, manufacturing employment has steadily declined in 

Maine since 1988. About 16 percent of Maine’s jobs are in manufacturing today. 

Maine’s principal goods-producing employers are the 

paper and allied products, transportation equipment 

(naval-defense related), and lumber and wood products 

industries. These industries employ about 42 percent of 

the state’s factory workers. In 1994 (latest available), 

Maine was four to six times more dependent than the 

national economy on paper, lumber, and forestry payrolls. The state’s reliance on earnings from naval 

defense (transportation equipment) manufacturing was 

about three times the national average in 1994. Maine 

does have a high-tech presence, including the 

National/Fairchild Semiconductor facility in Portland, 

but employment in this industry is relatively modest. 

Computer Chips Versus Wood Chips: Globally, technology-related manufacturing, especially electronics, 

has been expanding thanks to rapidly growing demand 

for computers, telecommunications gear, and related 

products. New Hampshire and Vermont have benefited 

from this trend, as reflected in the significance of technology-related jobs in each state. 

In contrast, Maine’s economic growth has been held 

back, as transportation equipment employment has 

withered under declining federal defense budgets. Also, 

forest products firms have cut payrolls for several reasons. Limited growth in demand coupled with increased 

worker productivity has reduced the need for large 

workforces. Also, jobs have been cut in an attempt to 

become leaner during an era of uncertainty over changing environmental regulations, limits on timber harvests, and rising risks and costs related to compliance 

with environmental regulations. Chart 2 points out the 

recent divergence in employment growth between the 

electronics industries in New Hampshire and Vermont 

and the forest products and defense (transportation 

equipment) industries in Maine. 

How Insured Institutions Have Fared 

As the previous discussion pointed out, Maine’s economy has generally fared less well than the other northern 

New England states, particularly New Hampshire. 

Although asset growth at insured institutions has been 

less robust as a result, these firms also may be less susceptible to any future downturn in the dominant 

economies of southern New England. 

A good deal of New Hampshire’s growth in recent years 

has been driven by the expanding Massachusetts economy. Two-thirds of New Hampshire’s labor force is 

located in three southeastern counties bordering the 

greater Boston area. This strong tie to Massachusetts 

has helped New Hampshire’s institutions grow more 

CHART 2 

Maine Is Losing Factory Jobs, While New 

Hampshire and Vermont Are Gaining 

Employment 

Index 1988 = 100 

120 Maine: transportation equipment* 

110 

100 

90 

80 Maine: lumber, wood, & paper 

70 

’88 ’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 Mar­

’97 

New Hampshire

 & Vermont: electronics 

* Data for 1990 - 1994 not reported, slope smoothed 

Source: Bureau of Labor Statistics 

Regional Outlook 12 Third Quarter 1997 
Regular Features Regional Economy
 

rapidly than those in Maine and Vermont during the past 

few years. Between 1994 and 1996, assets grew only 2.9 

percent in Maine and 4.4 percent in Vermont, but rose 

7.4 percent in New Hampshire. 

If recent history is a reliable indicator, New 

Hampshire’s stronger asset growth also could be more 

tenuous than recent gains in Maine and Vermont. 

During the last recession it was New Hampshire’s 

insured institutions that suffered the most of any state in 

northern New England. This was primarily due to expoCHART 3 

-1.0 

-0.5 

0.0 

0.5 

1.0 

1.5 

2.0 

’86 ’87 ’88 ’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 

Source: Bank and Thrift Call Reports 

(Median return on assets, percent, annual average) 

New Hampshire Institutions Influenced by 

Trends in Massachusetts 

U.S. 

New Hampshire Massachusetts 

Maine 

sure to an overbuilt commercial real estate market, 

fueled by a rapidly expanding Massachusetts economy. 

In 1991, 12 banks in New Hampshire failed, representing 25 percent of the state’s prior year-end assets. 

Profitability, as measured by median return on assets 

(ROA), fell from an average of 0.8 in 1988 to a negative 

0.4 in 1990 (see Chart 3). Between 1988 and 1992, 

assets in the state fell 20 percent—banking assets in 

Massachusetts fell about 17 percent during this time. 

By contrast, fewer institutions in Maine and Vermont 

faltered, because of those states’ weaker ties to 

Massachusetts. Median ROA in Maine fell from 0.9 in 

1988 to 0.5 in 1990 and had recovered fully by 1992. 

Vermont’s median profitability also stayed out of the red 

during the early 1990s. 

Implications: New Hampshire’s strong economy in 

recent years has allowed its remaining insured institutions to recover significantly from the last recession. 

However, its insured institutions are exposed not just to 

conditions in their own state’s economy but also to 

developments in the Massachusetts economy. 

Institutions in Maine and Vermont, on the other hand, 

would be less affected by any future downturn in the 

Region’s dominant economy. 

Norman Williams, Regional Economist 

Regional Outlook 13 Third Quarter 1997 
Regular Features	 Financial Markets
 

Financial Markets
 

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

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

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

•	 During the first quarter of 1997, the Boston Regional Bank Index outperformed the S&P Composite Bank 

Index. The Boston Region’s Community Bank Index moved ahead fairly steadily but gained less than the 

S&P 500 and the other bank indices. 

Trends in the Home-Equity Asset-Backed 

Market Are Important to Banks 

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

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

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

delinquencies. Banks that are investing in HEL ABS, 

considering securitizing HELs, or lending significantly 

for debt consolidation should be aware of credit quality 

developments in the HEL ABS market. 

The distinction between HELs and first-lien residential 

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

1993 and early 1994 resulted in a change in the makeup 

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

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

lower rates to refinance their first mortgages for 

amounts greater than the remaining principal balance 

instead of adding a second mortgage. 

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

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

burdens. According to the Consumer Bankers 

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

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

to 1992, home improvement was the primary reason for 

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

significant risk implications because, unlike funds lent 

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

The rapid growth of the HEL securitization market has 

been attended by signs of relaxed underwriting. 

Adverse credit quality trends have been particularly 

prominent for loans that were originated in 1995. Chart 

2 (next page) shows the total delinquency rates for 

closed-end loan pools originated in 1995 versus 1994. 

The sharp upward path of delinquency rates for loan 

pools originated in 1995 raises concern that aggressive 

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

levels. Furthermore, HEL originations in 1996 more 

CHART 1 

1993 1994 1995 1996

0 

5 

10 

15 

20 

25 

1993 1994 1995 1996

Securitization of Home Equity 

Loans Has Risen Substantially 

Lines of Credit 

Closed End 

Source: Moody’s Investors Service 

$ Billion 

Regional Outlook	 14 Third Quarter 1997 
Regular Features Financial Markets
 

than doubled 1995 levels, causing market observers to 

suspect that underwriting standards continued to lapse. 

The trends in the HEL ABS market may portend credit 

quality trends in nonsecuritized cash-out refinancing. If 

similar unfavorable trends exist in bank-originated 

cash-out refinancing, evidence of these trends would be 

obscured by banks’ larger and less risky portfolios of 

purchase mortgage loans. The trends would be obscured 

because banks report all first mortgage lending on 1 to 

4 family residential properties without distinguishing 

between purchase mortgages and cash-out refinancings. 

The unfavorable trends in the HEL ABS market suggest 

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

able to monitor trends in the credit quality of these loans 

separate from purchase mortgage loans. 

A Combination of Several Factors Could Induce 

More Banks to Securitize HELs 

Although the present volume of bank-originated HEL 

securitizations is relatively small, banks have recently 

entered this finance company-dominated market, and a 

combination of several factors is likely to cause more to 

follow. First, home equity lines of credit are currently 

growing at rates exceeding total consumer lending, and, 

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

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

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

because bank-originated lines are perceived to have 

lower credit risk. The funding benefits and profitability 

of securitizing bank-originated home-equity lines of 

credit could entice more banks into the securitization 

CHART 2 

0 

2 

4 

6 

8 

10 

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

Months since Origination 

1995-Originated Loans 

Source: Moody’s Investors Service 

Percent 

Higher Delinquency Rates Are Occurring 

Earlier in More Recently Originated Loan Pools 

1994-Originated Loans 

Closed-end Loans 

market. Finally, the combination of these factors with 

the potential cost savings provided by using the new 

financial asset securitization investment trust (FASIT) 

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

amounts. 

Securitizing HELs can change the balance sheet and 

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

Beginning in 1997, when 

a company sells loans, it 

must comply with the 

requirements of Financial 

Accounting Standard 

(FAS) 125. If the company retains servicing rights 

on the assets sold, FAS 

125 requires the seller to 

book an asset related to the gain on sale that represents 

the future income derived from servicing the loans. This 

asset is similar to mortgage servicing rights in that it 

represents the present value of future expected cash 

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

not materially affect its financial statements, reported 

servicing assets at almost 90 percent of equity, and 

gains associated with the sale of serviced assets at 71 

percent of total revenue. 

The value of servicing assets is based on management’s 

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

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

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

early repayment through foreclosure of serviced assets, 

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

FASITs Promise to Change the ABS Market 

The Small Business Job Protection Act of 1996 created 

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

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

provide tax certainty for ABS issuers and purchasers 

and enhance the flexibility of asset securitizations. The 

FASIT provisions take effect on September 1, 1997. 

Regional Outlook 15 Third Quarter 1997 
Regular Features Financial Markets
 

The advent of the FASIT is likely to change the ABS 

market in important ways. First, the FASIT will clarify 

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

taxation is administratively costly, and it restricts the 

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

pools that can be feasibly securitized. With FASITs and 

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

community banks entering the securitization market. 

ABS issuers believe that the market for their product 

has been hampered by the restrictive nature of current 

asset-backed tax ambiguity, which prevents them from 

responding to investor preferences for varying maturities, coupon types, and 

prepayment and credit 

risk profiles. FASITs 

allow sponsors the flexibility to create multipleclass securities that 

satisfy these preferences 

with the certainty that 

the securities will count 

as debt and that the 

FASIT will not be treated as a taxable corporation. This 

combination of flexibility and tax certainty could lead 

to the kind of innovations in ABS structures that followed the 1986 REMIC legislation, which brought analogous benefits to the mortgage-backed market. 

FASITs make possible additional innovations. FASITs 

will bring to the ABS market the ability to add and 

remove assets throughout the life of a securitization. 

This feature could be applied by securitizing revolving 

construction loans and then replacing the revolving 

loans with permanent financing when construction is 

completed. A FASIT also will be able to contain a 

mixed pool of assets such as real estate, non-real estate 

assets, and unsecured credit, allowing exposures to very 

different markets from the same security. Finally, a 

FASIT can hold swaps and other hedging instruments. 

Using this feature, an issuer could combine a mortgage 

passthrough security with a hedging instrument that is 

designed to offset mortgage prepayment risk, such as a 

reverse-index amortizing swap. 

The increased flexibility that the FASIT promises to 

bring the ABS market comes with the potential for 

greatly increased complexity and risk. Banks that invest 

in FASIT securities will need to understand fully not 

only the risk characteristics existing at the outset of 

security but also the risk that could arise throughout the 

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

Changes in Interest Rates and Bond Values 

The Treasury yield curve (see Chart 3) rose following 

March 25, 1997, when the Federal Open Market 

Committee (FOMC) met and raised the target federal 

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

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

Thursday following the meeting and remained there for 

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

1997, and left the target rate unchanged. 

The model portfolio responded to the rise in rates, but 

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

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

Treasury between December 31, 1996, and March 31, 

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

correlate more with changes in the five-year Treasury 

rate than with the 30-year bond rate. 

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

that the market expects the curve to continue to flatten 

through the remainder of the year with short rates rising 

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

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

portfolios, the model portfolio has been “shocked” to 

CHART 3 

The Treasury Yield Curve Is Steeper 

and Higher since Year-end 1996 

5.0 

5.5 

6.0 

6.5 

7.0 

7.5 

3­

month 

2­

year 

7­

year 

30­

year 

Source: Bloomberg 

Percent 

3/31/97 

4/30/97 

12/31/96 

Regional Outlook 16 Third Quarter 1997 
Regular Features Financial Markets
 

TABLE 1 

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

Portfolio WAL from a 25 bp Rate 

as of 12/31/96 Increase on 

12/31/96 to 5/28/97 

3/31/97 

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

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

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

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

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

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

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

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

simulate the effect of an instantaneous 25 basis point 

shift in the yield curve on May 28, 1997. 

Again, the interest rate risk benefits of maintaining a 

portfolio of relatively short weighted average life are 

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

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

the most sensitive to rate changes owing to its longer 

maturity. The mortgage passthrough security also is 

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

underlying mortgage holders from prepaying their 

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

combination unfavorable to the security’s value. 

CHART 4 

The Boston Regional Bank Index Outperformed 

the S&P Composite Bank Index and the S&P 

500 during the First Quarter of 1997 

The Boston Regional Bank Index’s nearly 21 percent 

gain through May 2, 1997, was sufficient to outperform 

the S&P Composite Bank Index’s gain by more than 7 

percentage points (Chart 4). The S&P Composite Bank 

Index, with an almost 13 percent gain by May 2, 1997, 

was still short of its year-to-date high on March 7, 1997, 

at which time it was up almost 20 percent on the year. 

The Boston Region’s Community Bank Index was 

spared much of the influence of a gyrating market, rising in value fairly steadily to an 8.5 percent gain 

through May 2, 1997. 

Allen Puwalski, Banking Analyst 

-1% 

4% 

9% 

14% 

19% 

31-Dec

10-Jan 

S&P 500 

Boston Regional Bank Index S&P Bank Index 

Source: Bloomberg, American Banker 

Change from 12/31/96 

Region’s Community Bank Index 

The Boston Region’s Community Bank Index Has Outperformed the S&P Bank Index 

So Far This Year 

3-Jan

17-Jan24-Jan31-Jan

7-Feb

14-Feb21-Feb28-Feb

7-Mar

14-Mar21-Mar28-Mar

4-Apr

11-Apr18-Apr25-Apr

2-May 

Regional Outlook 17 Third Quarter 1997 
Regular Features	 Regional Banking
 

Regional Banking Conditions
 

•	 First-quarter results for the Boston Region saw a continuance of the strong performance produced in 1996. 

•	 Consumer credit problems appear to be worsening. 

•	 Surging commitments suggest a pickup in loan activity; however, lackluster core deposit growth may constrain on-balance-sheet loan growth. 

• An increasing percentage of the Region’s insured institutions are using derivatives to manage exposures to 

various market risks. 

The Earnings Engine Roars Onward 

The Region’s insured institutions started 1997 with 

more of the same strong financial performance that 

characterized 1996. In the aggregate, first-quarter earnings topped $1 billion in the Region for the first time, 

resulting in an annualized 1.26 percent return on assets 

(ROA), comparable to the 1.27 percent earned in the 

prior quarter. Commercial and savings institutions had 

ROAs of 1.41 percent and 1 percent, respectively, as 

compared with national average ROAs of 1.26 percent 

and 0.96 percent, respectively. Only 2 percent of the 

Region’s insured institutions posted losses during the 

quarter. 

On a statewide basis, New Hampshire-based institutions 

had the strongest ROA at 2.02 percent, bolstered by the 

strong reported earnings of the state’s credit card institutions. Connecticut-based institutions continued to 

trail the rest of the Region owing to persistently higher 

levels of nonperforming assets and provisions for loan 

losses, a result of the slow pace of economic recovery in 

that state (see the second-quarter 1997 Regional 

Outlook for a discussion of the Connecticut economy). 

Results for the first quarter also were held down by a 

large restructuring at a major institution. 

Adjusting for this large one-time charge, Connecticutbased banks earned a collective ROA of 1.17 percent. 

These performance results suggest that insured institutions in Connecticut are rapidly closing the earnings gap 

with institutions in the rest of New England (see Chart 1). 

The Region’s strong earnings relative to the nation as a 

whole are largely attributable to lower provisions for 

loan losses. Lower provision expenses are the direct 

result of improved asset quality and a concomitant drop 

in the level of the allowance for loan and lease losses to 

gross loans. In December 1991, aggregate loan loss 

reserves for the Region were 2.94 percent of gross loans 

and have dropped every subsequent quarter to the present level of 1.79 percent. This level of reserves is in line 

with the national average. Lower relative reserve levels 

have been driven in part by charge-offs in excess of provision expenses. On a cumulative basis, net charge-offs 

have exceeded provision expense by $1.7 billion since 

year-end 1991. 

The Region’s total past-due loan ratio of 2.4 percent is 

now lower than the national average for the first time in 

the 1990s. Delinquencies were highest at New 

Hampshire-based institutions (3.3 percent) due to a high 

concentration of consumer loans (28 percent of total 

loans versus 9 percent for the rest of the Region). In 

Massachusetts, whose insured institutions hold twothirds of the Region’s assets, delinquencies were only 

2.1 percent of total loans. 

CHART 1 

Connecticut Is Closing the Earnings 

Gap with the Rest of the Region 

1.17 

Adjusted 

1.30 

-1.0 

-0.5 

0.0 

0.5 

1.0 

1.5 

1991 1992 1993 1994 1995 1996 1997 

Return on Assets % 

Source: Bank and Thrift Call Reports 1997 = 1st Quarter Annualized 

Region Excluding Connecticut 

Connecticut-Based Institutions 

Regional Outlook	 18 Third Quarter 1997 
Regular Features Regional Banking
 

Consumer Loan Problems Persist 

Consumer loans remain an area of concern for the 

industry. Nationally, net charge-offs on bank credit card 

portfolios rose to 4.95 percent of average loans (versus 

4.21 percent in net credit card charge-offs for banks in 

the Region) and have risen every quarter since early 

1995. Fitch Investors Service reported that the gross 

charge-off rate on securitized credit card receivables 

reached 6.95 percent in May, well above levels attained 

during the recession of the early 1990s (see Chart 2). 

Losses on other consumer loans are rising as well. As 

reported in the first-quarter 1997 Regional Outlook, 

bankruptcy rates continue to rise and are an important 

factor driving increases in consumer loan charge-offs. 

The Administrative Office of the U.S. Courts recently 

announced that bankruptcy filings for the 12-month 

period ended March 31, 1997, totaled 1.25 million, an 

all-time high. This level of filings is a 27 percent 

increase from the prior 12-month period. Filings for the 

most recent quarter were 335,000, which also is a 

record high. The sharp rise in bankruptcy filings has 

prompted the Judicial Conference of the United States 

to transmit a proposal to Congress to create 18 additional bankruptcy judgeships to deal with the rising 

backlog of cases. 

Implications: Rising consumer bankruptcies and consumer charge-off rates are occurring during a time of 

economic prosperity. During the last recession, credit 

card losses rose to approximately 1.5 times their prerecession levels. It is reasonable to expect bankruptcy 

filings and consumer loan losses to go even higher 

under worsening economic conditions. Such a scenario 

would undoubtedly have a negative effect on other sectors of bank loan portfolios as well. 

CHART 2 

Commitments May Portend Faster Loan Growth 

and Tighter Liquidity 

Total unused loan commitments in the Region advanced 

at an annualized 30 percent rate during the past six 

months (see Chart 3). Credit card lines have been a 

major contributor to this growth rate (up 39 percent). 

However, “other unused commitments,” which encompasses nearly 60 percent of all unused loan commitments, have grown 32 percent over this same time 

frame. This category includes commitments for commercial loans and credit lines and residential real estate, 

but excludes home equity lines. 

A pickup in either loan closings or drawdowns on existing lines may place additional strains on liquidity at 

some of the Region’s insured institutions. The Region’s 

institutions are becoming increasingly dependent on 

noncore sources to fund asset expansion. For example, 

core deposits (which exclude certificates of deposit over 

$100,000 and foreign deposits) have fallen $9 billion 

since December 31, 1992, a 5 percent decline. Over that 

time, total assets grew $43 billion (to $322 billion), and 

borrowings and large deposits grew $41 billion. 

Implications: While the recent sharp rise in loan commitments suggests that loan production activity is 

increasing, it may not directly translate into loan balances on the books of insured institutions. 

Commitments for refinancings of existing debt or for 

loans originated for sale are two reasons for this rise. 

However, the increase in commitments does indicate 

that insured institutions have ample opportunities to 

book new business. Whether they will do so remains to 

be seen. Many institutions have looked to the secondary 

markets to sell new production rather than booking new, 

CHART 3 

Loss Rates in Securitized Credit Card 

Pools Show No Sign of Easing 

Gross Charge-Off % 

6.95 

0 

1 

2 

3 

4 

5 

6 

7 

8 

5/91 5/92 5/93 5/94 5/95 5/96 5/97 

Source: Fitch Investors Service 

Growth in Commitments Suggests 

Pickup in Loan Production Likely* 

111 

136 

100 

110 

120 

130 

140 

150 

6/94 12/94 6/95 12/95 6/96 12/96 

Unused Loan Commitments 

Loans Outstanding 

Source: Bank and Thrift Call Reports * Total Loans Excluding Credit Cards % of Base Year Outstanding 

Regional Outlook 19 Third Quarter 1997 
Regular Features Regional Banking
 

competitively priced business at relatively thin spreads, 

because of the higher costs associated with noncore 

funding. 

Spotlight on Derivatives 

Derivatives have received extensive media coverage over the 

past few years, primarily in a 

negative light, because of substantial losses incurred by some 

entities actively involved in the 

use of these instruments to 

enhance returns. Some mutual 

funds incurred substantial losses, and the share price of 

some money market funds dipped below the $1.00 per 

share value because of substantial derivative losses. 

(The $1.00 mark is considered a psychological barrier, 

below which consumers tend to lose confidence.) Many 

financial institutions realized a more significant decline 

than expected in the value of their holdings when rates 

rose sharply in early 1994. Nevertheless, most financial 

institutions appear to have used derivatives responsibly, 

generally to reduce exposures to various market risks. 

This section will focus on the derivative activities of the 

Region’s insured institutions. 

On-Balance-Sheet Items: Between 1991 and early 

1994, the Region’s insured institutions gradually began 

to shift their investment securities mix away from U.S. 

Treasury and mortgage pass-through instruments into 

mortgage derivative products such as collateralized 

mortgage obligations and real estate mortgage investment conduits. During this period, the percentage of 

total securities invested in mortgage derivatives 

increased from approximately 9 percent to 14 percent. 

This percentage has remained fairly constant since 

1994. 

Some evidence exists that investments in mortgage 

derivative products pose less risk now than in early 

1994, when rising interest rates illuminated the inherent 

risks associated with some of these investments. Insured 

institutions did not begin reporting “high-risk” mortgage-backed securities (MBS), as defined by the 

Federal Financial Institutions Examination Council, 

until March 1995. At that time, 48 institutions in the 

Region reported holding $354 million of high-risk 

MBS, 4 percent of total reported mortgage derivative 

investments. These holdings have declined steadily 

since, and as of March 31, 1997, 27 institutions (out of 

473) reported holdings of $111 million (down 69 percent), only 1 percent of total mortgage derivatives. 

Separate disclosure of structured notes (nonmortgage 

securities containing embedded derivatives) also was 

instituted with the March 1995 Call Report. At that 

time, nearly one-third of the Region’s institutions 

reported holding $1.4 billion of structured notes, 2 percent of total securities. Investment in these instruments 

has followed a pattern similar to that noted for high-risk 

MBS; they now total $583 million (down 59 percent), 

less than 1 percent of total securities. 

The downward trends noted in high-risk MBS and 

structured note investments, coupled with the stabilization of investment in mortgage derivatives, are partially 

related to the significant decline in the issuance of these 

instruments. However, the trends also suggest that 

insured institutions have consciously pulled away from 

derivative investments as understanding and awareness 

of the risk/reward relationships associated with them 

have improved. The improved earnings of the industry 

also may be a factor, as institutions appear less inclined 

to seek enhanced returns by taking on the additional 

risks imbedded in structured securities. 

Trends in the asset-backed securities (ABS) market and 

the composition of investment portfolios also suggest 

that insured institutions are not aggressively expanding 

investment in structured securities. As discussed in the 

second-quarter Regional Outlook, ABS issuance has 

been rising rapidly over the past three years. Insured 

institutions do not separately disclose ABS investments; 

they are typically reported as “other domestic debt securities.” Nationally, “other domestic debt securities” held 

by banks have declined 24 percent in volume over the 

past three years, from 4 percent to 3 percent of total 

securities. Similar trends are noted in the Region, where 

the decline has been 33 percent over the same period. It 

is difficult to ascertain the mix of “other domestic debt 

securities,” and it is possible that there has been a shift 

within this category toward ABS. However, the decline 

in “other domestic debt securities,” in both nominal dollars and as a percentage of total securities, suggests that 

most insured institutions have not aggressively entered 

the ABS market. 

Off-Balance-Sheet Items: The notional dollar amount 

of exposure to off-balance-sheet derivatives in the 

Region as of March 31, 1997, was $291 billion (bank 

Call Report filers only), 97 percent of which was concentrated in five institutions that actively trade offRegional Outlook 20 Third Quarter 1997 
Regular Features Regional Banking
 

balance-sheet derivatives. Interest rate contracts represented 59 percent of that total, foreign exchange 

accounted for 40 percent, and equity and commodity 

contracts comprised the remaining 1 percent. 

Approximately two-thirds of the total was held for trading. Excluding the five banking organizations that 

actively trade derivatives, 99 percent of the remaining 

organizations’ exposure was in a nontrading capacity. In 

all, 58 banking organizations (72 institutions) reported 

off-balance-sheet derivative exposures as of March 31. 

Since year-end 1992, the number of organizations entering into off-balance-sheet contracts has increased from 

7 percent of all organizations in the Region to 13 percent. Greater participation in these types of contracts 

seems to indicate a desire to manage exposure to market risk more effectively, as opposed to pure speculative 

activities. Interest rate contracts are the most commonly used derivatives. Of the 72 institutions holding derivatives, 59 held at least one form of interest rate contract 

(see Table 1). Excluding the five large trading organizations, 97 percent of the remaining organizations’ notional exposures are concentrated in interest rate contracts. 

TABLE 1 

The most common ways the Region’s insured institutions hedge exposure to interest rate volatility are 

through the purchase of options (38 institutions), predominantly caps and floors, and the use of interest rate 

swaps (31 institutions). Forward contracts are reported 

by 14 entities, many of which appear to be related to 

mortgage banking operations. 

Implications: The funding mix of the Region’s institutions is shifting to a greater reliance on market-based 

funding. This shift means that incremental asset growth 

is being booked at thinner spreads than in the past, with 

funds bearing higher rate sensitivity. Accordingly, it 

appears likely that institutions will continue using offbalance-sheet instruments as a means to protect and stabilize net interest margins. As long as these and other 

derivative instruments are used for hedging purposes 

and not for speculative purposes, the Region’s insured 

institutions will be better able to endure periods of 

increased interest rate volatility. 

Daniel Frye, Senior Regional Analyst 

Institutions Reporting Off-Balance-Sheet Derivatives as of March 31, 1997 

INTEREST FOREIGN ANY 

CONTRACT TYPE RATE EXCHANGE EQUITY COMMODITY EXPOSURE* 

FUTURES 

FORWARDS 

WRITTEN OPTIONS 

PURCHASED OPTIONS 

SWAPS 

3 

14 

7 

38 

31 

1 

9 

3 

3 

2 

1 

0 

12 

3 

0 

2 

3 

1 

1 

0 

5 

21 

18 

40 

31 

ANY EXPOSURE* 59 9 13 3 72 

TRADING CAPACITY* 9 9 6 2 17 

*Totals do not add due to duplications between classes and types. 

Source: Bank Call Reports 

Regional Outlook 21 Third Quarter 1997 


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