Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION FIRST QUARTER 2002 

FDIC
 

Boston
 

Region
 

Division of
 

Insurance
 

Daniel Frye,
 

Regional Manager
 

Norman Williams,
 

Regional Economist
 

Cameron Tabor,
 

Senior Financial
 

Analyst
 

Andrea Plante,
 

Economic Analyst
 

Regional Perspectives 

◆ Region’s Economic Conditions—The current recession is less severe than the 

downturn during the early 1990s; however, certain information technology industries 

have been affected more negatively by the recent weakness. Thus far, the housing sector 

has remained robust, but areas that recently experienced significant price appreciation 

may falter, especially if the recession continues. See page 3. 

◆ Rising Concentrations in Long-Term Assets Are Elevating the Interest Rate 

Risk Profiles of the Region’s Savings Institutions—Asset maturities continue to 

lengthen while liabilities remain short. Optionality is becoming a key funding issue, and 

measuring and projecting the sensitivity of nonmaturity deposits or retail CDs to rising 

rates will prove difficult. As a result, interest rate risk measurement and management 

are becoming more complex. See page 4. 

By the Boston Region Staff 

In Focus This Quarter 

◆ Housing Market Has Held Up Well in This Recession, but Some Issues Raise 

Concern—Recent trends in mortgage underwriting are of particular interest, as an 

estimated $2 trillion in mortgage debt, approximately one-third of the total outstanding, 

was underwritten during 2001. Nonconstruction residential mortgages traditionally 

have represented one of the better-performing loan classes during prior downturns. The 

level of credit risk, however, may be higher this time around because the mortgage lending business has changed since the last downturn. This article examines these changes, 

including increased involvement by insured institutions in the higher-risk subprime 

credit market, the acceptance of higher initial leverage on home purchases, and greater 

use of automated underwriting and collateral valuation processes, which have not been 

recession-tested. 

◆ Home price softening could have an adverse effect on residential construction and 

development (C&D) and mortgage portfolios. In the aggregate, the level of risk appears 

modest. However, insured institutions with significant C&D loan exposures in markets 

that experienced ongoing residential construction during 2001, despite slowing local 

economies, are at higher risk. Weakening home prices could hurt loan quality in selected markets. The San Francisco Bay area stands out as a place to watch in this regard. 

See page 9. 

By Scott Hughes, Regional Economist 

Judy Plock, Senior Financial Analyst 

Joan Schneider, Regional Economist 

Norm Williams, Regional Economist 

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

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

financial institutions and financial institution regulators. It is produced for the following eight 

geographic regions: 

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

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

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

Dallas Region (CO, NM, OK, TX)
 

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

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

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

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

The first and third quarter issues of the Regional Outlook feature in-depth coverage of the economy and the banking industry in each Region and consist of a national edition and eight regional editions. The second and fourth quarter issues are a single national edition that provides an overview 

of economic and banking risks and discusses how these risks relate to insured institutions in each 

FDIC Region. These issues tell the national story and, at the same time, alert the reader to specific 

trends and developments at the regional level. 

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 Donald E. Powell 

Director, Division of Insurance Arthur J. Murton 

Executive Editor George E. French 

Writer/Editor Kim E. Lowry 

Editors Lynn A. Nejezchleb 

Maureen E. Sweeney 

Richard A. Brown 

Ronald L. Spieker 

Publications Manager Teresa J. Franks 
Regional Perspectives
 

Regional Perspectives
 

•	 Home price appreciation continued throughout the Region during 2001, but moderated in some areas with 

higher-priced homes. 

•	 Long-term asset concentrations have grown significantly among the Region’s savings institutions, heightening exposure to rising interest rates. 

•	 Liability duration has not kept pace with the lengthening of assets; in response, institutions are relying more 

on managing core deposit costs as a way to mitigate interest rate risk during a rising rate environment. 

Region’s Economic Conditions 

Nation and New England Fall 

into Recession in 2001 

The New England economy slowed along with that of 

the nation through 2001; the ten-year economic expansion, the longest on record, ended in the first quarter. 

According to Economy.com, Connecticut and New 

Hampshire were in a recession, and the rest of the New 

England states were close to a recession as of year-end 

2001. The six states in the Boston Region reported 

unemployment rates below the national average as of 

December; however, rates have been rising since firstquarter 2001. Unemployment rates in Massachusetts, 

Maine, and New Hampshire have risen more than 1.5 

percentage points from record lows at the beginning of 

the year. Personal bankruptcy filings in the Region also 

continued to trend higher through third-quarter 2001.1 

The current economic environment in the Region differs 

from the recession of the early 1990s, when cyclical 

weakness was compounded by a downsizing defense 

industry and overbuilt commercial real estate sector. 

The current recession reflects a cyclical downturn, 

although certain white-collar industries, such as software and telecommunications, have been affected more 

significantly. A recent study conducted by Northeastern 

University reported that layoff announcements in Massachusetts have been concentrated among information 

technology (IT) companies, such as Cisco Systems, 

EMC, and Lucent Technologies.2 In fact, unemployment 

claims in the third quarter were rising three to five times 

faster in areas with concentrations in IT employment. 

Housing Market Pushes On 

The Region’s housing market is cooling but remains a 

faint bright spot in the economy. Growth in existing 

home sales in the Region was weak through thirdquarter 2001 compared with the nation, but remained 

positive. New home construction (measured by building 

permit issuance) slowed in the Region through 2001, 

following strong gains in the late 1990s. Vermont was 

the only state in the Region with an increase in new 

home construction over the past 12 months. 

Despite the softening economy, home price appreciation 

continued in metropolitan areas throughout the Region 

in 2001, suggesting that the weakness in sales was not 

due to a softening in demand. According to data reported for 14 of the Region’s metropolitan markets from the 

Office of Federal Housing Enterprise Oversight 

(OFHEO), only Hartford, Connecticut, experienced an 

increase in home prices that was slightly less than the 

national average of 8.3 percent through third-quarter 

2001. In fact, half the Region’s metropolitan areas 

reported double-digit increases in home prices over the 

period, following robust gains in 2000. The strongest 

appreciation occurred in the areas surrounding greater 

Boston—including Lawrence, Lowell, and Worcester, 

Massachusetts, and Manchester, New Hampshire— 

which have lagged Boston in the past. 

The Slowing Economy Has Affected 

Home Prices in Certain Towns 

1 The number of year-to-date filings through third-quarter 2001 was While aggregate home prices in the Region’s metropol­ 12 percent higher than one year ago. 

2 Boston Globe, itan areas continued to rise, certain pockets began to “State job losses soar; those who rode tech boom are 

hit hardest,” December 20, 2001. experience weakening conditions following years of 

Boston Regional Outlook 3	 First Quarter 2002 
Regional Perspectives 

gain. Town-level data provided by The Warren Group3 

for southern New England4 show that urban areas that 

prospered most during the late 1990s boom witnessed 

the largest gains in median home prices (see Map 1). At 

the same time, several towns in rural areas, such as 

western Massachusetts and northwestern Connecticut, 

experienced modest growth from 1995 to 2000. 

Through October 2001, however, price appreciation 

moderated in some areas that experienced rapid price 

appreciation over the past five years. Specifically, many 

towns in southwestern Connecticut and eastern Massachusetts—areas where employment is concentrated in 

finance or technology—showed little or no growth in 

median prices year-to-date through October 2001, 

while some registered declines in median prices compared with 2000. Some of the larger towns include 

Greenwich and Westport, Connecticut, and North 

Reading and Swampscott, Massachusetts. 

Moreover, anecdotal evidence suggests that prices of 

high-end homes in several towns have increased only 

moderately or even declined. Because the current 

downturn has affected the Region’s IT sector disproportionately, it has led to some price weakness in the 

market for high-end properties concentrated in these 

areas. This situation differs from the previous recession, when the market for starter homes and condominiums suffered more as manufacturing and other 

3 The Warren Group is a Boston-based publishing and information 

services firm serving professionals in real estate, banking, and commerce. 

4 Data are available for Massachusetts, Connecticut, and Rhode 

Island. 

MAP 1 

Most Pronounced Home Price Gains
 

during Late-1990s Tended to Be in 


Urban Areas with IT/Finance Clusters and
 

Vacation/Retirement Areas
 

Median Home Resale Price 

% Change, 1995–2000* 

(U.S. = 26%) 

> 2X U.S. > U.S. Decline 

average average 

* Data reported at town level are mapped by ZIP code. Only towns with at least 

ten sales transactions in both 1995 and 2000 were examined. 

Source: The Warren Group 

blue-collar industries bore the brunt of the downturn. 

As noted in the In Focus article, the Northeast is prone 

to volatile home prices and has experienced declines in 

affordability over the past five years; however, the fundamentals of the current housing market are stronger 

than during the previous recession. Residential real 

estate markets in the Boston Region have seen little 

speculative building, and there is a limited inventory of 

unsold homes. However, should the economic downturn continue for some time, softening in housing 

prices could become widespread. 

Rising Concentrations in Long-Term Assets Are Elevating
 

the Interest Rate Risk Profiles of the Region’s Savings Institutions
 

The volume of long-term assets held by the Region’s 

insured institutions has increased steadily since the mid1990s. While growth moderated following the refinancing boom of 1998, concentration levels are again on the 

rise as a result of a resurgence of refinancing activity in 

2001. For many of the Region’s insured institutions, the 

growing concentration of investment in long-term assets 

may be creating significant exposure to future increases 

in interest rates. This concern was addressed in the 

Boston Regional Outlook, Second Quarter 2000, and 

remains relevant today. This article evaluates recent 

trends and factors that are contributing to this growing 

exposure, as well as trends related to the funding side of 

the balance sheet that may complicate interest rate risk 

management. The rising exposure is particularly pronounced among the Region’s small savings institutions 

(total assets less than $1 billion). This article focuses on 

those institutions, which comprise nearly two-thirds of 

the Region’s insured institutions; however, many of the 

trends noted for these institutions are present in large 

savings banks and commercial banks as well, albeit to a 

lesser degree. 

Boston Regional Outlook 4 First Quarter 2002 
Regional Perspectives
 

Eroding Net Interest Margins Spur 

Investment in Longer-Term Assets 

It appears that a major contributing factor to the growing concentration in long-term assets is the persistent 

decline in net interest margins (NIMs) that has eroded 

earnings steadily over the past few years. For example, 

the median NIM for the Region’s savings institutions 

dropped 58 basis points from its 1993 peak to 3.54 percent for the nine months ending September 2001. In 

1994, only 15 percent of savings institutions reported a 

NIM of less than 3.5 percent (see Chart 1); that percentage had steadily increased to 48 percent by September 

30, 2001. 

It is interesting to note that during the last significant 

Fed easing in the early 1990s, savings bank NIMs 

improved considerably. Two deposit-related factors contributed to this improvement. Between 1992 and 1993, 

institutions departed from the previous industry practice 

of paying a fixed rate on savings and negotiable order of 

withdrawal (NOW) accounts. This change caused a significant one-time drop in funding costs. In addition, and 

perhaps more significant, the pricing mentality in New 

England changed as the banking crisis unwound. 

Between 1988 and 1990, the median deposit cost for the 

Region’s banks was approximately 60 basis points above 

the median for the rest of the country. By 1993, the 

median was 7 basis points below the median for the rest 

of the country. 

The ratcheting down of rates on savings and NOW 

accounts, combined with the unwinding of the competitive premium for deposits in the Region, provided a 

shot in the arm for savings and commercial banks alike. 

CHART 1 

Margins Continue to Slide in Region,s 

Savings Banks 

% of Savings 

Institutions with 

Net Interest Margins of: 

0 

20 

40 

60 

80 

100 

4.0% to 4.5% 

< 3.5% 

3.5% to 4.0% 

, , , , , , , , , 85 87 89 91 93 95 97 99 01 

Source: Bank and Thrift Call Reports 

These greatly improved margins allowed institutions to 

maintain a largely variable-rate asset mix, as there was 

no need to buffer margins by emphasizing higheryielding fixed-rate assets. Despite a significant refinancing wave during the early 1990s, the Region’s 

median ratio of long-term assets to earning assets 

remained fairly low and stable throughout the period. 

Unfortunately, in the current low rate environment, circumstances are vastly different. Nonmaturity deposit 

costs have been maintained at low levels since they were 

driven down in 1993. In fact, in that year, the federal 

funds rate averaged 3.02 percent and the median cost of 

savings deposits (including money market deposit 

accounts) for the Region’s banks was 2.87 percent. In 

2000, the federal funds rate averaged 6.24 percent and 

the median cost of savings accounts was only 2.89 percent; thus, these accounts had far less room to respond 

to the decline in interest rates than was the case in the 

early 1990s. Also, for the first nine months of 2001, the 

median deposit cost in the Region was 55 basis points 

below the median for the rest of the country. Thus, the 

Region’s insured institutions may find it difficult to 

boost margins by lowering offered rates, particularly on 

certificates of deposit, without risking deposit flight. 

As a result, many institutions are holding higheryielding, long-term, fixed-rate assets in an effort to keep 

margins from falling further. The current interest rate 

environment (steep yield curve) has created an even 

greater incentive to retain longer-term assets, as the 

reinvestment opportunities on the short end of the curve 

provide significantly lower returns than those that can 

be had by retaining long-term, fixed-rate, mortgagerelated assets. These efforts to protect the current earnings stream may place longer-term earnings at risk if 

interest rate risk management practices are not implemented to contain exposure to rising interest rates. Only 

10 percent of savings institutions reported that longterm assets exceeded 40 percent of earning assets in 

1995 (see Chart 2, next page). As of September 30, 

2001, more than half reported a similar concentration 

level, a clear indication of the extent to which asset 

duration has increased among the Region’s savings 

institutions. 

Banks Experience a New Refinancing Wave 

The record level of refinancing that occurred in fourthquarter 2001 (see Chart 3, next page) will likely result 

in higher long-term asset concentration levels in the 

Boston Regional Outlook 5 First Quarter 2002 
Regional Perspectives
 

CHART 2 

Long-Term Asset Concentrations Continue 

to Rise in Savings Banks 

% of Institutions with 

Long-Term Assets/ 

Earning Assets of: 

0 

20 

40 

60 

80 

100 

> 20% to 30% 

> 30% to 40% > 40% 

, , , , , , , , , , , 91 92 93 94 95 96 97 98 99 00 01 

Source: Bank Call Reports 

short term. As shown in the chart, nationally, only about 

20 percent of the dollar volume of new loans applied for 

in 2001 were adjustable-rate mortgages (ARMs). 

A recent increase in the loan amount for qualifying, 

conforming loans may extend the refinancing wave into 

2002 even without further rate cuts and may spur a large 

group of borrowers to refinance. The previous conforming limit of $275,000 was raised in January 2002, to 

$300,700. Fannie Mae and Freddie Mac estimate that, 

nationwide, 120,000 jumbo mortgages will refinance as 

a result of the increased limit.5 This increase in the 

jumbo limit is expected to be a factor in the Boston 

Region, particularly in portions of Massachusetts and 

Connecticut, where home prices are among the highest 

in the country. 

Borrower preference for fixed-rate loans continues to 

erode the ARM portfolios of small savings banks.6 In 

1997, the median percentage of ARMs to total residential first mortgages for these institutions was 64 percent. 

By September 2001, that percentage had fallen to 41 percent. While comparable data are not reported for thrifts, 

the median percentage of ARMs to total mortgagerelated assets (including passthrough mortgage-backed 

securities) fell from 60 percent in September 1996 to 36 

percent by September 2001. Residential loans make up 

the largest share of earning assets for small savings 

banks, and the significant shift from adjustable- to fixedrate loans has contributed to the asset extension reflected in Chart 2. Borrower preference for fixed-rate loans 

5 “Few See Rerun Soon of GSEs’ Cap Hike,” American Banker,
 

December 10, 2001.
 

6 Call Filers only—excludes savings and loans (thrifts).
 

has resulted in a significant lengthening of nonresidential portfolios as well. 

The tremendous volume of refinancing activity over the 

past few years has been dominated by fixed-rate origination. Institutions have been faced with the decision 

either to book the long-term loans or sell them and reinvest the proceeds in shorter-duration investments, which 

would put downward pressure on earnings. Rather than 

hold the loans in portfolios that were becoming heavily 

concentrated in fixed-rate loans, many institutions securitized the loans and retained them as securities to bolster asset yields. The decision to hold these assets has 

contributed to the rising concentration in long-term 

assets. As of September 30, 2001, the median percentage of mortgage passthrough securities that mature or 

reprice in five years or more was 88 percent for small 

savings institutions, compared with 43 percent in 1997. 

In addition, the median percentage of all other debt 

securities with a comparable repricing horizon increased 

from 7 percent to 20 percent over the same period, suggesting that the securities portfolios are not being managed actively to mitigate the rising interest rate risk in 

the loan portfolios. 

Liabilities Come Up Short 

While the balance sheets of insured institutions have 

shifted toward longer-term assets, the liability side consists of relatively short-term instruments. Seventy-five 

percent of time deposits in the Region’s savings institutions mature or reprice in one year or less. This percentage has risen over the past few years, as customers have 

become less willing to invest in longer-term instruments, 

CHART 3 

0 

10 

20 

30 

40 

50 

60 

,

91 ,93 ,95 ,97 ,99 ,

% of Conventional Applications 

01

in ARMs ($ basis) 

0 

1,000 

2,000 

3,000 

4,000 

5,000 

Conventional Refinance Index 

(Seasonally Adjusted, 3/16/90 = 100) 

Source: Mortgage Bankers Association of America 

Share of Adjustable-Rate Mortgages Decreased 

as Refinancing Wave Took Hold in 2001 

Share in ARMs (L) 

Refi Index (R) 

Boston Regional Outlook 6 First Quarter 2002 
Regional Perspectives
 

particularly when yield spreads (over U.S. Treasuries) 

offered by shorter-term instruments have become more 

favorable than those for longer-term instruments. 

Savings institutions have tried to increase the duration of 

liabilities by extending the maturity of borrowings. As 

of September 30, 2001, 51 percent of all other borrowings were reported to mature or reprice in three years or 

more, an increase from 14 percent in 1997. However, 

this lengthening of maturities may not be reducing exposure to higher interest rates. Longer-term borrowings 

may contain options that allow the issuer to call the 

advances when interest rates rise. The Federal Home 

Loan Bank (FHLB) of Boston is the primary source of 

term borrowings for the Region’s savings institutions. 

The FHLB’s 2000 Annual Report indicates that, as of 

year-end 2000, approximately 63 percent of outstanding 

advances with a remaining maturity of three years or 

more could be redeemed early (at the FHLB’s option), 

with most callable within one year. This suggests that a 

high percentage of the longer-maturity borrowings 

reported on Call Reports are, in effect, short-maturity 

liabilities in the event of a rising rate environment and 

do little to offset the rising interest rate risk that may 

accompany increased long-term asset concentrations. 

Another area in which option risk may be rising is in 

certificates of deposit (CDs). In the current interest rate 

environment, new CDs are being written at historically 

low interest rates; therefore, existing prepayment penalties may not be sufficient to deter customers from 

redeeming CDs in a rising rate environment. A modest 

increase in rates may be all that is necessary to negate 

the penalty and trigger a redemption. An evaluation of 

prepayment penalties may be worthwhile in light of the 

low rates being paid on new CDs. 

As noted in our previous article on interest rate risk, 

there appears to be little change in the maturity structure 

of on-balance-sheet liabilities to offset the continued 

growth of long-term assets. From an off-balance-sheet 

perspective, 7 percent of small savings institutions continue to report some use of interest rate derivatives (primarily interest rate swaps and options). This percentage 

has stayed fairly constant since long-term asset concentration levels began to rise in the mid-1990s. 

While rising interest rate risk can be mitigated through 

active management of securities portfolios, extension of 

funding sources, or off-balance-sheet mechanisms (such 

as interest rate swaps), these options come at a cost that 

could pressure already deteriorating margins. However, 

it will be very difficult to correct existing imbalances 

through the normal course of business in a reasonably 

short time. Prepayment rates on the long-term assets 

booked over the past few years are likely to be modest 

and, in a rising rate environment, are likely to slow considerably. The ability to control funding costs when 

interest rates rise is paramount, but it may prove difficult. As mentioned previously, CDs may offer only a 

limited means of holding down rates because of the 

already low prevailing rate environment in the Region 

relative to the rest of the country and the higher level of 

competition for this type of funding. 

Nonmaturity deposits are a significant portion of 

interest-bearing liabilities. Rates paid on these deposits 

historically have not been as volatile as those paid on 

borrowings and time deposits, particularly in a rising 

rate environment. However, in such an environment, 

institutions that lag the market are more likely to lose 

balances as funds move into better-yielding instruments, 

either within the institution or elsewhere. Under either 

scenario, costs to the institution rise. Clearly, sensitivity 

exists to interest rate movements, no matter what pricing 

philosophy an institution adopts. The question is how 

much sensitivity? Customer behavior is difficult to predict, and an overreliance on management of core deposit 

costs to mitigate interest rate risk may prove problematic for some institutions. 

Conclusion 

Clearly, interest rate risk is rising among the Region’s 

savings institutions. Asset maturities continue to lengthen, while liabilities remain short. Optionality is becoming a key funding issue, and measuring and projecting 

the sensitivity of nonmaturity deposits or retail CDs to 

rising rates will prove difficult. As a result, interest rate 

risk measurement and management are becoming 

increasingly complex. 

As mentioned in the Boston Regional Outlook, Second 

Quarter 2000, interest rate risk management must 

ensure that an institution can weather conditions that 

can reasonably be expected to occur. A sharp rise in 

short-term rates of up to 400 basis points has not been 

particularly uncommon in the past; on the basis of the 

current level of short-term rates, the possibility of a significant rise should not be underestimated. A modest 

rise in long-term rates at the same time would dampen 

prepayment speeds on long-term assets significantly. In 

such a scenario, many institutions likely would suffer 

Boston Regional Outlook 7 First Quarter 2002 
Regional Perspectives
 

further margin erosion—some significantly. Steps cer­ turn, risk reduction strategies may be much more diffitainly can be taken to mitigate some of the risk; howev­ cult to implement. 

er, there will be a trade-off between short-term profits 

and long-term earnings stability. Now is a good time for 

institutions to take action. When the rate cycle begins to By the Boston Region Staff 

Boston Regional Outlook 8 First Quarter 2002 
In Focus This Quarter
 

Housing Market Has Held Up Well in This 


Recession, but Some Issues Raise Concern
 

Trends in housing markets are important performance 

drivers for many FDIC-insured institutions. The health of 

residential markets can affect the credit quality of residential mortgage loans, home equity loans, and loans to 

finance residential construction and is linked indirectly to 

the performance of other types of consumer and smallbusiness debt. Further, an estimated $2 trillion in mortgage debt, approximately one-third of the mortgage 

market, was underwritten during 2001, with 56 percent of 

this activity in refinancing transactions.1 This activity 

makes recent trends in underwriting of particular interest. 

An ancillary issue for many mortgage lenders, interest 

rate risk, is not addressed in this article.2 

The U.S. economy entered a recession in March 2001, 

and the question arises as to how consumer creditworthiness, housing values, and recent mortgage-lending 

practices will fare during this downturn. Developments 

contributing to increased credit risk include higher consumer debt burdens, looser mortgage loan underwriting 

standards, and the emergence of subprime mortgage 

lending as a significant line of business for some banks. 

Mitigating this risk has been the steady appreciation of 

home prices, which have shown signs of softening in 

some markets but not to the extent seen at a comparable 

stage in previous recessions. 

Home price weakness may be more pronounced in 2002 

as the effects of the recession take hold, but in the 

authors’ judgment, systemic weakness in home prices is 

unlikely, absent a deep and long recession. Adverse mortgage lending trends are not expected to threaten the capital or earnings of the vast majority of insured 

institutions. Nonconstruction residential mortgages, even 

during the most pronounced periods of stress in the 1980s 

and early 1990s, remained the best-performing loan 

class, especially for lenders specializing in residential 

real estate; and, historically, these mortgages have been 

1 Mortgage Market Forecast, www.mbaa.org/marketdata/forecasts/,
 

January 2002.
 

2 For a discussion of this issue, see “Regional Perspectives,” Boston
 

and Chicago Regions, Regional Outlook, First Quarter 2002.
 

one of the lowest credit-risk loan types for all manner of 

insured institutions.3 

That said, however, there are pockets of risk for 

insured institutions. There is evidence that borrowers 

with weak credit may be experiencing greater repayment difficulties, elevating the risks faced by subprime 

mortgage lenders. Further, a slump in residential real 

estate markets could be especially detrimental to 

insured institutions with significant exposures to 

housing construction because projects might not sell at 

projected asking prices or as quickly as anticipated. 

Finally, in specific markets where housing prices may 

have achieved unsustainable levels, some increase in 

housing-related credit quality problems can be expected, and in this regard, the San Francisco Bay area 

stands out as a place to watch. 

The Recession Thus Far Has Had 

a Minimal Impact on Mortgage 

Delinquencies at Insured Institutions 

Despite three quarters of recession, most housing indicators remained quite healthy this past year relative to 

trends seen in past recessions. For example, new and 

existing home sales both set records during the year, 

while new home construction failed to decline, an 

occurrence not seen in the past six recessions. Another indicator, year-over-year growth in existing home 

prices—as measured by either the Office of Federal 

Housing Enterprise Oversight (OFHEO) repeat sales 

price index or the National Association of Realtors 

(NAR) median single-family price statistic—showed 

deceleration but remained well above trends seen at 

similar points in past recessions. This behavior partly 

reflected the early robustness of household income in 

the face of recession and relatively low fixed mortgage 

rates during 2001, which helped to counter some of the 

3 See “Region’s Insured Institutions Exhibit Lower Risk Profile than 

the Nation’s, Appendix: Risk-Weighting Methodology,” Table A in 

Boston Region, Regional Outlook, First-Quarter 2000. 

Boston Regional Outlook 9 First Quarter 2002 
In Focus This Quarter
 

CHART 1 CHART 2 

Through September 2001, Mortgage-


Related Delinquencies Remained Modest
 

Although the Much Larger Market for 

Existing Homes Has Held Up, New Home 

Prices Are Under Pressure 

Percentage Change from

Prior Year 

Sources: Census (new), National Association of Realtors (Existing) 

Existing 

New 

–10 

–5 

0 

5 

10 

15 

20 

,

79 ,81 ,83 ,85 ,87 ,89 ,91 ,93 ,95 ,97 ,99 ,

01 

Percentage 

30+ Days Past Due 

0 

2 

4 

6 

8 

10 

12 

,

91 ,93 ,95 ,97 ,99 Sep ,

01 

0 

1 

2 

3 

4 

5 

6 

Percentage 

30+ Days Past Due 

95th Percentiles (R) 

mortgages equity lines 

75th Percentiles (L) 

NOTE: Sample consists of banks with at least $1 million in equity lines 

or mortgages that are also at least 5 percent of bank's Tier 1 capital. 

Source: Bank and Thrift Call Reports 

initial adverse effects of the recession on housing 

demand. 

One sign of potential weakness appeared late in 2001 

in the modest year-over-year decline in median prices 

of new single-family homes (see Chart 1). Because 

existing home sales outnumber new home sales roughly fivefold, price trends in the latter are generally not 

predictive of prices for the much larger existing home 

market.4 However, as discussed later in this article, 

adverse pricing trends in the new home segment do 

raise concerns for residential developers and insured 

institutions that finance residential construction. 

The steady increase in prices of existing homes depicted in Chart 1 masks considerable regional variation. 

As detailed later in this article, home price growth 

began to weaken in 2001 in a number of metropolitan 

statistical areas (MSAs). While there is no clear common denominator among the markets in which this 

occurred, a number of these markets had both extremely rapid home price growth in the recent past and significant slowdowns in employment growth or outright 

contractions in employment last year. 

Credit quality indicators for insured institutions’ mortgage loans have shown only preliminary signs of 

weakness thus far. Through the first nine months of 

2001, insured institutions showed negligible advances 

in median past-due ratios for mortgages and equity 

4 Existing home prices are also more reflective than new home prices 

of trends in broader economic indicators, such as aggregate per capita personal income. 

lines of credit, although continued strong mortgage 

origination activity in 2001 may have masked (in the 

aggregate) developing credit problems for more seasoned mortgage loans. For institutions that held at 

least $1 million in residential mortgages or home equity lines of credit and whose exposures comprised at 

least 5 percent of Tier 1 capital, some modest deterioration is evident in the worst-performing mortgages 

and home equity lines since 1999, as seen in Chart 2.5 

Even if this recession lingers, worsens, or both, residential mortgage lending (nonconstruction and development-related) likely poses only modest risk to most 

insured institutions’ earnings and capital, since it has 

held up better in prior recessions than other loan types. 

What Are the Risks Facing Housing 

Lenders in 2002 and Beyond? 

In an environment of significantly slower economic 

growth than prevailed during the 1990s, can the 

strength of housing prices and the relatively benign 

credit quality environment for housing lenders be 

expected to continue? The answer will depend on the 

interplay of economic conditions and lenders’ risk profiles. In the remainder of this article, we discuss the 

gradual increase in the risk profile for insured mortgage lenders that appears to have occurred during the 

5 It is interesting to examine the (adverse) tail of the credit quality distribution when looking at residential mortgage trends, as average and 

median past-due ratios move little and are typically very low—thus, 

only the highest 25th and 5th percentiles of past-due ratios are presented in Chart 2. 

Boston Regional Outlook 10 First Quarter 2002 
, UT

Miami– 

y, NY

Phoenix, AZ

, NV–AZ 

, MO–IL 

Tucson, AZ

Oklahoma City

, NY

, OK 

Kansas City

Tulsa, OK

, MO–KS

, NC–SC 

mingham, AL

, TN-AR–MS

Honolulu, HI

, SC 

Entire Nation

, FL

e City

alo

ville

 Lauderdale

Alban

Buff

 Louis

Green

egas

lotte

Salt Lak

Memphis

Las V

Char

St.

Bir

Ft.

In Focus This Quarter
 

1990s, as well as some cyclical risks to their performance that may exist as the recession plays out. 

Evolving Lending Practices Have Increased 

the Risk Profile for Mortgage Lenders 

Although history suggests that residential mortgage 

defaults will be relatively low even in a recession, 

changes in the mortgage market since the 1990–1991 

recession could affect mortgage performance during the 

present downturn. Many underwriting changes over the 

past decade have been driven in part by the growing 

importance of the secondary market for mortgage debt, 

and of Fannie Mae and Freddie Mac in particular. In 

1980, federal and related agencies had direct or indirect 

interests in approximately 17 percent of all mortgage 

debt.6 By 2000, their share of the mortgage market had 

increased to roughly 41 percent. Insured bank and thrift 

mortgage exposures grew over the same period, but, as 

a share of direct mortgage debt, bank and thrift mortgage holdings decreased from 59 to 35 percent. These 

trends notwithstanding, insured institutions still provide 

substantial funding, directly or indirectly, to the housing 

market: as of September 30, 2001, 1 to 4 family mortgage loans and mortgage-backed securities held by 

insured institutions aggregated $2.3 trillion, up 37 percent from five years earlier. 

Although an active secondary mortgage market has 

broadened homeownership, improved mortgage loan liquidity, and allowed insured institutions to allay credit 

risk, it has also heightened market competition and transformed the lending process. In presecondary market 

CHART 3 

1993 2000 

days, lenders largely had to retain originated mortgages 

in their own portfolios. Consequently, only lenders with 

ready funding sources (such as banks, thrifts, and insurance and finance companies) were able to compete in the 

mortgage markets. The advent of the secondary market 

enlarged the pool of available funding and permitted both 

insured institutions and other originators to transfer their 

mortgage business readily into entities such as mortgage 

pools and trusts. Consequently, many new players, 

including on-line and brick-and-mortar mortgage brokers, have entered the mortgage origination market. 

The resulting robust mortgage loan competition, combined with Internet-based consumer research tools, has 

led to considerable commodification of the mortgage 

market. Rather than competing on the basis of traditional 

relationships, lenders’ market shares are increasingly 

driven by price. For smaller savings institutions that focus 

heavily on residential mortgage underwriting, this issue 

has likely elevated business risk. Heightened competition 

has caused some loosening of mortgage underwriting 

standards and pushed lenders to use technology to expedite and streamline the underwriting process. Consequently, credit-scoring mechanisms and automated 

valuation techniques currently in place have not been 

tested through a full credit cycle. Because pricing competition has pressured margins, some mortgage lenders 

have pursued subprime or high loan-to-value (HLTV) 

mortgages. The ability of insured institutions to mitigate 

subprime losses through an economic downturn is untested to a large extent as well—finance companies dominated the high-risk mortgage market in past recessions. 

High Loan-to-Purchase Price Ratios Are Increasingly Common in Some Metro Areas 

Percentage of Mortgages with Loan-toPurchase Price Ratios Exceeding 90 Percent 

60 

40 

20 

0 

Source: Federal Housing Finance Board 

6 These interests include residential, commercial, and farm real estate debts held directly by, or held in mortgage pools or trusts issued by, federal 

and related agencies. Source: Table 1186, Statistical Abstract of the United States: 2001, page 733. 

Boston Regional Outlook 11 First Quarter 2002 
In Focus This Quarter
 

In general, mortgage underwriting standards have loosened industrywide over the past decade. For instance, 

lenders have increasingly accepted higher loan-topurchase price (LTPP) ratios for purchase money mortgages.7 According to the Federal Housing Finance 

Board, LTPP ratios are high and have risen in several 

metropolitan areas over the past seven years (see Chart 3). 

Between 1993 and 2000, the Honolulu, Tulsa, and Tucson markets exhibited the largest increases in mortgages 

with LTPP ratios exceeding 90 percent. 

Although lenders often mitigate the risk of loss associated with low downpayments by requiring private mortgage 

insurance (PMI), recently the mortgage industry has 

allowed borrowers to avoid purchasing PMI. In particular, 

“piggyback” financing has made homeownership 

increasingly possible for households that cannot afford 

the traditional 20 percent down payment or do not wish to 

pay for PMI. With piggyback financing, the borrower 

often arranges a conforming 80 percent LTPP first mortgage and finances a portion of the remaining 20 percent 

with a concurrent second mortgage on the property (e.g., 

“80-10-10”). This type of transaction has become popular 

because interest paid on the (albeit more expensive) second mortgage is tax-deductible, whereas PMI premiums 

are not. Thus, piggyback financing is probably most 

attractive to individuals in higher-cost/tax areas or higher 

tax brackets, such as those in the Northeast and California. This trend effectively shifts the first loss position 

on all low down payment loans to the lender that 

retains the junior position. These institutions are, of 

course, compensated for some of this risk with the 

higher interest rates charged on the piggyback portion 

of these mortgages. 

Competitive factors have prompted the industry to 

enhance underwriting automation. As part of the push, 

credit scoring has become a routine part of the credit 

analysis process, and, increasingly, lenders are using 

automated valuation models (AVMs) to determine collateral coverage. However, credit scoring and collateral valuation models have been in popular use only 

since the 1990–1991 recession; consequently, their 

predictive ability in a downturn is uncertain. Although 

some have touted AVMs as the answer to appraisal 

fraud, the ability of statistical models to simulate the 

qualitative judgments considered critical to traditional 

appraisals is unknown. Paper appraisals reportedly 

7 Purchase money mortgages are loans extended solely for the initial 

purchase of a home. Statistics on loan-to-value ratios for supplemental home equity loans/lines (e.g., piggyback or “80-10-10” financing), as well as refinanced mortgages, are not readily available. 

continue to dominate the industry; however, recently, 

the two largest government-sponsored enterprises have 

begun accepting AVMs in lieu of standard appraisals 

for loans under $275,000.8 For lenders that specialize 

in HLTV mortgages, there is less room for error with 

AVMs. 

Cyclical Weakness Is Already Apparent 

in Subprime Mortgage Lending 

Historically, certain insured institutions have made 

mortgage loans with narrow collateral margins or to 

borrowers with limited or blemished credit histories. 

However, significant entry by FDIC-insured institutions into mortgage lending to borrowers with weak or 

marginal credit, as a targeted line of business, generally has occurred only since the early 1990s. These 

“subprime” mortgages are neither defined nor reported on Bank Call Reports. As a result, gauging the 

extent of bank involvement in subprime lending at any 

point in time is difficult. However, the FDIC estimates 

that fewer than 1 percent of all insured institutions 

have significant subprime residential mortgage exposures. Nevertheless, according to some measures, subprime mortgages as a share of total mortgage 

originations peaked at 13 percent in early 2000, before 

moderating somewhat during the first three quarters of 

last year.9 Thus, a much larger number of institutions 

probably have some limited involvement in subprime 

mortgage lending. A survey by the Minneapolis Federal Reserve Bank found that 29 percent of banks in 

the Minneapolis District offered loans to low-credit 

quality consumer borrowers in 1999.10 

Subprime mortgage loan performance appears to have 

deteriorated notably during 2001. One source of support for this observation comes from delinquency 

trends on Federal Housing Agency (FHA)-insured 

mortgages, which are often granted to first-time homebuyers with troubled credit histories and borrowers 

with low down payments. The Mortgage Bankers 

Association reports that while the national delinquency rate on conventional mortgages rose 58 basis points 

in the year ending third-quarter 2001, the delinquency 

rate on FHA mortgages shot up by 234 basis points, to 

11.4 percent (see Chart 4). This growing gap between 

8 “Automated Appraisals Require Caution by Lenders,” American 

Banker, October 10, 2001. 9 Based on dollar volumes, data from Inside Mortgage Finance Publications, Bethesda, MD. 

10 Ron Feldman and Jason Schmidt, “Why All Concerns About Subprime Lending Are Not Created Equal,” Fedgazette, Minneapolis 

Federal Reserve, July 1999. 

Boston Regional Outlook 12 First Quarter 2002 
In Focus This Quarter
 

CHART 4 

Recent Mortgage Delinquencies for HigherRisk Loans Reached All-Time Highs 

Percentage of Mortgages

30+ Days Past Due

FHA 

Conventional 

,

79 ,81 ,83 ,85 ,87 ,89 ,91 ,93 ,95 ,97 ,99 ,01 

0 

2 

4 

6 

8 

10 

12 

Source: Mortgage Bankers Association 

delinquency rates on conventional and governmentinsured mortgages suggests that marginal and subprime borrowers are facing growing repayment 

difficulties. 

A database of more than 6.5 million subprime loans 

tracked by Loan Performance Corporation (formerly 

Mortgage Information Corporation) reported similar 

trends. The nationwide third quarter 2001 ratio of seriously delinquent subprime mortgages was 7.3 percent, up 

from 5.5 percent one year earlier.11 Moreover, subprime 

delinquencies significantly exceeded those found among 

prime mortgages, as just under 0.5 percent of conventional prime mortgages were seriously delinquent.12 Also 

of possible concern are vintage data trends, which show 

how pools of primary and junior-lien subprime mortgages perform over time. Mortgages originated in 2000 

are performing poorly in relation to previous years’ vintages.13 This simply could reflect the impact of the current 

recession. Alternatively, Loan Performance Corporation 

analysts have suggested that the 2001 refinancing boom 

might have created some adverse selection in mortgage 

pools originated during the relatively higher interest rate 

environment of late 1999 and early 2000.14 Because high11 The Market Pulse, Loan Performance Corporation (formerly Mortgage Information Corporation), Winter 2001 and Fall 2001. 

12 The Market Pulse, Loan Performance Corporation, Fall 2001. 13 Per Loan Performance Corporation delinquency data, subprime primary mortgages originated in 2000 displayed higher delinquency 

ratios for their age compared with similarly seasoned subprime loans 

originated in 1996, 1997, 1998, or 1999. Moody’s second-quarter 

2001 Home Equity Index Update found the same to be true of subprime home equity loans. 

14 “Another Look at the 2000 Book,” The Market Pulse, Loan Performance Corporation (formerly Mortgage Information Corporation), 

Winter 2001. 

er-coupon and variable-rate loans comprised a significant 

share of mortgage originations during that period, overall 

prepayment rates on the 2000 vintage might have been 

unusually high during 2001. Consequently, the best-quality loans in the 2000 pool might have refinanced, leaving 

loans of lesser credit quality behind and elevating the 

residual delinquency experience in that pool. 

Given these trends, an important issue for subprime 

lenders is their ability to anticipate and plan for the 

impact of an economic slump on their operations. Some 

institutions clearly adopt subprime lending as part of an 

overall business strategy, setting up monitoring and collection departments geared to dealing with such loans. 

Among large, national lenders, for example, one institution that makes 5 to 10 percent of its loans to subprime 

borrowers recently provided additional resources to its 

loan services and default management departments. This 

action followed a period when one-third of its increase in 

nonperforming single-family mortgage loans was associated with loans to subprime borrowers.15 

C&D Lending Risks May Be Elevated in MSAs 

with Potential Supply/Demand Imbalances 

Historically, lending to finance housing construction is 

riskier than mortgage lending on existing structures. 

Insured institutions report construction and development 

(C&D) lending in a single category that includes both 

commercial and residential construction. While it is thus 

impossible to ascertain from quarterly call reports the 

extent of bank involvement in financing housing construction, anecdotal evidence suggests that, although 

smaller insured institutions engage to some degree in 

commercial property development, their C&D lending 

largely finances single-family construction. If markets 

with an oversupply of housing see weaker economic performance, insured institutions engaged in financing residential real estate development may be at risk. This could 

result in an increase in C&D loan delinquencies, losses, 

and other-real-estate-owned (OREO). 

Demand for housing can be affected by two distinct 

trends: secular, or longer term; and cyclical, or shorter 

term. Over the long term, demographic trends, such as 

population growth rates and concentrations of households by age cohort, can affect overall demand for housing, as well as the types of homes demanded. Demand in 

local housing markets also can be affected by more cyclical factors such as recent changes in economic 

15 Calmetta Coleman, “Default Worries on Home Loans Escalate as 

Lenders Report Delinquency,” Wall Street Journal, October 29, 2001. 

Boston Regional Outlook 13 First Quarter 2002 
In Focus This Quarter
 

conditions, including interest rates. New supply of homes 

in local housing markets is produced in response to perceived or estimated future demand. Correct interpretation 

of market and economic signals is critical to the success 

of builders in metropolitan areas; however, this activity is complicated by the lags associated with developing, permitting, and constructing properties. The effect 

of overestimating future demand could be multiplied if 

several builders inaccurately gauge changes in 

demand. Consequently, a construction market with 

numerous smaller developers, such as Atlanta, may 

see amplified swings in construction activity and may 

experience excess supply during certain periods. 

Although conceptually straightforward, measuring the 

balance between housing demand and supply is challenging, particularly at lower geographic levels. Shortcomings in data availability, quality, and timeliness 

can limit the effectiveness of this type of analysis. As 

already mentioned, some insight about current housing 

market conditions in specific metropolitan areas may 

be gained by analyzing both secular and cyclical 

trends. However, given the onset of recession last year, 

the role of cyclical factors is of prime concern at this 

time. 

To measure the cyclical aspect of the relationship 

between a market’s supply and demand, some analysts 

rely heavily on the concept of employment-driven 

demand.16 Such analysis involves tracking a demand/ 

supply ratio based on employment growth and permit 

issuance. Areas where permitting activity continues to 

accelerate while employment levels decrease may produce an increasing imbalance in the local housing 

market.17 

Using a simplified version of employment-driven 

demand, we identified a number of metropolitan areas 

as being at risk for a rising imbalance in their housing 

markets (see Chart 5), the largest of which are Chicago, Greensboro (NC), Minneapolis, Phoenix, Portland (OR-WA), St. Louis, and, most notably, Atlanta. 

These markets are displaying signs that residential 

16 For example, see www.myersgroup.com. 17 This approach, although more reflective of recent economic events 

than perhaps more secular measures, is not without its drawbacks. For 

example, employment data from the Bureau of Labor Statistics’ establishment survey are frequently revised, and, consequently, employment-driven demand may need to be reexamined. 

CHART 5 

–120 

–100 

–80 

–60 

–40 

–20 

20 

40 

60 

(5,000) (2,500) 2,500 5,000 

December 2001 Year-to-Date Permits 

(Year-Ago Change) 

December 2001 Employment

(Year-Ago Change, Thousands) 

Sources: Bureau of Labor Statistics, U.S. Census Bureau (Haver Analytics) 

Some Larger MSAs Continued to See 

Permit Growth during 2001, despite 

Declining Employment 

0 

Greensboro, 

Minneapolis, 

& St. Louis 

Chicago 

Atlanta 

Portland, OR–WA 

Phoenix 

construction activity may not be responding in kind to 

local economies that have started to contract during 

this recession. Further, Phoenix, Portland, and Atlanta 

were identified previously as banking markets exhibiting elevated risk profiles.18 

Chart 6 displays the level (y axis) and trend (x axis) in 

C&D lending exposures for the top 25 MSAs by median C&D concentration as a share of assets.19 It is 

apparent that some markets identified in Chart 5 as 

having significant banking exposure to C&D lending 

also may have a cyclical imbalance in home building. 

Atlanta, for example, demonstrates one of the highest 

exposures, with a ratio of median C&D to total assets 

of 17 percent in third-quarter 2001, a roughly 100­

basis-point increase from year-end 2000. In other 

words, while employment-driven demand has softened 

in the metropolitan area, single-family construction 

activity has continued, and community bank lenders 

may have increased their level of residential financing 

commitments. 

Cyclical Risks May Be Developing 

with Respect to Home Prices 

Popular comparisons have been made recently 

between the healthy run-up in housing prices during 

18 See “In Focus This Quarter,” Regional Outlook, Fourth-Quarter 

2001. 

19 We considered only MSAs that had at least six locally headquartered community banks that engaged in C&D lending activity and 

then charted the top 25 MSAs ranked by September 2001 median 

C&D/assets. 

Boston Regional Outlook 14 First Quarter 2002 
In Focus This Quarter
 

CHART 6 

Some Banking Markets Are Seeing Rising Construction and Development (C&D) 

Exposure Coupled with Potentially Growing Supply/Demand Imbalances 

Sources: Bank Call Reports, Bureau of Labor Statistics, U.S. Census Bureau (Haver Analytics) Median C&D Loans-to-Assets (Third-Quarter 2001, %) 

0 

5 

10 

15 

20 

25 

30 

Change in Median C&D Loans-to-Assets 

(Percentage Point Change, from Fourth-Quarter 2000 to Third-Quarter 2001) 

–2 0 2 4 6 8 10 

Salt Lake City 

Atlanta Provo-Orem, UT 

Stockton, CA 

Greensboro 

Portland, OR–WA 

Phoenix 

MSAs with declining employment

 but rising permitting during 2001 

the past several years and the technology stock-fed 

speculative “bubble” in equity prices that persisted 

through early 2000. The subsequent bursting of this 

bubble and the resulting economic distress have raised 

concerns of a sequel featuring housing prices. 

According to the OFHEO repeat sales price index, 

there has never been an instance of outright declines in 

aggregate U.S. existing home prices.20 However, home 

prices do exhibit strong cyclical tendencies, with the 

rate of appreciation slowing during national recessions. In addition, there have been some decidedly 

CHART 7 

negative episodes during the past few decades in various metropolitan markets. At the national level, existing-home price growth historically has followed trends 

in population-adjusted personal income growth,21 and 

some have pointed to a growing imbalance between 

the two as a sign that home prices may weaken as the 

effects of the recession take hold (see Chart 7). 

Given that home price bubbles have occurred in the 

past, most notably in Texas, California, and the Northeast during the 1980s, and that their ultimate deflation 

MAP 1 

Change on Year Ago (%) Note: E=estimate 

Sources: OFHEO, U.S. Census Bureau 

The Widening Gap between Home Price and 

Income Growth Has Raised Some Concern 

Per Capita Income 

Home Price Index 

’85 ’87 ’91 ’93 ’97 ’01E ’89 ’95 ’99 

0 

2 

4 

6 

8 

10 

Drops in Affordability since the Mid-1990s
 

Are Most Prevalent in California 


and the Northeast
 

Top 10 percent of
 

MSAs ranked by decline
 

in affordability index, 1996
 

to 2001 (through June)
 

NOTE: Anchorage, AK, is included, but not shown. 

Source: Economy.com 

20 According to the National Association of Realtors’ U.S. median price, a few episodes of price declines (on a quarterly, year-ago basis) are present in the time series—specifically first- and second-quarter 1989; fourth-quarter 1990; and first-quarter 1993—only the 1990 episode occurred
 

during a recession. Also, as shown in Chart 1, U.S. median new home prices have experienced meaningful declines.
 21 This relationship is generally true at the metropolitan level as well.
 

Boston Regional Outlook 15 First Quarter 2002 
In Focus This Quarter
 

resulted in significant negative fallout for these areas’ 

economies and insured institutions, it is useful to look 

at these historical examples as a potential “worst-case” 

scenario (with very low probability) for residential 

real estate markets during the current recession. It is 

unlikely that significant, systemic risks from home 

price bubbles have arisen yet for residential lenders. 

Of course, this situation could change if the current 

recession deepens or is protracted, or if growth during 

the subsequent recovery is anemic. Further, national 

trends can obscure dramatic variations in local markets, and a handful of MSAs today are coming off several years of rapid home price growth and falling 

affordability. These markets, and the residential lenders 

targeting them, may be more at risk as local economic 

growth falters. 

Map 1 shows markets that have seen the most significant reductions in affordability (sharp price gains) 

during the past several years. Not surprisingly, many 

of them—namely larger cities in California and the 

Northeast—are those that historically have seen the 

biggest swings in prices and a penchant for speculative 

excess. 

In markets with rapidly declining affordability, credit 

risk arises from the increasing likelihood that new 

borrowers will commit a greater share of household 

financial resources to meet monthly payments. Credit 

problems could become more readily apparent given 

any subsequent disruptions to employment or income 

in these markets—especially among households with 

limited wealth or that require multiple job holders to 

meet mortgage payments. These risks may be amplified by the increased underwriting of HLTV and subprime mortgages during the past decade. 

Disruptions to aggregate household liquidity from lost 

employment or decreased income can result in rising 

mortgage delinquencies. With respect to foreclosures, 

however, some research has suggested that the decline 

in prices relative to the balance owed on the mortgage 

(rising loan-to-value ratio) is the most significant factor.22 Even in instances of prolonged job/income loss, 

owners with positive equity are likely able to sell their 

22 For instance, “Mortgage Default Risk and Real Estate Prices: The 

Use of Index-Based Futures and Options in Real Estate,” Case, 

Shiller, & Weiss, NBER Working Paper #5078, NBER, April 1995, 

finds this to be the case, while citing past work that identified the link 

between rising LTVs and foreclosure rates. 

CHART 8 

Rising Foreclosure Rates Followed Falling 

Home Prices in New England a Decade Ago 

Sources: OFHEO (prices), Mortgage Bankers Association (foreclosures) 

Annual Home Price Change (%) 

’79 ’84 ’89 ’94 ’99 

Inverse 

Price (R) 

Foreclosure (L) 

–20 

–10 

0 

10 

20 

30 

Foreclosure Started

(% of Existing Loans) 

0.00 

0.10 

0.20 

0.30 

0.40 

0.50 

homes profitably, thus avoiding foreclosure. Chart 8 

shows the strong relationship between declining home 

prices and increasing foreclosure rates in New England a decade ago (the chart plots the inverse price 

change in order to emphasize the relationship).23 

The data available through late 2001 were mixed with 

respect to home resale price trends at the MSA level. 

On the one hand, while existing home prices as measured by the OFHEO home price index showed no 

markets with year-over-year price declines in fourthquarter 2001, NAR’s median resale price metric did 

show about a dozen markets with year-over-year 

declines, none exceeding four percent. A deceleration 

in year-over-year home price growth was evident for 

many markets (and the nation) using either measure. It 

should be noted that the OFHEO data do not include 

sales of high-priced homes and are less influenced by 

changes in the mix of homes sold than are average and 

median prices;24 this issue is more meaningful in the 

nation’s most expensive markets, such as MSAs in the 

23 In states where dominant metro areas have seen large price declines 

in past years, such as Massachusetts, this relationship is more pronounced than in larger states or the nation as a whole. For example, 

the two-decade correlation between foreclosures started and price 

change is –78 percent in Massachusetts versus roughly –60 percent in 

both California and the nation. 

24 Data are obtained from aggregating repeat sales or refinancings of 

the same properties over time and using statistical methods to calculate an overall rate of home price appreciation for each market. Sampled properties are confined to those whose mortgages are 

“conventional” and do not exceed a conforming loan limit (set at 

$275,000 in 2001) required for securitization through Fannie Mae and 

Freddie Mac. For more information, see www.ofheo.gov/house/. 

Boston Regional Outlook 16 First Quarter 2002 
In Focus This Quarter
 

TABLE 1 

As Recession Evolved, Home Price Appreciation Waned through 2001 

...Further Deceleration in Growth (or Declines) May Be Possible in 2002 

ANNUAL PERCENT CHANGES 

MSAS RANKED 

BY DECELERATION 

IN HOME PRICE INDEX 

FROM 1Q01 TO 4Q01 

OFHEO HOME PRICE INDEX 

NONFARM 

EMPLOYMENT 

1998– 

2000 1Q01 2Q01 3Q01 4Q01 

1998– 

2000 2001 

UNITED STATES 6.3 9.6 9.1 8.8 6.9 2.4 0.3 

SAN JOSE CA PMSA 17.7 24.4 16.9 8.4 0.6 3.4 –0.4 

SANTA CRUZ-WATSONVILLE CA 

PMSA 16.8 25.7 17.3 11.9 5.9 N/A N/A 

SAN FRANCISCO CA PMSA 16.5 19.4 13.9 9.1 3.5 3.3 1.3 

SALINAS CA MSA 13.7 24.3 22.4 19.0 9.4 3.3 0.9 

SANTA ROSA CA PMSA 14.8 22.7 19.6 13.6 8.6 4.1 1.6 

OAKLAND CA PMSA 14.7 22.3 18.0 14.1 8.2 3.4 2.0 

AUSTIN-SAN MARCOS TX MSA 9.4 15.2 12.1 7.7 5.0 5.9 2.1 

MERCED CA MSA 6.4 24.6 21.8 17.3 15.7 N/A N/A 

JAMESTOWN NY MSA 4.9 9.9 0.8 7.4 1.6 N/A N/A 

STOCKTON-LODI CA MSA 9.0 22.8 25.2 20.6 14.9 3.7 3.0 

WHEELING WV-OH MSA 4.1 10.8 7.7 11.7 3.7 1.1 –0.5 

GOLDSBORO NC MSA 4.0 7.9 3.2 1.6 0.9 N/A N/A 

CUMBERLAND MD-WV MSA 2.7 8.6 8.4 8.1 1.8 N/A N/A 

LEWISTON-AUBURN ME NECMA 4.2 14.0 8.6 10.1 7.1 4.4 –0.4 

BANGOR ME NECMA 3.7 13.2 7.4 9.3 6.5 N/A N/A 

FARGO-MOORHEAD ND-MN MSA 4.0 11.1 6.5 5.4 4.6 2.1 –0.3 

BARNSTABLE-YARMOUTH MA 

NECMA 12.8 17.6 14.5 14.6 12.5 3.9 1.3 

PINE BLUFF AR MSA 2.2 6.6 9.7 5.0 0.3 0.8 –1.7 

DUBUQUE IA MSA 3.9 8.8 6.0 6.9 2.5 1.1 –0.6 

BOULDER-LONGMONT CO PMSA 10.9 14.6 11.7 11.7 8.3 5.1 3.2 

DENVER CO PMSA 11.1 13.7 11.8 10.9 7.9 3.8 2.3 

UTICA-ROME NY MSA 3.5 14.6 9.5 8.4 9.1 2.4 0.1 

VALLEJO-FAIRFIELD-NAPA CA PMSA 11.8 20.0 19.1 16.6 14.7 4.7 2.8 

BRYAN-COLLEGE STATION TX MSA 4.8 11.1 2.1 5.6 5.8 4.0 0.7 

SAN DIEGO CA MSA 11.8 15.6 13.8 12.9 10.4 4.3 2.7 

SAN LUIS OBISPO-ATASCADERO­ PASO ROBLES CA MSA 11.4 19.2 18.0 17.8 14.2 N/A N/A 

TUCSON AZ MSA 3.3 8.6 8.0 6.8 3.6 3.5 0.8 

JERSEY CITY NJ PMSA 8.0 11.1 17.6 13.7 6.2 2.1 2.7 

CLARKSVILLE-HOPKINSVILLE TNKY MSA 3.3 9.1 4.2 6.5 4.2 N/A N/A 

RAPID CITY SD MSA 6.2 8.9 9.3 7.7 4.1 3.1 0.1 

LA CROSSE WI-MN MSA 5.7 7.4 5.8 5.1 2.6 2.3 1.0 

ST. CLOUD MN MSA 6.9 10.4 8.5 9.4 5.7 3.8 1.4 

Sources: Office of Federal Housing Enterprise Oversight (OFHEO), Bureau of Labor Statistics 

Boston Regional Outlook 17 First Quarter 2002 
 

In Focus This Quarter
 

San Francisco Bay Area25 and parts of the Northeast, 

since prices for high-end homes (typically financed by 

jumbo mortgages) may be more volatile over the economic cycle. 

Table 1 lists markets whose 2001 deceleration in home 

price growth was in the top 10 percent of the more 

than 300 metro areas for which the OFHEO statistic is 

available. The table also provides (where available) 

each MSA’s recent employment trend as an indicator 

of overall economic conditions. These markets may yet 

see even more pronounced deceleration in home price 

growth or even declines in home prices this year (as 

may others not shown). This possibility will be determined for the most part by the performance of each market’s local economy. 

The metro areas in the table are 

ordered by the magnitude of their 

deceleration in home price growth 

over the initial quarters of this recession. As a result, the marked deceleration in year-over-year price 

growth in the recently overheated 

San Francisco Bay Area puts many of its MSAs near the 

top of the list. In the table, San Jose, San Francisco, 

Oakland, Denver, and San Diego also previously were 

identified as banking markets with elevated risk profiles.26 For some of the smaller MSAs in Table 1 with 

more volatile appreciation rates, such as Utica and 

Fargo, comparisons of recent price trends are more 

appropriate using the 1998–2000 average as a benchmark, as these markets experienced pronounced spikes in 

year-ago price growth during first-quarter 2001. 

It is hard to generalize about which markets will see the 

most pronounced home price weakness as the recession 

continues. However, certain markets have shown a tendency in the past to be driven to a greater degree by speculative, rather than fundamental, factors. These markets 

are more likely to see significant downward corrections 

in price when economic activity falls for a prolonged 

period or by a sufficient magnitude. One study from the 

mid-1990s found, in comparing 14 cities in the Northeast and West with 16 inland cities, that while both 

groups tended to respond similarly to local and national 

25 As considered here, this includes the following MSAs: San Jose,
 

Santa Cruz-Watsonville, San Francisco, Santa Rosa, Oakland, Salinas, and Vallejo-Fairfield-Napa.
 

26 See “In Focus This Quarter,” Regional Outlook, Fourth Quarter
 

2001.
 

economic forces (fundamental, or “equilibrium,” price 

drivers), prices in the former group tended to be influenced to a greater degree by speculative, or “disequilibrium,” variables, including recent trends in price 

appreciation.27 Cities along the nation’s coasts also have 

tended to see the most significant price swings over the 

past 20 years. 

History also provides some insights into the nature and 

extent of any price declines in markets where economic 

conditions deteriorate. A study of two significant examples, Boston and Los Angeles in the 1980s and early 

1990s, concluded that declines differed by property type 

(i.e., condos versus single-family) and price class (i.e., 

high-end versus entry-level).28 This dispersion in price 

declines arose from differing rates of appreciation (properties that experienced the greatest inflation during the 

boom saw the largest deflation) and from the nature of 

each city’s economic decline, which differed according to 

concentrations of job losses by industry and wage type, 

underlying demographic factors, and housing supply 

trends. 

Looking at recent developments, it seems that the greatest near-term risk of a significant downward adjustment 

in housing prices is in the San Francisco Bay area. In 

recent years, this area witnessed double-digit home price 

appreciation that exceeded growth in per capita income 

by a wide margin. A recent analysis from the University 

of California-Berkeley’s Haas School of Business forecast that prices in the Bay Area housing market will 

decline by 15 percent overall (and by 30 percent for luxury homes) by the time the local economy’s recession 

ends late this year.29 Meanwhile, the larger MSAs in 

Southern California have not seen as significant a disparity between home price appreciation and personal 

income growth during this cycle as during the 1980s. 

Also in contrast to the 1980s, New England (and the 

Northeast generally) has seen little speculative purchase 

or construction activity in recent years, which should 

help to mitigate any price weakness through the current 

recession in these markets.30 

27 Jesse M. Abraham and Patric H. Hendershott, “Bubbles in Metropolitan Housing Markets,” Working Paper #4774, NBER, June 1994. 

28 Karl E. Case and Robert J. Shiller, “A Decade of Boom and Bust in 

the Prices of Single-Family Homes: Boston and Los Angeles, 1983 to 

1993,” New England Economic Review, March/April 1994. 29 David Goll, “Bay Area Housing Market Will Remain Slow,” East 

Bay Business Times, January 23, 2002. 30 “Regional Perspectives,” Boston Region, Regional Outlook, First 

Quarter 2002. 

Boston Regional Outlook 18 First Quarter 2002 
In Focus This Quarter
 

Conclusion 

Home prices are holding up in most markets, and, generally, permanent residential mortgages have fared 

well in prior recessions. However, history might 

understate credit risks for insured institutions during 

this cycle because the mortgage lending business has 

changed since the last recession. Chief among these 

changes are robust mortgage market competition, 

which has contributed to narrower collateral margins; 

increased reliance on underwriting automation; and 

expanded involvement in the subprime credit market. 

In addition, residential C&D lenders in certain markets might be particularly vulnerable, since C&D credits typically undergo higher loss rates and some areas 

are experiencing continued construction despite a 

cyclical slowdown (as measured by employment 

trends). Permanent mortgage lenders in certain areas, 

such as the San Francisco Bay area, could also face 

higher loss rates and foreclosures going forward, as the 

current economic weakness places downward pressure 

on home prices and dampens the ability of households 

to meet mortgage payments. 

Scott Hughes, Regional Economist 

Judy Plock, Senior Financial Analyst 

Joan Schneider, Regional Economist 

Norm Williams, Regional Economist 

Boston Regional Outlook 19 First Quarter 2002 
✁
 

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