Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION FIRST QUARTER 2001 

FDIC
 

New York
 

Region
 

Division of 

Insurance 

Kathy R. Kalser,
 

Regional Manager
 

Robert DiChiara,
 

Financial Analyst
 

Norman Gertner,
 

Regional Economist
 

Alexander J.G.
 

Gilchrist,
 

Economic Analyst
 

Regional Perspectives 

◆ The Region’s Economic Growth Slowed as 2000 Came to a Close— 

After a record nine years of economic expansion, the nation’s and Region’s economies 

slowed at the end of last year. Slower job and income growth suggests that the pace of 

the Region’s expansion will moderate during the first half of 2001. See page 4. 

◆ Banking Conditions Are Becoming More Challenging—The Region’s 

insured institutions reported slightly lower profitability through the nine months 

ending September 30, 2000, than a year ago, as higher funding costs and competitive pressures constrained net interest margins. Credit quality of commercial and 

industrial loans at the Region’s large banks showed signs of continued weakening. 

See page 6. 

◆ Community Banks’ Margins Decline despite Strong Loan Growth and 

a Shift into Traditionally Higher-Risk Loan Categories—Benefiting from 

the record long economic expansion, the Region’s community banks have reported 

strong growth in commercial loan types over the past several years. Despite the 

increased credit risk profile, net interest margins have declined, reflecting increased 

competitive pressures and a relatively flat Treasury yield curve. See page 7. 

◆ New Bank Formation Has Increased in the Region—Several factors, 

including strong economic conditions, have contributed to new bank formation in the 

Region. Several of the Region’s metropolitan statistical areas that are home to a 

greater percentage of new banks are more dependent on some troubled industry sectors. The Region’s new banks also have an increasing credit risk profile, evidenced by 

growing commercial real estate loan portfolios and increased use of noncore funding. 

See page 9. 

By the New York Region Staff 

In Focus This Quarter 

◆ Credit Problems for U.S. Businesses Continue to Rise—Commercial 

loan quality indicators of insured banks have steadily worsened since 1998. Factors 

contributing to this deterioration include rising financial leverage in the corporate 

sector as well as weaknesses within certain domestic industries. Many market 

observers also have attributed the increase in problem commercial loans to a 

heightened appetite for risk and relaxed underwriting standards from 1996 to 1999. 

The apparent softening in economic conditions in recent months reduces prospects 

that business loan quality will improve any time soon. In the meantime, lenders, 

analysts, and supervisors continue to pay close attention to U.S. business lending 

conditions. See page 14. 

◆ Outlook for Three Industries Facing Uncertainty—Industries as 

diverse as telecommunications, health care, and textiles have been experiencing 

problems, despite the economic expansion that began nine years ago. Although the 

sources of their difficulties are quite different, these industries share some common 

concerns and challenges. Fierce competition characterizes their operating environment. Armed with a better grasp of the origins of stress in these industries, we will 

have a better basis for understanding the lending risks associated with a changing 

policy and economic environment in the years to come. See page 22. 

By the Division of Insurance Staff 

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

Insurance Corporation 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)
 

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 New York Region’s Regional 

Outlook, please call Kathy Kalser at (917) 320-2650 or send an e-mail to kkalser@fdic.gov. 

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

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

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

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

the Federal Deposit Insurance Corporation. 

Chairman Donna Tanoue 

Director, Division of Insurance Arthur J. Murton 

Executive Editor George E. French 

Writer/Editor Kim E. Lowry 

Editors Lynn A. Nejezchleb 

Maureen E. Sweeney 

Richard A. Brown 

Ronald L. Spieker 

Publications Manager Teresa J. Franks 
 

 

 

Letter from the Executive Editor
 

To the Reader: 

The goal of the Regional Outlook is to provide useful risk-related information to bankers, banking agency staff, and 

other interested readers. To do this more effectively, the second quarter 2001 edition will have a new look. We will 

publish a single national edition that will provide an overview of economic and banking risks and discussions of these 

risks as they relate to insured institutions in each FDIC Region. We will tell the national story and, at the same time, 

alert the reader to specific trends and developments at the regional level. 

After considering our experience with this new format, we may adopt it permanently for the second and fourth quarters of each year. The first and third quarter editions will continue to feature in-depth coverage of the economy and 

banking industry in each Region. Trying new formats will help us find the right balance between regional coverage 

of specific topics and analysis of economic and banking issues that cut across regional lines. 

After you have read the next edition of the Regional Outlook, we would like to hear from you. Does this new 

approach provide a more effective vehicle for reporting on banking and economic trends? What other suggestions do 

you have for improving our presentation of risk-related information? Call us with your comments at (877) 275-3342 

or (800) 925-4618 (TDD) or e-mail them to lnejezchleb@fdic.gov. 

Sincerely, 

George E. French
 

Executive Editor 


New York Regional Outlook 3 First Quarter 2001
 
Regional Perspectives
 

Regional Perspectives
 

•	 The Region’s economic growth rate slowed toward the end of 2000. Slower job growth in the manufacturing 

and financial services sectors has contributed to a less robust economic outlook. 

•	 Insured institutions reported slightly lower profitability through the nine months ending September 30, 

2000, than a year ago, primarily because of higher funding costs, which pressured net interest margins. 

Commercial and industrial loan quality weakened at the Region’s large banks. 

•	 To counter margin pressure, the Region’s community banks grew their loans and shifted into traditionally 

higher-risk loan categories as the Region’s economy showed signs of slowing. 

•	 Similar to the 1980s experience, new bank formation increased during the recent economic expansion; however, compared with their 1980s peers, today’s new banks report greater concentrations of commercial real 

estate loans, suggesting an elevated credit risk profile. 

Region’s Economic and Banking Conditions 

Economic Growth across the Nation and in the 

Region Slowed in the Second Half of 2000 

After a record nine years of economic expansion, growth 

in the nation’s economy slowed as 2000 came to a close. 

The gross domestic product, the nation’s broadest barometer of economic activity, rose 2.2 percent annually during third quarter 2000, the slowest quarterly growth rate 

in four years. Furthermore, in December 2000, the survey 

of consumer confidence declined to the lowest level in 

two years, indicating that consumers are growing more 

wary about the economy.1 A confluence of factors, including rising energy prices, lower corporate profits, and the 

lagged effects of tighter monetary policy by the Federal 

Reserve Board, has raised the prospect of slower economic growth in the nation. Over the past nine years, productivity gains helped boost U.S. corporate profits. 

However, intensifying global competition, a strong dollar, and less robust productivity growth began to squeeze 

many companies’ profit margins in the latter half of 2000. 

Moreover, spreads between corporate debt and U.S. Treasury securities significantly widened at the end of the 

year, signaling heightened credit concerns among 

investors. Furthermore, reflecting less robust economic 

conditions, an increasing number of U.S. firms scaled 

back earnings forecasts for fourth quarter 2000. 

Reflecting the national trend, economic growth among 

the Region’s states also moderated during 2000. In fact, 

Economy.com forecasts a significant reduction in the 

rate of economic growth for the Region.2 Slower job and 

income growth contributed to the expectation that the 

economy will slow. The Region’s job growth has 

declined, in part because of tight labor markets, which 

have been further constrained by limited population 

growth in many of the Region’s states. In fourth quarter 

2000, the Region added 295,000 new jobs, representing 

a gain of 1.3 percent compared with about a 1.6 percent 

increase for the nation (see Chart 1). 

Lower rates of employment growth primarily reflected 

slower job growth in several of the Region’s major 

CHART 1 

Source: Bureau of Labor Statistics 

Job Growth, Historically, Has Been Slower

 in the Region than in the Nation 

–4 

–2 

0 

2 

4 

’90’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00 

Percent Change 

N.Y. Region 

U.S. 

4th Quarter 

1 The Conference Board, a not-for-profit business membership and
 

research organization, produces the survey of consumer confidence. 2 State gross product forecasts as of January 2001.
 

New York Regional Outlook 4	 First Quarter 2001
 
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Regional Perspectives
 

industries, including the finance, insurance, real estate, 

services, and manufacturing sectors. Declining equity 

valuations, particularly on the NASDAQ; decreased initial public offering activity; and reduced issuance of 

corporate debt have curtailed the hiring plans of many 

of the Region’s investment banking and financial service providers. In fact, several investment firms have 

announced layoffs. Employment growth in the Region’s 

service sector, although healthy, also has slowed. During the first three quarters of 2000, employment growth 

in this sector ranged between 2 percent and 2.5 percent, 

below the 3 to 4 percent rate of the past five years. In 

addition, the Region’s manufacturing employment has 

declined over the past several decades, as many manufacturers have left for lower-cost venues. 

The Region’s housing sector also may be feeling the 

effects of a slowing economy and the higher mortgage 

rates that prevailed throughout much of 2000. The volume of home sales declined in some of the Region’s 

largest metropolitan statistical areas (MSAs) during 

2000.3 Prices for single-family homes, however, continued to rise in third quarter 2000, primarily in the suburbs of New York City, Baltimore, and Washington, 

D.C., as demand outstripped supply. Nevertheless, a 

weakening stock market and growing consumer uncertainty could slow housing activity in the Region. 

Region’s Economy Remains Healthy, 

but Areas of Weakness Are Emerging 

Despite signs of more modest growth, economic conditions were relatively healthy in 2000. The Region has 

experienced strong productivity, high levels of household 

income, and generally favorable commercial real estate 

conditions. However, the Region’s economy may be more 

vulnerable to certain risks than other parts of the nation, 

particularly weakness in the financial markets. The securities industry accounted for over 40 percent of New York 

state’s increase in gross state product and over 20 percent 

of the Region’s economic growth between 1990 and 

1998. Moreover, because financial, legal, and business 

services generally are linked to stock and bond market 

activity, a slowdown on Wall Street could affect the 

Region’s service sector adversely. For example, 41 percent of Delaware’s economy is related to financial service activities. Higher business costs, prevalent in many 

of the Region’s larger cities, also could make the Region 

more susceptible to economic weakness. Areas in the 

Region experiencing increased labor costs, higher real 

estate prices, and greater reliance on petroleum products 

could be more vulnerable than other areas to the downside of a business cycle, as companies curtail higher-cost 

operations (see Chart 2). 

CHART 2 

Most Cities in the Region Have Higher Business Costs than the Nation
 

Percent of United States
 

140
 

120
 

100
 

80
 

Note: U.S. equals 100. 

Source: Economy.com 

3 Data provided by Economy.com as of January 2001.
 

New York Regional Outlook 5 First Quarter 2001
 
Regional Perspectives
 

Banking Conditions Are Becoming More Challenging
 

The New York Region’s insured institutions reported 

slightly lower profitability for the nine months ending 

September 30, 2000, than for the same period a year 

ago, reflecting an increasingly competitive banking 

environment and changes in the level and shape of the 

Treasury yield curve. The Region’s banks have benefited from the nation’s long economic expansion, experiencing strong loan demand and favorable credit quality. 

However, competition for loans, deposits, and other 

bank products and services is becoming increasingly 

aggressive, with a wide variety of nonbank financial 

companies offering traditional banking services. 

Attracting low-cost core deposits has been a particular 

challenge for many of the Region’s insured institutions, 

reflecting the increased popularity of noninsured 

deposit alternatives, including mutual funds. Because 

loan demand has outpaced core deposit growth, the 

Region’s banks have increased reliance on noncore 

funding, which has contributed to a tightening of bank 

net interest margins (NIMs) and has heightened liquidity risk at some institutions. A relatively flat Treasury 

TABLE 1 

yield curve that prevailed throughout much of 2000 also 

contributed to lower NIMs. 

Large Banks’ Profitability Is Pressured by 

Lower Margins and Weaker Credit Quality 

The New York Region’s large insured institutions4 reported moderately lower profitability for the nine-month 

period ending September 30, 2000, compared with the 

same period a year ago (see Table 1). The median return 

on assets declined primarily because of a decrease in the 

NIM as funding costs increased more than the yield 

earned on assets. For the fifth consecutive quarter the 

average cost of funds increased for the Region’s large 

banks, reflecting higher wholesale market interest rates. 

Noninterest income increased from 47 percent of operating income5 during the first nine months of 1999 to 53 

percent during the same period in 2000. This percentage 

declined, however, during the second and third quarters 

of 2000, reflecting weakness in the capital markets. 

Tightening NIMs Pressure the Profitability of the Region’s Insured Institutions 

ASSETS GREATER ASSETS BETWEEN ASSETS LESS THAN 

THAN $25 BILLION $1 BILLION AND $25 BILLION $1 BILLION 

SEP ’00 SEP ’99 SEP ’98 SEP ’00 SEP ’99 SEP ’98 SEP ’00 SEP ’99 SEP ’98 

RETURN ON ASSETS (ROA) 1.03 1.13 1.11 1.06 1.15 1.14 0.93 0.95 0.97 

NET INTEREST MARGIN (NIM) 3.23 3.56 3.84 3.55 3.58 3.84 3.93 3.94 4.04 

EFFICIENCY RATIO 60.03 56.70 56.91 54.52 53.59 56.52 63.41 64.39 63.10 

NONINTEREST INCOME/ 

OPERATING INCOME 53.32 47.36 45.93 18.36 17.56 16.42 11.27 11.16 10.59 

PAST-DUE RATIO—TOTAL 

LOANS 1.66 1.89 1.69 1.39 1.43 1.80 1.56 1.76 2.17 

PAST-DUE RATIO—C&I 

LOANS 2.01 1.47 1.59 1.51 1.39 1.96 0.96 1.19 1.27 

CORE DEPOSITS/ASSETS 35.95 36.61 38.78 59.56 59.41 59.02 72.79 74.44 76.08 

LOANS/ASSETS 59.35 60.42 59.05 62.37 60.12 59.69 63.88 61.58 61.16 

RESERVES/LOANS 1.37 1.52 1.91 1.10 1.14 1.22 1.02 1.03 1.10 

TIER 1 LEVERAGE RATIO 6.78 6.60 6.11 7.53 7.54 7.82 9.64 9.66 9.89 

TIER 1 RISK-BASED 

CAPITAL RATIO 8.66 8.37 8.01 11.52 11.88 12.74 16.42 16.67 17.44 

Notes: Median data excluding institutions in operation less than three years and credit card banks. 

Operating income = net interest income plus noninterest income 

Past-due ratio = loans past due 30 days or more plus nonaccrual loans divided by gross loans 

Source: Bank and Thrift Call Reports for the nine-month period ending September 30 

4 Institutions with total assets greater than $25 billion, excluding credit card banks. The banking analysis uses median figures unless otherwise noted. 

5 Operating income is defined as the sum of net interest income and noninterest income. 

New York Regional Outlook 6 First Quarter 2001
 
 

Regional Perspectives
 

Overall reported asset quality at the Region’s large 

institutions improved compared with a year ago, evidenced by lower past-due and charge-off-to-total-loans 

ratios; however, commercial and industrial (C&I) 

credit quality continued to show signs of weakening. 

While well below levels reported a decade ago, the 

median past-due C&I loan ratio increased for the 

Region’s large banks, reaching a seven-year high of 

2.01 percent as of September 30, 2000 (see Chart 3). 

The increase in syndicated loans adversely classified 

under the Shared National Credit program,6 higher 

CHART 3 

corporate bond defaults, relatively wider corporate 

debt spreads to Treasuries, and an increased proportion of rating downgrades to upgrades on corporate 

bonds suggest continued weakening of commercial 

credit quality. According to Fitch/IBCA, defaults on 

high-yield bonds likely will remain at above-average 

levels throughout 2001.7 Slowing economic and corporate profit growth, higher interest rates, and less disciplined underwriting standards during the mid- to late 

1990s likely contributed to the weakening of C&I loan 

quality at large banks.8 

Large Banks’ Commercial and Industrial Loan Portfolios Show Signs of Weakening 

Note: Data represent median figures as of September 30. 

Source: Bank and Thrift Call Reports 

0 

2 

4 

6 

8 

10 

’88 ’89 ’90’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00 

0.0 

0.5 

1.0 

1.5 

2.0 

2.5 

Past-Due C&I Loans to 

Total C&I Loans (left axis) C&I Charge-off 

Rate (right axis) 

Recession Period Percent Percent 

6 Joint release by the Board of Governors of the Federal Reserve System, Office of the Comptroller of the Currency, and Federal Deposit Insurance Corporation. October 10, 2000. Bank Regulators’ Data Show Continued Increase in Adversely Classified Syndicated Bank Loans.
 

7 Fitch/IBCA. December 2000. High Yield Default Rates Continue to Climb to a 9-yr Peak.
 8 The Federal Reserve Board’s Senior Loan Officer Opinion Surveys on Bank Lending Practices from 1996 to 1998 indicated easing of C&I lending standards nationwide.
 

Community Banks’ Margins Decline despite Strong Loan Growth 


and a Shift into Traditionally Higher-Risk Loan Categories
 

The Region’s community banks9 reported slightly lower 

profitability during the first nine months of 2000 compared with a year ago as improved asset yields, which 

reflected higher market interest rates and strong loan 

growth, were more than offset by increased funding 

costs (see Table 1). Benefiting from strong economic 

conditions, loans increased in the aggregate by 10 percent during the past 12 months, slightly more than the 9 

percent growth rate reported a year ago.10 Commercial 

9 Institutions with total assets less than $1 billion, excluding institutions in operation less than three years and credit card banks. 

10 The growth rates reported are for the 12-month periods ending 

September 30, 2000, and September 30, 1999, and are adjusted for 

mergers. 

loan11 levels grew most rapidly, increasing 17 percent, 

more than double the 7 percent growth rate of residential loans. 

Reported asset quality among the Region’s community 

banks was favorable, evidenced by a median past-due 

loan ratio that was lower than a year ago and well below 

levels reported before the recession of the early 1990s 

(see Chart 4, next page). After declining for several 

years, the dollar amount of delinquent loans reported by 

the Region’s community banks leveled off in the first 

nine months of 2000, suggesting that improvements in 

11 Defined as the total of commercial and industrial, commercial real 

estate, and construction and development loans. 

New York Regional Outlook 7 First Quarter 2001
 
 

Regional Perspectives
 

CHART 4 

Credit Quality Reported by the Region’s Community Institutions Remains Strong 

Note: Median data for community institutions (those with total assets less than $1 billion), excluding credit card banks and institutions in operation less than three years. 

Data as of September 30. 

Source: Bank and Thrift Call Reports 

0.00 

0.05 

0.10 

0.15 

0.20 

1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 

0 

1 

2 

3 

4 

5 

Charge-offs to Total Loans (percent) Past-Due Loans to Total Loans (percent) 

credit quality may be waning. Residential loans, which 

remain community banks’ largest loan category, continue to show a low past-due ratio; however, a national 

trend warrants attention. According to a study by Mortgage Information Corporation, the delinquency ratio 

for mortgage loans originated nationwide in 2000 

exceeded that for loans originated in 1999 and 1998, 

and was double the level for 1993 and 1994 vintages.12 

Despite the current economic expansion and higher 

loan-to-asset (LTA) ratios, the median NIM reported by 

the Region’s community banks has trended down since 

the mid-1990s (see Chart 5). Unlike large banks, which 

have more diversified revenues, the Region’s community banks are heavily dependent on the NIM or “spread” 

CHART 5 

income. As a result, loan growth and asset yields are key 

to community banks’ profitability. 

Strong loan growth during an expanding economy is consistent with the experience of the Region’s community 

banks during the 1980s business expansion. During the 

last cycle, these banks increased LTA ratios by growing 

residential and commercial loan portfolios at the expense 

of consumer loans. During the 1990s economic expansion, community banks also have emphasized commercial loans, which traditionally are higher yielding and 

higher risk, and have significantly reduced consumer 

loan concentrations. As of September 30, 2000, commercial loans accounted for 33 percent of community banks’ 

loan portfolios, compared with 26 percent four years ago. 

Community Banks’ NIMs Decline despite Higher Loan-to-Asset Ratios
 Percent Percent
 

52 

55 

58 

61 

64 

67 

3.4 

3.6 

3.8 

4.0 

4.2 

4.4 

4.6 

NIM (left axis) 

Loans to Assets (right axis) 

1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 

Note: NIM = net interest margin. Median figures. Year-end numbers except for 2000, which are as of September 30. 

Source: Bank and Thrift Call Reports for community institutions (those with total assets less than $1 billion), excluding credit card institutions and institutions in operation less 

than three years 

12 The Mortgage Information Corporation. Summer/Fall 2000. The Market Pulse. The delinquency ratio is for conventional, prime-quality mortgages. The measure used is 60 days or more past due. 

New York Regional Outlook 8 First Quarter 2001
 
 

Regional Perspectives
 

Growth in commercial lending has been widespread 

among the Region’s community banks, with 65 percent 

of banks reporting a higher concentration in commercial 

loans than four years ago.13 While the credit risk profile 

of the Region’s community banks may be increasing, 

median capitalization and reserve-to-loan ratios are higher than a decade ago, providing a greater degree of protection against potential credit quality weaknesses. 

Increased Competition Has Pressured 

Community Banks’ Margins 

Increased competition for bank products and services 

has contributed to community bank margin compression. The growth of nonbank financial service 

13 Data are adjusted for mergers. 

providers, increased credit union membership and services, and expanded market share of mortgage companies have heightened competition for community banks. 

Membership in credit unions increased nationally from 

68.2 million in 1996 to 76.7 million in 2000,14 and many 

credit unions now compete with banks for residential 

mortgages and business loans. Competition from mortgage companies also has grown. Mortgage companies’ 

share of annual residential mortgage originations 

increased from 35 percent in 1990 to 56 percent in 

1997.15 Furthermore, increased new bank formation in 

the Region provides additional competition for the 

Region’s established community banks (see Box). 

14 National Credit Union Administration. 2000. Mid-Year Statistics for 

Federally Insured Credit Unions. 

15 Mortgage Bankers Association of America. Most recent data available were from 1997. 

New Bank Formation 

Has Increased in the Region 

CHART 6 

The strong economy has contributed to increased new 

bank16 formation in the Region, both in number and 

proportion. As of September 30, 2000, the percentage 

of new banks in the Region slightly exceeded the level 

achieved at the height of the 1980s business cycle (see 

Chart 6). While the Region’s proportion of new banks 

to total banks is roughly equivalent to the national 

average (8 percent for the Region17 compared with 7 

percent for the nation), some of the Region’s MSAs 

have a more significant concentration of new banks 

(see Map 1, next page). 

Several factors have contributed to the level of new 

bank formation in the Region, including strong economic growth18 and relatively high wealth concentration.19 Merger activity also may be a contributing 

factor. As smaller community banks are acquired by 

larger, and in many instances out-of-state, banks, a 

16 For the purposes of this article, new banks are defined as insured 

institutions that have been chartered for three years or less. 

17 When including only “true” de novos—that is, those without a 

large parent company—the proportion drops to roughly 6 percent 

of total banks. 

18 Moore, Robert R., and Edward C. Skelton. First quarter 1998. 

Federal Reserve Bank of Dallas. “New Banks: Why Enter When 

Others Exit?” Financial Industry Issues. 19 Correlation between new bank formation and growth in capital 

gains in the New York Region is strongly positive. 

niche exists for new local banks to provide personal 

service and capitalize on management ties to the local 

community. The Region’s MSAs, with a larger proportion of new banks than the nation, also experienced a 

greater degree of bank consolidation over the past five 

years than the rest of the Region.20 

Deposit market share data for the Region also suggest 

that bank consolidation may be a contributing factor 

to new bank formation. Deposits have become more 

20The average rate of contraction between 1995 and 2000 in the ten 

highly concentrated MSAs cited above is 26 percent, while the 

rate for the Region as a whole is only 15 percent. The rate of consolidation was 60 percent in Nassau-Suffolk, 40 percent in Washington, D.C., and 33 percent in Newark. 

New York Regional Outlook 9 First Quarter 2001 

Strong Economy Promotes 

New Bank Formation 

Note: Data as of September 30. 

Source: Bank and Thrift Call Reports 

’84 ’86 ’88 ’90’92 ’94 ’96 ’98 ’00 

Number Share of Total (%) 

0 

20 

40 

60 

80 

100 

120 

0 

2 

4 

6 

8 

10 
Regional Perspectives
 

concentrated among fewer institutions during the past 

five years,21 particularly in those MSAs with a greater 

percentage of new banks than the national average. 

In most of these MSAs, large, out-of-state banks 

have increased deposit market share by acquiring 

local institutions, creating an opportunity for new, 

neighborhood-oriented institutions. Although deposit 

market share has become more concentrated in these 

MSAs, the level of deposit concentration varies. The 

Region’s major metropolitan areas, including New 

York City, Philadelphia, and Washington, D.C., 

which are home to larger banks, reported a higher 

level of deposit concentration than the smaller MSAs 

of Nassau-Suffolk, Middlesex-Somerset-Hunterdon (Middlesex), and Newark. 

The Risk Profile of New 


Banks Has Increased
 

Like the Region’s established community banks, new 

banks face an increasingly challenging banking environment. Pressure to meet profitability forecasts, in 

light of strong competition for loans and deposits, may 

be reflected in the loan profiles of the Region’s new 

banks. Although the LTA ratio reported by the Region’s 

new banks was 55 percent as of September 30, 2000, 

slightly lower than the 60 percent achieved by new 

banks at the peak of the 1980s expansion, loan composition at the current crop of new banks suggests an 

increased credit risk profile compared with a decade 

ago. As of September 30, 2000, commercial real estate 

(CRE) loans constituted the largest share of new banks’ 

loans (33 percent), more than the Region’s established 

community banks and more than new banks a decade 

ago. The increased proportion of CRE loans at today’s 

new banks suggests that these entrants are targeting 

higher-yielding but potentially higher-risk loans in 

order to bolster profitability. 

Like the Region’s established community banks, 

new banks are facing increased competition for core 

deposits and, as a result, are relying more on noncore 

funding. During the past five years, the ratio of noncore funding to assets reported by the Region’s new 

banks doubled from 10 percent to 20 percent. Whole21 FDIC Summary of Deposit Data. June 30, 1999. The deposit 

concentration metric is the Herfindahl-Hirschman Index (HHI). A 

higher HHI number indicates a greater concentration of deposit 

market share in the area or a less competitive—more monopolistic—market structure. 

MAP 1 

New Banks Form in Areas
 

of Strong Economic Growth
 

Nassau-Suffolk–2 

DC–3 

New York–7 

AC–2 

Greater than 15% of Banks 

Between 7% and 15% of Banks 

Between 1% and 7% of Banks 

No New Banks 

Note: Map shows MSAs with at least two new banks and at least five banks 

total, third quarter 2000. 

Source: Bank and Thrift Call Reports 

Trenton–2 

Newark–4 

Middlesex–6 

Monmouth-Ocean–3 Philadelphia–12 

Baltimore–3 

Lancaster–2 

sale funding, including brokered certificates of 

deposit and large time deposits, may facilitate new 

banks’ access to liquidity, but can be more expensive 

than traditional core deposits. Furthermore, types of 

wholesale funding may be more sensitive to changes 

in market interest rates and investors’ perceptions of 

credit quality conditions than core funding, conditions that could challenge banks’ liquidity management. 

Several of the Region’s MSAs with a higher percentage of new banks also have significant exposure to 

troubled industry sectors, including manufacturing 

and high tech. For example, almost a quarter of the 

workforce in the Lancaster, Pennsylvania, MSA is 

employed in the manufacturing sector, which has 

experienced declining employment for years. The 

Middlesex, New Jersey, MSA economy has an 

increased exposure to the telecom and high-tech sectors, which are experiencing industry consolidation, 

lower profitability, and reduced access to financing. 

The Middlesex MSA also has significant exposure to 

the financial services industry and therefore is susceptible to weakness in the capital markets. The 

Atlantic-Cape May, New Jersey, MSA depends on 

tourism and gaming, two of the more cyclical industries. Philadelphia and Newark have significant exposure to the health care and pharmaceuticals industries, 

both of which have been consolidating. 

New York Regional Outlook 10 First Quarter 2001
 
 

 

Regional Perspectives
 

Characteristics of Banks between significant share of CRE loans, 34 percent of the 

loan portfolio as of September 30, 2000, compared Four and Seven Years Old May with 24 percent for this group of institutions in third 

Suggest Heightened Risk Profile	 quarter 1989. Although commercial real estate conditions were generally favorable throughout the 

Region through the first nine months of 2000, local 

economic conditions vary, and these variations have A study by the Chicago Federal Reserve Bank22 

implications for commercial real estate conditions. suggests that the probability of a bank’s failure is Weaknesses in credit quality may emerge if assump­ greatest during the period four to seven years after it tions used in the underwriting of recent CRE loans begins operation. During the first three years of oper­ are based on a continuation of the robust economic ation, a bank is typically required to hold higher cap- growth rates achieved over the past two years. ital ratios to offset operating losses that are usually 

incurred while it establishes an earnings base. Competition also could affect the financial condition Following the third year of operation, capital require- of the Region’s unseasoned banks. For example, ments are typically eased as an institution’s business increased competition among banks in a local area matures. An insured institution, however, may experi­ could pressure loan underwriting and pricing terms, ence heightened levels of credit risk after the third resulting in tighter margins. However, leverage cap- year, as newly minted loans season and become more ital ratios for the Region’s four- to seven-year-old vulnerable to credit problems. According to the study, banks were slightly higher than those of established the probability of failure typically declines dramati­ community banks as of September 30, 2000, and cally following a bank’s seventh year of operation as exceeded levels maintained by community banks earnings stabilize and the bank’s businesses are more and the four- to seven-year-old group at the height of established. the last economic expansion. Nevertheless, four- to 

seven-year-old institutions that experience difficulty Like new banks, banks in the Region that have been meeting original profitability targets, whether in operation between four and seven years23 hold a because of increased competition or less favorable 

22 economic conditions, may be tempted to alter origi­ DeYoung, Robert. Third quarter 1999. Federal Reserve Bank of 

Chicago. “Birth, Growth, and Life or Death of Newly Chartered nal business plans and engage in potentially higherBanks.” Economic Perspectives. risk business lines or extend into less familiar 23 As of September 30, 2000, the Region was home to 20 banks markets, increasing risk profiles. 

that were between four and seven years old. 

The proliferation of mutual funds and other alternatives 

to bank deposits also has hindered community banks’ 

ability to grow retail core deposits, adding pressure to 

NIMs. Investments in mutual funds nationwide totaled 

less than one-third of bank deposits throughout the early 

1990s but now exceed the total deposits held by insured 

institutions.24 Although core deposits remain community 

banks’ largest funding source, the median ratio of core 

deposits to assets for the New York Region’s community 

banks has declined steadily since 1992, from 84 percent 

to 73 percent, consistent with national trends (see Chart 

7, next page). Furthermore, the mix of core deposits has 

shifted from lower-cost savings and money market 

deposit accounts (MMDAs) to typically higher-cost time 

deposits. Savings accounts and MMDAs have declined 

from 39 percent of core deposits in 1992 to 31 percent in 

24 Federal Reserve Board (Haver Analytics). Third quarter 2000. Bank 

and Thrift Call Reports. 

2000, while time deposits have increased from 35 percent 

to 40 percent during the same period. Furthermore, 

because of increased competition for core deposits, banks 

have turned to noncore funding sources such as brokered 

deposits and Federal Home Loan Bank borrowings, 

which typically are more costly than retail core deposits. 

Community Banks’ Margins Also Are 

Challenged by the Flat Yield Curve 

Changes in the shape of the yield curve also have affected community banks’ NIMs. Community banks tend to 

offer deposit rates based on shorter-term interest rates, 

while pricing loans on the basis of longer-term rates. 

Therefore, a flattening yield curve, characterized by a 

decline in the spread between short- and long-term U.S. 

Treasury rates, can pressure NIMs. As indicated in 

New York Regional Outlook 11	 First Quarter 2001
 
 

Regional Perspectives
 

CHART 7 

Community Banks Experience Decline in Core-Deposits-to-Assets Ratio during the 1990s 

Note: Year-end numbers except for 2000, which are as of September 30. Median figures displayed. 

Source: Bank and Thrift Call Reports for community banks (those with total assets under $1 billion and in operation more than three years, excluding credit card banks) 

Core Deposits to Assets (percent) New York Region 

70 

72 

74 

76 

78 

80 

82 

84 

86 

88 

Nation (excluding the New York Region) 

1984 1986 1985 1987 1988 19901993 1994 1989 1991 1992 1995 1996 1998 2000 1997 1999 

Chart 8, the flattening of the yield curve in the second 

half of the 1990s accompanied declining NIMs for the 

Region’s community banks.25 Furthermore, as long-term 

rates declined in 1997 and 1998, consumers and commercial borrowers preferred longer-term loans. Similar 

to the extension of residential mortgage portfolios as 

the result of the mortgage refinancing wave of 1998, the 

maturity structure of nonresidential mortgage loan portfolios has lengthened during the current period of 

economic expansion (see Chart 9).26 Extension in maturity could expose community banks to greater interest 

rate risk because of community banks’ typically shortterm funding structure. In addition, longer-term loans 

could heighten credit risk because banks’ funds are 

CHART 8 

committed for a longer period, allowing more time for 

credit weaknesses to develop. 

Today’s Community Banks Face Cyclical 

and Competitive Challenges 

The Region’s community banks have benefited from the 

nation’s economic prosperity, as did their peers during 

the 1980s. Much as banks did during the 1980s, today’s 

crop of community banks has increased loan portfolios 

to meet the growing financing needs of consumers and 

businesses. Recent loan growth has been focused on 

commercial lending, a typically higher-yielding, higherFlattening Yield Curve Contributes to Tightening NIMs 

NIM = net interest margin 

Note: Median NIM of institutions with total assets under $1 billion, excluding banks in operation less than three years and credit card banks. The spread is the difference 

between the yield on ten-year U.S. Treasury notes and three-month U.S. Treasury bills. 

Sources: Federal Reserve Board (Haver Analytics) and Bank and Thrift Call Reports 

–100 

0 

100 

200 

300 

400 

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

3.5 

3.7 

3.9 

4.1 

4.3 

Spread (left axis) NIM (right axis) 4.5

Basis Point Spread Percent 

25 Steepness of the yield curve is measured by the difference in yield on ten-year and three-month U.S. Treasury securities. An increase in the spread
 

indicates a steepening of the yield curve; a decrease in the spread indicates a flattening yield curve.
 

26 Nonresidential mortgage repricing data include commercial, consumer installment, and all other nonmortgage loans.
 

New York Regional Outlook 12 First Quarter 2001
 
Regional Perspectives
 

CHART 9 

Nonmortgage Loan Maturity Lengthened 

during the Economic Expansion 

September ’97 September ’00 

<1 Year 

1–3 Years 

3–5 Years 

>5 Years 

47.7 41.6 

17.4 15.6

18.8 22.7 

15.6 19.8 

60% 

Note: Percentage of nonresidential loans maturing/repricing within listed timeframes,
 

using aggregate data.
 

Source: Bank Call Reports (excludes thrift institutions), for community banks (total
 

assets under $1 billion and in operation more than three years, excluding credit
 

card banks)
 

60% 40% 20% 0% 20% 40% 

risk lending segment. Community banks now face the 

prospect of slower national and regional economic 

growth. Favorable credit quality has aided community 

banks’ profitability in the face of declining NIMs; however, should the economy slow further, credit quality 

may deteriorate. While capital and reserve ratios are 

generally higher than a decade ago, the Region’s community banks are exhibiting an increasing credit risk 

profile as the economy enters a period of slower growth. 

Moreover, despite strong loan growth reported by the 

Region’s community banks, margins have been strained 

from increased competition and a flat yield curve. 

Although the shape of the Treasury yield typically 

varies over time, increased competition in the banking 

industry is likely here to stay. As a result, NIMs may 

continue to narrow despite favorable changes in the 

shape of yield curve and a shift into traditionally higheryielding, higher-risk loan categories. 

Kathy R. Kalser, Regional Manager 

Robert DiChiara, Financial Analyst 

Norman Gertner, Regional Economist 

Alexander J.G. Gilchrist, Economic Analyst 

New York Regional Outlook 13 First Quarter 2001
 
In Focus This Quarter
 

Credit Problems for U.S. Businesses 


Continue to Increase
 

•	 Commercial credit quality trends have been slipping since 1998, despite generally favorable U.S. 

business conditions. 

•	 The recent economic slowdown, coupled with 

tighter credit conditions, points to continued deterioration in business credit quality over the coming months. 

•	 Trends in bond defaults, syndicated lending, corporate profitability, and expected default levels 

reveal a number of industry sectors that pose a 

heightened degree of risk to lenders. 

Introduction 

Continuing increases in problem commercial loans have 

focused the spotlight on business lending conditions. 

On September 30, 2000, commercial banks reported the 

highest relative level of noncurrent1 commercial 

loans—at 1.52 percent of total commercial loans— 

since third quarter 1994. In fact, commercial banks have 

been reporting steadily higher rates of noncurrent 

domestic commercial loans since the second quarter of 

1999. The first quarter 2000 edition of Regional Outlook identified several factors contributing to the 

decline in business credit quality despite the strong economic indicators then in place. These factors, which are 

still relevant today, include the rise in financial leverage 

for domestic corporations, greater investment risk 

appetite and looser underwriting standards from 1996 to 

1999, and increasing financial stress within various 

industry sectors. More recently, an apparent slowdown 

in economic growth increases prospects for further 

deterioration in business credit conditions. 

Large Banks Experience a Reversal 

in Commercial Credit Quality Trends 

Through much of the 1990s, a sustained period of economic growth produced improving commercial loan 

credit quality indicators for insured commercial banks. 

This trend reversed itself in 1998, when banks began 

1 Nonaccrual loans plus loans 90 days or more delinquent. 

experiencing a steady rise in nonperforming and delinquent commercial loans. While the initial catalyst for 

this reversal was related mainly to events abroad,2 a 

slowing domestic economy has since taken center stage 

as the underlying driving force behind worsening commercial credit quality trends. 

As of September 30, 2000, noncurrent commercial and 

industrial (C&I) loans held by commercial banks stood 

at $15.6 billion, a 46 percent increase over the previous 

year. Roughly 97 percent of this increase is attributable 

to the rise in nonaccrual and delinquent credit to U.S. 

domiciled borrowers. Net C&I loan loss rates are also 

rising. Through the first three quarters of 2000, annualized C&I loan loss rates reached 0.64 percent, up from 

0.58 percent in 1999. The last time banks saw C&I loss 

rates this high was in 1993 (0.74 percent). 

Larger banks, which have the greatest exposures to 

large- and middle-market corporate credits, have been 

hardest hit by the turnaround in business credit conditions. As shown in Chart 1, banks with over $1 billion 

in assets have experienced most of the recent deterioration in C&I noncurrent loan rates. Since the fourth 

quarter of 1997, the noncurrent C&I loan rate of large 

CHART 1 

Noncurrent Loan Rates
 

Are Rising at Larger Banks
 

Percentage of C&I loans on nonaccrual
 

and 90 days or more past-due 5.2 

4.8 

4.4 

4.0 

3.6 

3.2 

2.8 

2.4 

2.0 

1.6 

1.2 

0.8 

0.4 

4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 

Small Banks 

(< $1 billion in assets) 

Large Banks 

(> $1 billion in assets) 

’88 ’90 ’91 ’92 ’93 ’95 ’96 ’97 ’98 ’00 

Source: Bank Call Reports 

2 Significant events that contributed to higher levels of problem foreign loans in 1998 include the collapse of Asian currency exchange 

rates and default by the Russian government on its sovereign debts. 

Some domestic industries that were highly dependent on exports 

(steel, for example) were also adversely affected by these events. 

New York Regional Outlook 14	 First Quarter 2001
 
In Focus This Quarter
 

banks has increased from 0.74 percent to 1.50 percent. 

Over the same period, noncurrent C&I loan rates at 

small banks were unchanged at 1.64 percent. While the 

increase in noncurrent loan rates at larger banks is significant, these higher rates remain well below those that 

preceded the 1990 to 1991 recession, when noncurrent 

loan rates at large banks were in the 3.40 percent to 3.60 

percent range. 

Much of the recent deterioration in banks’ business 

credit quality is attributable to the seasoning of credits 

underwritten during a period of relaxed lending standards. Each of the three bank supervisory agencies has 

recognized and warned about the potential impact of 

loosened loan underwriting standards in the event of a 

slowdown in the economy. For example, just over a year 

ago, the Office of the Comptroller of the Currency 

(OCC) issued a warning to banks about the “...cumulative effect of the past four years of easing standards...” 

for commercial loans.3 The shift toward more liberal 

credit standards from 1996 to 1999 was fueled by various factors, including a robust economy, intense competition to originate syndicated credits, and an increased 

appetite for risk. During this period, a number of banks 

moved aggressively into non-investment-grade lending to 

combat narrowing interest margins and declining investment-grade yields. According to a recent Standard & 

Poor’s commentary, several banks have acknowledged 

the role of 1997 and 1998 vintage credits in producing 

higher levels of problem loans.4 

Business Loan Performance Is Not Likely 

to Improve Any Time Soon 

Prospects for any near-term reversal in deteriorating 

commercial loan trends are dimming as signs of slower 

economic growth and tighter credit conditions emerge. 

Economic indicators suggest an aging economic expansion that is losing momentum. In third quarter 2000, the 

U.S. economy recorded its 39th consecutive quarter of 

growth. However, real gross domestic product growth 

for the third quarter was only 2.2 percent, well below 

the previous quarter’s growth of 5.6 percent and below 

the 4.9 percent average quarterly growth rate during the 

past eight quarters. Corporate earnings also appear to be 

slowing. Annualized corporate profit growth in the third 

3 Office of the Comptroller of the Currency Press Release. October 5,
 

1999.
 

4 July 20, 2000. “U.S. Bank Loan Portfolios Reflect Rise in Corporate
 

Bond Defaults.” Standard & Poor’s Commentary.
 

quarter slowed to 5.1 percent, down from a 15.6 percent 

annualized growth rate in second quarter 2000 and a 

10.4 percent average growth rate over the past eight 

quarters.5 Corporate earnings are widely anticipated to 

slow even further based on the number of companies 

that have warned of profits falling below expectations 

in the fourth quarter.6 

Prospects for slower economic growth prompted the 

Federal Reserve to lower its target for the federal funds 

rate (the rate charged on overnight lending) by 1/2 percentage point to 6 percent on January 3, 2000. This cut 

follows a 175-basis-point increase in the targeted federal funds rate since the end of June 1999. Although higher interest rates have undoubtedly raised borrowing 

costs for U.S. corporations, business borrowing rates— 

even before the Federal Reserve cut interest rates in January 2001—are well below those prevalent during much 

of the 1980s (see Chart 2, next page). Moreover, 

changes in rates have been far less volatile in the latter 

part of the 1990s than they were during the 1980s and 

early 1990s. 

Tolerance for risk on the part of investors and lenders is 

waning. In a November 2000 survey of underwriting 

practices, the Federal Reserve Board noted that 44 percent of U.S. banks tightened credit terms for large- and 

middle-market borrowers in the past three months, the 

highest incidence of tightening since fourth quarter 

1990. This tightening of credit terms is primarily in 

response to economic concerns, industry-specific problems, and a lower tolerance for risk. Banks appear to be 

especially apprehensive about taking on additional 

credit risk related to merger and acquisition financing 

deals, new borrowing prospects, and specific industry 

segments such as health care, movie theaters, and communications.7 

Tighter credit terms by banks will have the greatest 

impact on high-risk companies, which have fewer 

financing options in an environment of slumping bond 

and stock prices. Moreover, there appears to be a significant increase in the volume of maturing debt that 

could be forced into default if capital market or bank 

5 These figures are taken from the U.S. Department of Commerce’s 

statistics on corporate profits with inventory valuation adjustments. 

6 According to First Call/Thomson Financial, 505 companies released 

warnings that fourth quarter 2000 earnings would fall below expectations, up 96 percent from the 257 companies with negative profit 

warnings for fourth quarter 1999. 

7 See the Federal Reserve Board’s November 2000 Senior Loan Officer Opinion Survey on Bank Lending Practices. 

New York Regional Outlook 15 First Quarter 2001
 
 

In Focus This Quarter
 

CHART 2 

Business Borrowing Rates Have Risen but Are Less Volatile than in Past Cycles 

Percent 

1Q82 3Q83 1Q85 3Q86 1Q88 3Q89 1Q91 3Q92 1Q94 3Q95 1Q97 3Q98 1Q00 

Note: LIBOR = London Interbank Offer Rate 

Sources: Federal Reserve Board, Moody's, FT London Interbank 

3-Month LIBOR 

Moody’s Baa Average Yield 

Prime Rate 

0 

2 

4 

6 

8 

10 

12 

14 

16 

18 

funding is not available. According to Moody’s, some 

$108 billion of rated speculative-grade corporate debt 

held by banks matures over the next three years, a 40 

percent increase over year-earlier levels. 

Higher-risk companies also have a lower capacity to 

absorb the cost of higher interest rates. Yet many companies with debt maturing in the near term will likely be 

forced to pay higher risk premiums than in the past. For 

example, Moody’s notes that in November 2000, speculative-grade bond yield spreads over seven-year Treasuries reached their widest level since February 1991, at 

771 basis points.8 Chart 3 illustrates further how credit 

spreads between just-investment-grade bond issues and 

near-investment-grade bond issues have widened considerably compared with spreads between lower-investment-grade bond issues since the beginning of 2000. 

Some of the most significant increases in credit spreads 

have been observed in the high-yield telecommunications sector, where credit spreads over seven-year Treasuries widened by 688 basis points in 2000.9 

The effects of tighter credit conditions and a reduced 

appetite for risk are beginning to emerge in loan origination volumes. According to Loan Pricing Corporation, originations of highly leveraged loans10 through 

8 December 2000. Moody’s Leveraged Finance Commentary. 

9 Merrill Lynch Global Bond composites. Issues facing the telecommunications industry are explored further in the article entitled 

“Three Industries Navigating in a Competitively Charged Environment” in this issue of the Regional Outlook. 10 Loan Pricing Corporation defines highly leveraged loan transactions as those carrying interest rates of 250 basis points or more over 

the London Interbank Offer Rate (LIBOR). 

the first three quarters of 2000 fell to $117 billion from 

$140 billion for the same period in 1999. 

Corporate bond trends provide further evidence of 

financial stress in the domestic market and suggest 

more near-term deterioration in problem business 

loans. Corporate bond default rates have climbed significantly since 1997 (see Chart 4). Through November 2000, trailing 12-month default rates on 

speculative-grade corporate bonds reached 6.8 percent, up from 3.5 percent at the end of 1998. Higher 

default rates have been accompanied by an accelerated 

pace of negative ratings revisions, which, according to 

Moody’s, reached a rate of 3.2 speculative-grade 

downgrades for every speculative-grade upgrade 

through the first 11 months of 2000.11 More signifiCHART 3 

Credit Risk Premiums for High-Yield 

Bond Issues Have Increased Sharply 

Basis Point Yield Spread Between 

220 

200 

180 

160 

140 

120 

100 

80 

60 

40 

20 

0 

A-rated and 

BBB-rated bonds 

BBB-rated and 

BB-rated bonds 

Jan Mar May Jul Sep Nov Jan Mar May Jul Sep Nov 

’99 ’99 ’99 ’99 ’99 ’99 ’00 ’00 ’00 ’00 ’00 ’00 

Source: Merrill Lynch 

11 See Moody’s Credit Perspectives, December 4, 2000. 

New York Regional Outlook 16 First Quarter 2001
 
In Focus This Quarter
 

cant, Moody’s projects that speculative-grade corporate bond defaults will continue to move higher to 9.1 

percent over the coming year. Given a fairly strong 

correlation between speculative bond default rates and 

banks’ noncurrent loan rates, these projections suggest 

a continuing rise in the relative level of problem commercial loans.12 

Loan Default Risk Is Rising 

in a Number of Industry Sectors 

Evidence from Corporate Bond Defaults 

Corporate bond defaults provide clues as to which 

industries may experience a higher rate of defaults. 

Chart 4 shows the historical trend in speculative-grade 

bond defaults since 1988. The initial upward spike in 

default rates in 1998 was largely the result of events 

abroad, when 74, or 59 percent, of 126 defaulted issues 

were attributed to foreign-domiciled issues.13 In 1999, 

the distribution of defaults shifted decidedly toward 

domestic issues, with U.S. firms accounting for 99, or 

67 percent, of 147 defaults. Of the U.S.-domiciled 

defaults in 1999, 64 percent were related to industrial 

CHART 4 

sectors, with concentrations in price-sensitive commodity and trade-dependent sectors such as oil and gas, 

shipping, and steel. Other domestic sectors that experienced a noteworthy rise in defaulted issues in 1999 were 

telecommunications and health care. Year-to-date 2000 

defaults continue to be dominated by U.S. firms.14 

According to Moody’s, year-to-date defaulted bond 

issues have been concentrated in health care; telecommunications; and textiles, leather, and apparel.15 

Evidence from Syndicated Loan Trends 

Past growth in syndicated loans may be another indicator of default risk. Many lenders appeared to increase 

their appetite for risk from 1996 through 1999, judging 

by the growth in leveraged loan and highly leveraged 

loan volumes during this period (see Chart 5, next 

page).16 Because rapid loan growth can be an indicator 

of aggressive risk taking, it is important to review some 

significant borrowing industries that experienced rapid 

credit growth from 1996 to 2000. It is also worthwhile 

to review industries where higher-risk (high-yield) borrowing accounted for a substantial proportion of syndicated loan transactions. 

Pace of Speculative Bond Defaults Expected to Rise Significantly
 

Bond Rating Downgrades to Upgrades (right axis) 

Trailing 12-Month Speculative-Grade Bond Default Rate 

Bank C&I Noncurrent Rate Projected 

Default and Noncurrent Loan Rate (%) Bond Downgrades to Upgrades 

0 

1 

2 

3 

4 

5 

6 

0 

1 

2 

3 

4 

5 

6 

7 

8 

9 

10 

11 

’88 ’89 ’90’92 ’91 ’93 ’94 ’95 ’96 ’97 ’98 ’99 3Q’00 3Q’01 

YTD* 

* Bond default rates through November 30, 2000 

Sources: Moody’s, Call Reports 

12 There is a strong correlation between historical speculative-grade corporate bond defaults and noncurrent loan rates. The correlation coefficient 

between these two variables for the period 1984 to the present is 0.67. 

13 Indonesia alone accounted for 32 defaulted issues in 1998, and sovereign issuers accounted for 36 percent of defaulted debt volume. Historical 

Default Rates of Corporate Bond Issuers, 1998. Moody’s Investor Service. 14 Historical Default Rates of Corporate Bond Issuers, 1999. Moody’s Investor Service. 15 Moody’s Credit Perspectives, December 11, 2000. Issues facing the health care and textile industries are explored further in the article entitled 

“Three Industries Navigating in a Competitively Charged Environment” in this issue of the Regional Outlook. 16 Loan Pricing Corporation defines leveraged transactions as those that carry interest rate spreads of 150 basis points or more over LIBOR and 

highly leveraged transactions as those that carry spreads of 250 basis points or more over LIBOR. Because these definitions are spread-driven, the 

rise in the proportion of higher-yield issuance is attributable in part to a general increase in credit spreads. This was the case particularly during 

the 1998 period, when credit spreads rose significantly. 

New York Regional Outlook 17 First Quarter 2001
 
In Focus This Quarter
 

CHART 5 

Source: Loan Pricing Corporation 

High-Yield Loan Syndications More 

Prevalent from 1996 through 1999 

Leverage Lending to Total 

Syndicated Lending (%) 

Syndicated Loan 

Originations ($ billions) 

High-Yield Leverage Lending 

to Total Syndicated 

Lending (left scale) 

0 

5 

10 

15 

20 

25 

30 

35 

0 

200 

400 

600 

800 

1,000 

1,200 

’90 ’91 ’93 ’95 ’97 ’99 ’92 ’94 ’96 ’98 ’00

Table 1 lists selected industries17 that accounted for a 

significant proportion of syndicated loan volumes from 

1996 to 2000, according to Thomson Financial Securities Data. Industries that experienced some of the most 

rapid growth rates in syndicated loan volumes during 

that time include utilities, telecommunications, and real 

estate investment trusts (REITs). Industries that recorded a particularly significant proportion of high-yield 

TABLE 1 

transactions during that period include real estate and 

construction, REITs, health care, and entertainment/ 

lodging/leisure. 

Evidence from Corporate Profit Trends 

Industry sector earnings trends may also be an indicator 

of industry default risk, because higher defaults are 

more likely in sectors with weak earnings. As noted 

above, profit growth rates of domestic firms appear to 

be decelerating following two years of strong earnings 

growth overall. Rapid growth in previous quarters 

appears to have been driven in large part by high-tech 

and related sectors, such as electronic equipment and 

communications. These sectors have to a large extent 

overshadowed noteworthy declines in profit growth in 

other sectors, such as metals, chemical production, 

medical services, property casualty insurance, apparel 

and textiles, manufactured housing, agriculture, transportation, and wholesale trade (see Table 2). 

Evidence from Credit Risk Models 

Credit default models have proliferated in recent years 

because of advances in technology, data availability, and 

financial theory. One such model is KMV LLC’s CredHistorical U.S. Syndicated Loan Trends 

Help Identify Possible Sources of Industry Credit Risks 

1996 TO 2000 

SHARE OF AVG. ANNUAL 2000 

1996 TO 2000 ISSUANCE ISSUANCE HY AS A % 

ISSUANCE GROWTH GROWTH 1996 TO 2000 

INDUSTRY (%) (%) (%) ISSUANCE 

WHOLESALE AND RETAIL TRADE 7.8 –2 –12 34 

ELECTRIC, GAS AND SANITARY 

UTILITIES 6.5 34 15 19 

TELECOMMUNICATIONS 5.4 28 54 29 

NONDEPOSITORY INVESTMENT 

COMPANIES 5.2 19 24 33 

OIL AND GAS 4.1 23 83 18 

SECURITIES BROKERS/DEALERS 3.7 15 13 4 

ENTERTAINMENT/LEISURE/LODGING 3.3 5 31 42 

REAL ESTATE INVESTMENT TRUST 2.7 27 25 49 

HEALTH CARE 2.6 –4 –41 44 

REAL ESTATE AND CONSTRUCTION 2.5 25 46 50 

Note: HY (high-yield) issuance includes deals priced at 125 basis points or more over LIBOR. 

Source: Thomson Financial Securities Data 

17 This list is taken from a group of 50 sectors defined using Standard Industrial Codes (SICs). Only industries that accounted for more than 2 percent of 1996 to 2000 origination volumes were considered for inclusion. 

New York Regional Outlook 18 First Quarter 2001
 
In Focus This Quarter
 

it Monitor®. This model, which uses publicly available 

information to estimate the likelihood of default for 

individual firms, is widely used by lenders to monitor 

and evaluate obligor risk and credit risk trends. While it 

is not the only model available, the KMV model can be 

applied consistently and easily to the analysis of industry sector credit risk across a broad range of industry 

groupings. 

In brief, the KMV model uses options-pricing theory to 

derive market-based expected default probabilities or 

an expected default frequency (EDFTM).18 The model 

relies mainly on three pieces of information: (1) a 

firm’s asset market value; (2) the volatility of a firm’s 

asset market values; and (3) the firm’s capital structure 

or financial leverage. Although EDFTM scores are company-specific, median industry expected default probTABLE 2 

abilities can be constructed and compared across 

industries and across time to discern relative rankings 

of industry risk and industry risk trends. These median 

EDFTM scores also can be mapped to other default measurement scales, such as external rating agency ratings, 

based on individual EDFTM scores of firms with rated 

debt. 

Since the second quarter of 1998, median EDFTM scores 

have risen significantly across a wide range of U.S. nonfinancial industry sectors (see Chart 6, next page). The 

service and trade sector includes the greatest proportion 

of firms with high default risk. The median probability 

of default for the manufacturing sector firms is lower, 

but it is rising and roughly equaled that of Standard & 

Poor’s BB-grade (sub-investment-grade) obligors as of 

December 2000. 

Various Industries Have Exhibited Negative Profitability Trends 

ANNUAL GROWTH IN NET INCOME 

1998 1996 TO 1999 1994 TO 1999 

INDUSTRY TO 1999 (%) AVERAGE (%) AVERAGE (%) 

STEEL –1,237.9 –428.6 –187.4 

COPPER –80.7 –65.5 13.2 

INTERNET –43.2 –42.7 –35.5 

TIRES AND RUBBER –81.9 –28.6 –12.7 

ALUMINUM –13.2 –13.9 156.4 

CHEMICALS –38.1 –3.9 18.4 

MEDICAL SERVICES AND 

INFORMATION SYSTEMS –48.2 –2.5 44.8 

PROPERTY CASUALTY INSURANCE –3.9 –2.0 3.8 

RECREATIONAL GOODS AND SERVICES .5 2.5 17.1 

APPAREL AND TEXTILES 2.5 10.4 3.3 

MANUFACTURED HOUSING AND 

RECREATIONAL VEHICLES –9.8 11.7 27.3 

AGRICULTURE –1.3 12.3 4.6 

WHOLESALE TRADE –8.8 13.7 13.7 

CEMENT AND AGGREGATES 1.2 21.6 60.5 

OILFIELD SERVICES AND PRODUCTION –373.7 39.9 19.3 

AIRLINES AND FREIGHT –13.2 1,085.5 666.5 

ALL CORPORATE PROFITS (WITH 

INVENTORY VALUATION AND CAPITAL 

CONSUMPTION ADJ.) 5.0 4.4 13.6 

Sources: Economy.com Precis Reports; U.S. Department of Commerce, Survey of Business Conditions 

18 Typically expressed as the probability of default over the coming year. 

New York Regional Outlook 19 First Quarter 2001
 
 

In Focus This Quarter
 

Although no one factor can explain the rise in expected CHART 6 

default measures for U.S. nonfinancial firms, rising 

financial leverage is clearly a major determinant. U.S. 

corporate debt burdens continue to rise in conjunction 

with the longest-running economic expansion in U.S. 

history. The debt-to-net-worth ratio (book value) of 

nonfarm, nonfinancial businesses rose to 83 percent in 

the second quarter of 2000, up from 72 percent at yearend 1996. Although these figures remain below the relative debt levels experienced in the late 1980s and early 

1990s,19 U.S. businesses are nevertheless becoming 

increasingly vulnerable to rising credit costs and disruptions in credit availability. Higher asset value volatility20 has also played a role in rising EDFTM scores, 

which, as in any options-based credit risk model, leads 

to a greater likelihood of default. 

Default Risk Is Rising Broadly 

among U.S. Nonfinancial Firms 

Source: Credit MonitorTM ©2000, KMV LLC, all rights reserved 

3Q 

’00 

1Q 

’96 

3Q 

’96 

3Q 

’97 

1Q 

’99 

3Q 

’98 

3Q 

’99 

1Q 

’00 

1Q 

’97 

1Q 

’98 

0.0 

1.0 

2.0 

3.0 

4.0 

5.0 

6.0 

7.0 

Service & Trade 

Manufacturing 

One-Year EDFTM in Percent

Comparative Median EDFTM 

of S&P Bonds Rated BB 

(as of December 2000) 

Chart 7 shows eight of the highest-risk industries in 

terms of changes in median EDFTM scores over the past 

two years. These industries were drawn from a list of 50 

financial and nonfinancial sectors segregated by Standard Industrial Codes (SICs). For each of these 50 sectors, median EDFTM scores were determined for 

December 2000 and compared with median EDFTM 

scores for the same sector in December 1998. Consistent with general industry observations, entertainment 

and leisure, health care, and telecommunications are 

among the sectors where default risk has risen most significantly over the past two years. 

CHART 7 

While Chart 7 illustrates sectors undergoing financial 

stress, it does not provide information on the relative 

importance of these sectors to lenders. Thomson 

Financial Securities Data provides information on the 

volumes of syndicated loan originations by banks and 

nonbanks. Matching industry-expected default trends 

with syndicated loan origination trends by industry is 

one way to determine the relative importance of higherrisk industry credit exposures.21 

Chart 8 shows median EDFTM and syndicated loan origination pairs for selected industries during the past three 

Industries That Experienced the Greatest Increase
 

in Expected Default Risk over the Past Two Years
 

Median Expected Default

Frequency (EDFTM) in Percent 14

12 

10 

8 

6 

4 

2 

0 

December 1998

 December 2000 

Comparative Median EDFTM 

of S&P Bonds Rated BB 

(as of December 2000) 

Entertainment Health Wholesale Apparel Business Agriculture Telecom Retail 

& Leisure Care Trade & Textile Services 

Source: Credit MonitorTM ©2000, KMV LLC, all rights reserved 

19 The debt-to-net worth ratio for U.S. nonfarm, nonfinancial businesses averaged slightly under 87 percent from 1988 to 1992. 

20 Implicit in changes in stock prices. 

21 Syndicated loan originations are an imperfect measure of actual loan exposures in the financial industry. For example, it is not possible to determine the level of outstanding exposures simply by summing up origination levels from year to year, because payments on long-term debt are not 

considered. Moreover, a substantial volume of debt represents revolving lines of credit where credit exposures roll over on a periodic basis. Nevertheless, trends in originations do contain some information on the relative level of industry exposures, because they show which industries are 

borrowing more or less during any given year. 

New York Regional Outlook 20 First Quarter 2001
 
In Focus This Quarter
 

years. Of the industries shown, the telecommunications 

industry appears to present the greatest degree of risk, 

given a nearly $50 billion increase in loan volumes from 

1998 to 2000, coupled with a 170 percent increase in 

median expected default levels over the same period. In 

contrast, loans to securities brokers and dealers can be 

considered relatively less risky—despite a $17 billion 

rise in originations from 1998 to 2000—because of a 

fairly modest rise in median expected defaults. It is also 

interesting to contrast the health care and entertainment 

and leisure sectors. Firms in both sectors have experienced a dramatic rise in expected defaults. However, 

since 1998, Thomson Financial Securities Data shows a 

significant curtailment in lending to health care companies, while entertainment and leisure originations have 

held steady over the same period. Because banks appear 

to be reducing credit exposures to health care firms, 

banks should eventually see a decline in the level of 

defaulting debt related to this sector. 

Chart 8 illustrates how U.S. syndicated loan issuance 

and expected default measures can be linked to produce 

a better sense of risk-weighted industry exposure volumes held by lenders. On the basis of this type of analysis, producing a list of industry sectors that appear to 

pose the greatest degree of syndicated loan default risk 

is relatively straightforward. Perhaps not surprisingly, 

industries such as telecommunications, wholesale and 

retail trade, entertainment and leisure, health care, and 

apparel and textiles rank high in terms of risk-weighted 

industry credit exposures using this analysis.22 

Conclusion
 

Many U.S. banks are experiencing deterioration in business loan quality measures. The adverse effects of higher interest rates, a tightening of credit terms, slowing 

profit growth, and industry sector weaknesses are the 

primary contributing factors to this deterioration. Several indicators—including a projected increase in corporate bond default rates, rising expected default trends 

in certain industry sectors, and evidence of lax underwriting practices in previous periods—suggest that 

banks could experience substantial further deterioration 

in business loan quality in the near term. 

Although worsening business loan quality is a concern, these negative trends must be put into perspective. In relative terms, current indicators of business 

loan problems do not approach the experience of 

banks during the last economic downturn of the early 

1990s. Moreover, continued strong earnings and capital provide a significant buffer for banks to weather 

the effects of higher levels of nonperforming business 

loans and business loan losses. Nevertheless, the 

prospect of a slowdown in the economy raises concerns about the possible severity of commercial loan 

problems, a situation that will undoubtedly be watched 

closely by both banks and bank supervisors in the 

coming months. 

Steven Burton, Senior Banking Analyst 

CHART 8 Median EDFTM in Percent 

Expected Default Data Can Be Used to Risk-Weight Industry Credit Risk 

Sources: Credit MonitorTM ©2000, KMV LLC, all rights reserved; Securities Data Corporation 

Health Care 

Syndicated Loan Originations by Industry Sector ($ Billions) 

0 

2 

4 

6 

8 

10 

12 

14 Entertainment & Leisure 

Wholesale Distributors 

Telecommunications 

Securities Brokers & Dealers 

0 20406080100 

2000 

1999 1998 

Legend: 

2000 Originations and Dec. ’00 EDFTM 

1999 Originations and Dec. ’99 EDFTM 

1998 Originations and Dec. ’98 EDFTM 

22 Fifty sectors, grouped by SIC codes, were considered. 

New York Regional Outlook 21 First Quarter 2001
 
In Focus This Quarter
 

Three Industries Navigating 


in a Competitively Charged Environment
 

The rising tide of a booming economy in the United 

States has lifted the boats of a broad spectrum of industries over the past nine years. Some industries, however, 

have fallen on hard times despite continued economic 

expansion. These industries represent a broad crosssection of the economy. Problems in these industries were 

precipitated by diverse factors, reflecting the differences 

among sectors in industries ranging from old economy 

(such as textiles) to services (such as health care) to those 

on the horizon (such as telecommunications). 

These industries will navigate in turbulent waters over 

the next few years. All three face an uncertain economic outlook, changing public policies that can influence 

their operating environment, and fierce competition. 

The importance of these industries to the U.S. economy 

varies based on employment. The telecommunications 

industry accounts for about 1.4 million jobs, or 0.85 

percent of total U.S. employment.1 Health care, on the 

other hand, contributes over 11 million jobs, or 7 percent of total employment. Textile industry employment 

has been falling steadily for many years and is now 

under 550,000, accounting for less than 0.40 percent of 

total U.S. employment. 

As diverse as these industries are, a common denominator exists. Intense competition characterizes their 

operating environment, leaving little room for strategic 

missteps. Indeed, there have been reports that these 

industries have been significant contributors to the 

recent rise in problem bank loans. 

With a better grasp of the origins of stress in these 

industries comes a basis for understanding the lending 

risks associated with a changing policy and economic 

environment in the years to come. The following discussion describes trends and developments contributing 

to stress in these industries and looks at the near- and 

long-term outlook. Our discussion also looks at the 

implications for the insured institutions lending to the 

telecommunications, health care, and textiles industries. 

1 Source: Economy.com. Includes employment in telecommunications 

services, telecommunications equipment manufacturing, and cable 

television. 

Telecommunications 

The telecommunications sector consists of several 

industry subsectors, including telecommunications services, cable television, and telecommunications equipment, all of which are facing significant challenges. 

Telecommunications Services 

Rapid growth in the telecommunications services 

industry has been fueled by strong domestic consumer 

demand. However, the pace of consumption of telecommunications services has slowed in recent months. This 

sector has experienced booming growth in revenues 

from computer network access since 1998, while local 

and long distance revenues have grown at a much more 

moderate pace (see Chart 1). 

Rapid change and intense competition characterize the 

industry environment. Long distance businesses, in particular, have experienced fierce competition, resulting 

in severe pricing pressures. Competitors include both 

established and new wireline long distance providers, as 

well as wireless services. Local telephone companies, 

however, have fared well in recent years, as residences 

and small businesses have added phone lines to accommodate the growing demand for Internet access. However, as high-speed DSL and cable Internet access 

become more readily available, the demand for additional telephone lines may diminish, cutting into a 

lucrative source of revenue for local phone companies. 

Capital spending by telecommunications services companies has soared in recent years, although it was 

expected to level off in 2000 in response to higher interest rates and reduced earnings growth. Nevertheless, 

high levels of telecommunications equipment investment are expected to continue for the foreseeable future, 

as telecom service firms require additional equipment 

upgrades to accommodate increased network traffic and 

wireless applications (see Chart 2). 

Cable TV 

Cable TV is another important component of the 

telecommunications services industry. According to 

Economy.com, “among the current technologies available, cable is viewed as the leading option for delivering 

New York Regional Outlook 22 First Quarter 2001
 
In Focus This Quarter
 

CHART 1 

* Forecast 

Source: Economy.com 

Growth in Telecom Services’ Network Access Revenues Soared in Recent Years 

Annual % Change in Residential

Service Revenues

Residential—Local Residential—Long Distance 

Residential—Network Access 

0 

5 

10 

15 

20 

25 

30 

35 

40 

45 

50 

55 

60 

65 

’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00* 

video, telephony, entertainment, and computing services to households and businesses.”2 Cable TV sales 

revenue has grown more than 19 percent a year since 

1995. In spite of this stellar revenue growth, most cable 

companies are not earning a profit because of the high 

levels of capital investment required. 

Telecommunications Equipment 

The telecommunications equipment industry is growing 

rapidly, as telecom service providers rush to upgrade 

infrastructure to enhance their offerings of high-speed 

broadband services. Telecommunications service 

providers are not only upgrading fiber optic and cable 

line networks; they are rapidly upgrading antiquated 

circuit-switched networks to more efficient packetswitch networks. However, the growth in revenues and 

profits was expected to moderate in 2000 because of 

higher interest rates and slower growth in the domestic 

economy (see Chart 3, next page). 

The wireless phone industry also has experienced problems since late 2000. The major mobile phone companies have missed earnings projections, casting doubt on 

the growth potential of the industry. Much is riding on 

the development of third-generation (3G) wireless technology, which is expected to allow wireless access to the 

Internet, transmission of video and other images, and 

videoconferencing—all from a handheld mobile phone. 

Although huge amounts of money are being invested to 

develop 3G technology, it is unclear what applications 

will generate the demand to make the investments profitable. 

CHART 2 

90,000 

80,000 

70,000 

(In $ millions)

60,000 

50,000 

40,000 

30,000 

20,000 

10,000 

0 

Telecom Services’ Capital Spending Growth Soars
 

’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00* 

* Forecast 

Source: Economy.com 

2 September 2000. Economy.com, Precis: Industry: Cable TV. 

New York Regional Outlook 23 First Quarter 2001
 
In Focus This Quarter
 

CHART 3 

Telecom Equipment Sales Revenue 

Moderates in 2000 

* Forecast 

Source: Economy.com Annual % Change in Telecom Equipment Sales Revenue 

0 

5 

10 

15 

20 

25 

30 

’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00* 

Outlook 

The telecommunications industry has been badly battered in both equity and bond markets in the past several months. A spate of bad news has resulted in sharply 

lower stock prices and higher costs in debt markets. As 

a result, the availability of financing for some higherrisk firms is now questionable. Investors are concerned 

about the prospect of slowing wireless subscriber 

growth, continuing capital expenditures, intense competition, and the rapid rise in telecom debt3 (see Chart 4). 

The long-term outlook for the telecommunications services industry is positive. The emergence of highmargin technologies and continued growth in wireless 

subscriber rates should enhance profitability in the 

future. Consumers and businesses are also expected to 

CHART 4 

spend an increasing share of their incomes on telecom 

services. Nevertheless, strong competition, huge investments in equipment upgrades, and rapidly changing 

technology will force firms to be nimble and innovative. 

The long-term outlook for the telecommunications 

equipment industry is positive, as the demand for data, 

Internet, and wireless services continues to grow 

strongly. Nevertheless, individual firms in the industry 

face a highly competitive environment and rapidly 

changing technology. 

Cable TV’s long-term outlook is also positive because 

of growing advertising sales and technological developments that should allow cable firms to offer a broader 

array of services. Still, the competitive environment is 

fierce. In addition to competing with a host of “traditional” telecommunications firms, cable firms must 

contend with satellite TV providers, which are partnering with major firms to offer sophisticated communications and entertainment services. 

Implications for Banks 

The most important characteristics of the telecom 

industry with respect to lending risks are its highly competitive environment and its pace of technological 

change. These characteristics suggest that the mediumto long-term outlook for a particular credit may not be 

well represented by current conditions. The success of 

telecom firms will be based on management’s ability to 

adapt to change and compete with a fluid set of competitors. 

Source: Standard & Poor's Compustat 

Growth in Telecom Debt since 1995 Dwarfs Other Sectors’ Debt Growth 

Telecom Industries 

Percent Change in Debt

(1995–1999) 

Radio/Tel. Broadcast/

Commun. Equip.

Basic Materials

ConsumerCyclical

Consumer

Staples

Health Care

Energy

Capital Goods

Technology

Communication

Services

Utilities 

Transportation

Radiotelephone

(Wireless)

Telephone, 

Except Wireless

Cable and Other

Pay TV Services 

0 

50 

100 

150 

200 

250 

300 

350 

400 

450 

500 

3 Solomon, Deborah, and Nicole Harris. October 18, 2000. “Talks on Merger By AT&T Wireless Face Investor Static.” Wall Street Journal. 

New York Regional Outlook 24 First Quarter 2001
 
 

In Focus This Quarter
 

CHART 5 

HMO Enrollment Rose Sharply through 1998 

as Employers Sought to Contain Health Care Costs 

HMO Enrollment as a

Percentage of Population 

’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00* 

0 

5 

10 

15 

20 

25 

30 

35 

* Forecast 

Sources: Economy.com, Interstudy 

With both equity and bond markets turning against the 

telecommunications industry, cash-hungry telecom 

firms may have difficulty obtaining financing. This 

could pose a serious risk for banks with a significant 

exposure to telecom start-ups without a major partner or 

an investor sponsor. 

The high capital requirements and financial leverage of 

many telecommunications firms complicate these lending risks. Some of these firms are borrowing heavily to 

put into place an infrastructure to accommodate a 

demand for services that is yet to come on-stream, 

meaning that the payback on this investment may not 

occur for a number of years. 

Health Care 

Industry trends such as declining hospital occupancy 

rates and rising outpatient visits to hospitals, intense 

competition, and the unexpected results of new 

Medicare policy combined to put the health care industry in difficult financial straits during the past few 

years. However, subsequent industry consolidation and 

streamlining and revised Medicare rules have helped to 

stabilize prospects for many health care providers. 

Recent Trends and Developments 

The health care industry has been suffering since the 

implementation of the Balanced Budget Act of 1997 

(BBA), which cut Medicare payments much more than 

expected. However, two subsequent bills were passed to 

“give back” a portion of the Medicare payment cuts 

implemented in the BBA. The Balanced Budget Refinement Act of 1999 should restore some $16 billion of the 

cuts to health care facilities over five years.4 Also, the 

recently passed Benefits Improvement and Protection 

Act of 2000 (BIPA) will restore about $35 billion in 

benefits to the industry over the next five years. BIPA 

will provide the greatest benefit to hospitals, managed 

care plans, nursing homes, and home health agencies. 

The health care industry’s financial situation has stabilized somewhat in the past year because of widespread 

consolidation of hospitals and other health care 

providers. This has helped the industry reach greater 

levels of efficiency as well as improved bargaining 

power in negotiations with managed care organizations. 

Notwithstanding these favorable developments, other 

trends continue to pose serious challenges to many 

firms. Higher labor costs, continued HMO penetration, 

breakthrough pharmaceutical therapies resulting in 

reduced demand for services, and increased outpatient 

volumes have buffeted many health care facilities (see 

Chart 5 and Chart 6, next page). 

Higher-Risk Sectors 

A better understanding of risks and trends in health care 

can be gained by discussing its specific sectors. We 

have segregated these sectors based on the results of an 

option-pricing model of firm default risk. These models 

estimate the probability that the market value of a firm’s 

assets will fall below a level that would trigger default. 

Firms that have low stock prices, volatile stock prices, 

or high debt levels will tend to be flagged as having 

high default risk by such models. 

4 June 15, 2000. Healthcare: Facilities. Standard & Poor’s Industry 

Surveys. 

New York Regional Outlook 25 First Quarter 2001
 
In Focus This Quarter
 

CHART 6	 Health care industry subsectors have been grouped into 

three categories: higher risk, moderate risk, and lower Outpatient Visits to Hospitals Grow Steadily risk, which refer to the degree of default risk relative to 

700 other subsectors in the industry. The estimated default 

Outpatient Visits to Hospitals

(millions) 

600 

500 

400 

300 

200 

100 

0 

’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00* 

* Forecast 

Sources: Economy.com, Morgan Quinto 

risk across these subsectors varies substantially. The 

highest-risk health care sectors include Offices of Medical Doctors; Skilled Nursing Care Facilities; Home 

Health Care Services; Specialized Outpatient Facilities, 

NEC; and Health Services (see Chart 7). 

Offices of Medical Doctors are largely physicians’ 

practice management firms. These firms acquire a practice of physicians based on a multiple of the practice’s 

discounted cash flow. The multiple can be several times 

the practice’s asset value at the time of purchase. However, these firms have had difficulty achieving profitability because of legal restrictions on referrals among 

affiliated groups of physicians, as well as the reluctance 

One such model that is readily available is Credit MonitorTM, which was developed by KMV LLC.5 We stratify 

health care sectors based on their median one-year 

default probability as estimated by expected default frequenciesTM (EDFsTM) generated by Credit MonitorTM. 

Sectors identified in this article as higher-risk sectors, 

therefore, are those with a relatively high percentage of 

firms with low stock prices, volatile stock prices, or 

high debt levels. Readers are cautioned that the risk profile of a specific company may be very different from 

the sector risk profiles described here. 

CHART 7 

of physicians to submit their medical practice to the criteria of cost control.6 Total liabilities in this sector have 

grown rapidly over the past few years. 

Skilled Nursing Care Facilities’ earnings have been 

hurt badly by the BBA. However, they stand to benefit 

from the Medicare “giveback” provided by the recently 

enacted BIPA, which seeks to rectify the deeper-thanexpected cuts in funding resulting from the BBA. 

Skilled nursing care facilities’ performance has also 

been adversely affected by (1) declining occupancy 

Estimated Default Risk Varies Widely among Health Care Subsectors, December 2000 

Median Expected Default

FrequencyTM (EDFTM)

in Percent 

Source: Credit MonitorTM ©2001, KMV LLC, all rights reserved 

Comparative Median EDFTM 

of S&P Bonds Rated BB 

(as of December 2000) 

0 

2 

4 

6 

8 

10 

12 

14 

16 

18 

20 

22 

8011: 

Doctors 

Offices 

8051: 

Skilled 

Nursing 

8082: 

Home 

Health Care 

8093: 

Spec. 

Outpatient, 

NEC 

8000: 

Health 

Services 

8071: 

Medical 

Labs 

8060: 

Hospitals 

6324: 

HMOs 

8090: 

Misc. Health 

Services 

8062: 

Med. & 

Surgical 

Hospitals 

5 Credit MonitorTM’s Expected Default FrequencyTM (EDFTM) estimates the probability of default within one year. KMV LLC’s proprietary calculation for EDFTM is based on (1) the current market value of the firm, (2) the structure of the firm’s current obligations, and (3) the vulnerabiltiy of 

the firm to large changes in market value measured in terms of asset volatility. EDFsTM are one of many potential measures of industry risk, and 

their use in this article should not be construed as an endorsement by the FDIC or Credit MonitorTM. 6 Gruehn, Charles. April 2000. Healthcare Industry Manual. Federal Reserve Bank of Atlanta. 

New York Regional Outlook 26	 First Quarter 2001
 
 

In Focus This Quarter
 

rates caused at least partly by increased competition 

from lower-acuity facilities such as assisted living facilities; (2) rising labor and legal costs; and (3) surging 

debt service costs. Many of these firms are experiencing severe financial stress. The stressed facilities have 

registered negative net income for the past year or so, as 

well as burgeoning debt levels. The high debt levels are 

the result of acquisitions of ancillary support services 

that in many cases are not generating adequate cash 

flow because of the BBA.7 Most of these firms have 

seen their interest coverage ratios decline sharply over 

the past few years. 

Home Health Care Services focus primarily on respiratory therapy programs and intravenous and infusion 

services. The industry is undergoing financial stress as 

a result of the Health Care Financing Administration’s 

implementation of a prospective payment system that 

reduced reimbursements on respiratory therapy and 

infusion therapy. 

Specialty Outpatient Facilities, NEC are primarily 

engaged in outpatient care of a specialized nature, such 

as alcohol and drug treatment and birth control/family 

planning. They have permanent facilities and medical 

staff to provide diagnosis, treatment, or both for patients 

who are ambulatory and do not require inpatient care. 

Many of the firms in this sector have experienced a rising debt burden over the past few years, pushing default 

risk to higher levels. 

Health Services firms are engaged primarily in furnishing medical, surgical, and other health services. Firms 

listed in this broad category rather than more specific categories include companies providing dental services, 

laser eye correction, and physical and occupational therapy. Many publicly traded firms in this category have 

experienced sharply rising liabilities over the past three to 

four years. 

Moderate-Risk Sectors 

Moderate-risk health care sectors include medical laboratories, hospitals, and HMOs. 

Medical Laboratories provide professional analytic or 

diagnostic services to the medical profession or to the 

patient as prescribed by a physician. Companies with 

diverse financial performance and risk of default are 

included in this sector. A number of medical laborato7 Ibid. 

ries have registered deteriorating interest coverage 

ratios in the past year or two. 

Hospitals, as defined for these purposes, are specialty 

hospitals. They are primarily engaged in providing diagnostic services, treatment, and other hospital services 

for specialized categories of patients. Only eight publicly traded firms are listed in this category. They are 

involved in providing specialized hospital care such as 

rehabilitation, diabetes treatment, and drug and substance abuse treatment. 

Hospital and Medical Service Plans (HMOs) are primarily engaged in providing hospital, medical, and 

other health services to subscribers or members in 

accordance with prearranged agreements or service 

plans. Generally, these service plans provide benefits to 

subscribers or members in return for specified subscription charges. Also included in this industry are separate HMOs that provide medical insurance. After 

several years of intense competition among HMOs, 

which restricted premium-rate hikes when medical 

costs were rising sharply, HMOs began to pursue a more 

aggressive approach toward price increases. This new 

approach has improved the near- and intermediate-term 

outlook for this sector. Yet, the prospect of the passage 

of a Patients’ Bill of Rights suggests that rising costs 

could be an issue for HMOs in the future. As an industry, HMOs are highly concentrated, with the top 10 

HMOs accounting for nearly two-thirds of total HMO 

enrollment in the United States.8 

Lower-Risk Sectors 

The lowest-risk sectors in the health care industry 

include miscellaneous health and allied services, and 

general medical and surgical hospitals. Many of these 

firms have an estimated default risk that puts them in 

speculative credit risk categories in spite of the fact that 

they are considered lower risk compared with other 

health care sectors. 

Miscellaneous Health and Allied Services firms are 

involved in providing kidney or renal dialysis services 

and outpatient care of a specialized nature, such as alcohol and drug treatment and birth control/family planning. Some firms are engaged in providing health and 

allied services such as blood banks, blood donor stations, childbirth preparation classes, medical photography and art, and oxygen tent services. 

8 August 31, 2000. Healthcare: Managed Care. Standard & Poor’s 

Industry Surveys. 

New York Regional Outlook 27 First Quarter 2001
 
 

In Focus This Quarter
 

General Medical and Surgical Hospitals provide general medical and surgical diagnostic and treatment services, other hospital services, and continuing nursing 

services. They have an organized medical staff, inpatient beds, and equipment and facilities to provide complete health care. According to a study conducted by 

HCIA-Sachs and Ernst & Young, “The BBA created the 

greatest financial instability that hospitals have experienced since the creation of Medicare in 1965. Yet the 

most severe reductions have just begun to impact hospitals, and will continue to do so through 2002. The 

recently enacted Balanced Budget Refinement Act provides little sustained relief to the industry, and significant financial problems are likely to remain.”9 The study 

also indicates that smaller hospitals (fewer than 100 

beds) are in the “greatest financial jeopardy.” The recent 

enactment of BIPA will help to stabilize the finances of 

hospitals over the next several years. However, other 

trends adversely affecting hospitals include as much as 

40 percent estimated excess capacity, rising labor costs, 

a severe shortage of nurses, continued HMO penetration, breakthrough pharmaceutical therapies, and 

increased outpatient volumes (see Charts 5, 6, and 8). 

Outlook 

The outlook for the health care industry has improved 

substantially in the past year. Industry consolidation and 

legislation to give back some of the Medicare cuts 

implemented in the Balanced Budget Act of 1997 have 

gone a long way to stabilize health care providers’ 

financial prospects, particularly those of hospitals and 

nursing homes. 

The passage of a Patients’ Bill of Rights in 2001 could 

also strengthen the hand of health care providers relative to HMOs. Such a bill could contain provisions that 

would weaken the position of managed care organizations to contain costs and negotiate with health service 

providers. 

Longer term, the demographic trends are positive, with 

the population aging and life expectancy increasing. 

The result should be a growing demand for health care 

services in the future. On the negative side, however, the 

current trends toward greater use of outpatient procedures and drug therapies will dampen the demand for 

inpatient hospital services. 

9 HCIA-Sachs, LLC, and Ernst & Young, LLP. May 1, 2000. The 

Financial State of Hospitals: Post-BBA and Post-BBRA. 

CHART 8 

Hospital Occupancy Rate 

Continues Steady Decline 

Hospital Occupancy Rate

(percent) 

* Forecast 

Sources: Economy.com, Morgan Quinto 

52 

54 

56 

58 

60 

62 

64 

66 

’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00* 

Implications for Banks 

The opportunities for financing health care firms will 

continue to grow into the future. Recent experience has 

shown that the financial performance of many health 

care providers is profoundly influenced by changes in 

Medicare policy. As Medicare expenditures grow to 

occupy a greater and greater place in the federal budget, 

Medicare policy will be scrutinized to an unprecedented degree, magnifying the importance of understanding 

the policy risk associated with health care lending. 

Powerful demographic trends should lead to the growth 

in demand for many health care services over the next 

10 to 20 years. For example, demand for nursing homes 

and assisted living facilities will increase sharply as 

baby boomers reach old age. However, regional supply 

and demand for these services can get out of balance as 

providers add facilities to meet demand. Monitoring 

local demand and supply trends is an important part of 

assessing the credit risks in these loans. 

Textiles 

The textile industry has been plagued by excess capacity, fierce competition from cheaper imports, and sagging textile prices. The result was a sharp drop in 

industry profits in 1999 and continued weakness in 

2000. 

Recent Trends and Developments 

The textile industry is a mature industry that by a number of measures has been declining. Intense competition 

from low-cost imports has taken its toll on domestic 

New York Regional Outlook 28 First Quarter 2001
 
 

In Focus This Quarter
 

textile businesses. Since 1995, textile imports have 

increased nearly 50 percent while exports have grown 

just under 10 percent. A strong dollar should help textile imports continue to outpace exports. As a result of 

industry consolidation and the movement of many operations offshore, textile employment has continued to 

fall steadily. Textile employment has dropped from 

663,000 in 1995 to an estimated 544,000 in 2000.10 

Closely linked to all these trends, labor productivity in
 

the textile industry is low relative to the average for 

other manufacturing industries because of low output 

prices and a heavier reliance on labor in the production 

process. 

The Department of Commerce reports that the industry’s profit as a percentage of sales declined from 3.2 

percent in 1998 to just 1.3 percent in 1999 (see Chart 

9).11 Also, drought in the South has had an adverse effect 

on textile manufacturing firms, as these firms use a 

large amount of water in bleaching and dyeing fabric.12 

Because of improving global demand and plant closings 

in the United States, many analysts believe textile prices 

have now reached a low point. Indeed, data for 2000 

show a slight increase and some firming of prices in the 

first three quarters of the year (see Chart 10, next page). 

Nevertheless, the profit picture seems to have weakened 

further in 2000 because of an increase in nonoperating 

expenses. 

Publicly traded firms in the textile industry can be separated into six major categories: knitting mills, textile 

mill products, broadwoven fabric mills–cotton, broadwoven fabric mills–manmade fiber/silk, carpets/rugs, 

and miscellaneous fabricated textile products. The 

default risk characteristics of these sectors vary significantly as measured by the median EDFTM. 

Higher-Risk Sectors 

The higher-risk sectors include knitting mills, Broadwoven Fabric Mills–Cotton, and Textile Mill Products 

(see Chart 11, next page). 

10 Economy.com. November 2000. Apparel and Textiles, Precis Industry. 

11 Office of Textiles and Apparel, U.S. Dept. of Commerce. September 6, 2000. Current Situation in the U.S. Textile, Apparel, and Manmade Fiber Industries. 12 Kilman, Scott, and Amy Merrick. July 25, 2000. “Drought in the 

South Crimps Economy in Region.” Wall Street Journal. 

CHART 9 

Textile Industry Profits as a 

Percentage of Sales Fall in 1999 

4.0 

3.5 

3.0 

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

Percent 2.5 

2.0 

1.5 

1.0 

0.5 

0 

Source: U.S. Dept. of Commerce, Current Situation in the U.S. Textile,
 

Apparel, and Manmade Fiber Industries, September 6, 2000
 

Knitting Mills are engaged in knitting, dyeing, and finishing hosiery, stockings, outerwear, underwear, and 

other products from yarn or knitted fabrics. Two public 

firms in this industry accounted for 66 percent of the 

sector’s 1999 sales. Three out of eight firms in this sector reported net losses and six out of eight reported 

declining sales in 1999. The trends are similar in 2000 

based on incomplete available data. 

Broadwoven Fabric Mills–Cotton are engaged primarily in weaving fabrics more than 12 inches in width, 

wholly or chiefly by weight of cotton. One dominant 

firm accounted for nearly 38 percent of the sales of all 

publicly traded firms in this sector in 1999. The performance of firms in this sector was mixed in 1999. Six out 

of nine of these firms recorded negative net income in 

1999. Two companies reported a sizable increase in 

1999 net income. Incomplete 2000 results suggest that 

six firms are in the black, leaving just three with negative net income. 

Textile Mill Products is a broad category that includes 

establishments engaged in performing any of the following operations: (1) preparation of fiber and subsequent manufacturing of yarn, thread, braids, twine, and 

cordage; (2) manufacturing broadwoven fabrics, narrow 

woven fabrics, knit fabrics, and carpets and rugs from 

yarn; (3) dyeing and finishing fiber, yarn, fabrics, and 

knit apparel; (4) coating, waterproofing, or otherwise 

treating fabrics; (5) the integrated manufacture of knit 

apparel and other finished articles from yarn; and (6) 

the manufacture of felt goods, lace goods, nonwoven 

fabrics, and miscellaneous textiles. Two firms dominate 

this sector. Together, they accounted for over 60 percent 

of the sector’s sales in 1999 (considering publicly traded 

New York Regional Outlook 29 First Quarter 2001
 
In Focus This Quarter
 

CHART 10 

Textile Prices Begin to Recover in 2000 

Producer Price Index

for Textile Mill Products

(NSA, Dec 1984=100) 

Source: Bureau of Labor Statistics 

113 

114 

115 

116 

117 

118 

119 

120 

’95 ’96 ’97 ’98 ’99 ’00 

firms only). Net income for both firms was off sharply 

in 1999. Still, some companies registered net income 

gains in 1999, building on several years of growth in net 

earnings. Although the 2000 data are incomplete, most 

firms in this sector have reported weak earnings. 

Indeed, several firms have reported more quarters of 

negative than positive net income. 

Moderate-Risk Sectors 

The moderate default risk sectors include Miscellaneous Fabricated Textile Products and Broadwoven Fabric Mills–Manmade Fiber/Silk. 

Miscellaneous Fabricated Textile Products includes 

businesses primarily involved in manufacturing curtains 

and draperies, house furnishings, textile bags, and canvas 

and related products; performing pleating, decorative and 

novelty stitching, and tucking for the trade; manufacturCHART 11 

ing automotive trimmings, apparel findings, and related 

products; Schiffli machine embroideries; and manufacturing fabricated textile products, not elsewhere classified. Net income for three out of the five publicly traded 

firms in this sector was negative in 1999. Two of those 

firms have experienced losses for at least two years’ running. Most of these firms reported negative net income 

through the first two or three quarters of 2000. The three 

largest firms’ total debt has grown considerably over the 

past few years. The increase is related primarily to 

financing acquisitions. 

Broadwoven Fabric Mills–Manmade Fiber/Silk are 

engaged in weaving fabrics more than 12 inches in 

width using primarily silk and manmade fibers, including glass. Net income for each of the six publicly traded firms in this category was down in 1999—in most 

cases down sharply. Earnings for most of these firms 

Estimated Default Risk in Textile Industry Subsectors, December 2000 

Median Expected Default

FrequencyTM (EDFTM)

in Percent 

Source: Credit MonitorTM ©2001, KMV LLC, all rights reserved 

2 

4 

6 

8 

10 

12 

14 

16 

18 

20 

22 

0 

Comparative Median EDFTM 

of S&P Bonds Rated BB 

(as of December 2000) 

2250: 

Knitting Mills 

2211: Brdwoven 

Fabric Mill, Cotton 

2200: 

Textile Mill 

Products 

2390: 

Misc Fabricated 

Textile Pds 

2221: 

Brdwovn Fabric 

Manmade, Silk 

2273: 

Carpets 

and Rugs 

New York Regional Outlook 30 First Quarter 2001
 
 

 

 

In Focus This Quarter
 

appear to have continued to deteriorate in 2000. Interest 

coverage ratios for several firms were down in 1999 and 

2000 because of lower income, higher liabilities in 

some cases, and higher interest rates. 

Lower-Risk Sector 

Manufacturers of carpets and rugs represent the only 

lower-risk sector in the textile industry. 

Carpets/Rugs businesses are involved in manufacturing woven, tufted, and other carpets and rugs. This sector, as a group, experienced strong income growth in 

1999. Only one out of six publicly traded firms failed to 

make a profit in 1999, and several firms reported sizable profit increases. Available 2000 data suggest that 

each of these firms will have generated positive earnings. Two firms dominate the carpet and rug sector, 

accounting for about 65 percent of 1999 sales for the 

group. Carpet and rug manufacturing is capital and 

research intensive, which gives the U.S.-based firms a 

comparative advantage over overseas companies, which 

do not have the same level of access to capital markets 

and an educated workforce. 

Outlook 

Some positive factors could temper the adversity being 

experienced by the U.S. textile industry. Low fiber costs 

and an improved trade situation with Asia should 

strengthen the textile industry in the future. Labor productivity has been rising slowly, as firms continue to 

invest in labor-saving computer technology and equipment. The industry is pursuing various strategies to 

remain competitive, including consolidations and mergers and setting up operations in Mexico.13 Nevertheless, 

the current slowdown in the U.S. economy and the 

increased risk of an actual recession has posed challenges for the textile industry. 

Another concern for U.S. producers is trade liberalization and its effect on textile imports. The normalization 

of trade relations with China and the elimination of 

import quotas by 2005 according to the World Trade 

Organization (WTO) Agreement on Textiles and Clothing could lead to even greater imports. 

Implications for Banks 

Banks lending to textile firms face an array of risks 

emanating from the economic environment in which 

these firms operate. These risks include the ebb and 

flow of demand associated with the business cycle of 

the U.S. and world economies; the exchange rate of the 

U.S. dollar, which affects the competitiveness of domestically produced textile products; and the prices of both 

inputs and textile products. U.S. trade policy will also 

have a profound impact on the competitive environment 

in which domestic textile firms operate. Banks need to 

monitor these developments carefully. 

Concentration risk can be a significant issue for some 

banks. Textile mill employment is highly concentrated 

geographically. About 72 percent of all textile mill jobs 

are located in five southeastern states (North Carolina, 

Georgia, South Carolina, Alabama, and Virginia). 

Almost 29 percent of these jobs are in North Carolina 

alone. Another 18 percent are in Georgia. Even within 

these states, textile employment can be regionally concentrated, introducing concentration risk to banks with 

significant exposures to local textile firms. This risk is 

measured in terms of not only the volume of textile 

loans in the portfolio but also the spillover effects that 

plant layoffs can have in the community.14 

In an increasingly global market, credit risk in textiles 

will depend on decisions about production processes 

and intercompany linkages. For example, capitalintensive domestic producers may be in a better position 

to compete with offshore firms with greater access to 

cheap labor resources. Some textile firms may be able 

to enhance profitability and control risk by entering into 

partnerships with domestic and overseas organizations. 

Stephen Gabriel, Financial Economist 

13 Reichard, Robert. January 2000. “New Year Offers Problems and 14 See “Regional Economy,” Atlanta Regional Outlook, second quarOpportunities,” Textile World. ter 1998. 

New York Regional Outlook 31 First Quarter 2001
 
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