Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION FOURTH QUARTER 2000 

FDIC
 

Chicago
 

Region
 

Division of
 

Insurance
 

Suzannah L. Susser,
 

Regional Manager
 

Joan D. Schneider,
 

Regional Economist
 

Michael Anas,
 

Senior Financial
 

Analyst
 

Ronald W. Sims, II,
 

Financial Analyst
 

Regional Perspectives 

◆ Bank Performance Stumbles in the Second Quarter—In the aggregate, 

the Region’s insured institutions reported narrowing margins and lower profitability. Aggregate earnings were hampered by an increase in provision expenses and 

securities losses at the Region’s largest commercial banks.While overall credit quality is strong, the largest commercial banks reported a higher level of noncurrent 

loans. Analysts expect problem loans to rise over the coming quarters, particularly 

among the largest commercial banks involved in syndicated and leveraged lending. 

See page 3. 

◆ New Bank Formation Increases the Region’s Risk Profile—New 

banks are forming at a rapid rate, particularly in the Region’s larger metropolitan 

areas, and are contributing to an already competitive banking environment. The 

risk profile of new banks appears to be higher compared with established community banks because of higher exposure to commercial and industrial loans and commercial real estate lending and greater reliance on noncore funding. See page 4. 

◆ Some Challenges to the Auto Industry Are Emerging—The auto industry is in the midst of a two-year expansion, but some evidence of potential weaknesses in the industry’s strong current performance is emerging. Because of the 

industry’s importance to the Region’s employment picture and its highly cyclical 

nature, continued attention is warranted as these challenges unfold. See page 7. 

◆ Underwriting Trends in Auto Leasing Point to Continued Weakness—Generous residual values, longer lease terms, higher mileage allowances, 

and the capitalization of origination charges indicate that this segment may continue to experience weak performance. Lessors are facing losses on the sale of leased 

vehicles, write-downs on the carrying value of lease residuals, and higher remarketing costs and other expenses. See page 9. 

By the Chicago Region Staff 

In Focus This Quarter 

◆ Emerging Risks in an Aging Economic Expansion—This article focuses 

on the potential risks of current economic conditions to insured depository institutions. Although the current conditions may appear to be ideal, some imbalances are 

emerging: rising energy prices, tight labor markets, a less robust stock market, a 

large trade deficit and strong U.S. dollar, rising household debt burdens, increased 

corporate leverage and rising potential default risk, and, in some metropolitan 

areas, overheated housing and commercial real estate markets. At the same time, 

aggregate risk within the banking industry appears to have risen, as evidenced by 

softening profitability, growing reliance on noncore funding, heightened levels of 

interest rate risk, and increasing concentrations in traditionally higher-risk loan 

categories. A confluence of these trends could heighten the vulnerability of some 

insured institutions. See page 11. 

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

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

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

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

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

Outlook, please call Suzannah Susser at (312) 382-6543 or send an e-mail to ssusser@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 

REVISION: 

The article “Ranking Metropolitan Areas at Risk for Commercial Real Estate Overbuilding” in 

the Third Quarter 2000 issue of the Regional Outlook has been revised to correct a data-related 

error. The revision affects Chart 4 and Chart 11 of the report. Please see www.fdic.gov/bank/ 

analytical/regional/ro20003q/correction.html for revised versions of Chart 4 and Chart 11, along 

with an additional explanation of how the revision affects the article. 
Regional Perspectives
 

Regional Perspectives
 

•	 Narrowing margins and lower noninterest income at the Region’s largest commercial banks combined with 

higher provision expenses and securities losses, reduced aggregate net income through second quarter 2000. 

•	 New bank formation in the Region remains at a high level. Recent evidence suggests that new banks are 

exhibiting an increasingly higher-risk profile than established banks. 

•	 The auto industry, which plays an important role in the Region’s economy, is in the midst of a two-year 

expansion. However, some significant challenges suggest that the industry’s strong performance may slow. 

•	 Auto leasing portfolios have exhibited some weakness in recent years, and some aspects of lease underwriting appear to be growing riskier. 

Region’s Economic and Banking Conditions 

Aggregate Performance Stumbles 

in the Second Quarter 

In the aggregate, the Region’s insured institutions 

reported narrowing margins and lower profitability. 

Margin compression continues as the cost of funding 

earning assets increases faster than the yield on earning assets. In past quarters, rising noninterest income 

bolstered aggregate net income. However, in second 

quarter 2000, noninterest income to average assets fell 

to 1.70 percent from 1.91 percent a year ago. Aggregate earnings also were hampered by an increase in 

provision expenses and securities losses at the 

Region’s largest commercial banks,1 resulting in a 10 

percent decline in aggregate net income from a year 

ago. 

While overall credit quality is strong in general, the 

largest commercial banks reported higher delinquencies. At the Region’s largest banks, noncurrent loans2 

increased nearly 43 percent from the prior year to $3.8 

million as of June 30, 2000. The ratio of noncurrent 

loans to Tier 1 capital for this group is 8.86 percent, its 

highest point since 1993. Provision expenses more 

than doubled from the same period a year ago, yet the 

reserve coverage on noncurrent loans continued to 

decline (see Chart 1). Pointing to a general easing of 

credit through the mid-1990s, analysts expect problem 

loans to rise over the coming quarters, particularly 

among the largest banks involved in syndicated and 

leveraged lending.3 However, regulatory surveys indi1 Commercial banks headquartered in the Chicago Region with total
 

assets greater than $10 billion.
 

2 Noncurrent loans are loans past due 90+ days and nonaccrual loans.
 

CHART 1 

Source: Call Reports for commercial banks with total assets greater than 

$10 billion 

Reserve Coverage of Noncurrent Loans Declines 

at the Region’s Largest Commercial Banks 

Loan Loss Reserves to 

Noncurrent Loans 

(right axis) 

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

June 

$ in Millions

Percent 

Noncurrent 

Loans 

(left axis) 

0 

500 

1,000 

1,500 

2,000 

2,500 

3,000 

3,500 

4,000 

4,500 

0 

50 

100 

150 

200 

250 

300 

cate that banks responded to the market turmoil in fall 

1998 by tightening loan terms, and this trend appears 

to be continuing.4 As a result, while analysts expect 

credit quality to weaken in the near term, they do not 

predict significant deterioration, but a return to more 

normal, historical levels.5 

Meanwhile, the Region’s community-insured institutions6 

reported modestly wider margins and stable profitability. 

3 KPMG Analysis Commercial Loan Portfolios: The Worst May Be
 

Yet to Come. July 18, 2000.
 

4 Senior Loan Officer Opinion Survey on Bank Lending Practices.
 

August 2000. Federal Reserve Board of Governors.
 

5 Commercial Lending Update. April 2000. Commercial Credit Risk
 

Rises Despite Strong Economic Conditions. Federal Deposit Insurance Corporation.
 

6 Community-insured institutions hold less than $1 billion in total
 

assets.
 

Chicago Regional Outlook 3	 Fourth Quarter 2000 
Regional Perspectives 

An increase in the median yield on earning assets outpaced an increase in the cost of funding earning assets 

over the 12 months ending June 30, 2000. Improved margins may reflect the moderately strong loan growth experienced by community institutions. Median net loan 

growth of 11.71 percent boosted the median loan-to-asset 

ratio to 67.6 percent at June 30, 2000, up from 64.4 percent recorded in each of the past two years. 

While overall community bank performance was solid, 

signs of modest deterioration were apparent. 

•	 The number of community institutions rated 3, 4, or 

5 was 104, or 6 percent of total community institutions in the Region as of June 30, 2000, up from 77, 

or 4 percent, a year ago. 

•	 While still low, the median level of adverse classifications to capital rose modestly to 8 percent as of 

June 30, 2000, from 6 percent as of June 30, 1998. 

•	 The number of unprofitable established community 

institutions7 has doubled in the past two years to 3 

percent of established community institutions. 

7 Established community-insured institutions hold less than $1 billion 

in total assets and have been in operation longer than three years. 

New Bank Formation Increases the Region’s Risk Profile
 

Fueled by a strong economy, new bank8 formation in the 

Region is high compared with the 1980s, and exceeds 

the last cycle’s peak, which occurred in 1990 (see Chart 

2). New banks represented more than 5 percent of 

insured institutions in the Region as of June 30, 2000, 

up from less than 2 percent in the early 1990s. 

Most new bank activity has been centered in the 

Region’s larger markets, particularly Chicago, Detroit, 

and Grand Rapids (see Map 1). As of June 2000, most 

new banks were located in Illinois (41) and Michigan 

(24). In fact, Illinois ranks third among all 50 states in 

CHART 2 

New Bank Formation Remains High 

45 

40 

35 

30 

25 

20 

15 

10 

5 

0 

’80’81’82’83’84’85’86’87’88’89’90’91’92’93’94’95’96’97’98’99’00* 

* Data through July 2000.
 

Source: Bank and Thrift Call Reports
 

8 New banks are defined as insured institutions established within the 

past three years. Number of New Institutions 

the number of new banks. Looking ahead, a review of 

new bank applications9 revealed that while the rate of 

new bank formation may moderate, formations will 

remain centered in Illinois and Michigan. 

In general, new banks historically have had inherently 

riskier profiles than more established banks. Anticipated losses during the start-up period, rapid asset and loan 

MAP 1 

New Banks Locate in the Region’s
 

Larger Markets
 

Institutions per County 

zero (289) 

1 to 2 (107) 

3 to 5 (26) 

6 to 9 (6) 

10 and over (8) 

Note: New bank formation shown from January 1980 through July 2000.
 

Source: Bank and Thrift Call Reports
 

9 As of August 24, 2000, there were 15 new bank applications pending in the Region, five in Illinois and four in Michigan. 

Chicago Regional Outlook 4	 Fourth Quarter 2000 
Regional Perspectives
 

growth, and the lack of a stable customer base may elevate new banks’ risk levels. Recent evidence suggests 

that new banks are exhibiting a higher risk profile than 

established banks in the Region. 

Interest income trends among new banks may point to 

increasing levels of risk relative to established institutions. This trend also raises questions about future net 

interest margins. New banks report higher levels of interest income than established institutions in the Region 

(see Chart 3). A wider interest income spread indicates 

that new banks may be operating more aggressively than 

in the past. Increased exposure to traditionally riskier, 

higher-yielding loan products, such as commercial real 

estate and commercial and industrial loans, is evidence of 

this more aggressive posture. Not only has the loan mix 

shifted at new banks, but aggregate loan-to-asset levels 

have increased significantly since 1995. 

Both new and established banks report higher funding 

costs. This trend is primarily associated with increased 

use of noncore funding and a highly competitive environment. However, the increase in new bank funding 

costs exceeds that reported by established banks and may 

indicate how aggressively new banks price deposits. In 

addition, new banks report a heightened reliance on more 

expensive noncore funding. While some established 

institutions have mitigated the effect of declining margins 

through increased noninterest income, newer institutions 

have reported a decline in the median ratio of noninterest 

income to average earning assets. 

CHART 3 

New Banks Report Higher Interest Income 

and Interest Expense Compared 

with Established Institutions 

Note: Spreads are based on median values and are relative to average earning 

assets. Only new institutions in their second or third year of operation are included. 

Source: Bank and Thrift Call Reports 

Interest Expense Spread 

(New Institutions—Established Institutions) 

Interest Income Spread 

(New Institutions—Established Institutions) 

Percentage Points 

–0.8 

–0.6 

–0.4 

–0.2 

0.0 

0.2 

0.4 

0.6 

0.8 

June 

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

As stated above, interest income levels among the 

Region’s new banks are higher than among established 

banks, in part because of a shift toward commercial 

lending. As of June 30, 2000, new bank loan portfolios 

were more heavily weighted toward commercial real 

estate and commercial and industrial lending than those 

of other small banks in the Region (see Charts 4 and 5). 

This has not always been the case. New banks have 

steadily increased their exposure to commercial and 

commercial real estate lending to a level that is now 

three times higher than in June 1990 (see Chart 6, next 

page). A subset of commercial real estate lending— 

construction and development lending—has increased 

to 10 percent of aggregate loans for new banks. In contrast, established community banks have increased 

New Bank Loan Portfolios Are Heavily Weighted Toward Commercial Lending 

CHART 4 CHART 5 

New Banks’ Average Loan Composition Established Banks’ Average Loan Composition 

Commercial Real
 

Estate
 

33%
 

Consumer
 

8%
 

Agriculture
 

2%
 

One- to Four-Family 

33% 

Commercial and
 

Industrial
 

24%
 

Commercial and
 

Industrial
 

13%
 

Agriculture
 

12%
 

Consumer 

11% 

One- to Four-


Family


45%
 

Commercial Real
 

Estate
 

19%
 

Note: Institutions in their second or third year of operation. 

Source: Bank and Thrift Call Reports, June 30, 2000 

Note: Institutions with less than $1 billion in assets as of June 30, 2000, excludingnew 

banks. 

Source: Bank and Thrift Call Reports, June 30, 2000 

Chicago Regional Outlook 5 Fourth Quarter 2000 
Regional Perspectives
 

CHART 6 

New Institutions* Focus on Commercial Lending 

Percentage of Total Loans

 (Aggregate) 

Commercial Real Estate Loans 

New Banks Commercial and Commercial 

Real Estate Loans 

Established** Banks 

Commercial Loans 

New Banks 

0 

10 

20 

30 

40 

50 

60 

70 

June 

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

* New institutions shown are in their second or third year of operation.
 

** Established institutions are community banks and thrifts (<$1 billion in assets) in the Chicago Region as of June 30, 2000.
 

Source: Bank and Thrift Call Reports 

aggregate commercial and commercial real estate levels 

only modestly during the past decade, indicating a more 

cautious profile. 

While a more aggressive loan posture may augment 

new bank income, the shift in loan mix could increase 

exposure to credit risk. For example, established institutions heavily engaged in commercial lending experienced higher net charge-off rates during the last 

recession (see Chart 7). Therefore, while commercial 

and commercial real estate loans historically have been 

higher yielding, these portfolios also have been more 

sensitive to economic downturns. The Federal Reserve 

has raised interest rates over the past year, and some 

economic indicators show that the economy is slowing. 

An abrupt or sustained economic slowdown could disproportionately affect new banks with exposure to commercial loans. 

CHART 7 

Many institutions in the Region, including both new and 

established banks, are relying on noncore funding as 

core deposits become more difficult to attain. Although 

new banks traditionally have held relatively higher 

levels of noncore funding, the more substantial growth 

in noncore funding at new banks has contributed to their 

divergence in interest expense from established banks. 

As of June 30, 2000, the ratio of noncore funding to 

assets was 39.6 percent for new banks, compared with 

23.0 percent for established community banks. 

Increases in noncore funding at new banks exhibit a different pattern from that of established banks, however. 

Other borrowings, such as Federal Home Loan Bank 

advances, have been the primary growth area in funding 

at established banks. In contrast, newer institutions rely 

on large time deposits and brokered deposits (see 

Chart 8, next page). 

During the Last Recession, Charge-Offs Were Higher at Institutions with Large Commercial Loan Exposure 

(Recession—July 1990 to March 1991) 

Commercial Loan Exposure Group Commercial Loan Exposure Group 1.4 Return on Assets 0.35

(left axis) Net Charge-Off Rate 

(right axis) 

Charge-Off 

Rate 

All Other 

Institutions 

Return on 

Assets 

All Other 

Institutions 

’89 ’90 ’91 ’92 ’93 

1.0 0.25

Percentage of Assets1.2 0.30 

Percentage of Loans 

0.8 0.20

0.6 0.15

0.4 0.10

0.2 0.05

0.0 0.00

Year-End 

Note: Commercial Loan Exposure Group Criteria—must have a 50 percent loan-to-asset ratio and the sum of commercial and commercial real estate lending must be greater 

than 50 percent of loans. Median values shown. 

Source: Bank and Thrift Call Reports 

Chicago Regional Outlook 6 Fourth Quarter 2000 
Regional Perspectives
 

To the extent that new banks are willing to pay high rates 

to attract local market deposits, they may well be attracting the most interest rate–sensitive deposits in the area. 

This situation may raise interest rate risk concerns at 

new banks and further increase competition for deposits 

among all insured institutions in a local market. 

The recent rapid rate of new bank formation, and the 

rising risk profile of new banks, has heightened the 

Region’s risk profile. In the markets where new bank 

formation has been active, institutions may be particularly subject to margin compression as new banks 

attempt to gain market share through competitive loan 

and deposit pricing. Deposits attracted through competitive pricing may be highly sensitive to interest rates. 

Also, if credit quality concerns arise for smaller institutions, such as those recently experienced by large commercial banks, new banks may be disproportionately 

affected because of their significant exposure to commercial and commercial real estate lending. 

CHART 8 

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

* Institutions in their second or third year of operation, excluding those with total 

assets greater than $1 billion in assets. 

Source: Bank and Thrift Call Reports, June 30 

Large Time Deposits and Brokered Funds Boost 

Noncore Funding Levels Higher at New Banks* Percent Percent 

Percentage of New Banks 

with Brokered Deposits Large Time 

Deposits 

to Assets 

0 

5 

10 

15 

20 

25 

30 

35 

0 

5 

10 

15 

20 

25 

30 

35 

Aggregate 

Brokered 

Deposits 

to Assets 

Strong Auto Sector Faces Challenges
 

The auto industry plays an important role in the 

Region’s economy. According to the 1997 Economic 

Census,10 the industry provided 620,000 jobs, or 3 percent of all jobs in the five-state Region. Auto manufacturers employ about 27 percent of this total and are 

among the largest employers in Indiana, Ohio, and 

Michigan. Auto parts manufacturers represent the 

remaining 73 percent of jobs in this industry. In fact, 

auto parts manufacturers employ more people than auto 

manufacturers in every state in the Region. The auto 

industry’s influence on the Region is compounded by its 

highly cyclical nature. In addition, the direction of the 

industry’s business cycle can shift quickly in a changing 

economic environment. 

The auto industry is in the midst of a two-year-long 

expansion; however, some potential weaknesses in the 

industry’s strong current performance are emerging. In 

1999, light vehicle sales surged to 16.7 million units, 

surpassing the previous annual sales record and the 

average of 15.1 million logged in the mid-1990s. Participants at the Federal Reserve Bank of Chicago’s seventh annual Auto Outlook Symposium held in June 

2000 forecasted a new record in light vehicle sales of 

17.3 million units for this year. Income growth, high 

consumer confidence, and demographic trends point to 

continued strength in the auto industry. However, a general uneasiness about the economy, rising interest rates, 

fluctuating gasoline prices, and growing foreign competition may dampen future sales, as indicated by the 

downward trend in the University of Michigan’s index 

of car-buying conditions (see Chart 9, next page). 

Recent increases in short-term interest rates have not 

affected new car sales substantially thus far, in part 

thanks to the actions of auto manufacturers’ captive 

finance companies. These finance companies did not 

pass along increases in interest rates that occurred after 

November 1999. Instead, they subsidized loan rates and 

thereby insulated consumers from the uptick in interest 

rates (see Chart 10, next page). In fact, auto company–sponsored car loan rates actually declined through 

much of 2000 before edging up slightly during the 

summer. 

Traditional incentives have increased as well. Retail 

promotion costs include rebates and discounts in addition to interest rate and lease subsidies. According to 

Autodata Corporation, retail promotion costs increased 

10 U.S. Census Bureau. 

Chicago Regional Outlook 7 Fourth Quarter 2000 
Regional Perspectives
 

CHART 9 CHART 10 

Buying Conditions for Cars Have Declined Subsidized Loan Rates Shield Consumers 

(Monthly Index Value and Five-Month Moving Average) from Rising Interest Rates in Early 2000 

9.0 

120 

130 

140 

150 

160 

Index Value

Five-Month Moving Average 

Monthly Index Value 

Jan 

’97 

Apr 

’97 

Jul 

’97 

Oct 

’97 

Jan 

’98 

Apr 

’98 

Jul 

’98 

Oct 

’98 

Jan 

’99 

Apr 

’99 

Jul 

’99 

Oct 

’99 

Jan 

’00 

Apr 

’00 

Jul 

’00 Jan AprJul OctJan AprJul OctJan AprJul OctJan AprJul 

Captive Auto Finance 

Company Loan Rate 

Federal Funds 

Target Rate 

8.5 

8.0 

Interest Rate7.5 

7.0 

6.5 

6.0 

5.5 

5.0 

4.5 

4.0 

Source: University of Michigan 

7 percent in July 2000 over the prior year. In fact, CNW 

Marketing Research reported that in late August incentives exceeded $4,000 per vehicle. 

With U.S. crude oil supplies near a 24-year low, the 

prospect of continued high gasoline prices looms. Several industry analysts have made cautious predictions 

about the near-term prosperity of American auto manufacturers, because the most profitable vehicles also are 

the least fuel-efficient. Sales of these vehicles may be 

more susceptible to higher gasoline prices. Indeed, light 

truck sales declined 8 percent in second quarter 2000 

from the prior quarter. However, new light truck sales 

remained up 2.2 percent from second quarter 1999. 

Credit MonitorTM, which was developed by KMV 

LLC®, is an analytical tool that measures credit 

risk. The application estimates the probability that a 

firm will default over a specified period of time. 

KMV’s measure, called Expected Default FrequencyTM, or EDFTM, expresses this probability. For 

example, an EDF of 2 indicates that a company has 

a 2 percent probability of default over the next 12 

months. An EDF of 2 is equivalent to the median 

EDF over the past five years for a Standard & 

Poor’s Credit Rating of “B.” According to Standard 

& Poor’s, an obligation rated “B” is more vulnerable to nonpayment, but the obligor currently has the 

capacity to meet its financial commitment on the 

obligation. Adverse business, financial, or economic conditions will likely impair the obligor’s capacity or willingness to meet its financial commitment 

on the obligation. 

’97 ’97 ’97 ’97 ’98 ’98 ’98 ’98 ’99 ’99 ’99 ’99 ’00 ’00 ’00 

Source: Federal Reserve Board via Haver Analytics 

Finally, foreign competition, led by Japanese brands, 

has emerged as another challenge for domestic auto 

manufacturers this year. Japanese manufacturers gained 

1.6 points of market share for a near-record 27.5 percent 

in July 2000. Korean and European manufacturers11 also 

gained market share. Foreign auto manufacturers are 

making gains in both the small car market and the profitable light truck market. 

Subsidies and other efforts to bolster sales of new 

American vehicles insulate parts manufacturers from 

some market pressure. However, the General Motors 

Corporation strike during summer 1998 showed the 

extent to which lean manufacturing production methods 

cause a strong ripple effect throughout the tightly linked 

auto supply chain. The 1998 strike at two General 

Motors Corporation–owned parts plants in Flint, Michigan, quickly shut down most of the company’s North 

American assembly operation. In turn, it caused production adjustments at many of the company’s independent suppliers. 

Auto parts manufacturers operate in a competitive environment and exert little pricing power with auto manufacturers. As a result, auto parts manufacturers often are 

in a weaker financial position. This difference is apparent in Chart 11, which compares the median Expected 

Default FrequencyTM (EDFTM) credit measure reported 

by Credit MonitorTM of a group of auto parts manufacturers headquartered in North America with the EDF of 

both General Motors Corporation and Ford Motor Com11 European manufacturers exclude Jaguar and Volvo, which are 

included in Ford Motor Company’s results, and Saab, which is included in General Motor Corporation’s results, but do include sales of 

DaimlerChrysler’s Mercedes-Benz division. 

Chicago Regional Outlook 8 Fourth Quarter 2000 
Regional Perspectives
 

pany. The median EDF of auto parts manufacturers is CHART 11 

nearly four times higher than that of the auto manufacturers themselves. 

The comparatively weaker financial condition of auto 

parts manufacturers also was apparent in a survey 

reported in Dismal Sciences, Inc.’s Précis: METRO for 

Grand Rapids, Michigan. The survey indicated that only 

20 percent of the area’s auto parts manufacturers were 

thriving financially, and 60 percent were barely making 

enough money to survive. The remaining 20 percent 

likely will fail if revenues do not improve. 

Therefore, while the U.S. auto industry appears poised 

to set a new sales record, a number of challenges are on 

the horizon. If these challenges result in reduced production by manufacturers, the Region’s many auto parts 

20.00 

15.00 

10.00 

7.00 

5.00 

2.00 

1.00 

0.50 

0.20 

0.15 

0.10 

0.05 

0.02 

Auto Parts Manufacturers Exhibit 

Higher Credit Risk 

* Median EDFTM credit measure for auto parts manufacturers headquartered in 

North America. 

Source: Credit MonitorTM KMV LLC®, all rights reserved 

Estimated Default FrequencyTM 

Measure*

B 

D CC CCC 

BB 

BBB 

A 

AA 

AAA 

Jan 

’96 

Jul 

’96 

Jan 

’97 

Jul 

’97 

Jan 

’98 

Jul 

’98 

Jan 

’99 

Jul 

’99 

Jan 

’00 

Jul 

’00 

Auto Parts Manufacturers 

General Motors Corp. 

Ford Motor Co. 

try’s importance to the Region in terms of employment 

manufacturers will feel the effect almost immediately and its highly cyclical nature, continued attention is 

and may face financial difficulty. Because of the indus- warranted as these challenges unfold. 

The Risk Profile of Auto Leasing Portfolios Remains High 

Leasing portfolios have exhibited some weakness CHART 12 

over the past few years. The problems in leasing port- Residual Values Exceed Guidebook Limits folios date back to 1994, when leasing activity began for Majority of Leases to grow and the used car market was strong. Lessors (Mean Percentage, Unweighted) were recording lease income and, when the lease term 60 

expired, were selling returned vehicles for more than 50 their residual value. Then, to build market share, 

lessors began to raise the estimate of residual value, 40 

effectively lowering the monthly lease payment for 

the consumer. 

The 2000 Automobile Finance Study conducted by 

the Consumer Bankers Association showed that by 

1999, the mean percentage of vehicles with a residual 

value greater than estimated by the Auto Leasing 

Guide was 53 percent, compared with 24 percent five 

years earlier (see Chart 12). When the residual value 

is higher than the current market value, consumers 

generally return the car at the end of the lease term 

instead of buying it. As a result, the used car market 

has become oversupplied. Lessors are facing losses 

on the sale of leased vehicles, write-downs on the carrying value of lease residuals, and higher remarketing 

costs and other expenses. 

In addition to generous residual values, other aspects 

of lease underwriting appear to be riskier. 

20 

10 

0 

’94 ’95 ’96 ’97 ’98 ’99
 

Source: 2000 Automobile Finance Study, Consumer Bankers Association
 

•	 The study showed that the percentage of lessors 

allowing dealers to approve leases without intervention continued to increase, from 50 percent in 

1998 to 56 percent in 1999. 

•	 New vehicle leasing terms lengthened in 1999, 

according to the study. The percentage of new 

vehicle leases originated with terms greater than 

37 months was 67 percent, up from 52 percent in 

1998. 

continued on next page 

Percent 30 

Chicago Regional Outlook 9	 Fourth Quarter 2000 
Regional Perspectives
 

Risk Profile of Auto Leasing Portfolios, continued 

•	 Lessors increased the average permitted miles. In percent of vehicles reaching full term were returned 

1997, study respondents reported that 40 percent to lessors, compared with 39 percent in 1998, accordof new leases allowed fewer than 15,000 miles per ing to the study. When vehicles are returned to 

year. Two years later, 53 percent of newly originat­ lessors, losses occur frequently, and these losses have 

ed leases allowed 15,000 miles per year. increased. Study respondents indicated that losses 

were recorded on 84 percent of all full-term vehicles 

returned to lessors in 1999, and the average loss •	 The study showed that the capitalization of charges increased to $1,920 from $1,185 in 1998. The large at origination, such as registration and license fees number of vehicles with residual values over Auto and warranty packages, has increased. In fact, 100 Leasing Guide values indicates that these losses may percent of survey respondents capitalized warranty continue. There also is concern that the used vehicle packages. market has a large supply of sports utility vehicles 

and pickups, the most popular vehicles in recent 

These trends indicate that leasing portfolios may con- years, and that it may take years to work through a 

tinue to experience weak performance. In 1999, 56 market glut. 

The Chicago Region Staff 

Chicago Regional Outlook 10	 Fourth Quarter 2000 
In Focus This Quarter
 

Emerging Risks in an Aging Economic Expansion
 

•	 The economy and the banking and thrift industries are reporting generally healthy conditions. However, the 

economic expansion is aging, and it is unlikely that the vigor experienced during the first half of 2000 can 

be sustained. 

•	 Likewise, record banking and thrift industry profits, healthy capital cushions, and good asset quality of 

recent years may not be sustainable. Declining net interest margins, rising commercial loan losses, tighter 

liquidity, and riskier asset composition are among the warning signs that industry performance may have 

peaked for this business cycle. 

•	 Specific areas of concern include growing reliance on noncore funding; heightened interest rate risk; 

increased exposure to market-sensitive revenues; deteriorating credit quality; rising leverage among businesses and households; and signs of imbalance in some residential and commercial real estate markets. 

Although no readily apparent situations or imbalances 

suggest that a recession or widespread banking problems will develop in the near term, warning signs are 

present. A highly competitive banking industry shapes 

the environment in which pressures on insured institutions are unfolding. The presence of a large share of 

newly chartered banks in some areas appears to be raising the risk profile among all institutions in certain markets. Publicly owned companies remain under intense 

pressure to grow earnings and increase shareholder 

value. In addition, local banking environments exist in 

which a confluence of risks is generating heightened 

vulnerability for all participants, even during healthy 

economic times. Complacency in these environments 

may have negative repercussions for many insured institutions going forward. 

Imbalances Are Appearing Amid a Healthy 

Macroeconomic Environment 

The performance of the U.S. economy contributes to the 

opportunities and risks financial institutions face. The 

current cyclical expansion, now nine and a half years 

old, is displaying signs of aging while setting a record 

for longevity. A consensus forecast calls for moderate 

real gross domestic product (GDP) growth through 

2001, following robust gains in the first half of 2000. 

Current conditions might be called a “soft landing,” in 

which real GDP growth slows to a sustainable noninflationary rate of 2.5 to 3.5 percent, and unemployment 

hovers around recent rates. 

Although the current macroeconomic environment 

might appear to be the best of all possible worlds, areas 

of concern exist. One is that sustained prosperity tends 

to foster higher levels of risk taking, overconfidence, 

and complacency. For example, the turmoil in world 

foreign exchange and financial markets during 1997 

and 1998 illustrates how dramatic imbalances can 

develop and trigger disruptive adjustments even during 

healthy economic times. 

Currently, no specific situation or imbalance seems to 

threaten the viability of the expansion. However, as 

detailed below, several likely will contribute to slower 

economic growth. Situations that warrant monitoring 

include the following: 

•	 The repercussions from higher energy prices are 

unfolding. Historically, oil price shocks have weakened several other long-lived economic expansions. 

•	 Short-term interest rates rose over the past year while 

longer-term rates declined, resulting in a modest 

inversion of the yield curve. This relationship may 

inhibit the profitability of some lenders’ practice of 

borrowing short term and lending longer term and 

also complicate the interest rate risk management 

process for some insured institutions. 

•	 Continuing low unemployment suggests that demand 

for additional workers will go unfilled, thus limiting 

economic growth or triggering bidding wars that 

increase workers’ compensation and, potentially, 

inflation. 

•	 Stock market sentiment is no longer strongly bullish. 

A pullback from high valuations and optimism could 

trigger negative repercussions on consumers’ net 

worth and spending as well as on the level of business investment. 

Chicago Regional Outlook 11	 Fourth Quarter 2000 
In Focus This Quarter
 

•	 A large international trade deficit and strong U.S. 

dollar may be an unsustainable combination over the 

long run. Meanwhile, repatriated profits of U.S. corporations are being trimmed by the dollar’s strength 

relative to the euro and other currencies. 

•	 Household debt burdens are historically high, with 

leverage rising the most in recent years among lowand middle-income households. These households’ 

access to credit has increased as lenders competed 

more fiercely for customers. 

•	 Corporations are more highly leveraged, and potential default risk rose in the past year across a range of 

industries. Meanwhile, downgrades of publicly traded corporate debt issues are exceeding upgrades by a 

2-to-1 ratio. 

•	 In some metropolitan areas, overheated housing markets are developing, in which home prices are rising 

dramatically and exceeding gains in median 

incomes. 

•	 Potential signs of excess commercial real estate construction are appearing in several urban areas where 

banks’ construction loan growth also is strong. 

Economic indicators of what lies ahead are not clearcut, and each possible scenario contains a set of potential challenges for insured institutions and regulators. 

Should economic growth slow considerably, current 

vulnerabilities, such as highly leveraged borrowers’ 

debt loads and overheated housing markets, could worsen significantly. As evidenced by the rash of bank failures during the 1980s, it doesn’t always take a national 

recession for problems to develop. Alternatively, sustained rapid growth might foster new vulnerabilities and 

allow current imbalances to intensify or build up. For 

example, speculative construction could accelerate, 

stock market volatility could increase, or ballooning 

trade deficits could generate turmoil in foreign 

exchange markets. 

Signs of Strain Are Also Appearing Amid 

Healthy Banking and Thrift Industries 

With the long economic expansion as a backdrop, 

insured institutions in the aggregate are performing 

very well. However, the record profits attained in recent 

years may not be sustainable. The losses posted recently by several large institutions are striking examples of 

increased appetite for risk resulting in significant financial loss during a period of strong economic growth. 

While these are isolated instances, they are indicative of 

the increasingly competitive environment facing the 

financial services industry. 

Overall industry profitability is beginning to soften, led 

primarily by rising commercial loan losses at large institutions and declining net interest margins in institutions 

of all sizes. Credit card loss rates, which had been 

steadily falling since late 1997, have stalled in recent 

quarters, suggesting that recent increases in interest 

rates and energy costs not only are affecting businesses 

but also are taking a toll on some consumers. Other 

signs suggesting that aggregate risk within the system 

has risen include the growing reliance on noncore funding to support asset growth, heightened interest rate risk 

at many institutions, growing concentrations in traditionally higher-risk loan classes, and a shift in institutions’ overall asset mix toward higher-risk categories. A 

brief discussion of these risks follows. 

Funding Patterns Heighten Liquidity Concerns 

Lackluster core deposit growth is placing pressure on 

bank earnings and contributing to rising liquidity risk in 

the banking system. During the past five years, the compounded annual rate of core deposit growth for all 

insured institutions was just 2.8 percent. Assets over this 

time grew at a 6.6 percent rate. Accordingly, a significant portion of the industry’s growth has been funded by 

noncore sources (see Chart 1). The higher cost and rate 

CHART 1 

Most of $2 Trillion of Asset Growth since 1995
 

Was Funded with Noncore Funds
 

Subordinated Debt 

and Other Liabilities

 5% 

9% 

Equity 

22%
 

Core Deposits
 

64%
 

Noncore Funding
 

Source: Bank and Thrift Call Reports, June 2000 and June 1995 

Chicago Regional Outlook 12	 Fourth Quarter 2000 
In Focus This Quarter
 

sensitivity of these funds put downward pressure on net 

interest margins, particularly in a rising rate environment. 

To compensate for higher funding costs, the industry 

has pursued growth in higher-yielding asset classes that 

are traditionally both riskier and less liquid. For example, almost 37 percent of the asset growth in the past 

five years has come from nonresidential real estate and 

commercial and industrial loans. 

For institutions that fund illiquid assets with wholesale 

sources, any adverse events that trigger a lack of confidence in the institution may result in higher funding 

costs, thus placing further pressure on margins. In 

efforts to obtain funding, an institution also may pledge 

a greater portion of its best quality assets as collateral, 

further reducing liquidity. Finally, in instances where 

funding needs have exceeded available liquidity, the 

forced sale of illiquid assets to meet funding outflows 

could result in losses if market conditions are unfavorable. Presumably, the FDIC, as insurer, would suffer 

greater losses if such an institution failed, because it 

would be relying on proceeds from the liquidation of 

less liquid, and potentially lower-quality, assets to satisfy the claims of insured depositors. 

Subprime lenders, in particular, tend to rely heavily on 

noncore funding to pursue aggressive growth strategies. 

Chart 2 illustrates the extent to which noncore funding 

exceeds the level of liquid assets for this group. The 

chart suggests the difficulty these institutions may 

encounter if forced to convert assets to meet funding 

outflows. Although subprime lenders may use noncore 

sources to fund riskier assets to a greater extent than the 

industry at large, this illustration exemplifies a systemic 

trend that is raising liquidity risk industrywide and is 

increasing risk to the insurance funds. 

Increasing Levels of Interest Rate Risk 

Challenge Some Institutions 

The refinancing boom of the late 1990s spurred a significant shift into longer-maturity assets for many 

insured institutions. During this period, a vast majority 

of mortgage borrowers opted for longer-term, fixed-rate 

loans, which they obtained at historically low rates. A 

great deal of the higher-rate or adjustable-rate loans that 

borrowers refinanced were held in the portfolios of 

insured institutions, which contributed to a general 

lengthening of the maturity of assets held at insured 

institutions. 

The trend toward longer-term, fixed-rate assets has been 

particularly pronounced among mortgage lenders. For 

example, state-chartered savings banks, which are traditionally mortgage lenders, have experienced a dramatic 

increase in long-term assets. As of June 30, 2000, 

almost 45 percent of the median savings bank’s earning 

assets were not scheduled to reprice for five years or 

longer (see Chart 3). 

Fixed-rate mortgage-related assets at federally chartered thrifts have risen similarly. From year-end 1995 

through first-quarter 2000, the percentage of fixed-rate 

mortgage-related assets at thrifts with assets less than 

$1 billion rose from 49 percent to 60 percent of mortgage-related assets. Some thrifts and savings banks, 

therefore, have significant exposure to rising rates from 

low-yielding long-term assets. 

CHART 2 $ Billions 

Source: FDIC Division of Supervision and Bank and Thrift Call Reports (data are 

merger adjusted) 

Subprime Lenders’ Growing Dependence

 on Noncore Funding Strains Liquidity 

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

0 

30 

60 

90 

All other loans 

Residential real estate loans 

Securities and shortterm investments 

Columns: Noncore funding 

CHART 3 

Growing Concentration in Long-Term 

Assets Elevates Interest Rate Risk 

Source: Bank Call Reports, excluding Thrift Financial Report filers 

Share of Assets Maturing or Repricing in Five Years or Longer 

Relative to Total Earning Assets (median percentage) 

Percent 

Savings Banks 

Commercial Banks 

50 

0 

10 

20 

30 

40 

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

Chicago Regional Outlook 13 Fourth Quarter 2000 
In Focus This Quarter
 

While most commercial banks do not have as high 

exposure to rising rates as savings banks, some may 

have taken on significant risk. The median savings bank 

has a ratio of long-term assets to earning assets that corresponds to the ratio level for the 93rd percentile of 

commercial banks. Although the 93rd percentile is in 

the tail of the commercial bank distribution, almost 600 

commercial banks have a concentration in long-term 

assets that exceeds that of the median savings bank. 

These institutions may be exposed to significant interest rate risk as well. 

While assets have lengthened considerably for many 

institutions, there has not been a corresponding extension of liabilities. To the contrary, funding pressures are 

tending to make bank liabilities more rate sensitive. 

These diverging trends generate concern, especially in a 

rising interest rate environment. That is, rate increases 

drive up the cost of funds more rapidly than earning 

asset yields at institutions with liability-sensitive interest rate risk postures. In a significantly higher interest 

rate environment, many institutions’ current postures 

likely would cause heavy margin erosion. 

Most institutions that have high concentrations in longterm assets also have strong capital and an asset mix 

that contains lower credit risk than that of many other 

institutions. Among savings banks, interest rate risk primarily arises from significant concentrations in residential mortgage loans, whereas the typical commercial 

bank’s exposure is more likely to arise from large holdings of long-term securities. However, some institutions 

with concentrations in long-term assets also may have 

lower capital levels, a higher-risk asset mix, or poor 

earnings. Rising rates could weaken these institutions 

and make it more difficult for them to weather adverse 

economic or other developments. 

Dependence on Market-Sensitive Revenues 

Increases Earnings Volatility for Some 

Institutions 

During the recent generally favorable conditions in financial markets, the share of revenue earned from business 

lines susceptible to financial market volatility has 

increased substantially for some of the industry’s largest 

institutions. Among these revenue sources are fees and 

gains from asset management, brokerage, investment 

banking, venture capital, and trading activities. The 19 

institutions most active in these lines of business earned 

over 26 percent of their net operating income from such 

sources in the second quarter of 2000. Other large institutions also have reported a growing dependence on these 

volatile sources of revenue. 

Turbulence in the financial markets has led to greater 

earnings volatility for some of these institutions. Stress 

in the financial markets could weaken the demand for 

underwriting services or significantly reduce trading 

revenues or venture capital gains. Furthermore, the 

same factors that are causing volatility in the financial 

markets could hamper loan growth and lead to slower 

revenue growth from core business lines. Should 

increased earnings volatility from exposure to marketsensitive revenues combine with slower revenue growth 

from core business lines, some institutions could face 

significant earnings challenges. 

The Rising Level of Problem Business Loans Is 

Centered in Large Banks 

Second-quarter 2000 commercial and industrial (C&I) 

credit quality indicators at banks deteriorated for the 

eighth consecutive quarter. Noncurrent C&I loans— 

those on nonaccrual status plus those 90 days or more 

past-due—rose 13 percent over first-quarter 2000 levels 

to $14.5 billion, or 1.4 percent of total C&I loans. Noncurrent loan levels for the period ending June 2000 were 

40 percent higher than the year-earlier level. Net C&I 

loan loss rates also continue to edge higher but remain 

well below those experienced by banks in the late 1980s 

and early 1990s.1 

Large banks, particularly those active in syndicated 

lending, are bearing the brunt of deteriorating C&I loan 

quality. Recent increases in criticized and classified 

shared national credits (SNCs), which are loans exceeding $20 million that are shared among three or more 

lending institutions, are illustrated in Chart 4. In the 

2000 SNC review, criticized and classified credits 

increased 44 percent over 1999 levels to 5.1 percent of 

total SNC commitments. Furthermore, the bulk of the 

increase was in the more severe classified categories, 

which now comprise 64 percent of total criticized and 

11

During second-quarter 2000, banks posted an annualized net C&I 

loss rate of 0.67 percent, up from 0.55 percent for second-quarter 

1999. For comparison purposes, net quarterly annualized C&I loss 

rates averaged 1.11 percent from fourth-quarter 1991 to fourthquarter 1993. 

Chicago Regional Outlook 14 Fourth Quarter 2000 
In Focus This Quarter
 

Note: C&I = commercial and industrial; SNC = shared national credit 

Source: Shared National Credit Program 

Syndicated Loan Problems Are on the Rise 

Percent

$ Billions 

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

Criticized and 

Classified SNC Loan 

Commitments (right 

scale) 

Percentage of SNC 

Commitments Criticized 

and Classified (left scale) 

0 

2 

4 

6 

8 

10 

12 

14 

16 

0 

20 

40 

60 

80 

100 

120 

140 

CHART 4	 riencing financial stress. KMV LLC has developed a 

model that uses publicly available information to estimate the likelihood of default of individual firms.3 

KMV’s model is used by many lenders to monitor and 

evaluate obligor risk and credit risk trends. Applied to 

the analysis of industries, the output of KMV’s model is 

just one of a number of indicators that suggest weaknesses in certain industry sectors. 

Sectors that include a high proportion of firms with 

high default probabilities (median one-year default 

probabilities exceeding 4 percent) are shown in Chart 5. 

Using entertainment as an example, the bars in the chart 

show that in September 2000, one-half of publicly held 

entertainment firms had greater than an 8 percent 

chance of defaulting on their obligations within one 

classified credits, compared with 54 percent at the yearearlier review. 

C&I loan quality indicators continue to deteriorate 

despite generally favorable economic conditions. Three 

factors explain much of this deterioration: certain weak 

industries, rising corporate debt burdens, and the seasoning of syndicated loans underwritten from 1997 to 

1998, when many banks significantly eased business 

lending standards. 

Industry Sector Weaknesses 

The financial stresses facing healthcare and entertainment companies (cinema operators in particular) have 

been well publicized. While the healthcare and entertainment sectors have contributed significantly to the 

decline in commercial credit quality, problems within 

these two sectors do not account for the full extent of 

the increase in noncurrent loans and problem SNC 

loans. Both of these sectors are within the broader services sector, which experienced a $4.6 billion increase 

in criticized and classified credits from the 1999 to the 

2000 SNC review. However, this increase accounts for 

only 15 percent of the $30.8 billion increase in criticized and classified SNCs overall.2 The expected 

default probabilities evident in market-based information can be used to identify other industry sectors expe2 See the interagency release of SNC results at www.occ.treas.gov/
 

ftp/release/2000-78a.pdf.
 

3 KMV Credit Monitor® uses information from a firm’s equity prices
 

and financial statements to derive KMV’s Expected Default Frequency (EDFTM), which is the probability of the firm defaulting within a
 

one-year period. The main determinants of a firm’s likelihood of
 

default: the firm’s asset value, the volatility of the firm’s asset value,
 

and the degree of financial leverage.
 

year. In September 1999, this same proportion of entertainment companies had a substantially smaller (6 percent) chance of defaulting within a 12-month period. 

The median likelihood of default for all the industries 

shown in the chart far exceeds that of Standard & 

Poor’s-rated, BB-grade (sub-investment-grade) obligors as of September 2000, as indicated by the dotted line 

in the chart. 

Rising Corporate Debt Burdens 

U.S. corporate debt burdens, as measured by the debtto-net-worth ratio for nonfarm, nonfinancial businesses, 

continue to increase. This ratio reached 83 percent in 

the second quarter of 2000, up from 72 percent as of 

year-end 1996. Although debt burdens remain below the 

1988–1992 average of almost 87 percent, U.S. businesses are nevertheless becoming increasingly vulnerable to rising credit costs and disruptions in credit 

availability. 

CHART 5 Median Expected Default Frequency (EDFTM) (percent) 

Various Industries Show High Levels 

of Expected Default Risk 

Comparative EDFTM

 of S&P Bonds Rated BB 

(as of September 2000) 

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

Entertainment 

HealthcareWholesale Trade 

Apparel &Textile

Misc. Manufac. LodgingMining 

AgricultureConstruction 

Retail

0 

1 

2 

3 

4 

5 

6 

7 

8 

9

 September 1999

 September 2000 

Chicago Regional Outlook 15	 Fourth Quarter 2000 
In Focus This Quarter
 

Seasoning of 1997–1998 Vintage Loans 

Results of recent supervisory surveys suggest that 

banks are tightening terms and conditions on loans to 

small-, middle-, and large-market obligors. However, 

this tightening follows a relaxation of standards in prior 

years that has contributed to a heightened level of risk 

in banks’ loan portfolios.4 Not coincidentally, the period 

between 1995 and 1998 saw a sharp rise in the proportion of lower-graded, higher-risk credits categorized as 

leveraged transactions by Loan Pricing Corporation. 

Leveraged loan originations—those priced at 150 basis 

points or more over the London Inter-Bank Offer Rate 

(LIBOR)—rose from 12 percent of total syndicated 

loan originations in 1995 to 31 percent in 1999. According to a recent Standard and Poor’s commentary, many 

banks have acknowledged that 1997 and 1998 vintage 

credits are beginning to produce higher problem loan 

levels.5 

Household Sector’s Leverage Is High, 

and Imbalances Are Appearing 

Consumers are enjoying the benefits of the economic 

expansion, as jobs are plentiful, home ownership 

remains generally affordable, and credit seems to be 

readily available for financing motor vehicles and other 

major purchases. These conditions contributed to record 

high sales of cars and light trucks during the first nine 

months of 2000, helping sustain the consumer spending 

growth shown in Chart 6. One corollary of high vehicle 

sales, however, is softening prices for used vehicles. 

Consequently, some lessors—including banks—are 

realizing lower-than-expected residual values on leased 

vehicles, which, in turn, are triggering losses in their 

lease portfolios. This situation illustrates one problem 

that lenders can encounter even in good economic 

times. 

Spending growth remained robust in recent quarters 

even as gains in disposable income slowed. The gap 

between income and spending growth is “financed” as 

households draw down savings, tap capital gains, refinance mortgages, assume more debt, or undertake some 

combination of these measures. 

4 See Federal Reserve Board’s Senior Loan Officer Opinion Survey on 

Bank Lending Practices for May and August 2000 and Surveys of 

Credit Underwriting Practices for 1999 and 2000 from the Office of 

the Comptroller of the Currency. 

5 “U.S. Bank Loan Portfolios Reflect Rise in Corporate Bond 

Defaults.” July 20, 2000. Standard and Poor’s Commentary. 

CHART 6 

Household Spending Growth 

Exceeds Income Growth 

Source: Bureau of Economic Analysis via Haver Analytics, Inc. 

Real Consumption Spending 

Real Disposable Income 

7 

–1 

0 

1 

2 

3 

4 

5 

6

Annual Growth Rate (percent) 

’86 ’87 ’88 ’89 ’90 ’91’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99’00 

Quarter 3 

From 1995 through 1998, and likely since then, the 

increase in both leverage and debt servicing burdens has 

been concentrated among low- and middle-income 

households. Among families holding debt in 1998, debt 

payments exceeded 40 percent of disposable income for 

nearly 20 percent in the $10,000 to $24,999 income 

group and nearly 14 percent in the $25,000 to $49,999 

group.6 One concern is that these debt-laden families 

may have inadequate financial resources to make payments should adverse conditions or job loss occur. In 

such instances, lenders could be doubly affected if 

households draw on their credit card and home equity 

lines of credit, further compromising their repayment 

ability, in order to sustain spending in excess of income. 

The recent rise in credit card losses in banks’ card portfolios and rising losses in the portfolios of subprime 

lending specialists may indicate that strains among 

some households are spilling over to lenders. Moody’s 

Investors Service expects credit card losses to rise 

through 2001, according to a recent analysis of 

prospects for the U.S. credit card industry. 

Overheated residential real estate markets in several 

metropolitan statistical areas (MSAs) may be another 

warning of economic imbalances. Dramatic gains in 

home resale prices in San Francisco stand out (see 

Chart 7, next page), but this market is not alone in 

experiencing appreciation considerably higher than 

income growth. In some markets, where financial-services or information-technology workers are concentrated, bidding wars for properties may reflect the fact 

6 Kennickell, Arthur B., Martha Starr-McCluer, and Brian J. Surette, 

“Recent Changes in U.S. Family Finances: Results from the 1998 Survey of Consumer Finances.” Federal Reserve Bulletin. Vol. 86. January 2000, 1–29. 

Chicago Regional Outlook 16 Fourth Quarter 2000 
In Focus This Quarter
 

that affordability is enhanced by gains in wealth rather 

than in income. Even so, similar surges in home resale 

prices in the past often were not sustainable. The subsequent years of stagnant or falling collateral values 

caused financial stress among some homeowners and 

their lenders. Further concern about residential real 

estate lenders arises because pockets of speculative 

construction under way in some markets may produce 

units that become increasingly difficult to sell at anticipated asking prices. 

Construction and Development 

Loan Growth Is Accelerating 

Commercial real estate (CRE) construction across all 

property sectors has grown during this expansion, with 

office construction particularly active. The amount of 

office space completed in mid-2000 was the largest 

since 1989 and is projected by Torto Wheaton Research 

to continue rising. Not surprisingly, construction and 

development (C&D) loan volume, growth rates, and 

concentrations are trending upward rapidly. While total 

private real estate spending grew about 6.5 percent over 

the four quarters ending midyear 2000, C&D loans at 

insured institutions rose by 26 percent. C&D loan 

growth has remained above 20 percent since 1997, and 

the aggregate volume of C&D loans is the highest since 

1989. 

Such growth is contributing to higher concentrations of 

C&D loans relative to Tier 1 capital. At current levels, 

concentrations do not begin to approach those of the 

late 1980s. However, several metropolitan areas have a 

CHART 7 

Median Home Resale Prices Soar 

in San Francisco Bay Area 

large percentage of insured institutions reporting high 

and rising concentrations. Table 1 (next page) shows 

MSAs with at least 15 nonspecialized community 

banks7 and at least one-third of those institutions reporting concentrations in C&D loans equal to at least 100 

percent of Tier 1 capital. The Atlanta MSA stands out. 

Sixty-five percent of Atlanta’s 85 nonspecialized community institutions reported C&D loans exceeding 100 

percent of Tier 1 capital on June 30, 2000, and 35 percent reported a concentration exceeding 200 percent. 

The aggregate C&D concentration for all 85 institutions 

in the MSA was 156 percent, the highest among MSAs 

with at least 15 institutions of similar size and nature. 

Several other markets also include significant shares of 

institutions with high concentration levels. 

Nine of the 16 markets highlighted in Table 1 not only 

have a relatively high percentage of C&D loan exposure but also appear vulnerable to overbuilding in two 

or more property types.8 While these markets show no 

clear signs of emerging economic stress, lenders there 

clearly may be at greater risk should economic or real 

estate conditions sour. Other concerns regarding CRE 

lending arise from a recent Office of the Comptroller 

of the Currency survey, which reports heightened 

credit risk in CRE portfolios and predicts it will 

increase through 2001. In addition, respondents to a 

midyear 2000 FDIC survey of examiners reported 

more frequent comments about excess office and retail 

space. 

Increasing Share of De Novo Institutions 

Raises the Stakes in Some Markets 

A common element among the metropolitan markets 

listed in Table 1 (next page) is the presence of newer 

institutions. In 10 of the 16 markets, at least 20 percent 

of the nonspecialized community institutions are less 

Percent Change from

Four Quarters Earlier 

Quarter 1 

–10 

–5 

0 

5 

10 

15 

20 

25 

30 

35 

’80 

’82 

’84 

’86 

’88 

’90 

’92 

’94 

’96 

’98 

’00

than three years old. The drive to build market share 

among these institutions, particularly if they are publicly traded entities, is increasing the competitive pressure on banks and thrifts in these markets. In some 

instances, the aggregate cost of deposits within the 

MSAs has risen faster than in the nation as a whole, risk 

7 The term “nonspecialized community bank” refers to institutions 

with total assets under $1 billion that are not specialty institutions 

such as credit card or trust banks. 

8 See “Ranking Metropolitan Areas at Risk for Commercial Real 

Estate Overbuilding,” Regional Outlook, third-quarter 2000, which 

Source: National Association of Realtors via Haver Analytics, Inc. identifies markets where new construction is high relative to existing 

stocks of space. 

Chicago Regional Outlook 17 Fourth Quarter 2000 
In Focus This Quarter
 

TABLE 1 

High C&D Loan Exposure Appears in Various MSAs 

SHARE (%) OF AGGREGATE C&D LOANS 

MSAS WITH 15 OR INSTITUTIONS* WITH C&D RELATIVE TO AGGREGATE 

MORE NONSPECIALIZED CONCENTRATIONS > OR = TIER 1 CAPITAL (AS %) 

COMMUNITY INSTITUTIONS* 100% OF TIER 1 CAPITAL IN THIS MSA* 

ATLANTA, GA 65 156 

PHOENIX-MESA, AZ 56 131 

MEMPHIS, TN-AR-MS 52 154 

PORTLAND-VANCOUVER, OR-WA 47 146 

OAKLAND, CA 47 163 

NASHVILLE, TN 44 103 

RIVERSIDE-SAN BERNARDINO, CA 42 110 

SAN DIEGO, CA 41 90 

GRAND RAPIDS-MUSKEGON-HOLLAND-MI 40 81 

SEATTLE-BELLEVUE-EVERETT, WA 39 98 

SALT LAKE CITY-OGDEN, UT 38 56 

FORT WORTH-ARLINGTON, TX 38 110 

DALLAS, TX 36 95 

LAS VEGAS, NV-AZ 35 119 

LEXINGTON, KY 34 80 

DENVER, CO 33 113 

*Sample includes institutions with total assets under $1 billion that are not specialty institutions such as credit 

card or trust banks 

Note: Boldface indicates major MSAs identified at risk for excess commercial real estate construction in Regional 

Outlook, third-quarter 2000 

C&D = construction and development, MSA = metropolitan statistical area 

Source: Bank and Thrift Call Reports for June 30, 2000 

profiles are being elevated, and aggregate leverage ratios 

are falling, despite the influx of capital from the new 

institutions. Highly competitive environments have the 

potential to increase risk taking by negatively affecting 

underwriting standards and balance sheet composition. 

Farm Sector Challenges Continue 

Much of the agricultural industry is experiencing 

stress because of low commodity prices, compounded 

in some areas by low yields resulting from weather- or 

disease-related problems. Strong global competition 

and high worldwide production during the past several years have resulted in large crop inventories, 

depressed prices, and limited prospects for a price 

turnaround in the near term. In the aggregate, record 

levels of government payments have helped the 

nation’s farms maintain a generally stable financial 

condition but have not eliminated the stress in this sector. In fact, the U.S. Department of Agriculture 

(USDA) projects that at least one in four farm businesses in several regions9 will not cover net cash 

expenses in 2000, suggesting that the viability of highly leveraged farmers may be in question. 

Fortunately, the aggregate condition of nearly 2,100 

insured agricultural banks—institutions with 25 percent 

or more of loan portfolios in agricultural credits— 

remains healthy. Generally, agricultural banks continue 

to report favorable asset quality, earnings, and capital 

positions. However, they are experiencing somewhat 

elevated levels of noncurrent loans compared with 

nonagricultural institutions. Agricultural banks are disproportionately represented among the weakest 25 percent of institutions nationwide in terms of noncurrent 

9 These are USDA’s Basin and Range, Mississippi Portal, Fruitful 

Rim, and Southern Seaboard regions. See www.ers.usda.gov/ 

briefing/farmincome/fore/regional/regional.htm. 

Chicago Regional Outlook 18 Fourth Quarter 2000 
In Focus This Quarter
 

loan levels. In addition, rising levels of carryover debt at 

farm banks may translate into higher losses in the future 

if commodity prices remain low. 

The strains in the farm sector also have implications for 

nonfarm banks in agricultural areas. In several agriculture-dependent states, such as Montana and the Dakotas, for example, where farmers’ earnings are depressed 

and the economies not well diversified, nonagricultural 

banks are reporting higher noncurrent levels than 

insured institutions elsewhere in the nation. 

Summary 

The long-lived economic expansion has contributed to 

the banking and thrift industries’ record levels of profitability and asset quality. However, as the expansion has 

matured, both consumer and corporate leverage has risen 

considerably. Bank liquidity is becoming increasingly 

strained by lackluster core deposit growth, which has 

been insufficient to fund strong loan demand. This trend 

has resulted in a decided shift into higher-risk asset 

classes to mitigate margin pressures arising from the 

greater reliance on noncore-funding sources. Furthermore, interest rate risk has risen significantly for many 

institutions and, after nearly a decade of improving asset 

quality, the level of problem loans is increasing. 

Clearly, high levels of profitability in recent years have 

been achieved, in part, by an increased appetite for risk. 

Concern arises because insured institutions’ current 

profitability is being negatively affected by some recent 

trends, despite the sustained economic expansion. And, 

while capital levels have remained fairly stable, the 

amount of risk being leveraged on the industry’s capital 

base is on the rise. Just as a rising tide is said to float all 

boats, a strong economy can mask potential problems 

that will become evident should the economic tide turn, 

particularly in institutions or markets where aboveaverage risk is concentrated. Insured institutions’ safety 

and soundness may be most vulnerable in situations 

where banks and thrifts are exposed to multiple challenges, whether because of strategic decisions or 

because of repercussions from economic and banking 

forces beyond their control. 

Daniel Frye, Regional Manager 

Joan D. Schneider, Regional Economist 

Steve Burton, Senior Banking Analyst 

Allen Puwalski, Senior Financial Analyst 

Ronald Spieker, Chief, Regional 

Programs and Bank Analysis 

Contributions by 

Analysis Branch Staff, Division of Insurance 

Regional Operations Staff, Division of Insurance 

Regional Managers, Division of Supervision 

And other regulatory agencies 

Chicago Regional Outlook 19 Fourth Quarter 2000 
✁
 

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