Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION THIRD QUARTER 2002 

FDIC
 

San Francisco 


Region
 

Division of
 

Insurance
 

and Research
 

Catherine I.
 

Phillips-Olsen,
 

Regional Manager
 

Phillip E. Vincent,
 

Regional Economist
 

Judy H. Plock,
 

Senior Financial
 

Analyst
 

John A. Roberts,
 

Economic Analyst
 

Shayna M. Olesiuk,
 

Economic Analyst
 

Regional Perspectives 

◆ More states in the San Francisco Region experienced layoffs during the 

recent downturn than during the 1990–1991 recession—Industries affected by 

the current recession—particularly high-tech manufacturing, software development, and tourism—are broadly dispersed across the Region. 

◆ Despite the greater geographic breadth of the recent recession, a repeat of 

the banking crisis of the 1980s and early 1990s is not anticipated—However, 

two key factors that affected insured institutions in the Region during the previous 

recession—increasing concentrations in commercial real estate loans during a 

period of softening real estate conditions and a high share of newly chartered 

institutions—are concerns in the current downturn. 

◆ Stress in the Region’s consumer sector could particularly challenge the 

Region’s subprime and concentrated consumer lenders—Some of these lenders 

have not experienced subprime lending through a full economic cycle. See page 3. 

By the San Francisco Region Staff 

In Focus This Quarter 

◆ The Road to Recovery for Commercial Credit Quality: Not without a Few 

Hurdles Ahead—The recession that began in March 2001 has been especially 

hard on the corporate sector. Banks that made loans to affected firms felt the 

immediate effects of the recession through rising problem commercial loans. 

Large banks took the brunt of this commercial credit deterioration, as indicated 

by a somewhat larger uptick in problem commercial loans among large banks 

compared with smaller banks. This credit deterioration was more apparent 

at banks that participated in loan syndications, one of the financing vehicles 

available primarily to large corporate customers. Various indicators pointing 

toward economic recovery, as well as an apparent decline in rating downgrades 

and default rates among corporate bond issuers in recent weeks, suggest that 

improvement in commercial credit quality may be just ahead. This recovery, however, faces a few hurdles, including continued high leverage, weak earnings, and 

prospects for a more difficult funding environment, particularly for speculativegrade corporations with maturing debt. See page 9. 

By Cecilia Lee Barry, Senior Financial Analyst 

A Publication of the Division of Insurance and Research 
The Regional Outlook is published quarterly by the Division of Insurance and Research of the 

Federal Deposit Insurance Corporation as an information source on banking and economic issues 

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

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

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

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

Dallas Region (CO, NM, OK, TX)
 

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

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

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

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

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

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

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

trends and developments at the regional level. 

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

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

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

For more information or to provide comments or suggestions about the San Francisco Region’s 

Regional Outlook, please call Catherine I. Phillips-Olsen at (415) 808-8158 or send an e-mail to 

cphillips-olsen@fdic.gov. 

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

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

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

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

the Federal Deposit Insurance Corporation. 

Chairman Donald E. Powell 

Director, Division of Insurance Arthur J. Murton 

and Research 

Executive Editor George E. French 

Writer/Editor Kim E. Lowry 

Editors Lynn A. Nejezchleb 

Maureen E. Sweeney 

Richard A. Brown 

Ronald L. Spieker 

Publications Manager Teresa J. Franks 
Regional Perspectives
 

Regional Perspectives
 

The San Francisco Region Economy Continued 

to Experience the Effects of the National 

Recession and Downturns in the High-Tech 

and Tourism Sectors through April 2002 

The combination of the slumping high-tech sector and 

the negative effects of the national recession and the 

September 11 attacks resulted in increasing economic 

weakness in the San Francisco Region from March 

2001 through April 2002. During this period, the 

Region’s unemployment rate jumped from 4.9 percent 

to 6.4 percent, slightly above the 6.0 percent national 

rate. Employment growth was negative for the year ending April 2002 in all states in the Region except 

Wyoming, Nevada, Alaska, Montana, and Idaho. 

Nevada’s growth rate, although positive, slowed significantly, declining from 6.8 percent at year-end April 

1999 to 1.2 percent at year-end April 2002. The state 

experienced pronounced employment contraction during fourth quarter 2001 and first quarter 2002 compared 

to year-ago levels, attributed to the adverse effects of 

the terrorist attacks on travel and tourism. In addition, 

nonbusiness bankruptcy filings rose throughout the 

Region and the nation in 2001. Bankruptcy rates in 

Nevada, Oregon, Utah, Montana, Wyoming, and 

Washington increased more rapidly than the national 

rate of 19.3 percent. Furthermore, weakness in the hightech sector continued to dampen demand for commercial real estate (CRE), contributing to increasing office 

vacancy rates, particularly in formerly fast-growing 

high-tech markets such as the San Francisco, San Jose, 

and Seattle metropolitan statistical areas (MSAs). 

Industrial vacancy rates also rose in most areas, and 

planned CRE projects have been slowed or shut down. 

Through first quarter 2002, the effects of the recent 

recession on the Region’s insured institutions were limited. As of March 2002, earnings and capital positions 

among most institutions remained strong. Most of the 

Region’s community banks1 were able to mitigate the 

negative effects of narrowing net interest margins and 

rising credit losses by controlling overhead costs or recognizing securities gains, or both. Nevertheless, the 

year-over-year median return on average assets ratio 

declined slightly, to 1.04 as of first quarter 2002. 

Asset quality indicators also deteriorated in some markets, particularly among established community institutions2 headquartered in the San Francisco MSA, where 

the median delinquent loan ratio more than doubled 

year-over-year, albeit from a very low level (see Chart 

1). Established community institutions2 headquartered 

in Seattle, Las Vegas, and Stockton also reported 

CHART 1 

Past-Due Loan Increases Were Widespread, but Delinquencies 

Were Highest in Utah’s Metropolitan Areas 

Past-due loans/total loans

(median %) 

6 

4 

2 

0 

–150 –100 –50 0 50 100 150 

Year-over-year change in median past-due loans/total loans (basis points) 

Los Angeles 

San Diego 

Stockton 

Las Vegas 

Seattle 

Salt Lake City 

Provo 

Ventura 

Santa Rosa 

San Francisco 

Portland 

Riverside Phoenix

Oakland 

Sacramento 

Tacoma 

Orange County 

Note: Includes metropolitan areas with at least five insured institutions that hold less than $1 billion each in assets and have been in business for at least three years.
 

Size of bubble denotes institution count.
 

Source: Bank and Thrift Call Reports (March 31, 2002)
 

1 Defined as insured commercial banks with less than $1 billion in
 

total assets.
 

2 Defined as insured institutions with less than $1 billion in assets that
 

have been in operation more than 3 years.
 

San Francisco Regional Outlook 3 Third Quarter 2002 
Regional Perspectives
 

increases; median past-due loan ratios in these markets 

topped 2 percent as of first quarter 2002. Established 

community institutions headquartered in the Salt Lake 

City and Provo MSAs continued to report the highest 

median delinquency rates. Delinquency rates among 

established community institutions headquartered in 

Utah have increased concurrent with bankruptcy rate 

increases since 1996, but they rose further during the 

past year in the wake of construction and manufacturing sector job losses. Softening real estate conditions 

have also translated into higher CRE loan delinquency 

levels3 among established community institutions in the 

Region’s major MSAs, with the largest increases occurring in the Provo, Salt Lake City, Stockton, and Seattle 

markets. Although signs of credit quality weakening 

have emerged, problem asset levels remain far below 

those experienced during the 1990–1991 recession. 

Some Similarities and Important Differences 

Exist between the 1990–1991 Recession 

and the Recent Downturn 

While we do not expect this downturn to be as severe as 

the last, a comparison offers insights into how insured 

institutions might fare in the face of the latest recession. 

It is important to note that more than 40 percent of the 

San Francisco Region’s banks and thrifts examined 

during the 1990–1991 recession earned a Uniform 

Financial Institution Rating (UFIR) of 3, 4, or 5. Also, 

the Region was home to 91 failed insured institutions in 

the five years following the 1990–1991 downturn. In 

contrast, 3-, 4-, and 5-rated institutions represented less 

than 10 percent of the Region’s rated institutions as of 

first quarter 2002, and only one of the Region’s insured 

institutions failed in the first six months of this year. 

Insured institutions have fared better through the recent 

recession, in part because the confluence of events that 

led to the last banking crisis did not play out in the same 

way this time. Some key elements contributing to the 

last wave of failures (most of which actually predated 

the 1990–1991 recession) were high interest rates and 

back-to-back recessions in the early 1980s, weak capital levels among many institutions, CRE overbuilding, 

and aggressive new chartering activity. Although the 

current level of troubled and failed institutions remains 

far below that experienced in the early 1990s, the effects 

of the downturn are more widespread in the Region. 

Furthermore, the industry remains vulnerable to some 

recurring risks: in particular, high CRE loan concentrations amid softening real estate conditions and elevated 

proportions of newly chartered institutions. In addition, 

insured institutions have embraced some new risks that 

were not present to the same degree during the last 

recession, the most important of which is subprime consumer lending. 

During 1990 and 1991, only California and Oregon 

experienced declining employment, while 7 of the 

Region’s 11 states reported job losses during 2001 and 

early 2002 (see Chart 2). Oregon and Washington experienced the greatest employment declines in the Region 

and reported the highest unemployment rates in the 

nation during first quarter 2002. 

The effects of the 1990–1991 economic downturn were 

focused in the highly concentrated defense and construction-dependent sectors. During the 1990–1991 

recession, the rapid drop in national defense spending 

following the end of the Cold War and the Persian Gulf 

conflict was a pivotal issue in the San Francisco Region. 

The center of the defense-contracting sector, Southern 

California, was particularly hard hit, although military 

bases were closed throughout the Region. In addition, 

the falloff in construction activity in the Region and 

across the nation adversely affected the lumber sector in 

the Pacific Northwest, particularly in Oregon. 

CHART 2 

Employment Declined in More States in the 

Region during the Recent Downturn than 

during the 1990–1991 Recession 

Note: States ordered by year-over-year growth as of March 2002. 

Source: Bureau of Labor Statistics Year-over-year employment change (%) –3 

–2 

–1 

0 

1 

2 

3 

4 

US WA OR HI AZ UT CA ID MT NV AK WY 

July 1991 

March 2002 

3 Includes construction, nonfarm/nonresidential real estate, and multifamily real estate loans 30 days or more past due or on nonaccrual status. 

San Francisco Regional Outlook 4 Third Quarter 2002 
Regional Perspectives
 

In contrast, the effects of the recent downturn were 

more widely felt across the Region, because employment declines occurred in the more geographically dispersed sectors of high-tech manufacturing, business 

services (which includes software development and 

temporary workers supplied to high-tech companies), 

and tourism (see Chart 3). These same sectors were the 

primary drivers in the Region’s phenomenal economic 

expansion during the 1990s. A significant influx of 

venture capital investment into the Region, primarily 

into dot-com companies in the San Francisco Bay Area 

and secondarily into Southern California and Seattle, 

increased high-tech industry employment in these metropolitan areas. Consequently, the sharp decline nationwide in demand for capital goods, including software, 

during 2001 and early 2002 and the pullback in venture 

capital investment contributed to the Region’s economic slowdown. Employment in the Region’s high-tech 

manufacturing and business services sectors declined 

10 percent from the peak in September 2000 through 

March 2002. 

A decline in tourist and business travel, particularly 

after the September 11 attacks, adversely affected many 

of the Region’s visitor-dependent states and metropolitan areas (see Chart 4). Travel-related job losses have 

been greatest in the Region’s larger metropolitan areas 

that are most dependent on tourism or the high-tech 

business sector: Honolulu, Las Vegas, and San Francisco. Revenue per available room (RevPAR) fell significantly through early 2002 in these key visitor 

CHART 3 

destinations. Smith Travel Research reports that yearover-year RevPAR in San Francisco, for example, was 

down 32 percent in March 2002. 

CRE Remains a Serious Concern 

for the Region’s Banking Industry 

Rapidly increasing CRE vacancy rates have been a common theme in both recessions, although the reasons for 

overbuilding differ. During the 1990–1991 recession, the 

buildup of excess space was associated with national and 

regional factors. Although federal legislation in 1986 

reversed favorable tax treatment implemented in 1981 

for CRE development, long planning and permit times 

resulted in continued high levels of construction.4 Investment by Japan and other Asian countries in West Coast 

and Hawaiian real estate also drove up values in the late 

1980s. Subsequent weakness among Asian economies 

significantly dampened investment and adversely affected values during the 1990s. In addition, the defense cutbacks in Southern California negatively affected area 

real estate markets. During the current slowdown, unrealistic estimates of future demand for commercial real 

estate in the San Francisco Region, fueled by the booming high-tech industry, have been the primary drivers of 

increases in office and industrial vacancy rates. 

The boom-and-bust environment in some of the Region’s 

high-tech centers has led to problems in CRE markets, 

particularly in the office and industrial subsectors. Rapid 

CHART 4 

4 Federal Deposit Insurance Corporation, History of the Eighties— 

Lessons for the Future. Vol. 1: An Examination of the Banking Crises 

of the 1980s and Early 1990s, Washington, DC: FDIC, 1997, chapters 

3 and 11. 

Employment in Key High-Tech and Tourism 

Sectors Declined More in the Recent Downturn 

than during the 1990–1991 Recession 

Source: Bureau of Labor Statistics 

–14 –12 –10 –8 –6 –4 –2 0 2

Lodging and 

recreation 

Instruments 

Business services 

Industrial and 

electronic 

equipment 

March 2002 

July 1991 

Year-over-year change (%) 

Tourism Employment Declined More during 

This Recession in Honolulu, Las Vegas, 

and San Francisco 

Note: Tourism employment includes lodging and amusements. 

Source: Bureau of Labor Statistics 

Year-over-year change (%) 

–12 –10 –8 –6 –4 –2 0 2 4 6 8 

Riverside 

San Diego 

Orange County 

Reno 

San Francisco 

Las Vegas 

Honolulu 

Nation 

March 2002 

July 1991 

San Francisco Regional Outlook 5 Third Quarter 2002 
Regional Perspectives
 

employment declines in the semiconductor, software 

development, and dot-com sectors have pushed up office 

vacancy rates in major high-tech-dependent MSAs, 

including Phoenix, Portland, San Francisco, San Jose, 

and Seattle. Between early 2000 and first quarter 2002, 

the average office vacancy rate in these five MSAs 

rapidly increased to 18 percent, the highest level since 

1989, according to estimates by Torto Wheaton 

Research (see Chart 5). During the recent downturn, 

negative net absorption of office space (i.e., return of 

previously leased space to the sublease market) occurred 

at the same time that new space was coming online. 

During the 1990–1991 downturn, CRE market softening, weak underwriting standards, and high CRE loan 

concentrations contributed to severe asset quality problems and failures among insured institutions, especially those based in Southern California and Arizona. 

Improvements in underwriting and appraisal standards 

during the 1990s and the increased availability of CRE 

market supply and demand data likely will forestall a 

repeat of these problems. However, a much larger share 

of the Region’s institutions now hold high CRE loan 

concentrations than during the last recession. As of 

March 1991, nearly 30 percent of the Region’s insured 

institutions reported CRE loan-to-total asset ratios 

exceeding 25 percent. As of March 2002, more than 

half the Region’s insured institutions reported these 

high concentrations. Although CRE loan delinquencies 

remain at manageable levels and are far below the 

CHART 5 

default rates reported during the early 1990s, continued 

CRE market weakness could, in time, contribute to a 

further weakening in credit quality. 

The change in CRE market conditions increases the 

challenges facing construction and development 

(C&D) lenders,5 which represent a larger share of the 

Region’s insured institutions now than during the previous recession.6 C&D lending traditionally has been 

one of the riskier categories of CRE, because loan 

repayment depends on the timely sale or leasing of the 

project at completion. A higher proportion of the 

Region’s commercial banks—except those headquartered in California and Hawaii—reported C&D loanto-total-asset ratios exceeding 10 percent in first 

quarter 2002 than during the 1991 recession (see 

Chart 6). More than 10 percent of these concentrated 

C&D lenders experienced UFIR downgrades between 

first quarter 2001 and first quarter 2002. Some could 

experience further rating deterioration; for example, 

even though the last recession ended in 1991, the share 

of concentrated C&D lenders in the San Francisco 

Region with a UFIR rating of 3, 4, or 5 did not peak 

until 1993, when nearly half of all concentrated construction lenders were deemed weak. In addition, more 

than 40 percent of the Region’s institutions that currently hold elevated C&D loan concentrations were 

chartered since the 1990–1991 recession and might not 

have the risk management systems in place to mitigate 

vulnerabilities in the portfolio. 

CHART 6 

Average Office Vacancy Rates in High-Tech 

Centers Rapidly Reached Late 1980s Levels 

Note: Combined data from Phoenix, Portland, San Francisco, San Jose, 

and Seattle. 

Source: Torto Wheaton Research Completions and absorptions (million sq. ft.) 

–10 

–5 

0 

5 

10 

15 

20 

’88 ’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00 ’01 ’02 

–10 

–5 

0 

5 

10 

15 

20 

Vacancy rate (right) Completions 

(left) 

Absorptions (left) 

Vacancy rate (%) 

High Concentrations of Construction Loans Are 

Now More Widespread among the Region’s Banks 

than during the 1990–1991 Recession 

Note: Excludes thrifts and states with fewer than ten insured commercial banks. 

Source: Bank Call Reports Share of commercial banks with construction and development loans/assets > 10% (%) 

0 

10 

20 

30 

40 

50 

60 

AZ NV OR WA UT CA ID WY MT 

March 

1991 March 

2002 

5 Defined as insured institutions with C&D loan-to-total-asset ratios
 

exceeding 10 percent.
 

6 For more information, refer to the San Francisco Regional Outlook,
 

first quarter 2002.
 

San Francisco Regional Outlook 6 Third Quarter 2002 
Regional Perspectives
 

De Novo7 Formation Rates Were High Preceding 

Both Recessions 

Brisk bank chartering activity in the years before a 

recession, which contributed to the high number of failures during the early 1990s, remains an area of concern 

for the Region. For 30 percent of the Region’s community institutions, the recent downturn is the first economic contraction they had experienced. The proportion 

of institutions open ten years or less is only slightly 

lower now than during the previous recession. States 

that experienced rapid job growth in the second half 

of the 1990s—Nevada, Arizona, Utah, Washington, 

Idaho, and Oregon—had particularly high concentrations of newly chartered8 institutions as of March 2002. 

At least 30 percent of insured community institutions in 

these six states were established during the past ten 

years (see Chart 7). The proportion of newly chartered 

institutions in these states contrasts sharply with the 

distribution during the previous recession, when newly 

established institutions dominated fewer banking markets. It is noteworthy that newly chartered institutions 

in California, which accounted for 30 of 78 failures in 

the state between 1991 and 1995, represent a smaller 

share of the state’s community institutions now than 

during the previous recession. 

The age composition of newly chartered institutions differs from the last downturn, which could affect how 

they perform following this recession. In the Region, 

institutions between three and ten years old experienced 

CHART 7 

a higher average annual failure rate during the last banking crisis than either less- or more-seasoned institutions. 

A Federal Reserve study suggests that insured institutions between three and ten years old might be most 

vulnerable to failure, because these institutions experience the effects of loan portfolio seasoning (and higher 

loan delinquencies and losses) as excess capital levels, 

maintained during the formative years, are depleted.9 

During the 1990–1991 downturn, 79 percent of newly 

chartered community institutions were between three 

and ten years old, largely because banking deregulation 

in the early 1980s prompted new chartering activity. In 

contrast, as of March 2002, only 57 percent of newly 

chartered community institutions had been doing business for three to ten years (see Chart 8). Although the 

proportion of three- to ten-year-old institutions remains 

high, the current age composition of newly chartered 

institutions could blunt some of the effects of this recession on the Region. 

Institutions less than three years old constituted 43 percent of the Region’s newly chartered community institutions as of first quarter 2002, more than double the 

proportion in first quarter 1991. Capital ratios among 

community institutions less than three years old generally compare favorably with those reported by more established institutions, a fact that could insulate them from 

the vagaries of the business cycle. Nevertheless, these 

very young institutions are characterized by untested 

underwriting, newly developed risk management systems, and unseasoned loan portfolios. Additionally, susCHART 8 

Several of the Region’s Fast-Growing States 

Are Home to a Large Share of Newly 

Chartered Community Institutions 

Note: Community institutions are defined as insured institutions that hold less 

than $1 billion in assets; newly chartered institutions are defined as insured 

institutions open less than ten years. 

Source: FDIC Share of community institutions under ten years old (%) 

0 

25 

50 

75 

100 

NV AZ UT ID WA OR CA WY MT 

March 

1991 

March 

2002 

Insured Institutions between Three and Ten Years
 

Old Represent a Smaller Share of the Region’s
 

Newly Chartered Institutions Now than
 

during the Past Recession
 

40 

35
 

30
 

25
 

20
 

15
 

10
 3–5 Years
 

5
 

0
 

March 1991 March 2002 

< 3 Years 

< 3 Years 

3–5 Years 

5–10 Years 

5–10 Years 

Note: Community institutions are defined as insured institutions that hold less 

than $1 billion in assets; newly chartered institutions are defined as insured 

institutions open less than ten years. 

Source: FDIC Share of San Francisco Region community institutions (%)

7 Defined as insured institutions open for three years or less. 

8 Defined as insured institutions chartered in the past ten years. 

9 Robert De Young, “Birth, Growth, and Life or Death of Newly Chartered Banks,” Economic Perspectives, Federal Reserve Bank of Chicago, 

1999, p. 26. 

San Francisco Regional Outlook 7 Third Quarter 2002 
 

Regional Perspectives
 

tained economic weakness could limit growth and earnings opportunities for these institutions at a time when 

they most need to attain profitability. Thus, although 

institutions less than three years old might, ironically, be 

better able to withstand the downturn because of higher 

capital levels, these institutions might have booked most 

of their early loans during the prerecession boom period, 

when lenders were optimistic about future economic 

conditions. As these loans season during a slowing economy, credit quality could deteriorate. 

Large Consumer and Subprime Lenders 

Pose a New Dimension of Risk 

Since the last recession, several of the Region’s insured 

institutions have pursued concentrated consumer10 and 

subprime lending niches, often using non-recessiontested credit scoring models to achieve large, highyielding loan portfolios. As of first quarter 2002, nearly 

44 percent of the Region’s concentrated consumer 

lenders had total assets of over $500 million each, compared with only 11 percent in 1991. Improved computer 

processing speeds and the increased popularity of credit 

scoring models have contributed to increased efficiency 

in underwriting and a concentration of consumer assets 

into fewer, larger institutions. 

The ability of subprime credit card yields, in particular, 

to compensate for heightened risk was tested during 

2001, when personal bankruptcy filings and consumer 

leverage reached record highs and consumer loan quality deteriorated. The Region’s 32 concentrated consumer 

lenders—approximately half of which held significant11 

subprime consumer loan exposures—reported median 

consumer loan delinquency and net charge-off ratios of 

3.37 and 3.62 percent, respectively, as of first quarter 

2002. Although the median delinquency ratio was comparable to that reported during the last recession, the 

median net loss rate far exceeded the 1.25 percent 

reported by the Region’s niche consumer lenders during 

first quarter 1991. Asset deterioration contributed to the 

February 2002 failure of Nextbank, one of the Region’s 

10 Concentrated consumer lenders are defined as insured institutions 

with credit card and other non-real estate–secured consumer loans 

exceeding 25 percent of total assets. As of March 2002, these lenders 

held $89.9 billion in assets—nearly 8 percent of all assets controlled 

by insured institutions headquartered in the Region. 11 Defined as holding direct or indirect interests in subprime consumer 

loans in excess of 25 percent of Tier 1 capital. 

larger subprime lenders. Nationally, these niche lenders 

represent a disproportionately large share of problem 

banks and recent failures. 

The growth of the secondary loan market has mitigated 

some of the increased risk experienced by consumer 

lenders by allowing many lenders to securitize riskier 

assets. While securitization affords liquidity to some 

consumer lenders, most securitizers retain relatively 

volatile “residual interests” in the securitized assets. 

Residual interests typically involve a first-loss position, 

and current values are assumption driven. Unexpected 

increases in prepayments, defaults, or interest rates 

could affect the value of these assets. Liquidity from 

securitized consumer assets is readily available only if 

purchasers remain receptive to these investments. An 

unexpected, significant deterioration in consumer credit 

quality would invalidate residual interest valuation 

assumptions and diminish the attractiveness of these 

assets to secondary market participants. As a result, it 

could be more difficult for some consumer lenders to 

use securitization vehicles as a source of liquidity. 

While Widespread Failures Are Not Anticipated, 

Some Insured Institutions Face Heightened Risk 

The current recession has had broad geographic and 

sectoral effects in the Region, which could pose new 

challenges to insured institutions. On the whole, 

insured institutions are better capitalized and more 

profitable, and have better risk management practices 

in place, than they did during the 1990–1991 recession. 

Nevertheless, patterns that contributed to the wave of 

banking problems during the late 1980s and early 

1990s have persisted and, in some cases, were more 

widespread during this recession. For example, during 

the recent downturn, CRE and C&D loan concentrations were higher among insured institutions in the 

Region, and several of the Region’s markets were characterized by a higher proportion of de novo institutions. 

Furthermore, the increased popularity of concentrated 

consumer and subprime lending adds to the challenges 

some insured institutions face. While newly established 

insured institutions, concentrated CRE lenders, or 

niche subprime institutions could experience additional 

asset quality weakening, a repeat of the last banking 

crisis is not anticipated. 

San Francisco Region Staff 

San Francisco Regional Outlook 8 Third Quarter 2002 
In Focus This Quarter In Focus This Quarter
 

The Road to Recovery for Commercial Credit Quality:
 

Not without a Few Hurdles Ahead
 

Introduction 

The banking industry as a whole has performed well in 

recent years, despite increasing loan delinquencies, 

notably in commercial credits. Although the extent of 

commercial loan deterioration has not reached levels 

experienced in the early 1990s, it nonetheless warrants 

scrutiny. With a variety of economic indicators pointing 

toward recovery, the volume of problem commercial 

loans held by insured institutions could plateau during 

2002. Many banks tightened business loan underwriting 

standards beginning in early 2000, a trend that should 

contribute to an eventual turnaround in commercial loan 

quality. Nevertheless, several factors could delay this 

improvement. Corporate profitability has yet to recover 

fully, and many firms continue to operate with significant financial leverage. Highly leveraged firms are 

especially vulnerable to declining revenues, which 

reduce the cash flow available to service debt obligations. More significantly, lower investor tolerance for 

risk has created a far less hospitable financing market 

for speculative-grade firms, possibly straining liquidity 

and increasing the likelihood that these companies 

could default as debts mature. 

Commercial Credit Deterioration Should 

Subside with the Economic Recovery 

While the banking industry has fared well through the 

latest recession, it did not escape the effects of the troubled corporate sector. Large banks (those with assets 

greater than $1 billion), in particular, have seen a significant rise in noncurrent commercial and industrial 

(C&I) loan and loss rates.1 While total C&I loans represented 25 percent of all outstanding loans held by all 

insured commercial banks as of March 31, 2002, net 

C&I loan losses comprised 32 percent of all loan 

losses. In first quarter 2002, noncurrent C&I loans 

reached 2.6 percent of outstanding loans (2.8 percent 

for large banks), the highest level since fourth quarter 

1993. The four-quarter moving average C&I loss rate 

also rose among small and large banks; however, the 

rate of increase for large banks was significantly higher, 

as shown in Chart 1. 

1 Noncurrent loans are defined as loans 90 or more days past due or 

on nonaccrual status. 

CHART 1 

Large Banks Experience a Rapid Rise in 

Commercial and Industrial Loan Loss Rates 

Source: Bank Call Reports, FDIC Research Information System 

Large banks 

(> $1 billion in assets) 

Four-Quarter Moving Average Commercial

and Industrial Loss Rates (%)

Small banks 

(< $1 billion in assets) 

0.0 

0.2 

0.4 

0.6 

0.8 

1.0 

1.2 

1.4 

1.6 

1.8 

2.0 

2.2 

1Q90 3Q91 1Q93 3Q94 1Q96 3Q97 1Q99 3Q00 1Q02 

Improving economic conditions and tighter underwriting standards suggest that commercial credit quality 

should improve. A range of indicators suggests that economic recovery is under way, albeit more slowly than 

some expected earlier this year. The housing sector 

remains robust, job conditions have stabilized, and real 

gross domestic product (GDP) grew 5.0 percent in first 

quarter 2002. Although GDP grew at a slower pace of 

1.1 percent in second quarter 2002, business equipment 

spending increased 2.9 percent, in contrast to a decrease 

of 2.7 percent in first quarter 2002. Also, the manufacturing sector began to show signs of recovery with the 

Institute for Supply Management (ISM) index for 

manufacturing reaching 56.2 and 50.5 in June and July 

2002, respectively. The ISM index has remained above 

50, which signals an economic expansion, for the six 

consecutive months since February 2002. Also, the 

index of coincident indicators, a gauge of current economic activity, rose 0.3 percent in June 2002. Furthermore, a survey of 50 leading corporate economists by 

Blue Chip Economic Indicators shows that analysts 

expect the U.S. economy to grow at a rate of 3.3 percent 

in third quarter 2002.2 

Recent changes in underwriting standards also bode 

well for credit quality at commercial banks. The Federal 

2 Blue Chip Economic Indicators, July 2002. Also see Regional 

Outlook, Second Quarter 2002, “Back to the Future: How This 

Downturn Compares to Past Recessions.” See http://www.fdic.gov/ 

bank/analytical/regional/ro20022q/na/index.html. 

San Francisco Regional Outlook 9 Third Quarter 2002 
In Focus This Quarter In Focus This Quarter
 

Reserve Board’s Senior Loan Officer Opinion Survey 

on Bank Lending Practices, which focuses on 

changes in the supply of and demand for bank loans to 

businesses and households over the previous three 

months, has shown consistent tightening of business 

loan standards during the past two years. The April 

2002 survey indicated some further tightening of standards, but the percentage of banks reporting this tightening has declined since the January survey, consistent 

with the anticipation of a continued economic 

rebound.3 Since credit quality typically lags the business cycle, near-term recovery appears more likely, 

provided the economy continues to improve. This 

recovery in commercial credit quality, however, is not 

without a few hurdles ahead. 

High Default Rates, Rating Downgrades, 

and Bankruptcies Persist 

While the U.S. economy is showing signs of recovery 

and underwriting standards have tightened, corporate 

credit quality could continue to be affected by several 

adverse trends. The number of bankruptcies filed by 

public companies this year is on pace to challenge 

the record set in 2001.4 Furthermore, default rates for 

CHART 2 

Current U.S. Corporate Credit Deterioration Is 

U.S. speculative-grade corporate bond issuers remained 

high at 10.3 percent in June 2002, and the high ratio of 

corporate rating downgrades to upgrades indicates continuing weakness in the corporate sector (see Chart 2).5 

The main reasons for rating downgrades have been poor 

profitability and high leverage. 

Corporate Profitability Remains Fragile 

Corporate profitability has been depressed since first 

quarter 2001 (see Chart 3). However, this trend is improving slowly in 2002. U.S. corporate profits rose during 

second quarter 2002 for the first time in five quarters.6 

However, the rate of recovery is not expected to be strong 

in 2002, as some 93 companies in the Standard & Poor’s 

500 have announced that third quarter earnings will be 

less than expected, more than twice the number of companies that have announced they will beat estimates.7 In 

fact, earnings forecasts have been revised downward 

consistently for the past several months, and analysts 

have warned recently that earnings estimates for the 

second half of 2002 are likely to be reduced. The bright 

spot in earnings continues to be the consumer sector, 

with automobile manufacturers and certain retail areas 

posting strong sales. The worst-performing sectors on a 

CHART 3 

Corporate Profits Remained Depressed 

Approaching Early 1990s Levels 

0 

1 

2 

3 

4 

5 

6 

7 

8 

9 

10 

11 

0.0 

0.5 

1.0 

1.5 

2.0 

2.5 

3.0 

3.5 

4.0 

4.5 

5.0 

Percent Ratio 

Bank commercial and 

industrial noncurrent 

rate (left scale) 

U.S. speculative-grade bond 

issuer default rate (left scale) 

U.S. Corporate bond ratings downgrades 

to upgrades (right scale) 

1988 1990 1992 1994 1996 1998 2000 1Q02 

Year-over-year growth in net income from

continuing operations for all S&P 500 firms (%)

35 

25 

15 

5 

–5 

–15 

–25 

through the First Quarter of 2002 

1997 1998 1999 2000 2001 2002 

Sources: Moody’s, Bank Call Reports, FDIC Research Information System 

3 Senior Loan Officer Opinion Survey on Bank Lending Practices, 

The Federal Reserve Board, April 2002. The survey reported that the 

percentage of domestic banks that reported tightened standards on 

C&I loans to large and middle-market firms (annual sales of at least 

$50 million) since the January survey declined to 25 percent from 

45 percent. The percentage of domestic banks that report tightened 

standards on business loans to small firms declined more, from 42 

percent in January to 15 percent in April. 

4 Bankruptcydata.com reports that 257 publicly traded companies 

filed for bankruptcy in 2001, while 114 companies had filed by 

June 30, 2002. 

Source: Standard & Poor’s 

5 In the first half of 2002, Moody’s downgraded 262 companies and 

upgraded 59, producing a downgrades to upgrades ratio of 4.4:1. 

6 On a year-over-year basis, 371 companies in the Standard & Poor’s 

500 Index that reported earnings through July 26, 2002, posted 

profits. 

7 Danielle Sessa, “U.S. Stocks Slide as Johnson & Johnson, Pepsi 

Shares Tumble,” Bloomberg.com, July 19, 2002. 

San Francisco Regional Outlook 10 Third Quarter 2002 
In Focus This Quarter In Focus This Quarter
 

year-over-year basis appear to be energy, transportation, 

utilities, capital goods, and communications services.8 

The latest recession was driven primarily by the sharp 

decline in the demand for capital goods. With the slow 

economic recovery, businesses have continued to limit 

capital spending. The rate of recovery for corporate profitability will depend in large part on how soon and to 

what extent businesses resume spending. 

The prospect of slow earnings growth could be particularly problematic for many highly leveraged corporations. Debt levels relative to cash flow have been 

rising because of anemic earnings (see Chart 4). Negative earnings news also comes at a time when several 

well-publicized accounting irregularities have shaken 

investors’ confidence in corporate earnings reports. A 

Huron Consulting Group study of financial restatements indicates that during the past five calendar 

years, the number of restated financial statements filed 

by public companies has grown from approximately 

120 in 1997 to 270 in 2001.9 The number of restatements continued to grow in 2001, despite a reduction in 

the number of public companies. That study found that 

CHART 4 

the largest source of restatements relates to how companies recognize revenue. With depressed corporate 

profits and diminishing investor confidence, some 

firms with debts maturing in the near term may have 

difficulty refinancing. 

Firms with Maturing Debts Could Face 

a Critical Period in the Near Term 

Moody’s estimates that $141 billion worth of U.S. 

speculative-grade corporate bonds and rated bank debt 

will come due over the next three years: $27 billion 

(19 percent) in 2002, $54 billion (38 percent) in 2003, 

and $60 billion (43 percent) in 2004.10 To put these 

numbers into perspective, total U.S. corporate bond 

defaults were $115 billion in all of 2001, of which 

95 percent of those defaulting were speculative-grade 

borrowers. Although Moody’s expects the bulk of 

high-yield debt maturing in 2002 to be refinanced 

despite unfavorable market conditions, concern exists 

about the large percentage of issues rated B1 or lower 

that will come due in 2003 and 2004 (see Chart 5).11 

CHART 5 

Corporate Debt Continues to Rise 

Relative to Cash Flows 

Source: Federal Reserve Board Ratio of nonfarm, nonfinancial debt to cash flow 

3.5 

4.0 

4.5 

5.0 

5.5 

6.0 

1975 1978 1981 1984 1987 1990 1993 1996 1999 1Q02 

Forty-Seven Percent of U.S. Speculative-Grade
 

Bonds and Bank Debt Maturing in 2003–2004
 

Are Rated B1 or Lower
 

Ba1 to Ba3 

53% 

B1 to B3 

36% 

Caa1 or lower 

11% 

Source: Moody’s 

8 Charles L. Hill, et al., This Week in Earnings, Thomson First Call, 

July 22, 2002. 

9 A Study of Restatement Matters, for the five years ended December 

31, 2001, Huron Consulting Group, June 2002. This study excluded 

restatements caused by changes in accounting principles and 

nonfinancial-related restatements. 

10 Tom Marshella, et al., “Refunding Risk for U.S. Speculative Grade 

Borrowers, 2002–2004,” Global Credit Research, Moody’s Investors 

Service, December 2001. Figures related to refunding risk presented 

throughout this article are taken from Moody’s refunding risk studies, 

conducted annually since November 1998. 

11 Speculative-grade debt ratings assigned by Moody’s in the order of 

declining credit quality are as follows: Ba, B, Caa, Ca, and C. 

Moody’s also applies numerical modifiers 1, 2, and 3 in each generic 

rating classification. The modifier 1 indicates that the obligation 

ranks in the higher end of its generic rating category, while the 

modifier 3 indicates a ranking in the lower end of that generic rating 

category. 

San Francisco Regional Outlook 11 Third Quarter 2002 
In Focus This Quarter In Focus This Quarter
 

Credit deterioration of bank loans is similar to the cur- TABLE 1 

rent trend in corporate bonds. Migration of maturing 

loans into lower grade categories has accelerated in 

recent years (see Chart 6). This ratings decay reflects 

the borrowers’ deteriorated financial condition and the 

effects of liberal underwriting conditions from 1996 to 

1998, when speculative-grade originations were more 

common. For example, the 1999 and 2000 refunding 

risk studies conducted by Moody’s noted that 16 percent 

and 17 percent, respectively, of all rated bank loans 

maturing in 2002 were rated B1 or lower. The trend 

worsened significantly in 2001, when the study noted 

that 39 percent of bank loans maturing in 2002 were 

rated B1 or lower. When firms have to refinance lowgrade debts in today’s environment, they may face 

additional pressure on earnings and liquidity. 

Loss Severity Has Increased 

with Higher Default Rates 

Moody’s credit ratings reflect the likelihood of default 

and the severity of loss given default. As a result, the 

migration of maturing bonds and loans into lower 

grades implies a greater risk of default or increased loss 

severity upon default, or perhaps both. Moody’s notes, 

as part of its 15th annual study of global corporate 

defaults and ratings performance, that average recovery 

rates fell for the third straight year in 2001.12 The recovery rate has deteriorated for all levels of security and 

CHART 6 

The Proportion of Maturing Bank Loans Rated
 

B1 or Lower Is Increasing
 30 

Ba 25 

Average Speculative-Grade 

Recovery Rates in 2001 Show a 

Declining Trend in Nearly All Levels 

of Security and Subordination 

AVERAGE
 

RECOVERY
 

PER $100
 

1982– 

SENIORITY/SECURITY 2000 2001 

SENIOR SECURED BANK LOAN $67.06 $54.68 

EQUIPMENT TRUST $64.65 NA 

SENIOR SECURED BONDS $52.09 $58.00 

SENIOR UNSECURED BONDS $43.82 $36.20 

SENIOR SUBORDINATED BONDS $34.59 $19.90 

SUBORDINATED BONDS $31.83 $16.45 

JUNIOR SUBORDINATED BONDS $22.48 NA 

Note: NA=not available 

Source: Moody’s 

subordination except for senior secured bonds (see 

Table 1). 

Higher-Risk Borrowers Pay High Premiums 

A speculative-grade company refinancing debt today 

will face a much higher price, in terms of spreads over 

a cost of funds index or risk-free instruments, compared to several years ago. Yield spreads between 

investment-grade and speculative-grade bonds have 

widened significantly since early 2000 (see Chart 7), in 

part because of lower investor tolerance for risk, rising 

CHART 7 

$ Billions 

20 

15 

10 

5 

0 

B1 or Lower 

2002 2003 2004 

Credit Costs for Higher-Risk Borrowers Rose 

Dramatically in Recent Years 

Sources: Merrill Lynch Bond Global Bond Indices, Federal Reserve Board Basis point spread over ten-year constant-maturity Treasuries

Investment-grade bonds 

High-yield bonds 

0 

100 

200 

300 

400 

500 

600 

700 

800 

900 

1000 

Jun 

’98 

Dec 

’98 

Jun 

’99 

Dec 

’99 

Jun 

’00 

Dec 

’00 

Jun 

’01 

Dec 

’01 

Jun 

’02 

Source: Moody’s 

12 David Hamilton, et al., “Default & Recovery Rates of Corporate 

Bond Issuers: A Statistical Review of Moody’s Ratings Performance 

1970–2001,” Global Credit Research, Moody’s Investors Service, 

February 2002. The recovery rate is defined as the secondary market 

price of the defaulted instrument approximately one month after the 

time of default. 

San Francisco Regional Outlook 12 Third Quarter 2002 
In Focus This Quarter In Focus This Quarter
 

defaults, and weakening corporate cash flows. After 

narrowing a bit in first quarter 2002, spreads have 

widened again on renewed concerns about accounting 

irregularities and the realization that the economic 

recovery may come at a slower pace than anticipated. 

Lower investor tolerance for risk has affected not only 

speculative-grade borrowers but also some investmentgrade borrowers. For example, the commercial paper 

(CP) market, which many investment-grade borrowers 

have used as a cheap source of funding, is no longer 

readily available to all investment-grade borrowers.13 

Drawn-Down Commercial Paper Back-up Lines 

Heighten Commercial Bank Exposure14 

Since its peak at the end of 2000, the CP market for 

domestic nonfinancial companies has shrunk by almost 

50 percent (see Chart 8). A reduction in the need for 

working capital and heavy refinancing activity have 

contributed to this contraction. However, the record 

number of downgrades among issuers of CP in 2001 

also contributed to this decline. Money market funds 

cannot hold more than 5 percent of assets in CP graded 

less than A1/P1/F1.15 Thus, the recent flux of downgrades effectively squeezed some issuers out of this 

market and forced them to refinance with fixed-rate 

bonds.16 Also, fears of deteriorating credit quality have 

shut some investment-grade companies out of the CP 

market. Since the collapse of Enron, investors have been 

reluctant to hold the debt of certain companies. Some of 

these companies reported accounting irregularities, and 

the restatement of financial statements revealed previously hidden losses. In some cases, issuers that were not 

involved with accounting irregularities were forced to 

draw on bank credit lines when they were unable to roll 

over their CP because of the lack of demand or extreme13 Commercial paper is short-term promissory notes issued by large 

firms, generally maturing in nine months or less. It is an important 

source of short-term funding for corporations that need a steady 

stream of working capital. 

14 A CP back-up line is a commitment to provide a liquidity support 

for a company’s CP program. It is typically a revolving credit, a 

364-day facility. The rationale is that the borrower does not intend 

to use the back-up line, which generally costs more than issuing 

CP, unless the CP cannot be rolled over or repaid. 

15 The CP market can be divided into three tiers: Tier 1 (A1/P1/F1 or 

better), Tier 2 (A2/P2/F2), and Tier 3 (A3/P3/F3). The first two 

groups make up the bulk of the market. The first rating refers to a 

rating assigned by Standard & Poor’s, while the second and third 

reflect ratings assigned by Moody’s and Fitch, respectively. 

16 Moody’s Investors Service, Moody’s Credit Perspectives, December 

31, 2001. Moody’s downgraded 38 commercial paper programs from 

P1 in 2001. 

CHART 8 

Domestic Nonfinancial Commercial Paper 

Outstandings Have Declined amid Investors’ 

Jitters about Credit Quality 

Source: Federal Reserve Board (Haver Analytics) $ Billions 

100 

150 

200 

250 

300 

350 

2Q95 2Q96 2Q97 2Q98 2Q99 2Q00 2Q01 2Q02 

ly high rates demanded by investors. When a CP issuer 

draws down on the back-up line, rating agencies often 

view this as a weakness in the company’s liquidity, and 

a rating downgrade can occur. In turn, lower ratings lead 

to higher funding costs for the borrowers. 

The steepness of the current yield curve also results in 

significantly higher refinancing costs for investmentgrade corporations that no longer have access to shortterm funding through the CP market. As these 

companies are forced to borrow longer term, they face 

higher refinancing costs in the long-term end of the 

current yield curve.17 For example, if a Tier 1 corporation formerly issuing 90-day CP was forced to issue 

ten-year fixed-term debt in mid-July 2002, the cost 

would have been almost 350 basis points higher than 

issuing 90-day CP. 

Using back-up lines of credit when companies cannot 

roll over maturing CP has become expensive for some 

issuers. Bankers are realizing that initial pricing does 

not reflect the risk inherent in drawn-down lines. As a 

result, bankers have started to impose high utilization 

premiums on BBB-rated CP back-up lines. Also, borrowers recently have been seeking term-out options, 

another sign that refunding risk is a concern.18 Recent 

transactions reported by Loan Pricing Corporation 

show that some investment-grade companies are seek17Bloomberg Fair Market Sector Curves, July 5, 2002. The spread
 

between 60-day and five-year Treasury instruments was nearly 300
 

basis points. 


18 Once the back-up line has been drawn down, the borrower again has
 

to repay or roll over the debt. A revolving facility can be “termed out”
 

so that it becomes an installment loan with a much longer maturity,
 

such as three to five years. Such an option, however, can be costly.
 

San Francisco Regional Outlook 13 Third Quarter 2002 
In Focus This Quarter In Focus This Quarter
 

ing term-out options even at a fee of 200 basis points. 

The higher premiums demanded reflect both the volatility in the market and deteriorating credit quality indicated by high default rates and rating downgrades in 

recent quarters. 

Conclusion 

During the boom times of the late 1990s, corporations 

enjoyed an abundance of liquidity sources and easy 

access to capital. Many corporations used debt to 

finance business expansions, and rolling over maturing 

debt was not a significant concern. Recently, however, 

stock prices have been declining and investors have 

been concerned about the possibility of more corporate 

financial restatements. In this environment, highly 

leveraged borrowers worry about maturing debts and 

refunding risk implications. Lenders are demanding 

higher spreads because of the volatile financial markets 

and the deteriorated financial condition and debt ratings 

of many borrowers. In general, firms seeking to roll 

over maturing debt clearly face a less hospitable financing market today. With corporate profitability not yet 

strong, highly leveraged companies may find it increasingly difficult to meet debt service requirements and 

loan covenants. Despite these hurdles, the economy 

appears to be improving, and more companies are 

beginning to report higher earnings. With an economic 

recovery and tighter underwriting standards, the deterioration in commercial credit quality should stabilize 

and turn around. 

Cecilia Lee Barry, Senior Financial Analyst 

San Francisco Regional Outlook 14 Third Quarter 2002 

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