San Francisco Kansas 

City 

Dallas 

Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION	 FOURTH QUARTER 2002 

Chicago	 as the corporate sector undergoes restructuring. The most likely scenario for the 

economy over the next few quarters is continued slow growth as the recovery gains New 

York	 momentum. If realized, this scenario could afford banks the benefits of an improving credit picture without dramatically altering the current favorable interest rate 

environment. Despite the overall positive outlook, there are some areas of concern 

for the banking industry, such as lingering commercial credit problems, portfolio 

concentrations in formerly fast-growing metro areas, and subprime mortgage and 

Atlanta 

FDIC
 

National
 

Edition
 

Division of 

Insurance 

and 

Research 

In Focus This Quarter 

◆ Economic Conditions and Emerging Risks in Banking—In spite of the lingering effects of the recession that began in March 2001, the banking industry as a 

whole remains well-capitalized and highly profitable. A steep yield curve has boosted net interest income, more than compensating for the rise in provision expenses 

associated with higher credit losses. Strength in consumer spending and home 

building mitigated the effects of the recession and continues to support the recovery 

consumer lending. See page 3. 

By Stephen Gabriel, Thomas Murray, and Lisa Ryu 

Regional Perspectives 

◆ Atlanta—Certain metro areas were 

ranked according to their vulnerability 

to weakening in the housing market. 

Insured institutions’ construction and 

development credit quality could deteriorate in these areas should uncertainty 

about the housing sector continue. See 

page 12. 

◆ Chicago—Loan quality concerns 

linger as credit quality improvement is 

expected to lag the economic recovery. A 

return to a flatter yield curve could challenge management of interest rate risk. 

See page 16. 

◆ Dallas 

Midsouth—Lower interest rates benefited net interest margins in second 

quarter 2002. However, recent narrowing of interest spreads suggests that 

margins could decline in the near term. 

See page 20. 

Southwest—Weak employment growth 

is contributing to rising office vacancy 

rates in some metro areas. At the same 

time, the insured institutions have significantly increased concentrations of commercial real estate loans. See page 23. 

◆ Kansas City—The drought could 

cause stress for a large number of the 

Region’s insured institutions. The effects 

of weakening in commercial real estate 

markets and earnings pressures are also 

of concern. See page 28. 

◆ New York 

Mid-Atlantic—Large bank profitability was mixed, with continued weakness 

in commercial credit quality. Interest 

rate risk management may be tested 

following record mortgage originations 

and changes in the yield curve. See page 

32. 

New England—Declining employment 

and earnings in the technology and 

financial services sectors are dampening 

regional economic growth. Overall, however, insured institution credit quality 

remains strong despite weak commercial real estate conditions. See page 36. 

◆ San Francisco—Job growth remained sluggish. Earnings and asset 

quality have deteriorated somewhat 

among community banks, and improvement in credit quality may lag the economic recovery. See page 39. 

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 

six geographic regions and two areas: 

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

Jack M.W. Phelps, Regional Manager, 678-916-2295 

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

David Van Vickle, Regional Manager, 312-382-7551 

Dallas Region (AR, CO, LA, MS, NM, OK, TN, TX) 

Southwest: Alan Bush, Regional Manager, 972-761-2072 

Midsouth: Gary Beasley, Regional Manager, 901-821-5234 

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

John Anderlik, Regional Manager, 816-234-8198 

New York Region (CT, DC, DE, MA, MD, ME, NH, NJ, NY, PA, PR, RI, VI, VT) 

Mid-Atlantic: Kathy Kalser, Regional Manager, 917-320-2650 

New England: Paul Driscoll, Regional Manager, 781-794-5502 

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

Catherine Phillips-Olsen, Regional Manager, 415-808-8158 

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 National Edition of Regional 

Outlook, please call Rae-Ann Miller at (202) 898-8523 or send an e-mail to rmiller@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 Maureen E. Sweeney 

Senior Technical Writer Kim E. Lowry 

Editors Rae-Ann Miller 

Richard A. Brown 

Ronald L. Spieker 

Publications Manager Teresa J. Franks 
In Focus This Quarter
 

In Focus: Economic Conditions 


and Emerging Risks in Banking
 

Introduction CHART 1

The recession that began in March 2001 appears to have 

ended in early 2002.1 Still, significant uncertainty 

remains about the future path of the U.S. economy. In 

spite of the lingering effects of the recession, Federal 

Deposit Insurance Corporation (FDIC)-insured banks 

and thrifts posted record earnings in the first half of 

2002. During this period, banks continued to experience 

rising credit losses, particularly on commercial loans to 

corporate borrowers. However, a steep yield curve 

helped boost net interest income, more than offsetting 

downward pressure on earnings resulting from credit 

quality deterioration. 

Most economists agree that the U.S. economy is likely 

to grow at a sub-par rate for the next several quarters. 

Under this “weak growth” scenario, bank earnings are 

expected to remain strong on the whole. However, risks 

for the banking sector remain, including a possibility of 

further credit quality deterioration in commercial loan 

portfolios, high credit exposure to previously fast-growing metro areas, and the ongoing problems of subprime 

consumer and mortgage lenders. 

U.S. Economy: Slow Recovery 

Appears to Take Hold 

The U.S. economy appears to be recovering from the 

mild recession that began in March 2001, but the pace 

of recovery has been slower than expected. From the 

peak of payroll employment in March 2001 to the 

trough in April 2002, the economy lost 1.78 million 

jobs. Although job growth has been positive in four of 

the past six months through October 2002, businesses 

have added only 215,000 jobs, on net, during that period. The weak employment picture thus far suggests that 

this recovery largely resembles the jobless recovery 

from the 1990–91 recession, which was also relatively 

short and mild. It took 34 months to recoup all of the 

jobs lost during that 9-month recession (see Chart 1). 

1 As of early December, the National Bureau of Economic Research 

(NBER) has not yet declared the end of recession. The NBER’s dating 

of a recession often lags the cyclical peaks and troughs by several quarters. See http://www.nber.org/cycles/recessions.html 

Job Growth Is Recovering Slowly,
 

as It Did a Decade Ago
 

Total Payroll Employment (Millions)
 

1990–91 Recession 2001 Recession
 

111 133 

110 132 

109 131 

108 

107 

106 

130 

129 

105 128 

104 127 

103 126 

102 125 

–25 –15 –5 5 15 25 

Months Before/After Onset of Recession 

35 

Sources: FDIC, Bureau of Labor Statistics 

Robust Consumer Spending 

Has Supported the Economy 

Consumer spending and home construction continue to 

be the twin pillars of economic activity. In spite of the 

weak employment outlook and dismal stock market performance, the average level of consumer spending during the first nine months of 2002 was 3.3 percent higher 

than year-ago levels. Some of the main drivers behind 

this robust growth include healthy growth in disposable 

personal income, low interest rates, and rising home 

values. 

Real disposable personal income (real DPI) in the second quarter of 2002 was 4.9 percent higher than a year 

earlier, a growth rate that slowed somewhat to 3.0 percent in the third quarter.2 While this robust growth in 

real DPI has been instrumental in supporting consumer 

spending, it can be argued that the growth was mostly 

the result of one-time events, including the 2002 tax cut 

and the extension of benefits paid to unemployed workers (see Chart 2). A declining tax burden and an 

increase in transfer payments accounted for 74 percent 

of the change in disposable personal income (net of the 

inflation adjustment) between second quarter 2001 and 

second quarter 2002, and 51 percent in third quarter 

2002. Without additional fiscal stimulus, these one-time 

2 Real DPI takes into account wages and salaries, interest, dividends, 

rental income, taxes and transfer payments, and measures gains net of 

the rate of inflation. 

Regional Outlook 3 Fourth Quarter 2002 
In Focus This Quarter
 

CHART 2 

Much of Recent Growth in Disposable Personal


 Income Can Be Attributed to One-Time Factors
 

Factors Responsible for Growth in U.S. Disposable Personal
 

Incomes in the 3rd Quarter of 2002 from Year-Ago Levels
 

Taxes Wages 

18% and 

Salaries 

25% 

Transfer Other 

Payments Income Items 

33% 24% 

Sources: FDIC, Bureau of Labor Statistics, Bureau of Economic Analysis 

effects largely will expire after the end of this year, 

returning the burden of income growth to the wages and 

salaries component. 

Lower interest rates and inflation have also bolstered 

consumer purchasing power, allowing consumers’ paychecks to stretch further. Auto dealers’ zero-percent 

financing incentives, introduced in the fall of 2001, 

have boosted car sales to levels just below the record 

pace of last year. However, there are some signs that 

consumers’ appetite for new automobiles may be waning. Despite continued availability of zero-interest 

financing programs, total vehicle sales fell from 18.7 

million units in August 2002 to 15.4 million units in 

October 2002 on a seasonally adjusted annual basis. 

Historically low mortgage rates continue to bolster the 

housing sector, which has been a key source of growth 

for the economy during this downturn. Strong increases 

in home prices have increased the equity of most U.S. 

homeowners, and many have converted a portion of 

3 Cash-out refinancing refers to mortgage refinancing that results in 

new mortgages that are at least 5 percent higher in amount than the 

original mortgages. 

4 http://www.freddiemac.com/news/archives/rates/2002/3qupb02 

.html 

By some estimates, residential housing market activity 

contributed as much as 40 percent of net U.S. economic 

growth last year and more than 20 percent of GDP 

growth in the first quarter of this year.5 While housing 

has been a welcome source of support for U.S. economic 

activity, it should also be recognized that even a slight rise 

in mortgage rates could sharply curtail refinancing 

opportunities and slow the rate of appreciation in home 

values. Because long-term interest rates may rise as economic activity picks up, housing may not play as large a 

supporting role in the recovery as it did in the recession. 

The Corporate Sector Restructures 

in Response to Declining Profits 

The corporate business sector is working slowly 

through problems associated with high debt loads, 

industrial overcapacity, impaired earnings, and corporate governance scandals. Corporate profits have been 

weak for more than a year and a half, weighed down by 

sluggish pricing power and flagging demand. The business sector has responded quickly by restructuring balance sheets and cutting jobs in an effort to restore 

profits. However, the recovery in corporate profits has 

been significantly weaker than expected in early 2002. 

Year-over-year growth in earnings from continuing 

operations for S&P 500 firms increased by a modest 3.5 

percent in second quarter 2002 from a depressed yearago level. In third quarter 2002, corporate profits rose 

8.5 percent from year-ago levels (see Chart 3). 

CHART 3 

their equity to cash through cash-out refinancing.3 

Freddie Mac estimates that homeowners took about $59 

billion in equity out of their homes during the first nine 

months of 2002, some of which was used to finance 

consumer spending and home renovations.4 Other 

households have chosen to lower their monthly mortgage payments by refinancing at the lowest mortgage 

rates in more than a generation. 

Year-over-Year Growth in Earnings from 

Continuing Operations for S&P 500 Firms (%) 

Source: Bloomberg 

Corporate Profit Outlook Calls 

for Continued Weak Recovery 

1997 1998 1999 2000 2001 2002

–25 

–15 

–5 

5 

15 

25 

35 

5 Estimates from economy.com. See http://www.homeownershipalliance 

.com/media/press/pressreleasespressrelease_060502.html 

Regional Outlook 4 Fourth Quarter 2002 
In Focus This Quarter
 

Businesses remain cautious amid a weak earnings environment and depressed equity markets. Accordingly, 

business investment also remains weak. Nonresidential 

fixed investment shrank by 5.2 percent in 2001, and 

economists surveyed by the Blue Chip Economic Indicators expect investment spending to contract by another 5.5 percent in 2002 before rising by a modest 4.0 

percent next year. By comparison, during the 1992–2000 

expansion, annual increases in business fixed investment 

averaged about 9 percent. 

The corporate sector continues to suffer from high levels of defaults, rating downgrades, and bankruptcies, 

although credit quality problems may have peaked in 

early 2002. According to Moody’s, the default rate for 

U.S. speculative-grade corporate bond issuers fell to 

10.4 percent in June 2002 from a peak of 11.5 percent 

in January 2002. The default rate is expected to fall to 

9.2 percent by the end of this year. Telecommunications 

firms, which were hardest hit by the recession, were 

responsible for 55 percent of defaults by volume and 37 

percent of defaulted issuers in the first half of 2002. 

Productivity Growth Has 

Driven the Economy Forward 

Perhaps the most positive signal to come out of the 

recent economic data is a resurgence in productivity 

growth. After slowing sharply in the middle of last year, 

year-over-year growth in output per hour in the nonfarm 

business sector surged to 4.4, 4.9, and 5.6 percent, 

respectively, in the first three quarters of 2002. Although 

the exact causes of productivity trends cannot be traced 

precisely, many economists believe that technological 

innovations of the late 1990s continue to spur the gains 

in labor productivity.6 And while these figures are subject to downward revision in the future, for now they 

provide evidence that businesses may be able to cut 

their costs at the same time workers benefit from higher wages and lower prices. 

Until recently, evidence indicated that most of the gains 

of productivity growth were accruing to households. 

6 “The Economic Outlook,” Testimony of Chairman Alan Greenspan 

Before the Joint Economic Committee, U.S. Congress, November 13, 

2002. Also see Stephen D. Oliner and Daniel E. Sichel, “Information 

Technology and Productivity: Where Are We Now and Where Are We 

Going?” The Federal Reserve Board Finance and Economics Discussion Series 2002-29, May 10, 2002, for more in-depth discussion on 

factors behind recent labor productivity gains. 

The employment cost index, a measure of changes in 

average wage and benefit compensation, increased by 

about 4.2 percent in both 2000 and 2001, well above 

both prevailing levels of consumer price inflation and 

increases in output per hour. The recent experience of 

the U.S. auto industry also shows how consumers have 

tended to capture productivity gains—as carmakers cut 

prices with zero-percent financing deals in late 2001 

and auto sales boomed to record levels, the U.S. automotive industry as a whole lost $9.5 billion for the year. 

But there is evidence that businesses are capturing a 

larger share of the 2002 productivity surge. Much of the 

recent increase in productivity has resulted not from 

higher investment spending but from trimming payrolls 

and using the existing workforce more intensively. During the first three quarters of 2002, productivity gains 

outstripped the increase in the average employment cost 

index, which grew by 3.9 percent from the same quarter 

a year earlier. What this means is that productivity 

growth increasingly is accruing to the corporate bottom 

line and may be an inducement to higher investment 

spending in future quarters. 

Where Is the Economy Headed from Here? 

The strength of the current economic recovery may well 

hinge on the speed of recovery in business investment 

and the sustainability of consumer spending going forward. The outlook for business investment remains cautious given the relatively modest rebound in corporate 

earnings and the continuing financial market slump. As 

the corporate sector tries to shore up its bottom line, 

employment growth is unlikely to accelerate sharply. 

Unless the housing sector continues to benefit from historically low mortgage rates and rising home values (a 

somewhat optimistic scenario), consumer spending may 

moderate from recent robust levels of growth. At present, it is the apparent rebound in productivity growth 

that gives analysts hope that the corporate sector can 

continue to cut costs even as households register wage 

gains that boost disposable incomes. However, even if 

this recovery scenario unfolds as hoped, economic 

activity and total employment are expected to grow at 

sub-par rates at least until mid-2003. 

A return to recession (often referred to as the “doubledip” scenario) remains a distinct, though unlikely, possibility. One reason for concern is that an economy 

growing below its potential is highly vulnerable to 

shocks that impair confidence and disrupt spending 

Regional Outlook 5 Fourth Quarter 2002 
In Focus This Quarter
 

plans. The current environment is rife with potential 

economic shocks: war with Iraq, a spike in oil prices, 

international trade frictions, the threat of terrorist 

attacks, and the emergence of new corporate governance 

scandals. It is likely that the uncertainties posed by factors such as these already are having a chilling effect on 

spending and hiring plans. If so, then the successful resolution of these tensions (for example, the conflict with 

Iraq) could reduce uncertainty and boost economic 

activity. However, the potential for a shock-induced 

double-dip recession remains of significant concern to 

the banking industry, in particular because of the deflationary pressures in the global economy and the dangers 

that deflation could pose for lenders (see Inset Box). 

Banks Have Posted Record 

Earnings Despite the Recession 

In spite of the recent recession and the slow pace of the 

apparent recovery, commercial banks posted record 

earnings of $45.3 billion in the first half of 2002. Earnings were up 16.6 percent from a year earlier. Despite 

rising loan losses, particularly among large banks that 

lend to large corporate borrowers, bank earnings have 

been bolstered by strong gains in net interest income 

from strong deposit inflows and a steep yield curve (see 

Table 1). 

TABLE 1 

How Real Is the Threat of 


Deflation in the United States?7
 

The minutes of the September 24, 2002, Federal 

Open Market Committee provide a glimpse into the 

policy debate about a likelihood of further price disinflation and its effect on the economy.8 As the U.S. 

economy recovers at a slower-than-expected pace 

with the inflation rate remaining below 2 percent, 

policymakers and economists have discussed the possibility of a deflationary scenario developing in the 

next few quarters. Of particular concern, from a policy point of view, is that the short-term interest rate is 

near an all-time low, leaving little room for policymakers to maneuver the short-term interest rate in 

order to boost domestic demand if a deflationary scenario develops. With a half-percentage-point reduction 

7 As the rate of inflation has declined in recent years, deflation 

has been more frequently discussed as a threat to the U.S. economy. See Paul Bishop, “How Will the Expansion End?” San 

Francisco Regional Outlook, second quarter 1998. 8 Federal Reserve Board, Minutes of the Federal Open Market 

Committee, September 24, 2002. www.federalreserve.gov/ 

fomc/minutes/20020924.htm. Disinflation refers to the still 

positive but falling rate of inflation, while deflation refers to a 

drop in the level of aggregate prices. 

continued on the next page 

Net Interest Income Bolstered Earnings during the First Half 

of 2002, while Provision for Loan Losses Rose Further 

FIRST 6 MONTHS FIRST 6 MONTHS 

ALL FDIC INSURED COMMERCIAL BANKS ($ IN MILLIONS) 2001 2002 

NET INTEREST INCOME $104,820.0 $117,627.3 

LESS: PROVISION FOR LOAN AND LEASE LOSSES 16,782.6 22,461.6 

PLUS: TOTAL NON-INTEREST INCOME 79,028.7 84,165.8 

LESS: TOTAL NON-INTEREST EXPENSE 110,026.7 113,397.6 

PLUS: GAIN ON SALE OF SECURITIES HELD TO MATURITY 2.3 -0.6 

PLUS: GAIN ON SALE OF SECURITIES AVAILABLE FOR SALE 2,028.3 1,715.3 

TOTAL INCOME PRE-TAX, PRE-EXTRAORDINARY ITEMS 59,070.0 67,648.6 

LESS: INCOME TAX 19,889.4 22,417.2 

TOTAL INCOME PRE-EXTRAORDINARY ITEMS 39,180.6 45,231.4 

PLUS: EXTRAORDINARY ITEMS NET OF TAXES -349.8 37.8 

NET INCOME $38,830.8 $45,269.2 

Sources: Bank Call Reports, Research Information System 

Regional Outlook 6 Fourth Quarter 2002 
In Focus This Quarter
 

in the target rate on November 6, 2002, the federal funds A recent study by the Federal Reserve observes that deflarate now stands at 1.25 percent, the lowest rate since the tion is very difficult to predict in advance, as evidenced by 

late 1950s. the recent case of Japan.9 The study concludes that the fact 

that deflation is more costly to the economy than inflation 

Whether the current disinflationary trend is a precursor warrants a most aggressive monetary policy response to 

to outright deflation remains to be seen. Some argue signs of a disinflationary trend. 

that the recent trend in aggregate prices is driven primarily by a few sectors and should not be viewed as an Clearly, deflation would have significant adverse effects 

economy-wide trend. Indeed, prices for services such on the banking industry, depending on its severity and 

as medical care and education continue to rise at a duration. Past episodes of asset and goods price deflation 

robust rate even as the overall inflation rate falls. Defla- often coincided with banking crises, particularly when 

tionary pressure is most pronounced in manufacturing the banking sector was already in a weakened financial 

sectors where excess capacity and a substantial demand position. Given the current income and balance sheet 

shortfall exist, such as in the telecommunications strength of the U.S. banking industry, short and mild 

industry (see Chart 4). The fuel and apparel industries deflation is likely to have a limited adverse impact. Howalso face significant deflationary pressure, although ever, prolonged deflation would present more serious 

fuel prices appear to be more dependent on geopolitics challenges to the industry by eroding the collateral value 

than economic conditions going forward. of assets and increasing the real debt burden of borrowers. Deflation could also lead to a decline in nominal 

CHART 4 income for households and businesses, reducing their 

1997 1998 1999 2000 2001 2002 

* Includes goods and services such as postage, telephone services, computer 

equipment, and software. 

Source: Bureau of Labor Statistics 

Year-Over-Year Change in the 

Consumer Price Index by Sector (%) 

Not All Industries Have Experienced 

Deflationary Pressure 

Education 

Healthcare Service 

Communication* 

Apparel 

8.0 

–6.0 

–4.0 

–2.0 

0.0 

2.0 

4.0 

6.0 

ability to repay outstanding debts. In combination, these 

developments likely would lead to significant credit 

quality deterioration, while an increase in real interest 

rates would weaken loan demand. 

Despite these dangers, there are good reasons to think 

that serious deflation is unlikely to occur in the United 

States. One reason is a well-capitalized banking sector 

with relatively low levels of nonperforming loans. 

Another is the fact that policymakers appear to be alert 

to the dangers of deflation and determined to take steps 

to prevent it from taking hold. Finally, it appears that 

modern financial instruments and risk management 

tools contribute to the financial flexibility of households 

and businesses, reducing the potential for a widespread 

liquidity crisis. One example is the use of credit derivatives by commercial lenders to off-load credit risk. 

Another is the benefits of loan prepayment options that 

However, as the U.S. economy continues to sort allow households and businesses to reduce their interest 

through the imbalances left over from the late 1990s, expenses by refinancing at lower interest rates. Together, 

the falling inflation rate and historically low interest these factors limit the possibility of a prolonged deflarates leave it vulnerable to deflationary pressure. The tion that could seriously harm the banking industry. 

equity price bubble of the late 1990s and its subsequent 

collapse have created a significant mismatch of supply 9 Alan Ahearne, et al., “Preventing Deflation: Lessons from Japan’s and demand in many sectors of the economy, which Experience in the 1990s,” Board of Governors of the Federal 

may not be resolved without some downward adjust- Reserve System International Finance Discussion Papers 729, 

ments in prices. June 2002. 

Regional Outlook 7 Fourth Quarter 2002 
In Focus This Quarter
 

In the first half of 2002, commercial banks saw their net 

interest income increase by $12.8 billion over year-ago 

levels. This increase was more than twice the growth in 

loan loss provisions, which rose by $5.6 billion. The disparity between growth in net interest income and loss 

provisions largely explains why credit quality deterioration associated with the recession has had little effect on 

overall earnings. If the economy continues on a path of 

slow recovery, most banks are expected to maintain relatively strong financial positions. 

The Number of Troubled Institutions Is Rising, 

but Remains Below Levels of the Early 1990s 

Supervisory ratings again deteriorated slightly during the 

first half of the year but remain far stronger on the whole 

than they were a decade ago. While the number and 

assets of troubled institutions remain low compared with 

the early 1990s, a significant upward trend is evident (see 

Chart 5).10 Approximately 7.3 percent of institutions were 

rated composite 3, 4, or 5 at September 2002, representing 3.4 percent of the industry’s total assets. Nearly 10 

percent of institutions had asset quality ratings of 3, 4, or 

5 at September 2002, representing 9.7 percent of the 

industry’s assets. Although the number of 3-rated institutions has remained relatively stable since year-end 2000, 

the number of 4- and 5-rated institutions has increased 

from 99 at December 2000, to 128 at December 2001, to 

148 at September 2002. 

Classified assets at large banks are growing faster than 

those at community banks.11 As a percentage of Tier 1 

capital plus reserves, large banks’ classified assets 

increased to 26.9 percent in the second quarter of 2002 

from 17.4 percent two years ago. At community banks 

this ratio increased to 14.6 percent in the second quar10 Supervisory ratings are assigned to banks according to the CAMELS 

rating system at the end of examinations based on performance in five 

areas: Capital adequacy, Asset quality, Management, Earnings, Liquidity and Sensitivity to market risk. Bank supervisors assign a 1 to 5 

rating for each of these components and a composite rating for the 

bank. (The composite CAMELS rating does not represent an arithmetic 

average of assigned component rating, and the weight attributed to any 

component in determining a bank’s overall composite rating depends 

on the degree of supervisory concern associated with the particular 

component.) Banks with ratings of 1 or 2 are considered to present few, 

if any, supervisory concerns, while banks with ratings of 3, 4, or 5 present moderate to extreme degrees of supervisory concern. For this analysis, banks with composite CAMELS ratings of 3, 4, or 5 are referred to 

as “troubled” institutions. 

11 Community banks are defined as banks with total assets less than 

$1 billion, while large banks are defined as those with total assets 

greater than $1 billion. 

CHART 5 

Number of Troubled Institutions 

Is Lower than in Early 1990s 

Institutions Rated 3, 4, or 5 (%) 

25 

20 

15 

10 

5 

0 

Asset Quality Composite 

9.90 

7.34 

1992 1994 1996 1998 2000 3Q02 

Sources: Bank and Thrift Call Reports, Exam Database 

ter of 2002 from 12.7 percent at second quarter 2000. 

One factor driving this trend is the loan mix at large 

banks compared to the loan portfolio composition of 

community banks. Commercial and industrial (C&I) 

loans are typically a higher percentage of total loans at 

large banks than at community banks. As of June 30, 

2002, banks with over $1 billion in assets held C&I 

loans equal to 21 percent of total loans, compared with 

just 15 percent for community banks. 

Market Indicators of Large Bank 

Performance Have Weakened 

In spite of rising losses in large banks’ commercial loan 

portfolios, the market perception of large banks appears 

to be mixed. Recent stock market declines have driven 

the median market-to-book ratio for the 25 largest U.S. 

banking companies down to 2.0 by September 2002 

from a peak of 3.1 in March 1999. Still, the current ratio 

is significantly above the median ratio of less than 1.0 

recorded in December 1990, during the last recession. 

The Philadelphia Bank Sector Index (24 large banking 

companies) dropped 14 percent during the year ending 

September 2002, although the index still managed to 

outperform the S&P 500 index. 

The Banking Industry Faces 

Three Challenges in the Year Ahead 

Although banking industry performance overall has 

remained strong in the wake of the recession, certain 

areas of heightened concern remain. Three areas that 

might pose problems are continued weakness in comRegional Outlook 8 Fourth Quarter 2002 
In Focus This Quarter
 

mercial credit quality, credit concentrations in formerly 

fast-growing metro areas, and subprime mortgage and 

consumer lending. 

Commercial Credit Quality. Excess capacity and weak 

pricing power continue to plague most of the business 

sector. Capacity utilization in U.S. manufacturing, mining, and utilities industries fell from 82.8 percent in June 

2000 to 74.4 percent in December 2001, and remained 

just above 75 percent as of October 2002. For the beleaguered high-tech sector, the capacity utilization rate 

remains about 63 percent, with the communication equipment sector reporting a capacity rate of less than 50 percent.12 In spite of attempts to cut debt loads, the level of 

corporate debt remains high relative to internally generated cash flow. The ratio of debt to cash flow for nonfarm, 

nonfinancial businesses fell from a historical high of 6.24 

in 2001 to 6.13 as of June 2002; however, it remains significantly above the historical average of 4.9 percent 

between 1970 and 2001 (see Chart 6). 

The weak economy and the problems of the technology 

and telecommunications sectors have pushed the percentage of criticized shared national credits (SNCs) to a 

ten-year high in 2002. Total criticized SNCs increased 

in 2002 to $236.1 billion (or 12.6 percent of total commitments), from $193 billion (9.4 percent) in 2001.13 

CHART 6 

Corporate Debt Remains High 

Relative to Cash Flows 

Ratio of Nonfarm, Nonfinancial Debt to Cash Flow 

7.0 

6.5 

6.0 

5.5 

5.0 

4.5 

4.0 

3.5 

2002 

Source: Federal Reserve Board 

6.1 

(2Q02) 

1990 1992 1994 1996 1998 2000 

12 The high-tech sector includes computers, communications equipment, and semiconductors.
 

13 Criticized credits include loans classified as “substandard,” “doubtful,”
 

or “loss,” plus those rated as “special mention.” For more information,
 

see the interagency press release on the 2002 Shared National Credit
 

review at: http://www.fdic.gov/news/news/press/2002/pr10402.html
 

Some 8.4 percent of SNCs ($157.1 billion in commitments) were classified as substandard, doubtful, or 

loss in the 2002 review. The level of classified credits 

grew by 34 percent from the year before—a deceleration from the 86 percent rate of increase noted in the 

previous report. The troubled telecommunications and 

cable industries accounted for 18.7 percent of all criticized SNCs and about 40 percent of SNC losses in the 

2002 review. In 2001, the telecommunications and 

cable industries represented 9.5 percent of all criticized SNCs. 

Declining business demand continues to take its toll on 

office and industrial commercial real estate (CRE) markets. The nation’s major office and industrial markets 

have experienced falling rental rates, rising vacancies, 

and negative net absorption. The national office vacancy rate climbed to 16.1 percent at the end of September 

2002, as declining rental rates and increasing vacancies 

continued to characterize all major markets. At the same 

time, the national industrial vacancy rate reached 10.9 

percent, exceeding the previous record of 10.8 percent 

set in 1992.14 

Although the outlook for CRE markets is rather pessimistic, banks have not yet seen a serious deterioration 

in CRE loan portfolios. Possible reasons for the apparent resilience of bank CRE portfolios in this cycle 

include stronger underwriting practices, continued 

scrutiny by federal bank regulators, increased participation by nonbank lenders, and the resulting scrutiny by 

market analysts. Still, stresses in CRE markets are starting to show up, with sporadic reports of office properties selling below replacement costs. Sales of properties 

at prices less than replacement costs were rampant in 

the late 1980s and early 1990s, resulting in severe loan 

losses to banks and thrifts and an interruption in commercial development that lasted for several years.15 

Credit Concentrations in Formerly Fast-Growing 

Metro Areas. Growth in economic activity during the 

1991–2001 expansion was not uniform across the 

nation. It tended to be most pronounced in certain metropolitan areas that specialized in high-tech or fastgrowing service industries. These areas, in turn, tended 

14 Torto Wheaton Research, Office and Industrial Outlook, Fall 2002. 

For perspective, the industrial property vacancy level of 10.9 percent 

as of September 30, 2002, translates to 1.2 billion square feet of 

vacant space, up by 50 million square feet from the previous quarter. 

15 Dean Starkman, “Another Victim of the Bubble: Office Building 

Prices Decline,” Wall Street Journal, October 29, 2002. 

Regional Outlook 9 Fourth Quarter 2002 
In Focus This Quarter
 

to be concentrated in the sunbelt and western states.16 

During the expansion, community banks operating in 

some of these areas accumulated large volumes of commercial and CRE loans relative to equity capital. While 

these high loan volumes are easy to understand in light 

of the need to finance high levels of economic activity, 

they also created concentrations of credit risk. Banks 

operating with a concentration in high-risk loans (commercial, construction, CRE, and multifamily) are particularly vulnerable to unexpected economic trends in their 

metro areas.17 

Since the onset of recession in March 2001, a number of 

these previously fast-growing metropolitan areas have 

experienced a marked deceleration or outright decline in 

job growth (Chart 7). An update of a methodology previously used to identify cities with both a concentration of 

higher-risk loans and significant slowdown in job growth 

results in a list of 13 cities where credit concentrations 

are a particular concern: Atlanta, Denver, Grand Rapids, 

CHART 7 

Economic Slowdowns in Formerly Fast
 

Growing Cities Raise Concerns
 

Net Decline Year Ended June 

in Job Growth 2002 Job Growth 

1992–2000 

Job Growth 

San Jose 

Atlanta 

Phoenix 

Austin 

Seattle 

Denver 

Las Vegas 

Orlando 

Portland 

Salt Lake City 

8.72% 

7.06% 

6.94% 

6.61% 

6.42% 

6.13% 

5.95% 

5.85% 

5.52% 

5.26% 

–8% –4% 0% 4% 8% 

Source: Bureau of Labor Statistics 

16 See “Back to the Future: How This Downturn Compares to Past 

Recessions,” Regional Outlook, second quarter 2002, http://www.fdic 

.gov/bank/analytical/regional/ro20022q/na/Infocus.html 

17 A similar methodology was used in “Back to the Future,” Regional 

Outlook, second quarter 2002, article to identify ten metro areas 

where credit concentrations were of particular concern. 

18 Eight of the 13 cities in this list were considered “markets at risk” 

for CRE overbuilding in “Ranking Metropolitan Area’s Risk For 

Commercial Real Estate Overbuilding,” Regional Outlook, third 

quarter 2000 (see http://www.fdic.gov/bank/analytical/regional/ 

ro20003q/na/index.html). 

Las Vegas, Orlando, Phoenix, Portland, Salt Lake City, 

San Francisco/Oakland, San Jose, Sarasota, Seattle, and 

Tampa.18 The purpose of this exercise is not to pass 

judgement on specific institutions or loan types, but 

rather to point to conditions that warrant extra attention 

to risk management practices on the part of lenders. 

Subprime Mortgage and Consumer Lending. Developed largely since the 1990–91 recession, subprime 

lending (defined as a program of lending to borrowers 

with limited or impaired credit histories) has been the 

subject of significant regulatory and market concern 

during the past few years. Although subprime lenders 

routinely incur much higher credit losses than prime 

lenders, they also tend to earn commensurately high 

returns. Since the onset of recession in March 2001, 

however, subprime lenders have seen loss rates rise 

sharply—in many cases well above levels predicted by 

internal credit models. These unanticipated losses have 

narrowed the difference in earnings between subprime 

and prime credit card lenders and are forcing subprime 

lenders to recalibrate their models. 

The FDIC currently identifies approximately 125 institutions with subprime loans equal to at least 25 percent 

of Tier 1 equity capital. Among credit card specialists 

in this group, net charge-offs in the second quarter of 

2002 were 8.4 percent of average outstanding balances, 

compared with 2.8 percent for credit card specialists 

that were not also identified as subprime lenders. Subprime credit card specialists reported a 4.2 percent 

return on assets in the second quarter, compared with a 

3.3 percent return on assets for non-subprime credit 

card specialists. 

Another source of concern is the continued prevalence 

of subprime lenders among failed and problem institutions. From the beginning of 1997 through the second 

quarter of 2002, 31 FDIC-insured institutions with $6.8 

billion in assets failed. Of these, 31 percent (holding 64 

percent of failed bank assets) had been identified as 

subprime lenders. Some 88 percent of estimated losses 

to the insurance funds resulted from the failure of subprime institutions. Subprime institutions continue to be 

over-represented among troubled institutions. The institutions identified as subprime lenders make up only 1.4 

percent of all FDIC-insured institutions. However, subprime lenders account for 8.2 percent of all troubled 

institutions. 

Regional Outlook 10 Fourth Quarter 2002 
In Focus This Quarter
 

Conclusion 

The recession that began in March 2001 is probably over 

and, on balance, it has had only limited adverse effects on 

the overall financial condition of FDIC-insured institutions. Credit losses have risen substantially at large banks 

that lend heavily to large commercial borrowers, but 

strong deposit growth and wider net interest margins have 

helped produce record bank earnings. Strong consumer 

spending and residential real estate activity have supported the economic recovery to this point, although a continuation of these positive trends is by no means certain. 

As the corporate sector restructures, the U.S. economy 

appears to be undergoing a modest recovery similar to 

the upturn that followed the 1990–91 recession. During 

this process, risks will predominate on the downside due 

to the unusually large number of economic and geopolitical uncertainties. These factors, which may be 

inhibiting economic activity at present, could at some 

point grow more serious and even threaten to push the 

economy back into recession. 

Specific areas of concern for FDIC-insured institutions 

include (1) continuing credit losses at large banks on 

loans to large, corporate borrowers, (2) concentrations 

of credit risk among smaller institutions headquartered 

in formerly fast-growing metro areas, and (3) subprime 

lenders, which continue to figure prominently among 

failed and troubled institutions. 

Stephen Gabriel, Senior Financial Economist 

Thomas Murray, Senior Financial Analyst 

Lisa Ryu, Senior Financial Economist 

Regional Outlook 11 Fourth Quarter 2002 
Regional Perspectives
 

Atlanta Regional Perspectives
 

Weak Economic Growth May Affect 

the Atlanta Region Housing Market 

The severity of the recent economic downturn, although 

keenly felt in several metropolitan area labor markets, 

has been mostly offset by strength in the Atlanta Region 

housing markets. Home prices have continued to appreciate and low mortgage rates have helped support home 

sales; however, this critical component of the Region’s 

economy may be showing some signs of weakening. 

This article attempts to identify markets that may be 

most vulnerable to this weakening and assess the implications for the Region’s banking economy. 

Low Interest Rates May Not Be Spurring Home 

Sales in the Atlanta Region as in the Past 

Traditionally, declines in mortgage rates have fostered 

increases in home sales, as more first-time homebuyers 

can afford homes, while existing homeowners may trade 

up in the market. However, during 2002, this relationship 

may not have been as strong as expected in the Atlanta 

Region. According to Freddie Mac, by late September 

interest rates on 30-year fixed-rate mortgages in the 

Southeast1 had fallen below the 6 percent threshold for 

the first time in more than two decades. Since March of 

CHART 1 

Home Sales in the South Leveled Off Even
 

Though Interest Rates Continued to Fall
 

this year, mortgage rates have declined 

prompting record levels of home refiappear to have 

the declining demand may be that homecome under pressure. Another symptom of 

by more than 100 basis points. While 

nancings, this decline did not result in 

a surge in home sales (see 

Chart 1). In fact, anecdotal 

evidence in a number of the 

Region’s markets indicates 

that demand for higher-end 

homes has weakened and 

prices for these homes have 

ownership rates in the South2 

peaked or even declined slightly during the year ending 

second quarter 2002. Housing markets may have 

reached a point at which lower interest rates do not result 

in a corresponding increase in sales. 

How We Measured Vulnerability 

in Housing Markets 

The importance of the housing sector to the Atlanta 

Region economy makes it essential to identify metropolitan area banking markets that are vulnerable to the 

effects of weaker housing demand. We constructed a 

housing market risk ranking measure that considers 

three factors: economic conditions, home priceincome growth divergence, and banking industry 

exposure. 

New and Existing Home Sales

(000s, 12-Month Moving Average) 2,700 

2,600 

2,500 

Home Sales 

Mortgage Rates 

6.0% 

6.5% 

7.0% 

7.5% 

Southeast 30-Year Fixed


Interest Rates (Inverted Scale)


Economic Conditions. Although any economic downturn can pose challenges to the banking industry, areas 

that have experienced a sea change in the level of 

growth may be particularly vulnerable. A period of 

rapid expansion followed by an unexpectedly sharp 

decline in the level of growth may prove exceptionally 

disruptive as the local economy struggles to readjust to 

the new business environment. The Atlanta metro area 

has experienced dramatic and rapid changes. During 

the 1990s, Atlanta’s rate of job growth ranked among 

2,400 8.0% 

2,300 8.5%

Jun Dec Jun Dec Jun 

00 00 01 01 02 

Sources: U.S. Bureau of the Census; National Association of Realtors; Freddie 

Mac (Haver Analytics) 

the nation’s highest. In contrast, during the year ending 

2 U.S. Census Bureau definition includes the following states: Alabama, Arkansas, Delaware, District of Columbia, Florida, Georgia, 1 Freddie Mac defines the Southeast as North Carolina, South Caroli- Kentucky, Louisiana, Maryland, Mississippi, North Carolina, Oklana, Tennessee, Kentucky, Georgia, Alabama, Florida, and Mississippi. homa, South Carolina, Tennessee, Texas, Virginia, and West Virginia. 

Regional Outlook 12 Fourth Quarter 2002 
Regional Perspectives
 

August 2002, the metropolitan area experienced the 

largest percentage of job losses in the Atlanta Region. 

To capture this effect, we compared the difference 

between 1992 to 2000 annual job growth and the percentage change in employment during the year ending 

August 2002 across all Atlanta Region metropolitan 

areas. 

Home Price-Income Growth Divergence. Although 

home prices in the Atlanta Region have continued to 

appreciate during the recent recession, disparities 

between home price and income growth over the 

longer term may contribute to the emergence of home 

price “bubbles.” Such disparities have occurred in several metropolitan markets, particularly in Florida, 

during the past few years. This component attempts to 

quantify this imbalance by comparing growth in personal income and home prices between 1998 and 

2001. 

Banking Industry Exposure. The third component of 

the risk ranking attempts to gauge the local banking 

industry’s level of participation in a metropolitan area’s 

homebuilding sector. For purposes of our analysis, we 

considered commercial banks with assets less than $1 

billion.3 We also limited our examination to markets 

with at least seven locally headquartered community 

banks, which restricted our universe to 25 metropolitan 

areas in the Atlanta Region. To measure the degree to 

which the local banking industry was involved in homebuilding, we compared the level and trend in construction and development (C&D) lending exposure. 

Although C&D lending includes residential and commercial construction loans, most community bank 

involvement has been in residential development.4 

The risk ranking measurement was equally weighted 

between the economic (economic conditions and home 

price-income growth divergence) and banking (level 

and trend in C&D exposure) components. 

3 Large banks (assets greater than $1 billion) were not considered in 

this analysis, as these institutions likely lend in several markets, and it 

is difficult to measure exposure to economic conditions in a particular 

metropolitan area. 

4 While Call Report data do not allow us to discern lending between 

residential construction and construction for other purposes in the 

Atlanta Region, the limited asset size of these institutions generally 

precludes their involvement in large office, industrial, and retail projects. Discussions with bank examiners and bankers also generally confirm that most of the C&D lending at community banks is for 

residential projects. 

Analysis of the Results of the Housing 

Market Risk Ranking Measurement 

The risk calculation5 resulted in a ranking of the 25 

metropolitan areas by economic and banking exposure, as shown in Table 1. Owing to the comparatively 

severe effects of the recent recession and the high and 

rising level of C&D exposure, Atlanta ranked first. 

Anecdotal evidence presented in a recent Atlanta 

Journal-Constitution article6 appears to confirm the 

vulnerability of the Atlanta area’s housing market. The 

effects of the metropolitan area’s economic weakness 

also may be emerging in the form of rising foreclosure 

rates. The relatively high level of banking exposure in 

the Atlanta area may be exacerbated by the fact that it 

is home to nearly 90 community banks, almost equal 

to the sum of the next seven highest-risk ranked metropolitan areas. Despite the effects of the recession on 

the local economy and the large banking exposure, 

home price appreciation and income growth in the 

Atlanta area have diverged only slightly since 1998, a 

fact that may help support price levels in the housing 

market. 

5 To capture major economic changes that may have occurred in each 

of the 25 markets, we looked at annual job growth for the periods 

1992 to 2000 and August 2001 to August 2002. Subtracting the two 

measures for each market, we obtained a basis point difference. Markets with the greatest difference (negative) were ranked higher in 

terms of divergence of economic growth. For example, Atlanta ranked 

first with job growth for 1992–2000 at 4.4 percent annually and for 

August 2002 (year-ago percentage change) at minus 2.9 percent—a 

difference of minus 727 basis points. 

We measured the divergence in growth between home prices and personal income by comparing the growth in these two measures 

between 1998 and 2001. Markets with the greatest basis point difference were ranked higher in terms of divergence in home price and 

income growth. For example, Norfolk ranked first, with home price 

growth of 11.1 percent versus 7.3 percent in personal income 

growth—a difference of 378 basis points. 

We measured the level of involvement in homebuilding by ranking 

median C&D exposure (loan-to-asset ratios). Atlanta ranked first, 

with a median exposure of 16.76 percent. The trend in this exposure 

during the recent recession may be as critical to gauging risk and was 

designated as the fourth component in our risk ranking. We ranked the 

change in median C&D exposure between second quarter 2002 and 

second quarter 2001. Fort Myers ranked first, with an increase in 

median C&D exposure of 451 basis points. 

We weighted the measures equally and summed the rankings for each 

metropolitan area. The metropolitan area with the lowest sum was 

ranked first in terms of overall market risk. Atlanta ranked first, with 

the lowest sum. Atlanta ranked 1 in economic growth divergence, 13 

in home price-income growth divergence, 1 in level of C&D exposure, and 4 in trend of C&D exposure, for a sum of 19. 

6 Michael Kanell, “Housing Market Shows Signs of Slowing,” Atlanta 

Journal-Constitution, October 17, 2002. 

Regional Outlook 13 Fourth Quarter 2002 
Regional Perspectives
 

TABLE 1 

Atlanta Ranks First in the Housing 

Market Risk Measure 

RANK METROPOLITAN AREA 

1 ATLANTA 

2 SARASOTA 

3 FORT MYERS 

4 WEST PALM BEACH 

5 FORT LAUDERDALE 

6 ORLANDO 

7 ROANOKE 

8 JACKSONVILLE 

9 DAYTONA BEACH 

10 TAMPA 

11 MOBILE 

12 GREENVILLE 

13 SAVANNAH 

14 RALEIGH 

15 MACON 

16 NORFOLK 

17 CHARLOTTE 

18 BIRMINGHAM 

19 CHATTANOOGA 

20 WASHINGTON 

21 GREENSBORO 

22 MIAMI 

23 FORT WALTON BEACH 

24 RICHMOND 

25 NAPLES 

Note: Risk rankings based on four factors: Change in 

rate of economic growth, divergence between home 

price and income growth, and construction and development lending levels and trends. 

The results of the ranking show the predominance of 

Florida’s metropolitan areas, which account for eight of 

the top ten metro areas. Although job losses in the 

state’s metropolitan areas during the year ending 

August 2002 generally were modest compared to those 

experienced in many other areas of the Atlanta Region, 

these losses often represented a substantial departure 

from performance during the 1990s expansion. Consequently, Florida’s markets ranked high in terms of the 

change in economic conditions. The Sarasota, Tampa, 

Fort Lauderdale, and Jacksonville economies also 

ranked high in terms of the level of disparity between 

home price appreciation and income growth. At the 

same time, insured institutions headquartered in each of 

these metropolitan areas have reported rising levels of 

C&D loan exposure, especially in Fort Myers, where 

the median C&D exposure in second quarter 2002 was 

11.32 percent, up more than 400 basis points from the 

previous year. Institutions headquartered in Orlando 

and Jacksonville reported increases in excess of 200 

basis points during the same period. 

In contrast to other Florida metropolitan areas, Naples 

ranked last among the 25 areas studied. Although the 

median C&D loan exposure among community banks 

in this metro area was 7.88 percent, up 90 basis points 

from the previous year, the area has not experienced a 

comparatively sharp change in the economic environment, and growth in personal income has outpaced 

home price appreciation. Miami also ranked at the 

lower end of the spectrum. However, given the substantial change in economic performance during the recession compared to the 1990s, in addition to other factors, 

such as weak growth in Latin America, the metropolitan area continues to be vulnerable to any weakening in 

the housing market. 

Metropolitan areas outside Florida tended to rank 

lower for different reasons. Raleigh, for example, 

ranked 14th, largely due to the fact that incomes have 

kept pace with home price appreciation. However, the 

metropolitan area witnessed a substantial adverse 

change in economic conditions, while C&D exposure 

remained high and continued to rise. Elsewhere in 

North Carolina, the Greensboro banking market continued to report rising levels of C&D exposure, 

despite declining employment levels. The Charlotte 

and Greensboro metro areas have experienced home 

price pressures in higher-end markets. 

Recent C&D Loan Performance among 

Atlanta Region Community Banks Remains 

Reasonably Strong 

Although the results of the housing market risk ranking highlighted market vulnerabilities, C&D loan 

credit quality has shown limited deterioration. Community banks in the 25 metropolitan areas covered by 

this analysis reported 1.18 percent of all C&D loans as 

noncurrent in second quarter 2002, up 33 basis points 

from one year earlier. The greatest increases occurred 

in Miami and Fort Walton Beach. However, credit 

quality deterioration may have been masked by borRegional Outlook 14 Fourth Quarter 2002 
Regional Perspectives
 

CHART 2 

The Construction and Development Loan Pipeline Ratio Remains 

High at Community Banks1 in the Atlanta Region 

1 Commercial banks with less than $1 billion in assets. 

2 Pipeline refers to the ratio of outstanding construction and development loans to outstandings plus unfunded commitments. 

Source: Bank Call Reports 

Four-Quarter Moving Average 

Pipeline Ratio2 (%) 

40 

45 

50 

55 

60 

65 

70 

75 

Sep. 

1990 

Sep. 

1991 

Sep. 

1992 

Sep. 

1993 

Sep. 

1994 

Sep. 

1995 

Sep. 

1996 

Sep. 

1997 

Sep. 

1998 

Sep. 

1999 

Sep. 

2000 

Sep. 

2001 

rowers drawing on credit lines, as could be suggested 

by the rising share of outstanding C&D loans to C&D 

loans plus unfunded commitments7 (see Chart 2). In 

addition, credit quality tends to lag the economic 

cycle, and, depending on the direction of housing markets, C&D loan quality may remain a concern in the 

coming quarters. Recent increases in residential foreclosure rates across the Atlanta Region may indicate 

7 Often referred to as the “pipeline ratio.” 

how housing markets will perform in the near term. 

Should uncertainty about the economy and the 

Region’s housing markets continue, lenders should 

monitor C&D loan performance for any signs of further deterioration. 

Jack Phelps, Regional Manager 

Scott Hughes, Regional Economist 

Ronald Sims, Senior Financial Analyst 

Pam Stallings, Senior Financial Analyst 

Regional Outlook 15 Fourth Quarter 2002 
Regional Perspectives Regional Perspectives
 

Chicago Regional Perspectives
 

Improving economic conditions in the Region1 suggest 

that economic recovery has been under way for the 

past year. Nevertheless, the nascent recovery has yet to 

return the Region’s economy to prerecession levels of 

employment or manufacturing activity. While the condition of the Region’s banks and thrifts is substantially 

stronger than immediately after the recession of the 

early 1990s, significant challenges remain. Although 

loan quality represents the greatest immediate risk, 

management of interest rate risk could be particularly 

challenging during the coming year. 

Loan Quality Concerns Linger while 

High-Risk Loan Exposures Grow 

As asset quality improvement may lag the economic 

recovery, asset quality among the Region’s insured institutions remains a significant concern. The aggregate 

past-due2 loan ratio for community banks3 has yet to 

show meaningful improvement. The past-due ratio for 

community banks stood at 2.34 percent on June 30, 

2002, only 15 basis points below the recent peak on 

December 31, 2001. This meager improvement has 

occurred among loans that are moderately past due. 

Noncurrent loans, a designation that encompasses loans 

90 days past due or in nonaccrual status, have held at 

1.06 percent of loans for the past two quarters, well 

above the 0.74 percent level experienced immediately 

before the recession. Should noncurrent loan rates rise 

further, profitability may be affected adversely, as the 

allowance for loan and lease losses (ALLL) may need to 

be bolstered.4 

Whether the slight improvement in total delinquencies 

observed in 2002 marks the beginning of a sustainable 

improvement in asset quality remains to be seen. Clearly, 

many commercial and consumer borrowers have refi1 Beginning in the first quarter 2003 edition of the Regional Outlook, 

the Chicago Region will include the state of Kentucky. 

2 Past-due includes loans at least 30 days delinquent or in nonaccrual 

status. 

3 Insured institutions with less than $1 billion in assets, excluding 

institutions less than three years old and specialty institutions, such as 

credit card banks or institutions with very low loan levels. 

4 Although the ratio of ALLL to total loan levels has increased steadily during the past two years, ALLL coverage of nonperforming loans 

is down sharply, from 156 percent two years ago to 112 percent as of 

June 30, 2002. During the same time period, Tier 1 leverage capital 

rose from 9.20 percent to 9.40 percent of average assets. 

nanced, availing themselves 

of lower interest rates to 

reduce debt service requirements. Nevertheless, certain loan 

gion’

s recession. 

segments, such as nonresidential 

commercial real estate (CRE), 

may have yet to experience the 

full effects of last year’

Softness in many of the Re s 

CRE markets may make it difficult for lessors to replace 

expiring leases on equally favorable terms.5 

Community banks continued the long-term trend 

toward increased concentrations in traditionally higher-risk loan segments, such as CRE lending, during the 

past two years. The greatest potential for credit quality 

issues going forward likely resides in the construction 

and development6 (C&D) and commercial and industrial (C&I) portfolios. C&D lending historically has 

been susceptible to relatively high charge-off rates. 

Within C&D, net charge-offs are already high relative 

to other loan types. Exposure to this business line, currently 6 percent of total loans, is roughly twice what it 

was in the early 1990s and has grown continuously, 

despite the weak macroeconomic environment of the 

past two years. The proportion of C&I loans has held 

steady throughout the past decade, but this portfolio 

segment recently has experienced a marked increase in 

delinquencies. The C&I loan portfolio had the highest 

noncurrent loan percentage of all loan types as of June 

30, 2002, reaching its highest level in the past two 

years (see Chart 1). 

Looking ahead, if the fragile recovery continues to gain 

strength, credit quality concerns are likely to subside. 

However, renewed macroeconomic weakness may pressure many insured institutions that have increased exposure in traditionally higher-risk loan segments, such as 

CRE and C&I lending. 

5 Office vacancy rates increased in all but one of the Region’s seven 

major CRE markets in second quarter 2002, with rates ranging from 

13.3 percent in Chicago to 22.0 percent in Columbus, Ohio. The 

vacancy rate in each market is significantly above the year-ago level. 

6 Call Reports do not distinguish between safer pre-sold owneroccupied residential construction loans and speculative residential 

real estate or commercial construction loans. 

Regional Outlook 16 Fourth Quarter 2002 
Regional Perspectives Regional Perspectives
 

CHART 1 

Noncurrent Loan Rates among the Region's 

Insured Institutions Have Yet to Improve 

Source: Bank and Thrift Call Reports for community institutions (less than 

$1 billion in assets, excluding de novos and specialty institutions) 

3Q99 

4Q99

1Q00

2Q00

3Q00

4Q00

1Q01

2Q01

3Q01

4Q01

1Q02

2Q02

Percentage of Loan Category

Noncurrent Commercial 

and Industrial Loans 

0.0 

0.2 

0.4 

0.6 

0.8 

1.0 

1.2 

1.4 

1.6 

1.8 

Total Noncurrent Loans 

Noncurrent Construction 

and Development Loans 

Interest Rate Risk and Persistent Net 

Interest Margin Compression Challenge 

the Region’s Insured Institutions 

The Region’s community institutions have faced declining net interest margins (NIMs) for the past decade, evidence of structural changes within the banking industry 

and an increasingly competitive environment. An 

increasingly competitive banking environment has 

resulted in pricing pressure on both sides of banks’ balance sheets. Growth in noncore funding,7 generally 

more expensive than core funds, has contributed to 

some of the long-term NIM compression. However, 

what makes the deteriorating NIM trend noteworthy is 

that it has occurred as community banks were using 

strategies that generally would be expected to improve 

NIMs. For instance, loan-to-asset levels have increased, 

and the portion of securities portfolios invested in 

lower-yielding Treasuries and Agencies has declined. 

Within loan portfolios, the share of CRE loans has risen 

markedly, which should boost loan yields. Furthermore, 

capital levels are high relative to ten years ago, reducing 

the need for interest-bearing liabilities. 

These strategies have not improved NIMs, as would normally be expected, because the Region’s community institutions have been faced with balance sheet and margin 

disruptions resulting from the significant steepening of 

the yield curve during 2001. Although steep yield curves 

are generally considered beneficial to NIMs, the rapid 

transition from a relatively flat to a steep yield curve 

proved detrimental to many institutions that would be 

7 Noncore funding consists of large time deposits, brokered deposits, 

foreign office deposits, and other borrowings. 

expected to benefit from a gradual decline in short-term 

rates. Initially, asset yields responded to falling rates more 

quickly than institutions could adjust funding costs, which 

exacerbated the competition-related NIM pressure. 

Recent margin improvements (see Chart 2), however, 

show that the disruptions associated with balance sheet 

restructurings have abated, and insured institutions are 

starting to benefit from the significant spread between 

long- and short-term rates. Across the Region, median 

NIMs were dipping even before the first interest rate cuts 

occurred in 2001. The trailing 12-month median NIM 

peaked June 30, 2000, and bottomed on December 31, 

2001. An analysis of the median quarterly annualized 

NIMs shows that the initial disruption was substantial, as 

prepayment options in loan and securities portfolios were 

exercised. Quarterly annualized NIMs, which give a 

more timely view of margin trends, essentially have 

reached early 2000 levels, even though full-year margins 

have turned upward only recently. Barring another rapid 

yield curve shift, trailing 12-month NIMs are expected to 

continue improving in the near term. 

Shifting Balance Sheets and a Return to a 

Flatter Yield Curve May Challenge Management 

of Interest Rate Risk for Some Institutions 

More recently, growth in loan-to-asset levels has contributed to the recent improvement in margins among 

insured institutions in the Chicago Region compared with 

institutions elsewhere in the nation. As loans are generally higher yielding than securities, margins have benefited. 

Furthermore, CRE lending, typically one of the higheryielding loan segments, has risen relative to total loans. 

CHART 2 

Net Interest Margins among the Region’s Insured
 

Institutions Have Rebounded Recently
 

Percent 

Median Quarterly 

Annualized NIM 

Median Trailing 12-Month 

Net Interest Margin 

4.10 

3.70 

3.75 

3.80 

3.85 

3.90 

3.95 

4.00 

4.05 

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

99 00 00 00 00 01 01 01 01 02 02 

Source: Bank and Thrift Call Reports for community institutions in the Chicago 

Region 

Regional Outlook 17 Fourth Quarter 2002 
Regional Perspectives Regional Perspectives
 

Conversely, community commercial banks8 have pulled 

back on residential real estate lending, despite significant mortgage origination volumes occurring nationally, 

perhaps an indication of increased preference in the 

Region for higher-yielding credits. Next year, any sharp 

decline in mortgage origination refinancing activity9 

likely will increase competition for home mortgage 

lending, further pressuring pricing. As institutions try to 

manage the expected decline in volume, management 

also will contend with an increased preference for 

adjustable rate mortgages (ARMs).10 Even though 30­

year fixed-rate mortgage rates are at 30-year lows, the 

spread between 30-year fixed-rate mortgages and oneyear ARMS is at a ten-year high.11 For many institutions, 

higher shares of ARMs will alleviate some interest rate 

risk challenges, but such a strategy comes at the cost of 

lower initial loan yields. 

In addition, a migration toward higher-yielding instruments has occurred in securities portfolios. The widening spread between the current yield on fixed-rate 

mortgages and comparable maturity U.S. Treasury 

securities has made mortgage-related investments 

appear more attractive.12 Higher shares of passthroughs and mortgage-backed securities have contributed to increased option risk in securities portfolios 

(see Chart 3). Furthermore, the percentage of passthrough securities effectively repricing after five years 

has been rising. Option risk resulting from these positions can manifest itself in two ways: mortgage-backed 

securities may lengthen in duration because of the 

deceleration of prepayments (i.e., increased extension 

risk) in a rising rate environment, or principal prepayments may occur (i.e., increased reinvestment risk) in a 

falling rate environment. 

Overall, the composition of liabilities has not changed 

appreciably over the past two years. The vast majority of 

time deposits continue to mature or reprice within one 

year, although the percentage has been falling. Although 

repricing data on other borrowings are not available 

from Call Reports, maturity information shows that 

CHART 3 

Mortgage-Backed Securities Represent a Growing Share of Securities 

Portfolios among the Region’s Insured Institutions 

MBS = mortgage-backed securities 

Source: Call reports for community commercial banks Percent 

0 

5 

10 

15 

20 

25 

30 

Pass-Throughs to Securities (left axis) 

MBS to Securities (left axis) 

Pass-Throughs with Earliest Repricing 

or Maturity over Five Years (%) 

4Q99 1Q00 2Q00 3Q00 4Q00 1Q01 2Q01 

64 

66 

68 

70 

72 

74 

76 

3Q01 4Q01 1Q02 2Q02 

8 Data for community commercial banks, which excludes thrifts, are 

used for the balance of this article, as thrifts do not report asset repricing and maturity information to the same level of detail as commercial banks. 

9 The Mortgage Bankers Association forecasts that refinancings will 

represent 29 percent of mortgage originations in 2003, down from 49 

percent forecast for 2002. Total mortgage originations are forecast to 

decline from $2.0 trillion to $1.4 trillion during the same period. 

10 The share of ARMs originated nationally has risen in recent quarters (up from 12 percent in fourth quarter 2001 to 20 percent in second quarter 2002). 

11 According to the Federal Home Loan Mortgage Corporation, the 

spread was 1.90 percentage points during third quarter 2002, compared with 1.02 and 1.14 in 2000 and 2001, respectively. 

12 As of August 31, 2002, the spread between 30-year fixed-rate mortgages and 7-year constant maturity Treasury notes was 2.41 percentage points, compared with 2.10 and 1.87 percentage points on 

average for 2000 and 2001, respectively. 

Regional Outlook 18 Fourth Quarter 2002 
Regional Perspectives Regional Perspectives
 

such borrowings are extending. Brokered deposits 

maturing in one year (now 50 percent) are falling as 

well. Lengthening of liability maturities, if properly 

matched with lengthening asset maturities, may reduce 

interest rate risk at some banks. 

Further Margin Improvement Will 

Likely Be Muted; Effective Interest 

Rate Risk Management Is Essential 

Further gains in margins may come if the yield curve 

maintains its steep upward slope, as time deposits 

would continue to reprice at low short-term rates. 

However, additional improvement is likely to be modest. Although the strength of the economic recovery 

remains uncertain, further significant short-term interest rate cuts may be unlikely. Nevertheless, if a reduction in short-term rates were to occur, any short-term 

benefit would likely be muted, as many deposit products are already at an effective rate floor. Furthermore, 

increased optionality in securities portfolios could 

contribute to more prepayments and banks reinvesting 

at lower market rates. 

If the recovery strengthens, higher short-term rates may 

result. Recent margin improvements among the Region’s 

insured institutions may be short-lived if institutions fail 

to prepare for a return to a flatter yield curve. Many banks 

may now be unduly exposed to rising short-term rates if 

they have been invested in longer-term assets at the same 

time depositors have avoided longer-term deposit instruments. Should the yield curve flatten, these institutions 

could again experience NIM compression. 

NIM performance during the past two years illustrates 

how significant yield curve changes can affect the 

Region’s institutions. The past two years also have provided an opportunity for asset and liability managers to 

evaluate the performance of interest rate risk monitoring 

systems, especially the validity of assumptions regarding borrower and depositor behavior. Although forecasting factors that will affect NIMs is complex, 

management must strive to develop interest rate risk 

systems that identify interest rate scenarios that may 

have the most detrimental effect on margins. 

Mike Anas, Senior Financial Analyst 

Regional Outlook 19 Fourth Quarter 2002 
Regional Perspectives Regional Perspectives
 

Dallas Regional Perspectives 


Midsouth Bank and Thrift Earnings Outlook1
 

A Weak Manufacturing Sector Continues to 

Have Adverse Effects on the Midsouth Economy 

Economic conditions in the Midsouth remained sluggish, with employment levels virtually unchanged during the second and third quarters of 2002. A key 

contributing factor is the lingering weakness in the 

area’s important but beleaguered manufacturing sector.2 This sector lost 128,000 jobs during the 27 

months ending September 2002. However, net job 

losses for the area were only 55,000, thanks to significant employment gains in the service sector. The rate 

of job losses in the manufacturing sector has slowed 

somewhat, indicating that the economy may be 

improving.3 However, weak employment conditions 

persisted in other sectors, including transportation, 

public utilities, and retail. 

Credit Quality and Earnings Improved 

during the First Half of 2002, Despite 

Economic Weakness 

Credit quality appears to have improved for most Midsouth insured institutions during second quarter 2002, 

but challenges continue in certain areas. Reported pastdue loan levels declined among 55 percent of insured 

institutions in the Midsouth,4 suggesting an improvement. However, institutions in areas where employment 

is highly concentrated in the manufacturing sector continue to report past-due loan ratios above the median for 

1 As used in this article, Midsouth refers to Arkansas, Kentucky,
 

Louisiana, Mississippi, and Tennessee. Beginning with first quarter
 

2003, analyses of Kentucky banking and economic conditions will
 

appear in Chicago Regional Perspectives.
 2 The manufacturing sector represents 16 percent of total employment
 

in the Midsouth, compared with 13 percent for the nation.
 

3 Evidence of recovery in the manufacturing sector is provided by two
 

measures, one national and the other regional:
 

• The Institute for Supply Management’s Purchasing Managers Index 

climbed from 48.1 at year-end 2001 to 56.2 by June 30, 2002. An 

index reading above 50 suggests expansion, while a reading below 

50 suggests contraction. However, by September 2002, the index 

had fallen to 49.5. 

• The average weekly hours worked by manufacturing sector employees rose sharply in the first half of 2002. Such an increase typically 

precedes an increase in employment in the sector (discussed in more 

detail in Memphis Regional Outlook, third quarter 2002). 4 Median past-due loans were 2.60 percent of total loans in second 

quarter 2002, down from 2.82 percent the previous quarter. 

the Midsouth.5 Furthermore, 17 percent of the area’s 

insured institutions reported relatively high past-due 

loan ratios of 5 percent or more in 

the second quarter, 

almost twice the 

median for this area. 

(Refer to Memphis 

Regional Outlook, 

first quarter 2002, 

for a detailed discussion of the effects of 

employment concentrations in the manufacturing sector on 

insured institution credit quality.) 

Banks and thrifts headquartered in the Midsouth reported sharply higher returns on assets (ROAs)6 in the first 

half of 2002, largely as a result of higher net interest 

margins (NIMs) compared with a year earlier (see 

Table 1). The improvement in earnings performance 

was widespread, with more than two-thirds of insured 

institutions reporting an increase in earnings in the first 

six months of 2002 compared with a year ago. 

TABLE 1 

Insured Institutions Headquartered 

in the Midsouth Reported Strong 

Earnings in the First Half of 2002 

MEDIAN RATIO 2001 2002 

ROA (%): 

1ST QUARTER 1.04 1.10 

2ND QUARTER 1.04 1.18 

NIM (%): 

1ST QUARTER 4.02 4.13 

2ND QUARTER 4.02 4.33 

Notes: ROA—return on assets; NIM—net interest 

margin (excludes de novos) 

Source: Bank & Thrift Call Reports 

5 The median past-due loan ratio was 2.71 in second quarter 2002 

among insured institutions headquartered in areas dependent on the 

manufacturing sector (areas with manufacturing employment at least 

16 percent of total employment). The past-due ratio was 2.10 for 

banks in other areas. 

6 The 14 basis point increase in second quarter 2002 ROA compared 

with a year ago is the largest increase in the past ten years. 

Regional Outlook 20 Fourth Quarter 2002 
Regional Perspectives Regional Perspectives
 

The favorable movement in interest rates during 2001 

and early 2002 strongly influenced NIMs. The yield 

curve steepened considerably from year-end 2000 

through first quarter 2002 as short-term rates fell more 

rapidly than long-term rates (shown by the widening 

spread between three-month London Interbank Offer 

Rate (LIBOR) and five-year Treasury rates in Chart 1.)7 

Historically, bank and thrift NIMs have tracked, with a 

slight lag, changes in the shape of the yield curve (see 

Chart 2). 

CHART 1 

The Interest Rate Environment Has Became 

Somewhat Less Favorable in Recent Quarters 

Future NIM performance will be influenced by the direction of interest rates as well as the movement of interest 

rate spreads. The narrowing of spreads between spring 

and fall 2002 suggests that the improvement in NIMs 

could possibly end in the fourth quarter, assuming NIMs 

continue to track changes in the shape of the yield curve. 

Any benefits to NIMs of additional downward movement 

in rates likely would be muted, as interest rates on many 

deposit products are already at an effective rate floor. 

Interest Rates (%) 

The Spread between Short- and Intermediate-Term Interest Rates Rose 

Sharply during 2001 but Has Narrowed since March 2002 

Interest Spread (%) 

Source: Federal Reserve Board 

Short-Term Rates Are 

Unchanged in Recent Periods, but 

Long-Term Rates Have Dropped Considerably 

Three-Month London Interbank Offer Rate (LIBOR) 

Interest Spread between Five-Year 

Treasury Note Yield at Constant 

Maturity and Three-Month LIBOR 

Five-Year Treasury Note Yield 

June 

’99 

Sept. 

’02 

Sept. 

’99 

Dec. 

’99 

June 

’02 

Mar. 

’00 

Mar. 

’01 

June 

’01 

Sept. 

’01 

Dec. 

’01 

Mar. 

’02 

June 

’00 

Sept. 

’00 

Dec. 

’00 

–2.0 

–1.5 

–1.0 

–0.5 

0.0 

0.5 

1.0 

1.5 

2.0 

2.5 

3.0 

0 

1 

2 

3 

4 

5 

6 

7 

8 

CHART 2 Net Interest Margin (%)

Interest Spread (%) 

Interest Spread between Five-Year Treasury Note Yield at Constant Maturity 

and Three-Month London Interbank Offer Rate (lagged three months, e.g., 

June-02 spread shown as of Sept-02) 

Source: Federal Reserve Board; Bank and Thrift Call Reports 

Net Interest Margins at Midsouth Banks and Thrifts Could 

Be Pressured by Recent Narrowing of Interest Spreads 

June 

’99 

Sept. 

’02 

Sept. 

’99 

Dec. 

’99 

June 

’02 

Mar. 

’00 

Mar. 

’01 

June 

’01 

Sept. 

’01 

Dec. 

’01 

Mar. 

’02 

June 

’00 

Sept. 

’00 

Dec. 

’00 

3.8 

4.0 

4.2 

4.4 

4.6 

Quarterly Net Interest Margin (bars) 

–2.0 

1.0 

0.0 

1.0 

2.0 

3.0 

7 Yield curve steepness peaked in March 2002 at 275 basis points. By 

late October, the spread had declined to 125 basis points. The ten-year 

average monthly spread is 77 basis points. Comparisons of short-term 

and long-term or intermediate-term interest rates other than threemonth LIBOR and five-year Treasury would yield similar results. 

Regional Outlook 21 Fourth Quarter 2002 
Regional Perspectives Regional Perspectives
 

The potential pressure on NIMs among Midsouth 

banks and thrifts results not from mismatches between 

asset and funding maturity/repricing,8 but rather from 

the effects of a nonparallel shift in rates on asset yields 

and funding costs. Since March 2002, intermediateand long-term rates, which influence the pricing of 

many asset classes, have fallen considerably, while 

short-term interest rates, which affect deposit pricing, 

remained largely unchanged (see Chart 1). As a result, 

the decline in yields as assets reprice downward is 

likely to proceed more rapidly than the reduction in 

funding costs. 

This recent shift in the yield curve likely will influence 

assets and liabilities, with perhaps the greatest effect 

on mortgage-related assets. The recent decline in 

longer-term rates led to a dramatic increase in home 

mortgage refinancing, affecting securities portfolios 

and lending activities of many insured institutions in 

the Midsouth. 

•	 Securities Portfolios: As discussed in Memphis 

Regional Outlook, third quarter 2002, investment 

decisions during 2001 at most established community banks and thrifts9 favored mortgage-backed 

securities (MBS) and mortgage derivative securities 

(MDS).10 The increased volume of mortgage refinancings contributed to acceleration in prepayments during the second half of 2002. Many of 

these investments are being called, and banks and 

thrifts must reinvest the proceeds in a lower interest 

rate environment. As a result, earnings could be 

affected adversely. 

•	 Mortgage Lending: Direct mortgage lending also 

has been affected, particularly by the tremendous 

volume of existing loans being refinanced at lower 

8 Many institutions have significantly extended reinvestment horizons 

or purchased instruments with complex embedded options in an effort 

to improve the yields of securities portfolios, a strategy that likely will 

increase the vulnerability of earnings performance to rising interest 

rates. This increased market sensitivity in investments is discussed in 

Memphis Regional Perspectives, third quarter 2002. 9 Established community banks and thrifts have less than $1 billion in 

total assets and have been in operation for more than three years. 

10 From December 31, 2000, to June 30, 2002, MBS plus MDS 

increased from 4.0 percent of total assets at established community 

banks to 6.3 percent. As a percentage of total securities, these securities rose from 16.8 percent to 26.5 percent during the period. 

Large banks (those with over $1 billion in assets) also increased 

holdings of MBS and MDS but by relatively smaller amounts 

(from 9.9 to 10.6 percent of assets and from 48.0 to 56.9 percent of 

securities). 

rates.11 Bank and thrift earnings have benefited from 

the considerable fee income generated by the high 

volume of mortgage originations. However, insured 

institutions that provide mortgage servicing on loans 

sold to the secondary market may suffer adverse 

earnings effects because of impairment write-downs. 

Those write-downs likely will be more pronounced 

during the second half of 2002 as large volumes of 

refinancing applications submitted in the late summer are processed. 

Future Earnings Performance Also Could Be 

Affected by Continued High Provision Expenses 

ROAs increased dramatically in the first half of 2002 

despite increased provision expenses. Although banks 

and thrifts reported declining loan delinquencies, loan 

charge-off rates remained above levels reported a year 

ago.12 Although the recent drop in delinquencies may 

lead to expectations of declining loan losses, vulnerabilities in the national economy, described in Economic Conditions and Emerging Risks in Banking, suggests that 

credit losses could increase in the near term. 

Most banks and thrifts in the Midsouth have appropriately increased their allowance for loan and lease losses 

(ALLL) to compensate for heightened credit risk stemming from uncertain economic conditions. Two broad 

measures of ALLL adequacy among insured institutions 

showed considerable improvement during the year 

ended June 2002: 

•	 The ratio of ALLL to total loans climbed from 1.25 

percent to 1.31 percent. 

•	 ALLL coverage of total nonperforming loans rose 

from 142 percent to 154 percent. Nonetheless, ALLL 

coverage remains below the national median of 167 

percent. 

Despite these ALLL trends, increased provisions may be 

needed should credit losses climb in the second half of 

11 Three-quarters of insured institutions headquartered in the Midsouth 

have significant holdings (at least 25 percent of total loans) of mortgages on one- to four-family residences. Call report data do not provide 

information on the volume of those loans that are or were originally for 

purchase of a home rather than being acquired to bolster collateral. 

12 The median past-due and nonaccrual loan ratio peaked at 3.05 percent on December 31, 2001, before falling to 2.6 percent as of June 

30, 2002. Loan charge-offs during the first six months of 2002 represented 8 basis points of average loans, compared with a 7 basis point 

loan loss rate reported during the first half of 2001. 

Regional Outlook	 22 Fourth Quarter 2002 
Regional Perspectives
 

2002. Factors that should be considered in determining 

allowance adequacy were discussed in Memphis Regional Outlook, second quarter 2002. 

Challenges Lie Ahead 

The potential for a less favorable interest rate environment exists and, coupled with sluggish economic 

growth and ongoing asset weakness, suggests that banks 

and thrifts in the Midsouth may not be able to sustain 

recent strong earnings performance. The effectiveness 

of interest rate risk monitoring systems will become 

extremely important as managers seek to make 

informed asset and liability management decisions. 

Memphis Staff 

Southwest Perspectives
 

The Southwest Continues to Experience 

the Aftermath of the Recession 

The economies of Colorado, New Mexico, Oklahoma, 

and Texas have performed differently from one another 

since the recession began in March 2001. As of July 

2002, nonfarm employment in Colorado and Texas 

remained below peak levels (see Chart 1), in large part 

due to continuing stress in the states’ key high-tech sector. Colorado’s nonfarm employment ranks second to 

last in the nation, with a negative growth rate of 2.6 percent. The Texas economy lost the greatest number of 

jobs in the nation (143,000) since the economy entered 

recession. By contrast, during the 1990s, Colorado and 

Texas ranked among the nation’s top six states in nonfarm employment growth. 

Employment growth rates in New Mexico and Oklahoma remain positive. However, total nonfarm employment is only modestly higher than when the recession 

began. The effects of the national recession on the 

CHART 1 

Employment Picture in the Southwest
 

Remains Weak
 

Nonfarm Employment

Index 100 = March 2001 

101.0 

100.5 

100.0 

99.5 

99.0 

98.5 

98.0 

97.5 

97.0 

Recession Began March 2001 

U.S.
 

OK
 

CO
 

NM
 

TX
 

Jan Apr Jul Oct Jan Apr Jul 

2001 2001 2001 2001 2002 2002 2002 

Note: Data are seasonally adjusted.
 

Source: Bureau of Labor Statistics (Haver Analytics)
 

economies of these two 

states have been muted, in 

large part thanks to the 

continuing strength of the 

government sector and 

the fact that high-tech 

manufacturing represents a smaller share of 

their employment. 

Despite positive employment trends 

in Oklahoma and New Mexico, the Southwest may lag the nation in employment growth because 

of ongoing problems in the Region’s high-tech and energy sectors. 

The Energy Sector Remains 

Troubled Despite Higher Oil Prices 

Oil prices have trended upward this year, increasing 

more than 50 percent (based on monthly averages) 

between January and September 2002.1 Price increases 

have been attributed to turmoil in the Middle East—the 

Israeli-Palestinian conflict and the possibility of U.S. 

military action against Iraq. Concern about potential oil 

supply disruptions that could be caused by the events in 

the Middle East add what one industry consultant terms 

a “fear premium” estimated at $3 to $5 per barrel of oil.2 

Additionally, the Organization of Petroleum Exporting 

Countries (OPEC) has reduced output by 3.5 million 

barrels a day since January 2002,3 causing U.S. oil and 

gas inventories to decline to the lowest level in more 

1 Based on West Texas Intermediate crude oil prices provided by the 

Wall Street Journal and Haver Analytics. September’s figure through 

September 23, 2002 was supplied by www.economagic.com 

2 Daniel Yergin, head of Cambridge Energy Research Associates, 

“Don’t Mention the O-Word,” The Economist, September 12, 2002. 3 Neela Banerjee, “OPEC Feels Pressure to Produce More Oil,” New 

York Times, September 16, 2002. 

Regional Outlook 23 Fourth Quarter 2002 
Regional Perspectives Regional Perspectives
 

than 20 years. This decline in inventories has also contributed to upward pressure on energy prices. 

Despite higher oil prices, however, the Region’s oil and 

gas industry has not performed well. Even as prices 

have increased, year-over-year employment growth has 

weakened since mid-year 2001 (see Chart 2). This 

weakness can be explained, at least in part, by the lag 

effect between oil prices and production and employment. Consequently, the decline in industry employment 

in 2002 reflects the 30 percent decline in oil prices from 

August to December 2001. 

Furthermore, a weak global economy, the effects of September 11, and a mild U.S. winter drove down demand 

for refined fuels and squeezed profit margins. For 

example, Exxon Mobil Corporation and Royal 

Dutch/Shell, two bellwether companies, reported 

sharply lower second quarter earnings at a time when 

the industry generally performs well, during the seasonal switch from heating oil to gasoline production. Equally important, the industry continues to consolidate, 

reducing costs through layoffs, selling existing operations, and shuttering inefficient plants, all developments 

that adversely affect employment levels. Moreover, 

many oil and gas firms are using the revenues from 

higher oil prices to pay down debt, meet stringent environmental regulations, and repair frayed balance sheets. 

Although these trends will help restore the industry’s 

profitability in the long run, production and employment will be dampened in the interim. 

CHART 2 

Employment in the Oil and Gas Sector Has
 

Weakened Despite Rising Oil Prices
 

Finally, the Southwest economy is unlikely to benefit 

from rising oil prices to the same extent as in previous 

years. Although all states in the Region rank high in oil 

and natural gas production,4 the transformation from 

natural resource-based economies in the 1980s to information technology and services-oriented economies in 

the 1990s has led to greater industrial diversification, 

tying the Region more closely to the U.S. business 

cycle. Sustained oil prices above $30 a barrel would 

hamper U.S. and global economic growth (perhaps contributing to a double-dip recession) and could result in 

higher inflation rates,5 possibly eroding confidence 

among consumers, businesses, and investors. Higher oil 

prices affect consumers in the form of higher gasoline 

prices, resulting in a decline in disposable personal 

income and a scaling back of consumer spending. 

Moreover, oil and natural gas are major cost inputs in 

many industries (e.g. manufacturing, transportation, and 

utilities), and higher prices would hurt business investment and exports. 

Problems in the High-Tech Sector Continue to 

Dampen the Region’s Economy 

The high-tech boom of the 1990s helps explain why the 

U.S. and Southwest economies performed well during 

the past decade. The economies of Colorado and 

Texas—states with high concentrations of telecommunications equipment manufacturers and services 

providers, semiconductor and personal computer firms, 

and software developers—grew faster than the U.S. 

economy,6 in part as a result of the strong demand for 

high-tech products. Moreover, states with highly developed technology sectors have shown a strong positive 

correlation with per capita income growth.7 

However, when the high-tech boom of the 1990s gave 

way to the high-tech bust in early 2000,8 many previously 

$/Barrel

Oil and Gas Employment,

Percent Change from a Year Ago 

West Texas Intermediate 

Crude Oil Prices (left axis) 

Oil & Gas 

Employment 

(right axis) 

40 

0 

5 

10 

15 

20 

25 

30 

35 

15 

–20 

–15 

–10 

– 5 

0 

5 

10 

4 Independent Petroleum Association of America, http://www.ipaa 

.org/info/econreports/stateinformation.asp 

5 To see how rising energy prices have affected the U.S. economy, refer 

to “Energy Price Impacts on the U.S. Economy,” http://www.eia.doe 

.gov/oiaf/economy/energy_price.html 

6 Between 1990 and 2000, Colorado and Texas nonfarm employment 

(seasonally adjusted) grew at annualized rates of 3.8 percent and 2.9 

percent, respectively, compared with 1.8 percent for the nation. 

7 The Progressive Policy Institute, “The 2002 State New Economy 

Index,” http://www.neweconomyindex.org/states/2002/summary.html 8 March 2000 is generally believed to be the start of the high-tech bust. 

The NASDAQ peaked at 5048.62 (closing) on March 10, 2000; five 

Jul Jul Jul Jul Jul Jul weeks later (April 14, 2000) the NASDAQ closed at 3321.29, having 

1997 1998 1999 2000 2001 2002 lost one-third of its value. Source: http://bigcharts.marketwatch 

Sources: The Wall Street Journal; Bureau of Labor Statistics (Haver Analytics) .com/historical/default.asp 

Regional Outlook 24 Fourth Quarter 2002 
Regional Perspectives Regional Perspectives
 

fast-growing areas fell into recession, characterized by 

declines in employment growth rates. Moreover, the 

high-tech sector probably will emerge last from the 

recession, because excess supply and weak demand 

have resulted in over capacity that will take time to correct. Capacity utilization rates for certain high-tech 

industries are far below industry trends (see Chart 3). 

Industries with low utilization levels generally are characterized by declining production and weak demand. 

Poor equity market performance that constrains business investment, limited pricing power, and shifting 

business and consumer preferences also are contributing to the malaise of the high-tech sector. 

CHART 3 

The importance of the high-tech sector to the Southwest’s economy and the likelihood that this sector will 

stay weak for some time suggest that economic growth 

in the Southwest will remain below levels of the mid- to 

late 1990s, particularly in Colorado and Texas. Many of 

the Southwest’s high-tech metropolitan areas have 

already shown evidence of these trends.9 Previously 

robust metropolitan economies, such as Austin, Boulder, Colorado Springs, Dallas, Denver, Fort Worth, 

Houston, Sherman, and Waco, have experienced 

declining payroll employment growth, falling output 

growth, or both (see Chart 4). 

Weakness in Office Employment Has 

Excess Capacity Exists in the Region’s 

Key High-Tech Industries 

Capacity Utilization (%), SA 

Source: Federal Reserve Board 

50 

55 

60 

65 

70 

75 

80 

85 

90 

95 

100 

Computers and 

Office Equipment 

Total Industry 

Semiconductors 

and Electronic 

Components 

Communications 

Equipment 

Jan 

1999 

Jul 

1999 

Jan 

2000 

Jul 

2000 

Jan 

2001 

Jul 

2001 

Jan 

2002 

Jul 

2002 

Contributed to a Rapid Rise in Vacancy Rates 

in Several Southwest Office Markets 

Office vacancy rates continue to climb nationwide, up 

630 basis points from 9.8 to 16.1 in the three-year period ending September 30, 2002, the largest increase in 

more than a decade. Vacancy rates in four Dallas Region 

metropolitan statistical areas (MSAs)—Dallas, Austin, 

Oklahoma City, and Denver—rank among the highest 

in the country as a result of declines in office employment in these MSAs.10 The Dallas MSA ranks highest in 

the nation, with a vacancy rate of 25.8 percent. Austin 

ranks second (25.7 percent), Oklahoma City ranks fourth 

(21.7 percent), and Denver ranks tenth (20.0 percent). 

CHART 4 

Weakness in the Region’s High-Tech Sector Continues to 

Affect Certain Metropolitan Statistical Areas Adversely 

BRZ 

TUL ABQ

OKC 

SHM BOL 

DEN 

AUS 

DAL 

CLR 

WAC USA FWA

HST

Payroll Employment (%) 

–4 

–3 

–2 

–1 

0 

1 

2 

3 

–4 –2 0 2 4 6 8 

Real Gross Metropolitan Product (%) 

Notes: ABQ = Albuquerque, AUS = Austin, BOL = Boulder, BRZ = Brazoria, CLR = Colorado Springs, DAL = Dallas, DEN = Denver, FWA = Fort Worth, HST = Houston, OKC 

= Oklahoma City, SHM = Sherman, TUL = Tulsa, USA = United States, WAC = Waco. Percentage change from a year ago, from second quarter 2001 to second quarter 2002. 

Sources: Economy.com; Bureau of Labor Statistics (Haver Analytics) 

9 Metropolitan areas selected had high-tech output as a share of total 

metropolitan output greater than 10 percent based on analysis done by 

DRI-WEFA for the U.S. Conference of Mayors, http://usmayors.org/ 

citiesdrivetheeconomy/chart3_tech.pdf 

10 Based on the 55 metro markets tracked by Torto Wheaton Research. 

Regional Outlook 25 Fourth Quarter 2002 
Regional Perspectives Regional Perspectives
 

Vacancy rate trends in each metro market have differed 

significantly, and rates also have diverged across metro 

area submarkets. 

The Austin and Denver MSAs have experienced rapid 

increases in vacancy rates, coinciding with the downturn 

in the high-tech and telecommunications sectors following a period during which the rates tracked at or below the 

national average. However, the vacancy rate in Austin has 

risen almost fivefold in three years, the most dramatic 

increase in the country. Furthermore, the Austin suburban 

market reported an office vacancy rate of 27.2 percent as 

of September 30, 2002, the highest in the nation, with 

about 10 percent attributable to sublease space.11 Sublease space often occurs when companies acquire space 

in anticipation of future growth. If that growth fails to 

materialize, as typified by the recent downturn in the 

high-tech sector, the excess space is returned to the market as sublease space. 

In contrast, office vacancy rates in the Dallas and Oklahoma City MSAs have remained significantly above the 

national average for the past decade, and pricing for this 

continued high level of office vacancies appears to have 

been factored into the market. However, vacancy rates in 

the Dallas MSA suburban markets have increased 10 

percentage points during the past three years, creating 

downward pressure on rent rates and property cash 

flows. 

TABLE 1 

Implications for the Region’s Insured Institutions 

As office vacancy rates have risen, insured institutions 

in the Southwest have expanded construction and commercial real estate (CRE) portfolios to record levels. As 

of June 30, 2002, 23 percent of the Region’s banks and 

thrifts reported CRE concentrations in excess of 300 

percent of Tier 1 capital, the highest level in the past 15 

years. Certain groups of insured institutions have 

expanded these portfolios to a greater extent (see Table 

1). As might be expected, metro banks report higher 

CRE concentrations than rural banks, and larger institutions tend to have higher concentrations than smaller 

institutions. 

More than half the banks and thrifts headquartered in 

the Dallas and Houston MSAs report relatively high 

CRE concentrations. Given the current high office 

vacancy rate in the Dallas MSA, this situation is especially problematic. 

Despite the fact that the Southwest’s insured institutions 

have increased concentrations in these traditionally 

higher-risk loans at the same time commercial real 

estate markets have weakened, banks and thrifts in the 

Southwest continue to perform well. The aggregate 

return on assets for the six months ending June 30, 

2002, was 1.46 percent, up 23 basis points from a year 

earlier, and the highest level since June 1996. 

Insured Institutions Increase CRE Exposure as Office Markets Weaken 

PERCENT OF INSURED INSTITUTIONS WITH 

COMMERCIAL REAL ESTATE LOANS GREATER 6/30/02 6/30/99 

THAN 300 PERCENT OF TIER 1 CAPITAL (%) (%) 

NATION 24 15 

SOUTHWEST 23 15 

AUSTIN MSA 32 18 

DALLAS MSA 52 32 

DENVER MSA 34 28 

HOUSTON MSA 56 37 

OKLAHOMA CITY MSA 33 24 

METRO—SOUTHWEST 40 25 

RURAL—SOUTHWEST 9 5 

MORE THAN $100M—SOUTHWEST 36 27 

LESS THAN $100M—SOUTHWEST 14 9 

Note: MSA = metropolitan statistical area 

Source: Bank and Thrift Call Reports 

11 Torto Wheaton Research. 

Regional Outlook 26 Fourth Quarter 2002 
Regional Perspectives Regional Perspectives
 

In addition, falling short-term interest rates combined 

with an upward-sloping yield curve have improved net 

interest margins among the Region’s insured institutions 

as interest expense has fallen below 2 percent, the lowest level in a decade.12 Capital levels remain strong, as 

evidenced by a core capital ratio of 8.36 percent, the 

highest level in the past ten years. Although aggregate 

12 The combined interest expense for the Southwest’s insured institutions for the six months ending June 30, 2002, was 1.82 percent of 

average assets. 

past-due and charge-off ratios are slightly higher than 

those reported for the past several years, they remain 

relatively low by historical standards. 

However, a note of caution is needed. Deterioration in 

credit quality often lags the business cycle. As a result, 

should the economic recovery take hold, weakness in 

certain segments of the loan portfolio, especially those 

with exposure to stressed industries, may yet emerge. 

Dallas Staff 

Regional Outlook 27 Fourth Quarter 2002 
Regional Perspectives Regional Perspectives
 

Kansas City Regional Perspectives
 

Many issues of concern to the nation’s insured institutions also are of concern to institutions in the Kansas 

City Region. The Region’s community banks are experiencing the effects of weakening in commercial real 

estate (CRE) markets and earnings pressures because of 

challenges to asset liability management, although to a 

lesser degree than institutions across the country (see 

text box). Overall, however, the drought could cause the 

greatest stress for a large number of the Region’s community banks. Although the drought is affecting areas 

across the country, its severity in the Kansas City 

Region, together with the Region’s disproportionately 

high number of farm banks, magnifies its potential 

adverse effects. 

Drought Is Stressing the Western 

Part of the Kansas City Region 

In mid-September, the National Oceanic and Atmospheric Administration reported that the average temperature for the contiguous United States from June 

through August was 73.9o F—the third hottest summer 

since record-keeping began in 1895, surpassed only 

by the summers of 1934 and 1936. Moderate to 

extreme drought1 now covers 45 percent of the United 

States. Much of the Great Plains and western United 

States was severely affected by drought in the spring, 

TABLE 1 

and drought conditions 

worsened during the 

summer. 

Poor crop conditions 

nationwide have translated into forecasts for 

significantly lower 

production of corn, soybeans, and wheat (see 

Table 1). In August, the 

U. S. Department of Agriculture (USDA) 

revised its monthly forecast for corn production downward 9.2 percent to 8.9 billion bushels nationwide, the 

smallest crop since 1995. The USDA also revised the 

forecast for the soybean harvest down 8.1 percent to 2.6 

billion bushels, the smallest crop since 1996. 

Western portions of the Kansas City Region, including 

much of Kansas, Nebraska, North Dakota, and 

South Dakota, are experiencing the worst drought 

since 1988. Forecast yields of corn, soybeans, and 

spring wheat and actual yields of winter wheat already 

harvested are substantially below 2001 levels. 

Nebraska has been more severely stressed by the 

drought than the other states in the Region, as measured 

by the value of lost crop production. Some farmers in 

USDA Forecasts Declining Crop Production Due to Drought 

SPRING WINTER 

CROP CORN SOYBEANS WHEAT* WHEAT 

KANSAS –30 –32 — –20 

NEBRASKA –21 –24 — –22 

SOUTH DAKOTA –8 –7 –15 62 

NORTH DAKOTA –28 18 –47 — 

Note: Table compares 2002 forecast production to 2001.
 

*actual production in 2002.
 

Source: USDA Crop Production reports, 2002.
 

1 The Drought Monitor, a joint project of the National Oceanic and 

Atmospheric Administration and the United States Department of 

Agriculture, defines “Moderate Drought” as occurring in areas with 

“Some damage to crops and pastures and some water shortages developing or imminent,” and “Severe Drought” as occurring in areas with 

“Crop or pasture losses likely; water shortages common; water 

restrictions imposed.” It defines “Extreme Drought” as occurring in 

areas with “Major crop or pasture losses; widespread water shortages 

or restrictions.” 

Regional Outlook 28 Fourth Quarter 2002 
Regional Perspectives Regional Perspectives
 

Kansas City Region Insured Pressure on Community Bank NIMs Continues

Competitive pressures on both sides of the balance Institutions Face Additional 

sheet continue to affect community bank net interest Challenges margins (NIMs). NIMs have changed significantly 

during the past several years (see Chart 1). Shifts in 

Insured Institutions Continue to Increase CRE monetary policy, combined with asset-sensitive balExposure Despite Weakening Office Markets ance sheets, contributed to a widening of NIMS in 

Many of the Region’s metropolitan markets have 2000 and a narrowing in 2001. NIMs currently are up

from year-ago levels, as interest rate shocks ended in experienced rapid increases in commercial office 

vacancy rates since 2000 as high completion rates late 2001, and the Region’s banks are benefiting from

outpaced low or even negative net absorption because a steep yield curve. Despite this volatility, long-term

trends suggest that NIMs overall are narrowing. of slowing employment growth. Torto Wheaton 

Moreover, slackening loan demand suggests that Research reports second-quarter 2002 office vacancy NIMs could continue to be pressured going forward. rates of 17.9, 16.9, and 14.5 percent, respectively, for 

the Region’s three largest markets, Minneapolis-St. CHART 1 

Paul, St. Louis, and Kansas City. Vacancy rates were 

below 10 percent in Kansas City and St. Louis and 

below 11 percent in Minneapolis-St. Paul at year-end 

2000. While office markets began softening in 2000, 

insured financial institutions in these markets continued to increase capital exposure to CRE lending. The 

median CRE loan-to-Tier 1 capital ratio for established institutions (over eight years) increased from 

209 percent at June 2000 to 228 percent at June 2002; 

newly chartered institutions nearly doubled the median ratio, from 97 percent to 180 percent. Despite these 

increasing concentrations during a time of market 

weakening, no material CRE credit deterioration has 

been reported; however, that could change if market 

weakness continues. 

Rising Loan-to-Asset Ratios Have Been 

Unable to Counter Pressures That Are Eroding 

Net Interest Margins at Community Banks 

Source: Bank Call Reports, community banks 

Net Interest Margins with Trend Line 

(left scale) 

Percent

Percent 

Loan-to-Asset Ratios 

(right scale) 

40 

45 

50 

55 

60 

65 

70 

4.1 

4.2 

4.3 

4.4 

4.5 

June ’93 ’94 ’95 ’96’97 ’98 ’99 ’00 ’01 ’02 

the western panhandle of Nebraska are experiencing 

the worst conditions since the Dust Bowl of the 1930s; 

many farmers in the Panhandle will produce no crop at 

all. The nonirrigated portions of Nebraska’s corn and 

soybean crops have suffered most, with corn production projected to be 30 percent less than last year. The 

University of Nebraska estimates the cost of the 

drought at $1.4 billion, or 2.5 percent of Nebraska’s 

gross state product. Many observers believe the actual 

impact will be considerably greater when the full 

extent of the damage becomes evident by year end. 

Map 1 shows the severity and duration of recent 

drought among the Region’s counties. 

Cattle producers are also feeling the effects of the 

drought (see Table 2). Kansas and Nebraska rank second 

and third, respectively, among the nation’s cattle-producing states, and the Region’s four states together represent 

20 percent of the nation’s herd. As Table 2 indicates, the 

drought has severely reduced the supply and quality of 

grazing pastureland as well as supplies of hay. 

Farmers and ranchers were forced to feed hay to their 

livestock over the summer because of the poor quality of 

pastureland, a practice that usually does not occur until 

autumn or winter. Declining supplies of hay and 

increased demand are pushing up prices, forcing livestock operators to seek alternatives, such as harvesting 

roadside ditches and cutting drought-stressed crops prematurely for silage. Moreover, because they were forced 

to use hay stocks this summer, many livestock operators 

are pessimistic about finding enough forage to last the 

winter months. 

In addition, some cow-calf operators in drought-affected 

areas are being forced to sell young cattle at severely 

Regional Outlook 29 Fourth Quarter 2002 
Regional Perspectives
 

TABLE 2 

USDA Data Show Effects of Drought on Region’s Grazing Conditions 

PASTURE/RANGE 

CONDITIONS 

VERY POOR 

(%) 

POOR 

(%) 

FAIR 

(%) 

GOOD 

(%) 

EXCELLENT 

(%) 

NUMBER OF CATTLE 

(IN 000S) 

KANSAS 

NEBRASKA 

SOUTH DAKOTA 

NORTH DAKOTA 

41 

58 

34 

30 

30 

28 

27 

27 

20 

10 

23 

27 

8 

4 

15 

15 

1 

0 

1 

1 

6,600 

6,400 

3,950 

1,970 

Sources: “USDA Weekly Weather and Crop Bulletin,” September 17, 2002. “USDA Cattle” report, February 2002. 

discounted prices to cattlemen in states with more plentiful forage supplies. For example, reports from a major 

livestock auction in Fort Pierre, South Dakota indicate 

that more than six times the usual volume of cattle are 

being sold in its weekly auctions, primarily to buyers 

from states where drought is not a problem. 

The economic distress caused by the drought has aggravated an already weak cattle market. Prices have been 

falling for the past year and a half. The prices of fed 

steers peaked above $79 per hundredweight in first 

quarter 2001, but have declined to below $66, the lowest price in the last two and half years. 

Farm Banks Could Be Affected 

Adversely by the Drought 

The drought could have a negative effect on many farm 

banks as well.2 The effects of the drought likely will not 

be evident until early 2003. However, the drought follows a period of stressed agricultural conditions in many 

states, particularly Nebraska, Kansas, and South Dakota, 

where crop prices have been at historically low levels for 

the past four years. While federal government financial 

assistance bolstered the farm sector, the prolonged period of low commodity prices has left many rural farm 

banks holding considerable levels of carryover debt.3 

Should the drought continue and levels of carryover debt 

increase, farm bank credit quality could weaken. 

Regional analysis by the FDIC indicates that farm banks 

in areas that have experienced prolonged drought conditions4 (dark-shaded counties in Map 1) are reporting 

2 An FDIC-insured bank is considered a farm bank if total agricultural production loans and loans secured by farm land equal at least 25 

percent of total loans. 

3 Carryover debt occurs when a farm operator is unable to repay monies 

borrowed to cover the current growing season’s operating costs. 

4 For analytical purposes, the FDIC considered a county to be in persistent drought condition if it was in a severe to exceptional drought 

condition in July 2002 and in at least a moderate drought condition in 

July 2001 or July 2000. 

MAP 1 

Much of Nebraska Has Experienced 

a Prolonged Period of Drought 

Drought 

Monitor 

map date 7/30/02 7/24/01 7/25/00 

Description of Drought Condition 

Severe to 

exceptional & At least moderate Or At least moderate 

Severe to 

exceptional 

Moderate 

& Less than 

moderate & Less than 

moderate 

Abnormally 

dry & At least moderate Or At least moderate 

Abnormally 

dry 

Normal 

& Less than 

moderate & Less than 

moderate 

Source: U.S. Drought Monitor (http://drought.uml.edu/dm) 

Regional Outlook 30 Fourth Quarter 2002 
Regional Perspectives
 

CHART 2 

Banks with Highest Loan Delinquencies
 

Clearly Show Drought’s Impact
 

5.0 Nonperforming Loan Ratio
 

of Farm Banks in Areas
 

4.5
 of Prolonged Drought 

Nonperforming 4.0 Loan Ratio of Farm 

Banks in Areas 3.5 Largely Unaffected 

by Drought 3.0 

2.5 

2.0 

June 2001 June 2002 

Note: Ratios shown are the 75th percentile figure for each group by year. 

Source: Bank Call Reports, farm banks only Percent 

greater weakening in asset quality than farm banks in 

areas that are largely unaffected by drought (nonshaded 

counties in Map 1). For example, delinquency rates are 

increasing more rapidly in areas that have experienced 

prolonged drought. The median nonperforming loan 

ratio of banks in areas of prolonged drought increased 

from 2.24 percent in June 2001 to 2.46 percent in June 

2002, while the median ratio for banks in areas largely 

unaffected by drought declined from 2.22 percent to 

2.04 percent. This disparity is even more pronounced 

among the worst performers in each group (see Chart 2). 

Examinations of insured institutions also note weakening credit quality among farm banks in areas of prolonged drought. Adversely classified assets as a share of 

capital are approximately 50 percent higher among farm 

banks headquartered in areas that have experienced prolonged drought conditions than in institutions in largely 

unaffected areas.5 

Although asset quality appears to be slipping, farm 

banks’ capital protection is near an historic high. The 

median leverage capital ratio of 9.9 percent as of June 30, 

2002, represents a slight 30 basis point decline over a 

two-year period. Moreover, the ratios of loan loss reserves 

to total loans and loan loss reserves to noncurrent loans 

remain high, at 1.65 percent and 122.73 percent, respectively. In fact, even after the recent period of prolonged 

drought, farm banks are better capitalized now than they 

were immediately before the last major drought in 1988. 

The median leverage capital ratio for the Region’s farm 

banks as of December 31, 1987, was 8.7 percent. 

Conclusion 

Farm incomes in the most drought-stricken areas are 

expected to be much lower than in previous years. The 

2002 farm bill enacted earlier this year does not provide 

relief for production losses, nor does it address the 

needs of livestock operators. Insured financial institutions and state lawmakers are lobbying for federal 

drought relief funds. Although there is uncertainty at 

this time about the specific provisions of any aid package, many observers expect that, should Congress pass 

a relief bill, funds would be made available for livestock 

and crop producers. 

Richard Cofer, Senior Financial Analyst 

Jeffrey W. Walser, Regional Economist 

5 Data are based on the examination ratio of adversely classified 

assets as a share of capital for examinations completed during the 

one-year period ending in September 2002. 

Regional Outlook 31 Fourth Quarter 2002 
Regional Perspectives Regional Perspectives
 

New York Regional Perspectives
 

Mid-Atlantic Perspectives1
 

Mid-Atlantic’s Job Growth Approximates the 

Nation’s, but Economic Uncertainty Clouds 

Outlook 

Since January 2001, the Mid-Atlantic’s employment 

trends have approximated the nation’s. However, employment growth among the Mid-Atlantic’s key industry drivers—financial services and manufacturing—has varied 

widely compared with national trends (see Chart 1).2 

CHART 1 Region Minus U.S. Change on Year-Ago, Three-Month Moving Average 

Region’s Job Growth Tracks Nation’s, but Growth 

in Finance, Insurance, and Real Estate (FIRE) 

Sector Is Weaker 

Source: Bureau of Labor Statistics. Data reflect difference between regional and 

national job growth through August 2002. U.S. data exclude Region. Above zero 

indicates Region's job change outperforms the nation; below zero indicates 

underperformance. 

Jan 

’01 

Mar 

’01 

May 

’01 

Jul 

’01 

Sep 

’01 

Nov 

’01 

Jan 

’02 

Mar 

’02 

May 

’02 

Jul 

’02 

FIRE 

Manufacturing 

Total 

–4% 

–3% 

–2% 

–1% 

0% 

1% 

2% 

3% 

Job growth in the Mid-Atlantic’s finance, insurance, and 

real estate (FIRE) sector has trailed the nation’s since 

March 2001 and has been negative since December 2001. 

Job losses are centered in New York City (the New York 

City metropolitan area has sustained among the nation’s 

highest rates of job loss in this sector) and New Jersey, 

and outweigh job growth in this sector elsewhere in the 

Mid-Atlantic. The FIRE sector fuels other key industries 

in the Mid-Atlantic, such as publishing and business 

services. Additionally, employees in this sector tend to be 

highly compensated, and as a result, layoffs and salary 

cuts have a significant downstream effect on the MidAtlantic’s economy. According to recent reports, Wall 

Street bonuses, often a significant component of total 

1 This article covers economic and banking conditions for insured 

institutions headquartered in Delaware, Maryland, New Jersey, New 

York, Pennsylvania, Washington, D.C., and Puerto Rico and the U.S. 

Virgin Islands. 

2 Employment growth data are year-over-year changes in three-month 

moving averages. U.S. data exclude the Mid-Atlantic Region as 

defined herein. 

compensation, could decline by at least 25 

wing a 30 percent 

acturing job losses in areas such as 

percent in 2002, follo

decline in 2001.3 

Overall, the rate of job loss in 

the Mid-Atlantic’s manufacturing sector has been less severe 

than the nation’s. The pace of 

job recovery in Buffalo and 

western Pennsylvania has been 

stronger than the nation, while 

manuf

Binghamton and Rochester, New York, Johnstown 

and Allentown, Pennsylvania, and Newark, New Jersey, 

have exceeded national trends. Because of their relatively strong concentration in high-tech manufacturing, 

Binghamton and Newark have been particularly hard hit 

by the downturn in telecommunications and technology-related industries. 

While the Mid-Atlantic’s labor markets have yet to gather 

momentum, several economic indicators suggest that economic recovery is under way. The Bank of TokyoMitsubishi/UBS Warburg U.S. Regional Retail Sales 

Survey for the Northeast, which tracks the level of retail 

sales for several of the Mid-Atlantic’s states, indicated that 

sales increased steadily from May 2002 through September 2002. In addition, a survey by Manpower Inc., which 

measures executives’ hiring plans and employment outlook, shows improvement since first quarter 2002, and the 

outlook for fourth quarter 2002 is for a net employment 

gain.4 A trend toward renewed growth in nondefense capital goods (excluding aircraft) expenditures on a yearover-year basis also suggests that the nation’s business 

sector may have improved in third quarter 2002, which 

would bode well for the Mid-Atlantic’s manufacturing 

sector.5 

Notwithstanding some favorable economic indications 

for the national and regional economies, vulnerabilities 

remain; many are associated with the potential for war in 

the Middle East, a possible disruption in the supply of oil, 

and increased financial market volatility. The economic 

3 Federal Reserve Board, Beige Book, October 23, 2002. Crain’s New
 

York Business, August 19–25, 2002, p. 1.
 4 Manpower Inc., Employment Outlook Survey Data for the Northeast,
 

All Industries, fourth quarter 2002.
 5 U.S. Department of Commerce, September 2002.
 

Regional Outlook 32 Fourth Quarter 2002 
Regional Perspectives Regional Perspectives
 

uncertainty that would arise from these developments 

could lead consumers and businesses to postpone economic decisions, which could weaken regional and 

national economic prospects. 

Mid-Atlantic’s Surge in Home Prices Feeds 

Speculation of a Potential “Housing Bubble” 

Fueled by record low mortgage rates and favorable 

demographics, single-family home prices around many 

of the Mid-Atlantic’s major metropolitan areas have 

soared over the past two years, often at double-digit rates 

and far in excess of income growth. Perhaps more significantly, in areas such as Bergen-Passaic, New Jersey, 

Nassau-Suffolk, New York, and around the District of 

Columbia, the pace of home price appreciation continued to rise through the first half of 2002, while easing 

slightly for the nation. 

Despite strong home price appreciation, some economists believe that a “housing bubble” may be avoided. 

While housing prices have increased sharply around 

some of the Mid-Atlantic’s major cities, the increase has 

been less than during the 1980s, when prices rose at 

double-digit rates for five to ten years. In addition, supplies of new homes in major metropolitan areas have 

been constrained by a lack of land, much of which was 

developed in the 1980s and 1990s. Housing demand in 

some of the Mid-Atlantic’s cities also has been supported by population growth in the 24-to-44 age bracket 

(those most likely to buy a first home) and increased 

immigration. As a result, although home prices in some 

areas may decrease, particularly if mortgage rates rise, 

prices are unlikely to drop sharply absent substantial 

declines in employment or income. 

Mid-Atlantic’s Office Markets Soften but 

Remain Better than a Decade Ago; 

Some Areas Warrant Monitoring 

Similar to national trends, during the past two years the 

Mid-Atlantic’s office market conditions weakened as a 

substantial amount of previously occupied space was 

sublet, which has contributed to higher vacancy levels 

and pressured office rents. In many of the Mid-Atlantic’s 

major metropolitan areas, sublet space represents approximately 20 to 30 percent of total vacant office space.6 

Even New York City, which lost 60 percent of downtown 

6 Torto Wheaton Research, Office Market Snapshot, Second Quarter 

2002. 

Manhattan’s Class A office space following September 11, has experienced a significant rise in vacancy rates 

and a moderate decline in rental rates.7 

Despite recent increases, vacancy rates in most of the 

Mid-Atlantic’s office markets were below the national 

average in second quarter 2002, and none of the MidAtlantic’s office markets have reached the peak vacancy 

levels experienced during the 1990–1991 recession. The 

relative lack of construction projects during much of the 

1990s may help the Mid-Atlantic weather the current 

downturn.8 Moreover, according to anecdotal reports, 

office construction starts declined during second quarter 2002 in several of the Mid-Atlantic’s larger markets, 

perhaps demonstrating better market discipline during 

this real estate cycle.9 Additionally, the rate of negative 

absorption (when space returned by existing tenants 

exceeds space occupied by new tenants) that characterized many of the Mid-Atlantic’s major office markets in 

2001 subsided in the first half of 2002. Nonetheless, 

some of the Mid-Atlantic’s office markets, primarily 

northern New Jersey and Baltimore, warrant monitoring, as demand for space has declined sharply while a 

moderate amount of new supply is projected for completion. Additional layoffs in key industries, including financial and business services and telecommunications, 

could further weaken office market demand. 

Sluggish Economic Environment May 

Challenge Banks Holding Higher 

Concentrations of CRE Loans 

Commercial real estate (CRE) loan quality reported by 

the Mid-Atlantic’s insured institutions has deteriorated 

only moderately during this economic downturn. The 

median percentage of delinquent CRE loans reported by 

the Mid-Atlantic’s insured institutions increased from 

.86 at year-end 2000 to 1.12 as of second quarter 2002 

7 TenantWise.com. “WTC Tenants Stabilize With 53 Percent Returning Downtown; However, Downtown Continues to Weaken With a 20 

Percent Availability Rate.” TenantWise.com. July 2002. 8 “The Region’s Commercial Real Estate Markets (CRE) Appear Better 

Positioned than a Decade Ago,” Regional Outlook, third quarter 2000. 9 “New Projects Grind to a Near Halt in San Francisco,” The Real Estate 

Journal, September 9, 2002. “A Look at Residential and Commercial 

Real Estate Markets,” The Federal Deposit Insurance Corporation Real 

Estate Study, September 19, 2002, also notes that the volume of speculative construction (nationwide) has been reduced from six months earlier. 

10 Ratios represent two-quarter moving averages of median CRE delinquency ratios. Delinquency is defined as loans 30 days or more past 

due or in nonaccrual status. Ratios are for institutions at least three 

years old and with CRE loans at least 10 percent of assets. 

Regional Outlook 33 Fourth Quarter 2002 
Regional Perspectives Regional Perspectives
 

and remained well below CRE delinquency rates experienced a decade ago.10 

However, institutions with high CRE loan exposure and 

those that increased CRE loan concentrations as the 

Mid-Atlantic’s office markets peaked may be more susceptible to credit quality weakness.11 In particular, institutions that made CRE loans that assume a continuation 

of high rents, low vacancy rates, and strong property 

cash flows could experience credit quality weakening if 

CRE market conditions remain soft for a prolonged 

period. Two-thirds of the Mid-Atlantic’s institutions that 

reported high and increasing CRE concentrations are 

headquartered in the Mid-Atlantic’s major metropolitan 

areas, each of which has experienced weaker CRE market conditions.12 One-third of the institutions that meet 

these criteria were chartered during the 1990s expansion and until recently had not experienced an economic slowdown. While capital ratios of the banks that have 

high and increasing CRE loan concentrations are lower 

on average than those of the Mid-Atlantic’s other institutions, their median ratio of loan loss reserves to delinquent loans is higher. 

Strong Housing Markets and a Steep Yield 

Curve Have Benefited Residential Lenders 

During this economic downturn, the Mid-Atlantic’s residential mortgage lenders13 have benefited from record 

mortgage originations and a relatively steep yield curve, 

and have experienced only slight credit quality weakening. After increasing slightly in 2001, the median pastdue ratio reported by residential lenders improved by 

second quarter 2002. Nevertheless, insured institutions 

with riskier mortgage loan portfolios, such as those 

11 Includes institutions that reported a ratio of CRE loans to Tier 1 

capital above the Region’s 75th percentile and those that reported an 

increase in the ratio of CRE loans to Tier 1 capital above the Region’s 

75th percentile during peak market conditions. The peak in market 

conditions is the time during which office vacancy rates were at the 

lowest point during the previous economic expansion (i.e., 1999 and 

2000). Of the Region’s 835 insured institutions, 127, or 15 percent, 

met the two criteria as of June 30, 2002. 

12 The Region’s major metropolitan areas are New York City, Philadelphia, Baltimore, Washington, D.C., and northern New Jersey. Northern New Jersey comprises the Bergen-Passaic, Jersey City, Newark, 

Middlesex-Hunterdon-Somerset, and Monmouth-Ocean metropolitan 

statistical areas. 

13 Residential mortgage lenders are insured institutions in operation at 

least three years with at least 50 percent of assets in residential mortgage loans and mortgage-backed securities. As of June 30, 2002, 246, 

or approximately 30 percent, of the Region’s institutions specialized 

in residential mortgage lending. 

involved in subprime lending, are susceptible to credit 

quality weakness, particularly should the economy deteriorate or home prices decline. 

Although the economic downturn has affected credit 

quality among residential lenders only moderately, 

changes in the level and steepness of the yield curve 

have affected net interest margins (NIMs) profoundly. 

Residential lenders typically fund short and lend long. 

As a result, the decline in long-term interest rates during the past two years, which has spurred strong 

demand for long-term, fixed-rate mortgages, has 

pushed asset yields lower. Since peaking in 2000, the 

median asset yield reported by the Mid-Atlantic’s residential lenders had declined by 110 basis points through 

second quarter 2002. During the same period, however, 

short-term market interest rates declined more than 

long-term rates, pushing down the median cost of funds 

by 137 basis points. As a result, four of every five of the 

Mid-Atlantic’s residential lenders reported a higher 

NIM in second quarter 2002 than a year ago. 

...But Challenges Lie Ahead 

With short-term market interest rates showing signs of 

stabilizing, the decline in banks’ cost of funds will likely slow. As indicated in Chart 2, the rate of decline in the 

cost of core deposits, which represent about 80 percent 

of the funding for the Mid-Atlantic’s residential lenders, 

may have bottomed. The median cost of time deposits, 

which responds more slowly to changes in market rates 

because of the time needed for these accounts to mature 

and reprice, continued to decline; however, the rate of 

CHART 2 

Quarterly Basis Point 

Change in Median Cost 

Source: Bank Call Reports (excludes thrift institutions). Data through 

second quarter 2002. 

30 

20 

10 

0 

–10 

–20 

–30 

–40 

–50 2Q97 1Q98 4Q98 3Q99 1Q01 4Q01 2Q00 

Time Deposits 

Savings Accounts 

Residential Lenders’ Core Deposit Costs 

May Have Bottomed 

Regional Outlook 34 Fourth Quarter 2002 
Regional Perspectives Regional Perspectives
 

decline has slowed. As a result, future margin improvement may be muted as core deposit costs approach a 

floor. 

The decline in long-term interest rates and flattening of 

the yield curve in third quarter 2002 also may limit future 

NIM improvement by residential lenders (see Chart 3). 

The large volume of mortgages originated at record low 

long-term rates could pressure loan yields, while 

increased prepayments on mortgage-backed securities 

could have a negative effect on yields earned on mortgage related investments. Nevertheless, the yield curve 

was steeper than its longer-term average (and steepened 

further at the start of the fourth quarter), which should 

keep NIMs from returning to lows reached in 2000. 

Moreover, fee income earned on new mortgages may 

somewhat mitigate the effect of lower yields on bank 

earnings. 

CHART 3 

Residential Lenders’ Interest Rate 

Risk Management May Be Tested 

Interest rate risk management by residential lenders 

likely will be tested following two years of substantial 

mortgage refinancings and shifting yield curve relationships. Evaluating a scenario in which deposit costs 

may be bottoming while loan yields have declined will 

be key to effective interest rate risk management. 

Assumptions used to determine the amount of deposit 

inflow and the sensitivity of deposit costs to market 

interest rates should be reviewed for reasonableness. 

Assumptions concerning loan prepayment activity 

also should be evaluated to help ensure that bank 

management receives accurate information about 

interest rate risk exposure. (Refer to New York 

Regional Outlook, second quarter 2002, for more 

information on interest rate risk among the MidAtlantic’s residential lenders.) 

Flattening Yield Curve May Limit Improvement in Residential Lenders’ Net Interest Margins (NIMs) 

Source: Bank and Thrift Call Reports. Banking data are through second quarter 2002. Excludes institutions in operation less than three years. Yield curve spread is the 

difference between the interest rate on ten-year U.S. Treasury and three-month U.S. Treasury. Yield curve spread data are through third quarter 2002. 

Yield Curve Spread in Basis Points (Left Axis) Median NIM Percentage (Right Axis) 

2.80 

3.00 

3.20 

3.40 

3.60 

1Q95 3Q95 1Q96 3Q96 1Q97 3Q97 1Q98 3Q98 1Q99 3Q99 1Q00 3Q00 1Q01 3Q01 1Q02 3Q02 

Seven-Year Average Spread 

–100 

0 

100 

200 

300 

400 

Regional Outlook 35 Fourth Quarter 2002 
Regional Perspectives
 

Large Banks’ Profitability Is Mixed; Credit Quality Remains a Concern 

The Mid-Atlantic’s large banks (those with total assets Noninterest income from investment banking business 

over $25 billion) reported mixed profitability results in lines, such as private equity, merger advisory, and tradthird quarter 2002. Most large banks reported increased ing activities, remained weak, and securities gains modloan loss provisions, reflecting concerns over corporate erated from 2001 levels. However, stable conditions in 

credit quality. Loan delinquency and charge-off rates securities servicing business and strength in consumer 

increased compared with second quarter 2002 and business lines, such as mortgage origination, bolstered 

remained well above year-ago levels.14 Credit quality dete- profitability of some of the Mid-Atlantic’s large banks. 

rioration was more significant for institutions with greater Historically low long-term interest rates spurred strong 

loan exposure to the telecommunications industry and demand for residential mortgage loans; however, mortArgentina, and expectations are for continued commercial gage demand may moderate should interest rates 

credit quality weakness through the remainder of this year. increase. Favorable performance in consumer business 

According to Moody’s Investor Service, the global default lines has helped offset weaker corporate performance. 

rate on speculative-grade bonds will continue to decline However, should economic weakness spread to the confrom 9.2 percent in September 2002 to 8.4 percent by the sumer sector, consumers and retail banking business 

end of this year. Moody’s, however, cautioned that corpo- lines may be affected negatively. 

rate quality remains under pressure and aggregate default 

rates will remain high in the near future.15 

14 15 Information on large bank performance (excluding credit card Moody’s Investor Service, Press Release: September Default 

banks) comes from company press releases for third quarter 2002. Report, October 18, 2002. 

New York Region Staff 

New England Perspectives
 

Weakness in the Technology and Financial 

Services Sectors Is Causing the Massachusetts 

Economy to Underperform Those of Other 

New England States 

The economic performance of each of the six New England states is quite disparate.1 The Rhode Island and 

Maine economies continue to perform relatively well, 

while nonfarm employment in Vermont and Connecticut dropped noticeably during the first nine months of 

2002 compared with a year ago. Economic conditions 

remain mixed in New Hampshire. 

Labor market conditions are weakest in Massachusetts; the state’s cumulative 2.7 percent job loss from its 

recent peak through September 2002 is more than double the peak-to-trough decline in the national economy 

during this recession. Similarly, the Massachusetts 

unemployment rate has risen and, at 5.2 percent in Sep1 See Boston Regional Outlook, third quarter 2002, for more on this 

topic. 

tember, was the highest among 

the New England states— 

although below the 5.6 percent national average. 

Much of the state’s continued economic weakness can 

be attributed to the national 

slump in business investment 

and information technology 

(IT) spending, as well as the 

bearish stock market. National 

payroll trends through September reflected continued 

deterioration in employment among securities and IT 

manufacturing and service firms (see Chart 1). Employees in these industries are more highly compensated and 

represent significant concentrations of employment in 

eastern Massachusetts and southern New Hampshire. 

Employment, income, and wealth derived directly or 

indirectly from the equity markets fuel economic 

growth in many parts of New England, particularly 

southwest Connecticut and greater Boston. As a result, 

the continued slump in U.S. equity markets likely has 

impeded New England’s economic growth this year. 

Regional Outlook 36 Fourth Quarter 2002 
Regional Perspectives Regional Perspectives
 

CHART 1 U.S. Employment Recent Peak = 100 

High-Paying U.S. Industries Continue to Cut Staff 

*IT = computer, electronics, and instrument manufacturing and computer and 

data processing services 

Source: Bureau of Labor Statistics 

105 

100 

85 

90 

95 

2001 2002 

Securities IT*

Communication 

Services 

Personal income growth also has been adversely affected by layoffs and pay cuts in New England’s highestpaying industries, as well as declines in the stock 

market. Chart 2 shows first-half data (latest available) 

on personal income and indicates that per capita income 

has probably suffered this year. Connecticut, Massachusetts, and New Hampshire—the three New England 

states with significant concentrations of jobs in IT and 

the stock market—could report the poorest per capita 

income performance in more than a decade once the 

tally is complete for 2002. 

Home Price Appreciation Is Abating 

Despite the recent recession, home sales, price appreciation, and new construction generally have performed 

CHART 2 Change from Year Ago (%) 

Source: Bureau of Economic Analysis and 2002 population growth estimates 

from the New England Economic Project 

Per Capita Personal Income Growth Slipped 

Significantly in Connecticut, Massachusetts, 

and New Hampshire in 2002 

95–00 avg 98–00 avg 

2002Q1–Q2 

U.S. Region CT MA ME NH RI VT 

–2 

0 

2 

4 

6 

8 

exceptionally well in most markets across the nation 

and in New England. However, recent home price gains, 

in many cases well in excess of income growth, have led 

to speculation about the existence of a home price “bubble,” implying that prices could soon decline significantly. At least in New England’s largest metro areas, 

this is currently not the case. In fact, the rate of price 

appreciation already has decelerated in several markets 

characterized by robust price increases in recent years. 

The Boston metropolitan statistical area (MSA) is a 

notable example. Should this trend continue, any price 

imbalances are likely to realign slowly, avoiding a sudden drop. An aggregate decline in home prices remains 

a modest risk, but it could become more significant if 

the current employment and income situation deteriorates further. Some smaller housing markets, characterized by robust price increases as well as rising supply, 

such as Portland, Maine, may be more vulnerable to a 

rapid deceleration (or possible decline) in home prices 

should weak economic conditions continue. 

The Commercial Real Estate 

Sector Has Yet to Recover 

New England’s commercial real estate markets continue 

to weaken as sublease space remains abundant and 

employment levels are slow to rebound. Markets appear 

to be hitting bottom; however, a recovery in this sector 

is not expected until 2003. According to Spaulding Slye 

Colliers, the Greater Boston office vacancy rate rose 5 

percentage points to 10.5 percent during the year ending 

second quarter 2002. The vacancy rate roughly doubles 

if the nearly 15 million square feet of available sublease 

space is included.2 The suburbs are the weakest market 

segment, with 25 percent of inventory on the market as 

of second quarter 2002. Also, during the past six quarters, office rents fell to 1999 levels. Continued layoffs 

and weak job growth could exacerbate current conditions, forestalling any recovery. However, the effects on 

insured institutions in the Boston MSA should be modest, because commercial real estate exposure relative to 

capital, although rising, remains low compared to the 

late 1980s. 

2 Spaulding Slye Colliers tracks vacant (direct space being actively 

marketed for occupancy) and sublease space separately. 

Regional Outlook 37 Fourth Quarter 2002 
Regional Perspectives Regional Perspectives
 

Credit Quality and Coverage 

Levels Remain Strong 

Credit quality among New England’s insured institutions has held up well. Increases in delinquency rates 

have been minor compared with the previous recession. 

While total loan delinquency rates remain modest as of 

second quarter 2002, some deterioration has been noted 

among larger banks (assets greater than $1 billion), 

which represent roughly 10 percent of insured institutions in New England. Following strong annual growth 

during the late 1990s, commercial loan growth tapered 

off overall among New England’s insured institutions 

during the past two years and remained modest at community institutions through second quarter 2002. Following marginal increases over the past year, 

commercial loan charge-offs remain low compared with 

those of the nation but may rise further should noncurrent loan volume continue to grow. Losses also grew in 

the consumer loan segment, particularly among credit 

card portfolios, during the year ending second quarter 

2002. Consumer loans represent a small share of New 

England’s insured institution portfolios.3 As a result, the 

effects of a weakening consumer sector on insured institutions will probably be muted. Allowance coverage of 

nonperforming loans remains strong throughout New 

England and should provide an adequate cushion in the 

near term if economic conditions worsen and credit 

quality deteriorates further. 

Interest Rate Risk Is Still a Concern 

Concentrations in mortgage-related assets, while bearing nominal credit risk, could heighten the level of 

interest rate risk for many of New England’s insured 

institutions. This concern was addressed in the Boston 

Regional Outlook (second quarter 2000 and first quarter 2002) and remains today. Rising levels of interest 

rate risk are particularly evident among small savings 

institutions (assets less than $1 billion), which represent 

nearly two-thirds of New England’s insured institutions. 

Large savings banks and commercial banks reflect similar exposures to interest rate risk, although not as pronounced because of lower levels of long-term, 

fixed-rate mortgage loans. 

The volume of long-term assets held by New England’s 

insured institutions, particularly small savings institu3 Consumer loans, which include credit card, other revolving credit, 

and installment loans, represent less than 6 percent of average loan 

portfolios in New England. 

tions, has increased steadily since the mid-1990s. The 

ratio of long-term assets to total earning assets rose 

from 23 percent to slightly over 40 percent between 

June 1995 and June 2002 in New England’s small savings institutions.4 During the same time, the ratio 

increased from 14 percent to 23 percent in New England’s commercial institutions and from 25 percent to 

29 percent in its large savings institutions. While growth 

of long-term assets moderated in 2000 after the refinancing boom of 1998, strong refinancing activity 

resumed in 2001 and continued into 2002, adding to 

concentrations of long-term fixed-rate assets. Through 

June 30, 2002, the nationwide refinancing index5 

reached relatively high levels, and adjustable-rate loans 

represented a low 16 percent of mortgage applications. 

Prepayment rates on the long-term assets booked during 

the low interest rate environment of the past few years 

will be low, especially when interest rates begin to rise. 

While balance sheets have shifted toward long-term 

assets, the liability side consists of relatively short-term 

instruments. As of the end of second quarter 2002, 74 

percent of time deposits held by New England’s small 

savings institutions were set to mature or reprice in one 

year or less. Nonmaturity deposits made up just over 45 

percent of interest-bearing liabilities, a number that has 

been on the rise for the past several years. When rates 

begin to rise, institutions are more likely to see deposits 

move to higher-yielding accounts, either in the institution or elsewhere, while assets are held in long-term, 

fixed-rate loans. As a result, institutions’ funding costs 

will rise. Without a similar rise in asset yields, margins 

and earnings could be affected adversely. 

Controlling funding costs when interest rates rise is 

challenging. The vast majority of time deposits are set 

to mature or reprice in less than one year, limiting the 

ability to control funding costs in a rising rate environment. Furthermore, nonmaturity deposit costs have 

been low since 1993, and overall deposit costs in New 

England typically have been lower than in other parts of 

the country. As a result, insured institutions will have 

difficulty retaining deposits if management tries to 

boost margins by lowering rates. Longer-term earnings 

are at risk if management practices do not reduce exposure to rising interest rates. 

Boston Staff 

4 Call Report filers only.
 

5 The Mortgage Bankers Association of America publishes the refinancing index. As of September 20, 2002, the index was 4607.5. The
 

benchmark is 100 as of March 16, 1990.
 

Regional Outlook 38 Fourth Quarter 2002 
Regional Perspectives Regional Perspectives
 

San Francisco Regional Perspectives
 

During 2002, the Region’s economy slowly recovered 

from the recession. Seasonally adjusted employment 

grew a meager 0.1 percent between year-end 2001 and 

August 2002. Most of the Region’s states reported sluggish to negative job growth during the first eight months 

of 2002; only four (Wyoming, Nevada, Montana, and 

Alaska) reported job growth exceeding 1 percent. Over 

the period, the manufacturing, transportation and public 

utilities, and construction sectors lost jobs, while the 

government and retail trade industries added jobs. 

Asset quality and earnings performance weakened 

among the Region’s insured institutions between mid2001 and mid-2002. This article discusses several 

additional factors that could pressure credit quality in 

the near term. High consumer debt service burdens 

and personal bankruptcy filing rates contributed to 

higher consumer loan losses and could continue to 

affect household credit quality adversely. Weak corporate sales and profits, which could be slow to improve, 

led to higher commercial loan delinquency ratios. 

Declining office employment and continued construction activity have pushed up office vacancy rates in 

most of the Region’s major markets during the past 

two years. High commercial real estate (CRE) loan 

exposures among the Region’s insured institutions 

increase their vulnerability to sustained weakness in 

CRE markets. 

CHART 1 

In addition, economic softness and 

interest rate declines have had a 

negative effect on earnings among 

some insured institutions. The 

second quarter 2002 median return 

on average assets (ROA) ratio for the 

Region’s insured institutions was 

1.08 percent, comparable to that 

reported by institutions elsewhere in the nation. However, 

earnings performance was 

uneven across institutions of various sizes and lending specialties. 

Personal Bankruptcies Aggravated 

Consumer Credit Quality Problems 

Nationally, the personal bankruptcy filing rate continued to climb this year, reaching a ten-year high during 

the second quarter. Personal bankruptcy trends were in 

part a reflection of near-record consumer debt service 

burdens. Utah and Nevada reported personal bankruptcy filing rates nearly twice the national average, 

and Idaho, Oregon, Washington, and Arizona also 

reported above-average rates. Similar trends were evident in residential foreclosures; Utah, Nevada, and 

Idaho reported rates higher than average for the 

Region and for the nation (see Chart 1). 

Note: Unlabeled points represent states outside the San Francisco Region. 

Sources: American Bankruptcy Institute; Mortgage Bankers Association of America 

Utah and Nevada Reported Two of the Highest Personal Bankruptcy and Foreclosure Rates in the Nation Number of Personal Filings/ 1,000 Households (12 Months Ending June 2002) 

Foreclosure Start Rate (Four-Quarter Average) 

0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 

NV UT

AZ 

WA ID 

OR 

HI 

WY 

CA 

AK 

MT Correlation = 0.72 

US 

0 

5 

10 

15 

20 

25 

30 

35 

Regional Outlook 39 Fourth Quarter 2002 
Regional Perspectives Regional Perspectives
 

Consumer loan1 delinquency and net charge-off ratios 

tracked trends in bankruptcy activity. The Region’s 

consumer lenders2 reported pronounced softening in 

asset quality. Among these institutions, the median 

past-due consumer loan ratio increased from 2.62 percent to 2.92 percent, and the median consumer loan 

net charge-off ratio rose significantly, from 1.46 percent to 2.05 percent between mid-2001 and mid-2002. 

Continued increases in household debt service burdens and bankruptcy rates, both within and outside the 

Region, could affect these institutions adversely, 

because they hold high consumer loan concentrations 

and often lend money on a broad geographic scale. In 

addition, some credit card lenders might be required to 

bolster loan loss reserves or adjust revenue recognition 

practices to conform to proposed guidelines for credit 

card account management and loss allowance.3 

Among the Region’s community institutions,4 the median past-due consumer loan ratio increased slightly from 

0.94 percent to 0.98 percent between June 2001 and 

June 2002. Delinquencies were highest among institutions headquartered in Utah and Montana, where median past-due consumer loan ratios topped 2 percent. 

Although increases in consumer loan delinquency were 

generally moderate, the median annualized consumer 

net charge-off ratio nearly doubled year-over-year, from 

0.10 to 0.18 percent. 

Unlike consumer loans, 1 to 4 family mortgage delinquency ratios did not rise uniformly across the Region. 

The Region’s past-due 1 to 4 family mortgage ratio 

declined from 0.81 percent to 0.69 percent between 

June 2001 and June 2002. However, community institutions headquartered in Washington, Alaska, Wyoming, 

and Nevada reported year-over-year delinquency 

increases. Robust refinancing activity during 2001 and 

2002 may have contributed to lower delinquencies in 

certain areas, allowing previously delinquent borrowers 

to restructure their debts. 

1 Consumer loans include credit cards and other non-real estatesecured loans to individuals. 

2 Consumer lenders include insured institutions with consumer loan to 

Tier 1 capital ratios exceeding 200 percent. 

3 For additional details, refer to the FFIEC Account Management and 

Loss Allowance guidelines issued for comment on July 22, 2002 

(http://www.ffiec.gov/PDF/pr072202_guidance.pdf). 4 Community institutions are defined as insured institutions in operation more than three years, with consumer loan-to-Tier 1 capital ratios 

below 200 percent and total assets of less than $1 billion. Industrial 

loan companies are excluded. Community institutions tend to be more 

geographically focused, and their performance may be more reflective 

of economic trends within a local market. 

Consumer and residential lenders could experience 

additional credit softening despite the Region’s economic recovery. Continued weak job creation (a “jobless recovery”) could limit households’ ability to sustain 

debt payments. Moreover, once the recovery takes hold, 

or should inflation fears return, future interest rate 

increases could raise household debt service burdens 

and dampen home price appreciation trends. Markets 

with already low housing affordability (e.g., several 

California metropolitan statistical areas (MSAs), 

including Salinas, Santa Barbara, San Luis Obispo, 

San Francisco, Santa Rosa, San Diego, and Orange 

County) could be susceptible to the effects of rising 

interest rates on home prices. The pool of potential buyers is limited in these markets because median family 

incomes are too low to finance median-priced homes. If 

interest rates rise, resulting in even higher debt service 

requirements, it is reasonable to expect home price 

appreciation to moderate.5 

Commercial and Industrial Credit Quality 

Softened Significantly among Large Institutions 

The Region’s larger institutions, in particular those 

holding more than $10 billion in total assets, reported 

pronounced deterioration in commercial and industrial 

(C&I) loan quality (see Chart 2). The recession-related 

squeeze on corporate profits and cash flows contributed 

to the trend. In addition, increasing stress in certain 

industries, such as telecommunications and high tech, 

CHART 2 

Note: Includes insured institutions in operation more than three years. 

Source: San Franciso Region Bank and Thrift Call Reports 

The Region’s Largest Institutions Reported the 

Highest Commercial Loan Delinquency Ratios Past-Due Commercial Loans/Total Commercial Loans (Median %)

$500 million–$1 billion 

< $500 million > $10 billion

$1–$10 billion 

Jun-90 

Jun-91 

Jun-92 

Jun-93 

Jun-94 

Jun-97 

Jun-98 

Jun-99 

Jun-00 

Jun-01 

Jun-02 

Jun-95 

Jun-96 

0 

1 

2 

3 

4 

5 

6 

7 

5 For additional information on housing affordability and residential 

real estate risks within the Region, refer to “San Francisco Regional 

Perspectives,” Regional Outlook, fourth quarter 2001 (http://www 

.fdic.gov/bank/analytical/regional/ro20014q/na/index.html). 

Regional Outlook 40 Fourth Quarter 2002 
Regional Perspectives Regional Perspectives
 

became evident in larger institutions’ syndicated loan 

exposures. 

The Region’s commercial lenders could continue to 

experience weakness in C&I portfolios until corporate 

earnings improve. While showing some improvement 

from year-earlier rates, U.S. corporate bond defaults 

remain near the levels experienced during the 

1990–1991 recession.6 Moodys expects corporate bond 

defaults to moderate through the remainder of 2002 but 

remain at relatively high levels, which could portend 

continued stress in C&I portfolios.7 

Rising Office Market Vacancy Rates Contributed 

to an Increase in Delinquencies in Some Areas 

By mid-2002, the Region’s office vacancy rates had 

risen substantially from year-earlier levels in almost all 

17 MSAs tracked by Torto Wheaton Research. The San 

Jose, San Francisco, Portland, Seattle, Sacramento, 

and Oakland MSAs experienced the greatest vacancy 

rate increases during the past year. Vacancy rates were 

between 8 and 12 percent in these markets in mid-2001; 

one year later, rates ranged from almost 13 to 19 percent. 

Second quarter 2002 vacancy rates in some markets 

topped levels reported during the early 1990s; however, 

CRE loan8 problems in the Region’s major MSAs 

remained relatively muted. Exceptions included community institutions headquartered in the Provo, Stockton, Salt Lake City, Cheyenne, Santa Rosa, and San 

Diego markets, where median CRE loan delinquency 

ratios exceeded those reported one year and ten years 

earlier. Although the median past-due CRE loan-to-total 

CRE loan ratio in each of these markets was below 2 

percent, loan quality deterioration is relevant, given the 

level and trend of concentrations in these markets. With 

the exception of Provo, the median CRE loan-to-Tier 1 

capital ratio exceeded 150 percent in each of these 

MSAs as of mid-year 2002, and CRE loan concentrations were up significantly from the early 1990s. 

6 Standard and Poors, “S&P Global Bond Markets’ Weakest Links &
 

Monthly Default Rate,” September 13, 2002 (http://www.standardand
 

poors.com/PressRoom/Ratings/Articles/091302_weakest.pdf).
 

7 Moodys, “Corporate Defaults Refuse to Yield in 2002,” Special
 

Comment, July 2002 (http://riskcalc.moodysrms.com/us/research/
 

defrate/Q202_comment.pdf).
 

8 Because this discussion focuses on office vacancy trends, CRE loan
 

data were limited to nonfarm-nonresidential-secured loans.
 

Although vacancy rate increases abated in more than half 

the Region’s office markets between the first and second 

quarters of 2002, Torto Wheaton forecasts continued 

vacancy increases in the Ventura, San Jose, Sacramento, 

Los Angeles, Seattle, and Portland MSAs through the 

first half of 2003.9 The median CRE loan-to-Tier 1 capital ratio among community institutions in these six markets exceeded 200 percent in mid-2002, double the ratio 

reported by MSA-based institutions elsewhere in the 

nation. Thus, lenders in these areas could be especially 

vulnerable to additional market softening. 

Weakening Asset Quality and Lower Interest 

Rates Resulted in Irregular Earnings Trends 

Although almost 90 percent of the Region’s 784 insured 

institutions were profitable through second quarter 

2002, earnings trends were uneven. The Region’s community banks10 reported slightly higher provision 

expense-to-average asset ratios and narrower net interest margins (NIMs). Between June 2001 and June 2002, 

the median year-to-date NIM among the Region’s community banks declined from 4.95 percent to 4.79 percent. Quarterly NIMs recovered somewhat in second 

quarter 2002. Banks appear to have stemmed declines in 

earning asset yields by diverting assets into higheryielding loans, in particular C&I and CRE credits. Such 

shifts might have introduced additional liquidity and 

credit risks, especially in light of lingering problems in 

the CRE sector. 

The effects of declining interest rates were more pronounced among community banks in the Region than in 

other areas of the nation, in part because of the structure 

of bank balance sheets in the West. Within the Region, 

the level of assets scheduled to reprice within one year 

tends to be high compared with the amount of liabilities 

scheduled to reprice in the near term. This mismatch 

likely relates to relatively high concentrations of C&I 

and CRE credits and lower investments in single-family 

mortgages. In general, C&I and CRE credits are structured on a short-term or variable-rate basis, whereas 

9 Torto Wheaton Research, Fall 2002 TWR Office Outlook. 10 Community banks are defined as insured commercial banks of all 

ages holding less than $1 billion in total assets. Net interest margins 

among these institutions tend to behave differently than those of 

thrifts, because commercial banks specialize in shorter-term commercial lending and are less reliant on wholesale borrowings. Community bank NIMs also tend to behave differently from large bank NIMs, 

because large banks are often more dependent on short-term, wholesale funding sources. 

Regional Outlook 41 Fourth Quarter 2002 
Regional Perspectives Regional Perspectives
 

one-to-four-family mortgages are typically longer term 

or fixed rate. 

Unlike community banks, savings institutions saw funding costs decline more quickly than asset yields; thus, the 

steeper yield curve boosted thrift NIMs and ROA ratios. 

However, sustained refinancing activity adversely affected fee income levels among some institutions. Onequarter of the Region’s thrifts that service mortgages for 

others reported servicing asset impairments sufficient to 

offset all servicing fee income.11 Such impairments could 

increase by year-end 2002, given very high mortgage prepayment speeds in the third quarter. Heavy refinancing 

activity and the popularity of fixed-rate and hybrid 

adjustable-rate mortgages during the period also might 

have increased concentrations of low-yielding long-term 

assets among thrifts. According to the Office of Thrift 

Supervision (OTS), the effective duration of assets and 

liabilities among thrifts in the OTS West Region grew 

between March 2001 and March 2002, and thrift assets 

continued to be supported by relatively shorter-term 

11 Per generally accepted accounting principles, one-time write-downs 

to mortgage servicing assets are netted against mortgage servicing fee 

income. 

CHART 3 

funding sources (see Chart 3).12 Should rates rise, new 

mortgages might not reprice in tandem with funding 

costs, thereby compressing thrift NIMs. 

Judy Plock, Senior Financial Analyst 

Note: Includes OTS-supervised thrifts in the OTS West Region (AK, AZ, CA, 

CO, HI, ID, MT, ND, NM, NV, OR, SD, UT, WA, WY, Guam, and Commonwealth of the Northern Mariana Islands). 

Sources: Office of Thrift Supervision (OTS) and Federal Reserve 

Effective Duration (Median Years) Percentage 

Low Long-Term Rates Prompted Asset and 

Liability Lengthening among Western Thrifts 

Assets 

1.0 

1.5 

2.0 

2.5 

6 

7 

8 

9 

Liabilities 

30-Year Mortgage 

Rate (right axis) 

1Q99 3Q99 1Q00 3Q00 1Q01 3Q01 1Q02 

12 Office of Thrift Supervision, The Quarterly Review of Interest Rate 

Risk, vol. 7, issue 1, first quarter 2002 (http://www.ots.treas.gov/docs/ 

11210.pdf). 

Regional Outlook 42 Fourth Quarter 2002 

✁
 

Subscription Form
 

To obtain a subscription to the FDIC Regional Outlook, please print or type the following information: 

Institution Name __________________________________________________________________________ 

Contact Person __________________________________________________________________________ 

Telephone __________________________________________________________________________ 

Street Address __________________________________________________________________________ 

City, State, Zip Code __________________________________________________________________________ 

Please fax or mail this order form to:	 FDIC Public Information Center 

801 17th Street, N.W., Room 100 

Washington, D.C. 20434 

Fax Number (202) 416-2076 

Federal Deposit Insurance Corporation

Washington, DC 20429-9990 

OFFICIAL BUSINESS 

PENALTY FOR PRIVATE USE, $300 

PRESORTED
 

STANDARD
 

MAIL
 

Postage &
 

Fees Paid
 

FDIC
 

Permit No. G-36