Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION FIRST QUARTER 2000 

FDIC
 

Chicago
 

Region
 

Division of
 

Insurance
 

Suzannah L. Susser,
 

Regional Manager
 

Joan D. Schneider,
 

Regional Economist
 

Michael Anas,
 

Senior Financial
 

Analyst
 

Ronald W. Sims, II,
 

Financial Analyst
 

In Focus This Quarter 

◆ Recent Trends Raise Concerns about the Future of Business Credit 

Quality—Commercial and industrial (C&I) lending is one of the largest and 

fastest-growing lending lines at insured institutions. Recent growth in C&I lending 

can be attributed to a strong U.S. economy, increased industrial merger activity, and 

a willingness of lenders to extend credit. While C&I credit quality remains relatively strong, signs of deterioration have recently begun appearing in C&I portfolios 

and in corporate bond defaults. These signs of weakness in commercial credit quality raise concerns because they are appearing during a period of economic strength. 

Business credit quality could deteriorate further in the event of an economic slowdown, higher interest rates, or a loosening of underwriting practices. See page 3. 

By Arlinda Sothoron, Alan Deaton 

◆ Local Industries in the Global Economy—The contribution of international trade to overall U.S. economic activity has been increasing for a number of 

years. Although the United States trades with many nations, most activity is concentrated in a few markets—Canada, Japan, and Mexico. Across a collection of 

industries, there is, however, considerable variation in both the level of exposure to 

export markets and the intensity of import competition.A number of industries are 

highly exposed to international markets, suggesting that economic conditions 

abroad are particularly important in any assessment of future revenue growth or 

profitability. See page 11. 

By Paul C. Bishop 

Regional Perspectives 

◆ Overview of Banking and Economic Conditions—The strength of the 

Region’s economy and health of its banks and thrifts are starting to exhibit some 

signs of weakening. Job growth in the Region has slowed and banks and thrifts 

have experienced modest deterioration in earnings, margins, and asset quality. See 

page 18. 

◆ Agricultural Concerns Are Centered in Illinois—A large number of 

banks with exposure to the farm sector are located in Illinois. Some Illinois agricultural banks’ balance sheets and earning statements reflect the financial strains 

experienced by crop farmers. See page 20. 

◆ Commercial and Industrial Loans Are Growing Rapidly—Growth in 

commercial and industrial (C&I) loans accelerated in the year ending September 

1999. Rapid C&I loan growth and the resulting increase in exposures raise concerns 

about how banks would fare should economic growth slow further. See page 22. 

◆ Rising Interest Rates May Dampen Profitability of Residential Real 

Estate Lenders—Residential real estate lenders’ profitability is being dampened 

by the past year’s interest rate increases, which slowed refinancing activity, led to 

higher shares of adjustable-rate mortgages, and contributed to slower growth in 

permits for new single-family homes. See page 25. 

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

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

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

geographic regions: 

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

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

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

Dallas Region (CO, NM, OK, TX)
 

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

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

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

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

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

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

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

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

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

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

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

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

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

the Federal Deposit Insurance Corporation. 

Chairman Donna Tanoue 

Director, Division of Insurance Arthur J. Murton 

Executive Editor George E. French 

Writer/Editor Kim E. Lowry 

Editors Lynn A. Nejezchleb 

Maureen E. Sweeney 

Richard A. Brown 

Steven E. Cunningham 

Ronald L. Spieker 

Publications Manager Teresa J. Franks 
In Focus This Quarter
 

Recent Trends Raise Concerns about the Future of
 

Business Credit Quality
 

•	 C&I loan portfolios have been growing rapidly 

during this economic expansion. 

•	 Indicators of weakening corporate credit quality 

have begun to appear, including higher C&I loan 

losses and rising corporate bond defaults. 

•	 The future of business credit quality will depend 

on the economy and on underwriting practices. 

Commercial and industrial (C&I) lending is one of the 

largest and fastest-growing segments of lending at 

insured institutions. As of the third quarter of 1999, 

C&I loans comprised 24 percent of total loans and 

leases held by FDIC-insured institutions, up from 21 

percent at the end of 1995. C&I loan portfolios have 

grown primarily because of strong loan demand driven 

by a long economic expansion during which the indebtedness on corporate balance sheets has expanded rapidly. Even as the economic expansion continues, C&I loan 

charge-offs have begun to trend upward, albeit from historically low levels. By some measures, banks and the 

financial markets appear to be assuming increased levels of risk that could lead to greater C&I loan losses 

when the economy eventually weakens. 

High rates of growth in commercial lending and weakening indicators of C&I credit quality raise concerns 

about the future of credit quality at insured institutions. 

This article examines the factors that have contributed 

to high C&I loan growth rates and discusses the drivers 

that will determine the direction of C&I credit quality in 

the future. While loan performance at insured institutions is relatively good at the present time, signs of deterioration and stress have begun to appear despite the 

continued strength of the domestic economy. The future 

of C&I credit quality will ultimately be determined by 

trends in underwriting and corporate debt levels, along 

with the performance of the U.S. economy. 

C&I Loan Growth Has Accelerated 

C&I loans held by FDIC-insured banks and thrifts grew 

by almost 9 percent during the 12 months ending in 

September 1999, down somewhat from a 13.4 percent 

rate of growth in 1998 (see Chart 1). By contrast, total 

CHART 1 

Commercial and Industrial (C&I) 

Loans Are Growing at a Faster Rate 

than Total Loans and Leases 

Loan Growth 

Rate (%) C&I Loans 

15 

10 

5 

0 

–5 

–10 

Note: 1999 data are annualized based on 3Q99 data. 

Source: FDIC Research Information System 

Total Loans 

and Leases 

’86 ’88 ’90 ’92 ’94 ’96 ’98 

loans and leases at insured institutions grew by only 7 

percent in the 12 months ending in September 1999. 

C&I loans accounted for approximately 29 percent of 

all net new loans booked during the 12 months ending 

in September 1999, while unfunded C&I loan commitments grew by approximately 17 percent to $1.6 trillion. 

Syndicated lending played a major role in C&I loan 

growth during the 1990s. As intense competition and a 

narrowing of financial institutions’ net interest margins 

have encouraged lenders to seek additional sources of 

revenue, larger institutions have become increasingly 

active as loan syndicators and as purchasers of syndicated credits. Syndicated loan volume reached its peak 

in 1997, when originations totaled some $1.1 trillion 

(see Chart 2, next page).1 After falling off in 1998, originations of syndicated loans rose by 17 percent in 1999 

to just over $1.0 trillion. Leveraged loans, in which the 

borrower’s debt-to-equity ratio is significantly higher 

than the industry average, served as a catalyst for syndicated lending growth in 1999, accounting for 32 percent of total syndicated loan originations. Leveraged 

lending is very attractive to lending institutions because 

of the generous fee income associated with leveraged 

originations. Leveraged loan originations grew to $320 

billion in 1999, partly because of the continued rapid 

pace of corporate mergers in 1999.2 

1 LPC Gold Sheets, Vol. XIV, No. 1. Loan Pricing Corporation.
 

January 10, 2000.
 

2 According to Houlihan Lokey’s Mergerstat, total M&A activity set
 

a new record of $1.4 trillion in merger deal value in 1999.
 

Chicago Regional Outlook 3	 First Quarter 2000 
In Focus This Quarter
 

Most of the C&I loan growth among insured institutions 

since 1997 has been concentrated in loans to domestic 

borrowers. C&I loans held in foreign offices declined 

following the Asian economic crisis and the Russian 

government bond default in 1997 and 1998, respectively, while domestic C&I lending was growing at doubledigit rates. During the 12 months ending in September 

1999, C&I loans held in domestic offices grew 12.2 

percent while C&I loans held in foreign offices 

declined by almost 6 percent. 

Is This Rapid Loan Growth a Cause 

for Concern? 

The effect of rapid loan growth on subsequent credit 

quality has been the subject of a number of articles. A 

recent study by the Federal Reserve Bank of Kansas 

City found that high rates of loan growth in the early 

1980s and early 1990s appeared to be positively correlated with future higher loss rates.3 The study also noted, 

however, that relatively high loan growth rates in the 

late 1980s did not result in sharply higher loss rates. 

Another study by the Federal Deposit Insurance Corporation found that banks that failed during the banking 

crisis of the 1980s were generally more likely to have 

grown their loan portfolios aggressively than banks that 

did not fail.4 But it remains to be seen whether the high 

C&I loan growth rates of today will necessarily contribute to higher losses for insured institutions in the 

future. The future course of industry loan losses 

depends on many factors, including the condition of the 

economy, the interest rate environment, and underwriting standards used in originating C&I credits. 

The Condition of the Economy 

Is an Important Driver of C&I Loan Growth 

Recent economic conditions have been particularly 

conducive to rapid growth in domestic C&I lending. 

Business investment has expanded at double-digit 

annual rates as firms have invested in new technologies 

to raise productivity and keep costs down. These productivity gains have been instrumental in allowing the 

3 William R. Keeton. “Does Faster Loan Growth Lead to Higher Loan
 

Losses?” Economic Review. Federal Reserve Bank of Kansas City.
 

Second quarter 1999. 


4 Federal Deposit Insurance Corporation, Division of Research and
 

Statistics. History of the Eighties: Lessons for the Future. Vol. 1, An
 

Examination of the Banking Crises of the 1980s and Early 1990s.
 

1997. http://www.fdic.gov/bank/historical/history/contents.html.
 

CHART 2 

Syndicated Loan Originations Rebounded 

in 1999 after Falling from Record Levels 

Source: Loan Pricing Corporation 

Syndicated Loan Originations

 ($ Billions) 

0 

200 

400 

600 

800 

1,000 

1,200 

’95 ’96 ’97 ’98 ’99 

economy to grow at a relatively rapid pace with low 

inflation. Strong growth in real wages has helped boost 

the consumer confidence index to an all-time high of 

144 in January 2000. Robust consumer demand for 

goods and services has kept business profits growing, 

further spurring business borrowing to finance inventories, new construction, and fixed assets such as computer networks. Amid all of these favorable trends, C&I 

loan charge-off rates have remained at record lows of 

less than 0.5 percent since 1994. Recently, however, 

despite a continuation of generally favorable conditions 

in the economy and the financial markets, signs of credit quality deterioration have begun to appear in C&I 

loan portfolios. 

Evidence from Financial Institutions Points 

to a Weakening in Business Credit Quality 

Despite strong business conditions and generally good 

asset quality, signs of deterioration in C&I credit quality have begun to appear in bank portfolios. While problem C&I loan levels remain low by historical standards, 

net C&I loan charge-offs during the 12 months ending 

in September 1999 were 63 percent higher than during 

the previous 12-month period. The net C&I loan chargeoff rate rose in the 12 months ending in September 1999 

to 0.5 percent, up from 0.3 percent one year earlier. 

Similarly, noncurrent C&I loans as of September 1999 

rose to $11.2 billion, or 1.2 percent of total C&I loans.5 

In dollar terms, this level of noncurrent loans is 30 percent higher than one year earlier. 

5 Noncurrent C&I loans include C&I loans past-due over 90 days and 

all C&I loans in nonaccrual status. 

Chicago Regional Outlook 4 First Quarter 2000 
In Focus This Quarter
 

Despite these increases in C&I charge-offs and noncurrent C&I loans, the current industry ratios for these measures remain well below the 1.9 percent and 4.5 percent 

ratios reported during the recession in 1991 for net C&I 

charge-offs and noncurrent C&I loans, respectively. 

Interagency Loan Review Reveals Increases 

in Problem Credits from Previously Low Levels 

The results of the 1999 Shared National Credit (SNC) 

review provide another indication of slipping credit 

quality at large commercial banks.6 According to the 

Federal Reserve Board of Governors, adversely classified syndicated loans rose to $37.4 billion in the 1999 

review, a level approximately 70 percent higher than that 

reported in 1998. This figure represents 2 percent of the 

$1.8 trillion in drawn and undrawn loan commitments 

reviewed in 1999. By contrast, adversely classified 

assets identified in the 1998 SNC review totaled only 

$22 billion, or 1.3 percent of loans reviewed in 1998.7 

While the level of adversely classified syndicated loans 

remains low, 14 percent of the loans adversely classified 

during the 1999 review were loans made to new borrowers since the 1998 SNC review. In reference to this 

finding, Office of the Comptroller of the Currency 

(OCC) First Senior Deputy Comptroller and Chief 

Counsel Julie Williams has noted that “Banks are booking new loans that are weak at their inception.”8 The 

high rate of adversely classified new loans could be 

attributable to the continued effects of loan originations 

made toward the end of a period of loosened underwriting standards in 1997 and early 1998. Alternatively, it 

could indicate a higher-risk credit mix in current C&I 

loan portfolios. 

Signs of corporate stress that may weaken credit quality at insured institutions are also reflected in recent 

Banc of America Securities analysis of publicly available bank loan amendments.9 This study shows a significant increase in the number of loan amendments 

6 The annual interagency process reviews commercial loans over 

$20 million that are shared by three or more participants. 

7 Federal Reserve Board Press Release. November 10, 1999. 

8 “OCC’s Williams Warns of Credit Risk in the Banking System; Calls 

for Bankers to Scrutinize Loan Portfolios More Closely.” OCC Press 

Release. October 5, 1999. 

9 “Leveraged Loans: The Plot Thickens.” Banc of America Securities 

Syndicated Finance Research. November 15, 1999. This loan amendment analysis was completed using only publicly available information 

from Loan Pricing Corporation and Banc of America Securities LLC. 

generated because of covenant relief requests, from 22 

percent of all loan amendments during the last six 

months of 1998 to 45 percent during the first ten 

months of 1999. 

Corporate Bond Defaults Soared in 1999 

Trends in corporate bond defaults also indicate increasing levels of stress in the corporate sector. During 1999, 

147 issuers defaulted on $44.6 billion in long-term debt. 

Default rates as a percentage of volumes outstanding (or 

dollar default rates) have trended upward each year 

since 1996, reaching 2.2 percent for all corporate issues 

at year-end 1999. Much of the increase can be attributed 

to a rising dollar default rate for speculative-grade 

issues, which peaked in November 1999 at 8.2 percent. 

Measured as a percentage of all issuers, the default rate 

for speculative-grade issues rose to a post-1991 high of 

6 percent in September 1999 (see Chart 3). According 

to Moody’s, year-end 1999 default rates improved marginally but are expected to remain high through mid2000.10 In addition, domestic speculative-grade issuers 

reported twice as many issuer downgrades as upgrades 

during the fourth quarter of 1999, although the dollar 

volume of upgrades exceeded the dollar volume of 

downgrades by 55 percent.11 

10 “Corporate Bond Default Rates Highest Since 1991.” Moody’s
 

Investors Service. October 13, 1999.
 

11 “Moody’s Default Rate Pendulum.” Moody’s October 1999 Commentary. Moody’s Investors Service. October 18, 1999.
 

CHART 3 

The Default Rate on Corporate Bonds Has
 

Been Driven by Defaults on Speculative Issues
 

Issuer-Weighted 

Default Rate (%) 

15 All Corporate Issues 

10 

5 

0 

Speculative Issues 

Dec ’89 Dec ’91 Dec ’93 Dec ’95 Dec ’97 Dec ’99 

Source: Moody’s Investors Service 

Chicago Regional Outlook 5 First Quarter 2000 
In Focus This Quarter
 

Why Are C&I Loan Losses Increasing 

Amid Strong Economic Growth? 

Several factors have contributed to the current signs of 

deterioration of C&I credit quality in an environment of 

favorable business conditions. These factors include 

global competition and deflationary pressures, an 

increase in corporate debt levels, loosened underwriting 

standards, and a greater appetite for risk. 

Global competition and deflationary pressures 

have squeezed revenues. An era of low inflation and 

intense global price competition has contributed to low 

or negative revenue growth in a number of domestic 

industry sectors, particularly commodities and manufacturing.12 The result has been an increase in loan 

losses and corporate bond defaults in these sectors. 

Moody’s noted that the industrial sector, weakened by 

low commodity prices, accounted for 64 percent of all 

defaults in 1999, with the oil and gas, steel, and shipping industries being especially hard-hit.13 For example, 

Standard & Poor’s (S&P) reports that third-quarter 

1999 earnings for the iron and steel sector declined 80 

percent from one year earlier after five consecutive 

quarters of negative year-over-year earnings growth. 

Initially, commodity price declines and the international economic turmoil in 1997 and 1998 resulted in 

slowed foreign C&I lending and increased net losses of 

C&I loans held in foreign offices. These losses accounted for the majority of net C&I loan losses in 1997 and 

1998. However, this adverse trend reversed itself in 

1999, when C&I loans held in domestic offices 

accounted for the majority of losses. 

Corporations are increasingly reliant on debt markets. Increasing levels of debt on corporate balance 

sheets have helped to foster C&I loan growth. The 

growth in corporate debt is partially a result of actions 

taken by firms to improve operating efficiency, including increasing merger and acquisition (M&A) activity 

and rising spending on fixed investments. Capital 

expenditures on fixed investments by businesses have 

increased at a steady rate since the 1990–91 recession, 

as evidenced by Chart 4. Cash flow has also been 

increasing, but at a slower rate, resulting in a growing 

“financing gap” that reached an annualized level of 

12 See also Richard A. Brown and Alan Deaton. “Falling Prices in
 

Commodities and Manufacturing Pose Continuing Risks to Credit
 

Quality.” Regional Outlook, third quarter 1999. http://www.fdic.gov/
 

bank/analytical/regional/ro19993q/na/t3q1999.pdf.
 

13 “Historical Default Rates of Corporate Bond Issuers, 1920–1999.”
 

Moody’s Investors Service, January 2000.
 

CHART 4 

The Financing Gap Has Widened

 for Nonfinancial Corporations 

$ Billions “Financing Gap” 

900 

700 

500 

300 

100 

Capital Expenditures Cash Flow 

’80 ’82 ’84 ’86 ’88 ’90 ’92 ’94 ’96 ’98 

Note: 1999 data are annualized based on 3Q99 data. 

Source: Federal Reserve Board (Haver Analytics) 

$142 billion in the third quarter of 1999. Where cash 

flow has not been available to finance investment, firms 

have turned primarily to debt financing as opposed to 

equity financing. Net new corporate equity issues by 

nonfarm nonfinancial corporations have been negative 

in each year since 1993, while net new corporate bond 

issuance has increased from $75 billion in 1993 to $219 

billion in 1998. 

Loosened underwriting standards in 1997 and early 

1998 are contributing to current losses. Signs of 

stress in C&I loan portfolios can be partially attributed 

to loosened underwriting standards in 1997 and early 

1998. During 1997 and early 1998, loan underwriting 

standards loosened, accompanied by reduced spreads 

and pricing. In May 1998, the Federal Reserve Board 

Senior Loan Officer Opinion Survey on Bank Lending Practices reported that domestic banks were “generally eager to make loans to businesses” and that 

during early 1998 “a large percentage cut their spreads 

on such loans.” Moody’s describes the second half of the 

1990s as a “mini credit cycle.” The cycle began in 1995, 

when the strong economy, accompanied by falling interest rates and low loan losses and default rates, encouraged investor demand for high-yield bonds and loans.14 

A record number of first-time speculative-grade deals 

were also brought to market during 1997 and early 

1998. The increase in the volume of issuance was itself 

enough to push the default rate lower, which in turn may 

have fueled investor demand for additional high-risk 

bonds. However, the Asian crisis during 1997 and the 

Russian debt default during the second half of 1998 

14 “Default Rate Pendulum.” October 18, 1999. 

Chicago Regional Outlook 6 First Quarter 2000 
In Focus This Quarter
 

caused new issuance of speculative-grade bonds to slow 

significantly while defaults rose sharply, to a rate of 6 

percent by issuer in September 1999. While speculativegrade bond issuance declined, banks stepped in to fill 

the void by raising originations of highly leveraged 

loans between second-quarter 1998 and fourth-quarter 

1999.15 

Financial markets have evidenced greater risk 

appetite. While the ratio of speculative-grade bond 

issues to total corporate bond issues has remained fairly stable at approximately 40 percent during the past 

decade, the composition of borrowings has shifted substantially. Moody’s reports a shift in the distribution of 

bond issue ratings within the speculative-grade category toward the lower end of the ratings scale (see Chart 

5).16 Evidence of this shift is demonstrated by the fact 

that bonds rated B3 or lower currently comprise approximately 35 percent of all speculative-grade issues, a 

record high and up from 24 percent in 1995.17 Furthermore, almost 50 percent of the issuers that defaulted 

during the year ending September 1999 were rated for 

three years or less.18 This change in the composition of 

ratings has contributed to the current increase in speculative-grade defaults and could affect the future volatility and liquidity of the market. The current high volume 

of corporate bond defaults reflects the looser standards 

in 1997 and 1998 for corporate debt issued by low-rated 

first-time issuers, who accounted for 40 percent of rated 

15 LPC Gold Sheets. January 10, 2000.
 16 Moody’s January 2000 Commentary. January 18, 2000.
 

17 “Refunding Risk for Speculative Grade Borrowers.” Moody’s Special Comment. Moody’s Investors Service. December 15, 1999.
 

18 “Default Rate Pendulum.” October 18, 1999.
 

CHART 5 

bond defaults in 1999.19 This relationship is analogous 

to the current increase in net C&I charge-offs partially 

attributable to weakened underwriting standards in 

1997 and early 1998. 

The Increase in Leveraged Lending Could 

Result in a Riskier Mix in C&I Loan Portfolios 

Leveraged lending comprises an important part of the 

syndicated lending market and generates considerable 

fee income for financial institutions. Leveraged loans 

have grown from 12 percent of total syndicated loan 

originations in 1995 to 32 percent in 1999 (see Chart 6, 

next page). Leveraged syndicated loan originations grew 

19 percent to $320 billion in 1999, as investors were 

seeking higher risk-adjusted returns and lenders were 

seeking higher fees. Paine Webber analysts estimate that 

leveraged lending accounts for over 80 percent of syndicated loan fees and profits earned by loan underwriters.20 

Highly leveraged lending increased to a new record of 

$190 billion in 1999.21 This growth in loan originations 

reflects the current high corporate demand for loans, and 

by definition these loans are being made to borrowers 

with higher-than-normal levels of financial leverage and 

risk. In return for their higher risk profile, leveraged borrowers must compensate financial institutions through 

higher pricing and higher fees. 

19 Moody’s January 2000 Commentary. January 18, 2000.
 

20 “The Biggest Secret of Wall Street.” Paine Webber Equity Research.
 

May 14, 1999.
 

21 Loan Pricing Corporation defines highly leveraged loans as those
 

for which pricing exceeds 250 basis points over LIBOR and generally involves sub-investment-grade credits.
 

The Composition of the Rated Bond Market Has Shifted

 toward the Lower Part of the Speculative-Grade Issues 

Distribution of Issuer Ratings 

as a Percentage of Total Issuers 

Note: Unrated issues of corporate debt fall below the speculative-grade “C” rating. 

Source: Moody's Investors Service 

Aaa Aa1 Aa2 Aa3 A1 A2 A3 Baa1 Baa2 Baa3 Ba1 Ba2 Ba3 B1 B2 B3 Caa1 Caa2 Caa3 Ca C 

Moody’s Bond Ratings 

January 1998 January 2000 

Investment-Grade Ratings Speculative-Grade Ratings 

0 

2 

4 

6 

8 

10 

12 

Chicago Regional Outlook 7 First Quarter 2000 
In Focus This Quarter
 

CHART 6 

$ Billions As a Percentage of 

Total Syndicated Loans 

Loans to Leveraged Companies Represent 

a Greater Portion of Syndicated Loans 

Originations of Syndicated Loans to Leveraged Companies 

Note: 1999 data are annualized based on 3Q99 data. 

Source: Loan Pricing Corporation 

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

400 

0 

100 

200 

300 

40 

0 

10 

20 

30 

Leveraged lending volumes have recently been partially 

driven by M&A lending, which comprised over 30 percent of the total syndicated loan market in 1999. M&A 

activity approached $1.4 trillion in total volume during 

1999, increasing the demand for capital and driving corporations to the loan market.22 Approximately 22 percent of leveraged loans originated in 1998 were to the 

media and telecommunications industries, which have 

experienced significant levels of M&A activity.23 Leveraged buyout activity contributed an additional 15 percent to leveraged lending volumes, surpassing 1998 

levels in quantity. 

Where Is Business Credit Quality Heading? 

The future direction of business credit quality will be 

influenced by several factors, including the condition of 

the economy, growth in the indebtedness of corporate 

borrowers, exposure to vulnerable industry sectors, the 

interest rate environment, the development of emerging 

markets, and underwriting standards. 

Economic growth will remain an important determinant of credit quality. Should economic growth slow 

and corporate profits decline, the demand for C&I loans 

is likely to fall, and problem asset levels are likely to 

rise. A recent S&P survey of global credit conditions 

noted that excessive credit, attributable to unsustainable 

corporate indebtedness and falling asset values, has 

weakened the financial systems of 20 nations. As for 

credit expansion in the United States, the survey noted 

22 Houlihan Lokey’s Mergerstat. www.mergerstat.com. 23 “The Biggest Secret of Wall Street.” May 14, 1999. 

that the ratio of private sector loans outstanding to gross 

domestic product rose from 101 percent in 1995 to 142 

percent in 1999. S&P also noted evidence that banks’ 

C&I loan portfolios may be relying too heavily on loan 

repayments based on projections that are realizable only 

if the current economic expansion continues. S&P estimates that 5 to 15 percent of bank loans could default 

should the United States experience a significant downturn in the stock market leading to a hard landing for the 

domestic economy.24 

Continued growth in corporate indebtedness could 

contribute to increased losses and defaults. The 

growth rate of corporate debt has surpassed the growth 

rate of the economy in each year since 1994. A widening financing gap and increasing debt levels could pose 

problems if there are adverse changes in the interest rate 

environment or if corporate revenue growth slows. Rising rates will increase the costs of servicing debt, while 

a slowdown in revenue growth would reduce the cash 

flow available to service outstanding debt. Under such a 

scenario, business bankruptcies and failures are likely 

to rise, causing increased loan losses and bond defaults. 

Lending to some industries involves high-risk exposures. Despite the strength of the U.S. economy, some 

domestic industries are continuing to experience stress. 

Exposures to weakened industry sectors, such as health 

care and oil and gas, could negatively affect C&I credit 

quality at insured institutions. One way to evaluate the 

relative riskiness of firms operating in a given industry 

is through KMV Corporation’s® Expected Default FrequencyTM (EDFTM) analysis. KMV Corporation® has 

developed a proprietary method of measuring the 

degree of credit risk inherent in corporate borrowers by 

calculating an EDFTM score to estimate the probability 

that a firm will default on its obligations within one 

year.25 Chart 7 diagrams syndicated loan exposures 

along with December 1999 EDFTM scores and the direction of change since December 1998. This chart illustrates one measure of the risk associated with the 10 

industry sectors having the highest expected default 

24 “Global Financial System Stress: The Weak, the Vulnerable, and 

Those Limping Toward Recovery.” Standard & Poor’s. December 17, 

1999. 

25 KMV’s® proprietary calculation for EDFTM is based on (1) the current market value of the firm, (2) the structure of the firm’s current 

obligations, and (3) the vulnerability of the firm to large changes in 

market value. Multiplying industry originations by median industry 

EDFTM scores provides an estimate of expected default volumes. This 

figure provides a more meaningful measure of aggregate lending risk 

exposure than pure origination volumes alone and can be used to rank 

industry exposures. 

Chicago Regional Outlook 8 First Quarter 2000 
 

In Focus This Quarter
 

volume based on the volume of 1999 syndicated loan 

originations. In 1999, loans originated to mortgage 

lenders (including subprime lenders), communications 

firms, oil and gas firms, health care firms, and retail 

trade organizations generated the five highest expected 

default volumes among 50 broad industry sector classifications. 

The interest rate environment and refunding risk 

affect the demand for and availability of credit. 

Declining interest yield spreads from 1996 to 1998 

benefited borrowers. As spreads declined, the rate of 

syndicated loan growth increased and refinancing 

activity was high. Increases in spreads since 1998, 

along with higher interest rates, have caused refinancing activity to slow significantly. However, rising rates 

have not significantly affected origination volumes, as 

new debt continues to come into the market. Rising 

interest rates and refunding risk particularly affect 

speculative-grade borrowers. Higher interest rates 

would raise businesses’ cost of borrowing, potentially 

decreasing the demand for business credit and impairing borrowers’ ability to repay their debts. Once a corporation’s debt service ability is compromised, access 

to new capital markets can become limited. A sharp 

rise in interest rates would particularly impair the ability of highly leveraged firms to repay floating-rate debt 

obligations. 

Refunding risk continues to be a concern for speculative-grade borrowers as they face potential problems 

refinancing the maturing portions of long-term debt. 

The current tightening of terms in the C&I market and 

increasing default rates heighten refunding risk to borrowers. Rising interest rates or limited access to secondary markets could also increase refunding risk. This 

situation could continue to be problematic, since a rising volume of speculative-grade borrowings, consisting 

largely of unsecured bank debt, matures in 2001 and 

2002. Specifically, $64 billion in speculative-grade debt 

matures in 2001 and 2002, and approximately 63 percent of the debt is unsecured.26 

Potential growth in new markets presents both 

opportunities and challenges. The Internet and European syndicated loan markets represent both future 

potential growth areas and possible sources of credit 

risk for C&I lenders. The Internet has introduced large 

new markets to the loan and bond markets and has 

26 “Refunding Risk for Speculative Grade Borrowers.” December 15, 

1999. 

CHART 7 

Lending to Some Industries May 

Involve Higher Risk Exposures 

Change in Expected Default FrequencyTM (EDFTM) 

for the 12 Months Ending in December 1999 

6 

8 

–2 0 2 4 6 8 10 12 14 16 18 20

 EDFTM as of December 1999 

1 

2 4 5

3 

6 

7 

9 

10 

4 

2 

0 

–2 

Industry Name and Origination Dollars in Billions:

 1. Communication Services - $234.6

 2. Motor Vehicles and Parts - $133.1

 3. Chemicals and Drugs - $96.1

 4. Retail Trade - $92.1

 5. Wholesale Trade - $46.5

 6. Health Care Services - $42.3

 7. Oil & Gas Extraction - $41.8

 8. Entertainment - $33.5

 9. Mortgage Lenders and Mortage-Backed Securities - $20.2 

10. Hotels & Lodging Services - $20.2 

Note: Data and bubble size represent total syndicated loan originations
 

for the year ending 1999.
 

Sources: Securities Data Corporation; KMV Credit Monitor®
 

increased market efficiency. The “Internet economy” 

grew 68 percent from the first quarter of 1998 to the 

first quarter of 1999, with annual revenue expected to 

exceed $500 billion in 1999.27 Internet technology has 

improved the efficiency of the syndicated loan markets, 

with recent changes including the development of public price reporting, credit ratings, and Internet sites for 

online trading.28 Increased levels of credit risk could 

result from the volatility of Internet stock prices and the 

competitive disadvantage faced by firms that do not 

have an Internet presence but must compete against 

firms that do. 

While the majority of syndicated loan financing currently occurs in the United States, analysts predict that 

syndicated lending activity in Europe will accelerate 

significantly because of increased cross-border competition generated by the introduction of the euro and new 

financing needs. In addition, the European high-yield 

bond market is still developing but produced $6.8 billion of volume in the third quarter of 1999, or 61 per27 “Internet Indicators.” The Center for Research in Electronic Commerce at the University of Texas Graduate School of Business. October 27, 1999. 

28 “Syndicated Loan Market Soars as Efficiency Increases.” The Wall 

Street Journal. December 6, 1999. 

Chicago Regional Outlook 9 First Quarter 2000 
In Focus This Quarter
 

cent of the total market.29 Domestic lenders have begun 

to compete for this market but face credit risks because 

the European markets also pose sovereign and foreign 

exchange risk. 

Underwriting Remains the Key to Assessing 

C&I Credit Quality 

The August 1999 OCC Survey of Credit Underwriting 

Practices reported some tightening of commercial loan 

underwriting standards. However, loan officers also 

reported increased embedded risks in commercial loan 

portfolios for the fifth consecutive year. Survey respondents attributed the increased risks to weakened underwriting standards in previous years. The November 

1999 Federal Reserve Board Senior Loan Officer 

Opinion Survey on Bank Lending Practices found that 

30 percent of domestic banks reported increasing risk 

premiums, credit line costs, and loan spreads during the 

preceding three months. Loan 

officers cited an uncertain or 

unfavorable economic outlook, 

an expected worsening of industry-specific problems, and a 

reduced tolerance for risk as reasons for tightening C&I lending 

standards. 

Despite signs of tightening underwriting standards, the 

mix of credits appears to be riskier than in recent times. 

The OCC issued an advisory to banks in May 1999 

warning of potential problems with leveraged lending. 

The OCC stated that highly leveraged corporations 

could be particularly vulnerable to economic weakness 

and may not be able to compete effectively in a rising 

29 LPC Gold Sheets, Vol. XII, No. 44. Loan Pricing Corporation. 

November 15, 1999. 

interest rate environment. The OCC also addressed 

reliance on enterprise value loans, which are often used 

to support leveraged lending. Enterprise values are calculations based on projections of the future income of a 

firm. If such estimates are overly optimistic, or if the 

company fails to meet the assumptions underlying these 

estimates, the lender may be subject to considerable 

credit risk. The last interagency SNC review also noted 

instances of inadequate documentation and support for 

enterprise loans.30 

Summary 

C&I lending is one of the largest and fastest growing 

lending lines at insured institutions. Recent growth in 

C&I lending can be attributed to a number of factors, 

including a favorable economy, merger and acquisition 

activity, and other sources of high loan demand, strong 

asset quality, aggressive pricing, and attractive fee 

income. While indicators of C&I loan performance 

remain generally strong, signs of deterioration in commercial credit quality have begun to surface. These 

signs are cause for some concern because they are surfacing during a period of remarkable economic 

strength. Increasing corporate indebtedness, signs of 

corporate stress, and adverse trends in corporate bond 

defaults suggest that an economic downturn could result 

in a much more challenging environment for business 

credit quality. 

By Arlinda Sothoron, Senior Financial Analyst 

Alan Deaton, Economic Analyst 

30 Remarks by OCC First Senior Deputy Comptroller and Chief Counsel Julie L. Williams before the Robert Morris Associates Conference 

on Lending and Credit Risk Management, October 5, 1999. 

Chicago Regional Outlook 10 First Quarter 2000 
In Focus This Quarter
 

Local Industries in the Global Economy
 

•	 The contribution of international trade to U.S. 

economic activity has risen rapidly during the 

past decade. The U.S. economy has been increasingly influenced by conditions abroad, such as the 

recent financial market turmoil in several emerging markets. 

•	 Canada, Japan, and Mexico are the largest U.S. 

trading partners, accounting for approximately 

40 percent of U.S. trade. Western Europe and Asia 

(excluding Japan) also account for a large share 

of U.S. trade. 

•	 The importance of trade at the industry level 

varies widely. The industries most dependent on 

trade, including machinery and transportation 

equipment, also account for a large share of U.S. 

trade. 

The value of goods and services traded on international 

markets has more than doubled during the past decade. 

More goods and services than ever are being shipped 

abroad and imported from all parts of the globe. Consequently, U.S. economic activity is increasingly influenced by the flow of goods, services, and capital across 

national borders. 

The increasing importance of international trade is 

reflected in different types and levels of exposure to 

international markets. First, total exports and imports 

compared with overall economic activity confirm the 

increasing contribution of trade to the economy as a 

whole. Second, the amount of U.S. trade with foreign 

markets, although widely varied, is concentrated in a 

small number of countries, namely Canada, Japan, and 

Mexico. Consequently, economic conditions in these 

countries are particularly important in assessing the 

influence of global economic conditions on U.S. trade. 

Third, the level of exposure to international trade across 

industry sectors varies considerably. Some industries are 

not influenced greatly by activity in international markets, while for other, more trade-dependent industries, 

conditions in the world economy are an important factor 

in determining the level of sales and profit. The exposure 

to international markets, either through reliance on trade 

with particular countries or via industries with a significant exposure to international markets, is an important 

consideration for lenders seeking to determine a firm’s 

future profitability and financial condition. 

International Trade Is of Growing Importance 

Over the past 30 years, international trade has grown 

more quickly than the economy as a whole. Exports, 

which include both merchandise and services, have 

risen from less than 5 percent of U.S. gross domestic 

product (GDP) in 1970 to approximately 12 percent 

today. The merchandise component accounts for about 

73 percent of exports and includes manufactured goods, 

agricultural products, and raw materials such as metals 

and oil. The services component of exports, accounting 

for about 28 percent of total exports, includes travel services, passenger fares, royalties, freight and port services, and a number of smaller sectors such as financial 

and educational services. 

Imports also account for a growing share of U.S. consumption of goods and services, exceeding 15 percent 

of U.S. GDP in 1999, up from 6 percent in 1970. Merchandise is the largest component of imports, accounting for 83 percent, while services account for 17 percent 

(see Table 1, next page). 

Although trade in services has grown quickly for many 

years, merchandise still accounts for the majority of all 

trade. The dominance of merchandise is attributable, in 

part, to the difficulty of trading many types of services. 

With few exceptions, services are generally produced 

and consumed within a local market because they cannot be transported easily and are subject to language 

and cultural barriers. Hospitals, dry cleaners, and movie 

theaters, for example, serve well-defined local markets 

and produce products that cannot be traded competitively on international markets. Although trade in services such as travel continues to grow, the remainder of 

this article focuses primarily on the dominant merchandise component. 

U.S. Trade Activity Has Reflected Recent 

Global Economic Turmoil 

Over time, conditions in the international economy have 

become an increasingly important influence on U.S. 

growth, since a rising share of all domestically produced goods and services is sold abroad. Similarly, an 

increasing volume of imported goods and services 

implies a higher level of competition for domestic producers that compete directly with imports. 

Chicago Regional Outlook 11	 First Quarter 2000 
In Focus This Quarter
 

TABLE 1 

Merchandise Is the Largest Component of Trade 

DOLLAR VALUE* PERCENT 1999 

(1998, $ MILLIONS) OF TOTAL GROWTH** 

Exports $ 933,910 100.0% 1.8% 

MERCHANDISE 682,138 73.0% 0.8% 

AGRICULTURE AND 

RELATED COMMODITIES 26,603 2.8% –1.8% 

MINERAL COMMODITIES 6,644 0.7% –17.4% 

MANUFACTURED GOODS 593,297 63.5% –0.1% 

OTHER MERCHANDISE 55,593 6.0% 39.5% 

SERVICES 263,662 28.2% 4.3% 

TRAVEL 71,250 7.6% 3.0% 

PASSENGER FARES 19,996 2.1% 2.7% 

ROYALTIES AND LICENSE FEES 36,807 3.9% 4.1% 

FREIGHT AND PORT SERVICES 25,520 2.7% 6.4% 

OTHER SERVICES 110,089 11.8% 5.0% 

ADJUSTMENTS*** (11,890) 

Imports $ 1,098,193 100.0% 10.3% 

MERCHANDISE 907,647 82.6% 10.4% 

AGRICULTURE AND 

RELATED COMMODITIES 22,859 2.1% –2.2% 

MINERAL COMMODITIES 38,619 3.5% 5.6% 

MANUFACTURED GOODS 803,384 73.2% 11.6% 

OTHER MERCHANDISE 42,786 3.9% –0.6% 

SERVICES 181,015 16.5% 9.6% 

TRAVEL 56,105 5.1% 7.2% 

PASSENGER FARES 19,797 1.8% 8.3% 

ROYALTIES AND LICENSE FEES 11,293 1.0% 11.0% 

FREIGHT AND PORT SERVICES 30,460 2.8% 11.4% 

OTHER SERVICES 63,360 5.8% 10.9% 

ADJUSTMENTS*** 9,531 

* Sum of components may not equal total due to rounding.
 

** First three quarters of 1999 versus first three quarters of 1998.
 

*** Because of different methods of estimating the merchandise and services components of trade, an adjustment
 

term is necessary. Consequently, percentages may not sum to 100.
 

Sources: Bureau of Economic Analysis; Bureau of Census
 

Chicago Regional Outlook 12 First Quarter 2000 
In Focus This Quarter
 

During the past two and a half years, for example, the 

international economy has been buffeted by a series of 

crises that resulted in steep exchange rate depreciations 

for a number of countries and a marked slowdown in 

economic growth in many emerging markets. Although 

the U.S. economy remained surprisingly strong during 

the worst of the emerging markets crises, the fallout 

was evident in the diverging performance of U.S. 

exports and imports over the period. 

From mid-1997 through mid-1999, U.S. exports were 

generally flat, reflecting the sluggish pace of growth in 

several important U.S. export markets. Export prices 

fell by 4 percent over the period in response to weak 

demand for U.S. exports. In particular, exporters of 

agricultural products, basic manufactured goods, and 

commodities faced rapidly deteriorating conditions in 

several important overseas markets. For example, the 

value of merchandise exports to the Pacific Rim fell by 

15 percent during the first six months of 1999 compared with the same period in 1997 because of the 

recent financial market turmoil in the region. 

U.S. imports continued to grow during the period, 

however, reflecting both strong demand for imported 

goods and falling prices. In fact, average import prices 

fell by 5 percent between 1997 and 1999. At the same 

time, competition from imports limited the pricing 

power of domestic producers that compete with goods 

produced abroad. Although producers that compete 

with cheaper imports experienced adverse effects on 

profitability, consumers and firms that purchased 

goods from abroad generally benefited from falling 

import prices.1 

The slowdown in U.S. export activity and the acceleration of import growth have resulted in an increasing 

trade imbalance (see Chart 1). The U.S. trade deficit, 

which reached a record $26.5 billion in November, has 

raised concerns among analysts about the vulnerability 

of the dollar. Faster growth abroad or a slowdown in 

U.S. growth could convince foreign investors to 

increase purchases of assets outside the United States, 

resulting in a sell-off of the dollar. Depending on the 

severity and speed of a sell-off, heightened financial 

market volatility and rising U.S. import prices could 

result. Although potentially many forces are at work in 

1 Weak import prices are a factor cited by analysts to explain the 

benign performance of U.S. inflation during the past few years. 

CHART 1 

U.S. Import Growth Has Accelerated 

while Exports Remain Flat 

$ Billions 

350 

300 

250 

200 

150 

100 

Imports 

Exports 

1992 1993 1994 1995 1996 1997 1998 1999 

Source: Bureau of Economic Analysis 

such a scenario, rising inflation or a falling dollar may 

ultimately result in higher interest rates and slower U.S. 

growth. The extent to which U.S. trade would be affected by such a scenario is difficult to assess, since 

changes in the prices of either imports or exports would 

result in both positive and negative effects on firms’ 

costs, revenue, and profitability.2 

Most U.S. Trade Is Concentrated 

in a Few Foreign Markets 

Because the United States trades with most nations, 

economic conditions abroad are one of the critical 

factors that determine the growth of U.S. trade. Foreign demand for U.S. goods and services depends on 

the strength of the markets to which exporters ship 

their goods. Consequently, economic weakness 

abroad often results in slower U.S. export growth. 

Economic conditions abroad also influence the level 

of import competition that U.S. firms experience. 

Foreign firms facing slack demand in their own 

domestic markets, much like manufacturers in Southeast Asia during the recent market turmoil, may 

2 During the early 1980s, the dollar rose by roughly 50 percent, as 

measured against a trade-weighted basket of currencies. The 

increase in the value of the dollar made U.S. exports much more 

costly on world markets and contributed to financial stress among 

export-dependent manufacturers and agriculture producers. Beginning in mid-1985 the dollar fell sharply, back to its pre-appreciation 

level. The resulting improvement in U.S. competitiveness contributed to robust growth in U.S. exports that lasted during the rest 

of the 1980s. 

Chicago Regional Outlook 13 First Quarter 2000 
In Focus This Quarter
 

reduce prices of their U.S.-bound goods to compete 

more effectively with U.S. producers.3 

Although the U.S. trades with many nations, a large 

share of U.S. trade is concentrated among a small number of countries. Canada, Mexico, and Japan account 

for more than 40 percent of merchandise exports and 

imports. Asia (excluding Japan) and Western Europe 

each account for just over 20 percent of U.S. exports 

and a broadly similar share of imports. Central and 

South America, despite proximity to the United States, 

account for less than 10 percent of exports and only 

5 percent of imports (see Chart 2). 

The United States has routinely run a trade deficit with 

its largest trading partners. The trade deficit with 

Canada was $22.8 billion through the first three quarters of 1999. The trade deficit with Mexico topped 

$18.8 billion during the same period. The trade 

deficits with Japan and China, by far the two largest at 

$53.4 billion and $49.4 billion, respectively, accounted for approximately 40 percent of the total U.S. merchandise trade deficit through the first three quarters 

of 1999. 

The Importance of Trade Varies 

among Industries 

The level of export activity or the intensity of import 

competition also varies across industries. Besides the 

overall dollar volume of exports, industries differ in the 

proportion of total production that is exported. 

Although some industries, such as leather products, 

account for a relatively small share of total U.S. 

exports, exports from this industry make up a large 

share of all U.S. leather goods production. In cases 

such as this, conditions in export markets are important 

for producers even if total export sales from a particular industry are small. 

Industries also differ in the share of total spending 

devoted to imports. Imports account for a relatively 

3 From the perspective of a foreign exporter, increased sales of goods 

abroad, even at reduced prices, may be a preferred strategy to offset 

lower sales within its own weaker domestic market. A foreign steel 

mill facing weak sales in its home market may choose to sell its output below cost on the world market if it can still cover its fixed costs 

of operation. There also may be an incentive to maintain or even 

expand market share and recoup current losses in the future when 

prices rebound. 

CHART 2 

Canada Is the Largest U.S. Trading Partner 

(1Q99 through 3Q99, ranked by exports) 

Eastern Europe 

Africa 

Central/South America 

Japan 

Mexico 

Asia (excluding Japan) 

Western Europe 

Canada 

Source: Bureau of Census 

–250 

$ Billions 

–150 –50 50 150 250 

Imports Exports 

small portion of all domestic spending on farm products such as grains and livestock, for example, while 

imports account for a relatively large share of all U.S. 

oil consumption. These differences expose U.S. industries to varying levels of competition from abroad. In 

industries characterized by high levels of import competition, import prices may largely shape the domestic 

pricing environment and, by extension, the revenue and 

profit growth of domestic firms. 

For the purposes of this article, industries can be 

assigned to one of three broad categories depending on 

their exposure to international markets either through 

exports or through the intensity of import competition. 

Firms in Less Exposed Industries are not directly influenced by conditions in the global markets. Export markets are not a particularly important source of revenue, 

and imports are a negligible share of all domestic consumption of goods produced by these industries. In 

contrast, some industries are highly exposed through 

their reliance on export markets, through competition 

from imports, or in some cases, through both. For firms 

in these Highly Exposed Industries, conditions in international markets are clearly one of the important factors influencing current and prospective financial 

performance. Industries not part of either group, or 

Moderately Exposed Industries, face some competition 

from abroad and may earn a relatively small amount of 

revenue from export markets. 

To gauge these differences more fully, a measure 

of exposure to international markets was calculated for 

a set of 26 industries (20 manufacturing industries, 

4 mining industries, and 2 agriculture sectors). Table 2 

Chicago Regional Outlook 14 First Quarter 2000 
In Focus This Quarter
 

TABLE 2 

Industry Exposure to International Trade 

IMPORT SHARE OF U.S. CONSUMPTION 

LOW MEDIUM HIGH 

EXPORT 

SHARE OF U.S. PRODUCTION 

LOW 

PRINTING AND PUBLISHING 

FOOD PRODUCTS 

LUMBER AND WOOD 

PRODUCTS 

PETROLEUM AND COAL 

PRODUCTS 

AGRICULTURAL SERVICES, 

FORESTRY, AND FISHING 

FURNITURE AND FIXTURES 

OIL AND GAS EXTRACTION 

MEDIUM 

COAL MINING 

TOBACCO PRODUCTS 

NONMETALLIC MINERALS, 

EXCEPT FUELS 

FABRICATED METAL 

PRODUCTS 

METAL MINING 

PAPER AND ALLIED 

PRODUCTS 

TEXTILE MILL PRODUCTS 

STONE, CLAY, AND 

GLASS PRODUCTS 

RUBBER AND PLASTIC 

PRODUCTS 

PRIMARY METAL INDUSTRIES 

MISCELLANEOUS MANUFACTURING INDUSTRIES 

APPAREL PRODUCTS 

HIGH 

FARM PRODUCTS CHEMICALS AND ALLIED 

PRODUCTS 

INSTRUMENTS AND 

RELATED PRODUCTS 

TRANSPORTATION 

EQUIPMENT 

INDUSTRIAL MACHINERY 

AND EQUIPMENT 

ELECTRONIC EQUIPMENT 

LEATHER AND LEATHER 

PRODUCTS 

Highly Exposed Industries 

Moderately Exposed Industries 

Less Exposed Industries 

summarizes the results of the assessment.4 Each row 

shows industries that have high, medium, or low 

reliance on export markets, defined as the share of U.S. 

production in a particular industry that is exported. 

Each industry was ranked by this measure, with the 7 

highest industries placed in the High category, the 7 

lowest in the Low category, and the remaining 12 in the 

4 Export share of production (rows in Table 2) was calculated as the 

ratio of inflation-adjusted exports at the industry level divided by 

inflation-adjusted production in that industry (Gross Output by Industry from the Bureau of Economic Analysis was used as a measure of 

industry production). The import share of consumption (columns in 

Table 2) was calculated as the share of inflation-adjusted industry 

imports divided by inflation-adjusted domestic production less 

exports plus imports. All calculations were based on 1997 data, the 

latest industry-level production data available. 

Medium category.5 Table 2 shows, for example, that a 

relatively low proportion of production in the printing 

and publishing, lumber and wood products, and oil and 

gas extraction industries is exported. In contrast, a relatively high percentage of production in the farm products sector, chemicals, and transportation equipment 

industries is exported. 

5 This allocation, while completely arbitrary, roughly corresponds to a 

distribution where 50 percent of the industries are assigned to the 

Medium category, with the remaining 50 percent evenly allocated 

between the High and Low categories. Breakpoints for the distribution of industries by export share of production were as follows: Low: 

less than 7 percent; High: greater than 13 percent. 

Chicago Regional Outlook 15 First Quarter 2000 
In Focus This Quarter
 

The industries in each column are categorized by the 

share of U.S. consumption expenditures in a particular 

industry that are satisfied by imports. Again, the Low 

and High categories each include 7 industries, and the 

Medium category includes the remaining 12 industries.6 

On the basis of this analysis, for example, a relatively 

low share of U.S. consumption of food, fabricated metals, and farm products is imported. In contrast, a large 

share of U.S. consumption of oil, apparel, and electronic equipment is imported.7 

As shown in the lower right cell of the table, four industries are highly exposed to both export markets and 

import competition. These industries—transportation 

equipment, industrial machinery, electronic equipment, 

and leather products—account for slightly less than half 

of total U.S. exports and a similar percentage of total 

U.S. imports. Not only are these industries more closely tied to international markets than most other industries examined, but they also account for a large share of 

U.S. international trade. 

Using the terminology introduced above, Highly 

Exposed Industries are defined as those assigned to 

either of the High categories; industries in this group 

either are very reliant on export markets or face high 

levels of import competition. Less Exposed Industries 

are defined as those that have little exposure to either 

export markets or import competition; they are shown 

in the upper left cell in the Low classification. The 

remaining industries are defined as Moderately 

Exposed Industries. 

Chart 3 illustrates the distribution of establishments in 

each of the three categories by Region.8 Among the 

6 Breakpoints for the distribution of industries by import share of 

consumption were as follows: Low: less than 9 percent; High: greater 

than 25 percent. 

7 Although not directly included in the analysis, most domestically 

produced services also have minimal reliance on export markets and 

face little import competition. Retail trade, construction, local transportation services, and government, for example, all operate in relatively sheltered markets and are dependent on the health of the local 

economy. Particular firms may engage in high levels of international activity in tradable services such as travel, but manufacturing, 

mining, and agriculture account for the majority of imports and 

exports. 

8 An establishment is defined as a single physical location at which 

business is conducted or services or industrial operations are performed. It is not necessarily identical with a company or enterprise, 

which may consist of one or more establishments. Data are from 

County Business Patterns (Bureau of Census, 1997). 

CHART 3 

Atlanta Boston Chicago Dallas Kansas Memphis New San 

City York Francisco 

Number of Establishments* Classified by 

International Trade Exposure by Region 

0 

10,000 

20,000 

30,000 

40,000 

50,000 

60,000 

FDIC Region 

Source: Bureau of Census, 1997 County Business Patterns Database 

*An establishment is a single physical location at which business is conducted. 

Highly Exposed Industries 

Moderately Exposed 

Industries 

Less Exposed Industries 

group of industries analyzed, most are in the Moderately Exposed Industries category. Of the FDIC Regions, 

Atlanta, Chicago, and San Francisco have the greatest 

number of establishments in this category. The Chicago 

and San Francisco Regions lead in the number of establishments in the Highly Exposed Industries group, followed by the New York and Dallas Regions.9 Less 

Exposed Industries account for a relatively small number of establishments. As suggested above, however, 

most service-sector, construction, and government 

enterprises, while not part of this analysis, could be 

classified as Less Exposed.10 

Although this analysis highlights the varying level of 

direct exposure to international markets, industries also 

may be exposed through a less direct secondary channel. 

Several industries, although not highly exposed themselves, are suppliers to Highly Exposed Industries. For 

example, the rubber and plastics industry produces 

goods that are used in the manufacture and assembly of 

transportation equipment, a Highly Exposed Industry. 

9 An alternative way of analyzing the establishment data is to calculate the percentage of all establishments across the 25 industries that 

are in Highly Exposed Industries. On the basis of this calculation, the 

Dallas Region ranks highest at 42 percent because of the large number of establishments engaged in oil and gas extraction. For the 

remaining Regions, the percentages vary between 25 percent and 35 

percent. Across all industries (including services and other sectors not 

part of this analysis), the percentage of Highly Exposed Industries in 

each Region ranges from 1.7 percent (Atlanta Region) to 3.4 percent 

(Boston Region) of total establishments. 

10 These data do not include a count of establishments in the farm 

products sector (Standard Industrial Code (SIC) 01 and SIC 02). 

Therefore, 25 industries are represented in the establishment data, and 

not 26 as in Table 2. 

Chicago Regional Outlook 16 First Quarter 2000 
In Focus This Quarter
 

Consequently, conditions in export markets for transportation equipment are of particular interest for manufacturers of certain types of rubber and plastic products. 

These supplier industries are also vulnerable to import 

competition through this secondary exposure to international markets. A transportation equipment manufacturer, in response to heightened competition in international 

markets for its products, may switch from a domestic 

supplier of rubber products to a cheaper foreign supplier 

if a favorable price differential emerges. Therefore, 

assessing the exposure of industries to either exports or 

imports requires consideration of any secondary linkages 

between suppliers and purchasers of industry products. 

Summary 

The contribution of international trade to overall U.S. 

economic activity has been increasing for a number of 

years. The growing significance of trade has been highlighted by the recent series of economic and financial 

crises across the globe. One result of recent global economic turmoil has been a slowdown in U.S. export 

growth resulting from both slumping international 

demand for U.S. goods and services and weak prices. 

Import growth has continued unabated, largely because 

of strong U.S. growth, leading to a rapidly widening 

trade deficit. The effects of import and export growth 

on particular industries vary because of differing levels 

of reliance on export markets and the extent of import 

competition. This analysis suggests that several industries are highly exposed to changing global economic 

conditions. Lenders should be aware that for firms in 

these industries, changes in global economic conditions, including demand for U.S. exports and prices of 

both imports and exports, largely determine pricing, 

revenue growth, and profitability. 

Paul C. Bishop 

Senior Financial Economist 

Chicago Regional Outlook 17 First Quarter 2000 
Regional Perspectives
 

Regional Perspectives
 

•	 While unemployment remains low, the strength of the Region’s economy and health of its banks and thrifts 

are starting to exhibit signs of weakening. For example, job growth in the Region slowed during 1999, and 

the Region’s banks and thrifts reported modest deterioration in earnings, margins, and asset quality. 

•	 Pressures on grain farmers’ finances appear to be generating not only larger amounts of carryover farm 

debt but also a modest rise in problem consumer loans among Illinois’ agricultural banks. Forecasts of 

continued low corn and soybean prices suggest that the pressure on farmers and agricultural lenders will 

continue. 

•	 Strong loan growth is centered in traditionally higher-risk commercial and industrial (C&I) loans. 

Although asset quality among C&I lenders was favorable in the third quarter, rapid C&I loan growth and 

the resulting rise in exposures raise questions about how banks would fare should the economy slow. 

•	 Profitability levels for banks specializing in residential lending appear vulnerable given recent increases in 

interest rates and weakening mortgage markets. 

Region’s Banking and Economic Conditions 

Institutions Are Generally Healthy 

The Region’s banks and thrifts report healthy conditions; however, signs of weakness are beginning to 

develop. Based on median values for all institutions in 

the third quarter, 

•	 the return on assets (ROA) for all institutions was 

1.03 percent in the third quarter; 

•	 the net interest margin (NIM) was 3.93 percent; 

•	 past-due and nonaccrual loans were 1.78 percent of 

total loans; and 

•	 the Tier One capital ratio was 9.34 percent. 

Although the levels of these and other aggregate measures of institutions’ condition suggest that performance 

remains healthy, they nevertheless have shown some 

slight weakening recently. The Region’s 1,835 established community institutions,1 for example, continued 

to show modest deterioration during the third quarter of 

1999. In addition, the percentage of community institutions with composite CAMELS (capital adequacy, asset 

1 Established community institutions are defined as banks and thrifts 

with assets of $1 billion or less, excluding those established in the 

past three years. 

quality, management, earnings, liquidity, and sensitivity) ratings of 3, 4, or 5 edged up in late 1999. Based on 

median values for September 30, 1999, conditions at 

all community institutions showed the following (see 

Chart 1): 

•	 ROA was 5 basis points lower than in September 

1998 and 8 basis points lower than in September 

1997; 

•	 NIM fell 21 basis points over the same two-year 

period; 

•	 Tier One leverage ratio was 27 basis points lower 

than in September 1997; and 

•	 adversely classified assets relative to capital 

increased 220 basis points from a low level two years 

earlier. 

Most types of lenders are beginning to exhibit modest 

signs of strain. Deterioration in agricultural banks’ performance reflects the effects of low crop prices and the 

significance of the farm sector in some lenders’ markets. A variety of factors underlie developments among 

other types of institutions. C&I lenders are experiencing 

strong loan growth, which may result in increased levels 

of credit risk. Institutions heavily exposed to residential 

real estate face potential earnings pressure from recent 

Chicago Regional Outlook 18	 First Quarter 2000 
10 

8 

6 

4 

2 

0 

Regional Perspectives
 

CHART 1 contrast, during 1998 the rate ranged between 1.7 and 

2.0 percent. The Region’s Established Community Banks
 

Appear Healthy but Not Improving
 Slower employment growth has affected states within 9.62 5.94 9.53 7.50 9.35 8.14

the Region differently. For example, third-quarter manufacturing employment was nearly 1 percent lower than Sept. 97 

Sept. 98 

Sept. 99 a year earlier in Illinois and Wisconsin, little changed 

in Ohio, and almost 1 percent higher in Indiana. A 1.3 

percent gain in Michigan likely was temporary, reflecting a rebound from a year-ago job count that was suppressed by a strike against General Motors. The 

weakness in hiring by manufacturers—an important 

Percent 

1.13

1.10

1.05 

4.16

4.06

3.95 

Return on Net Interest Tier 1 Adversely 

Assets Margin Leverage Classified 

(median) (median) (median) Assets Relative 

to Capital (median) 

Sources: Bank and Thrift Call Reports and FDIC’s Research Information 

System Data Warehouse 

interest rate increases and mortgage market developments. Challenges facing agricultural, C&I, and residential real estate lenders are discussed later in this 

article. 

Economy Is Healthy but May Be Slowing 

Economic conditions also remain healthy but show 

signs of softening. While the Region’s unemployment 

rate hovered below 4 percent in 1999, the job growth 

rate slowed to 1.1 percent in the third quarter. This pace 

was more than half a percentage point slower than in 

1998 and 1997, partly because about 30,000 manufacturing jobs were cut during 1999. 

Conditions in the Region’s major sectors and communities likely will become more uneven should the pace of 

recent cutbacks in manufacturing employment continue 

and the consensus forecast2 for slower growth come 

true. Developments in labor markets, the consumer sector, and residential housing markets illustrate how mild 

pressures may be building and affecting areas within the 

Region differently. 

Labor markets are experiencing slower job growth, partly because low unemployment is limiting employers’ 

ability to hire additional workers. On a year-over-year 

basis, the Region’s job growth rate in the first three 

quarters of 1999 ranged between 1.3 and 1.1 percent. In 

2 See, for example, Ford, Constance Mitchell, “Economists Are 

Euphoric About the Prospect for 2000—Nearly All Surveyed Believe 

Expansion Will Become Longest on Record,” The Wall Street Journal, 

January 3, 2000, page A2. 

swing sector in this Region—warrants monitoring as a 

possible indicator of slower economic growth overall. 

The strength of household spending for goods and services (along with gains in stock market indices) continues to surprise many forecasters. Even so, certain 

developments suggest that the strength of the consumer 

sector in recent years might weaken. Last year’s tremendous boost to households’ purchasing power from mortgage refinancing, for example, stalled when mortgage 

rates stopped falling. Further, the pace of job growth 

has slowed, and rising interest rates over the past year 

have increased the cost of financing a home and other 

major purchases. Any resulting weakening in demand 

for durable goods, such as motor vehicles and appliances, likely will be felt promptly by some of this 

Region’s manufacturers and their employees. 

Residential housing indicators also are generally showing less vigor. Demand for new and existing homes may 

continue to soften because many households have 

already purchased a home or traded up, interest rates 

have risen, and job growth has slowed. Should the housing market slow in 2000, demand for appliances, home 

furnishings, and other related items that typically follow 

the purchase of a home (and that may be produced in 

this Region) will likely weaken. Such a development 

could further slow the pace of job growth and household spending. 

Growth in the issuance of single-family permits slowed 

by varying degrees among the Region’s states toward 

year-end 1999 (see Table 1, next page), even though 

activity in all states was affected by slower job growth 

and higher mortgage rates. Despite the slowdown, Illinois, Ohio, and Wisconsin continued posting doubledigit gains. Sales of existing homes also varied among 

states. Growth in home resales slowed noticeably in Illinois but moderately in Indiana and Ohio. Wisconsin and 

Michigan recorded modest gains, but they were insufficient to offset the prior year’s retrenchment. 

Chicago Regional Outlook 19 First Quarter 2000 
Regional Perspectives
 

TABLE 1 

Residential Housing Developments Are Mixed 

(percent change from a year earlier) 

Region 

ILLINOIS 

INDIANA 

MICHIGAN 

OHIO 

WISCONSIN 

SINGLE-FAMILY PERMITS 

3Q98 3Q99 3Q98 3Q99 

12.2 8.8 3.8 4.3 

10.5 10.4 18.3 4.2 

12.8 8.1 12.6 10.7 

9.8 4.4 –13.6 0.9 

14.2 12.2 5.2 4.3 

15.6 10.1 –5.3 2.5 

SALES OF EXISTING HOMES 

Sources: Bureau of the Census and National Association of Realtors, via Haver Analytics, Inc. 

Agricultural Concerns Are Centered in Illinois
 

The effects of low corn and soybean prices continue to 

concern the Region’s agricultural lenders. These crops 

account for about 70 percent of farmers’ total cash 

receipts in Illinois, 58 percent in Indiana, 40 percent in 

Ohio, and lesser shares elsewhere in the Region. 

The negative consequences of low commodity prices on 

net farm income are being tempered by federal assistance payments. However, several years of declining 

prices appear to have eroded farmers’ financial health. 

The financial positions of approximately 22 percent of 

Illinois grain farms are classified as stressed or severe 

and a slightly lower percentage as vulnerable, according 

to a recent study of 1,076 farms by experts at the University of Illinois (see Chart 2).3 The southern part of 

the state is most affected because of recent poor growing conditions and low yields. Average projected 1999 

net farm income in the east-southeast district is estimated to be $17,000, compared with the statewide average 

of $25,000.4 The southwest and southeast districts are 

quality, Illinois agricultural banks’ balance sheets are 

beginning to reflect the problems affecting grain farmers.6 For example, the median ROA for this group fell to 

1.03 percent as of September 30, 1999, from 1.16 percent a year earlier and 1.20 percent two years earlier. 

Moreover, the growing number of Subchapter S institutions in the Region produces an upward bias in ROA 

because of the tax benefits. To address this bias, one can 

6 Illinois had 232 established banks and thrifts for which agricultural 

production loans plus farm real estate loans totaled 25 percent or 

more of loan portfolios on September 30, 1999. Three newly established Illinois banks with significant shares of agricultural loans are 

excluded from this discussion. 

CHART 2 

Weaker Financial Position of Illinois
 

Grain Farmers since 1997
 50 46 1997 44 44 43 1998 

40 1999 baseline projection 

Strong Stable Vulnerable Stressed Severe 

projected to report negative average income.5 

Although call report data do not reveal any significant 

deterioration in insured institutions’ earnings or asset 

Percentage of Farms 

1999 projection, including federal 

30 disaster assistance payments 30 25 23 22 

20 17 

14 12 9 10 8

21 21 19 

3 Lattz, Dale, Paul Ellinger, and Gary Schnitkey, Estimated 1999 

Farm Income and Financial Position of Illinois Grain Farms, Department of Agriculture and Consumer Economics and The Center for 

Farm and Rural Business Finance, University of Illinois at UrbanaChampaign, October 1999. 

4 Ibid. 

5 Ibid. 

1 0 1 1 0 

Source: Lattz, Dale, Paul Ellinger, and Gary Schnitkey, Estimated 1999 Farm 

Income and Financial Position of Illinois Grain Farms, Department of 

Agriculture and Consumer Economics and The Center for Farm and Rural 

Business Finance, University of Illinois at Urbana-Champaign, October 1999. 

Chicago Regional Outlook 20 First Quarter 2000 
Regional Perspectives
 

look at pretax ROA, which has been slipping and was 28 

basis points lower on September 30, 1999, than it was 

two years earlier (see addendum to Table 2). Meanwhile, Illinois agricultural banks’ Tier One leverage 

ratio has declined slightly, past-due and nonaccrual 

ratios are rising, and the allowance for loan and lease 

losses relative to noncurrent loans (the reserve coverage 

ratio) is shrinking (see Table 2). 

The reduction in reserve coverage occurred as the median value of all past-due and nonaccrual loans among 

Illinois agricultural banks rose modestly, reaching 2.01 

percent of total loans on September 30, 1999, from 1.81 

percent in the prior two Septembers. Eleven percent of 

Illinois agricultural institutions reported past-due and 

nonaccrual ratios exceeding 5 percent at quarter-end, up 

from 8.6 percent of these institutions on September 30, 

1998. This increase highlights the need to evaluate the 

relative level of the allowance for loan losses carefully 

in light of conditions affecting grain farmers and the 

expectation that corn and soybean prices will remain 

relatively low in 2000.7 

The median value of past-due and nonaccrual agricultural loans on September 30, 1999, remained low—well 

below 1 percent. The increasing extension of carryover 

7 U.S. Department of Agriculture, World Agricultural Supply and 

Demand, December 10, 1999. 

TABLE 2 

debt8 may help to explain why agricultural loan performance in Illinois has worsened only slightly despite sustained softness in crop prices. Should lenders become 

less willing to extend carryover debt or should Congress 

not appropriate additional emergency assistance funds, 

banks’ past-due and nonaccrual agricultural loans could 

rise abruptly. 

Recent developments among Illinois agricultural banks 

illustrate that all segments of the loan portfolio warrant 

attention when economic conditions in the surrounding 

community weaken, regardless of whether agriculture 

or heavy manufacturing, for example, is the area’s dominant industry. Spillover effects from the softness in 

corn and soybean farmers’ incomes appear to be affecting local lenders in other loan categories. For example, 

the median level of past-due and nonaccrual consumer 

loans at Illinois agricultural banks increased by 10 basis 

points over the past year to 2.42 percent on September 

30, 1999. In contrast, the state’s consumer institutions9 

8 Nationally, 37 percent of agricultural banks posted a “moderate” 

increase in carryover debt and 5 percent showed a “sharp” increase, 

according to the FDIC’s Report on Underwriting Practices for April 

through September 1999. The current share of institutions reporting a 

moderate or sharp increase in the level of carryover debt compares 

with 32 percent in the prior six-month period and is more than three 

times higher than in the six months ending March 1998. 

9 Consumer institutions are defined as banks and thrifts with one- to 

four-family mortgage loans plus loans to individuals greater than 50 

percent of total assets, excluding banks less than three years old. 

Overview of Illinois’ Agricultural Banks 

SEPT. 97 SEPT. 98 SEPT. 99 

Number of Institutions 245 244 232 

Tier One Leverage 10.34 10.61 10.40 

Asset Quality 

PERCENTAGE OF LOANS PAST-DUE AND NONACCRUAL 1.81 1.81 2.01 

ALLOWANCE FOR LOAN AND LEASE LOSSES TO 

NONCURRENT LOANS 1.83 1.64 1.29 

PERCENTAGE OF INSTITUTIONS WITH PAST-DUE AND 

NONACCRUAL LOANS >5 PERCENT 7.35 8.61 11.21 

Earnings 

RETURN ON ASSETS (ROA) 1.20 1.16 1.03 

NET INTEREST MARGIN 4.00 3.50 3.84 

Addendum: Subchapter S Institutions 

NUMBER OF INSTITUTIONS 19 32 37 

PRETAX ROA 1.63 1.53 1.35 

Note: Median values shown where appropriate. 

Source: Bank and Thrift Call Reports 

Chicago Regional Outlook 21 First Quarter 2000 
Regional Perspectives
 

reported significant improvement in past-due and 

nonaccrual consumer loans to a much lower 1.84 percent over the same period. In addition, the 2.14 percent 

past-due and nonaccrual rate for residential one- to 

four-family mortgages at Illinois agricultural banks 

exceeds those at agricultural banks in Indiana, Wisconsin, and Michigan, where the past-due and nonaccrual 

rates for residential mortgages were 1.55 percent or less 

on September 30, 1999. 

Recent evidence that earnings and loan quality are 

being pressured and the outlook for another year of low 

corn and soybean prices suggest that agricultural banks 

and farmers in Illinois and other affected areas may face 

another challenging year in 2000. 

Commercial and Industrial Loans Are Growing Rapidly
 

A robust economy has created expansion opportunities 

for entrepreneurs and existing businesses, which has 

helped fuel C&I loan demand in the Chicago Region. 

Banks considered C&I lenders10 experienced strong 

C&I loan growth as of year-end September 30, 1999. 

There were 601 banks in this category, and the median 

C&I loan growth for this group was approximately 18 

percent during the year ending September 30, 1999, up 

from 14 percent a year earlier (see Chart 3). Furthermore, almost one-half of C&I lenders recently experienced C&I loan growth rates of 20 percent or more, a 

much larger share than for other loan types, with the 

exception of commercial real estate (see Table 3). As 

mentioned in this issue’s In Focus article, factors such 

as a widening corporate financing gap and merger and 

acquisition activity are driving C&I loan growth 

nationwide. In addition, small commercial loans 

(defined as C&I loans with an original balance of $1 

10 Commercial and industrial lenders are defined as established banks 

with commercial and industrial loans greater than or equal to 10 percent of total assets. 

CHART 3 

TABLE 3 

million or less) have shown strong growth in the Chicago Region. 

Small commercial loans are a major part of the Region’s 

C&I lenders’ loan portfolios. These loans comprised at 

least 30 percent of the C&I loan portfolios at 96 percent 

(558) of the C&I banks as of June 30, 1999.11 Small 

commercial loans at the Region’s C&I lenders grew to 

$35 billion by June 30, 1999, up from $31 billion a year 

earlier. Much of this growth occurred in institutions 

with assets greater than $250 million. The increasing 

use of computerized credit-scoring models and massmarketing efforts by larger institutions have facilitated 

growth of these smaller commercial loans and intensified competition (see “Will Credit Scoring Transform 

the Market for Small Business Lending?”; Regional 

Outlook, Second Quarter 1997). While credit scoring 

can help standardize operations and reduce loan 

11 Data on the size of C&I loans are collected once a year in the June 

call report. 

C&I Loans Are Growing 

at Faster Rate among the 

Region’s C&I Lenders 

Source: Bank and Thrift Call Reports 

Year Ending September 

1995 1996 1997 1998 1999 

Year-over-Year Percentage Change 

0 

2 

4 

6 

8 

10 

12 

14 

16 

18 

20 Many of the Region’s Institutions Report 

Rapid Commercial Loan Growth 

TYPE OF LOAN 

PERCENTAGE OF 

INSTITUTIONS WITH OVER 

20% LOAN GROWTH* 

AGRICULTURAL 12 

COMMERCIAL AND INDUSTRIAL 47 

COMMERCIAL REAL ESTATE 47 

CONSUMER 28 

RESIDENTIAL REAL ESTATE 20 

* Only institutions with at least 10% of assets in each loan category, 

excluding institutions established after September 30, 1995. 

Source: Bank and Thrift Call Reports, September 30, 1999 

Chicago Regional Outlook 22 First Quarter 2000 
Regional Perspectives
 

overhead, the application of these techniques to smallbusiness credits is relatively new and has not been tested during an economic downturn. 

A Rising Share of C&I Loans Could 

Indicate Greater Credit Risk 

Growth in C&I loans has increased the share of these 

assets held by the Region’s C&I lenders. At the end of 

third quarter 1999, the median C&I loan level was 22 

percent of total loans, up from 18 percent at September 

30, 1997. The shift in asset composition toward higheryielding C&I loans could be a response to declining 

NIMs experienced by these banks over the past couple 

of years. As a result, profitability levels—as measured 

by ROA—may have been buoyed by the higher yields 

received from a growing C&I loan portfolio. ROA, 

which fell slightly during the first nine months of 

1999 to 1.27 percent from 1.33 percent a year earlier, 

remained above the level reported two years earlier, 

when C&I loans represented a smaller portion of the 

overall loan portfolio. The increasing exposure to C&I 

lending, traditionally a higher-risk form of lending, 

could be a growing concern in the case of potential 

downturns in the economy. 

The median C&I total past-due ratio of the Region’s 

C&I lenders improved as of September 30, 1999, to 

1.67 percent from 1.96 percent in the year-earlier period. However, the rapid growth in C&I loans over the 

past couple of years may make it more difficult to identify asset quality problems at these institutions. A 

declining past-due ratio is typical during times of rapid 

loan growth. Newly originated loans are unlikely to fail 

to perform initially; consequently, the large volume of 

new loans tends to have lower reported past-due levels, 

which gives the appearance of improved asset quality. 

Given the relative newness of these credits, it is uncertain how these loans will perform during an economic 

contraction. 

Risk in C&I Portfolios May Vary 

with the Area’s Economic Diversity 

In the event of an economic slowdown, the performance 

of an institution’s C&I loan portfolio will depend largely on the industry concentrations represented in that 

portfolio and the economic conditions in the lending 

area. Nearly one-half of C&I lenders (288 banks) are 

rapidly increasing exposure to C&I loans (i.e., they 

experienced growth of 20 percent or more in the C&I 

portfolio from third quarter 1998 to third quarter 1999). 

A majority (60 percent) of these “fast-growing” C&I 

lenders are located in the Region’s metropolitan statistical areas (MSAs), including Chicago, Illinois (50 

banks); Milwaukee-Waukesha, Wisconsin (10 banks); 

and Madison, Wisconsin (8 banks). Furthermore, most 

of the C&I lenders experiencing rapid C&I loan growth 

are community banks12 that are likely lending to a diversified group of small businesses rather than lending predominantly to one or two industries. If a bank is located 

in a large, economically diverse MSA and reflects the 

diversity of its community, it is not likely that a downturn in one industry would significantly affect the 

bank’s C&I credit quality. 

The Chicago and Indianapolis MSAs are the most economically diverse MSAs in this Region, according to 

the Regional Financial Associates (RFA) Index of 

Industrial Diversity13 (see Chart 4, next page). The 

Cincinnati, Cleveland, and Columbus MSAs also are 

relatively diverse, with index values of 0.73, 0.70, and 

0.72, respectively. Index values for the Region’s MSAs 

are calculated relative to the U.S. economy, which is the 

most diverse and is assigned a value of 1.00. For a geographic area, the lower the index value, the greater its 

vulnerability to a downturn in its dominant industry. A 

significant number of fast-growing C&I lenders are 

located in the Milwaukee and Madison MSAs, which 

show only moderate economic diversity. However, 

other MSAs show very little economic diversity. For 

example, despite the fact that it is one of the most populous MSAs in the Region, the index value for the 

Grand Rapids-Muskegon-Holland MSA is quite low 

because of its exposure to the manufacturing industry, 

especially Steelcase and General Motors. A downturn 

in the manufacturing industry alone, or one of its major 

employers, could significantly dampen the economic 

health of small businesses in the MSA and, consequently, could adversely affect community banks’ C&I 

portfolios. 

12 Banks with assets of $1 billion or less, exclusive of those established in the past three years.
 

13 This index incorporates every three-digit Standard Industrial Code
 

classified industry.
 

Chicago Regional Outlook 23 First Quarter 2000 
Regional Perspectives
 

CHART 4 

Rapidly Growing C&I Lenders Are Located in MSAs with Varying Degrees of Economic Diversity 

Industrial Diversity Index 

Most Diversified Less Diversified 

0.0 

0.1 

0.2 

0.3 

0.4 

0.5 

0.6 

0.7 

0.8 

0.9 

1.0 

50 6 

10 8 

<5 

<5 

6 6 5 6 <5 

<5 

Number of fast-growing* C&I Lenders in 

MSA 

United Chicago Indianapolis Milwaukee- Madison Springfield Champaign- Rockford Grand Peoria- Appleton- Wausau DuluthStates Waukesha Urbana Rapids- Pekin Oshkosh- Superior 

Muskegon- Nennah 

Holland * Includes C&I lenders where year-over-year C&I loan growth was 20 percent or more as of 9-30-99. 

Note: The index includes all three-digit Standard Industrial Code classified industries. 

Source: Regional Financial Associates, June 1999 

A total of 116 fast-growing C&I lenders are located 

outside the Region’s MSAs. These banks tend to be 

smaller, with an average asset size of $149 million. 

They typically do not have the same advantages, in 

terms of economic diversity, as institutions within 

MSAs. Assuming that these banks’ C&I portfolios 

reflect the industry exposures of the local area, asset 

quality would be much more vulnerable to a downturn 

in a single industry. For example, approximately 18 

percent of the fast-growing C&I lenders located outside an MSA are also heavily exposed to agricultural 

lending; thus, the stress in agricultural communities 

might spill over into these institutions’ C&I portfolios. 

Summary 

Recent loan growth among the Region’s C&I lenders has 

been strong. C&I loans represent an increasing share of 

C&I lenders’ loan portfolios, which might indicate 

greater credit-risk exposure. Although past-due and loan 

loss levels currently remain low, rapid growth in the C&I 

loan segment could make it more difficult to identify 

asset quality problems. In the event of an economic 

downturn, performance of an institution’s C&I portfolio 

could depend greatly on the economic diversity of the 

lending area. While the past favorable economic and 

interest rate environments may have encouraged some 

institutions to expand C&I lending portfolios, the 

increasing exposure of this loan type should be carefully monitored. 

Rising Interest Rates May Affect Residential Real Estate Lenders’ Profitability
 

Interest rates rose noticeably in 1999, raising questions 

about how residential real estate (RRE) banks14 might 

be affected. The last time interest rates rose appreciably, 

in 1994, profitability at RRE banks weakened quickly 

and substantially (see Chart 5). There are, of course, 

distinctions between the interest rate climates of 1994 

and 1999. In 1994, the Federal Reserve raised shortterm rates six times for a total of 250 basis points. In 

1999, the yield curve steepened while short-term rates 

14 Residential real estate banks are defined as banks and thrifts with 

50 percent of assets in the sum of one- to four-family loans and mortgage-backed securities. 

increased more modestly than in 1994. To date, tighter 

monetary policy has weakened mortgage markets and 

real estate conditions, reduced fee income, and resulted 

in securities portfolio depreciation. Profitability, not 

credit quality, is this group’s primary concern, given its 

relatively conservative credit risk profile. 

Softening Mortgage Markets May Affect 

the Region’s RRE Lenders 

Mortgage activity, particularly refinancing activity, 

slowed significantly when interest rates stopped falling 

Chicago Regional Outlook 24 First Quarter 2000 
Refinancings

Jan ’89

Nov ’89

Sep ’90

Jul ’91 

May ’92

Mar ’93

Jan ’94

Nov ’94

Sep ’95

Jul ’96 

May ’97 

Mar ’98 

Jan ’99 

Nov ’99 

Regional Perspectives
 

in 1999 (see Chart 6). Because year-end 1999 refinancings already represent a very low percentage of total 

originations, any further interest rate increases likely 

will not affect refinancing activity significantly. However, loans to finance the purchase of residential real 

estate might decline if RRE conditions continue to slow 

(for further discussion see “Economy Is Healthy but 

May Be Slowing,” page 19). 

As refinancings have subsided, some analysts have predicted that consumers will take out more second-lien 

home equity loans because they can no longer increase 

cash flow by refinancing first liens at a lower rate. Community RRE banks have indeed experienced a steadily 

rising share of home equity loans; however, such loans 

currently represent only 2.88 percent of total loans. 

Looking forward, the Mortgage Bankers Association’s 

chief economist recently stated that the mortgage industry is headed for a steep cyclical downturn in 2000. 

Already, the industry has seen layoffs and restructuring 

at some of the nation’s largest lenders. Mortgage lenders 

hoping to maintain volume may be forced to compete 

strongly on price, which may lead to further erosion of 

these banks’ margins. 

The Interest Rate Increases in 1999 

May Strain Profitability 

Recent interest rate increases and a consensus opinion 

for slower economic growth15 may continue to pressure 

15 Ford, op. cit. 

CHART 5 

Rising Interest Rates Typically Trigger Declining
 

Aggregate Profitability among Residential Lenders
 

% % Return on Assets: All Other 

4 

5 

6 

7 

8 

9 

10 

11 

12 

30-Year Mortgage Rates 

(Right axis)

 Return on Assets: RRE Banks

 (Left axis) 

Community Institutions (Left axis) 

0 

0.2 

0.4 

0.6 

0.8 

1.0 

1.2 

1.4 

Sources: Bank and Thrift Call Reports and the Federal Reserve Board 

RRE banks’ margins, as occurred in 1994. The interest 

rate increases in 1994 likely hurt these institutions’ 

profitability—in part, because they were liability sensitive in the aggregate. This assumption is consistent with 

the fact that many community institutions have shorter 

average maturities on the liability side of the balance 

sheet than on the asset side. 

No generalizations can be made about current aggregate 

interest rate risk levels because institutions’ balance 

sheet structures and interest rate risk management differ. Because long- and short-term rates increased in 

1999, the effects on margins may be muted, and 

increased loan yields may compensate. Timing differences may temporarily strain margins, as loans often 

have longer maturities and will take longer to reprice at 

higher rates. As a result of experiences in 1994, many 

institutions may now be more actively managing interest rate risk positions to help ensure that profitability 

levels are not as vulnerable to rising interest rates as 

they have been in the past. 

However, asset yields will likely be pressured because 

of increased borrower preference for lower-yielding 

adjustable-rate mortgages (ARMs). ARMs represent an 

increasing percentage of loan originations and, according to the MBA, are expected to continue to do so.16 The 

adjustable-rate share of conventional purchase loans 

rose substantially from 11 percent in January 1999 to 30 

percent as of November 1999. 

16 Mortgage Bankers Association, Mortgage Finance Forecast, 

December 8, 1999. 

CHART 6 

Refinancing Activity Dropped 

Substantially in 1999 

Refinancing Index (applications)

3/16/90 = 100 

Source: Mortgage Bankers Association via Haver Analytics 

Originations 

Jan ’90Jun ’90 

0 

500 

1,000 

1,500 

2,000 

2,500 

3,000 

3,500 

0 

50 

100 

150 

200 

250 

300 

350 

Origination Index (applications) 

3/16/90 = 100 

Jun ’91

Jun ’92Jun ’93Jun ’94Jun ’95Jun ’96Jun ’97Jun ’98Jun ’99 

Chicago Regional Outlook 25 First Quarter 2000 
Regional Perspectives
 

Rising Competition and Interest Rates Have 

Hurt RRE Bank Profitability 

Weakening mortgage markets and higher interest rates 

already may have affected the Region’s RRE banks, 

most of which are small institutions that are experiencing declining profitability. Currently, 316 community17 

institutions in the Region are considered RRE banks; 

they hold aggregate assets of $47.8 billion. Reported 

asset quality and capital levels and trends appear favorable; however, profitability has dropped during the past 

two years from a median ROA of 0.87 percent to 0.70 

percent as of September 30, 1999. This trend has 

occurred largely because of NIM compression. 

During this past decade, RRE banks’ net interest margins peaked in 1993 and trended downward over the 

next six years. Much of the margin compression has 

occurred during a period of declining interest rates and 

strong mortgage markets, underscoring the fact that 

structural and competitive factors have played a significant role. In addition, the Region’s RRE banks have 

relied to a greater degree than institutions elsewhere on 

borrowings, which often have higher costs than core 

funding. However, some RRE banks may experience 

less change in funding costs from recent interest rate 

hikes because of increased use of longer term borrowings, which can take longer to reprice. 

RRE banks with the lowest levels of earnings have 

experienced the greatest declines in profitability on a 

percentage basis. RRE banks with profits in the 25th 

percentile have seen ROA slip from 0.47 percent to 0.32 

percent over the past two years. Increasing variability in 

RRE banks’ profits may be indicative of the stress this 

group is already experiencing because of increased 

competition and a slowdown in mortgage markets. 

Should margins tighten further as a result of recent 

interest rate hikes, this group of institutions may see 

profitability decline further. Such an event could lead 

some institutions to engage in traditionally riskier forms 

of lending in an effort to increase profitability. 

Securities Portfolios Have Depreciated Notably 

RRE banks’ securities portfolios also have been significantly affected by modest interest rate increases 

in 1999. The negative convexity inherent in many 

17 Community institutions are defined as institutions with less than 

$1 billion in assets. 

mortgage-backed securities has likely led to more significant depreciation in RRE bank portfolios. For example, when interest rates rise, the market value of these 

securities declines, much like any fixed-income investment. The reduction in market value is often more 

severe in the case of these instruments, because the 

expected maturity may increase as homeowners are less 

likely to prepay mortgages after interest rates rise. As a 

result, these securities may yield less than market rates 

and have an expected maturity longer than initially 

anticipated. 

The effects of recent interest rate increases are apparent 

at the 123 banks18 in the community RRE group. As of 

December 31, 1998, appreciation in these banks’ securities portfolios totaled 4.1 percent of aggregate Tier 

One capital. As of September 30, 1999, these same 

banks’ securities portfolio depreciation totaled 3.6 percent of aggregate Tier One capital. Declines in market 

values have been slightly higher for RRE banks compared with the remainder of the Region’s banks. 

Some RRE banks have considerable depreciation, 

which may have earnings or liquidity ramifications. 

Sixteen of these institutions had depreciation in excess 

of 10 percent of Tier One capital as of September 30, 

1999. Should interest rates and depreciation levels continue to rise, a reluctance to sell securities will likely 

follow. The earnings of institutions that retain securities 

at depreciated market values will be constrained 

because they are holding lower-yielding investments. 

Banks and thrifts selling depreciated securities in order 

to reinvest at the current market rate or to meet unexpected liquidity needs will have to realize losses in the 

period when they are sold. 

Some Residential Real Estate Lenders Will 

Benefit from Mortgage Servicing Rights 

As of September 30, 1999, slightly fewer than one-half 

of the banks19 in the RRE group held mortgage servicing rights. The median level held was 18 percent of 

assets. Recent interest rate increases should increase the 

average life of this servicing income and partially offset 

potential lost income resulting from reductions in originations and refinancings at these institutions. However, 

18 Thrift institutions do not report securities appreciation and depreciation.
 

19 Thrift institutions do not report the notional value of mortgage
 

servicing rights.
 

Chicago Regional Outlook 26 First Quarter 2000 
Regional Perspectives
 

only a small percentage of banks in this group have significant servicing portfolios that may allow them to 

benefit from rising interest rates. 

Implications for RRE Banks 

Profitability has trended downward, and recent interest 

rate increases will make sustaining profitability levels 

more difficult for many members of this group. RRE 

banks with low long-term borrowings, small servicing 

portfolios, and significant mortgage-backed securities 

portfolios will likely see the greatest NIM squeeze 

should rates continue to rise. Also, credit quality issues 

could arise if these institutions loosen underwriting 

standards or engage in riskier forms of lending to maintain volume or profits. 

Diane Ellis, Senior Financial Analyst 

and the Chicago Region Staff 

Chicago Regional Outlook 27 First Quarter 2000 
✁
 

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