Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION THIRD QUARTER 1997 

FDIC
 

San Francisco
 

Region
 

Division of
 

Insurance
 

Catherine I.
 

Phillips-Olsen,
 

Senior Regional
 

Analyst
 

Gary C. Zimmerman,
 

Regional Economist
 

Roger Stephens,
 

Financial Analyst
 

In Focus This Quarter 

◆ Subprime Lending: A Time for Caution—The extent of subprime lending is increasing as strong competition for high-quality borrowers has 

some lenders moving down the credit quality spectrum. Subprime lending requires 

a commitment of resources and expertise beyond that required in more conservative lending, and the consequences of deficiencies in underwriting, servicing, and 

collection can be severe. See page 3. 

By Kathy R. Kalser, Debra L. Novak 

◆ Retail Shakeout: Causes and Implications for Lenders— 

Despite favorable economic conditions, the retail industry is experiencing slow revenue growth in a highly competitive environment. The confluence of rapid change 

in store formats and slow revenue growth has led to an ongoing shakeout among 

both large and small retail chains, and this shakeout may adversely affect credit 

quality at some insured institutions. See page 6. 

By Richard A. Brown, Diane Ellis 

Regular Features 

◆ Regional Economy—Personal income and employment growth in the 

San Francisco Region remain strong and continue to outpace the nation. Analysts 

are predicting continued expansion in 1997, although enthusiasm is somewhat tempered because the Region’s strength is currently fueled by industries with a history 

of boom and bust cycles. See page 10. 

By Gary C. Zimmerman 

◆ Financial Markets—Securitization of home equity loans is growing 

rapidly . . . consumer debt consolidation loans may be driving this growth . . . signs 

of relaxed underwriting have appeared . . . the arrival of FASITs could increase the 

appetite of community banks to enter the ABS market. See page 14. 

By Allen Puwalski 

◆ Regional Banking—Healthy net interest margins, rising levels of noninterest income, and the implementation of several regulatory reporting changes 

boosted reported first-quarter profits at the Region’s depository institutions.As the 

pace of merger activity increases, a recent SEC ruling tightening criteria pooling of 

interest method for mergers may increase popularity of the purchase method. 

See page 18. 

By Catherine I. Phillips-Olsen, Roger Stephens, DiAnn Bielaczyc 

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

Insurance Corporation for the following eight geographic regions: 

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

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

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

Dallas Region (CO, NM, OK, TX)
 

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

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

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

San Francisco Region (AK, AZ, CA, 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 San Francisco Region’s 

Regional Outlook, please call Catherine I. Phillips-Olsen at (415) 974-4247 or send an e-mail to 

caphillips-@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 Andrew C. Hove, Jr. 

Director, Division of Insurance Arthur J. Murton 

Editor George E. French 

Managing Editor Stephen Linehan 

Associate Editor Maureen E. Sweeney 

Assistant Editors Paul C. Bishop 

Richard A. Brown 

Steven K. Burton 

Diane Ellis 

Kathy R. Kalser 

Ronald L. Spieker 

Publications Manager Teresa J. Franks 
In Focus This Quarter
 

Subprime Lending: A Time for Caution
 

•	 Subprime lenders specialize in lending to borrowers with blemished or limited credit histories. 

•	 The consequences of deficiencies in underwriting, 

servicing, and collection can be severe with subprime lending. Lenders that fail to dedicate the 

necessary resources in these areas likely will have 

trouble succeeding in the increasingly competitive 

market for subprime loans. 

•	 Some institutions insured by the FDIC have failed 

to properly assess and control the risks associated 

with their subprime lending programs. 

What Are Subprime Loans? 

Faced with strong competition and shrinking margins 

on loans to high-quality borrowers, some lenders are 

moving down the credit quality spectrum. The strategy 

to extend loans to borrowers perceived as less creditworthy is referred to as “subprime” lending. Subprime 

lending is most commonly associated with auto, home 

equity, mortgage, and secured credit card loans to borrowers who have blemished or limited credit histories. 

Generally, the characteristics of a subprime borrower 

include a history of paying debts late, personal bankruptcy filings, or an insufficient credit record. 

Subprime loans also are referred to as marginal, nonprime, or below “A” quality loans. There are no established guidelines for determining the degree to which a 

borrower is considered subprime, so one lender’s “B” 

customer could be another lender’s “C” customer. 

Definitional variations aside, some general market 

parameters on ranking loans are presented in Table 1. 

TABLE 1 

Criteria for Loan Rankings 

GRADE PAYMENTS LATE BANKRUPTCY 

30 DAYS FILING
 

PRIME
 NONE NONE
 

A­ LESS THAN 2 NONE IN 5 YEARS 

B LESS THAN 4 NONE IN 3 YEARS 

LESS THAN 6 NONE IN 2 YEARS 

D CONSTANTLY LATE NONE IN 1 YEAR 

Sources: Duff & Phelps, Standard & Poor’s, Mortgage 

Market Information Services 

How Big Is the Market? 

The lack of a standard definition for a subprime loan 

makes it difficult to accurately determine the extent of 

the market. However, some industry experts estimated 

that during 1996, subprime loans secured by residences, 

including both home equity and mortgage loans, 

amounted to between $100 billion and $150 billion compared to the estimated $800 billion in originations of 

conventional mortgages. Subprime auto loans have been 

estimated to range between $75 billion and $100 billion, 

or about 20 percent of total auto loans outstanding. 

Who Makes Subprime Loans? 

In the past, subprime lending was primarily the domain 

of a limited number of finance companies. These firms 

specialized in making high-priced loans to borrowers 

with limited access to credit. 

The number of subprime lenders, however, has surged 

in recent years as more companies have been attracted 

by the significantly higher rates and fees earned on subprime loans. In some cases, yields on these higher risk 

assets have been as high as 15 percent to 30 percent. 

The new subprime participants include finance companies that traditionally served prime borrowers, new specialized subprime lenders, and banks. 

The increase in the number of subprime lenders has been 

fueled by strong demand from investors for asset-backed 

securities (ABS). This method of funding enables the 

lender to effectively raise cash at a lower rate to fund 

loan growth. In addition, the subprime ABS market has 

attracted lenders that previously refrained from making 

subprime loans because they did not want to maintain 

these high-risk loans or the associated reserves on their 

balance sheet. By issuing securities backed by subprime 

loans, lenders now have the ability to originate subprime 

loans and sell them to ABS investors. 

Favorable stock market conditions also helped to fund 

the growth of subprime lenders. Approximately 30 subprime lenders raised nearly $3 billion from stock offerings from January 1995 through April 1997, according 

to market watchers. This financing avenue may become 

less accessible, as investors’ concerns over financial 

problems of several major market participants have 

Regional Outlook	 3 Third Quarter 1997 

C 
In Focus This Quarter
 

caused stock prices of subprime lenders to decline significantly during the first part of 1997. 

Financial Difficulties of Some Subprime 

Lenders 

Market participants have observed that, as in credit card 

lending, increasing competition may be compelling some 

subprime lenders to compromise 

underwriting standards and lower 

pricing in order to protect market 

share. Financial difficulties reported by major subprime auto lenders 

Jayhawk Acceptance Corporation 

and Mercury Finance Company 

highlight these concerns. 

Problems in subprime lending are not limited to auto 

loans. Lenders that specialize in subprime home equity 

loans and mortgages also are showing signs of stress. In 

April 1997, Moody’s Investors Service lowered the rating on subordinated debt issued by a leading originator 

of subprime mortgage and home equity loans. The reason was concern over the increasing level of delinquencies in the issuer’s loan portfolio and the highly 

competitive environment for subprime home equity 

loans (see Financial Markets). 

Differences between Prime and Subprime 

Lending 

There are key differences between the underwriting, servicing, and collection methods used for prime and subprime lending programs. The goal of the subprime 

underwriting process is to differentiate those subprime 

borrowers whose past credit problems were due to such 

temporary events as illness or job loss from the habitually bad credits. Subprime lenders often supplement a 

prospective borrower’s credit bureau report with such 

additional information as income, employment history, 

and the nature of prior credit problems. This process 

allows the lender to better determine the credit risk or 

“grade” of the borrower. If this determination is successful, the lender can better establish the price at which 

the loan will be profitable. 

Servicing and collection of subprime loans tends to be 

more labor intensive and costly than in prime lending. 

Subprime lenders tend to monitor payments more closely than prime lenders. Some purportedly call their borrowers regularly to remind them when a payment is due. 

In addition, while prime lenders may be willing to work 

with late borrowers by adjusting minimum amounts or 

payment schedules, subprime lenders generally pursue 

collections more aggressively and repossess collateral 

more quickly. 

Insured Institutions and the Subprime Market 

Bank involvement in subprime lending is difficult to 

quantify because subprime loans are not delineated in 

bank and thrift Call Reports. However, both large and 

small banks reportedly are participating in credit card, 

auto, home equity, and mortgage subprime lending. 

Insured institutions have used various strategies to establish a presence in the subprime market. Some have: 

•	 acquired or formed joint ventures with companies 

specializing in subprime lending; 

•	 built subprime lending programs internally, using 

existing resources; and 

•	 tapped a network of loan brokers with access to subprime borrowers. Smaller banks entering the market 

for subprime mortgages may use this method more 

commonly. 

Through these strategies, insured institutions have: 

•	 extended loans directly to subprime borrowers or 

purchased subprime loans from loan brokers; 

•	 lent to subprime specialty lenders in the form of loan 

participations, warehouse lines, liquidity facilities, 

or dealer lines; and 

•	 serviced subprime loans or invested in asset-backed 

securities secured by subprime loans. 

A recent survey of examiners identified 39 institutions 

in the San Francisco Region involved in subprime lending. Some of the subprime lending activities include the 

following: 

•	 C, D, and E grade automobile paper; 

•	 secured credit card loans; 

•	 debt consolidation loans; 

•	 accounts receivable factoring; 

•	 B and C grade mortgages; 

•	 Federal Housing Administration Title I mortgages; 

and 

•	 no-documentation mortgages. 

Approximately half of the identified institutions are 

located in California. 

Regional Outlook	 4 Third Quarter 1997 
In Focus This Quarter
 

Risks Associated with Subprime Lending Need 

to Be Considered Carefully 

According to a Financial Institutions Letter (FIL), FIL 

44-97 issued by the FDIC’s Division of Supervision, 

recent examinations revealed that a number of financial 

institutions involved in subprime lending have failed to 

properly assess and control the risks associated with 

subprime lending. Because of the relatively high default 

rates on such loans, the FIL indicates that this type of 

lending warrants particular caution and management 

attention. 

Institutions need to be thoroughly aware of the 

increased risks and costs associated with lending to 

higher risk borrowers. Some of these risks include: 

•	 Delinquencies and defaults tend to be more frequent 

and occur sooner on lower quality loans (see 

Chart 1). 

•	 Loan loss reserves that would have been adequate for 

prime lending may not properly cover higher loss 

rates associated with subprime loans. 

•	 Strains on underwriting and collection resources 

may emerge. 

•	 Because selling collateral is more frequently the 

source of repayment on subprime loans, failure to 

accurately estimate recovery values could severely 

affect the profitability of subprime lenders. For 

example, several subprime auto lenders recently 

reported lower profits when the supply of better 

quality cars coming off leases depressed the prices 

they received on repossessed cars. 

Insured institutions that rapidly increase subprime 

exposures also may need to reevaluate delinquency 

CHART 1 

0% 

10% 

20% 

30% 

40% 

50% 

1 4 7 10 13 16 19 22 25 28 31 34 

Months since Origination 

"C" Auto Loans 

"A/B" Auto Loans 

"D" Auto Loans 

Source: Fitch Investors Service, L.P. 

Default Rate 

Defaults Are More Frequent and Occur 

Sooner on Lower Quality Auto Loans 

measurement methodologies. Rapid loan growth can 

make it more difficult to accurately track delinquency 

and default trends. Generally loans do not default 

immediately, but “season” or reach peak loss rates over 

a period of time. Delinquency and default rates can be 

deceptively low if the proportion of new loans exceeds 

the proportion of seasoned loans in a lender’s portfolio. 

Calculating default rates over time for loans originated 

in a particular period or lending program, instead of as 

a percentage of total outstanding loan balances, helps 

reduce the distortion caused by rapid loan growth. This 

method of computing delinquency and default rates, 

known as “static pool” or “vintage analysis,” is a common measurement tool among investment analysts. 

Banks involved in subprime lending also should realize 

that the recent increase in subprime lending has 

occurred during relatively healthy economic conditions. 

The repayment capacity of subprime borrowers may be 

more susceptible to downturns in the economy, which 

could further exacerbate the already high level of 

delinquencies and defaults typically recorded on subprime loans. 

In addition, banks that lend to subprime specialty 

lenders, who rely heavily on securitization, should evaluate the accounting treatment of securitization and the 

effect securitization may have on earnings (see 

Financial Markets). 

Conclusion 

The extent of involvement by insured institutions in 

subprime lending is difficult to quantify. To be successful in subprime lending requires a commitment of 

resources and expertise. Conversely, deficiencies in 

assessing and controlling the risks of subprime lending 

can have serious consequences. Such deficiencies have 

surfaced at a number of FDIC-insured institutions. 

Striking an appropriate balance between the risks and 

rewards of subprime lending is a challenge for bankers 

and merits the continued attention of bank supervisors. 

Kathy R. Kalser, Chief 

Financial Sector Analysis Section 

Debra L. Novak, 

Division of Resolutions and Receiverships 

San Francisco Region material provided by: 

Gail A. Kirwan 

Division of Supervision 

Regional Outlook	 5 Third Quarter 1997 
In Focus This Quarter
 

Retail Shakeout: Causes and Implications for Lenders
 

•	 Changes in the marketplace, technology, and 

finance are transforming retailing. 

•	 These trends have given rise to rapid growth in 

the new “big box” store format. 

•	 Consolidation in retailing is evident in mergers, 

acquisitions, and bankruptcies. 

•	 The potential for overbuilding in retail real estate 

markets may pose a risk for insured depository 

institutions. 

For the past two decades, construction of retail space 

has outstripped many indicators of demand such as 

growth in retail sales, population, and income. The 

broadest measure of the industry’s health is sales per 

square foot, and, for shopping centers, it has fallen by 

around 35 percent in real terms since 1972. Chart 1 

shows how growth in leasable shopping center space 

has exceeded growth in shopping centers’ sales since 

1972. 

Based on signs of “overstoring,” a number of retail 

industry analysts have concluded that too many stores 

are chasing too few consumer dollars, indicating an 

emerging shakeout in the retail sector. To the extent that 

insured depository institutions provide financing to 

retailers or for retail real estate, they are exposed to 

heightened credit risk as the shakeout unfolds. 

New Forces Are Reshaping the Retail Landscape 

A combination of demographic and economic forces 

has reduced growth in demand for retail goods from the 

boom days of the 1970s and mid-1980s. Meanwhile, 

technology is reconfiguring the way retail goods are 

marketed and delivered, and a low cost of capital has 

stimulated investment in new retail space and new 

retailing concepts. 

A retail industry boom began roughly in 1970 when 

baby boomers and women began entering the work 

force in record numbers. At the same time, proliferation 

in general-purpose credit cards facilitated an extension 

in consumer borrowing power. As a result, there was a 

CHART 1 

100 

150 

200 

250 

300 

350 

’72 ’76 ’80 ’84 ’87 ’89 ’91 ’93 ’95 

Leasable 

Space* 

Inflation-adjusted 

Sales * 

* Does not include non-shopping center space. 

Source: International Council of Shopping Centers 

1972=100 

Construction of Shopping Center Space Has 

Outstripped Sales Growth 

98 percent increase in inflation-adjusted retail sales 

from 1967 to 1994. 

To meet this demand and serve expanding suburban 

communities, developers built shopping centers at a 

rapid pace. The number of shopping centers, from small 

neighborhood strip centers to huge regional malls, grew 

from about 13,000 in 1972 to over 41,000 in 1995. 

Despite economic conditions that seem favorable for 

the retail sector, revenue growth has been painfully 

slow in the 1990s. Payrolls have seen net growth of 13.4 

million jobs since mid-1991, while real disposable personal incomes and consumer confidence have risen 

commensurately. An optimistic household sector has 

shown a willingness to take on debt under these favorable conditions and has done so with the benefit of 

lower interest rates compared to the 1980s. 

Even with generally positive economic conditions, 

retail demand has grown slowly in the 1990s (see Chart 

2, next page). Annual rates of increase in real expenditures on many durable and, especially, nondurable goods 

have lagged behind rates of the previous two decades. 

Slow growth in retail revenues can be explained in part 

by the fact that retail goods overall have risen in price at 

only around two-thirds of the general rate of inflation 

during the 1990s, while the appliance, electronics, and 

personal computer sector has seen actual price deflation. 

Regional Outlook	 6 Third Quarter 1997 
In Focus This Quarter
 

An aging consumer base is another factor holding down 

retail sales growth. The total number of households 

headed by persons age 20 to 35—the age at which families are getting established and acquiring household 

durable goods—is the same now as it was in 1980. The 

lack of growth in this key demographic group has limited growth in retail demand and should continue to do 

so for the foreseeable future. The total population in the 

20 to 35 age bracket is projected to decline slightly by 

2007. 

Other broad trends have contributed to slower retail 

sales growth. Retail sales as a percentage of personal 

income fell from 46 percent to 38 percent between 1967 

to 1996 as consumers shifted more of their disposable 

income to the purchase of personal services, housing, 

education, travel, and entertainment. A Standard and 

Poor’s Industry Survey reports 

that consumers have reduced 

their number of trips to shopping 

malls by 35 percent since 1980, 

while total shopping hours are 

down 70 percent. 

Looking ahead, mail-order retailing through electronic media, 

including cable television and the Internet, may be 

poised to gain significant market share at the expense of 

shopping centers. “Virtual shopping malls” such as 

Amazon.com, an Internet bookseller, have made headlines with their initial successes, although analysts caution that widespread adoption of high-tech shopping 

may be some years down the road. 

Technology has become a key to distribution and marketing. Faced with slower revenue growth, retailers have 

been investing in technology to cut their expenses and 

boost their bottom lines. For example, point-of-sale 

scanning delivers a vast amount of information that can 

be used to target marketing efforts and manage and control inventories—providing a distinct competitive 

advantage for large retail chains with vast marketing 

and distribution networks. 

A low cost of capital has fueled investment. Low interest rates and a booming stock market have made market 

financing plentiful and cheap. This environment has 

allowed retailers to overhaul retail strategies and invest 

heavily in technology, inventory, and retail space— 

investments that might otherwise have been infeasible. 

Since 1991, around 1.13 billion square feet of new retail 

space has been added nationwide representing an 

increase of about 12 percent to the total stock of retail 

real estate over five years. Net additions to retail inventories since 1991 have totaled almost $33 billion in 

inflation-adjusted dollars, an increase of over 18 percent. No figures are available on investments made in 

information systems, although they are known to be 

sizeable. 

Growth of the “Big Box” Format 

Leading retailers have responded to these forces with 

aggressive expansion in the “big box” store format. Big 

box retailers are typically discount stores and superstores, such as Circuit City, PetSmart, and The Home 

Depot, Inc., which tend to cluster in large strip malls 

called “power centers.” In many towns and cities, the 

arrival of big box stores has left smaller, local retail 

establishments with only a small fraction of their former 

share of the local market. 

The big box format has a number of advantages. Among 

the most important is the ability to offer a large, diverse 

on-shelf selection. This approach enables a single location to dominate that retail category in the local market, 

which is why the big box chains are often referred to as 

“category killers.” Large retail chains also have more 

leverage over suppliers. They can negotiate more favorable prices and demand cooperative advertising from 

manufacturers. Large retailers typically have the financial resources to invest in the latest distribution methods 

and technology. Finally, unlike smaller traditional retailers, these large chains can obtain financing through the 

capital markets. 

CHART 2 

Inflation-Adjusted Retail Sales Have Grown 

Slowly in the 1990s 

Real Growth in Retail Sales*, 

Compound Annual Rate 

3.0% 

2.5% 

2.0% 

1.5% 

1.0% 

0.5% 

0.0% 

1970s 1980s 1990s 

* Retail sales excluding autos, deflated by the consumer price index. 

Source: Bureau of the Census and Bureau of Labor Statistics 

Regional Outlook 7 Third Quarter 1997 
In Focus This Quarter
 

Industry Consolidation to Continue 

Rapid expansion among the large retail chains has contributed to a highly competitive retail sector marked by 

intense battles for domination of the major retail categories. The result of this competition, analysts say, will 

be consolidation in the industry as weaker chains give 

way to market leaders. 

One sign of this consolidation is in multibillion dollar 

acquisitions, such as Federated Department Stores’ 

acquisition of R.H. Macy. The five largest department 

store chains (JC Penney, Federated, May, Dillard, and 

Nordstrom) now account for 87 percent of department 

store sales nationwide. The top three discount department store chains (Wal-Mart, K-Mart, and Target) 

account for 87 percent of full-line discount department 

store sales. 

Intensely competitive conditions also are reflected by 

retail bankruptcies and restructurings. Both Woolworth 

Corp. and K-Mart Corp. recently closed a number of 

stores in restructurings that reflect the loss of market 

share to Wal-Mart. Smaller companies that have fewer 

restructuring options are more likely to be forced into 

bankruptcy. Dun & Bradstreet reports that domestic 

business failures among retail establishments rose in 

1995 by 2.8 percent to 12,952. While most of these failures were individual stores and small chains, a number 

of larger chains also filed for bankruptcy during 1995, 

including Barney’s, Bradlees Inc., Caldor, The 

Clothestime Inc., Edison Brothers Stores, ElderBeerman, Herman’s Sporting Goods, Jamesway, and 

Today’s Man. 

As the retail shakeout moves forward, any credit losses 

on commercial and industrial loans to retailers are more 

likely to arise from bankruptcies and restructurings than 

from mergers and acquisitions. Unfortunately, it is difficult to say in advance exactly how consolidation in the 

industry is likely to take place. 

Overbuilding Is a Risk for Retail Real Estate 

Retail industry analysts are particularly concerned 

about the potential for overbuilding of retail space. 

Because of this concern, lenders and examiners should 

be alert to possible credit quality problems with commercial real estate loans secured by retail properties. 

CHART 3 

0 

20 

40 

60 

80 

100 

120 

140 

160 

’88 ’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 

0% 

2% 

4% 

6% 

8% 

10% 

12% 

New Supply Has Recently Outpaced 

Absorption of Retail Space 

Source: FDIC, The Real Estate Report (Summary for 58 major markets) 

Vacancy 

Rate 

Net New Supply Absorption 

Millions of 

Square Feet 

Although a vacancy rate of 7.7 percent does not suggest 

that the U.S. retail market is vastly overbuilt at present, 

there are warning signs. One is that the U.S. aggregate 

vacancy rate has begun to tick upward since 1995 as net 

completions of new retail space have caught up to and 

surpassed the absorption of that space by retailers (see 

Chart 3). Another frequently cited indicator of overbuilding is a falling ratio of sales per square foot in the 

industry, reflecting the fact that additions to retail space 

have outpaced sales growth for some time. In any case, 

local market conditions may be somewhat more volatile 

than the national figures would suggest, particularly in 

areas where a great deal of construction activity has 

recently taken place (see inset, Strength of the San 

Francisco Region’s Retail Real Estate Markets Is 

Mixed). 

Besides market conditions, underwriting is the other 

major determinant of credit quality in retail real estate 

lending. Market analysts report that many of the problems resulting from local market downturns have been 

on loans with 1980s-vintage underwriting, particularly 

those with high loan-to-value ratios. Analysts also voice 

concern that the rapid expansion of space may be 

putting downward pressure on lease rates. In light of an 

ample supply of space and a number of large chains 

continuing to add space, any valuations that assume 

future growth in lease rates should be closely reviewed. 

The viability of rapid expansion on the part of the large 

retail chains would undergo a particularly severe test in 

the event of a recession. 

Richard A. Brown, Chief, Economic Analysis Section 

Diane Ellis, Senior Financial Analyst 

Regional Outlook 8 Third Quarter 1997 
In Focus This Quarter 

Strength of the San Francisco Region’s 

Retail Real Estate Markets Is Mixed 

Overall, most of the San Francisco Region’s major 

metropolitan areas are reporting favorable trends in 

vacancies, relatively low vacancy rates, or both. 

However, conditions around the Region vary, as illustrated in Table 1. Several markets are reporting vacancy rates that are well below the 1996 national average 

of 7.7 percent for retail real estate, while other markets 

report relatively high rates. 

A combination of expanding residential markets, positive job creation, limited development space, and 

higher median incomes help alleviate some concerns 

for high vacancies in markets such as Phoenix, 

Riverside, and Oakland. However, several markets in 

the Region warrant closer scrutiny because of developing negative trends in vacancy rates, such as the 

increasing supply of new retail space and the lagging 

absorption of retail space. Indeed, 9 of the 14 markets 

listed below have been identified as “oversupplied” 

with a low probability of achieving equilibrium before 

the year 2000, according to a quality ranking developed by Landauer Associates, Inc. (This ranking, 

shown in Table 1, incorporates existing inventory, 

planned construction, and growth.) 

CHART 4 

Honolulu Retail Vacancy Rate Rising 

Square Feet (000's) Vacancy Percentage 

1600 9 

1400 8 

1200 7 Vacancy Rate Net New Supply 6 1000 Absorption 5 800 4 600 3 

400 2 

200 1 

0 0 

Source: FDIC, The Real Estate Report, April 1997 

Two of the Region’s markets are of particular interest. 

Real estate in general has long been an issue in 

Hawaii, which has endured a major real estate slump 

and a long recession. The retail real estate market in 

Honolulu is no exception, as indicated by rising retail 

vacancy rates over the past three years. Retail vacancy 

rates are now at their highest level of the decade, as 

shown in Chart 4. This high level is in part a reflection 

of the state’s weak economy and the lower level of 1988 

spending on retail goods by tourists in Hawaii. 1989

Sacramento is also an interesting market because of 1990

the relatively high vacancy rates that have existed for 

the past two years, up noticeably from 1994. In con­ 1991

TABLE 1 junction with high vacancies, Chart 5 shows that 1992

Sacramento has a history of only modest absorption of San Francisco Region Retail Real 

retail real estate in recent years. Some analysts are 1993

Estate Market Quality Ranking (MQR) 

expressing concerns regarding the direction of this and Vacancy Rates Vary 1994 1995 1996 1988 1989 1990 1991 1992 1993 1994 1995 1996 

market because of the anticipated surge in new supply 

1993 1994 1995 1996 MQR* that could reduce sales per square foot. 

LOS ANGELES 6.2% 3.8% 4.9% 4.8% 5 

OAKLAND 10.9% 8.3% 7.6% 9.4% 6 Gary Zimmerman, Regional Economist 

ORANGE 8.5% 6.9% 6.5% 6.2% 6 CHART 5 

RIVERSIDE 12.6% 9.3% 10.5% 9.5% 5 

SACRAMENTO 10.2% 8.,7% 10.1% 9.9% 7 Retail Vacancy Remains High in Sacramento 

SAN DIEGO 6.7% 7.3% 7.3% 7.4% 6 Square Feet (000's) Vacancy Percentage 

SAN FRANCISCO 

SAN JOSE 

HONOLULU 

3.7% 

7.0% 

5.4% 

4.1% 

6.4% 

8.4% 

3.9% 

5.9% 

7.9% 

3.3% 

6.9% 

8.8% 

6 

6 

7 

3500 

2500 

Net New Supply Vacancy Rate 

(right scale) 

16 

14 

12 

LAS VEGAS 7.3% 5.6% 4.5% 4.2% N/A 1500 10 

PHOENIX 11.4% 10.3% 9.9% 10.3% 4 8 

PORTLAND 4.3% 3.6% 4.4% 4.4% 4 500 6 

SALT LAKE CITY 

SEATTLE 

6.6% 

3.0% 

5.6% 

3.1% 

4.6% 

3.4% 

5.6% 

4.3% 

6 

6 

-500 Absorption 

4 

2 

UNITED STATES 9.0% 7.6% 7.4% 7.7% N/A -1500 0 

*Landauer Associates, Inc. (1=Very Strong, 7=Very 

Weak) 

Sources: FDIC The Real Estate Report, April 1997 Source: FDIC, The Real Estate Report, April 1997 

Regional Outlook 9 Third Quarter 1997 
Regular Features	 Regional Economy
 

Strong Growth in Services, Aerospace, and High-Tech
 

Boosts the San Francisco Region’s Performance
 

•	 The San Francisco Region as a whole continues to outperform the nation in generating income and creating jobs. 

•	 High-technology, aerospace, and construction, three industries with a history of boom and bust cycles, are 

presently key sources of strength in the Region. 

•	 Business services and tourism boosted the performance of the service sector and are contributing to the 

Region’s prosperity. 

Strong Growth Continues in the San Francisco 

Region 

Over the past year the San Francisco Region has grown 

at a much faster pace than the nation as a whole, both 

in terms of personal income and employment. In addition, high-tech and commercial aerospace manufacturing, construction, and business and tourist services all 

have exhibited noteworthy strength over the past year. 

Most analysts continue to give the Region favorable 

marks and anticipate continued expansion in 1997, 

although perhaps at more moderate rates. The robust 

performance of the Region is clearly a factor in the 

strong earnings and generally improving asset quality of 

the Region’s banking industry. 

The Region continues to lead the nation in generating 

employment, as it has over the past two years. Over 

724,000 jobs were added in the Region in the 12-month 

period ending April 1997. The 3.3 percent increase in 

nonfarm payroll employment was the fastest over a 

comparable one-year period since the national recovery 

began in 1991. Job growth in 6 of the Region’s 11 states 

(Arizona, California, Nevada, Oregon, Utah, and 

Washington) was 3 percent or better, well above the 2 

percent increase in employment elsewhere in the nation. 

Idaho, which had been showing signs of slowing over 

the past year, slipped to a 2.5 percent growth rate over 

the past 12 months, down from 3.3 percent a year ago. 

Over the past year, employment growth rates for the 

Region’s slowest growing states—Alaska, Hawaii, 

Montana, and Wyoming—ranged from 1.1 percent in 

Montana to zero in Hawaii. 

The manufacturing sector is presently a key source of 

strength for the Region. Over the 12 months ending 

April 1997, the Region’s manufacturing employment 

grew 3 percent. In contrast, elsewhere in the nation 

manufacturing employment actually contracted. The 

bulk of the nearly 88,000 new manufacturing jobs created in the Region over the past year were in the production of durable goods. 

The strength in two manufacturing industries, high-tech 

and aerospace, was especially noteworthy. Chart 1 

shows that several states, and the Region as a whole, are 

much more dependent on the health of these two industries than is the nation as a whole. Nationally, high-tech 

and aerospace employment combined made up only a 

little more than 10 percent of total manufacturing 

employment, according to the 1995 Census Bureau 

survey on manufacturing employment. In contrast, over 

one-quarter of all manufacturing jobs in both 

Washington and California were in either aerospace or 

high-tech. Arizona and Idaho also have a relatively high 

concentration of their manufacturing jobs in these two 

industries. 

CHART 1 

High-Tech and Aerospace Dominate 

Manufacturing in the Region 

Source: Department of Commerce, Census Bureau, Annual Survey of Manufacturers, 1995 

0% 10% 20% 30% 40%

U.S. 

Region 

Washington 

California 

Idaho 

Utah 

Oregon 

Arizona 

Aerospace 

High-Tech 

Percentage of Manufacturing Employment 

Regional Outlook	 10 Third Quarter 1997 
Regular Features Regional Economy
 

High-Tech Should Improve with the Chip 

Market 

High-tech employment is defined here to include jobs 

in manufacturing computers, electronic components, 

communications, and measurement and control equipment. The Region accounted for over 34 percent of the 

nation’s employment in high-tech electronics in 1995, 

according to the Census Bureau survey on manufacturing employment. The importance of California to the 

nation’s high-tech industry is illustrated in Chart 2. 

California accounts for less than 11 percent of the 

nation’s employment, yet 25 percent of the nation’s 

high-tech manufacturing jobs are located in the state. 

The soft demand for chips and computer products that 

surprised the industry in 1996 is expected to give way to 

a moderate increase in production in 1997. Recent forecasts by industry analysts suggest that the chip market 

should grow between 5 and 12 percent in 1997. That 

rate of expansion would benefit both California and the 

growing number of states, including Arizona, Idaho, 

Oregon, Utah, and Washington, that have developed 

sizeable high-tech manufacturing industries. 

Within California, high-tech is most dominant in the 

booming Silicon Valley. A low unemployment rate, a 

scarcity of skilled workers, housing shortages, and 

extremely low commercial real estate vacancy rates all 

attest to the impact of the industry on business conditions in the Silicon Valley. Moreover, the boom is 

extending to other parts of the Bay Area and the 

Sacramento region, as well as to out-of-state manufacturing centers. 

CHART 2 

The San Francisco Region Has a Large Share 

of High-Tech Employment 

Arizona 3% California 25% 

Other States
 

in the Region
 

6%
 Rest of the
 

Nation
 

66%
 

Source: Department of Commerce, Census Bureau, Annual Survey of 

Manufacturers,1995 

Expansion, however, continues to present challenges for 

the Silicon Valley. Technological changes, competition, 

and the lure of lower-cost production facilities continue 

to lead firms to relocate their manufacturing facilities 

outside the Silicon Valley. Several manufacturers have 

recently announced that it is more cost-effective to build 

new facilities in other locations than to refurbish an 

obsolete plant in the Valley. According to Strategic 

Marketing Associates, an industry market-research 

firm, of the 14 large semiconductor fabrication facilities planned to open around the world by the year 2000, 

only three will be built in the United States, and none 

will be located in California. 

Movement from the Silicon Valley has benefited many 

emerging manufacturing centers located in other areas. 

While other states in the Region have much smaller 

high-tech industries than California does, their growth 

rates have outpaced California’s. Computer-manufacturing employment grew at rates in excess of 20 percent 

in Oregon and Washington last year, compared with a 

7.7 percent increase for California. 

Aerospace Is Booming in Washington State 

The Region’s share of the nation’s aerospace jobs is 

even greater than its share of high-tech employment. 

Aerospace employment is defined here to include jobs 

in manufacturing aircraft, missiles and spacecraft, and 

search and navigation equipment. As shown in Chart 3, 

next page, the Region accounts for 40 percent of aerospace employment nationally. For comparison purposes, 

the Region accounts for under 19 percent of the nation’s 

employment. The bulk of the aerospace employment in 

the Region is in Washington and California. 

Commercial aerospace manufacturing, especially in 

Washington, is reaping the benefits of a favorable economy, growth in airline passenger traffic, and the need to 

replace aging or noisy jet fleets. The surge in demand 

has built a huge backlog of orders, more than half of 

which are from foreign air carriers whose fortunes are 

less closely tied to U.S. economic conditions. Boeing, 

headquartered in Seattle, and its many subcontractors 

have responded to the aerospace boom by increasing 

production to meet the demand. Boeing alone is slated 

to add another 10,000 employees over the course of 

1997 following the addition of more than 20,000 

employees in 1996. 

Regional Outlook 11 Third Quarter 1997 
Regular Features Regional Economy
 

CHART 3 

The San Francisco Region Has a Large Share 

of Aerospace Employment 

Rest of the 

Nation 

60% 

Region 

40% 

Source: Department of Commerce, Census Bureau, Annual Survey of 

Manufacturers,1995 

In 1996 Washington’s aerospace employment surpassed 

that of California, and by April 1997 it again exceeded 

the 100,000 level. Despite the current boom, Washington 

aerospace employment still is well below the peak of 

118,000 it hit in 1989 before the full impact of defense 

cutbacks hit the industry. However, Washington’s turnaround still compares favorably with California, which 

because of its dependence on defense contracts has yet 

to experience an upturn in aerospace. 

Technology and Aerospace Stand Out Because 

of Their History of Wide Business Cycle Swings 

Both the high-tech and aerospace manufacturing industries have a history of experiencing more severe business cycle swings than do most other sectors of the 

economy. High-tech and aerospace investments are sensitive to interest rates movements. Weak industry or 

economic conditions also may warrant postponing hightech investments or costly aircraft purchases until conditions improve. In addition, demand for aircraft tends 

to move in cycles that depend on air traffic volume and 

the performance of the world’s airlines, factors that are 

strongly influenced by economic conditions. 

These highly cyclical industries usually are procyclical; 

they tend to boost the Region’s growth during good times 

and weaken it during recessions. Chart 4 shows the 

exaggerated business cycle swings since the mid-1970s 

for California’s high-tech industry compared with total 

employment (excluding high-tech). Chart 5 (see next 

page) shows the similar patterns for Washington’s aerospace industry. Aerospace also has been subject to wide 

swings related to increases, and more recently decreases, 

in defense spending. At the state and local levels, where 

these industries may account for a large portion of local 

economic activity, their boom and bust cycles can be 

especially important. 

Implications: Hightech and aerospace 

tend to exhibit wide 

swings in growth over 

the course of the business cycle that can 

affect business conditions at the local, state, and regional levels. The San 

Francisco Region’s exposure to these swings is even 

greater than the nation’s because the Region is much 

more dependent on these industries. Thus, while the 

growth phase of the business cycle for these industries 

may stimulate expansion in other industries and 

increase the demand for loans, the contraction phase 

traditionally has weakened economies that are dependent on these industries and caused deterioration in 

asset quality. Because of the highly cyclical nature of 

these industries, it is important to understand both their 

current contribution to the Region’s economic health 

and their future prospects. 

Construction Employment Climbs as Real Estate 

Markets Heat Up 

A third highly cyclical industry is construction. The San 

Francisco Region is slightly more dependent on construction employment than is the nation. Current conditions in the Region’s construction sector are generally 

robust, with the key exceptions of Hawaii and some 

areas of Southern California. Over the 12 months ending in April 1997, the sector added more than 80,000 

CHART 4 

California High-Tech Employment Growth Rates
 

Vary More Than Other Employment
 

-10% 

-5% 

0% 

5% 

10% 

15% 

20% 

197419761978198019821984198619881990199219941996 

All Other Employment 

High-Tech Manufacturing* 

*Excludes communications. 

Source: Bureau of Labor Statistics. 

Regional Outlook 12 Third Quarter 1997 
Regular Features Regional Economy
 

CHART 5 

-20% 

-10% 

0% 

10% 

20% 

30% 

All Other Employment 

Aerospace Employment* 

Source: Bureau of Labor Statistics 

Washington Aerospace Employment 

Growth Rate Is Highly Cyclical 

1974

197619781980

19821984

19861988199019921994

1996 

*Includes aircraft and parts only 

jobs. This increase of 7.7 percent is nearly twice the rate 

of growth nationally. Despite a sharp decline in housing 

permits, residential construction activity remained 

strong in Nevada during the first quarter. Building 

activity also has picked up in California in the aftermath 

of the devastating flooding earlier in the year and the 

mild winter that followed. 

Relatively low commercial vacancy rates in most office 

and industrial markets in the Region, along with 

increased activity in the commercial real estate industry, 

also are contributing to the pickup in construction 

employment. As noted in Retail Shakeout: Causes and 

Implications for Lenders, most analysts believe that 

vacancy rates and market fundamentals for retail-based 

real estate in most metropolitan areas of the Region 

remain positive. 

Strength in Services and Tourism 

The service sector tends to experience relatively small 

variations in annual growth rates over the business 

cycle, a sharp contrast with the behavior of high-tech, 

aerospace, and construction. Not only has the service 

sector been more stable in recent decades, it also has 

been the fastest growing sector. Its current performance 

is consistent with that trend. 

The Region’s service sector added 309,000 jobs over the 

past year, a robust 4.7 percent growth rate. Business 

services, which encompasses an array of rapidly growing activities including programming and software services, equipment leasing, and temporary employment 

agencies, added more than 129,000 jobs over the past 12 

months, an increase of 9.3 percent. 

Tourism and travel services also scored gains in much 

of the Region and helped boost service sector activity. 

The healthy economy has stimulated both business and 

tourist travel. Five states reported noteworthy strength 

in tourism: Arizona, California, Nevada, Oregon, and 

Utah. The San Francisco and Los Angeles areas recorded increased tourism in 1996, and analysts expect similar favorable conditions for 1997. Arizona reported 

nearly a 4 percent increase in domestic visitors last year, 

and Utah reported rapid growth in lodging employment. 

High occupancy rates have improved conditions for 

hotels in Las Vegas, Portland, and San Diego. Finally, 

both the travel and amusement industries are reporting 

rising employment levels. 

Implications: The simultaneous robust performance of 

three cyclical industries over the past year is a key factor in the current health of the Region’s economy. Still, 

the boom in all three highly cyclical industries bears 

monitoring. While all three are presently doing well, 

and most analysts anticipate continued favorable conditions, this Region is much more dependent on the health 

of these industries than is the nation as a whole. 

Furthermore, the strong economy is an important reason 

for the robust performance of the Region’s banking 

institutions. However, in the past, downturns in these 

sectors, like aerospace in Washington in the early 1980s 

or California in the 1990s, high-tech in the Silicon 

Valley in the mid-1980s, or real estate in California in 

the first half of the 1990s, all have adversely affected 

both the Region and some of its banks. 

Gary C. Zimmerman, Regional Economist 

Regional Outlook 13 Third Quarter 1997 
Regular Features	 Financial Markets
 

Financial Markets
 

•	 Deteriorating credit quality trends in the rapidly growing home-equity backed securities market could portend trends in bank residential mortgage lending. 

•	 Financial asset securitization investment trusts, known as FASITs, promise to change the asset-backed securities market significantly and could make securitization more accessible to community banks. 

•	 The Treasury yield curve is steeper and higher than it was at year-end 1996. 

•	 During the first quarter of 1997, the San Francisco Region’s Community Bank Index gained steadily 

despite disturbance in the broad market and other bank indices. 

Trends in the Home-Equity Asset-Backed 

Market Are Important to Banks 

The home-equity loan (HEL) asset-backed securities 

(ABS) market has grown by over $20 billion or 251 percent since 1993, with total issuance of HEL ABS topping $27 billion in 1996 (see Chart 1). The rapid growth 

of the market, which has been driven largely by consumer debt consolidation lending, has been accompanied by abnormally early and high levels of 

delinquencies. Banks that are investing in HEL ABS, 

considering securitizing HELs, or lending significantly 

for debt consolidation should be aware of credit quality 

developments in the HEL ABS market. 

The distinction between HELs and first-lien residential 

mortgages is eroding in the HEL ABS market. The refinancing boom spurred by the decline in rates during 

1993 and early 1994 resulted in a change in the makeup 

of the HEL ABS market, causing much higher percentages of the securities to be backed by first-lien HELs 

than previously had been the case. First-lien home-equity lending, know as cash-out refinancing, grew substantially when home-equity borrowers were motivated by 

lower rates to refinance their first mortgages for 

amounts greater than the remaining principal balance 

instead of adding a second mortgage. 

Debt consolidation is the primary reason for homeequity borrowing. Nonbanks that expanded their mortgage lending capacity during 1993 have been 

aggressively marketing to an increasing number of borrowers who desire to consolidate their growing debt 

burdens. According to the Consumer Bankers 

Association 1997 Home-Equity Loan Study, debt consolidation accounted for 36 percent of home-equity 

lines of credit and 40 percent of closed-end loans. Prior 

to 1992, home improvement was the primary reason for 

home-equity borrowing. This trend toward debt consolidation as the reason for home-equity borrowing has 

significant risk implications because, unlike funds lent 

for home improvement, the proceeds of a debt consolidation loan do not enhance the lender’s collateral value. 

The rapid growth of the HEL securitization market has 

been attended by signs of relaxed underwriting. 

Adverse credit quality trends have been particularly 

prominent for loans that were originated in 1995. Chart 

2 (next page) shows the total delinquency rates for 

closed-end loan pools originated in 1995 versus 1994. 

The sharp upward path of delinquency rates for loan 

pools originated in 1995 raises concern that aggressive 

competition for volume, and apparently relaxed underwriting standards, could lead to unprecedented default 

levels. Furthermore, HEL originations in 1996 more 

than doubled 1995 levels, causing market observers to 

suspect that underwriting standards continued to lapse. 

CHART 1 

1993 1994 1995 1996

0 

5 

10 

15 

20 

25 

1993 1994 1995 1996

Securitization of Home Equity 

Loans Has Risen Substantially 

Lines of Credit 

Closed End 

Source: Moody’s Investors Service 

$ Billion 

Regional Outlook	 14 Third Quarter 1997 
Regular Features Financial Markets
 

The trends in the HEL ABS market may portend credit 

quality trends in nonsecuritized cash-out refinancing. If 

similar unfavorable trends exist in bank-originated 

cash-out refinancing, evidence of these trends would be 

obscured by banks’ larger and less risky portfolios of 

purchase mortgage loans. The trends would be obscured 

because banks report all first mortgage lending on 1 to 

4 family residential properties without distinguishing 

between purchase mortgages and cash-out refinancings. 

The unfavorable trends in the HEL ABS market suggest 

that banks that engage in significant cash-out refinancing and other forms of home-equity lending should be 

able to monitor trends in the credit quality of these loans 

separate from purchase mortgage loans. 

A Combination of Several Factors Could Induce 

More Banks to Securitize HELs 

Although the present volume of bank-originated HEL 

securitizations is relatively small, banks have recently 

entered this finance company-dominated market, and a 

combination of several factors is likely to cause more to 

follow. First, home equity lines of credit are currently 

growing at rates exceeding total consumer lending, and, 

by and large, the deposit growth to fund this lending is 

less than robust. In addition, according to Moody’s 

Investors Service, investor demand is high for bankoriginated home-equity line of credit securitizations 

because bank-originated lines are perceived to have 

lower credit risk. The funding benefits and profitability 

of securitizing bank-originated home-equity lines of 

credit could entice more banks into the securitization 

market. Finally, the combination of these factors with 

the potential cost savings provided by using the new 

financial asset securitization investment trust (FASIT) 

CHART 2 

0 

2 

4 

6 

8 

10 

1 3 5 7 9 11 13 15 17 19 21 23 

Months since Origination 

1995-Originated Loans 

Source: Moody’s Investors Service 

Percent 

Higher Delinquency Rates Are Occurring 

Earlier in More Recently Originated Loan Pools 

1994-Originated Loans 

Closed-end Loans 

structure (see discussion below) could produce momentum that will result in banks, large and small, securitizing home equity loans in significantly increased 

amounts. 

Securitizing HELs can change the balance sheet and 

income statement of the securitizer significantly, resulting in significant servicing assets and gains on 

sale. Beginning in 1997, 

when a company sells 

loans, it must comply 

with the requirements of 

Financial Accounting 

Standard (FAS) 125. If 

the company retains servicing rights on the assets sold, FAS 125 requires the 

seller to book an asset related to the gain on sale that 

represents the future income derived from servicing the 

loans. This asset is similar to mortgage servicing rights 

in that it represents the present value of future expected 

cash flows derived from loan servicing. One major 

home-equity securitizer, which indicated that FAS 125 

would not materially affect its financial statements, 

reported servicing assets at almost 90 percent of equity, 

and gains associated with the sale of serviced assets at 

71 percent of total revenue. 

The value of servicing assets is based on management’s 

assumptions about the future cash flows to be generated by the assets. Because these assumptions are based 

largely on historical performance, unexpected deterioration, like that associated with 1995- and possibly 

1996-originated loans, that results in charge-offs or 

early repayment through foreclosure of serviced assets, 

could require the adjustment of the valuation assumptions and the write-down of the servicing assets. 

FASITs Promise to Change the ABS Market 

The Small Business Job Protection Act of 1996 created 

two new sections of the Internal Revenue Code that create and govern FASITs. The FASIT provisions, patterned in part on the real estate mortgage investment 

conduit (REMIC) rules issued in 1986, are intended to 

provide tax certainty for ABS issuers and purchasers 

and enhance the flexibility of asset securitizations. The 

FASIT provisions take effect on September 1, 1997. 

The advent of the FASIT is likely to change the ABS 

market in important ways. First, the FASIT will clarify 

Regional Outlook 15 Third Quarter 1997 
Regular Features Financial Markets
 

the tax treatment of securitizations. Because of the current tax ambiguity, designing ABS structures to avoid 

taxation is administratively costly, and it restricts the 

forms that securitizations can take. The higher administrative cost associated with current securitization techniques establishes a practical minimum size for asset 

pools that can be feasibly securitized. With FASITs and 

the reduced costs associated with tax clarity, the economically feasible pool size may be significantly smaller. The lowering of this threshold could result in more 

community banks entering the securitization market. 

ABS issuers believe that the market for their product 

has been hampered by the restrictive nature of current 

asset-backed tax ambiguity, which prevents them from 

responding to investor 

preferences for varying 

maturities, coupon types, 

and prepayment and 

credit risk profiles. 

FASITs allow sponsors 

the flexibility to create 

multiple-class securities 

that satisfy these preferences with the certainty 

that the securities will count as debt and that the FASIT 

will not be treated as a taxable corporation. This combination of flexibility and tax certainty could lead to the 

kind of innovations in ABS structures that followed the 

1986 REMIC legislation, which brought analogous 

benefits to the mortgage-backed market. 

FASITs will bring to the ABS market the ability to add 

and remove assets throughout the life of a securitization. This feature could be applied by securitizing 

revolving construction loans and then replacing the 

revolving loans with permanent financing when construction is completed. A FASIT also will be able to 

contain a mixed pool of assets such as real estate, nonreal estate assets, and unsecured credit, allowing exposures to very different markets from the same security. 

Finally, a FASIT can hold swaps and other hedging 

instruments. Using this feature, an issuer could combine 

a mortgage passthrough security with a hedging instrument that is designed to offset mortgage prepayment 

risk, such as a reverse-index amortizing swap. 

The increased flexibility that the FASIT promises to 

bring the ABS market comes with the potential for 

greatly increased complexity and risk. Banks that invest 

in FASIT securities will need to understand fully not 

only the risk characteristics existing at the outset of 

security but also the risk that could arise throughout the 

security’s life if assets are to be removed and replaced. 

Changes in Interest Rates and Bond Values 

The Treasury yield curve (see Chart 3) rose following 

March 25, 1997, when the Federal Open Market 

Committee (FOMC) met and raised the target federal 

funds rate 25 basis points to 5.50 percent. The yield on 

the 30-year Treasury bond rose above 7 percent on the 

Thursday following the meeting and remained there for 

the next 23 days. The FOMC met again on May 20, 

1997, and left the target rate unchanged. 

The model portfolio responded to the rise in rates, but 

only modestly (see Table 1). The relatively short weighted average maturity of the portfolio served to moderate 

the effect of the 54 basis point rise in the five-year 

Treasury between December 31, 1996, and March 31, 

1997. As discussed in Regional Outlook, Second 

Quarter 1997, changes in the value of the model portfolio correlate more with changes in the five-year 

Treasury rate than with the 30-year bond rate. 

The yields along the April 30, 1997, yield curve imply 

that the market expects the curve to continue to flatten 

through the remainder of the year with short rates rising 

somewhat. In order to gauge what affect a 25 basis point 

rise in the yield curve could have on bank fixed-income 

portfolios, the model portfolio has been “shocked” to 

simulate the effect of an instantaneous 25 basis point 

shift in the yield curve on May 28, 1997. 

CHART 3 

The Treasury Yield Curve Is Steeper 

and Higher since Year-end 1996 

5.0 

5.5 

6.0 

6.5 

7.0 

7.5 

3­

month 

2­

year 

7­

year 

30­

year 

Source: Bloomberg 

Percent 

3/31/97 

4/30/97 

12/31/96 

Regional Outlook 16 Third Quarter 1997 
Regular Features Financial Markets
 

TABLE 1 

Type of Security Par Value Percent Maturity Percent Change Reof or Change sulting from 

Portfolio WAL from a 25 bp Rate 

as of 12/31/96 Increase on 

12/31/96 to 5/28/97 

3/31/97 

U.S. TREASURY 5.6% 2,000 20% 1 YR –0.30% –0.16% 

FNMA AGENCY 5.8% CALLABLE 1,200 12% 2 YR –0.50% –0.38% 

STATE COUNTY MUNICIPAL GO 4.8% 800 8% 11 YR –2.05% –2.03% 

FNMA MORTGAGE PASSTHROUGH 7.5% 3,000 30% 8 YR –1.78% –1.44% 

FNMA (REMIC) 8.0% PAC 2,000 20% 2.5 YR –1.27% –0.50% 

CREDIT CARD ASSET-BACKED SECURITY 1,000 10% 5 YR –0.09% 0.00% 

TOTAL 10,000 100% 4.85 YR –1.08% –0.77% 

Note: Portfolio composition based on estimates derived from aggregated Bank Call Report information. 

Again, the interest rate risk benefits of maintaining a 

portfolio of relatively short weighted average life are 

apparent. The U.S. Treasury and the agency, the shortest 

lived instruments, and the floating-rate ABS demonstrate the least price sensitivity. The municipal bond is 

the most sensitive to rate changes owing to its longer 

maturity. The mortgage passthrough security also is 

more sensitive to rising rates because its weighted-average life (WAL) extends as rising rates discourage the 

underlying mortgage holders from prepaying their 

loans. The decline in prepayment rates results in extending the maturity of the security while rates are rising, a 

combination unfavorable to the security’s value. 

CHART 4 

Community Bank Stocks in the San Francisco 

Region Performed Smoothly Despite Turmoil 

in the Broad Market during the First Quarter 

of 1997 

Both the Standard & Poor (S&P) Composite Bank 

Index and the San Francisco Regional Bank Index have 

been subject to similar performance swings this year 

(Chart 4). The S&P Composite Bank Index, with an 

almost 13 percent gain by May 2, 1997, was still short 

of its year-to-date high on March 7, 1997, at which time 

it was up almost 20 percent on the year. The San 

Francisco Region’s Community Bank Index was spared 

much of the influence of a gyrating market, rising in 

value steadily to an 18.59 percent gain through May 2, 

1997, exceeding the S&P Composite Bank Index’s gain 

by almost 6 percentage points. 

Allen Puwalski, Banking Analyst 

-1% 

4% 

9% 

14% 

19% 

S&P 500 

San Francisco Regional Bank Index 

S&P Bank Index 

Source: Bloomberg, American Banker 

Change from 12/31/96 Region’s Community Bank Index 

The Region’s Community Bank Index Outperforms Regional Bank Indices and the S&P 500 31-Dec 10-Jan 3-Jan 17-Jan 24-Jan 31-Jan 7-Feb 14-Feb 21-Feb 28-Feb 7-Mar 14-Mar 21-Mar 28-Mar 4-Apr 11-Apr 18-Apr 25-Apr

2-May 

Regional Outlook 17 Third Quarter 1997 
Regular Features	 Regional Banking
 

Current Regional Banking Conditions
 

•	 Reported earnings, asset quality, and capital continue to improve during the first quarter, boosted not only 

by positive economic conditions in the Region but also by the adoption of Generally Accepted Accounting 

Principles (GAAP) for regulatory reporting purposes. 

•	 Regulatory reports in the San Francisco Region were most affected by the adoption of the GAAP accounting standards related to mortgage servicing rights, assets sold with recourse, and the extended amortization 

period for intangible assets. 

•	 In the first quarter of 1997, unrelated merger candidates in the Region favored the purchase method of 

accounting. The purchase method may have gained popularity among merger candidates as a result of a 

recent Securities and Exchange Commission (SEC) ruling that tightens rules on stock buyback programs 

and a Call Report change that lengthens the goodwill amortization period from 15 to 25 years. 

Region’s Profit Levels Highest since the 

Recession 

The San Francisco Region’s depository institutions continue to report strong performance as positive economic conditions, coupled with the long period of relatively 

low interest rates, boosted first-quarter earnings to the 

highest level since the recession (see Strong Growth in 

Services, Aerospace, and High-Tech Boosts the San 

Francisco Region’s Performance). A return on assets 

ratio of 1.17 percent was attained in the first quarter, 

with commercial banks earning 1.32 percent and thrifts 

0.83 percent. First-quarter profits were buoyed not only 

by healthy net interest margins and increasing levels of 

noninterest income, but also by the implementation of 

several regulatory reporting changes. 

The Region’s banks reported 

record profits despite an 

increase in loan loss reserves 

at large credit card banks. 

These banks increased their 

allowance for loan and lease 

losses to cover another uptick 

in delinquent credit card loans. 

Credit card loans past due 30 

days and over climbed from 

4.17 percent of average total credit card loans at yearend 1996 to 4.47 percent as of March 31, 1997, 

although delinquency rates for total loans in the Region 

fell below the national level for the second quarter in a 

row. 

Regulators Adopt Generally Accepted 

Accounting Principles 

First-quarter 1997 financial results were affected by the 

Federal Financial Institutions Examination Council’s 

1995 decision to adopt Generally Accepted Accounting 

Principles (GAAP) for regulatory reporting purposes. 

The regulators’ objective in adopting GAAP, which 

became effective January 1, 1997, was to provide 

greater consistency between an institution’s regulatory 

reports and its general-purpose financial statements. 

The regulators did not, however, change their capital 

regulations. Consequently, differences continue to exist 

between GAAP equity capital calculations and regulatory capital calculations. 

Institutions in the San Francisco Region were most 

affected by the adoption of GAAP in the following 

areas: 

•	 Extension of goodwill amortization from a maximum 

of 15 years to a maximum of 25 years. 

Banking regulators extended the amortization period 

for intangible assets to achieve consistency with the 

Securities and Exchange Commission Staff Accounting 

Bulletins. This change affected both the balance sheet 

and income statement at several institutions in the 

Region. 

As shown in Table 1 (see next page), goodwill increased 

by $1.6 billion during the quarter. This increase stems 

from two sources: (1) premiums paid for acquired institutions and (2) write-up of previously amortized goodwill. Several institutions retroactively adjusted the life 

Regional Outlook	 18 Third Quarter 1997 
Regular Features	 Regional Banking
 

TABLE 1 

Key Components of Accounting Changes in the Region 

(IN MILLIONS OF DOLLARS) 

12/31/96 3/31/97 CHANGE 

INTANGIBLE ASSETS $16,428 $19,211 17% 

GOODWILL $10,678 $12,315 15% 

MORTGAGE SERVICING $1,309 $2,121 62% 

OTHER INTANGIBLES $4,442 $4,765 7% 

ASSETS SOLD WITH RECOURSE N/A $28,401 N/M 

CUMULATIVE EFFECT OF 

RETROACTIVE ACCOUNTING CHANGES $0 $1,124 N/M 

n/a = not available, n/m = not meaningful. 

Source: Call and Thrift Call Reports. 

of their recorded goodwill to the new 25-year maximum 

by writing up their goodwill asset. Evidence suggests 

that some 40 percent of the increase in goodwill may be 

attributable to this write-up. Insured institutions reported the cumulative effect of the goodwill write-up as a 

direct adjustment to their capital accounts. 

It also appears that the extended amortization period is 

responsible for the 23 percent decline in intangible 

amortization expense that occurred despite a 17 percent 

quarter-over-quarter increase in total intangible assets. 

Based on historical intangible amortization expense 

ratios, the extended amortization period boosted the 

Region’s aggregate return on assets during the quarter 

by approximately six basis points. 

•	 Elimination of the distinction between normal and 

excess servicing fees receivable (ESFR) and other 

charges related to servicing of financial assets. 

Servicing fees receivable, or servicing rights, as defined 

in Financial Institution Letter 106-96 dated December 

27, 1996, are the contractual obligations undertaken by 

an institution to provide servicing for loans and other 

financial assets owned by others, typically for a fee. For 

regulatory reporting purposes prior to January 1, 1997, 

servicing rights were divided into the following two categories: 

1. Purchased servicing rights, which were servicing 

rights purchased from others. 

2. Originated servicing rights, which generally arose 

when an institution originated and subsequently sold 

the financial assets but retained the rights to service 

those assets. When an institution sold these financial 

assets with servicing retained and the servicing fees 

exceeded the normal servicing fee rate, it booked 

ESFRs. 

In the past two years, however, GAAP accounting treatment for servicing rights changed significantly. 

Effective in 1996, the Financial Accounting Standard 

Board’s Statement No. 122, “Accounting for Mortgage 

Servicing Rights” (FAS 122), eliminated the distinction 

between purchased mortgage servicing rights and originated mortgage servicing rights. It required that these 

assets, together known as mortgage servicing rights, be 

treated as a single asset for financial statement purposes, regardless of how the servicing right was acquired. 

Effective January 1, 1997, FAS 125, “Accounting for 

Transfers and Servicing of Financial Assets and 

Extinguishments of Liabilities,” reclassified the interest 

cash flows associated with normal and excess servicing 

contracts into the following two categories: 

1. Servicing assets, which are measured based on contractually specified servicing fees. 

2. Interest-only strips receivable, which represent interest cash flows received on the serviced assets in 

excess of the contractually specified servicing fees. 

To qualify as an interest-only strip, the servicer must 

have the right to retain the excess cash flows if the 

related servicing asset is sold or the related servicing contract is shifted to a new servicer. 

During the first quarter, the adoption of these GAAP 

guidelines for regulatory reports affected both the balance sheet and the income statements at several of the 

Region’s banks because, prior to 1997, there were sigRegional Outlook	 19 Third Quarter 1997 
Regular Features	 Regional Banking
 

nificant regulatory accounting 

differences related to the servicing of financial assets. First, 

banks were allowed to recognize 

only gains and book assets on 

ESFRs for first lien 1 to 4 residential real estate mortgage 

loans. With the adoption of 

GAAP and FAS 125 on January 1, 1997, banks can now 

recognize income and book originated servicing assets 

on all types of financial assets, not just mortgage loans. 

Second, servicing assets were classified differently and, 

because of their respective classifications, they were 

treated differently in regulatory capital calculations. 

Prior to 1997, mortgage servicing rights were classified 

as intangible assets and limited to 50 percent of Tier 1 

capital. Conversely, ESFRs were considered tangible 

“other assets,” and 100 percent of these assets were 

included for capital adequacy purposes. In addition, any 

purchased servicing rights on assets other than mortgages were classified as intangible assets for regulatory 

reporting purposes but were deducted from capital in 

their entirety. 

Although the adoption of GAAP eliminated the balance 

sheet and income statement differences related to the 

servicing of financial assets, these assets continue to be 

treated differently in regulatory capital calculations. As 

of January 1, 1997, 100 percent of interest-only strips 

generally are included in capital, while mortgage servicing assets are limited to 50 percent of Tier 1 capital. 

Servicing assets on financial assets other than mortgages are limited to 25 percent of capital at savings 

associations but are totally excluded in bank capital calculations. The total of all servicing assets that may be 

recognized at any savings association is limited to no 

more than 50 percent of Tier 1 capital. 

In the San Francisco Region, most ESFRs were reclassified from tangible “other assets” to intangible “mortgage servicing assets” during the first quarter primarily 

because the servicers were unable to retain the excess 

cash flows if the related servicing assets were sold. This 

reclassification of ESFRs accounted for approximately 

one-half of the $812 million increase in the mortgage 

servicing assets outstanding (see Table 1). Although the 

reclassification did not change asset totals, it did affect 

capital ratios of individual institutions with large mortgage servicing portfolios, because intangible mortgage 

servicing assets are limited for regulatory capital purposes. 

•	 Removal of certain loans and other assets sold with 

recourse from the balance sheet. 

With the adoption of GAAP in the first quarter, institutions in the Region reported a cumulative total of over 

$28 billion in assets sold with recourse. About $4 billion of this total relates to loans sold during the first 

quarter of 1997. These assets, which were primarily 

credit card loans, account for the majority of a $4.3 billion decline in loans at the Region’s banks during the 

quarter. 

For regulatory accounting purposes prior to January 1, 

1997, banks could record a transfer of assets other than 

residential mortgage loans as a sale only when the transferring institution (1) retained no risk of loss from the 

assets transferred and (2) had no obligation to pay principal or interest on the assets transferred. With the adoption of GAAP, however, assets sold with recourse prior 

to 1997 can now be recognized as sales if the amount of 

recourse can be reasonably estimated and the transferring institution establishes an appropriate reserve for the 

recourse liability in a separate liability account. 

•	 Retroactive application of GAAP in regulatory 

reports. 

In the San Francisco Region, over 40 institutions elected to amend their financial statements for prior years 

and adopt the GAAP accounting changes retroactively. 

These institutions reported the cumulative effect of the 

nonrecurring accounting adjustment, which totaled 

$1.1 billion, as a direct adjustment to equity capital, net 

of applicable income taxes. Although this adjustment is 

the net effect of several different accounting entries, a 

CHART 1 

0 

10 

20 

30 

40 

50 

60 

70 

80 

90 

’85 ’87 ’89 ’91 ’93 ’95 1Q97* 

# of Mergers 

Purchase Method Pooling Method 

*Mergers in 1Q97 not annualized 

Source: Bank and Thrift Call Reports 

Region’s Preferred Merger Method Varies 

Historically 

Regional Outlook	 20 Third Quarter 1997 
Regular Features	 Regional Banking
 

large portion relates to the write-up of goodwill discussed above. 

Implications: Both financial institutions and industry 

analysts should benefit from the adoption of GAAP for 

regulatory financial statements. Financial institutions 

no longer will have to maintain a separate set of records 

for regulatory purposes, and analysts will find greater 

consistency between regulatory reports and the institution’s general-purpose financial statements. However, 

these changes will create challenges for the analysts and 

regulators who use the 1997 regulatory financial statements and make comparisons to prior periods. Analysts 

and regulators will need to carefully scrutinize shifts in 

balance sheet structure and earnings levels to ascertain 

what effects, if any, are attributed to the 1997 regulatory reporting changes. 

In addition, regulators will be analyzing interest-only 

strips and servicing rights on all types of financial 

assets, not just residential real estate mortgage loans. 

The capitalized value of the servicing rights on each of 

these financial assets is influenced by servicing costs, 

prepayment speeds, discount rates, and other factors. 

Assumptions about these factors have an important 

effect on the related values of these assets and are worthy of attention by regulators and bank analysts. 

Merger Activity and Regulatory Changes Renew 

Debate over Accounting Methods 

Increased merger activity in the nation, as well as in the 

Region, has resulted in increased discussion about 

merger accounting methods in both the regulatory and 

corporate arenas. Currently, corporations merging with 

or acquiring other companies can account for the transaction either through the pooling of interests (pooling) 

or the purchase method of accounting. 

Unlike national trends, which show a definite preference for pooling, Chart 1 shows that historically the 

Region’s merging banks have shown no clear preference 

for either of the two accounting methods. In 6 of the 

past 12 years, merging banks in the Region preferred 

the purchase method of accounting for mergers. 

Although 18 of the Region’s 27 mergers in the first 

quarter of 1997 used pooling, the majority of the pooling mergers involved related companies. However, in 70 

percent of the mergers involving unrelated entities, the 

purchase method was favored. 

Merger Methods Offer Different Advantages 

With pooling, the companies exchange stock, and the 

assets, liabilities, and capital of each institution are 

added together on a line-by-line basis without adjustments for fair market value. However, for an applicant 

to be eligible for pooling, it must meet 12 separate criteria outlined in Accounting Principles Board (APB) 

No. 16. Merger applicants who meet the pooling eligibility requirements can benefit from the following factors: 

•	 Future earnings are not reduced by amortization of 

goodwill; therefore, reported income, return on 

assets, and return on equity can be higher. 

•	 Valuation of acquired assets and liabilities, which 

can be a complicated process, is avoided. 

•	 Assets with significant appreciation are booked at 

historical cost, so taxes are avoided. 

•	 Regulatory capital ratios are not affected by the need 

to deduct goodwill. 

In comparison, the 

purchase method 

accounts for a 

business combination as the acquisition of one company by another. Assets and liabilities 

are recorded on the acquiring institution’s books at their 

fair market values. Any amount paid in excess of the net 

fair market value of the assets and liabilities acquired is 

recorded as goodwill and amortized against future earnings. The purchase method can be attractive for the following reasons: 

•	 Purchase transactions are not limited to the exchange 

of stock; for example, a buyer could offer a combination of both cash and stock. 

•	 The method allows more flexibility in disposing of 

assets for cost-cutting purposes. 

Securities and Exchange Commission Closes 

Stock Buyback Loophole 

Recent bank mergers combined with stock buyback 

programs prompted the Securities and Exchange 

Commission (SEC) to review and tighten stock buyback 

rules for merger candidates using the pooling method of 

accounting. As a result of these revised rules, some analysts believe purchase accounting will gain popularity 

among merger candidates. 

Regional Outlook	 21 Third Quarter 1997 
Regular Features Regional Banking
 

With earnings reaching historical highs and the industry’s focus on earnings per share, many banks involved 

in mergers have been returning excess capital to shareholders through stock buyback programs. Stock buyback programs also are quite popular when additional 

stock is issued as part of the merger transaction and the 

new stock dilutes earnings per share. Although merger 

candidates using the purchase method can use stock 

buyback programs, one of the 12 conditions for pooling 

of interests described in APB Opinion No. 16 prohibits 

the combined company from repurchasing any of the 

common stock exchanged in the transaction. 

To overcome this restriction, a number of banks merging under the pooling method took advantage of 

ambiguous language in APB Opinion No. 16 and instituted stock buyback programs. However, in March 

1996, the SEC closed this loophole by issuing Staff 

Accounting Bulletin No. 96. This bulletin clarifies that 

in most circumstances there can be no planned stock 

repurchases for a maximum of two years after a pooling 

of interests merger is consummated. 

Purchase Method of Accounting May Gain 

Popularity 

Industry analysts suggest that purchase accounting will 

become even more popular if investors alter their 

method of analyzing earnings per share: Some merger 

partners are encouraging investors to focus on “cash 

earnings per share,” which uses earnings before amortization of intangible assets, to evaluate merger transactions. They argue that goodwill amortization is merely a 

byproduct of an accounting method and should not 

affect the economic value of a merger. 

Additionally, some industry analysts believe the 

Financial Accounting Standards Board (FASB) and the 

SEC may further limit the use of the pooling method. 

One reason for this view is that international accounting 

practices generally allow pooling only when it is impossible to tell which company is the acquiring company, as 

in a merger of equals. In addition to promoting consistency with international practices, proponents of the 

purchase method argue that pooling does not reflect the 

economic substance of a transaction because the fair 

market value of assets and liabilities is not recognized. 

Alternatively, the FASB may maintain pooling but make 

purchase accounting less onerous by eliminating the 

amortization of goodwill. 

Implications: Further restrictions on pooling would 

likely result in both a greater use of the purchase 

method of accounting for mergers and an increase in 

recorded goodwill. Consequently, assessing the potential effects of goodwill may become increasingly important when analyzing a bank’s earnings performance. 

Catherine I. Phillips-Olsen, Senior Regional Analyst 

Roger Stephens, Financial Analyst 

DiAnn Bielaczyc, Examiner, Division of Supervision 

Regional Outlook 22 Third Quarter 1997 

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