Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION FIRST QUARTER 1998 

FDIC
 

Boston
 

Region
 

Division of
 

Insurance
 

Daniel Frye,
 

Regional Manager
 

Norman Williams,
 

Regional Economist
 

Cameron Tabor,
 

Financial Analyst
 

In Focus This Quarter 

◆ Y2K—Preventing the Year 2000 (Y2K) computer problem is becoming ever more 

costly as the time and resources left to do so disappear. Equally costly, according to 

some estimates, will be the litigation that follows in the problem’s wake. A failure to 

address Y2K exposures immediately and successfully may amount to a gamble backed 

by the value of the bank franchise and the officers and directors who run it. See page 3. 

By Gary Ternullo 

◆ Trends in Commercial Real Estate Loan Pricing and 

Underwriting—An abundant supply of financing is placing pressure on commercial real estate loan pricing and underwriting standards. Underwriting standards are being increasingly influenced by the rapid growth in commercial 

mortgage-backed securities and real estate investment trusts. While many within the 

industry believe that broader public funding of commercial real estate projects will 

lead to greater market transparency and improved underwriting discipline, there 

are a number of unique risk considerations related to the rapid growth and continuing development of these alternative funding sources. See page 7. 

By Steven Burton 

◆ Total Return:A Useful Tool for Monitoring Investment Portfolio 

Risk—The Federal Financial Institutions Examination Council is rescinding the 

1991 policy that required “high-risk” testing for mortgage derivative products and 

has released for comment a policy encouraging risk management across all types of 

instruments on an investment portfolio basis. Total return, a concept that includes 

fluctuations in market value, is a useful tool for measuring the performance of an 

investment portfolio and providing information about market risk at the portfolio 

level. See page 13. 

By Allen Puwalski 

Regular Features 

◆ Regional Economy—For much of the Region, 1997 was the strongest year 

seen thus far during this economic expansion...An expected slowdown in the national economy, in part fueled by weakness in Asia, as well as increased import competition and a tight labor market, may act to slow the Region’s economy in 1998...New 

England’s economic growth is at greater risk than the nation’s from a stock market 

crash or protracted bear market. See page 16. 

By Norman Williams 

◆ Regional Banking—The Region’s banks continue to show healthy 

results...dependence on real estate heightens vulnerability to refinancing 

wave...flattening yield curve will likely place downward pressure on margins and 

earnings...strong asset/liability and interest rate risk management programs are 

increasingly critical to deal with the current rate environment. See page 21. 

By Daniel Frye, Cameron Tabor, Elizabeth McDonough 

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

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

form found on the back cover to the FDIC Public Information Center. Contact the Public 

Information Center for current pricing on bulk orders. 

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

publish/regout. For more information or to provide comments or suggestions about the Boston 

Region’s Regional Outlook, please call Daniel Frye at (781) 794-5678 or send an e-mail to 

dfrye@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 

Assistant Editors Daniel Frye 

Craig A. Rice 

Publications Manager Teresa J. Franks 
In Focus This Quarter
 

Y2K: Banking in the twenty-first century may provide
 

grand new opportunities—but you have to get there first
 

•	 As a result of a three-decades-old programming 

convention, January 1, 2000, may find some computer systems unable to function correctly, if at 

all. Links within and between systems and organizations make the problem a complex one. 

•	 Cures are expected to be difficult and costly. If 

those cures fail, litigation could be equally costly, 

and much of it may be aimed at directors and 

officers. 

•	 Accordingly, senior bank management should be 

actively involved in making sure the cure takes 

place. A failure to do so amounts to a gamble 

backed by the value of the bank franchise and 

those who run it. 

Complex Problem, Complex Cure 

By now the story is well known. At midnight on 

December 31, 1999, computer systems that process 

dates using only the last two digits of a year will cease 

to function correctly, if at all. Equipment that contains 

embedded systems—chips or circuitry designed to perform specific functions—also may fail. And the problem is pervasive. It lies within systems and between 

systems, in both software and hardware. The large number of ways dates are used, the number of places they 

can occur, and the number of creative ways for naming 

them confounds an accurate assessment. 

Fixing the Year 2000 (Y2K) problem will require considerable time and effort. Computers and applications 

must be inventoried, examined for date usage, corrected 

where necessary, and then tested—not just by themselves but in combination with every other system with 

which they interact. This includes not only a bank’s own 

systems but also those of its servicers, correspondents, 

customers, vendors, and trading counterparties. 

Moreover, there are a variety of ways to address the 

problem, ranging from expanding date fields to four 

digits to simply subtracting 28 years from every date 

before processing—any of which could introduce new 

incompatibility problems when systems that have been 

fixed in different ways attempt to interact.1 And because 

not all systems can be corrected at once, interfaces or 

bridges between corrected and uncorrected systems also 

must be developed to maintain business system continuity. Most important, it must all be done before the 

non-negotiable deadline of December 31, 1999. 

For bank management, there are two ways to find out 

how serious the problem will be. The first is to commit 

resources to determining just how exposed the bank’s 

systems are—the first concrete step in actually solving 

the problem. The second is to gamble the franchise by 

doing little or nothing and letting the century date 

change provide the ultimate stress test. 

Costs 

The costs of a cure are many. First, there are the costs of 

actually finding and fixing the problem. Estimates of 

this cost have ranged widely, although the Gartner 

Group’s estimate of $300 to $600 billion worldwide is 

the most widely quoted. Using a different approach, 

Software Productivity Research (SPR) places the global number at over $1.3 trillion, including a $176 billion 

slice for the United States alone. Then there are the estimated costs of litigation. At the low end, SPR places 

them at $300 billion globally and projects that fully onethird of that amount will be generated in the United 

States. At the high end, the Giga Information Group 

sees a much more litigious future—estimating that 

Y2K-related legal costs could exceed $1 trillion. 

Significant opportunity costs may accrue as well, and 

the degree to which Y2K-related outlays fail to provide 

1 Every 28 years the same combination of dates and days recurs. 

Subtracting 28 years from a date before processing and then adding 

them back upon output has been suggested as a temporary but partial 

remedy because it permits applications to continue measuring time by 

subtracting two-digit years from each other. Windowing is another 

partial correction whereby some two-digit years—say those less than 

“50,” for example—are assumed to be preceded by “20” (thus “49” 

becomes “2049” in date calculations) while the remainder are 

assumed to be preceded by a “19” (thus “50” becomes “1950”). Both 

approaches only delay the need for permanent corrections. 

Boston Regional Outlook 3	 First Quarter 1998 
In Focus This Quarter
 

more efficient or functional systems will serve as a 

starting point for measuring the value of technology 

investments forgone. These forgone improvements will 

be especially costly for institutions that have started 

their repairs too late. They may find not only that the 

time for system improvements and upgrades has slipped 

away, but that they have insufficient time for anything 

beyond a patchwork solution that will continue to cost 

them beyond the year 2000. 

At the macro level, the tally of potential Y2K costs 

includes declining stock values, business failures, and 

recession. J.P. Morgan has estimated that as much as 40 

percent of organizations’ remediation costs have not 

been accounted for in their information technology budgets, presumably indicating that many firms will see 

their share value erode as the costs of Y2K fixes and 

related losses are priced into their future earnings. The 

cost of not being Y2K compliant might be substantial as 

well. According to the Gartner Group, as many as one 

in two firms may discover just how substantial as they 

head into 1999 with even their most mission-critical 

systems unfixed. The potential for these firms to fail 

looms large among the factors that have led Edward 

Yardeni, chief economist at Deutsche Morgan Grenfell, 

to assign a 40 percent chance of recession in the year 

2000. Peter de Jager, a consultant who also has commented extensively on Y2K issues, went even further, 

suggesting that 1 percent of all businesses would fail 

because of Y2K problems. Whatever the eventual 

number, many of these businesses will also be bank 

borrowers. 

Systems and Systemic Risks 

More immediate than the risk of borrower failures is the 

risk that a bank’s own systems may fail. Banks are heavily dependent on software applications that employ 

dates. Among other things, they use them for calculating interest paid or due and for managing the horizons 

of their assets and liabilities. If these applications begin 

returning erroneous calculations, bank operations could 

be seriously disrupted.2 If they fail altogether, the bank’s 

2 For example, interest due from borrowers for a one-year period 

beginning in 1999 and ending in 2000 might be calculated not as one 

year’s interest due but rather as nearly one century of interest payable 

(00 − 99 = − 99) if only the last two digits of the year are used in the 

calculation. Similarly, any other time calculation that straddles the 

century date change might return answers wrong in both size and 

sign. 

credibility—and hence its franchise value—can be substantially damaged or even irrevocably lost. 

The solution is often described in software terms, but 

executable software is not the only problem. Correcting 

software to process four-digit years does little good if 

bank databases that store the critical information about 

who owes what to whom and when still store them in 

two-digit form. Hardware is another critical area. 

Nearly all electronic devices have embedded, permanently programmed chips that can be difficult to find 

because the functions they perform are not always 

apparent. This situation could lead to a host of nuisances, with automated teller machines, point-of-sale 

terminals, bank vaults, check and credit card processing 

equipment, and even building systems succumbing to 

the Y2K problem. 

This dependence on external components and services 

creates a systemic exposure as well. The substantial 

efficiencies that now exist in transmitting payments 

among and between banks and borrowers are a direct 

result of technology. Servicers and 

clearinghouses fulfill computerintensive intermediary roles in this 

high-velocity business—pooling 

payments from those who owe and 

redistributing them among those 

to whom they are due. Anything 

that interrupts these flows can 

have a substantial impact on the ability of banks to settle with their customers and with each other. 

Accordingly, both the Bank for International 

Settlements and the U.S. Federal Reserve are concerned 

about the Y2K threat for two reasons—first because it 

can interrupt the operations of systems dedicated to 

making interbank payments and second because it can 

interrupt the operations of the individual participants 

and generate a liquidity shock that could cause other 

institutions to fail. 

Unfortunately for banks, even a fully successful, 

industry-wide Y2K fix will not completely mitigate 

their risk. The year 2000 story is simply too dramatic 

and lends itself too well to sensationalism. Therefore, 

in addition to managing the cure, bankers will have to 

manage the perceptions of their customers and of the 

public at large—a considerable challenge given that a 

loss of confidence by a small number of customers 

could precipitate liquidity problems for institutions 

even in the absence of a genuine threat. 

Boston Regional Outlook 4 First Quarter 1998 
In Focus This Quarter
 

Liability in the Executive Suite 

It bears frequent repeating that Y2K is a business problem and not just a technical one. Its intricacies go 

beyond those of the systems themselves and extend into 

the labyrinth of business relationships and fiduciary 

obligations that bind directors and officers—and the 

assorted attorneys, auditors, consultants, and service 

providers who assist them—to their banks. Through this 

network could pass liability and litigation that could be 

several times the cost of fixing the problem itself. And 

although the problem may have had a technical origin, 

claims would likely be directed against those with deeper pockets who jointly and severally, it will be argued, 

should have corrected or disclosed the institution’s Y2K 

exposures. 

While the bank failures of the late 1980s and early 

1990s are often attributed to unforeseen economic 

events, it will be difficult to assert such a defense for a 

failure to address the Y2K problem. It is simply too visible and offers too much advance notice. This is one reason why the potential potency of Y2K litigation should 

be taken seriously. Moreover, placing the blame, no 

matter how well deserved, at the feet of vendors and 

consultants may offer little protection. The Federal 

Financial Institutions Examination Council (FFIEC) 

has indicated that senior bank management should be 

fully aware of their vendors’ progress and develop contingency plans should those vendors fail.3 This pronouncement has elevated the standard for prudent Y2K 

actions in such a way as to make imperative the active 

involvement of top bank management in both solving 

3 Safety and Soundness Guidelines Concerning the Year 2000 Business 

Risk, December 1997. The full text is available on the FFIEC website 

at www.ffiec.gov. 

Managing the Y2K Process 

On May 5, 1997, the Federal Financial Institutions Renovation. Renovation includes not only fixing the 

Examination Council—an interagency group com- problem internally but monitoring the efforts of cusposed of the Federal Deposit Insurance Corporation, tomers, counterparties, vendors, and service 

Federal Reserve, Office of the Comptroller of the providers. The prudent execution of due diligence and 

Currency, Office of Thrift Supervision, and National best practices at this stage will provide a measure of 

Credit Union Administration—released a statement confidence that exposures have been addressed. It 

on Year 2000 project management awareness that will also provide a measure of protection from liabilincluded an outline of the Y2K management process. ity claims should problems nevertheless emerge. 

That outline identified five phases that each financial 

institution would have to navigate in identifying and Validation. Validation means testing how a bank’s 

fixing its Y2K exposures: systems will respond on their own as well as when 

connected with those outside the bank. The FFIEC 

Awareness. Before Y2K exposures can be fixed, they believes that one full year should be available for testmust be seen as problems. Creating awareness, how- ing and correcting problems that either remain or are 

ever, is not easy because the pervasiveness of compo- introduced by the renovation process. Accordingly, 

nents and intersystem links that can harbor or pass the institutions should plan on completing the previous 

problem create complexities that are neither intuitive three phases by the end of 1998. 

nor easily quantified. However, it is critical that senior 

managers understand the problem and fully support Implementation. Testing corrected systems to ensure 

the commitment of resources to fixing it. their compliance does not complete the process. The 

final step is to gain acceptance by the users as to the 

Assessment. In this phase, all information systems, ability of the system to satisfy business requirements. 

electronic equipment, and building systems must be A failure at this stage will require further correction 

evaluated for specific Y2K exposures. Remediation or the implementation of contingency plans. 

plans must then be devised. In addition to plans for 

fixing the problem, contingency plans will be needed For the full text of this and other FFIEC guidance, see
 

as a precaution against unforeseen Y2K failures orig- the FFIEC website at www.ffiec.gov.
 

inating from both within and outside the bank.
 

Boston Regional Outlook 5 First Quarter 1998 
In Focus This Quarter
 

the problem and ensuring that the franchise will be protected if one or more of those solutions fail. 

Betting the Franchise 

The FFIEC has divided Y2K remediation into five 

phases—awareness, assessment, renovation, validation, 

and implementation (see Inset 1, page 5). As a benchmark for progress, the FFIEC has indicated that the validation phase—the phase in which testing of Y2K fixes 

is conducted—should be well under way for all banks 

by the end of 1998. This leaves less than a year for laggards to complete the first three phases. Banks that are 

not devoting adequate resources to identify and address 

their exposures need to be aware that the consequences 

of delay or inaction could be severe. The bank supervisory agencies, Congress, and the financial markets are 

taking the risk to heart. So too are attorneys intent on 

sharing in what has been described as potentially the 

most expensive litigation in history. 

Insurance companies are concerned as well, as evidenced by extremely high Y2K policy premiums or outright refusal to write Y2K coverage. Thus, any business 

interruptions and liability that emerge may have to be 

financed from the bank income statement and balance 

sheet. As such, a bet that Y2K will not be a problem 

might well amount to a gamble backed by the bank franchise and those who run it. (See Inset 2 below for additional sources of information.) 

Gary Ternullo, Senior Financial Analyst 

gternullo@fdic.gov 

For Further Information 

Further information on the Y2K problem can be obtained from banking regulatory agencies at the websites shown 

below. 

Federal Deposit Insurance Corporation (FDIC) www.fdic.gov 

Federal Financial Institutions Examination Council (FFIEC) www.ffiec.gov 

U.S. Federal Reserve Board of Governors www.bog.frb.fed.us 

National Credit Union Administration (NCUA) www.ncua.gov 

Office of the Comptroller of the Currency (OCC) www.occ.treas.gov 

Office of Thrift Supervision (OTS) www.ots.treas.gov 

The following websites contain additional information concerning the Y2K problem. Their inclusion here does 

not serve as an endorsement by the FDIC of any information contained therein. 

Market Partners Inc.—Year 2000 Resources for Banks www.marketpartners.com 

Gartner Group—Technology Consultant www.gartner.com 

Software Productivity Research (SPR)—Technology Consultant www.spr.com 

De Jager LLC (Peter de Jager)—Technology Consultant www.year2000.com 

Giga Information Group—Technology Consultant www.gigaweb.com 

Y2K LLC (Williams, Mullen, Christian & Dobbins)—Attorneys www.Y2K.com 

Economics Network (Dr. Edward Yardeni)—Economist www.webcom.com/yardeni 

Boston Regional Outlook 6 First Quarter 1998 
In Focus This Quarter
 

Trends in Commercial Real Estate 

Loan Pricing and Underwriting 

•	 An abundant supply of capital is placing signifi- CHART 1 

cant pressure on commercial real estate loan Banks’ Commercial Real Estate and pricing. Construction Lending Rebounds 

• Considerable evidence suggests that a large per- Construction Loans 

centage of insured institutions are easing commercial real estate and construction lending 

underwriting standards. 

• The rapid rise in commercial mortgage-backed 

securities and real estate investment trust funding 

could change the way banks underwrite commercial real estate loans and have important effects 

on their competitive position in the lending 

Year-over-Year (%) Growth

20 Commercial Real Estate Loans 

10 

0 

–10 

–20 

–30 

YE90 YE91 YE92 YE93 YE94 YE95 YE96 3Q97 

markets. 

As reported in last quarter’s Regional Outlook, banks 

provided the largest share of funding for commercial 

real estate during 1995 and 1996 compared with all 

other financing sources (see Strong Demand and 

Financial Innovation Fuel Rebounding Commercial 

Real Estate Markets). Chart 1 shows that banks’ commercial real estate and construction lending continues 

to increase and that year-over-year growth rates in these 

two loan categories are accelerating. At the same time, 

however, alternative funding sources in the form of 

commercial mortgage-backed securities (CMBS) and 

real estate investment trusts (REITs) are also experiencing significant growth. Commercial Mortgage Alert 

reports that $26 billion in CMBS was issued through 

September 1997, up from $17 billion for the same period in 1996. The same publication projects that CMBS 

issuance will top $40 billion during 1997, compared 

with last year’s record issuance of $29.8 billion. 

Measures of REIT activity also indicate impressive 

growth. According to the National Association of Real 

Estate Investment Trusts, REITs issued $26.3 billion in 

equity through October, compared with $12.3 billion 

for all of 1996. In addition, REIT market capitalization 

rose $50 billion (64 percent) through the first nine 

months of 1997. 

While it is good news to borrowers, the abundance of 

capital for commercial real estate projects raises the 

often-quoted concern that “too much money is chasing 

too few deals.” Market observers worry that fierce competition and an excessive supply of financing are leadSource: Commercial Bank Call Reports 

ing to both inadequate loan pricing relative to risks 

borne by lenders and looser loan underwriting standards. This article examines current trends in commercial real estate loan pricing and loan underwriting. It 

also explores the possible influences of CMBS and 

REITs on loan underwriting practices and commercial 

real estate markets. 

An Abundance of Capital Has Placed 

Significant Pressure on Commercial Real 

Estate Loan Pricing 

Chart 2 (next page) shows that prime-graded commercial mortgage spreads have steadily declined since 1992 

and are now at levels not seen since the real estate boom 

years of 1988 and 1989. At 113 basis points above tenyear treasuries, current spreads on ten-year commercial 

mortgages are only slightly higher than A-rated ten-year 

industrial corporate bonds, which traded at spreads of 

66 basis points over comparable-term treasuries as of 

September 1997. Some property sectors have experienced more narrowing of spreads than others. 

American Council of Life Insurance (ACLI) data show 

that mortgage spreads relative to treasuries compressed 

31 basis points for industrial, 22 basis points for hotel, 

21 basis points for retail, 11 basis points for multifamily, and 10 basis points for office real estate from March 

1996 to March 1997. Moreover, because of continuing 

downward pressure, current pricing varies little across 

Boston Regional Outlook 7	 First Quarter 1998 
In Focus This Quarter
 

CHART 2 CHART 3 

Commercial Mortgage Spreads Are Pricing Narrows between High- and 

Tightening 

Basis Point Spread over

Ten-Year Treasuries 

Source: Barron’s/John B. Levy 

0 

50 

100 

150 

200 

250 

Jan ’87Jan ’89Jan ’91Jan ’93Jan ’95Jan ’97 

Spread between AAA and BBB


Grades (Ten-Year Average Life)
 

Medium-Grade CMBS 

Basis Points 

140 

120 

100 

80 

60
 

40
 

20
 

0 

Q1 ’95Q3 ’95Q1 ’96Q3 ’96Q1 ’97Q3 ’97 

Source: Nomura Securities International 

the quality spectrum. For instance, Chart 3 indicates 

that spreads between AAA- and BBB-rated CMBS have 

narrowed considerably since year-end 1995, from 110 

basis points to a scant 28 basis points. 

It seems likely that competitive factors will continue to 

place pricing pressure on lenders. The relatively recent 

entrance of Wall Street firms into the financing arena 

via conduits is a striking example of just how competitive the market for commercial real estate financing has 

become.1 Conduits are rapidly becoming the dominant 

issuer of CMBS and underlie much of the rapid growth 

in CMBS noted above. Through the first nine months of 

1997, Commercial Mortgage Alert reported that conduits accounted for 50 percent of total CMBS issuance, 

compared with 30 percent during the same period in 

1996. 

Many industry participants see conduits and REITs as 

significant and increasing competitive threats to traditional lenders. For example, a recent issue of 

Commercial Real Estate South discussed the continuing expansion of conduit business into a much wider 

range of property and credit quality types. This publication noted that conduits have a particular incentive to 

aggressively pursue higher quality loans in order to 

strengthen pools that contain weaker credits. Such 

aggressiveness threatens to squeeze banks’ profit margins on low-risk deals, which might give banks an 

incentive to pursue lower quality credits. Given their 

focus on larger credits, conduits presently pose a competitive threat primarily to larger lenders. However, the 

1 Conduits are entities created to originate mortgage loans for distribution to investors in the secondary market. 

rapid growth of capital within the industry may eventually force larger lenders to target smaller markets, which 

would in turn increase competition at the regional or 

local community level. While their influence is less 

direct, the growing use of REITs to finance commercial 

real estate projects also places pressure on loan pricing 

spreads, since lenders must compete for a smaller pool 

of customers. With their access to a seemingly limitless 

source of public funding, REITs could pose a particular 

threat to community bankers by dominating certain geographic markets or property sectors. 

Narrowing pricing spreads raise concerns over whether 

lenders are being adequately compensated for the operational, funding, credit, and market risk inherent in 

originating, servicing, and holding commercial real 

estate loans. More important, tightening spreads raise 

prospects that lenders will ease other loan terms and 

relax loan standards to the extent that they are unable to 

differentiate their product based solely on price. While 

such easing may enable lenders to retain business in the 

face of stiff competition, imprudent underwriting could 

ultimately lead to higher loan losses than would otherwise be the case in the event of a downturn in commercial property markets. 

Are Commercial Real Estate Loan Underwriting 

Standards Becoming Looser? 

Most industry experts have argued that the memory of 

the real estate downturn of the late 1980s and early 

1990s keeps lenders from becoming overly aggressive 

in making commercial real estate loans despite the 

abundance of funding alternatives currently available to 

Boston Regional Outlook 8 First Quarter 1998 
In Focus This Quarter
 

borrowers. These experts point out that today’s loan-tovalue (LTV) ratios are lower than they were at the peak 

of the last real estate boom, that lenders are concentrating more on obtaining adequate debt-coverage ratios, 

and that lenders are requiring borrowers to bring more 

cash equity to the table. One might also argue that practices have improved and become much more uniform 

with the implementation of regulatory appraisal standards and the adoption of interagency guidelines for 

real estate lending policies. Rating agencies impose 

additional guidelines and standards as lenders originate 

loans for possible sale into the secondary markets. 

While information about specific quantitative underwriting criteria applied to new loan originations by 

commercial banks is not readily available, some sense 

of industry trends may be gleaned from competitors’ 

practices. For example, the ACLI performs a quarterly 

survey of underwriting criteria for commercial real 

estate loan commitments originated by major life insurance lenders. The ACLI’s second quarter 1997 survey 

indicated that new commitments (total volume of $4.1 

billion) had a weighted average LTV for all property 

types of 66 percent and a weighted average debt-coverage ratio (DCR)2 of 1.6 times. These figures compare 

favorably to an LTV ratio in late 1989 approaching 75 

percent and a DCR just under 1.3 times. 

ACLI data suggest that recent commercial mortgage 

originations are better supported by borrower equity 

and property cash flows than they were in the late 

1980s. It is important to recognize, however, that LTV 

and DCR ratios are driven largely by market conditions 

and expectations. Property valuations take into account 

recent sales and expected cash flows, and cash flows 

available to service debt are based on projected net 

operating revenues, which often incorporate projected 

increases in rents and other revenue sources. In other 

words, the overwhelmingly favorable conditions in 

today’s real estate markets may also be a factor in the 

improved LTV and DCR ratios. Keeping in mind the 

cyclical nature of real estate, one can easily see how a 

shift from today’s positive outlook to a more pessimistic 

outlook might result in a sharp reversal in these commonly cited ratios. 

Notwithstanding these quantitative considerations, 

there are indications that banks are easing commercial 

2 The debt-coverage ratio measures annual net operating income generated by a property relative to annual principal and interest payments 

due on the underlying loan. 

real estate underwriting standards. This evidence, 

derived from industry and examiner surveys conducted 

by the three banking agencies, includes the following 

observations: 

•	 In the Office of the Comptroller of the Currency’s 

(OCC’s) 1997 Survey of Credit Underwriting 

Practices, OCC examiners reported eased commercial real estate lending standards in 38 percent of 

banking companies surveyed. For comparison purposes, the 1996 survey reported eased standards in 

16 percent of banking companies surveyed. Among 

institutions with eased lending standards in the 1997 

survey, examiners noted a 75 percent incidence of 

reductions in loan fees or rate spreads, a 43 percent 

incidence of eased guarantor requirements, and a 29 

percent incidence of lower collateral requirements. 

Examiners cited competitive factors and a change in 

economic outlook as the main reasons for changes in 

underwriting standards. 

•	 Chart 4 summarizes current and historical results of 

the Federal Reserve Board Senior Loan Officer 

Opinion Survey for responses to the question of 

whether bank credit standards for approving applications for commercial real estate loans have eased, 

tightened, or remained unchanged. These survey 

results show that banks have had a tendency to ease 

underwriting standards since the fourth quarter of 

1996. This tendency appears to have become 

stronger through the third quarter 1997 survey but 

moderated somewhat in the most recent survey. The 

most recent survey showed that large banks (over 

$15 billion in assets) were much more likely to indicate easing commercial real estate standards than 

CHART 4 

Survey Shows Tendency to Ease Commercial 

Real Estate Underwriting Standards 

Percentage 

Source: FRB Senior Loan Officer Opinion Surveys 

2Q96 3Q96 4Q96 1Q97 2Q97 3Q97 4Q97 

–15 

–10 

–5 

0 

5 

10 

15 

20 

25

 % Respondents Tightening

 % Respondents Easing

 Net % Tightening (Easing) 

Boston Regional Outlook 9	 First Quarter 1998 
In Focus This Quarter
 

smaller banks. Specifically, 21 percent of large 

banks reported easing standards, while only 3 percent reported tightening standards. In comparison, 

only 9 percent of smaller banks reported easing 

standards, while 13 percent reported tightening 

standards. 

•	 Results from the FDIC Report on Underwriting 

Practices indicate possible easing of standards for 

construction and development (C&D) loans at 

FDIC-supervised banks. A comparison of examiner 

responses for the third quarter 1997 survey (covering 

examination reports filed from April through 

September 1997) with responses for the third quarter 

1996 survey leads to the following observations3

: 

•	 The percentage of banks frequently or commonly 

originating C&D loans tied to speculative projects 

(that is, projects lacking meaningful preleasing or 

presales, or loans without a formal take-out commitment for permanent financing following completion 

of construction) rose markedly, from 11 percent to 

29 percent. 

•	 The percentage of banks frequently or commonly 

granting C&D loans without considering alternative 

repayment sources other than income generated by 

the project being financed rose significantly, from 8 

percent to 20 percent. 

•	 The percentage of banks frequently or commonly 

basing C&D loans on unrealistic appraisals rose 

from 5 percent to 11 percent. 

•	 The percentage of banks frequently or commonly 

funding or deferring interest payments during the 

term of construction loans rose from 7 percent to 15 

percent. 

Much of the commentary in recent issues of various 

trade journals echoes the results of these regulatory surveys.4 In brief, many industry participants are seeing a 

higher incidence of (1) banks funding construction loans 

without preleasing commitments on major portions of 

rentable space, (2) banks easing LTV ceilings, (3) 

3 The authors of this survey note that comparisons of survey results 

across time periods must be interpreted with caution since the survey 

samples are dictated principally by examination scheduling factors. 

As a result, sample populations may be materially different from one 

period to another. 

lenders curtailing reserve requirements for such items as 

tenant improvements and insurance, and (4) nonrecourse 

lending. Some industry participants have also noted the 

increasing acceptance of “trended rents,” whereby property valuations are based on positive rent projections 

extrapolated several years into the future. Of course, 

these trended rents will hold true only if economic circumstances remain favorable for extended periods— 

an assumption that may not be reasonable given 

the cyclical nature of real estate coupled with 

the advanced age of the current economic 

expansion. 

With a combination of relatively low 

interest rates, rising real estate prices, 

and an expanding economy, it is perhaps not too surprising that some 

lenders have eased commercial real 

estate underwriting standards. Such 

easing may be a natural response to 

improved confidence in the real estate 

markets. However, indicators that show 

loosening standards may also be warning flags that lenders have succumbed to tighter pricing 

and competitive pressures. To avoid losses like those 

sustained by banks during the last real estate downturn, 

prudent lenders will refrain from incorporating unrealistic expectations into their lending practices. 

CMBS Could Change the Way 

Lenders Underwrite Loans 

Much as residential mortgage lending standards were 

shaped by the advent of mortgage-backed securities, 

CMBS promise to change the way banks underwrite and 

service commercial real estate loans. For instance, lending terms and practices could become increasingly standardized as lenders attempt to improve the liquidity and 

marketability of their commercial mortgage portfolios. 

Banks that choose to deviate from these emerging standards will sacrifice flexibility in terms of their ability to 

manage portfolio risks and respond rapidly to liquidity 

demands. 

The ability to securitize commercial real estate loans 

also may fundamentally alter the way lending decisions 

4 See, for example, Commercial Real Estate South, “Public Markets 

Fuel Financing Glut” (October 1997); Midwest Real Estate News, 

“Wall Street and Main Street Squeeze Lenders” (October 1997); and 

Commercial Property News, “Michelson, Greenland Seize Low 

CMBS Spreads” (1 May 1997). 

Boston Regional Outlook 10	 First Quarter 1998 
In Focus This Quarter
 

are made. Before the development of CMBS markets, 

loan approval was essentially a binary, good-or-bad, 

accept-or-reject decision whose primary focus was on 

the credit risk inherent in a single asset. In contrast, the 

most important elements in CMBS are deal structure, 

price execution for multiple tranches, credit enhancements, and portfolio composition. Here, the loan originator is more likely to use a portfolio approach in 

making credit decisions: That is, how will this loan 

enhance the expected return and risk diversification of 

the overall pool? 

External rating agencies will become increasingly 

important as CMBS markets expand, since these agencies’ guidelines will effectively dictate the underwriting 

standards applied to securitized loans. While such standardization could arguably improve market discipline 

and loan performance disclosure, there are several 

potential risks to consider as the CMBS markets evolve: 

•	 While rating agencies do incorporate qualitative considerations into their analysis, issue ratings and credit enhancement level decisions are driven primarily 

by quantitative factors, namely debt service coverage 

and expected loss levels. Moreover, most of the qualitative factors the agencies consider involve an 

analysis of portfolio balance and pool diversification. Hence, weak or poor qualitative standards (for 

example, lack of alternative repayment sources or 

minimal borrower equity in the project) applied to 

individual loans within the pool may receive only 

secondary consideration. A quantitative perspective 

also ignores such immeasurable factors as borrower 

“character” and the existence of long-standing 

lender-borrower relationships. 

•	 Rating agencies cannot be relied upon as a backstop 

to unsound underwriting practices. While they generally review a substantial volume of the loans within a pool, typically the largest individual credits, they 

are not practically able to review every credit in the 

securitization. Some within the industry have even 

suggested that investment bankers commonly move 

one problem property, discovered through one 

agency’s sample, into pools reviewed by another 

agency in the hope that it will not be sampled. 

•	 Competition among the rating agencies could 

become a factor in the underwriting process. This 

“shopping of the agencies” could result in continual 

pressure for rating agencies to ease their underwriting guidelines. 

•	 In theory, bank-issued CMBS transfer much of the 

underlying credit risk associated with commercial 

real estate lending to investors. However, like other 

types of asset securitization, CMBS raise concerns 

over the degree to which banks will voluntarily 

absorb investor losses. Bank issuers may be more 

likely than nonbank issuers to provide voluntary support to poorly performing CMBS for at least two reasons: A tarnished reputation in one aspect of a bank’s 

operations could carry over to other business activities like deposit taking and borrowing due to a bank’s 

broad brand name association within the marketplace; and banks often have greater financial 

resources than nonbanks with which to support securitization activities. 

Because the rapid growth in CMBS has been a relatively recent phenomenon, current underwriting guidelines 

applied by the rating agencies to CMBS have not been 

tested during a cyclical downturn in real estate prices. It 

remains to be seen how the market will react to rising 

loan losses that result in investor losses. 

Will Increased Public Funding through CMBS 

and REITs Improve Market Discipline? 

Many contend that the increased transparency brought 

to the market by CMBS will temper cyclical swings in 

real estate values. This viewpoint argues that investors 

will serve as a constraint against the natural tendency to 

overbuild commercial real estate during boom periods, 

since less funding will be allocated to segments of the 

market where excess capacity exists. This viewpoint 

presupposes that the investing public is sophisticated 

enough to recognize when markets are out of balance 

and when projects are economically infeasible. In this 

sense, CMBS shift much of the burden of monitoring 

credit quality standards and credit performance from 

lenders to public investors. 

In contrast, others have argued that lenders are much 

better suited than investors to make judgments about 

credit quality standards and project feasibility. This line 

of reasoning suggests that the increase in public ownership of property through CMBS and REITs could actually reduce market discipline, since the most 

sophisticated participants with access to the best information (that is, lenders) may come to have less at stake 

in making prudent credit decisions. Of course, excessive losses attributable to any one CMBS issuer might 

lead to differentiation in pricing based on investors’ 

Boston Regional Outlook 11	 First Quarter 1998 
In Focus This Quarter
 

perceptions of the quality of underwriting applied by 

specific issuers.5 

Putting market efficiency arguments aside, the sheer 

volume of REIT and CMBS activity causes some concern over the extent to which such financing is driving 

property valuations. With such an abundance of capital 

flowing into the commercial real estate market, it is perhaps easy to see why lenders might opt to ease standards 

rather than lose business. However, to the extent securitization activities are driving decisions in today’s commercial real estate markets, lenders might wish to 

consider how property values would react if the availability of such financing were sharply diminished. The 

most recent real estate downturn provided a ready 

example of how tighter credit availability compounded 

the effects of declining commercial property values by 

limiting the ability of lenders to sell distressed properties. While there may not be consensus on whether 

CMBS and REITs will temper cyclical price swings, the 

underwriting standards and practices evolving in 

response to these financing vehicles will likely play a 

crucial role in determining the magnitude of losses 

experienced by investors and banks during the next 

downturn in commercial property values. 

Steven Burton, Senior Banking Analyst 

sburton@fdic.gov 

Selected Articles
 

for Further Reading
 

Bloomfield, Craig. “Michelson, Greenland Seize 

Low CMBS Spreads.” Commercial Property News. 

1 May 1997. p. 33. 

“CMBS Issuance Seen Topping $40 Billion.” 

Commercial Mortgage Alert. 10 November 1997. 

p. 1. 

Fitch Investor Services, Inc. “Commercial 

Mortgage Stress Test.” Fitch Research: Structured 

Finance Special Report. 8 June 1992. 

Office of the Comptroller of the Currency. Advisory 

Letter 97-3: Credit Underwriting Standards and 

Portfolio Credit Risk Management. 3 March 1997. 

Sinderman, Martin. “Public Markets Fuel 

Financing Glut.” Commercial Real Estate South. 

October 1997. p. 1. 

Wolf, Barney. “Wall Street and Main Street 

Squeeze Lenders.” Midwest Real Estate News. 

October 1997. p. 1. 

5 The evolution of the credit card securitization markets is one example of how investors now differentiate between issuers in terms of 

pricing. 

Boston Regional Outlook 12 First Quarter 1998 
In Focus This Quarter
 

Total Return: A Useful Tool for
 

Monitoring Investment Portfolio Risk
 

•	 The Federal Financial Institutions Examination 

Council (FFIEC) is replacing the 1991 policy that 

contained a specific “high-risk test” for mortgage 

derivative products (MDPs) held by insured institutions with a policy that encourages risk management across all types of instruments on an 

investment portfolio basis. 

•	 A good way to start measuring portfolio risk is by 

monitoring an appropriate measure of return. 

•	 Total return, a concept that includes fluctuations 

in market value, is a more appropriate tool than 

simple yield for measuring the performance of an 

investment portfolio, especially one that contains 

bonds with embedded options. 

The Federal Financial Institutions Examination Council 

(FFIEC) has released for comment a new Joint Agency 

Policy Statement on Investment Securities and EndUser Derivatives Activities that will replace a statement 

issued February 3, 1992. While much of the content of 

the former statement has been retained, the section 

requiring specific “high-risk” testing for mortgage 

derivative products (MDPs) has been eliminated. The 

“high-risk” test applied specifically to bonds collateralized by residential mortgage pass-through certificates 

or whole loans but that distributed cash flows to bondholders on a basis other than pro rata.1 

The goal of the original policy statement was to deter 

banks from investing in products that presented risks 

that they were not able to adequately monitor and control. MDPs were singled out because of their rapid 

growth, nontraditional and potentially risky nature, and 

common use by insured financial institutions. The new 

policy states that, as a sound management practice, 

institutions should conduct prepurchase and ongoing 

analysis of all their investments at a level appropriate to 

the size and complexity of those holdings. 

1 A security was deemed “high risk” if it exhibited any of the following characteristics: (1) it had a weighted average life of more than ten 

years; (2) its average life extended by more than four years or shortened by more than six years from a 300 basis point parallel shift in 

rates; (3) its price changed by more than 17 percent given a 300 basis 

point parallel shift in rates. 

The policy change is in part a response to increasing 

bank investment in securities that have complex cash 

flows analogous to MDPs but that escaped the analysis 

requirement of the previous policy. Mortgage index 

amortizing notes are an example of popular bank investments that potentially exhibit all the risks of MDPs but 

were not subject to the testing requirement of the soonto-be rescinded policy because they are not collateralized by mortgages. Callable agency and “step-up” 

bonds are popular bank investments because they offer 

a slightly larger spread to Treasury than noncallable 

agency securities, and they were not subject to the 

“high-risk” test under the old policy. However, the additional yield offered on these kinds of securities compensates the investor for assuming additional risk. 

Appropriately measuring portfolio return can enhance 

the ability to monitor the extent to which these kinds of 

securities put future earnings at risk. 

Total Return Analysis Is a Useful Tool for 

Analyzing Risk at the Portfolio Level 

Total return analysis is a basic but useful tool that can 

alert management to the level of certain risks in an 

investment portfolio. It can also provide information 

that is useful for validating the assumptions used in 

more sophisticated models. Total return is calculated 

from three components: beginning price, income and 

reinvested cash flow, and ending price (market value) at 

a horizon date. Total return incorporates the change in 

the market value of the investment, resulting in a more 

comprehensive measure of performance than other 

measures that ignore such changes. Monitoring total 

return on a portfolio basis can provide institutions with 

important information about the risks inherent in the 

portfolio and how these risks may be changing over 

time. 

In two articles in the ABA Banking Journal,

2 Nicholas 

Betzold and Richard Berg convincingly dispute the 

2 The articles were published in December 1996 and April 1997. 

Reprints of the articles are available at the ABA Banking Journal website at http://www.banking.com.aba/backissues.htm. 

Boston Regional Outlook 13	 First Quarter 1998 
In Focus This Quarter
 

view that if the investment strategy is to buy and hold to 

maturity, total return is not relevant. Consider the following example. In 1990, Bank A purchases a sevenyear security yielding 8.83 percent that is callable after 

three years. At the same time, Bank B buys a noncallable seven-year agency security yielding 8.53 percent. For three years, Bank A’s bond yields 30 basis 

points more than Bank B’s. However, from 1990 to 

1993, interest rates fell almost 300 basis points. Bank 

A’s bond would likely be called, forcing the bank to 

reinvest at a significantly lower rate for the remaining 

four years of the seven-year investment horizon. Over 

the seven-year horizon, Bank A could expect an average 

yield that is about 150 basis points less than Bank B’s. 

From the yield perspective, 

Bank A enjoyed three years of 

superior performance. However, during those three years, 

monitoring total return might 

have revealed a less favorable 

but more accurate picture of 

Bank A’s performance relative 

to Bank B’s. Here is why: As 

rates fell from 1990 to 1993, bonds gained in value. 

However, as rates fell, the market value of the callable 

security would have gained incrementally less than the 

noncallable bond because each downward tick in rates 

increased the expectation that the bond would be called, 

and the higher coupon would be earned over a shorter 

period. In contrast, the noncallable security’s market 

value would have enjoyed the full benefit of the falling 

rate environment because its maturity and cash flows 

are fixed. 

The disparate change in the market value of the two 

bonds reflects the fact that Bank A, in essence, sold a 

call option to the bond issuer. The issuer bought the 

right to repurchase the debt at par after three years. 

Bank A was compensated for selling this right to the 

issuer with increased yield. In the example, the issuer’s 

option to call the bond would have gained value as rates 

fell. The increasing positive value of the call option to 

the issuer represents an increasing negative value to the 

bondholder and erodes the value of the bond. 

Step-up bonds present reinvestment risk similar to that 

of generic callable bonds, but with the added complexity of a coupon that rises, usually annually, if the bonds 

are not called. Total return analysis would similarly 

reveal adverse changes in the value of the embedded 

call options and the extent to which the additional 

coupon is compensating for call risk. 

UBPR Yield 

Bank management often uses the portfolio yield that is 

calculated in the Uniform Bank Performance Report 

(UBPR) to assess performance of the bank’s securities 

portfolio against its peers. This yield measure is calculated by dividing annualized book income on a tax 

equivalent basis (plus or minus amortization or accretion of any premium or discount) by the amortized cost 

of the securities. This measure of present yield says little about potential future yield and the extent to which, 

because implicit options have been sold, the latter has 

been put at risk for the sake of the former. 

Total return measures the risk-adjusted return of a portfolio more closely than yield because it incorporates 

changes in reinvestment risk over time. Ultimately, a 

portfolio manager who earns total returns consistently 

higher than average will earn more in terms of simple 

yield. Conversely, a manager who earns less in terms of 

total return will eventually find an unfavorable reinvestment environment that will erode reported yield. 

The popularity of using yield to gauge the performance 

of bank securities portfolios may be due to the convenient presentation of bank peer portfolio yields in the 

UBPR. Some managers may be reticent to evaluate 

portfolio performance using total return without a peerlike benchmark for calibrating total return expectations. 

Betzold and Berg have devised an investment portfolio 

index (introduced in the April 1997 ABA Banking 

Journal) that is designed to track the total return of a 

typical bank portfolio composed of the same percentages of investment sectors as the average bank. The 

portfolio on which the index is based is rebalanced 

monthly as principal pays down, and it is rebalanced 

quarterly to reflect the latest Call Report data on portfolio allocations. Table 1 depicts the investment weighting of the index as of December 31, 1996, based on 

September 30, 1996, Call Report data. 

According to Betzold and Berg, this index produced 

total returns that closely approximated those of the actuBoston Regional Outlook 14 First Quarter 1998 
In Focus This Quarter
 

al median bank total portfolio measured by Call Report 

data from 1993 through third quarter 1997.3 They concluded that their index seems to provide a reasonable 

proxy for the total return of the “average” bank investment portfolio. 

Chart 1 shows the performance of the index so far this 

year.4 Changes in the index value over time can be translated into total returns that approximate the median 

bank portfolio’s total return. For example, the annualized total return for the index from year-end 1996 

through third quarter 1997 was 6.72 percent and is calculated as follows: 

Calculate the bond equivalent semiannual yield 

and express the semiannual bond equivalent yield 

as an effective annual yield. 

4

: 105.00 3

6.72% = 100 [(:) − 1

100.00 ]

The performance of the index for 1997 suggests that 

banks’ total investment portfolio returns were highly 

negatively correlated with changes in the five-year 

Treasury rate (see Chart 2). This finding indicates that 

changes in total return from period to period can provide useful information about the level of a portfolio’s 

interest rate sensitivity. As emphasized above, these 

changes in total return over time include the effects of 

changes in market value of any call options on a bank’s 

investment securities and hence provide information 

about the degree to which future income is at risk. 

Given the increasing level of optionality embedded in 

the average bank securities portfolio—even if it arises 

solely from callable agency debt and “step-up” structured notes—yield should not be the sole measure of 

overall portfolio performance. Total return analysis is an 

appropriate supplement that gauges the risk-return characteristics of an investment strategy that involves selling 

implicit options. 

Allen Puwalski, Senior Financial Analyst 

3 While the Call Report does not contain the information necessary to
 

compute total return precisely, the authors computed an estimate
 

using the reported yield and market value data.
 

4 The index is published monthly in the ABA Banking Journal.
 

TABLE 1 

Composition of Betzold Berg Index 

December 31, 1996 

PERCENT 

SECURITY TYPE OF INDEX 

TREASURIES 24.52 

AGENCIES 24.38 

MUNICIPAL BONDS 12.26 

FIXED-RATE MORTGAGE OR 

MORTGAGE-RELATED PRODUCTS 19.93 

OTHER SECURITIES 6.09 

ADJUSTABLE-RATE SECURITIES 13.00 

Source: Bank and Thrift Call Reports, September 30, 

1996 

CHART 1 Index Value 

Index Tracks the Total Return of an 

“Average” Bank Portfolio 

Source: ABA Banking Journal 

100.84 

104.31 

Dec Jan Feb Mar Apr 

100 

101 

102 

103 

104 

105 

106 

May Jun Jul Aug Sep 

100.51 100.71 

101.49 

102.23 

103.06 

104.03 

105.00 

100.00 

CHART 2 

Total Return Index Is Correlated 

to Changes in Interest Rates 

Source: ABA Banking Journal, Bloomberg 

5-year Treasury 

(right scale) 

Betzold Berg Index 

(left scale) 

Percent Change Percent Change 

–10 

–5 

0 

5 

10 

Jan-97

Feb-97

Mar-97

Apr-97

May-97

Jun-97

Jul-97

Aug-97

Sep-97 

–0.20 

0.00 

0.20 

0.40 

0.60 

0.80 

1.00 

Boston Regional Outlook 15 First Quarter 1998 
Regular Features	 Regional Economy
 

Greatest Risks to Region’s 


Current Expansion Will Come ‘From Away’
 

•	 New England’s economy, except for a few pockets of weakness, performed very well in 1997. 

•	 Slower but continued growth seems to be the most likely scenario for the Region’s economy in 1998. 

•	 A national recession would likely put an end to the current New England expansion. 

•	 Either a significant, abrupt stock market decline or a protracted bear market could adversely affect the 

Boston Region’s economy. 

New England’s Economy Saw Above-Average 

Growth in 1997 

On the basis of preliminary measures such as income 

and job growth, 1997 seems to have been one of the 

strongest years of the current expansion for the Boston 

Region’s economy. New England manufacturing, for 

example, is likely to show its first annual net increase in 

employment this decade, thanks to a return to net job 

gains among Massachusetts factories and continued 

growth in the manufacturing sectors of New 

Hampshire and Vermont. Some of the positive developments in the Region’s economy during 1997 are 

discussed below, as are a few of the risks that could 

pose a threat to its continued expansion over the near 

term. 

Income Growth May Continue to Exceed 

U.S. Average 

Job Gains Were Strong Overall, but Eased in 

New Hampshire and Vermont 

Table 1 presents preliminary estimates for 1997 nonfarm payroll employment growth (through November) 

for the states in the Boston Region. Most states witnessed growth rates that matched or exceeded their 

average pace for this expansion through 1996 (the far 

right column in Table 1). New Hampshire was again 

among the Region’s fastest growing states last year, but 

its growth rate slowed after a gain nearly double the U.S. 

pace in 1996. Vermont’s rate of job growth also eased 

last year. However, given that Vermont’s current expansion is among the longest running of any state in the 

Region, some slowing is to be expected. 

Job growth in the Region’s largest labor markets also 

increased last year. Massachusetts, with 2.5 percent 

growth in 1997, exceeded the rate of net job creation for 

CHART 1 

Income per capita likely rose by a healthy 5.8 percent 

during 1997 in New England, compared with an estimated gain near 5 percent for the nation as a whole. Per 

capita income gains last year were likely strongest in the 

Region’s largest economies, with anticipated gains of 

6.2 percent in Massachusetts and about 6.0 percent in 

Connecticut. 

Chart 1 illustrates the recent history of per capita 

income for New England and the nation. The fall 1997 

forecast by the New England Economic Project calls 

for the Region to continue to post larger gains in per 

capita income than the nation in 1998. This projection is 

expected to hold true for all states in the Region except 

Rhode Island. Source: U.S. Census Bureau 

New England 

U.S. 

Region’s Income Growth Inched Ahead of 

National Average in 1997 

(income per capita, annual change) 

* estimated by author 

Percent 

0 

2 

4 

6 

8 

10 

12 

’81 ’83 ’85 ’87 ’89 ’91 ’93 ’95 ’97* 

Boston Regional Outlook 16	 First Quarter 1998 
Regular Features Regional Economy
 

TABLE 1 

Most States Saw Accelerated Job Growth during 1997 

(percent change in average nonfarm employment from year ago) 

1997* 1996 TREND THIS EXPANSION** 

U.S. 2.2 2.1 2.0 

NEW ENGLAND 2.1 1.7 1.8 

CONNECTICUT 1.9 1.4 0.9 

MAINE 1.7 0.3 1.3 

MASSACHUSETTS 2.5 2.0 2.1 

NEW HAMPSHIRE 2.3 3.7 3.0 

RHODE ISLAND 0.9 0.4 0.9 

VERMONT 1.4 1.8 2.0 

* Year-to-date through November ** Compound annual rate, 1996/last trough 

Source: Bureau of Labor Statistics 

the nation. Connecticut, which has posted increasing 

rates of job growth every year since 1992, also continued to gain steam. 

Unemployment Rates Generally Low, but 

Chronic Pockets of Weakness Persist 

By 1997, the combination of modest labor force growth 

and increasing job gains across much of the Region 

resulted in unemployment rates well below the U.S. 

average in many states. Chart 2 shows that a broad 

swath of counties across the Region had very tight labor 

markets last year. 

Through November, unemployment rates were below 

the Regionwide average (and well below the U.S. average) in 31 counties, many of them in New Hampshire, 

Vermont, southern Maine, and eastern Massachusetts. 

These counties account for a little over one-third of the 

Region’s total population. Conversely, all but one of 

Rhode Island’s counties exceeded the 5.0 percent U.S. 

average unemployment rate between January and 

November 1997. 

The sparsely settled counties of northern Maine also 

continued to see fairly high unemployment rates last 

year. Washington County had the highest unemployment with an average rate of 10.1 percent. Other pockets of high unemployment existed in northeastern 

Vermont, which, like northern Maine, has had consistently soft labor markets during this expansion. 

In Massachusetts, weakness persisted in the western and 

southeastern counties (areas historically more reliant on 

volatile manufacturing industries, such as textiles and 

paper products). In Connecticut, Fairfield County and 

(sparsely populated) Tolland and Litchfield Counties 

were the only subareas with unemployment rates below 

4.3 percent (the Regionwide average). Except for 

Middlesex County (4.8 percent), the remaining four 

counties exceeded the U.S. average unemployment rate 

of 5.0 percent during the first 11 months of 1997. 

Persistent pockets of relatively high unemployment are 

Connecticut’s legacy from the last recession, when 

cyclical factors were amplified by the secular downsizing of the state’s defense, insurance, and banking 

industries. 

CHART 2 

Many Parts of the Region Continue to
 

See Tight Labor Markets
 

(Jan-Nov 1997 average unemployment rate,
 

not seasonally adjusted) 

5.2% or higher

5.0% to 5.1% (US = 5.0%)

4.5% to 4.9%

4.2% or lower

Source: Bureau of Labor Statistics 

(22)
 

(4)
 

(6)


4.3% to 4.4% (Region = 4.3%) (4)
 

(31)
 

Boston Regional Outlook 17 First Quarter 1998 
Regular Features Regional Economy
 

Outlook: Slower Growth Ahead? 

Looking forward, last year’s strong employment growth 

rate is expected to slow in 1998, according to the fall 

1997 forecast by the New England Economic Project. 

Based on expectations of slower national growth this 

year, the group is calling for a net increase in employment of 1.6 percent in New England, a rate that would 

still compare favorably with an anticipated U.S. rate of 

1.2 percent. Much of the expected slowdown in New 

England derives from the fact that our economy is 

increasingly tied to the national business cycle. The 

Region’s growing scarcity of qualified workers in 

expanding industries may also slow growth. These factors, combined with the lack of any significant imbalances in the Region’s economy at present, mean that the 

current expansion is most at risk from a national recession or other outside influences. 

Implications: Slower growth over the next year may 

increase pressure on insured institutions to relax underwriting standards or to take other risky measures to generate new business and retain existing customers. 

Downward pressure on pricing coupled with increased 

risk taking could exacerbate any problems that develop 

when the economy does enter the next recession. 

Risks to New England Expansion 

to Come ‘From Away’ 

Mainers have an expression for outsiders—they are 

“from away.” This colloquialism is quite appropriate to 

the risks that could derail the expansion New England 

has enjoyed for the past five years. As discussed above, 

the Region’s states are performing quite well, and the 

most likely scenario going forward is one of moderating 

growth. 

Unlike the last recession, there 

appear to be no major imbalances 

in the Region’s real estate markets, nor is another round of huge 

defense and insurance industry 

layoffs likely any time soon. The 

other major factor aggravating 

the last recession, namely a large 

restructuring in New England’s computer industry, is 

also unlikely to recur. The shift in market demand to 

PC-dominated open systems in the late 1980s and early 

1990s, and the massive layoffs that resulted among the 

Region’s once-dominant minicomputer giants, left a 

more diverse landscape of computer hardware firms in 

New England. Now that employment is spread over 

more firms and a broader range of products, the 

Region’s computer industry should be better able to 

avoid large-scale layoffs when the next major shift in 

computer technology occurs. 

New England Not Immune 

to a National Recession 

Since the Region has no imbalances, its next recession 

will most likely occur concomitantly with a national 

downturn. However, the general consensus is that a 

national recession is not very likely in the near term. For 

instance, of the 39 economists/forecasters surveyed by 

the National Association for Business Economics in 

November 1997, none saw a recession in 1998, and only 

11 (28 percent) thought the economy would turn down 

in 1999. An In Focus article by Paul Bishop in next 

quarter’s Regional Outlook will examine some potential U.S. recession scenarios. 

Asian ‘Crisis’ May Slow Region’s 

Growth Slightly 

The spreading southeast Asia currency “crisis” in the 

latter half of 1997 led many economists to forecast that 

ongoing weakness in that part of the global economy 

would result in an easing of growth in U.S. gross 

domestic product (GDP) by 0.5 to 1.0 percentage points 

in 1998. While some portions of the country will be 

more adversely affected than others, the effect on the 

Boston Region should be modest. Growth in the 

Region’s economy will slow, as local exporters see a 

decline in demand because of weaker Asian economies 

and because devalued Asian currencies make U.S. 

goods more expensive in those markets. This analysis 

also applies to the Region’s many colleges and universities that “export” education services to foreign students 

studying at local schools. Local manufacturers whose 

products compete with Asian goods may see demand 

slacken as exchange rate fluctuations make some Asian 

goods more affordable. On the bright side, total exports 

account for less than a 10 percent share of the various 

New England states’ gross products, except in Vermont, 

where IBM’s exports to Canada raise the figure to near 

17 percent. State exports to Asia (eight nations), China, 

and Japan generally made up only 1 to 3 percent of each 

state’s estimated gross state product in 1996, while 

nationally this figure was 2.4 percent of GDP. Thus, the 

Boston Regional Outlook 18 First Quarter 1998 
Regular Features Regional Economy
 

direct effects on the Region’s export- or import-competing industries are likely to be no more severe than they 

will be for the nation as a whole. Only if the Asia problem unduly depresses U.S. equity markets would this 

Region be more adversely affected than other parts of 

the nation. 

Equity Market Crash or Protracted Bear Market 

Poses Risks to the Region’s Expansion 

Despite some weakness in January, many would agree 

that by most measures the stock market remained 

“pricey” in early 1998. Given the fleeting nature of the 

October 1997 market correction, the possibility of a significant stock market decline remains high. Also, the 

negative effects of slumping Asian economies and a 

slowing domestic economy on U.S. corporate earnings 

growth have the potential to contribute to a flat, or even 

bearish, market in the near future. 

In New England, the Massachusetts economy is at 

greatest risk from a negative shock to equity markets. 

Connecticut may also bear a greater risk, given its growing securities employment and Fairfield County’s ties to 

the New York City economy. The risks of a market 

decline or shift to a longer term bear market are twofold 

for the Massachusetts economy (a primary driver of this 

expansion). First, a larger than average share of state 

income is tied to equities. Second, expanding employment in certain high-growth sectors depends, to some 

extent, on continued strength in the stock market. 

On the first point, a recent analysis by Regional 

Financial Associates1 indicated that “only Florida has a 

higher share of taxable income from capital gains than 

Massachusetts’ residents.” In a declining equity market, 

households would curtail spending as the value of their 

equity holdings (and thus their income through realized 

capital gains) fell. Consumption is a major driver of 

illustrates the ratio of two states’ shares of nonfarm 

employment in securities to that for the United States as 

a whole. A value of 1.0 would mean that a state’s share 

of jobs in the securities industry is equal to that for the 

U.S. economy. 

Massachusetts (in particular the greater Boston area) 

and parts of New Hampshire, Rhode Island, and 

Connecticut have seen increasing employment in the 

securities industry in recent years. As can be seen in 

Chart 3, Massachusetts was almost three times as reliant 

on employment in the securities industry as the United 

States as a whole in 1996. While consistently above the 

United States since 1980, this dependence has been 

growing markedly in recent years. Connecticut, too, has 

seen a rising share of employment in the industry, 

exceeding the U.S. share since 1990. 

A declining U.S. equity market would certainly derail 

the recent spate of rapid job growth in this industry. 

Securities employment could even decline if either the 

duration or depth of a market downturn were sufficiently pronounced. 

Information technology, particularly software and related services, is another area that has generated significant gains in employment and income for the Region 

during this expansion. Most established publicly traded 

technology firms are modestly leveraged, relying primarily on their equity to fund investment and to expand 

their businesses. Information technology startups are 

also reliant on a strong equity market to attract venture 

capital to the industry. Most venture capital is placed 

with the ultimate goal of an initial public offering in 

CHART 3 

Region’s Reliance on Securities* Industry
 

Employment Is Increasing
 

3.0

Ratio of state share of nonfarm jobs to

share of nonfarm jobs U.S.

economic activity. Slower growth or an outright decline 

in consumer outlays would curtail the Region’s economic expansion. 

On the second point, the securities (primarily asset management) and high-technology industries have been 

among the Region’s strongest generators of new jobs in 

recent years. Chart 3 highlights the importance to the 

Region of securities industry employment. The graph 

2.5 

2.0 Massachusetts

1.5 Connecticut

1.0 U.S. 

0.5 

0.0 

’80 ’82 ’84 ’86 ’88 ’90 ’92 ’94 ’96 

1 “Stock Market Mania,” Mark M. Zandi, Regional Financial Review, * Securities and commodities brokers, dealers, and services 

Source: Bureau of Labor Statistics 

September 1997. 

Boston Regional Outlook 19 First Quarter 1998 
Regular Features Regional Economy
 

mind, as taking a startup public allows the venture capital firm to profit from its investments. Without a strong 

market to support public offerings, the supply of venture capital might be curtailed. This situation would 

most likely slow job and income growth at young firms, 

while reduced equity values would also impede growth 

at more established companies. 

CHART 4 

Software Industry’s Importance to Massachusetts 

(computer services, software, and data processing wages,* 

share of total private sector wages) 5.0 

4.5 

4.0 

3.5 

3.0 Massachusetts

Percent 

In recent years, a large share of venture capital in New 2.5 

England has gone to software startups, thanks to strong 

growth in Internet-related applications. Chart 4 highlights the importance of the wages generated by the 

software (and related services) industry to 

Massachusetts. In 1996, the state was about twice as 

reliant on jobs and income from this industry as the 

nation as a whole. Private sector wages in this industry 

grew by about 15 percent per year (at a compound annual rate) between 1990 and 1996 in Massachusetts, versus a much more sedate annual pace of 4.5 percent for 

all private sector wages. 

Implications: Direct exposure of insured institutions to 

equity markets is generally modest in the Region. The 

few institutions with large equity holdings relative to 

Tier 1 capital generally have significant unrealized 

gains or adequate capital positions or both to weather a 

substantial decline in the market. However, institutions 

may also have indirect exposure to the equity markets 

2.0 

1.5 U.S. 

1.0 

0.5 

0.0 

’88 ’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 

Source: Bureau of Labor Statistics * SIC code 737 

through loans to companies in the securities industry or 

through loans secured by equity securities. Further, to 

the extent that a market downturn would impede consumer spending and otherwise weaken growth in the 

Region’s economy, insured institutions, along with 

firms in most other industries, could expect to see 

heightened pressure on revenues and profits. 

Norman Williams, Regional Economist 

Boston Regional Outlook 20 First Quarter 1998 
Regular Features	 Regional Banking
 

Regional Banking Conditions
 

•	 The Region’s insured institutions continue to report strong profits and improved asset quality. 

•	 A focus on return on equity at publicly traded companies results in lower capital levels. 

•	 A flattening yield curve would likely pressure margins and earnings in 1998 and beyond. 

•	 Strong asset/liability management skills will be required to deal with a prolonged period of refinancing 

activity in the current interest rate environment. 

Overall Conditions Remain Upbeat 

The Boston Region’s insured institutions continue to 

report strong performance. Profits have risen to record 

highs, capital and reserve levels are adequate, and loan 

delinquencies and charge-offs are low and appear to be 

headed lower. As of September 30, 1997, the Region’s 

institutions posted an aggregate year-to-date return on 

assets (ROA) of 1.30 percent. This compares favorably 

to the year-to-date ROA posted by all insured institutions of 1.18 percent and is 15 percent higher than the 

comparable period in 1996. Profits continue to be driven by strong net interest margins, improved asset quality, and gains in operating efficiency. Additionally, 

noninterest income continues to grow relative to asset 

size for the Region’s large or specialized firms, in large 

part because of continued strong growth in the equities 

market and its concomitant positive effect on fees associated with asset management and capital markets-related activities. 

TABLE 1 

Earnings continue to boost aggregate capital levels; 

however, leverage ratios vary widely depending on the 

nature of institution ownership. Publicly traded institutions and those that are subsidiaries of publicly traded 

companies maintain significantly lower capital levels 

than closely held banks and mutually owned savings 

institutions (see Table 1). For institutions headquartered 

in the Boston Region, the Tier 1 capital ratio is inversely related to asset size, with subsidiaries of the largest 

publicly traded companies maintaining the lowest average Tier 1 capital levels. Asset growth has not kept pace 

with capital formation, and as a result, dividend payouts 

are high for publicly traded organizations to ensure that 

a relatively higher degree of leverage is maintained. 

Investor demands for high returns on equity result in the 

redeployment of “excess capital” from subsidiary banks 

and thrifts to other corporate purposes, such as acquisitions, stock repurchase programs, and higher dividend 

payouts at the corporate level. As a result, these institutions are achieving higher returns on equity than their 

nonpublic counterparts but are doing so from a weaker 

capital position. 

Publicly Traded Institutions Use Greater Degree of Leverage to Boost ROE 

(Ordered by ownership, type, and asset size) 

PUBLICLY TRADED INSTITUTIONS CLOSELY HELD/MUTUAL 

INSTITUTIONS 

COMMERCIAL SAVINGS COMMERCIAL SAVINGS 

PERCENTAGES > $25 $1 TO $25 < $1 ≥ $1 < $1 < $1 ≥ $1 < $1 

BILLION BILLION BILLION BILLION BILLION BILLION BILLION BILLION 

RETURN ON ASSETS 1.35 1.20 1.22 1.02 1.11 0.92 1.09 1.02 

RETURN ON EQUITY 17.52 15.06 14.06 12.92 13.13 9.71 10.07 8.83 

DIVIDEND PAYOUT (YTD) 93.30 62.90 25.00 50.20 31.80 30.10 14.40 — 

TIER 1 RATIO 6.84 7.43 8.70 7.30 8.21 9.23 10.16 10.96 

* Excludes Credit Card Banks and Trust Specialists 

Source: Bank & Thrift Call Reports 

Boston Regional Outlook 21	 First Quarter 1998 
Regular Features Regional Banking
 

Total past-due loans are now less than 2 percent of total 

loans. With the exception of consumer loans, all loan 

categories have downward delinquency and charge-off 

trends. Credit card loans continue to drive up delinquencies and charge-offs in the consumer loan category. Delinquent credit card loans rose 81 basis points 

from a year ago, to 4.24 percent. During the third quarter, the credit card charge-off rate was 4.91 percent, up 

from 3.18 percent in the year earlier period. These 

increases continue to mirror national credit card performance trends and increases in personal bankruptcy filings, and they underscore the need for continued close 

monitoring of the consumer sector by both industry participants and regulators. 

The strong net interest margins that have elevated earnings to record levels have resulted from very favorable 

swings in interest rates during the 1990s. The prime rate 

is at a historically high spread over short-term interest 

rates, and a wholesale shift of consumer deposits from 

certificates of deposit into savings and NOW accounts 

in the early 1990s has greatly benefited most insured 

institutions. Since interest rates rose in 1994, these institutions have been able to retain a substantial portion of 

the shifted funds in the lower cost accounts despite paying rates that are well below short-term, money market 

rates. However, lower inflation expectations and declining federal deficits, coupled with the ripple effects of 

the troubled economies and currencies of southeast Asia 

on U.S. financial markets, have resulted in declining 

long-term interest rates and a dramatic flattening of the 

yield curve. If it persists, this interest rate environment 

will pressure earnings for many of the Region’s insured 

institutions. In the long term, bankers may have to operate on thinner margins while incurring more interest 

rate risk, particularly if Federal Reserve monetary policy remains restrictive in real terms. The following discussion explores the issue of prepayment risk and 

identifies several factors suggesting that the Region’s 

insured institutions, particularly those under $1 billion 

in total assets, may be at greater risk of prepayment 

activity than insured institutions in other parts of the 

country. 

Dependence on Real-Estate-Backed Assets 

Places Region’s Insured Institutions at Risk 

of a Refinancing Wave 

As discussed in the fourth quarter 1997 Boston 

Regional Outlook, real estate lending is the primary 

source of revenue for most of the Region’s insured institutions. As of September 30, 1997, the 418 institutions 

with assets less than $1 billion reported that 87 percent 

of total loans were centered in real estate. Excluding the 

Region’s three largest banks (only a 29 percent real 

estate concentration), the remaining 38 institutions with 

assets over $1 billion had 70 percent of total loans centered in real estate. Approximately three-quarters of the 

real estate loan exposure is centered in the residential 

sector. 

Adjustable rate mortgages (ARMs) and balloon mortgages comprise about 60 percent of the residential portfolio, a significantly higher percentage than the overall 

mortgage market. The Federal Housing Finance Board 

estimates that nationally, less than 30 percent of all residential mortgages originated since year-end 1989 have 

been in shorter term instruments. The concentration in 

ARMs and balloons in the Region is consistent with the 

historical desire of insured institutions to hold shortduration mortgages and sell longer term, fixed-rate 

paper into the secondary market to minimize interest 

rate risk. During the third quarter of 1997, both the 

fixed and adjustable rate portfolios were generating 

aggregate yields in excess of 8 percent. 

In early January 1998, Freddie Mac’s Primary 

Mortgage Market Survey (PMMS) indicated that the 

average interest rate for 15-year and 30-year, fixed-rate 

mortgages had fallen to 6.46 percent and 6.89 percent, 

respectively. These rates are within 10 basis points of 

lows reached in October 1993 and may be leading to 

another refinancing boom. The Mortgage Bankers 

Association of America announced that during January 

1998, its Refinancing Index rose to an all-time high and 

was nearly double the peak reached during the last big 

refinancing wave in the fall of 1993. This burst of activity is occurring despite the fact that average fixed mortgage rates are slightly higher than the prior trough. 

Additionally, the refinancing waves in 1991 through 

1993 followed an 11-year period when the average 

interest rate for 30-year, fixed-rate mortgages, according to the PMMS, was in excess of 10 percent every single year. According to Bloomberg, as of December 31, 

1997, only 11 percent of all securitized Federal National 

Mortgage Association/Federal Home Loan Mortgage 

Corporation 30-year mortgage pools bore coupons in 

excess of 8 percent. With the rate differential between 

outstanding mortgages and current rates much narrower than it was in the early 1990s, what is driving the 

renewed prepayment activity? 

Boston Regional Outlook 22 First Quarter 1998 
Regular Features Regional Banking
 

A Flat Yield Curve Will Spur a Shift into LongTerm, Fixed-Rate Mortgages 

One of the primary factors in the renewed prepayment 

activity is the shape of the yield curve. With short-term 

rates high relative to long-term rates, holders of 

adjustable rate mortgages have a strong incentive to 

refinance into fixed-rate instruments. Chart 1 contrasts 

the shape of the yield curve in early January 1998 and 

in October 1993. As the chart indicates, the one-year 

treasury yield was nearly 200 basis points lower in 

1993. The one-year treasury is a common index for 

ARMs in the Region, and in 1993, a fully indexed ARM 

had a current coupon in the low 6s, well below fixedrate mortgages. In today’s environment, a fully indexed 

ARM is likely to have a current coupon in excess of 8 

percent, well above current fixed rates. Additionally, 

there is very little difference between current long-term, 

fixed rates and those on five- and seven-year balloon 

mortgages. Balloon mortgages were popular during the 

refinancing waves of the early 1990s and are now at 

points where they are converting to one-year ARMs or 

maturing. This fact suggests that borrowers holding 

adjustable rate and balloon mortgages will likely lead 

the next refinancing wave if current conditions continue. Many insured institutions would be affected considerably, as these shorter duration mortgages comprise the 

largest portion of residential portfolios. 

The shape of the yield curve will also create reinvestment problems for insured institutions. During the earlier refinancing waves, the short end of the yield curve 

was sufficiently low that ARMs and balloon mortgages 

still had rates that were attractive to consumers. ARM 

teaser rates approximating 3 percent were common, and 

CHART 1 

A Flat Yield Curve in 1998 Could Depress 

ARM Originations in Favor of Fixed-Rate Products 

(U.S. Treasury Yield Curves) 

Percent 

7 

6 

5 

4 

3 

2 

1 

0 

–1 

1st week of January 1998 

October 1993 

Difference 

3 month 10 year 30 year 

the spread between the five- and ten-year treasury was 

nearly 60 basis points, which also gave balloon mortgages an attractive rate advantage compared with longer 

term mortgages. Inside Mortgage Finance recently 

published data made available by Freddie Mac which 

indicated that during the earlier refinancing waves, 

approximately 15 percent of fixed-rate loans actually 

refinanced into ARMs or balloons. For ARMs, 30 to 40 

percent of refinancings went back into the shorter duration mortgages, and for balloon mortgages, over 70 percent did so. Refinancing provided an ample supply of 

shorter duration mortgages for insured institutions looking to replace runoff and expand their loan portfolios. 

The flatter yield curve this time around will not provide 

the same opportunities. The Freddie Mac data indicate 

that in the third quarter of 1997, over 96 percent of 

fixed-rate loans, and approximately 90 percent of 

ARMs and balloons, refinanced into fixed-rate mortgages of 15 or more years. 

This Time Around, the Region’s Homeowners 

Are Better Positioned to Take Advantage of 

Refinancing Opportunities 

The Region’s insured institutions may face a heightened 

risk of prepayments. During the earlier refinancing 

waves, the country was just emerging from recession, 

while New England remained weak. Jobs were still 

being lost in some of the Region’s key industries, and 

consumer confidence was low. Additionally, home 

prices in the Region had fallen considerably from peaks 

in the late 1980s, leaving many consumers “upside 

down” on their mortgages and unable to refinance 

because of the lack of equity in their homes. Credit was 

tight as well. Lenders were working through ongoing 

real estate problems and were not aggressively seeking 

new business as they focused on restoring capital levels. 

The effects of these problems were seen in the relatively slower prepayment rates in securitized mortgage 

pools backed by mortgages generated in New England. 

In 1998, conditions in the Region are vastly improved. 

Unemployment is low, and wages and consumer confidence are high and rising. Additionally, data compiled 

by the Office of Federal Housing Enterprise Oversight 

indicate that for many markets in New England, home 

prices have recovered what was lost during the last 

downturn and have reached new highs (see Chart 2, next 

page). Borrowers now have greater equity in their 

homes, providing them with not only the ability to refinance but also the potential to eliminate costly mortBoston Regional Outlook 23 First Quarter 1998 
Regular Features Regional Banking
 

CHART 2 

Region’s Home Prices Have Mostly Recovered Paired Home Sales Price Index 1989Q1 = 100130 

120 

110 

100 

90 

80 

U.S. 

New England 

’97 

gage insurance that is required for mortgages in excess 

of 80 percent of the appraised value of the underlying 

collateral. Additionally, the single-family mortgage 

limit for “conforming” mortgages was recently raised to 

$227,000, considerably higher than the $202,000 limit 

in 1992 and 1993. This increase will be beneficial to 

homeowners in New England, where home prices have 

historically been well above national averages. The 

opportunity to eliminate the premium paid for being 

classified as a “jumbo” mortgage, coupled with the 

opportunity to reduce or eliminate private mortgage 

insurance, provides refinancing incentives in addition to 

those already created by lower interest rates. The elimination of these surcharges could lower a borrower’s 

effective interest rate by more than 1 percent. Finally, 

the current environment will offer consumers an opportunity to consolidate consumer debt, which has risen 

steadily over the past few years, in the form of both 

credit cards and home equity loans. Freddie Mac estimates that in 1996, nearly half of all refinancings were 

“cash-out refis,” and that percentage is on the rise. A 

significant portion of the “cash-out” is used for debt 

consolidation. Increased refinancing activity will also 

negatively affect earning asset yields to the extent that it 

replaces higher yielding consumer and home equity 

debt. 

Risks Are Not Limited to Residential 

Real Estate Portfolios 

’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 

Source: Office of Federal Housing Enterprise Oversight 

If the current interest rate environment persists, asset 

yields are likely to fall considerably. The decline will 

not be limited to the residential loan portfolio. 

Commercial real estate markets have improved throughout the Region, and commercial borrowers are also 

actively refinancing existing debt. Insured institutions 

also have large investments in mortgage backed securities (MBS) that will see increased prepayment activity. 

In aggregate, more than two-thirds of the earning assets 

for the Region’s insured institutions (excluding the 

largest three banks) are backed by real estate. 

Additionally, in the past few years, insured institutions 

have shifted the non-MBS portion of investment portfolios from U.S. Treasury securities toward U.S. agency 

debt. A large portion of this debt, particularly that 

issued in the past three years, is callable. Portfolio concentrations in callable debt securities will provide additional downward pressure on asset yields. In addition to 

the downward pressure on asset yields resulting from a 

refinancing wave, several institutions may see declines 

in noninterest income because of reduced mortgage servicing income or writedowns of mortgage servicing 

assets, including interest-only strips, as paydowns on 

underlying serviced portfolios accelerate. 

Implications and Concerns 

Loan Quality 

Competition will add fuel to the prepayment fire as 

banks and nonbanks alike aggressively fight to retain 

customers and replace runoff. Marketing campaigns 

and media coverage will continue to increase consumer 

awareness of refinancing opportunities as well. These 

pressures raise additional concerns that underwriting 

standards may be compromised as institutions strive to 

retain or book new business. Intense competition and 

demand for loans has already resulted in declining 

spreads relative to U.S. Treasury securities. John G. 

Medlin, Chairman of Wachovia Corp., was recently 

quoted in the American Banker as saying, “Credit standards are the weakest at any time during my nearly four 

decades in banking.” Mr. Medlin said that many banks 

simply are not pricing for risk, but are using “stretchsock pricing”—one rate fits all. With margins already 

considered “razor thin,” the easing of other terms and 

conditions that could affect overall credit quality may be 

on the rise and warrants close scrutiny. 

Interest Rate Risk Management 

More than 80 percent of the funding structure of the 

Region’s insured institutions is in either nonmaturity 

deposits or deposits and borrowings with maturities of 

one year or less. The short end of the yield curve has not 

moved materially lower and will provide only minimal 

interest rate relief on the funding side of the balance 

Boston Regional Outlook 24 First Quarter 1998 
Regular Features Regional Banking
 

sheet. Therefore, it is likely that a prolonged period with 

a relatively low and flat yield curve will place a great 

deal of downward pressure on net interest margins. The 

result will be a modest decline in profitability for many 

of the Region’s insured institutions that increases the 

importance of maintaining a strong capital position. 

With earnings at historically high levels, a modest 

decline in profitability alone does not create great concern. The greater concern centers on how insured institutions are ultimately positioned for the future. With the 

potential for a significant amount of refinancing activity, much of which will be into fixed-rate instruments, 

many institutions will be faced with the decision to 

either book longer term assets or sell them and reinvest 

in shorter duration instruments. The latter alternative 

will put further downward pressure on margins. With 

pressure to produce strong current earnings, particularly for publicly traded companies, the decision to sacrifice short-term earnings in favor of a more balanced 

interest rate risk posture will not come easily. Asset/ 

liability management skills will be tested. Asset/liability 

management strategies will have to be carefully considered and interest rate risk management tools carefully 

evaluated to ensure that management accurately quantifies an institution’s exposure. As the current situation 

indicates, models that evaluate exposure to simple, parallel shifts in the yield curve may not be appropriate for 

most institutions, given the large concentration in realestate-backed assets. Strong interest rate risk measurement and management systems are critical to effectively 

deal with the current environment and to position the 

Region’s insured institutions for the bumps that 

inevitably lie down the road. 

Daniel Frye, Regional Manager 

Cameron Tabor, Financial Analyst 

Elizabeth McDonough, Bank Examiner 

Boston Regional Outlook 25 First Quarter 1998 
✁
 

Subscription Form
 

To obtain a subscription to the FDIC Regional Outlook, please print or type the following information: 

Institution Name ______________________________________________________________ 

Contact Person ______________________________________________________________ 

Telephone ______________________________________________________________ 

Street Address ______________________________________________________________ 

City, State, Zip Code ______________________________________________________________ 

Please fax or mail this order form to:	 FDIC Public Information Center 

801 17th Street, N.W., Room 100 

Washington, D.C. 20434 

Fax Number (202) 416-2076 

Please indicate below each Region’s issue you wish to receive: 

Atlanta Boston Chicago 

Dallas Kansas City Memphis 

New York San Francisco All 

FDIC 

Federal Deposit Insurance Corporation 

Washington, DC 20429-9990 

OFFICIAL BUSINESS 

PENALTY FOR PRIVATE USE, $300 

BULK RATE
 

MAIL
 

Postage &
 

Fees Paid
 

FDIC
 

Permit No. G-36