Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION THIRD QUARTER 2000 

FDIC
 

Chicago
 

Region
 

Division of
 

Insurance
 

Suzannah L. Susser,
 

Regional Manager
 

Joan D. Schneider,
 

Regional Economist
 

Michael Anas,
 

Senior Financial
 

Analyst
 

Ronald W. Sims, II,
 

Financial Analyst
 

Regional Perspectives 

◆ Region’s Economy Remains Healthy, Even as Interest Rates Rise— 

Economic activity in the Chicago Region remained healthy through mid-2000 

despite rising interest rates. However, several factors that tempered the effect of rising interest rates are weakening, and short-term rates rose an additional 50 basis 

points in mid-May 2000. As a result, the traditional interest rate sensitivity of the 

Region’s manufacturing and housing sectors may become more apparent in the 

future, particularly if interest rates continue to rise. See page 3. 

◆ Liquidity Management Is Becoming Increasingly Important— 

Although most institutions in the Region appear to have adequate liquidity levels, 

recent trends indicate that liquidity management may become more complex in the 

future. Securities portfolios are providing less liquidity, short-term borrowings and 

brokered deposits are increasing, and unused commitments have risen slightly. In 

addition, Federal Home Loan Bank advances are poised for continued growth, 

partly because of the enactment of the Gramm-Leach-Bliley Act. See page 6. 

By the Chicago Region Staff 

In Focus This Quarter 

◆ Ranking Metropolitan Areas at Risk for Commercial Real Estate 

Overbuilding—Commercial real estate construction has boomed in a number of 

U.S. metropolitan markets during recent years amid falling vacancy rates and growing demand for new space. Insured depository institutions have reasserted their role 

as primary sources of capital for this construction boom, particularly in the wake of 

the 1998 financial markets crisis that left some important market-based lenders on 

the sidelines. Recent data for some metropolitan areas show that on-balance-sheet 

exposures of FDIC-insured institutions are by some measures higher now than at the 

peak of the last commercial real estate cycle during the late 1980s. This article 

reassesses major U.S. metropolitan real estate markets in search of possible signs of 

overbuilding that could drive up vacancy rates and drive down rents in the near term. 

This review points to an underlying trend of markets experiencing more vigorous construction activity across multiple property types. See page 10. 

By Thomas A. Murray, Senior Financial Analyst 

◆ Rising Home Values and New Lending Programs Are Reshaping the 

Outlook for Residential Real Estate—Rising home prices and high levels of 

activity in the single-family housing market have been supported by excellent economic conditions and generally low interest rates. However, as interest rates have 

begun to rise, housing market activity has slowed. Historically, residential real 

estate has been one of the best-performing asset classes at insured institutions. Concerns have recently arisen, however, that new, higher-risk lending lines of business 

could adversely affect the future credit quality of residential real estate portfolios. 

See page 18. 

By Alan Deaton, Financial Economist 

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

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

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

geographic regions: 

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

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

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

Dallas Region (CO, NM, OK, TX)
 

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

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

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

San Francisco Region (AK, 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. For 

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

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

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

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

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

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

the Federal Deposit Insurance Corporation. 

Chairman Donna Tanoue 

Director, Division of Insurance Arthur J. Murton 

Executive Editor George E. French 

Writer/Editor Kim E. Lowry 

Editors Lynn A. Nejezchleb 

Maureen E. Sweeney 

Richard A. Brown 

Ronald L. Spieker 

Publications Manager Teresa J. Franks 
Regional Perspectives
 

Regional Perspectives
 

•	 Several factors that tempered the effect of increasing interest rates on the Region’s economy during the past 

year and a half may become less influential in coming quarters. Thus, the traditional sensitivity of the 

Region’s economic health to higher interest rates may be more evident as 2000 unfolds, particularly if interest rates continue to rise. 

•	 Recent trends have highlighted the importance of liquidity management in the Region. The number of institutions with weak liquidity ratings, while at historically low levels, has increased slightly over the past two 

years. Some newer institutions are also showing evidence of liquidity pressures. Securities portfolios are providing less liquidity, short-term brokered deposits and borrowings are increasing, and unused commitments 

have risen slightly. In addition, Federal Home Loan Bank advances are likely to continue to grow, in part 

because of enactment of the Gramm-Leach-Bliley Act. 

Despite Rising Interest Rates, Region’s Economy Remains Healthy 

On the surface, it appears that rising interest rates since 

late 1998 have done little to moderate the level and pace 

of economic activity in the Region. The subdued reaction may be surprising because demand for a relatively 

high proportion of the Region’s output historically has 

been sensitive to rising interest rates and financing 

costs. Recent developments, however, suggest that the 

impact of higher interest rates may become more pronounced as the year unfolds. 

Looking back, interest rates on U.S. Treasury securities 

have been rising since late 1998, and the yield curve 

became relatively flat in 2000 (see Chart 1). The yield 

curve was previously flat in 1998. At that time, the flattening reflected financial investors’ dramatic flight to 

highly liquid federal debt and accommodative monetary 

policy. In contrast, the recent flattening of the yield 

curve is characteristic of the situation that typically 

CHART 1 

10-Year Treasury 

Bond Yield 

Source: Federal Reserve Board via Haver Analytics 

Yield Curve Flattens as Interest Rates Rise 

June 

3 

4 

5 

6 

7 

8 

9 

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

Percent per Annum

1-Year Treasury 

Bill Yield 

occurs late in a business cycle expansion. Specifically, 

interest rates are rising across the maturity spectrum, 

with rates on short-term securities rising faster than on 

longer-term securities. Yet it appears that rising interest 

rates have done little thus far to moderate the level and 

pace of economic activity in the Region. 

Growth in the Midwest Manufacturing Index (MMI)1 

accelerated after mid-1999 (see Chart 2). Faster 

growth in the machinery sector and the return of 

growth to the steel sector2 were contributing factors 

CHART 2 

–10 

–5 

0 

5 

10 

15 

’85 ’86 ’87 ’88 ’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00 

Percentage Change Year-to-Year

0 

2 

4 

6 

8 

10 

12 

Percent per Annum 

Midwest Manufacturing Activity Picked 

Up despite Rising Interest Rates 

Midwest 

Manufacturing Index 

(left scale) 

Fed Funds Rate 

(right scale) 

Sources: Federal Reserve Bank of Chicago; Federal Reserve Board via Haver 

Analytics 

First Quarter 

1 The MMI is compiled by the Federal Reserve Bank of Chicago to 

reflect activity in manufacturing industries important in the area’s 

economy. 

2 The machinery sector covers industrial machinery and equipment, 

electronic and other electric equipment, and instruments and related 

products. The steel sector covers primary and fabricated metal 

industries. 

Chicago Regional Outlook 3	 Third Quarter 2000 
Regional Perspectives
 

(see Chart 3). In part, these sectors are improving 

because the brunt of the negative effect from Asia’s 

economic turmoil has passed. In addition, foreign 

demand for the Region’s manufacturing exports is 

strengthening. The auto sector component3 of the 

MMI, which may be less dependent on demand from 

abroad, has posted moderate growth recently, and 

activity in the resource sector4 expanded modestly in 

1999 before leveling out in first quarter 2000. 

Motor-vehicle sales and production remain robust, with 

first quarter 2000 sales of automobiles and light trucks 

setting a record of 18.1 million units (at an annual rate), 

partly because of motor-vehicle manufacturers’ sales 

incentives. Although news reports suggest that rising 

market interest rates may trigger a shift away from 

reduced-rate financing by producers, other sales incentives may be offered. About 646,000 jobs in the transportation equipment sector,5 or 35 percent of the 

nation’s total, are concentrated in the Chicago Region. 

Manufacturers’ new and unfilled orders suggest that, 

should interest rates plateau at current levels, the 

Region’s manufacturing sector may be expected to continue producing goods at a healthy pace for some time. 

New orders for manufactured goods (exclusive of 

defense and aircraft and parts, which are not major drivers of the Region’s economy) have rebounded since 

CHART 3 

Improvement Seen in Steel 

and Machinery Sectors 

Source: Federal Reserve Bank of Chicago via Haver Analytics Percentage Change Year-to-Year 

First Quarter 

’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00 

Machinery 

Sector 

Steel Sector 

30 

–20 

–10 

0 

10 

20 

3 The auto sector index covers transportation equipment, rubber, and 

miscellaneous plastic products. 

4 The resource sector covers food and kindred products; lumber and 

wood products; paper and allied products; chemicals and allied products; petroleum and coal products; and stone, clay, and glass products. 

5 The transportation equipment sector is broader than motor vehicles 

and parts. 

mid-1999. Because orders have grown faster than production, firms’ backlog of orders also has risen (see 

Chart 4). Unless order cancellations surge, orders currently on manufacturers’ books should support healthy 

production by the Region’s manufacturers over the next 

few quarters. 

The effect of rising interest rates on housing markets in 

the Region appears modest to date, as the levels of 

resales and new permits remain high. Households’ ability to afford a home remains in the range of recent years 

even though an index of affordability6 was 12 percent 

lower at midyear 2000 than in late 1998 and early 1999. 

Mortgage payments as a percentage of income remain 

relatively low, at less than 20 percent of household 

income. The Region’s healthy 4.5 percent personal 

income growth in 1999 helped maintain affordability. 

Despite these conditions, housing activity in the Region 

appears to be leveling off: Single-family home permits 

in the first five months of 2000 were no higher than in 

the comparable 1999 period, and year-over-year growth 

in home resales also had stalled. In addition, price 

appreciation in the Midwest, which is composed of the 

FDIC’s Chicago and Kansas City Regions, slowed to 

less than 2.0 percent during the first five months of this 

year. This pace compares with 4.0 percent in 1999 and 

6.9 percent the year earlier. 

Finally, rising interest rates might be expected to trim 

bank loan growth. Historical experience, however, suggests that this relationship is lagged. Some borrowers, 

for example, may borrow more from banks when interCHART 4 

Manufacturers’ Orders Growth Rebounds 

–10 

–5 

0 

5 

10 

15 

20 

’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00 

Percentage Change Year-to-Year 

Note: Orders data are for nondefense capital goods excluding aircraft and parts. 

Source: Bureau of the Census via Haver Analytics 

New Orders 

Unfilled Orders 

First Quarter 

6 The National Association of Realtors calculates an affordability 

index based on national data for median family income, the median 

price of an existing home, and mortgage rates. 

Chicago Regional Outlook 4 Third Quarter 2000 
Regional Perspectives
 

est rates rise because capital market funding becomes 

more difficult or expensive to obtain. In the Chicago 

Region, continued economic growth and other factors 

countered the effect of higher rates, leading to median 

growth of 11 percent in banks’ and thrifts’ loan portfolios during the year ending March 31, 2000. This pace 

was the fastest in at least a decade (see Chart 5). 

Has the Region’s Vulnerability to Interest Rates 

Changed? 

The Region’s continued economic health and accelerating bank loan growth through early 2000, in the face 

of rising interest rates, does not mean that economic 

activity in the area has become noticeably less sensitive to interest rates and financing costs. Rather, a 

number of other factors apparently tempered the effect 

of interest rate increases through mid-2000, including 

the following: 

•	 Seventy-five basis points of the increase in the federal funds rate merely reversed the easing of monetary policy that took place in 1998 during a period of 

turmoil in domestic and foreign financial markets. 

Similarly, the rise in yields on Treasury securities 

reversed about half the decline experienced in 1998. 

•	 The results of changes in monetary policy may be 

slow to manifest themselves, and the economy’s conCHART 5 

0 

2 

4 

6 

8 

10 

12 

’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00 

2 

4 

6 

8 

10

Median Percentage Change from Year Ago

Percent per Annum 

Region’s Loan Growth Not Inhibited 

by Modestly Higher Interest Rates 

Loan Growth 

(left scale) 

Fed Funds Rate 

(right scale) 

Sources: Bank and Thrift Call Reports; Federal Reserve Board via Haver Analytics 

March 

tinuing strength in the first half of 2000 may reflect 

the tail end of stimulus resulting from interest rate 

reductions in 1998. 

•	 Interest rates are not the sole driver of the Region’s 

economic growth. To date, for example, the potential 

dampening effect from rising interest rates may have 

been mitigated by continuing job growth, reviving 

foreign demand for the Region’s exports, and the 

halting of steel dumping in U.S. markets. 

•	 Consumer confidence in the Region remains high, 

which suggests that the past year’s interest rate 

increases have not seriously crimped households’ 

purchasing power or attitudes. 

Although the Region weathered rising interest rates 

without slowing significantly through mid-2000, it 

remains more vulnerable than other parts of the country 

to manufacturing sector weakness, which could be triggered by rising rates. The Region’s economy is more 

diversified now than 15 years ago, but the manufacturing sector remains relatively more dominant in this 

Region than elsewhere in the country. Last year, the 

manufacturing sector generated 25 percent of nonfarm 

earnings in the Region, compared with 29 percent in 

1989 and 36 percent in 1979. Despite this trend, the 

Region’s current 25 percent share is 1.7 times the share 

of manufacturing elsewhere in the nation. 

Should interest rates continue to rise,7 the direct and 

indirect effects may combine with other developments 

to slow the Region’s growth more noticeably. Other factors that may dampen growth include a shortage of 

workers seeking employment and higher energy prices, 

which are trimming households’ discretionary income 

and increasing costs for some businesses. In addition, 

stock market corrections in the first half of 2000 

trimmed the market value of some investors’ portfolios, 

although many still reflect net appreciation over the past 

two- or three-year period. 

7 Several Federal Reserve officials suggested in early June that another increase in interest rates is likely, according to The New York 

Times. See Lou Uchitelle, “Small but Uncertain Indications That the 

Economy Is Slowing,” The New York Times, June 14, 2000. C1. 

Chicago Regional Outlook 5	 Third Quarter 2000 
Regional Perspectives
 

Liquidity Management Is Becoming More Important in the Chicago Region
 

Aggregate loan-to-asset levels and noncore funding are 

increasing, leading to declining liquidity trends. Traditional liquidity measures, such as the loan-to-deposit 

ratio, have been deteriorating modestly for some time; 

however, these measures are declining in usefulness. A 

broader view reveals concern as institutions report 

lower levels of marketable and short-term securities, 

higher noncore funding8 levels, and more unused loan 

commitments. At the same time, deposits have trended 

toward shorter maturities. Furthermore, widespread 

profitability declines may continue to pressure institutions to operate with lower liquidity levels. 

Lower levels of liquidity have the potential to exacerbate financial difficulties that may occur. Financial 

institutions relying significantly on noncore funding 

may be more vulnerable to events such as an auditor’s 

adverse opinion, a sudden loss of profitability, or economic developments that may lead to funding difficulties. In an economic scenario of severe monetary 

tightness, the cost of purchased funds may become 

prohibitive to some insured institutions. 

Examination Information Reveals Heightened 

Liquidity Risk at Some Institutions 

Recent examination information shows an increase in 

the number of institutions with weak liquidity ratings,9 

though the number remains historically low. The number of relatively new institutions that have weak liquidity ratings has been rising as well.10 Banks that are 

maintaining less liquidity expose themselves to the possibility that financial difficulties, such as asset quality 

or earnings problems, will be exacerbated. In fact, 

Deputy Regional Director Susan Madson, of the FDIC’s 

Division of Supervision, addressed this situation during 

the Interagency Liquidity Conference at the Federal 

Reserve Bank of Chicago in May. According to Madson, the FDIC has recently encountered a few commu8 Refer to the Chicago Region’s Regional Outlook, third quarter 1999, 

for a detailed discussion of trends in bank funding strategies. 

9 As of March 31, 2000, 66 insured financial institutions, or 3.33 percent of total institutions in the Chicago Region, had liquidity ratings 

of three, four, or five. This is a slight increase from the prior year, 

when 43, or 2.12 percent of institutions, were rated three, four, or five. 

10 As of March 31, 1998, 6 percent of new institutions (defined here 

as those established within the past nine years) had liquidity ratings 

of three, four, or five. The percentage had risen to 12 percent as of 

March 31, 2000. 

nity banks whose problems have been magnified 

because of their volatile funding base. Madson stated 

that while banks have historically failed because of 

equity insolvency, there is now an increasing likelihood 

that liquidity problems may arise. 

Securities Portfolios Are Less Liquid, Longer 

Term, and Represent a Smaller Percentage of 

Assets 

Over the past several years, the increased availability of 

liability-side funding options and margin pressures 

apparently have led to less reliance on securities portfolios for meeting liquidity needs. Commercial banks’ 

securities portfolios have shrunk, the ratio of highly 

marketable securities11 to total securities has declined, 

and the ratio of pledged securities to total securities has 

increased (see Chart 6). At the same time, banks have 

lengthened the maturities of the securities they do hold. 

As of March 31, 2000, community commercial banks12 

reported 56 percent of combined securities portfolios 

maturing or repricing after three years, compared with 

46 percent two years ago. Not surprisingly, recent interest rate increases and lengthening maturities have 

resulted in more banks experiencing significant depreciation (see Chart 7). Despite increased reliance on 

liability-side funding options, the securities portfolio 

may become increasingly important as a source of 

liquidity in a period of economic stress, particularly if 

an institution’s funding sources lose confidence in its 

financial soundness. 

Federal Home Loan Bank Borrowings Are 

Poised for Continued Strong Growth 

On the liability side of the balance sheet, banks and 

thrifts in the Region have turned to alternative funding 

sources to supplement weak core deposit growth. Federal Home Loan Bank (FHLB) advances have grown at 

a particularly strong rate, and several recent develop11 U.S. Treasury, U.S. government agency, and U.S. governmentsponsored agency obligations (excluding mortgage-backed securities) 

are generally considered highly marketable for the purposes of this 

analysis. However, some securities issues in this category may have 

characteristics that negatively affect liquidity. 

12 Community commercial banks are defined here as banks with less 

than $1 billion in assets, excluding institutions established within the 

past three years. 

Chicago Regional Outlook 6 Third Quarter 2000 
Regional Perspectives
 

CHART 6 

Securities Portfolios Are Providing Less Liquidity 

Note: Only debt securities are shown. 

MBS = mortgage-backed securities 

Source: Commercial bank Call Reports for community banks (<$1 billion in assets), excluding de novos 

22 

24 

26 

28 

30 

32 

34 

36 

38 

40 

Percentage of Securities 

0 

10 

15 

20 

25 

30 

35 

Percentage of Assets 

% of Securities Pledged 

(right axis) 

3Q 

’94 

4Q 

’94 

1Q 

’95 

2Q 

’95 

3Q 

’95 

4Q 

’95 

1Q 

’96 

2Q 

’96 

3Q’ 

’96 

4Q 

’96 

1Q 

’97 

2Q 

’97 

3Q 

’97 

4Q 

’97 

1Q 

’98 

2Q 

’98 

3Q 

’98 

4Q 

’98 

1Q 

’99 

2Q’ 

’99 

3Q 

’99 

4Q 

’99 

1Q 

’00 

U.S. Treasuries 

U.S. Agencies (excludes MBS) 

Municipals 

Other Debt Securities 

2Q 

’94 

1Q 

’94 

5 

CHART 7 

Rising Rates Have Led to Significant Depreciation for Many Banks 

7.00 

10-Year Treasury Yield 

(left axis) 

1- Year Treasury Yield 

(left axis) 

Percentage of Institutions with Depreciation 

>10 Percent of Tier 1 Capital (right axis) 

6.50 

6.00 

5.50 

5.00

Percentage 

Percentage 

15 

4.50 10

4.00 

3.50 

3.00 

1Q97 2Q97 3Q97 4Q97 1Q98 2Q98 3Q98 4Q98 1Q99 2Q99 3Q99 4Q99 1Q00 

Source: Call Reports for commercial banks, excluding de novos; Federal Reserve Board 

ments point to even greater use of FHLB advances in 

the future. For example, the Gramm-Leach-Bliley Act 

broadened access to the FHLB system for institutions 

with less than $500 million in assets: 

•	 More small banks can meet membership requirements. Banks with assets less than $500 million are 

exempt from the requirement that 10 percent of 

assets must be held in residential mortgages. 

•	 Agricultural and small business loans, in addition to 

mortgage loans, can be pledged as collateral for 

advances. 

•	 The amount of stock that must be purchased to gain 

membership to the FHLB has been reduced, making 

access to the system less costly for community 

banks. 

Based upon these changes, nearly all institutions in the 

Chicago Region are eligible for membership in the 

FHLB. 

Recent Trends in FHLB Advances May Affect 

Liquidity Management 

Although FHLB and other forms of borrowing do present the opportunity for institutions to lock in funding 

over a long period, FHLB advances have trended toward 

shorter maturities. As of year-end 1999, the percentage 

of FHLB advances with a maturity greater than one year 

had fallen to 50 percent from 62 percent a year earlier.13 

13 Federal Home Loan Bank System, 1999 Financial Report. FHLB 

borrowing data in this article are for banks, thrifts, insurance companies, and credit unions. 

Chicago Regional Outlook 7	 Third Quarter 2000 

25 

20 

5 

0 
Regional Perspectives
 

In addition, the extent to which banks rely on convertible advances14 is an important consideration in liquidity management. Convertible advances were 13 percent 

of total advances as of year-end 1997 and 28 percent a 

year later. As of year-end 1999, the level had dropped to 

22 percent,15 likely because many of these advances had 

been converted as interest rates rose. Shorter-term and 

convertible FHLB advances will require greater oversight in the context of banks’ liquidity management 

strategies, particularly if interest rates continue to rise. 

Depositors Shift toward Shorter Maturities 

and Brokered Deposits Continue to Grow 

Recent interest rate increases appear to have influenced 

depositors to opt for even shorter-term investments in 

certificates of deposits, likely in order to avoid locking 

in savings rates during the recent rise in interest rates. 

As of March 31, 2000, 75 percent of total time deposits 

at community banks were scheduled to mature or 

reprice within one year (see Chart 8), compared with 

73 percent two years earlier. As a result, even core 

deposits, which comprise a substantial proportion of 

these time deposits, are increasingly becoming a liquidity consideration. Not only has the competitive 

environment made attracting core deposits more difficult and costly, but the potential for short-term deposit 

outflows has increased as depositors opt for shorterterm instruments. 

CHART 8 

Time Deposit Maturities Remain Short 

3 months to 1 year
 

45%
 

During the past several years, the number of institutions 

funding a fairly significant percentage of assets with 

brokered funds has been increasing (see Chart 9). Brokered deposits also are becoming a more immediate 

funding concern as a higher percentage of brokered 

funds are scheduled to mature within one year. 

Although longer-term brokered deposits do not present 

immediate liquidity concerns, reliance on short-term 

volatile funds does present heightened liquidity risk. 

Funding Strategies May Be Affected by the 

Increased Popularity of Internet Banking 

Even though only a small number of banks and thrifts 

are using the Internet to attract deposits nationally 

today, it is clear that more institutions will be using this 

delivery channel to remain competitive and maintain 

deposits in the future. A recent survey16 found that 29 

percent of community banks are experiencing demand 

for Internet banking services from their existing customers and that 54 percent of community banks 

believe that Internet delivery is essential to attract new 

customers. 

The Internet is being used more frequently to attract 

depositors from outside banks’ traditional geographic 

market areas. In some instances, community institutions 

offer higher interest rates on deposits generated through 

the Internet. This strategy may alienate existing customers who bank through traditional channels. However, if they offer the higher rate to existing customers, 

CHART 9 

Brokered Deposit Use Is Rising 

and Becoming Shorter-Term 

Brokered Deposits Maturing within One Year 9 70 

Percentage of Institutions 

Funding More than 

3 Percent of Assets with 

Brokered Funds 

(left axis) 

(right axis) 

’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00 

8 1 year to 3 years 7 22% 50 

40 

30 

3% 2 

3 months or less 

Percentage6 

Percentage 

5 

4 

over 3 years 3 20 

1 30% 0 

Source: Community bank (<$1 billion) Call Reports, excluding de novos First Quarter 

Source: Commercial bank Call Reports for community banks (<$1billion), excluding 

de novos 

14 Convertible advances generally give the FHLB the option to convert 

the advance from a fixed to a floating rate if interest rates increase or 

to terminate the advance and extend additional credit on new terms. 

15 Federal Home Loan Bank System, 1999 Financial Report. 

16 Grant Thornton’s Seventh Annual Survey of Community Bank 

Executives, March 2000. 

Chicago Regional Outlook 8 Third Quarter 2000 

60 

10 

0 
Regional Perspectives
 

CHART 10 

Aggregate Unused Commitment Levels 

Have Risen Slightly 10 

9 

8 

7 

6
 

5
 

4
 

3
 

2
 

1
 

0
 

Other (primarily business lines of credit) 

Commercial Real Estate 

Revolving, Open-End Lines of Credit 

(e.g., home equity lines) 

1992 1993 1994 1995 1996 1997 1998 1999 2000 

Percentage of Assets

First Quarter 

Note: Unused credit card commitments are not shown. 

Source: Call Reports for commercial banks (<$1billion in assets), excluding 

de novos 

banks may be placed in the position of paying more for 

existing accounts that were not that sensitive to interest 

rates. Notwithstanding the low penetration of Internet 

banking in the Chicago Region, similar mechanisms 

exist for obtaining nonlocal deposits. For instance, 

anecdotal evidence indicates that “bulletin-board” computer systems that allow banks to post certificate of 

deposit rates nationally are experiencing increased use. 

Although deposits gathered through this mechanism 

often are not considered brokered deposits, they presumably will cost more and will be more price-sensitive 

than traditional core deposits. 

Unused Commitment Levels Have Risen 

Slightly, and Commitment Funding Patterns 

May Be Changing 

During the 1990s, unused commitments increased 

slightly as a percentage of total commercial bank assets 

in the Region (see Chart 10). This growth has occurred 

in all categories and is likely being driven by strong 

demand for credit and the increasing emphasis that 

some institutions are placing on generating noninterest 

income. Higher levels of unused commercial real estate 

commitments may indicate that the strong commercial 

real estate loan growth experienced in the Chicago 

Region will continue. The Grand Rapids, MI; Champaign, IL; Madison, WI; Milwaukee, WI; and Chicago 

metropolitan statistical areas (MSAs) are among those 

that have the highest community commercial bank 

exposure to unfunded commercial real estate commitments relative to assets. The levels range from 7.55 percent in the Grand Rapids MSA to 3.55 percent in the 

Chicago MSA. 

The reevaluation of funding assumptions regarding 

unused commitments seems prudent given recent 

increases in interest rates and prospects for slowing in 

the economy. Assessing the likelihood of funding loans 

and how they would be funded as well as how borrowers’ prospects may change in a weaker economy will 

help institutions manage liquidity profiles. 

Unencumbered Liquid Assets17 and Open 

Communication Are Becoming Increasingly 

Important 

The need for unencumbered assets and open communication is increasing in light of rising loan-to-asset levels, less liquid securities portfolios, and the trend 

toward shorter-term liability structures. Institutions that 

rely on noncore funding should be aware of the potential for heightened reputation risk because many noncore funding sources are volatile and susceptible to 

withdrawal when signals point to financial difficulties. 

If an institution’s reputation becomes tarnished and 

funding sources lose confidence, the availability of 

unpledged securities or other marketable assets will 

become increasingly important. These “name neutral” 

assets can be a key source of funds if liquidity problems 

develop. 

Also, if an institution relies heavily on a limited number 

of funding sources, communication between the institution and those funding sources becomes paramount. If a 

bank or thrift encounters financial difficulties, communication with its largest funding sources will help 

ensure that withdrawals do not occur because of a lack 

of information. 

The Chicago Region Staff 

17 Unencumbered assets are those that are not pledged and therefore 

available for liquidity needs. 

Chicago Regional Outlook 9 Third Quarter 2000 
In Focus This Quarter
 

Ranking Metropolitan Areas at Risk for 


Commercial Real Estate Overbuilding
 

•	 In analyses conducted in 1998 and 1999, nine metropolitan areas were identified as at risk for overbuilding; this analysis notes more vigorous 

building occurring across multiple property types 

and identifies 13 markets, including eight of the 

previous nine, as at risk for overbuilding. 

•	 Construction activity has accelerated during the 

current economic expansion with cyclically high 

levels of supply and demand. 

•	 Capital markets scaled back their investments in 

commercial real estate in 1998 and 1999, while 

FDIC-insured institutions increased their construction and development lending by more than 

20 percent each year. 

The banking industry and the FDIC learned during the 

late 1980s that once commercial real estate (CRE) markets become overbuilt, losses can mount quickly. During the 1980s and early 1990s, losses on CRE loans 

were responsible for hundreds of bank and thrift failures 

and billions of dollars in insurance losses for the FDIC. 

Since then, commercial vacancy rates have improved 

dramatically in a number of major U.S. metropolitan 

markets. In turn, CRE charge-offs reported by FDICinsured institutions have fallen to very low levels—less 

than 0.05 percent of average loans in both 1998 and 

1999. 

Two recent studies published by the FDIC evaluate the 

risk of overbuilding in major U.S. metropolitan areas.1 

These studies identified nine cities—Atlanta, Charlotte, Dallas, Las Vegas, Nashville, Orlando, 

Phoenix, Portland (Oregon), and Salt Lake City—as 

markets at risk for rising commercial vacancy rates. 

This article revisits the FDIC’s previous analysis of 

CRE markets. Using a more restrictive definition of 

at-risk markets, we find that eight of the previously 

identified nine markets remain on the list, joined by 

five additional markets: Denver, Fort Worth, Jacksonville, Sacramento, and Seattle.2 In general, more 

markets are experiencing increased levels of construc1 See “Ranking the Risk of Overbuilding in Commercial Real Estate 

Markets,” Bank Trends, October 1998, and “Commercial Development Still Hot in Many Major Markets, but Slower Growth May Be 

Ahead,” Regional Outlook, first quarter 1999. 

tion activity across multiple CRE property sectors than 

was the case just two years ago. 

Like the two earlier studies, this analysis does not predict an imminent rise in vacancies and losses in the atrisk markets. Instead, as before, the goal is to raise 

awareness about substantial growth in real estate development and the corresponding increases in risk exposure to financial institutions. 

Previous Real Estate Cycles 

Are Well Documented 

Many analysts view the late 1980s U.S. experience as 

the very definition of adverse conditions in CRE markets. The factors that brought about these adverse conditions are well documented.3 During the early and 

mid-1980s, CRE construction boomed. Total office 

space completed in 54 major U.S. markets tracked by 

Torto Wheaton Research exceeded 100 million square 

feet per year every year from 1982 through 1987. 

Insured banks and thrifts were prime sources of credit 

for this building boom. Total outstanding construction 

and development (C&D) loans on the balance sheets of 

insured institutions grew by 52 percent, or $52.5 billion 

dollars, in 1985 alone, followed by three successive 

years of growth in outstanding C&D loans. A key factor 

behind this surge in lending was intense competition 

among lenders. In response to the heightened competition, many lenders loosened their underwriting standards, often extending credit on speculative projects on 

terms that did not protect them from downside risk. 

Examples of aggressive lending practices from this 

period included more collateral-based lending, higher 

loan-to-value limits, reliance on overly optimistic 

appraisals, and inattention to secondary repayment 

sources. 

2 The one metropolitan area identified in the prior analyses as at risk 

for overbuilding that did not fall into the same category using the 

stricter criteria in this analysis is Nashville. Nevertheless, Nashville 

still ranks high in terms of construction activity at fifth highest in the 

U.S. for retail and twelfth highest for office construction activity. 3 See, for example, Freund et al. 1997. History of the Eighties: 

Lessons for the Future, Chapters 9 and 10. FDIC. 

Chicago Regional Outlook 10	 Third Quarter 2000 
In Focus This Quarter
 

Poorly underwritten credit and massive increases in 

construction resulted in overbuilding in a number of 

large U.S. metropolitan markets. Nationwide, the office 

vacancy rate for competitively leased space peaked at 

over 19 percent in 1991.4 In the Southwest and New 

England, where the cycle of overlending and overbuilding was most pronounced, metro real estate markets 

were in even worse shape. Office vacancies in Dallas 

peaked at over 27 percent in 1988, while office vacancies in Boston reached over 17 percent in 1990. As 

vacancies rose and rents fell, lenders in the Southwest, 

Northeast, and elsewhere increasingly found themselves in possession of nonperforming loans and 

impaired real estate assets. The result was a sharp 

increase in the number of failed banks in the Southwest 

and Northeast.5 

Following the CRE debacle of the late 1980s and early 

1990s, commercial construction and lending volumes 

slowed. C&D loan growth at FDIC-insured institutions 

declined every year from 1989 through 1994, while a 

similar drop in private construction expenditures lasted 

through 1993. 

Factors Contributing to Cycle 

of Overbuilding in CRE 

One reason that CRE markets are 

prone to periodic bouts of overbuilding is the business cycle itself, 

which saps demand for new space 

when business activity turns downward. But another 

important contributing factor is the lag time in the 

development process as new construction moves from 

inception to completion. Heavy demand at the start of a 

project may wane or vanish before completion occurs. 

In general, the time lag associated with CRE development is longest for hotel and office projects and 

becomes shorter for retail, multifamily, and industrial 

properties, respectively. The associated degrees of lending risk mostly follow the same pattern. In general, less 

risk is associated with industrial buildings and multifamily projects, which typically take less than one year 

to build. 

4 The U.S. vacancy rate is calculated as an aggregate of selected major 

markets tracked by Torto Wheaton Research. 

5 As further detailed in the History of the Eighties, combined assets of 

failed banks in the Northeast and Southwest comprised over 70 percent of assets of all banks failing between 1980 and 1994. 

To the extent that commercial construction projects 

involve a lag between inception and completion, net 

additions to supply can be anticipated in advance. Much 

progress has been made during this real estate cycle 

toward increased availability of information on CRE 

markets, particularly in regard to supply characteristics. 

Market transparency has been promoted in part by a 

heightened level of public ownership of CRE properties 

and the corresponding higher degree of disclosure by 

the owned entities, such as real estate investment trusts 

(REITs) and commercial mortgage-backed securities 

(CMBSs). 

Changes in demand are harder to predict. A current 

example may be the high level of demand generated by 

Internet start-up companies that rely heavily on financing provided by venture capital funds and initial public 

stock offerings. Because many of these start-ups depend 

so heavily on cash inflows from investors as opposed to 

operating revenues, their viability as tenants and their 

continued demand for high volumes of office space may 

depend more on capital market conditions than on their 

own business performance. While demand may appear 

strong under robust business conditions, it is prone to 

decline rather suddenly in the event of an economic 

downturn. Given these attributes of CRE markets, the 

process of gauging the success for lease-up of a proposed project involves not only looking at new supplies 

of competitive space coming onto the market, but also 

evaluating how vulnerable the market is to a downturn 

in demand for space. 

Recent Developments 

Following a lull in commercial construction activity that 

resulted from adverse market conditions in the early 

1990s, construction activity has gradually accelerated 

during the current economic expansion. The increased 

pace of construction occurred first in industrial and 

retail markets, where growth in net new completions of 

space picked up starting in 1993. The pace of multifamily construction accelerated in 1995, followed by 

increasing levels of office and hotel construction in 

1997. Regionally, commercial construction activity 

recovered first in the Southeast and Northwest, where 

the effects of the previous overbuilding had been the 

least pronounced. Only later did the pace of construction increase in California, the Southwest, and the 

Northeast. As the U.S. economic expansion endures into 

its tenth year, construction activity continues to pick up 

steam across most property types. In the 54 major metChicago Regional Outlook 11 Third Quarter 2000 
In Focus This Quarter
 

ropolitan areas tracked by Torto Wheaton Research, 

total annual office space completions rose from just 

over 3 million square feet in 1994 to 78.7 million square 

feet in 1999. 

National private expenditures on hotel and retail construction for 1999 exceeded all prior years on both a 

current-dollar and an inflation-adjusted dollar basis. 

Similarly, national private construction expenditures on 

office space in 1999 were at an all-time high on a current-dollar basis. On an inflation-adjusted dollar basis, 

office construction expenditures in 1999 were still not 

as high as they were during the mid-1980s. 

A new characteristic of the CRE industry in the current 

expansion has been the marked increase in capital availability through the financial markets. Annual issuance 

of CMBSs has grown from negligible amounts in 1990 

to over $67 billion in 1999. Financing made available 

through REITs has been the other link to the capital 

markets. REIT market capitalization increased from 

approximately $10 billion in 1994 to nearly $145 billion 

in 1999. 

While the availability of market-based sources of capital has helped to facilitate growth in construction during 

this expansion, the financial market turmoil of late 1998 

cast a cloud over the CMBS market that has yet to lift 

fully. Significant events in the global capital markets in 

1997 and 1998, including the Asian economic crisis and 

the Russian government bond default, significantly curtailed the ability of major CMBS issuers to go to the 

market for financing. Significant liquidity problems 

resulted for a number of commercial mortgage firms. 

Nomura, Lehman Brothers, CS First Boston, and others 

incurred losses, while Criimi Mae, Inc., was forced to 

declare bankruptcy. 

As the capital markets pulled back from CRE investments, insured banks and thrifts stepped in to fill the 

void. Chart 1 shows that the total volume of C&D loans 

on the balance sheets of FDIC-insured institutions rose 

by more than 20 percent per year in both 1998 and 

1999, even as growth in U.S. private construction 

expenditures slowed to a crawl.6 

In terms of overall construction market activity, the 

current situation appears to be one of cyclically high 

6 U.S. private construction expenditures, as calculated by the Bureau 

of the Census, include multifamily (two or more units), industrial, 

office, hotel, and retail space. 

CHART 1 

’86 

Growth Rates (%) 

Growth Rates of Private Construction 

Expenditures and C&D Loans Diverge 

during the Past Two Years 

–30 

–20 

–10 

0 

10 

20 

30 

40 

50 

60 

C&D = construction and development loans 

Sources: Bureau of the Census (Haver Analytics), Bank and Thrift Call Reports 

(Research Information System) 

’85 ’87 ’88 ’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 

C&D Loans 

Priv. Const. 

levels of supply and demand. Because significant 

growth in net new space is forecast for many markets 

and property types during 2000 and 2001, a drop in 

demand for space could impair absorption rates and 

lead to higher vacancies and lower rents. Most analysts 

feel that future trends in real estate demand will be 

closely linked to national and regional economic conditions. 

Identification of Markets at Risk 

for Overbuilding 

Previous FDIC studies have identified CRE markets at 

risk for broad-based overbuilding on the basis of comparative rankings in the rates of growth in commercial 

space. In a 1998 study, U.S. metropolitan areas were 

ranked according to 1997 new construction activity as a 

percentage of existing stock for the five main property 

types: office, industrial, retail, multifamily, and hotel.7, 8 

In that study, any metro area that appeared in the top 15 

for any two of the commercial property types was 

labeled “at risk.” Nine cities were identified as being at 

risk for overbuilding: Atlanta, Charlotte, Dallas, Las 

Vegas, Nashville, Orlando, Phoenix, Portland 

(Oregon), and Salt Lake City. 

7 Federal Deposit Insurance Corporation. October 1998. Ranking the 

Risk of Overbuilding in Commercial Real Estate Markets, Bank 

Trends. 

8 Construction activity is measured in square feet and includes projects completed during the year, plus projects still under construction 

as of year-end. This figure is then divided by the total stock of space 

to obtain a construction activity percentage for use in comparative 

rankings. 

Chicago Regional Outlook 12 Third Quarter 2000 
In Focus This Quarter
 

This study updates the previous results using year-end 

1999 data.9 In doing so, it applies more restrictive criteria to identify at-risk metropolitan real estate markets. As before, the metro areas are ranked according 

to new construction as a percentage of existing stock 

in each of the five main commercial property types. 

However, in this analysis, to be considered at risk, a 

metro area must rank in the top ten for any two of the 

property types. Despite the fact that it was harder for 

individual markets to qualify as being at risk, all but 

one of the previously identified nine markets remain 

on the at-risk list. Moreover, they are joined by five 

additional metropolitan areas: Denver, Fort Worth, 

Jacksonville, Sacramento, and Seattle. It is evident 

that more metropolitan areas are emerging with vigorous CRE construction and development across multiple property sectors. 

Most Active Construction Markets 

Charts 2 through 6 represent the property sectors of 

office, industrial, retail, multifamily, and hotel. They 

also list, for each property sector, the metropolitan 

areas having the highest levels of construction activity, 

relative to existing stock, for the year ending December 

31, 1999. The overall national construction activity rate 

is also shown for comparative purposes for each of the 

property sectors. Each metropolitan area is ranked 

from the highest to lowest for levels of construction 

activity. 

As shown in these charts, Las Vegas, Orlando, and 

Phoenix are standouts, with each placing among the top 

ten metropolitan areas in the country for construction 

activity in at least four of the five different property sectors. Las Vegas is among the top ten in construction 

activity for all five property sectors except for hotel 

construction, where it ranks twenty-sixth.10 Las Vegas 

ranks first in retail construction and second in industrial construction. Orlando is first in both office and multifamily construction. Phoenix is among the top ten for 

9 For the five property sectors reviewed in this report, data sources 

were Torto Wheaton Research for office and industrial and F.W. 

Dodge for retail, multifamily, and hotel. Torto Wheaton Research’s 

data for office and industrial encompass 54 and 53 metropolitan statistical areas (MSAs), respectively. F.W. Dodge’s data for retail, multifamily, and hotel encompass 58 MSAs. 

10 Las Vegas has the most hotel rooms in the country, with slightly 

fewer than 124,000 rooms as of year-end 1999. During 1999, Las 

Vegas experienced the greatest addition of rooms (in absolute numbers) of any market. With over 13,000 new rooms added during 1999, 

Las Vegas had nearly twice the level of the next highest metropolitan 

area, which was Orlando, with an additional 7,000 rooms. 

CHART 2 

CHART 3 

CHART 4 

Top 15 Office Development Markets—Construction 

Activity in 1999 as a Percentage of Stock 

(Square Footage) 

Orlando 

Phoenix 

Seattle 

Salt Lake City 

Charlotte 

Columbus 

Jacksonville 

Austin 

Las Vegas Completions Wilmington 

West Palm Beach Under 

Construction Nashville 

Oakland
 

Sacramento
 

Minneapolis
 

National 

0% 5% 10% 15% 20% 25% 

Source: Torto Wheaton Research 

Top 15 Industrial Development Markets— 

Construction Activity in 1999 as a Percentage 

of Stock (Square Footage) 

Riverside 

Las Vegas 

Ventura County 

Fort Lauderdale 

Phoenix 

Sacramento
 

San Diego
 

Fort Worth
 

Cincinnati Completions Atlanta
 

Austin
 Under 

Dallas Construction 

Fresno 

Jacksonville
 

Orlando
 

National
 

0% 2% 4% 6% 8% 10% 12% 14% 16% 

Source: Torto Wheaton Research 

Top 15 Retail Development Markets— 

Construction Activity in 1999 as a Percentage 

of Stock (Square Footage) 

Source: F.W. Dodge 

National 

Greensboro 

Jacksonville 

Denver 

Greenville 

Tampa 

Richmond 

West Palm Beach 

Sacramento 

Atlanta 

Fort Worth 

Nashville 

Phoenix 

Orlando 

Dallas 

Las Vegas 

0% 5% 10% 15% 20% 25% 30% 35% 40% 

Under 

Construction 

Completions 

Chicago Regional Outlook 13 Third Quarter 2000 
In Focus This Quarter
 

each of the five property sectors except hotel construction, where it ranks sixteenth. 

Other markets deserve notice for their high or moderately high levels of construction activity in one or more 

property sectors. Columbus, Ohio, ranks sixth in the 

nation for its high level of office construction and 

twelfth for both multifamily and hotel construction. 

Greenville is tenth in the nation for hotel construction 

and twelfth for retail. West Palm Beach is ninth for 

retail and eleventh for office. Austin is eighth for 

office, eleventh for both multifamily and industrial, and 

thirteenth for hotel. 

C&D Loan Concentrations 

Concentrations of C&D loans at community banks in 

the at-risk markets are generally higher now than they 

were at the peak of the last cycle in the 1980s.11 As 

shown in Chart 7, the median ratio of C&D loans to 

total assets as of March 31, 2000, was higher than the 

median ratio as of December 31, 1988, in ten of the thirteen at-risk markets.12 The median C&D loan concentration is currently higher than the national average in 

all 13 at-risk markets.13 

At present, overall loan performance remains very good 

for the C&D portfolios of insured institutions. Reported 

delinquent and nonaccrual C&D loans remain at nominal levels as a percentage of total loans, although the 

ratio for both measures increased marginally during the 

first quarter of 2000. 

Construction Employment Concentrations 

The percentage of a metropolitan area’s workforce 

employed in construction is an indicator of the sensitivity of the local economy to construction. Six of the 

13 metropolitan areas at risk for overbuilding are 

found among the top 12 most concentrated construction 

employment markets (see Chart 8).14 In addition, all of 

the 13 have construction concentration levels exceeding the national average. With slightly under 10 per11 Community banks are FDIC-insured institutions with assets less 

than $1 billion. 

12 For community banks that have C&D loans. 

13 Since 1992, the aggregate C&D-to-asset ratio for the nation’s community banks has been higher than the C&D-to-asset ratio for institutions larger than $1 billion. This is a reversal of the condition from 

1984 through 1991 when the aggregate C&D-to-asset ratio for institutions larger than $1 billion exceeded the C&D-to-asset ratio for 

community banks. 

14 Construction concentrations are the percentage of construction 

employees relative to the nonfarm workforce. 

CHART 5 

Top 15 Multifamily Development Markets—
 

Construction Activity in 1999 as
 

a Percentage of Stock (Units)
 

Orlando
 

Charlotte
 

Raleigh
 

Portland
 

Dallas
 

Las Vegas
 

Denver
 

Seattle
 

Atlanta
 Completions Phoenix
 

Austin
 Under
 

Columbus
 Construction
 

Tampa
 

Jacksonville
 

Nashville
 

National
 

0% 2% 4% 6% 8% 10% 12% 

Source: F.W. Dodge 

CHART 6 

Top 15 Hotel Development Markets— 

Construction Activity in 1999 as a Percentage 

of Stock (Square Footage) 

Fort Worth
 

Jacksonville
 

Portland
 

Orlando
 

Salt Lake City
 

Denver
 

Charlotte
 

Dallas
 

Seattle
 Completions Greenville
 

Oakland
 Under 

Columbus, OH Construction 

Austin 

Greensboro 

San Jose 

National 

0 5% 10% 15% 20% 25% 30% 

Source: F.W. Dodge 

CHART 7 

Most of the At-Risk Markets’ Community Banks 

Have Higher Median C&D Loan-to-Asset Ratios 

at 3/31/00 than at Peak of Last Cycle (12/31/88) 

Salt Lake City
 

Atlanta
 

Portland
 

Las Vegas
 

Sacramento
 

Phoenix
 

Seattle
 

Fort Worth
 

Dallas
 3/31/00 

Orlando 12/31/88
 

Charlotte
 

Denver
 

Jacksonville
 

National
 

0 2 4 6 8 10 12 14 16 18 

Median C&D Loan-to-Asset Ratios (%) 

C&D = construction and development 

Source: Bank and Thrift Call Reports (Research Information System) 

Chicago Regional Outlook 14 Third Quarter 2000 
In Focus This Quarter
 

cent of its nonfarm workforce employed in construction, Las Vegas has the highest construction-concentrated workforce of all metropolitan areas in the 

United States and is slightly over twice the national 

rate of 4.8 percent. 

High Construction Activity and High 

Vacancy Levels 

Newly constructed, speculative space competes directly 

for tenants against already-built and vacant space. To 

assess at-risk markets fully, it is useful to compare the 

levels of construction activity for each metropolitan 

area’s property sector against its associated vacancy 

levels.15 

Charts 9 through 13 show, by property sector, each 

city’s level of construction activity plotted against the 

corresponding vacancy rate. It is axiomatic that a metropolitan area with high vacancies and high construction is cause for concern for builders and lenders alike. 

It follows for metropolitan areas with high construction 

and high vacancy that newly arriving CRE projects will 

face significant competitive pressures in obtaining tenants. Consequentially, barring any preleasing or any 

fundamental upward shifts in demand, rental concessions may be needed to obtain tenants, and property values may be depressed. 

CHART 8 

Many of the 13 At-Risk Markets Are among the
 

Nation’s Metropolitan Statistical Areas Having the
 

Highest Construction Employment Levels as of
 

First Quarter 2000
 

LAS VEGAS 

Riverside 

Houston 

PHOENIX 

DENVER 

Greenville 

SALT LAKE CITY 

CHARLOTTE 

Birmingham 

Albuquerque 

Richmond Note: Capitalized cities 

SACRAMENTO are among the 13 

Norfolk markets identified as at 

Oakland risk for overbuilding. 

Raleigh 

National 

0% 2% 4% 6% 8% 10% 12% 

Construction Employees as a Percentage of the Nonfarm Workforce 

Source: Bureau of Labor Statistics (Haver Analytics) 

15 The data vendors do not provide category breakdowns for construction activity into speculative versus nonspeculative (preleased) 

properties. 

Many of the 13 At-Risk Markets Report 

High Office Construction Activity and High Office 

Vacancy Rates 

0 

5 

10 

15 

20 

25 

0% 5% 10% 15% 20% 25% Vacancy Rate 

Note: Capitalized cities are among the 13 markets identified as at risk for 

overbuilding. 

Source: Torto Wheaton Research Construction Activity as Percentage of Stock

SEATTLE 

ORLANDO 

CHARLOTTE 

PHOENIX 

Austin 

Wilmington 

SACRAMENTO 

West Palm Beach 

DALLAS 

LAS VEGAS 

SALT LAKE CITY 

JACKSONVILLE 

Riverside Oklahoma City 

Bakersfield 

Columbus 

Nation 

CHART 9 

CHART 10 

CHART 11 

Many of the 13 At-Risk Markets Report High 

Industrial Construction Activity and High Industrial 

Vacancy Rates 

0 

2 

4 

6 

8 

10 

12 

14 

16 

Construction Activity as a Percentage of Stock 

0% 2% 4% 6% 8% 10% 12% Vacancy Rate 

Source: Torto Wheaton Research 

Austin Cincinnati 

JACKSONVILLE Fresno 

ORLANDO DALLAS Washington, 

D.C. 

Hartford 

Long Island 

Westchester 

ATLANTA 

FORT 

WORTH 

PHOENIX 

San Diego 

SACRAMENTO 

Ft. Lauderdale 

LAS VEGAS 

Riverside 

Ventura 

Note: Capitalized cities are among 

the 13 markets identified as at risk 

for overbuilding. 

Nation 

Many of the 13 At-Risk Markets Report High 

Retail Construction Activity and High Retail 

Vacancy Rates 

0 

5 

10 

15 

20 

25 

30 

35 

40 

0% 2% 4% 6% 8% 10% 12% 14% 16% 

Source: F.W. Dodge 

Vacancy Rate 

Construction Activity as a Percentage of Stock

Note: Capitalized cities 

are among the 13 

markets identified as at 

risk for overbuilding. 

LAS VEGAS 

ORLANDO DALLAS 

PHOENIX 

ATLANTA SACRAMENTO 

Tampa DENVER 

JACKSONVILLE 

Greensboro 

FORT 

WORTH 

W. Palm Beach 

Greenville 

Nation 

Nashville 

Chicago Regional Outlook 15 Third Quarter 2000 
In Focus This Quarter
 

What Market Analysts Are Saying 

Views of industry analysts provide additional perspective on the risks pertaining to each of the five property 

sectors and the individual metropolitan areas. 

Office 

Newly constructed nationwide office supply will outpace demand in 2000 and beyond, according to Torto 

Wheaton Research.16 Some 65 million square feet of 

space is scheduled for completion in 2000. However, net 

absorption is projected to be only 58 million square feet 

in 2000, resulting in an excess supply of 7 million square 

feet. Torto Wheaton Research predicts that office completions will outpace absorptions for all projected yearends through 2005, and corresponding vacancy rates will 

climb to slightly more than 14 percent at year-end 2005. 

Overall office fundamentals are in equilibrium, according to Donaldson Lufkin & Jenrette (DLJ), thanks to 

preleasing and sufficient demand.17 Still, DLJ identifies 

a number of markets as being at greater risk for excess 

new supply. DLJ’s markets to watch for possible overbuilding are Charlotte, Fort Lauderdale, Minneapolis, 

and Sacramento. More than 9 percent in new supply is 

projected for Sacramento over the next 18 months, with 

only a 3 percent increase in demand. DLJ identifies the 

Sacramento suburbs as the major center of construction 

activity and notes with concern the existing 13 percent 

suburban vacancy rate for this metropolitan area. 

Overall office construction levels will peak this year, 

according to the Urban Land Institute (ULI).18 Increases 

in suburban office vacancy rates to nearly 11 percent by 

the end of 2000 are projected, with downtown rates falling 

to slightly over 8 percent. ULI notes the possibility of a 

rash of space returns by Internet companies and others in 

the technology sector as a significant going-forward risk. 

Many analysts caution about the ability of new office 

construction to be absorbed in certain markets where 

labor supplies remain tight. In recent Wall Street Journal articles, Dallas and Seattle are reported to be actively recruiting high-tech engineers through immigrants 

from India and China to fill in the gaps in their tight 

labor-market pool for high-technology jobs.19, 20 

16 Torto Wheaton Research. Spring 2000. Office Outlook.
 17 Thierry Perrein, Donaldson, Lufkin & Jenrette. April 2000. DLJ
 

REIT Corporate Handbook, “Cautious Optimism.”
 

18 Urban Land Institute. ULI 2000 Real Estate Forecast.
 19 Templin, Neal. June 7, 2000. Economic Focus: Houston, Dallas
 

Are Draw for Immigrants. The Wall Street Journal.
 20 Barnes, Brooks. June 7, 2000. Economic Focus: Seattle Enjoys
 

Influx of Foreign Workers. The Wall Street Journal.
 

In a recent office market report by Moody’s Investors 

Service, three metropolitan areas (Jacksonville, 

Nashville, and Phoenix) are coded as “red”—indicating 

danger for high supply and declining demand factors.21 

Charlotte is coded as “yellow,” and its office demand is 

projected to grow by only 5 percent this year, while supply will increase by over 11 percent. 

Multifamily 

Recent mortgage rate increases will slow purchases of 

single-family homes, thereby increasing the demand for 

multifamily properties, according to a recent article by 

PaineWebber.22 Nevertheless, concerns are raised for 

oversupply conditions for multifamily construction in 

Atlanta, Dallas, Houston, and Las Vegas—cities characterized as “low barrier-to-entry markets.” 

Markets appearing weak to DLJ for the multifamily 

property sector include Charlotte, Denver, Jacksonville, 

Orlando, Portland, Raleigh, Salt Lake City, and Seattle.23 

Industrial 

Atlanta and Dallas are weaker for the industrial property 

sector, according to DLJ, because of significant new supply levels.24 A 7 percent supply growth is projected for 

Phoenix in 2000, with only a 4 percent increase in demand. 

Retail 

For retail properties, DLJ believes a number of markets 

have excess supply; the standouts are Austin, Las Vegas, 

Orlando, Phoenix, and Sacramento.25 

Hotel 

Analysts point to specific concerns for a “glut” of limited-service hotels in certain markets and note many hotel 

developers taking advantage of low barriers to entry for 

hotel construction. In response, many developers argue 

that “product differentiation” within different hotel sectors justifies further development. 

Growth in expenditures on hotel construction has been 

above 7 percent for each of the past several years, while 

room revenues grew at a more moderate pace, according 

to PaineWebber.26 The poor growth in room revenue is 

attributed to supply exceeding demand. 

21 Gordon, Sally. June 2, 2000. Moody’s Investors Service, Special
 

Report—CMBS: Red-Yellow-Green Update, Second Quarter
 

2000, Quarterly Assessment of U.S. Property Markets.
 

22 PaineWebber. June 6, 2000. Real Estate Investment Trust—Initiating Coverage on the REIT Industry.
 

23 Ibid.
 

24 Ibid.
 

25 Ibid.
 

26 PaineWebber. June 1, 2000. Industry Outlook Lodging, U.S.
 

Hotel Construction Update—First Quarter 2000.
 

Chicago Regional Outlook 16 Third Quarter 2000 
In Focus This Quarter
 

CHART 12 CHART 13 

Many of the 13 At-Risk Markets Report High 

Hotel Construction Activity and High Room 

Availability (Vacancy) Rates 

0 

5 

10 

15 

20 

25 

30 

15% 20% 25% 30% 35% 40% 45% 

Vacancy Rate 

Source: F.W. Dodge Construction Activity as a Percentage of Stock

Note: Capitalized cities 

are among the 13 

markets identified as at 

risk for overbuilding. 

FORT WORTH 

JACKSONVILLE 

ORLANDO 

PORTLAND 

DENVER 

SALT LAKE CITY 

Oakland SEATTLE CHARLOTTE 

Nation 

DALLAS 

Austin Columbus Greenville 

Greensboro 

Many of the 13 At-Risk Markets Report High 

Multifamily Construction Activity and High 

Multifamily Vacancy Rates 

0 

2 

4 

6 

8 

10 

12 

3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 

Source: F.W. Dodge Vacancy Rate Construction Activity as a Percentage of Stock

Note: Capitalized cities 

are among the 13 

markets identified as at 

risk for overbuilding. 

ORLANDO 

CHARLOTTE 

PORTLAND Raleigh DALLAS 

DENVER LAS VEGAS SEATTLE 

PHOENIX 

ATLANTA 

Nation 

JACKSONVILLE Columbus 

Tampa Austin 

Indianapolis Houston 

Birmingham 

As shown in the referenced charts, multiple cities are 

experiencing high volumes of construction activity concurrent with high vacancy rates. Seven of the 13 at-risk 

cities show up in the upper-right quadrants, exhibiting 

both high rates of construction and vacancy: Atlanta 

for industrial and multifamily; Dallas for office and 

retail; Fort Worth for retail and hotel; Jacksonville for 

office and hotel; Las Vegas for office and industrial; 

Orlando for office and multifamily; and Salt Lake 

City for office and hotel. 

Other metropolitan areas beyond these 13 are precariously situated at the furthermost positions on the charts 

for high vacancy and high construction levels: Austin 

and Houston for multifamily; Greensboro for hotel; 

Greenville for retail and hotel; and West Palm Beach 

for office and retail. 

Conclusion 

Since 1997, responding to a void left by the departure of 

other capital market lenders, community banks have 

stepped up their CRE lending activity. At the same time, 

more metropolitan areas are emerging with vigorous 

CRE construction and development across multiple 

property sectors. In the 1998 and 1999 FDIC analyses, 

nine metropolitan areas were identified as being at risk 

for overbuilding across multiple property types. In the 

present analysis, 13 metropolitan areas, including eight 

of the nine from the prior analyses, receive this designation. Given strong levels of CRE completions, these 

metropolitan areas are particularly sensitive to any 

decline in real estate demand that could result from a 

slowdown in the national or regional economy. 

Thomas A. Murray, Senior Financial Analyst 

Chicago Regional Outlook 17 Third Quarter 2000 
In Focus This Quarter
 

Rising Home Values and New Lending Programs Are 


Reshaping the Outlook for Residential Real Estate
 

•	 Home prices have risen rapidly in several major 

U.S. metropolitan areas. 

•	 The credit quality of residential real estate loan 

portfolios traditionally has been solid. 

•	 New lending programs such as subprime and high 

loan-to-value lending could change the historical 

loss experience associated with residential real 

estate. 

Introduction 

The median price of an existing single-family home has 

been rising rapidly in several U.S. metropolitan areas. 

After a prolonged period of stagnant or slowly rising 

resale prices in many of these markets throughout most 

of the 1990s, prices have rebounded strongly, reaching 

double-digit rates of growth in some areas. Not surprisingly, these markets have also experienced relatively 

robust job growth, particularly in high-tech sectors that 

have been the catalyst for growth in the New Economy.1 

However, as existing home prices in some markets have 

been rising rapidly, new building activity has recently 

begun to slow because of rising interest rates. After 

reaching a 19 percent year-over-year growth rate in the 

fourth quarter of 1998, single-family housing starts 

declined by 2.8 percent in the second quarter of 2000. 

Similarly, year-over-year growth in single-family housing permits declined by 8.4 percent in the second quarter of 2000. Higher home mortgage rates, along with the 

prospect for more moderate job growth, have dampened 

market activity. 

Single-family mortgages have traditionally been associated with low loss rates compared with other, higherrisk lending lines at insured institutions. However, the 

real estate market is still susceptible to boom and bust 

cycles, which could pose a risk to institutions with 

exposures to residential real estate. This risk would be 

heightened by the formation of asset price bubbles in 

local markets. Furthermore, as the competition among 

1 For a discussion on what is meant by the term “New Economy,” see 

“Banking Risk in the New Economy,” Regional Outlook, second 

quarter 2000; http://www.fdic.gov/bank/analytical/regional/ro20002q/ 

na/t2q2000.pdf. 

mortgage lenders becomes more intense, insured institutions are increasingly participating in new, higher-risk 

types of mortgage lending, such as high loan-to-value 

(LTV) lending and subprime lending. These new lending practices—still largely untested in a recession— 

raise some concerns about the future credit quality of 

residential loan portfolios. 

Home Prices in Some Local Markets 

Are Soaring 

Home prices have been soaring recently in a number of 

large U.S. metropolitan markets. Rapid price increases 

in some of these areas have come on the heels of a period of slow or stagnant growth (see Chart 1). Table 1 

(next page) identifies the top 20 metropolitan markets 

based on the median price of an existing single-family 

home. Many of the areas identified in the table are also 

places where home prices are increasing most rapidly. 

Healthy job growth, tight labor market conditions, and 

a tight supply of available homes have contributed to 

price increases in these areas. 

Some of the same metropolitan areas that are experiencing significant home price appreciation are also 

highly dependent on the high-tech sector. The shaded 

areas in Table 1 highlight the metro markets that not 

only have the highest median home prices in the nation 

but also have a concentration of high-tech employees in 

the workforce greater than 5 percent. Explosive growth 

CHART 1 

–10% 

–5% 

0% 

5% 

10% 

15% 

20% 

25% 

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

Some Large U.S. Metropolitan Areas Have 

Seen the Return of Soaring Home Prices 

Source: National Association of Realtors (Haver Analytics) 

Year-over-Year Growth of the Median Existing Single-Family 

Home Price 

San Francisco 

Boston 

Chicago Regional Outlook 18	 Third Quarter 2000 
In Focus This Quarter
 

TABLE 1 

Of the 20 U.S. Cities with the Most Expensive Housing, 

More than Half Have a Concentration in High-Tech Employment 

THE SHADED AREAS INDICATE MARKETS WHERE HIGH-TECH EMPLOYEES CONSTITUTE AT LEAST 

5 PERCENT OF THE TOTAL PAYROLL EMPLOYMENT (SEE NOTE). 

METROPOLITAN STATISTICAL AREA 

RANKING BY MEDIAN HOME PRICE 

MEDIAN PRICE OF AN EXISTING 

SINGLE-FAMILY HOME 

MARCH 2000 

PERCENT CHANGE 

FROM ONE YEAR AGO 

1 SAN FRANCISCO, CA $418,600 25.0% 

2 ORANGE COUNTY, CA $300,800 10.3% 

3 HONOLULU, HI $289,000 –2.0% 

4 BOSTON, MA* $255,000 8.4% 

5 SAN DIEGO, CA $251,400 16.1% 

6 BERGEN-PASSAIC, NJ $250,200 9.8% 

7 NEWARK, NJ $229,500 18.8% 

8 SEATTLE, WA $226,100 8.3% 

9 NEW YORK, NY $221,500 14.3% 

10 NASSAU-SUFFOLK, NY $209,200 12.8% 

11 LOS ANGELES, CA $202,900 5.6% 

12 MIDDLESEX, NJ $198,500 8.6% 

13 MONMOUTH-OCEAN, NJ $186,200 19.4% 

14 DENVER, CO $181,500 12.9% 

15 WASHINGTON, DC-MD-VA $177,500 5.6% 

16 PORTLAND, OR $166,700 0.8% 

17 CHICAGO, IL $166,700 0.4% 

18 LAKE COUNTY, IL $162,600 –2.2% 

19 AURORA-ELGIN, IL $158,200 7.5% 

20 RALEIGH-DURHAM, NC $156,300 –4.2% 

NATION $133,533 2.7% 

* Ranking based on the latest data available (third quarter 1999). 

Note: High-tech, as defined by Dismal Sciences, Inc., includes industries such as pharmaceuticals, computers, 

electronic components, communications equipment, and communications services. 

Sources: National Association of Realtors (Haver Analytics); Dismal Sciences, Inc. 

in technology industries during this expansion has created new job opportunities in many metropolitan areas 

where high-tech companies and employment tend to be 

concentrated. The influx of highly skilled, and often 

highly compensated, high-tech workers into these areas 

has boosted the demand for both new and existing 

homes, pushing up home prices. For example, in San 

Francisco, where high-tech employees now comprise 

7.1 percent of the total workforce, home prices rose by 

22 percent in calendar year 1999 and are expected to 

rise another 14 percent in 2000.2 

2 July 21, 2000. Your Money Matters: Turning Down the Heat on 

Home Prices—Forecasters Find More Evidence That the Market Is 

Cooling; San Francisco Still Rocks. The Wall Street Journal. 

Soaring home prices in these metro areas have created 

the possibility of speculative price bubbles that could 

cause problems for mortgage lenders. If a decline in 

high-tech employment or company earnings were to 

cause a deterioration in home values in these markets, 

the credit quality of mortgage portfolios at insured institutions could be jeopardized. 

Favorable Economic Conditions Have Sustained 

Consumer Spending Patterns 

As the current U.S. expansion entered its 113th month 

in July 2000, consumer spending continued along a path 

of rapid growth. In the second quarter of 2000, personChicago Regional Outlook 19 Third Quarter 2000 
In Focus This Quarter
 

al consumption expenditures increased by 8 percent 

over the previous year. Nearly ideal conditions for consumers have contributed to high levels of spending. The 

unemployment rate remains near the record low of 3.9 

percent set in April 2000, and consumer confidence 

remains near the record high set in January 2000. Moreover, consumer buying power has been boosted by real 

wage gains, generally low interest rates, and stock market earnings. 

One of the only negative aspects for consumers has 

been the recent rise in interest rates, which has 

increased the cost of borrowing. From the end of 1998 

to June 2000, both the bank prime lending rate and the 

average mortgage contract rate for purchase of a previously occupied home rose by more than 100 basis 

points. However, the flexibility offered by adjustablerate mortgages (ARMs) has helped consumers shield 

themselves from the full effects of interest rate increases. As of the second quarter of 2000, the share of ARMs 

as a percentage of all loans closed had risen from 10 

percent in the fourth quarter of 1998 to 30 percent (see 

Chart 2). 

Nonetheless, as interest rates have risen, overall activity 

in the single-family housing market has slowed noticeably. After reaching an annualized rate of 1.4 million 

units in December 1999, monthly starts of single-family 

homes have declined by more than 15 percent to 1.2 

million units in June 2000. Similarly, the annualized 

rate of single-family permits issued in June 2000 was 

down 14 percent from January 2000 levels. The National Association of Realtors (NAR) reports that, despite 

current high levels of activity, deteriorating affordability conditions are expected to slow the resale housing 

market over the course of the year.3 In June 2000, NAR’s 

composite Housing Affordability Index fell to its lowest 

point since September 1996. To the extent that any 

decline in economic conditions would produce a less 

favorable environment for consumers, the housing market would likely slow even further. 

Overall Credit Quality of Residential 

Mortgages Has Been Solid 

Historical losses from residential real estate exposures 

at insured institutions are well documented. In the 

1980s, areas such as Texas, California, and New Eng3 National Association of Realtors Press Release. August 1, 2000. 

Housing Affordability Drops to Eight-Year Low, NAR Reports. 

CHART 2 

6.5% 

7.0% 

7.5% 

8.0% 

8.5% 

9.0% 

Jan-97 Sep-97 May-98 Jan-99 Sep-99 May-00 

5% 

10% 

15% 

20% 

25% 

30% 

35% 

More Consumers Have Chosen ARMs 

as Mortgage Rates Have Risen 

Sources: Federal Reserve Board; Federal Housing Finance Board (Haver 

Analytics) 

Contract Rate on Conventional 

30-Year Mortgage 

Commitments 

Adjustable-Rate Home 

Mortgage Loans as a 

Percentage of All Loans Closed 

land experienced strong economic growth, rapid residential development, and sharp home price appreciation 

that created asset price inflation. Coastal California 

markets, in particular, experienced double-digit growth 

rates that propelled the median home price in California 

to more than double the national average.4 

Regional recessions in many of these areas took a toll 

on residential real estate markets. Home values either 

stagnated or declined precipitously, and the foreclosure 

rate on residential real estate began to rise rapidly. Nevertheless, very few bank failures can be attributed solely to losses on residential mortgages. Loss rates on 

residential loans have traditionally been low compared 

with other loan categories. 

The credit quality of conventional single-family mortgage portfolios has generally been good throughout this 

economic expansion. The percentage of conventional 

loans past due during this expansion has averaged 2.8 

percent, compared with 3.5 percent during the last 

expansion from 1982 to 1990.5 Moreover, past-due conventional loans fell for the sixth consecutive quarter in 

the first quarter of 2000 to 2.3 percent (see Chart 3, next 

page). Foreclosures started, while slightly higher on 

average than the previous expansion, remain at a 

healthy level well below 1 percent of loans (see Chart 4, 

next page). 

4 Federal Deposit Insurance Corporation, Division of Research and 

Statistics. 1997. History of the Eighties: Lessons for the Future. Vol. 

1, An Examination of the Banking Crises of the 1980s and Early 

1990s. http://www.fdic.gov/bank/historical/history/contents.html. 5 “Past due” refers to loans that are 30 or more days past due. 

Chicago Regional Outlook 20 Third Quarter 2000 
In Focus This Quarter
 

By contrast, Veterans Administration (VA) and Federal 

Housing Administration (FHA) loans have performed 

less well during this expansion. These loan types are 

both designed to aid less creditworthy borrowers in 

securing a home loan. VA and FHA loans, which 

include a portion of the higher-risk high-LTV and subprime loans, have historically experienced higher pastdue and foreclosure rates than other classes of mortgage 

loans (see Charts 3 and 4). 

The overall performance of 1–4 family residential mortgages at insured institutions has been solid. As of March 

2000, delinquent 1–4 family loans remained well under 

1 percent of total 1–4 family loans, and the percentage 

of charge-offs was nearly zero. Charge-offs may have 

reached the bottom of the credit cycle in 1998, however, after peaking at a record high in 1993 (see Chart 5). 

CHART 3 

Past-Due Rates on FHA and VA Loans Have
 

Historically Been Higher than
 

on Conventional Loans
 

Loans Past Due as a Percentage of All Loans 

10.0 Federal Housing Administration 

8.0 

6.0 

Veterans Administration Loans 

Loans 

4.0 

2.0
 

Conventional Loans
 

0.0
 

4Q82 3Q85 2Q88 1Q91 4Q93 3Q96 2Q99 

Source: Mortgage Bankers Association (Haver Analytics) 

CHART 4 

Foreclosure Rates on FHA and VA Loans
 

Remain Higher than on Conventional Loans
 

Foreclosures Started as a Percentage of All Loans 

0.8 

0.7 Federal Housing Administration 

Loans 

0.6 

0.5 

0.4 

0.3 

0.2 

0.1 

Veterans Administration Loans 

Conventional Loans 

0.0 

4Q82 3Q85 2Q88 1Q91 4Q93 3Q96 2Q99 

Source: Mortgage Bankers Association (Haver Analytics) 

A trend toward higher charge-off rates might be cause 

for concern at a time when conditions in the consumer 

sector seem to be excellent. Moreover, as with regional 

problems that surfaced in the late 1980s and early 

1990s, the aggregate data may still mask evolving submarket residential real estate problems associated with 

local economic and business conditions or new, higherrisk lending lines of business. 

Concerns have arisen recently about the future of residential loan credit quality and consumer credit quality 

in general. The Board of Governors of the Federal 

Reserve System warned that, although the consumer 

sector seems healthy by most measurable standards, 

“[consumer] delinquency rates may be held down, to 

some extent, by the surge in new loan originations in 

recent quarters because newly originated loans are less 

likely to be delinquent than seasoned ones.”6 Consumer 

credit outstanding grew by nearly 8 percent in the second quarter of 2000, the highest growth rate in the past 

three years. At the same time, 1–4 family loans at 

insured institutions expanded by 11 percent from March 

1999 to March 2000, the highest year-over-year growth 

rate since 1997. 

High growth rates are not the only concern regarding 

the future credit quality of residential loan portfolios. 

Rising interest rates have raised the cost of borrowing 

for consumers at a time when consumer credit has been 

expanding rapidly. Mortgage debt service payments as a 

percentage of disposable personal income rose to nearly 6 percent in the first quarter of 2000, continuing an 

CHART 5 

1–4 Family Loan Charge-Offs May Have 

Reached the Bottom of the Credit Cycle 

1–4 Family Loan Charge-Offs as a Percentage 

of All 1–4 Family Loans 

0.30 

0.25 

0.20 

0.15 

0.10 

0.05 

0.00 

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

Fourth Quarter 

Source: Bank and Thrift Call Report Data (Research Information System) 

6 Board of Governors of the Federal Reserve System. July 20, 2000. 

Monetary Policy Report to the Congress, p. 7. 

Chicago Regional Outlook 21 Third Quarter 2000 
In Focus This Quarter
 

upward trend since mid-1994. This level was last 

reached in 1991, when the economy was emerging from 

an economic recession and some local residential markets were in turmoil. Further increases in interest rates 

would push mortgage debt service payments higher, 

which could impair the ability of mortgage holders to 

service both mortgage debt and other consumer debt. 

Moreover, other consumer loans would likely enter 

delinquency before mortgage loans, as consumers are 

more likely to pay their mortgages before other consumer debt. 

New Residential Lending Programs May 

Heighten the Risk Exposure of Insured 

Institutions 

Recent trends in high-LTV and subprime lending have 

heightened the risk exposure of insured institutions. 

Intense competitive pressure in the banking industry has 

narrowed the margins of traditional lending lines, 

inducing banks to seek more profitable lines of business. Both high-LTV and subprime lending offer wider 

margins, but at the price of increased risk to the lender. 

High-LTV loans represent greater risk to lending institutions when collateral values decline. If a home loan is 

underwritten on the basis of an inflated home value, 

there is a greater possibility of default if the value of the 

home declines. Furthermore, a decline in the value of 

the home could reduce the possibility of recovering the 

loan in the event of default and foreclosure. 

The share of high-LTV loan originations is growing.7 

The percentage of loans with an LTV ratio greater than 

90 percent has risen from around 5 percent to more than 

20 percent over the past ten years.8 Table 2 identifies the 

metropolitan areas where more than 30 percent of the 

conventional home loans underwritten in 1999 carried 

an LTV ratio greater than 90 percent. Given that the historical cycles of boom and bust in residential real estate 

have often been geographically isolated, both regional 

and national trends in high-LTV lending should be carefully monitored. 

7 See also Diane Ellis. “High Loan-to-Value Lending: A New Frontier in Home Equity Lending.” Regional Outlook, first quarter
 

1999; http://www.fdic.gov/bank/analytical/regional/ro19991q/na/
 

t1q1999.pdf.
 

8 Federal Housing Finance Board.
 

Subprime lending is a term commonly used to refer to 

loans that are extended to borrowers who are perceived 

as less creditworthy.9 As insured institutions have 

increased their involvement, the subprime lending 

market has presented banks with new growth opportunities and new risks. Subprime loans represent a small 

but growing share of total mortgage originations (see 

Chart 6, next page). To be sure, higher pricing on subprime loans promises wider margins and higher revenues for lenders, but the credit risk associated with 

less-than-prime borrowers requires ongoing oversight 

and management to prevent credit losses from eroding 

margins. Some financial institutions that have either 

grown subprime portfolios or acquired subprime affiliates are now scaling back their involvement in subprime 

TABLE 2 

Pockets of Risk May Be Forming 

Where the LTV Is Highest 

PERCENTAGE 

METROPOLITAN STATISTICAL OF LOANS 

AREA (MSA) OR CONSOLIDATED WITH LTV 

MSA RANKED BY PERCENTAGE OVER 90 OF LOANS WITH LTV GREATER PERCENT 

THAN 90 PERCENT 1999 

1 GREENVILLE-SPARTANBURGANDERSON, SC
 50% 

2 HONOLULU, HI 42% 

3 MEMPHIS, TN 38% 

4 CHARLOTTE-GASTONIAROCK HILL, NC-SC 37% 

5 BIRMINGHAM, AL 35% 

6 HOUSTON-GALVESTONBRAZORIA, TX 35% 

7 ATLANTA, GA 32% 

8 JACKSONVILLE, FL 32% 

9 NASHVILLE, TN 32% 

10 OKLAHOMA CITY, OK 32% 

11 TULSA, OK 32% 

12 GREENSBORO–WINSTONSALEM–HIGH POINT, NC 31% 

13 KANSAS CITY, MO-KS 30% 

14 LAS VEGAS, NV-AZ 30% 

LTV = loan-to-value 

Source: Federal Housing Finance Board 

9 See also Kathy R. Kalser and Debra L. Novak. “Subprime Lending: 

A Time for Caution.” Regional Outlook, third quarter 1997; 

http://www.fdic.gov/bank/analytical/regional/ro19973q/pdf/roa1997. 

pdf. 

Chicago Regional Outlook 22 Third Quarter 2000 
In Focus This Quarter
 

lending activities to limit projected losses.10 In some 

cases, excessive losses related to the business of underwriting subprime loans have contributed to the failure 

of insured institutions. 

A recent report from Inside Mortgage Finance states 

that subprime portfolios are showing evidence of weakness.11 According to this report, the serious delinquency 

rate in the overall subprime market rose from 6.5 percent in 1998 to 6.9 percent in 1999.12 Furthermore, the 

percentage of A-rated borrowers in the subprime market 

fell from 59 percent to 53 percent during the same period. The implication is that both subprime and prime 

mortgages originated this year could likely underperform relative to prior years, adversely affecting credit 

quality at insured institutions. 

The potential for higher future losses related to subprime lending is of particular concern. The delinquency rate on subprime mortgages has traditionally been 

much higher than that of prime mortgages. As of 

December 1999, seriously delinquent prime mortgage 

loans comprised only 0.5 percent of total mortgage 

loans, compared with 3.2 percent of the best-rated subprime loans. Subprime mortgage loan seasoning analysis shows that 1999 vintage subprime loans have so far 

outperformed both 1997 and 1998 vintage loans (see 

Chart 7). However, there is a concern that adverse 

CHART 6 

Subprime Mortgage Loans Are Growing as a
 

Percentage of Total Mortgage Originations
 

Subprime Mortgage Subprime Mortgage Loans as a
 

Loan Originations, Percentage of Total Originations
 

200 

in Billions of Dollars 

20% 

150 15% 

100 10% 

50 5% 

0 0% 

’94 ’95 ’96 ’97 ’98 ’99 1Q00 

Sources: The Mortgage Market Statistical Annual for 1999; Inside B&C Lending 

10 Subprime Mortgage Market Faces More Challenges in Second Half 

of Turbulent 2000. Inside Mortgage Finance. July 7, 2000. 11 Mortgage Delinquency Rates Decline in Early 2000 But Industry 

Braces for Shift in the Wind. Inside Mortgage Finance. July 14, 2000. 12 Seriously delinquent loans are defined as loans at least 90 days 

delinquent or in foreclosure. 

changes in economic conditions and the health of the 

consumer sector could cause the foreclosure rate on 

subprime mortgage loans to increase more steeply than 

in prior years. 

Conclusion 

Rising home prices in some U.S. metropolitan areas 

may be a warning sign that asset price bubbles may be 

forming in some areas. A number of these areas also 

contain concentrations of employment in the high-tech 

sector, placing them at higher risk in the event of a 

downturn in that sector. Mortgage lenders in these areas 

should carefully monitor developments that could 

adversely affect home prices and collateral values. 

Nationally, single-family housing market activity 

appears to be slowing after a period of rapid growth 

supported by a long economic expansion and generally 

favorable interest rates. 

Historically, mortgage loans at insured institutions 

have been one of the best-performing asset classes. As 

1–4 family loan charge-offs have approached zero, it 

appears as if the credit cycle may have bottomed out, 

implying that loss rates may be rising. Moreover, as 

insured institutions increase involvement with subprime and high-LTV lending, the potential for higher 

future losses on residential real estate also increases. It 

will be important to keep an eye on developments in 

the economy and the consumer sector that could affect 

the future credit quality of residential real estate at 

insured institutions. 

Alan Deaton, Financial Economist 

CHART 7 

1999 Vintage Subprime Residential Loans Have 

Outperformed Earlier Vintages 

Foreclosure Rate on the Dollar Volume of B&C Grade 

Subprime Single-Family Residence 

7.0% 

6.0% 

5.0% 

4.0% 

3.0% 

2.0% 

1.0% 

0.0% 

1997 Vintage 

1998 Vintage 

1999 Vintage 

6 9 12 15 18 21 24 27 30 33 36 39 

Months of Seasoning 

Source: Mortgage Information Corporation 

Chicago Regional Outlook 23 Third Quarter 2000 
✁
 

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