Outlook
 

SUMMER 2006 

In Focus This Quarter: 


The Evolution of the Credit Cycle
 

The notion of the credit cycle—or a periodic fluctuation in the volume and quality of credit—has a long and colorful history. 

Cycles of expanding, and then contracting, credit volumes are observed in virtually every type of lending, but they may differ 

markedly across the various bank loan types. Following the late-20th century deregulation of financial services, some argue that 

cycles in bank lending and loan performance are rising in importance as drivers of banking industry performance. This issue of 

FDIC Outlook first discusses the credit cycle in conceptual terms, and then examines how applicable the concept may be to 

the three most important loan types for FDIC-insured institutions. 

Cycles of Thought: An Historical Context 

for the Modern Credit Cycle 

Theories about credit cycles and their importance have a 

surprisingly long history and have evolved steadily over 

time. This article provides an overview of the topic and 

discusses how modern ideas about the credit cycle came 

into being. See page 3. 

Outlook for C&I Credit Quality 

Commercial and industrial (C&I) loan balances are once 

again growing at double-digit rates at FDIC-insured institutions, and the performance of these loans remains at or 

near an historic high. The question on the minds of 

bankers and regulators now becomes: How much will C&I 

credit quality deteriorate when the cycle turns? To address 

this question, our analysts assess the outlook for the U.S. 

nonfinancial business sector. See page 8. 

Short-Term Cycles Are Evident

amid Larger Trends in Bank Lending

Note: Depository institutions include commercial banks, thrifts, and credit unions. 

Source: Federal Reserve Board (Flow of Funds). 

$0 

–$400 

–$200 

$200 

$400 

$600 

$800 

$1,000 

$1,200 

1953 1957 1961 1965 1969 1973 1977 1981 1985 1989 1993 1997 2001 2005 

Net Change in Loans Outstanding by Depository Institutions 

(in billions of 2005 dollars) 

Recessions Five-year 

moving 

average 

CRE Credit Expansion Raises Portfolio Concentrations 

The credit cycle in commercial real estate (CRE) lending differs from other lines of business in large part due to the long lead 

times associated with the development of CRE projects. Historically, cyclical imbalances between CRE supply and demand have 

resulted in periods of oversupply. The volatility of the CRE cycle appears to have been smoothed recently, in part because of 

improved transparency and the increased availability of market-based financing. However, as FDIC-insured institutions continue to 

grow their portfolios of CRE loans, concentrations in this line of business have risen to historic highs. See page 14. 

Breaking New Ground in U.S. Mortgage Lending 

The U.S. residential mortgage market continues to reinvent itself. While government involvement remains extensive, private 

asset-backed issuers have doubled their share of the market in just the past two years. Meanwhile, the structure of U.S. mortgage 

loans has undergone dramatic changes—the consequences of which remain unclear. Despite strong loan performance at present, 

there are concerns about increased risk taking on the part of lenders and homeowners. See page 21. 

FEDERAL DEPOSIT INSURANCE CORPORATION 
 

The FDIC Outlook is published quarterly by the Division of Insurance and Research of the Federal Deposit 

Insurance Corporation as an information source on banking and economic issues for insured financial institutions and financial institution regulators. 

The FDIC Outlook provides an overview of economic and banking risks and discusses how these risks relate to 

insured institutions nationally and in each FDIC region. 

Single copy subscriptions of the FDIC Outlook can be obtained by sending the subscription form found on the 

back cover to the FDIC Public Information Center. 

The FDIC Outlook is available online by visiting the FDIC’s Web site at www.fdic.gov. For more information or to 

provide comments or suggestions about FDIC Outlook, please call Richard A. Brown at 202-898-3927 or send 

an e-mail to rbrown@fdic.gov. 

The views expressed in the FDIC 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 Sheila C. Bair 

Director, Division of Insurance Arthur J. Murton 

and Research 

Executive Editor Maureen E. Sweeney 

Managing Editor Mary Ledwin Bean 

Editors Richard A. Brown 

Christopher J. Newbury 

Ronald L. Spieker 

Kim E. Lowry 

Norm Williams 

Publications Managers Elena Johnson 

Geri Bonebrake 

Contact information for the FDIC’s six geographic regions: 

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

Marlon G. Cook, Acting Regional Manager, 678-916-2295 

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

David Vallee, Acting Regional Manager, 312-382-7551 

Dallas Region 

Midsouth (AR, LA, MS, TN): Gary Beasley, Regional Manager, 901-821-5234 

Southwest (CO, NM, OK, TX): Alan Bush, Regional Manager, 972-761-2072 

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

Richard Cofer, Acting Regional Manager, 816-234-8198 

New York Region 

Mid-Atlantic (DC, DE, MD, NJ, NY, PA, PR, VI): Kathy Kalser, Regional Manager, 917-320-2650 

New England (CT, MA, ME, NH, RI, VT): Paul Driscoll, Regional Manager, 781-794-5502 

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

John Anderlik, Acting Regional Manager, 415-808-8158 

FDIC OUTLOOK 2 SUMMER 2006 
Cycles of Thought: An Historical Context for the
 

Modern Credit Cycle 

Since ancient times, credit markets have undergone 

periodic booms and busts. In 594 BC, for example, 

the Greek state of Attica found itself under severe 

economic stress because of the massive debt incurred 

by many of its citizens. The ensuing civil disorder 

resulted in a handover of power to Solon, one of the 

“seven wise men” of Greece. Solon took radical steps 

to restore balance to the economy, such as canceling 

debts, freeing those enslaved for failing to repay their 

loans, and devaluing the currency by 25 percent.1 

Although times have changed, the credit cycle and 

its dynamics of credit extension and retrenchment 

continue to affect the course and health of the economy and the banking sector. 

Simply put, credit cycles are fluctuations in loan quality 

and quantity. They are often correlated with, but not 

always identical to, business cycles, which are based on 

fluctuations in the overall output of goods and services. 

This article provides an overview of credit cycles in 

general, exploring their theoretical underpinnings and 

history over the past 200 years. 

Credit Cycles Relate to Both Quantity and Quality 

Credit and credit cycles have two dimensions: quantity 

and quality. In terms of quantity, the credit cycle essentially traces the ups and downs in the supply and 

demand for credit, encompassing both long-term and 

cyclical components. Chart 1 shows inflation-adjusted 

lending by banks, thrifts, and credit unions during the 

past 50 years. While loan growth typically decelerates 

during recessions, two periods stand out as exceptions. 

One is the sharp contraction in credit during the early 

1990s; the other is the strong credit growth of the past 

five years, driven by historically low interest rates and 

an unprecedented surge in mortgage activity.2 

1 Sidney Homer and Richard E. Sylla, A History of Interest Rates, 

3rd ed. (New Brunswick, NJ: Rutgers University Press, 1991). 2 The early 1990s was a time of major stress in the banking industry, 

which experienced hundreds of failures and a significant rebuilding 

of capital. Credit growth was significantly curtailed during this time. 

For more information, see: Federal Deposit Insurance Corporation 

(FDIC), History of the Eighties—Lessons for the Future (Washington, 

DC: FDIC, 1997), http://www.fdic.gov/bank/historical/history. 

Chart 1 

Short-Term Cycles Are Evident

amid Larger Trends in Bank Lending

Note: Depository institutions include commercial banks, thrifts, and credit unions. 

Source: Federal Reserve Board (Flow of Funds). 

$0 

–$400 

–$200 

$200 

$400 

$600 

$800 

$1,000 

$1,200 

953 1957 1961 1965 1969 1973 1977 1981 1985 1989 1993 1997 2001 2005 

Net Change in Loans Outstanding by Depository Institutions 

(in billions of 2005 dollars) 

Recessions Five-year 

moving 

average 

Credit cycles can also be characterized by various measures of credit quality, such as delinquency rates and 

charge-off rates. Generally, these statistics can only 

be measured several years after the credit has been 

extended, because the borrower’s problems usually 

occur some time after the loan’s origination. Like 

credit growth, the metrics of credit cycle quality tend 

to be fairly well coordinated with the overall business 

cycle, as shown in Chart 2. Because companies and 

consumers have more trouble paying their debts when 

the economy is stagnant or in recession, loan performance tends to deteriorate during those periods. 

Chart 2 

Like Loan Growth, Loan Delinquencies and 

Charge-Offs Are Also Cyclical

Note: Data are for all commercial banks insured by the Federal Deposit Insurance 

Corporation, seasonally adjusted.

Source: Federal Reserve Board.

Loan Delinquency Rate

(percent)

Loan Charge-Off Rate

(percent)

0

2

3

4

5

6

7

8

1985 1988 1991 1994 1997 2000 2003 2006

0.00

0.25

0.50

0.75

1.00

1.25

1.50

1.75

2.00 Recessions

FDIC OUTLOOK 3 SUMMER 2006 
The Evolution of the Credit Cycle 

So, is the credit cycle merely a reflection of the general 

business cycle, or is it a phenomenon unto itself? 

Clearly, looking at quantity and ex-post quality measures, 

such as charge-offs, the credit cycle in recent decades 

has tracked the economic cycle fairly closely. However, 

many observers of the credit cycle throughout history 

believed that credit extension and contraction drive 

business activity, rather than the other way around. 

Credit cycles may not be just a contemporaneous 

response to economic conditions. They can reflect 

reductions in underwriting standards and other ex-ante 

measures of loan quality motivated by times of overoptimism, heightened competition, or narrowing net 

interest margins. Underwriting standards wax and wane, 

and banks sometimes take on more risk than they ordinarily would for a given level of compensation.3 

A better understanding of how underwriting standards 

change over time can benefit both bankers and their 

regulators. By the time loan performance deteriorates, 

it is often too late to salvage the credit, and the risk 

it poses to the institution is at its highest. Identifying 

emerging lending risks earlier by keeping a close eye 

on marketing practices and underwriting standards 

can help reduce future losses. 

Early Thoughts on the Credit Cycle 

Much of our understanding of how the credit cycle 

develops in terms of underwriting standards comes 

from its earliest theorists. Study of the credit cycle 

was particularly prominent in the 19th century, a time 

much more prone to violent economic fluctuations 

than today. Many contemporary commentators blamed 

the tendency for economies to boom and bust on 

credit cycles. In the words of economic historian 

David Laidler: 

It was not until the 1830s that it became widely recognized that financial crises were simply one repeating 

event in a cyclical pattern.... The name commonly 

given to that pattern, “the credit cycle” suggests that it 

3 Federal Reserve Governor Susan Bies noted that “banking supervisors are always worried that, in good times of rising loan growth and 

competition among bankers, more-aggressive underwriting may set 

the stage for future deterioration in credit quality.” Quoted from a 

speech by Susan Bies given at the American Bankers Association 

Chief Financial Officers Exchange Conference, Chicago, Illinois, 

June 7, 2005, and available at http://www.federalreserve.gov/ 

Boarddocs/Speeches/2005/20050607/default.htm. 

was regarded primarily as a phenomenon of organized 

financial and commodity markets.4 

The first theories of the credit cycle centered on the 

importance of speculation, not unlike the “irrational 

exuberance” theories of the late 1990s. Although many 

contradictory theories were proposed to explain how 

the cycle worked, one might simplify and group their 

advocates into “American theorists,” who focused on 

banks overextending credit, and “British theorists,” 

who focused on overborrowing by speculators. 

The American theorists, perhaps because of the rapid 

growth and fragmented nature of the 19th-century 

banking system, tended to blame banks for extending 

too much credit in good times and then tightening too 

much or too quickly when conditions turned bad. In 

1841, Albert Gallatin, who had been secretary of the 

Treasury under Thomas Jefferson, argued that “all 

active, enterprising, commercial countries are necessarily subject to commercial crises.... Those revolutions 

will be more frequent and greater in proportion to the 

spirit of enterprise and to the extension or abuse of 

credit.”5 Edmund Dwight argued in 1857 that panics 

are an inherent part of banking: “The law of interest is 

always urging [banks] towards the last point of expansion, and that of necessity and safety hurrying back to 

contraction.... The only recognized limit is danger ... 

and the mode of contraction, therefore, suits the cause; 

it is run for life.”6 Nineteenth-century economic downturns tended to be sudden and were often attributed to 

a lack of investor and creditor confidence, as opposed 

to downturns since the Great Depression, which have 

usually been preceded by other types of shocks, such as 

rising interest rates. Hence these earlier downturns, 

with their roots in financial markets, were usually 

called “panics,” whereas modern downturns are more 

often called “recessions” (see Table). 

A great deal of blame for these financial panics was 

placed on banks contracting credit, as “the banks were 

... accused of aggravating the panic [of 1857] by their 

policy of calling in loans both precipitately and indiscriminately.”7 The Great Depression, wrote a contem4 David Laidler, “Rules, Discretion and Financial Crises in Classical
 

and Neoclassical Monetary Economics,” Economic Issues 7 (part 2;
 

September 2002): 13.
 

5 Harry Miller, “Earlier Theories of Crises and Cycles in the United
 

States,” Quarterly Journal of Economics 38, no. 2 (1924).
 6 Ibid.
 

7 Samuel Rezneck, Business Depressions and Financial Panics:
 

Collected Essays in American Business and Economic History
 

(New York: Greenwood Press, 1969), 105.
 

FDIC OUTLOOK 4 SUMMER 2006 
Cycles of Thought 

Table 

Major Financial “Panics” of the 19th Century 

Name Cause 

Panic of 1819 The Second Bank of the United States, 

worried about land speculation, abruptly 

reined in lending, causing a six-year 

depression. 

Panic of 1837 The Specie Circular, under which the 

federal government would accept land 

payment only in gold and silver, helped 

start a run on banks and the failure of 

more than 800 of them. 

Panic of 1857 Failure of the New York City branch of Ohio 

Life Insurance and Trust Co. led to bank 

runs and widespread bankruptcies. 

Panic of 1873 Speculation in railroads led to the insolvency of Philadelphia bank Jay Cooke and 

Co. Eighty-nine of the nation’s 364 railroads 

went bankrupt. 

Panic of 1893 Controversy over the gold standard 

provoked “Industrial Black Friday” on the 

stock market. More than 500 banks and 

16,000 businesses failed. 

Source: Samuel Rezneck, Business Depressions and Financial Panics: Collected Essays 

in American Business and Economic History (New York: Greenwood Press, 1969). 

porary economist, was precipitated by excessive credit 

creation, particularly by selling goods on installment 

plans, a popular financial innovation of the time.8 

In contrast to their American peers, British theorists 

tended to blame speculative investors more than banks 

and particularly focused on the role of emotions and 

expectations in the credit cycle. The philosopher John 

Stuart Mill attributed cycles to “some accident which 

excites expectations of rising prices” among speculators 

with “a generally reckless and adventurous feeling.”9 

In his 1867 book entitled On Credit Cycles and the 

Origin of Commercial Panics, economist John Mills 

presented the first methodical explanation of investor 

psychology by using four terms to describe the phases of 

the cycle: activity, excitement, collapse, and depression. 

William Beveridge in 1909 claimed that expectations 

were the “single underlying” factor of cycles.10 Arthur 

8 Charles Persons, “Credit Expansion, 1920 to 1929, and Its Lessons,”
 

Quarterly Journal of Economics 45, no. 1 (1930): 94.
 9 John Stuart Mill, Principles of Political Economy with Some of Their
 

Applications to Social Philosophy, ed. William J. Ashley, 7th ed.
 

(London: Longmans, Green and Co., 1909), http://www.econlib.org/
 

library/Mill/mlP41.html#Bk.III,Ch.XII.
 

10 The New School for Social Research, “Psychological and Lead/Lag
 

Theories: The Anglo-American Tradition,” http://cepa.newschool.edu/
 

het/essays/cycle/psycho.htm.
 

Pigou claimed in 1927 that “the varying expectations 

of business men ... and not anything else, constitute 

the immediate and direct causes or antecedents of 

industrial fluctuations.”11 

The Increasing Sophistication of Credit Cycle 

Theories 

By the early 20th century, credit cycle theory had 

become more complex and refined, taking into account 

the effects of monetary policy and interest rates. Irving 

Fisher popularized the “quantity theory” of money, 

which states that inflation is caused by an increase in 

the money supply.12 Because interest rates and prices 

are “sticky” and rise more slowly than they should 

given the rate of money supply increase, investors have 

an incentive to borrow more, which increases asset 

prices. Once interest rates adjust to the correct level 

and borrowing slows, the value of the assets decreases, 

forming a credit cycle. Meanwhile, the Swedish economist Knut Wicksell emphasized the difference between 

the “real” (or “natural”) interest rate, which equalizes 

supply and demand in the market for goods and services, and the “money” interest rate, which refers to the 

interest rate in the capital markets.13 A money rate 

below the real rate will encourage overinvestment, 

which leads to rising prices, encouraging more investment. Wicksell called this the “cumulative process.” 

He also emphasized the role of banks in creating money 

through credit, arguing that rising investment leads to 

a higher money supply (as opposed to Fisher’s theory). 

In A Treatise on Money, John Maynard Keynes separated the concepts of saving and investment, defining 

the credit cycle as “the alternations of excess and defect 

in the cost of investment over the volume of saving 

and the accompanying see-saw in the purchasing power 

of money due to these alternations.”14 Attempts by 

businesses to invest more than is available through 

savings—because of technological innovation, overconfidence, or some other reason—will lead to higher 

output and prices in that sector. The initial increase 

will then spread and lead to higher levels of production 

11 Pigou as quoted in David Collard, “Pigou and Modern Business
 

Cycle Theory,” Economic Journal 106, no. 427 (1996): 916.
 12 Irving Fisher, “The Equation of Exchange,” American Economic
 

Review 1, no. 2 (June 1911): 296–305.
 13 Knut Wicksell, Lectures on Political Economy, vol. 2 (London:
 

Routledge & Kegan Paul, 1906).
 

14 John Maynard Keynes, A Treatise on Money (New York: Harcourt,
 

Brace, and Co., 1930), 277.
 

FDIC OUTLOOK 5 SUMMER 2006 
The Evolution of the Credit Cycle 

of all types of goods, as well as inflation. This “contains 

within it the seeds of a reaction,” as supply catches up 

with demand and prices return to normal.15 Thus, 

Keynes was firmly planted in the British tradition of 

associating credit cycles with speculating investors, 

coining the term “animal spirits” to refer to business 

confidence and its impact on the economic cycle. 

After the Keynesian revolution of the 1920s, 

academic interest in the credit cycle shifted to other 

explanations of economic fluctuations. An early 

example of this change in attitude was British economist R. G. Hawtrey’s writings in 1929 about the 

“trade cycle.” Acknowledging that “it was the credit 

cycle that attracted attention before the other 

phenomena of the trade cycle,” he argued that 

“that view is no longer universally accepted” and 

thought that monetary policy was more important.16 

The Modern View of the Credit Cycle and the 

Changing Nature of Regulation 

Interest in the credit cycle fell off dramatically during 

the middle of the 20th century. Economists turned their 

attention to building mathematical models that 

contained perfectly rational, profit-maximizing borrowers 

and lenders. Meanwhile, the U.S. financial system was 

heavily regulated, with legislative prohibitions effectively 

acting to dampen the pace of financial activity.

17 During 

this time, conservatively underwritten bank loans dominated both corporate and consumer financing options; it 

was the era of 20 percent down payments on houses and 

a free toaster with every new savings account. 

Toward the end of the century, however, the financial 

services market was substantially deregulated, leading to 

a wealth of new products and dramatically increased 

competition. The savings and loan crisis and localized 

banking problems during the 1980s and early 1990s were 

the first wide-scale disruptions in the financial sector 

since the Great Depression, although they might have 

looked familiar in some respects to people who lived in 

15 Ibid., 302.
 

16 R. G. Hawtrey, “London and the Trade Cycle,” American Economic
 

Review 19, no. 1 (March 1929): 70.
 17 The Banking Act of 1933, also known as the Glass-Steagall Act,
 

prohibited commercial banks from selling securities, created the
 

FDIC, and capped interest rates (implemented by the Federal
 

Reserve’s Regulation Q). It was partially repealed by the GrammLeach-Bliley Act in 1999.
 

the 19th century.18 The international financial system 

experienced another near-crisis in 1997 and 1998 with 

the successive financial collapses of several East Asian 

countries, a massive Russian debt default, and the abrupt 

demise of the large hedge fund Long-Term Capital 

Management. In some respects, these events resembled 

an old-fashioned financial panic as investors rushed to 

the safest, most liquid instruments available, culminating 

in a severe credit disruption. On the whole, however, 

there is evidence to suggest that deregulation has benefited the financial services industry, which accounted for 

approximately one-third of domestic corporate profits in 

the first half of this decade.19 Theoretical advances and 

more powerful information technology have enabled 

lenders to measure and price risk more accurately, while 

consumers have benefited from improved access to 

credit. In fact, household debt relative to gross domestic 

product (GDP) is at an all-time high of 90 percent.20 

Nonfarm, nonfinancial corporate debt has also risen, 

although at a slower pace (see Chart 3).21 

Do the regulatory changes in the banking industry over 

the past 25 years mean that 19th-century-style credit 

cycles are more likely to occur in the future? The empirical evidence does not yet firmly point one way or the 

other. Even if deregulation has increased volatility, financial innovation and the deepening of capital markets 

could help smooth credit availability compared with the 

experience of the 19th century. While banks emerged 

from the 2001 downturn with record levels of earnings 

and capital, some analysts argue that increased risk 

taking over the past few years on the part of all market 

participants may have simply prolonged an inevitable 

credit bust.22 Furthermore, different asset types may be 

18 For more information, see: FDIC, History of the Eighties. 19 Profits of the financial industry as a percentage of total domestic 

profits rose from an average of 19 percent in the 1970s and 17 percent 

in the 1980s to 25 percent in the 1990s and 35 percent since 2000 

(source: Bureau of Economic Analysis). 

20 Data as of fourth quarter 2005. Household debt is in excess of 100 

percent of personal income, which is the sum of individuals’ wages, 

salaries, rental income, and other types of income. 

21 FDIC regression analysis reveals that both of these ratios are 

increasing at a statistically significant rate. Household debt as a 

percentage of GDP is growing at a trend rate of approximately 0.8 

percent per year, and nonfinancial corporate debt relative to GDP 

is growing at a trend rate of approximately 0.4 percent per year. 

22 Mark Whitehouse, “Year-End Review of Markets & Finance 2005: 

Bonds’ Gravity-Defying Act,” Wall Street Journal, January 3, 2006. 

Whitehouse writes: “Believers in the idea that markets go through 

cycles of greed and fear ... find [current conditions] spooky. ‘I can’t 

tell you when, but it’s all going to end very badly,’ says Dan Vandivort, 

chief investment officer at Weiss, Peck & Greer Investments in New 

York. ‘That’s the way the credit cycle works.’” 

FDIC OUTLOOK 6 SUMMER 2006 
Cycles of Thought 

Chart 3 

Both Households and Corporations

Are Taking On More Debt

Sources: Federal Reserve Board; Bureau of Economic Analysis.

100

90

80

70

60

50

40

30

20

10

0

1952 1956 1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004

Debt as a Percentage of Gross Domestic Product

Households

Nonfarm,

nonfinancial

corporations

Recessions

subject to their own distinct credit cycles, as other articles in this FDIC Outlook explain. 

The economics profession has recently begun to 

reconsider the role of psychology and expectations in 

investment decisions. Recent research has found that 

underwriting standards, as measured by the Federal 

Reserve Board Senior Loan Officer Opinion Survey 

on Bank Lending Practices, are a better determinant 

of future business lending than either GDP or the 

federal funds rate.23 Similarly, analysis of a Federal 

Deposit Insurance Corporation survey of underwriting 

standards finds that underwriting standards are an 

important determinant of future loan losses.24 A 

modern theoretical response to this finding might be 

that credit markets are efficient and that loan officers, 

having just as good access to GDP and interest rate 

numbers as anyone else, should make decisions that 

incorporate all available information in a rational, 

profit-maximizing way. Another interpretation from a 

19th-century perspective might describe the easing 

and tightening of standards as the reflection of alternate swings between “greed and fear.”25 

23 Cara Lown and Donald P. Morgan, The Credit Cycle and the Business
 

Cycle: New Findings Using the Loan Officer Opinion Survey, Research
 

Report Series 27 (Stockholm: Swedish Institute for Financial Research,
 

2004).
 

24 John O’Keefe, Virginia Olin, and Christopher A. Richardson, “Bank
 

Loan Underwriting Practices: Can Examiners’ Risk Assessments
 

Contribute to Early-Warning Systems?” (Working Paper No. 2003-06,
 

FDIC, November 2003), http://www.fdic.gov/bank/analytical/working/
 

wp2003_06/index.html. 


25 See note 22 regarding the reference to “greed and fear.”
 

Finding the Balance between Risk Management 

and Market Innovation 

The “generally reckless and adventurous feeling” 

among borrowers and lenders that John Stuart Mill 

described a century and a half ago appears to play an 

important role in a dynamic economy. Shifts in 

investor sentiment were associated with extreme 

credit cycles in the 19th and early 20th centuries that 

contributed to periods of financial instability. While 

increased regulation in the middle years of the 20th 

century appears to have helped dampen these credit 

swings, this stability may well have been achieved at 

the cost of a less competitive and less dynamic banking industry. Over the past 20 years, as the financial 

services industry has operated in a more deregulated 

environment, credit markets may once again be 

demonstrating a tendency toward greater cyclicality. 

This rising variability in the credit environment 

places a greater premium on banks’ ability to measure 

and manage risks in order to minimize the fallout of 

adverse credit trends. 

Greater cyclicality creates both opportunities and 

challenges for market participants. Bankers have 

proven to be highly responsive to the changing needs 

of households and businesses, both by expanding the 

availability of credit to meet rising demand and by 

developing innovative products to meet new marketplace needs. However, they must remain aware that 

credit volume and quality are both unlikely to follow 

a continuous upward path. Bankers must manage their 

exposures and their lending policies with an eye 

toward what will happen when the cycle inevitably 

takes a turn for the worse. For their part, regulators 

must also recognize that the banking industry does not 

operate in a static credit environment. Their task is to 

define and enforce standards of safety and soundness 

and fair treatment of consumers consistently across 

both the highs and the lows of the credit cycle. In 

doing so, regulators must be careful not to needlessly 

stifle marketplace innovations that could benefit 

lenders and borrowers. For both bankers and regulators, achieving the sometimes difficult balance 

between optimism and caution is essential to maintaining financial stability throughout the credit cycle. 

Andrew Felton, Economic Analyst 

AnFelton@fdic.gov 

FDIC OUTLOOK 7 SUMMER 2006 
Outlook for C&I Credit Quality
 

The commercial and industrial (C&I) lending cycle 

is closely related to conditions in the business sector. 

During much of the 1990s, the volume of C&I loans 

outstanding at financial institutions insured by the 

Federal Deposit Insurance Corporation (FDIC) 

increased steadily as business financing needs for capital equipment, inventories, and acquisitions grew 

along with corporate profits. However, the corporate 

recession in 2001 led to 13 quarters of declining C&I 

loans on the books of the nation’s commercial banks 

and thrifts. After the recovery, corporate profits 

rebounded, but ample internal funds kept C&I loan 

demand at bay until 2004, when loan growth resumed. 

C&I credit quality trends are also linked to business 

conditions. During the mid-1990s, the C&I charge-off 

rate reached a trough as corporate profits soared. 

However, profits weakened considerably in the late 

1990s, causing a rise in C&I loan charge-off rates 

that did not peak until fourth quarter 2001.1 

Now C&I loans are growing, and credit quality seems 

to be as good as it gets. The question on the minds of 

bankers, regulators, and analysts alike is: When will 

the cycle start all over again? This article provides 

some insights that may help answer that question. 

C&I Lending Is Very Competitive When 

Demand Is High 

The external financing needs of U.S. businesses have 

been growing steadily over the past 20 years. In real 

(inflation-adjusted) terms, growth was interrupted 

only by the recessions of 1990 and 2001. Businesses 

borrow to finance a wide variety of needs, including 

capital equipment purchases, accounts receivables, 

acquisitions, and stock repurchases. When the economy is strong and business is expanding, the demand 

for financing is generally robust. As the economy 

slows and the outlook dims, businesses tend to pull 

back their expansion plans, which softens external 

financing demand. 

1 The C&I loan credit cycle is driven mostly by large banks. Consequently, the trends and developments discussed in this article primarily relate to large banks active in C&I lending. 

One gauge of business loan demand is the adjusted 

financing gap, which consists of business-sector capital 

spending plus net new equity issues less internal funds. 

In this equation, the component of net new equity 

issues is a proxy for the spending associated with 

acquisitions and stock repurchases.2 A rising adjusted 

financing gap suggests growing loan demand; 

conversely, a falling adjusted financing gap points to 

declining loan demand. During most of the 1990s 

when business was booming in the United States, 

the adjusted financing gap soared, and C&I loans 

outstanding grew to a peak of $1.1 trillion in fourth 

quarter 2000 (see Chart 1). By that time, however, 

real corporate profits had been sliding for a few years, 

and the 2001 recession was just around the corner. 

The result was about three years of falling C&I 

loans held by FDIC-insured institutions. 

Chart 1 

C&I Loan Volume Is Driven by Capital

Expenditures, Acquisitions, and Other Spending

Adjusted Financing Gap

(four-quarter moving average, dollars in billions)

C&I Loans Outstanding

(FDIC-insured institutions,

dollars in billions)

$135,000

$115,000

$95,000

$75,000

$55,000

$35,000

$15,000

–$5,000

$1,200

$1,000

$800

$600

$400

$200

$0 1985 1988 1991 1994 1997 2000 2003 2006

Note: C&I = commercial and industrial.

Sources: Federal Deposit Insurance Corporation; Federal Reserve Board.

The faltering business sector of the late 1990s through 

2001 only partly explains the declining C&I loan 

balances outstanding earlier this decade. Competition 

from other nonbank lenders, as well as corporate bond 

issuances, also led to lower market share for banks and 

thrifts. The period from 2001 to 2003 was marked by 

relatively poor C&I credit quality and tight underwriting standards that made other sources of financing 

2 Zoltan Pozsar, “Another Look at the U.S. Financing Gap,” Dismal 

Scientist, Moody’s Economy.com, February 14, 2006. 

FDIC OUTLOOK 8 SUMMER 2006 
C&I Credit Outlook 

more attractive.3 Indeed, nonbank competitors have 

become a fact of life in the C&I line of business. The 

increased appetite of these new players for commercial 

loans is evidenced by their growing participation in 

the Shared National Credit (SNC) Program.4 Nonbank lenders expanded their share of SNC commitments from 8 percent in 2001 to 13 percent in 2005. 

However, nonbank lenders seem to be targeting higherrisk credits than commercial banks. From 2001 through 

2005, adversely classified loans as a percentage of total 

commitments have been significantly higher for 

nonbanks than for banks—11.7 percent versus 1.6 

percent in 2005, for example.5 

The difficult competitive situation faced by commercial 

banks and thrifts vying for a piece of the C&I market is 

confirmed by the fact that, after adjusting for inflation, 

there was almost no growth in the secular trend for C&I 

outstanding loans from 1984 to 2005 (see Chart 2). 

However, there was a distinct positive trend for all 

credit market debt, other nonbank loans, and corporate 

bonds. From first quarter 1984 to fourth quarter 2005, 

the inflation-adjusted volume of C&I loans outstanding 

was up just 3.2 percent—essentially no growth. Other 

nonbank loans, however, increased 123 percent, while 

corporate bonds outstanding increased 242 percent. 

Overall, total credit market debt increased some 117 

percent during this period. 

Not only is the cycle for C&I loan volume oscillating 

around a fairly flat secular trend line, but its cycles are 

more pronounced than those of other forms of business 

debt. More marked volume cycles for C&I loans may 

be due to the fact that banks tend to tighten underwriting standards in response to growing credit problems, 

encouraging businesses to seek alternative sources of 

3 Bank underwriting standards during this period made it very difficult 

for companies—in particular, in industries like telecom and high 

tech—to obtain credit. In addition, many speculative-grade companies found the high-yield market very receptive. For example, the 

high-yield market required no covenants, and loans had longer terms 

than were available at banks. Once problem-loan levels dropped, 

banks started getting back into the deals, loosening covenants, 

lowering pricing, and competing for the business. 

4 The SNC Program provides a mechanism to efficiently and consistently review and classify large syndicated loans and loan commitments of at least $20 million that are shared by three or more financial 

institutions. 

5 Board of Governors of the Federal Reserve System, FDIC, Office of 

the Comptroller of the Currency, and Office of Thrift Supervision, 

“Data Show Continued Improvement in Credit Quality, Slight Increase 

in Credit Commitment Volume,” joint news release, September 15, 

2005, http://www.fdic.gov/news/news/press/2005/pr9105.html. 

Chart 2 

The C&I Loan Cycle Has Been Far More

Pronounced Than Other Business Debt

All Credit Market Debt lef axis)

Nonfarm, nonfinancial corporate business

C&I Loans (right axis)

FDIC-insured institutions

Other Nonbank Loans (right axis)

Nonfarm, nonfinacial corporate business Corporate Bonds (left axis)

Nonfarm, nonfinacial corporate business

$700

$600

$500

$400

$300

$200

$100

$0

$3,000

$2,500

$2,000

$1,500

$1,000

$500

$0

1984 1987 1990 1993 1996 1999 2002 2005

Note: C&I = commercial and industrial.

Sources: Federal Deposit Insurance Corporation; Federal Reserve Board.

(in billions of 1982 to 1984 dollars)

financing. Also, the regulatory environment for the 

various business lenders differs considerably. Banks may 

be more responsive to credit problems than nonbank 

lenders because of the bank supervisory process. 

C&I Credit Quality Reflects Business Conditions 

and Underwriting Standards 

Banks generally extend commercial loans based on the 

perceived ability of the borrower to repay the loan with 

interest in a timely manner after considering the 

borrower’s recent earnings history, current performance, 

and future prospects. When corporate profit weakens, 

it likely falls short of what was assumed in the loan 

underwriting process, increasing the chances of a 

delinquent loan payment and, ultimately, a charge-off. 

Conversely, when business conditions are healthy and 

corporate profits are rising, the business’s capacity to 

service its loans exceeds expectations, and the likelihood of credit problems declines. 

This pattern is borne out in the aggregate as well. Since 

1984, the C&I loan net charge-off rate has risen when 

real corporate profits declined and fallen when earnings 

were strong and rising (see Chart 3). Of course, there 

can be lags between when the profit trend turns and 

when C&I charge-offs respond to the change in conditions. For example, real corporate profits hit a low 

point in third quarter 2001, but it took a full four quarters for the C&I charge-off rate (four-quarter moving 

average) to reach its peak. Since that time, corporate 

profits have continued to rise, and the charge-off rate 

has tumbled to extremely low levels. 

FDIC OUTLOOK 9 SUMMER 2006 
The Evolution of the Credit Cycle 

Chart 3 Chart 4 

C&I Credit Quality Tends to Deteriorate as

Corporate Profits Weaken

2.5%

2.0%

1.5%

1.0%

0.5%

0.0%

Note: C&I = commercial and industrial.

Sources: Federal Deposit Insurance Corporation; Bureau of Economic Analysis.

1984 1987 1990 1993 1996 1999 2002 2005

C&I Loan Net Charge-Off Rate,

FDIC-Insured Institutions

(four-quarter moving average)

Real Corporate Profits after Tax

(seasonally adjusted annual rate,

in billions of 1982 to 1984 dollars)

$700

$600

$500

$400

$300

$200

$100

$0

Bank Charge-Offs Tend to Rise after Periods of

Loosening Credit Standards

Banks Tightening Standards 

for C&I Loans (net percent) 

C&I Loan Net Charge-Off Ratio, 

FDIC-Insured Institutions (percent) 

70 

60

50

40

30

20 

10

0

–10 

–20 

–30 

3.0 

2.5 

2.0 

1.5 

1.0 

0.5 

0.0 1991 1994 1997 2000 2003 2006 

Note: C&I = commercial and industrial.

Sources: Federal Deposit Insurance Corporation; Federal Reserve Board.

Another factor contributing to favorable C&I loan 

performance is that corporate balance sheets are the 

strongest they have been in a long time. In fact, it has 

been 20 years since the ratio of liabilities to net worth 

of nonfarm, nonfinancial corporate businesses was 

lower than it is today. 

Underwriting standards also play a crucial role in determining the incidence of C&I credit problems over 

time. It is likely that underwriting standards both react 

and contribute to changes in C&I loan charge-off rates. 

Based on responses to the quarterly Federal Reserve 

Board Senior Loan Officer Opinion Survey on Bank 

Lending Practices, bank underwriting standards seem 

to tighten as charge-off rates rise (see Chart 4). Banks 

clearly react to the elevated risk associated with rising 

charge-offs by raising their underwriting standards. This 

circumstance occurred in the late 1990s and in the 

early part of this decade, when real corporate profits 

waned and charge-offs began to soar. 

Many analysts believe that underwriting standards also 

have a strong influence on future bank loan quality.6 

Banks’ weak underwriting standards of today generally 

come back to haunt them tomorrow when the business 

cycle turns and corporate profits begin to flag. The last 

cycle demonstrated this condition clearly when C&I 

charge-offs surged after several years of relatively loose 

6 John O’Keefe, Virginia Olin, and Christopher A. Richardson, “Bank 

Loan-Underwriting Practices: Can Examiners’ Risk Assessments 

Contribute to Early-Warning Systems?” (Working Paper No. 2003–06, 

FDIC, November 2003), http://www.fdic.gov/bank/analytical/working/ 

wp2003_06/index.html; and Patrick Asea and S. Brock Blomberg, 

“Lending Cycles” (Working Paper No. 5951, National Bureau of 

Economic Research, March 1997). 

underwriting. Today, a strong economy combined with 

robust business conditions and fierce competition for 

commercial lending business has resulted in more than 

two years of relatively loose C&I underwriting. In fact, 

a recent study by Fitch Ratings found that in 2005, 

fewer covenants were applied to credit extended in the 

syndicated loan market.7 It is reasonable to expect that 

when the business environment sours in the future, 

many of the problem commercial loans that surface will 

be those made under the more relaxed underwriting 

standards of the past two years. 

Recent Innovations in C&I Lending 

In the years since the last recession, banks have 

changed the way credit risk is managed. New riskmanagement tools and financial market developments 

have helped banks monitor and control risk more 

effectively. Some of the more important developments 

include the adoption of improved risk-measurement 

tools, the rapid growth in the use of credit default 

swaps (CDS), the expanded secondary market, and 

the use of economic capital modeling. 

Improved Risk-Measurement Tools. Large-bank riskmeasurement tools have evolved into more objective, 

model-based control systems and away from using “expert 

judgment” to quantify risk. The proposed transition to 

Basel II capital standards has also provided some impetus 

for more transparent measurement techniques. For example, consider a scenario in which a bank has 22 distinct 

7 William May and Mariarosa Verde, “Loan Volumes Surge, Covenants 

Shrink in 2005,” Credit Market Research, Fitch Ratings, April 5, 2006. 

FDIC OUTLOOK 10 SUMMER 2006 
C&I Credit Outlook 

ratings bands, and analysts are spread across the country 

trying to grade each obligor accurately. The likelihood 

of error is high as each analyst attempts to differentiate 

“above-average” from “well-above-average” cash flow. 

In today’s system, banks have identified the key drivers 

that measure risk, and they set breakpoints to measure 

such factors as cash flow, leverage, liquidity, and 

company size. Grades are automatically selected based 

on the borrower’s financial data. Thus, the use of expert 

judgment is greatly reduced, yet still included to override the grading system when necessary. Overrides are 

then tracked to monitor the frequency and cause of 

each occurrence. Banks use this information to refine 

risk drivers and breakpoints further to reduce future 

overrides. The primary advantages of such a system are 

fewer errors in risk identification, more accurate riskbased capital calculations, and better support for determining the level of reserves maintained by the bank. 

Use of Credit Default Swaps. One of the risk-mitigation 

tools widely used today involves buying and selling CDS 

to manage risk. CDS protect buyers from loss following 

certain credit events. For example, if a borrower files for 

bankruptcy, the bank can exercise its right to exchange 

its loan with the CDS seller for par, thereby protecting 

the bank from loss on the notional amount. In return, 

the bank pays the seller an upfront fee as well as periodic payments to maintain the derivative protection. 

The CDS market has grown exponentially over the past 

few years, enabling banks to purchase protection on 

an ever-increasing volume of borrowers (see Chart 5). 

However, most positions actually are purchased on 

Chart 5 

U.S. Bank Credit Derivative Volume

Has Grown Rapidly in Recent Years

Source: Federal Deposit Insurance Corporation.

National Credit Derivative Volume at U.S. Banks

(in billions of dollars)

$7,000

$6,000

$5,000

$4,000

$3,000

$2,000

$1,000

$0

1997 1998 1999 2000 2001 2002 2003 2004 2005

investment-grade companies, rather than used to 

mitigate the deteriorating situation of subinvestmentgrade firms. In reality, once a credit situation begins 

to worsen, protection in the form of CDS usually 

becomes too expensive to be economically feasible. 

Banks also sell CDS, which effectively allows them to 

increase exposure to a particular company, industry, or 

geographic region without having to physically make 

the loan. In addition to CDS, derivative products can 

be sold as an index to increase credit risk on a more 

diverse position and help achieve a more optimal mix 

of assets. Selling protection also provides fee income to 

the bank without increasing assets. 

Expanded Secondary Market. Syndicated credit facilities 

now trade very actively in the secondary market 

compared with just five or six years ago. During the 

1990s, the secondary market was restricted primarily to 

large, investment-grade obligors. This market now has 

expanded to include many smaller companies. In addition, the type of credit trading ranges from investment 

grade to distressed debt, giving management more 

options to reduce positions, if necessary. If a satisfactory 

price can be obtained in the secondary market, the 

expense of purchasing a CDS becomes unnecessary. 

Most of the impetus for the expansion of the secondary 

market is the ever-increasing number of new players 

looking for this type of asset. Hedge funds, mutual 

funds, private equity firms, and other institutional 

investors make up most of the nonbank participants. 

The expansion of new investors has also prompted 

additional structuring of debt for the syndicated market. 

Deals now routinely contain a mix of revolver, term, 

and second-lien loans covering a variety of pricing. 

Agent banks have become quite adept at selling this 

paper on the secondary market. Many times, positions 

can be reduced to only the senior position or even 

completely eliminated to reap only the benefit of fee 

income. The mix of structures has fluctuated over time, 

depending on what the marketplace is seeking. This 

trend is expected to continue, with the product mix 

changing to meet market requirements. 

The development of the secondary market for commercial loans likely has amplified the competitive pressures 

faced by commercial banks and thrifts. However, it has 

also provided an effective mechanism for transferring 

risk to institutions willing to accept it. 

FDIC OUTLOOK 11 SUMMER 2006 
The Evolution of the Credit Cycle 

Economic Capital Modeling and Portfolio Diversification. 

The advent of economic capital modeling also has 

provided banks a more objective method of evaluating 

risk and return for any given asset or group of assets. 

Theoretically, the models should determine the level 

of capital necessary to support the risk taken on by the 

bank. Management can then use the results to set hold 

levels by product, industry, and geographic location to 

maximize diversity in the portfolio. Beyond these aggregate hold limits, management can then set individual 

hold limits on single-name exposures to maximize the 

return for the level of risk. The results should help 

banks reach an optimal mix of assets to produce the 

maximum return with the minimum risk. 

Risk-Management Innovations May Influence 

the C&I Credit Cycle 

New tools for measuring, managing, and transferring 

credit risk could lead to less-severe C&I credit cycles 

in the future, all other things being equal. During the 

2001 downturn, the growing secondary market for 

C&I loans and the relatively small, but emerging, use 

of CDS may have helped to moderate that cycle.8 

Thus, it is reasonable to expect that bankers’ ability 

to transfer risk and adjust exposures using CDS and 

the secondary market should result in lower peaks in 

charge-off and delinquency rates when the incidence 

of problem loans begins to climb. Conversely, one 

might expect shallower troughs in credit quality measures if banks can measure their risk more accurately, 

allowing them to achieve the best return given their 

risk tolerance. That is, when times are good, banks 

can seek higher-risk, higher-return investments with 

greater confidence because of their enhanced ability 

to generate accurate risk-return metrics. Nevertheless, 

the business world is dynamic, and new risks will 

emerge to test the skills of today’s risk managers. 

C&I Outlook Hinges on Future Business Conditions 

Commercial credit quality is not likely to improve 

much more during this cycle. The net charge-off rate 

stood at 0.22 percent in first quarter 2006, down from 

8 For example, William Bassett and Egon Zakrajsek pointed out that 

during the 2001 downturn, a number of banks sold distressed C&I 

loans in the secondary market, allowing them to accelerate chargeoffs and reduce delinquencies. See: William F. Bassett and Egon 

Zakrajsek, “Recent Developments in Business Lending by Commercial 

Banks,” Federal Reserve Bulletin, December 2003. 

0.28 percent a year earlier and a peak of 2.37 percent 

in fourth quarter 2001. The percentage of noncurrent 

C&I loans has followed a similar pattern: In third 

quarter 2002, the percentage of noncurrent C&I loans 

peaked at just under 3 percent, falling every quarter 

until reaching 0.70 percent in first quarter 2006.9 

If the C&I charge-off rate is, indeed, at the beginning 

of a trough, how long will the trough continue, and 

when will commercial loan charge-offs begin a decisive 

trend upward? The answers to these questions lie in 

the outlook for the economy and the business sector. 

Indeed, higher interest rates and high, volatile energy 

prices form a cloud of uncertainty on the horizon. The 

consensus forecast of Blue Chip Economic Indicators 

predicts that the U.S. economy will grow steadily at 

about 3 percent through the end of 2007. It also is forecasting sharply lower growth in real corporate profits in 

2007 (see Chart 6). These projections suggest continued low charge-off rates that may extend through 

2007, although a gradual upward drift is possible. 

Another approach to assessing the outlook for the C&I 

charge-off rate is to look at Moody’s forecast for the 

global speculative-grade corporate bond issuer default 

rate (speculative bond default rate).10 Indeed, the C&I 

loan net charge-off rate appears to be highly correlated 

to the speculative bond default rate (see Chart 7). 

Moody’s is forecasting the speculative bond default rate 

to increase from 1.7 percent in March 2006 to about 

2.7 percent in March 2007, which supports the notion 

that the C&I default rate may drift upward somewhat 

over the next couple of years. But, most important, 

C&I loan quality is likely to remain fairly strong 

through 2007, barring an unexpected economic shock 

that pulls the economy and the nation’s business sector 

into either a recession or a much slower growth path. 

Conclusion 

The C&I credit cycle is closely associated with developments in the U.S. business sector. Based on the 

current outlook, C&I charge-offs and other measures 

of loan performance problems are likely near their low 

points for the cycle. An appreciable, sustained improvement in C&I loan quality is not expected. Conversely, 

9 This article has focused on the C&I charge-off rate as a measure
 

of credit quality. The percentage of noncurrent C&I loans generally
 

follows a pattern similar to that of charge-offs.
 

10 Moody’s, “Moody’s Monthly Default Report,” Default Research,
 

http://www.moodys.com. 


FDIC OUTLOOK 12 SUMMER 2006 
C&I Credit Outlook 

Chart 6 Chart 7 

Real Corporate Profits Are

Projected to Flatten Out in 2007

Note: C&I = commercial and industrial.

Sources: Bureau of Economic Analysis; Blue Chip Economic Indicators.

Corporate Profits after Tax

(in billions of 1982 to 1984 dollars)

$600

$500

$400

$300

$200

$100

$0 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Blue Chip

Economic Indicators’

Consensus Forecast

The C&I Charge-Off Rate Is Likely to Begin 

a Gradual Ascent in 2006 

Note: C&I = commercial and industrial.

Sources: Federal Deposit Insurance Corporation; Moody’s Investor Service.

C&I Net Charge-Off Rate, 

FDIC-Insured Institutions 

Global Speculative-Grade 

Corporate Bond Issuer Default Rate 

3.0% 

2.5% 

2.0% 

1.5% 

1.0% 

0.5% 

0.0% 

14% 

12% 

10% 

8%

6%

4%

2%

0%

984 1987 1990 1993 1996 1999 2002 2005 

Moody’s Forecast 

although charge-off rates may rise gradually over the 

next year or so, steady economic growth and healthy 

corporate profits suggest that no decisive increase is 

likely in the near term. 

The consequences of the current aggressive underwriting will not be known until the next market downturn. 

When that time comes, will the new nonbank participants continue to provide liquidity to the secondary 

market? Will spreads on CDS remain affordable 

enough that lenders can use them effectively for risk 

mitigation? Regardless of the recent advances in riskmanagement techniques, banks must remain vigilant 

in controlling risk. The next downturn will likely 

differ somewhat from those of the past, introducing 

its own unique circumstances and spawning a new set 

of risk-management tools for the future. 

Stephen C. Gabriel, Senior Financial Economist 

SGabriel@fdic.gov 

Mark D. Sheely, Examination Specialist, 

FDIC Division of Supervision and Consumer Protection 

MSheely@fdic.gov 

FDIC OUTLOOK 13 SUMMER 2006 
 

CRE Credit Expansion Raises Portfolio
 

Concentrations
 

Commercial real estate (CRE) lending has come to be 

recognized as a highly cyclical business.1 Waves of 

construction and growth in credit to support CRE 

investment often have been followed by gluts of 

commercial space, rising vacancies, and sometimes 

severe credit problems arising from the sector. During 

the last broad CRE credit cycle, collapsing property 

values in the southwestern United States and New 

England contributed to many of the more than 2,000 

failures of institutions insured by the Federal Deposit 

Insurance Corporation (FDIC) that occurred between 

1980 and 1993.2 From this experience, one could make 

the case that CRE and construction and development 

(C&D) lending are among the riskiest of asset classes 

over the complete cycle. 

Much has changed since the last broad CRE credit 

cycle. The volatility of the cycle may have been 

dampened by more and better structures to bring capital market financing to CRE, including commercial 

mortgage-backed securities (CMBS) and real estate 

investment trusts (REITs), better market data available 

to all participants, and relatively improved underwriting standards.3 However, FDIC-insured institutions 

continue to face risks related to the CRE credit cycle. 

CRE loan concentrations at FDIC-insured financial 

institutions now exceed levels seen in the last cycle. 

With so much at stake, it is important to understand 

the nature and stages of the CRE credit cycle. This 

article describes the unique attributes of the CRE 

credit cycle, looks at how the cycle has evolved over 

time, and examines the nature of the current CRE 

credit cycle, which started in the mid-1990s. 

1 For purposes of this analysis, CRE loans include nonfarm nonresidential real estate loans, multifamily housing loans, and construction and 

development (C&D) loans. Complicating this analysis somewhat is the 

fact that C&D loans as reported in regulatory reports include loans 

made for both residential and commercial property construction. 

2 For more information, see: James Freund et al., “Commercial Real 

Estate Crises of the 1980s and Early 1990s,” in History of the 

Eighties—Lessons for the Future (Washington, DC: FDIC, 1997), 

http://www.fdic.gov/bank/historical/history/137_165.pdf. 3 A REIT is a company that owns and usually manages CRE properties. 

To qualify as a REIT, a company must pay at least 90 percent of its 

taxable income to its shareholders every year, have at least 100 shareholders, invest at least 75 percent of its total assets in real estate, and 

derive at least 75 percent of its income from rent or mortgage interest 

from properties in its portfolio. 

A Theory of CRE Credit Cycles 

In one of the earliest characterizations of the U.S. CRE 

cycle, Homer Hoyt described a lack of transparency 

contributing to overbuilding when he chronicled 

changes in Chicago land values over a 100-year period 

ending in 1933: 

A great many men worked secretly and independently 

on a great variety of structures in many sections of the 

city. There was no central clearing house to correlate 

the impending supply of buildings with the probable 

demand, so that when all these plans came to fruition, 

an astonishing number of new structures had been 

erected.4 

Hoyt described four phases of the U.S. real estate 

cycle.5 In the first phase, expansion occurs at the beginning of a CRE cycle when improving business conditions and increasing corporate profits prompt the hiring 

of new workers and an increased demand for CRE 

space. The second phase occurs as more workers fill 

available space, vacancy rates fall, rents rise, and the 

remaining space is offered at higher prices. The third 

phase is characterized by declining vacancies and rising 

rents placing upward pressure on property values, which 

signals developers that constructing new CRE supply 

would be profitable. In turn, new construction begins 

but reaches completion only after the lengthy time 

inherent in CRE product development. In the fourth 

and final phase, new construction continues until 

supply exceeds demand, and the resulting oversupply 

leads to rising vacancies, falling rents, and lower property values. As has been the case with a number 

of U.S. CRE cycles since Hoyt’s theory was published, 

builders’ incentives to halt construction occur only 

after the new supply exceeds demand and the profit 

4 Homer Hoyt, One Hundred Years of Land Values in Chicago, 1830– 

1933 (Chicago: University of Chicago Press, 1933). Hoyt’s book chronicles five real estate cycles that occurred in the 100-year period during 

which the population of Chicago grew from only a few hundred to 

more than 3.5 million. At the same time, land values increased from a 

few thousand dollars to more than $5 billion. 

5 Ibid. Hoyt’s original descriptions are retained, but expanded upon, in 

this framework. Hoyt examined the period between 1830 and 1933 and 

identified five boom periods and six troughs, or bust periods. He noted 

that property values varied from 80 percent below to more than 456 

percent above what he deemed “normal” prices during the 100 years, 

and that business troughs lasted nearly twice as long as the peaks. 

FDIC OUTLOOK 14 SUMMER 2006 
 

 

 

CRE Credit Expansion 

potential disappears.6 The severity of the bust phase of 

the CRE credit cycle can be measured by the extent of 

the increase in vacancies, decline in rents, deterioration 

in property prices, and increase in CRE loan defaults.7 

Cycles in CRE lending are tied to the nature of the real 

estate business. First, CRE cycles are often productspecific. Demand for commercial space is not uniform 

across the five major CRE property types (office, industrial, retail, hotel and motel, and multifamily); one 

sector may be hot while others are retrenching. Second, 

CRE cycles tend to be local. Although there are 

national elements that relate to the business cycle and 

to interest rates, the broader national trends are 

distinctly punctuated by regional booms and busts.8 

The most obvious recent examples were the 

pronounced boom-and-bust cycles of the southwestern 

United States and New England, much of which was 

attributable to local factors.9 

Past Evidence of CRE Credit Cycles 

CRE cycles are certainly influenced by standard business cycles, but they tend to be longer than other types 

of credit cycles. The reason is that CRE loans are 

subject to considerable delays in the process of bringing 

underlying properties to market. It may be several years 

from the time that a project is approved and funded to 

the time the new property is ready for occupancy. 

The 1970s CRE credit cycle had a construction boom 

in the early part of the decade that was fueled by 

increased capital flows from mortgage REITs. According to Mueller, the office market crash in the mid1970s followed from the recession of 1974 and the 

slowdown in employment growth.10 In the aftermath, 

vacant properties were foreclosed on, construction 

6 For additional research on CRE cycles, see: Stephen Pyhrr, Stephen
 

Roulac, and Waldo Born, “Real Estate Cycles and Their Strategic
 

Implications for Investors and Portfolio Managers in the Global
 

Economy,” Journal of Real Estate Research 18, no. 1 (1999). 
 7 A CRE credit cycle features involvement by financial intermediaries,
 

such as insurance and pension companies and banks, in providing
 

capital for CRE loans. The repayment of CRE loans comes from either
 

the property rental income or sale of the building.
 

8 For a more in-depth discussion of the unique property cycles of U.S.
 

cities, see: R. G. Witten, “Riding the Real Estate Cycle,” Real Estate
 

Today, 1987. 
 9 For more information, see: Freund, “Commercial Real Estate Crises,”
 

in History of the Eighties.
 

10 Glenn R. Mueller, “What Will the Next Real Estate Cycle Look Like?”
 

Journal of Real Estate Portfolio Management 8, no. 2 (2002).
 

loans defaulted and never converted to permanent 

loan status, and the nascent mortgage REIT industry 

retrenched as REIT market capitalization shrunk from 

more than $10 billion at the beginning of the 1970s to 

about $2 billion in 1975.11 

The expansion, or boom, phase of the next CRE cycle 

began in the early 1980s. The deceleration (bust) phase 

started in the late 1980s and continued for a number of 

years. Several external events exaggerated the boom 

and the bust phases. For example, tax law changes in 

the early 1980s, along with new regulations that 

expanded the CRE lending powers of savings institutions, fueled and funded the heightened investor 

demand for CRE properties.12 Because net returns on 

CRE investments exceeded those of other asset classes, 

investor demand for CRE intensified. Another factor 

was that additional regulatory changes implemented in 

1982 enabled thrifts (but not banks) to take a small 

ownership share, and therefore participate, in any 

upside potential from their CRE investments.13 

From 1983 to 1985, savings institutions increased CRE 

holdings by $16 billion per year, compared to $4 billion 

per year in the previous six years.14 Heightened competition for CRE credits contributed to a loosening of 

underwriting standards—debt coverage levels were 

relaxed, and low (or zero) borrower equity in speculative CRE projects became commonplace. Poor and 

often overly optimistic appraisals also contributed to a 

brewing storm.15 

Also during this time, CRE investors relied on substantial federal tax write-offs to sustain the profitability of 

“passive” CRE investments; the boom was driven in 

part by investors’ expectations that this tax shelter 

would continue. The 1986 Tax Reform Act limited 

deductions for losses from passive investments, making 

many CRE investments unprofitable. The oversupply 

of CRE properties that had developed during the 

previous several years began to correct quickly. As a 

result, CRE vacancies rose, rents fell, and property 

11 Ibid. Mueller states that the mortgage REITs were created by
 

commercial banks to bypass regulatory restrictions on real estate
 

project investments. 


12 For more information, including details on the tax, legislative, and
 

regulatory changes, see: Freund, “Commercial Real Estate,” in History
 

of the Eighties.
 

13 Ibid., 178.
 

14 Ron Donohue, “Fund Flows and Commercial Real Estate Investment:
 

Evidence from the Commercial Mortgage Market,” Journal of Real
 

Estate Research, October–December 2004.
 15 Freund, “Commercial Real Estate,” in History of the Eighties, 157.
 

FDIC OUTLOOK 15 SUMMER 2006 
The Evolution of the Credit Cycle 

prices declined quickly.16 The CRE credit cycle 

remained in this bust, or trough, phase for several 

years, and during this time, more than 2,500 federally 

insured banks and thrifts failed.17 

In response to the significant number of federally 

insured institution failures during the last CRE credit 

cycle, Congress passed the Financial Institutions 

Reform, Recovery and Enforcement Act of 1989.18 This 

law restricted thrift lending powers and subjected federally insured institutions to closer supervisory scrutiny. 

Also, new capital standards were being phased in at 

this time that forced institutions to increase ratios of 

capital to risk-weighted assets either by raising capital 

or reducing assets with higher risk weights, such as CRE 

loans. In the early 1990s, federally insured institutions 

began to reduce their CRE loan exposure and increase 

Treasury holdings.19 The new capital requirements 

contributed to less liquidity in CRE markets as federally 

insured institutions scaled back CRE lending. 

The Current Cycle Has Benefited from 

CMBS Growth 

In response to the limited liquidity at the end of the 

last cycle, a new financial intermediary has gained 

prominence: commercial mortgage-backed securities.20 

The CMBS share of outstanding CRE loans grew from 

5 percent to 18 percent between 1994 and 2004 (see 

Chart 1).21 This sector was jump-started by the Resolution Trust Corporation (RTC), the government agency 

charged with disposing of the nonperforming assets 

of failed thrifts from the last cycle. Selling loans individually would have exerted further downward pressure 

16 According to the National Council of Real Estate Investment Fiduciaries, the value of different CRE property types declined at varying 

rates, with office buildings dropping in value by almost 57 percent. 

17 Not all of the federally insured institution failures were directly 

attributable to the CRE cycle, as many occurred in combination with 

fraud and poor risk management practices. For more information, 

see: “Scenarios for the Next U.S. Recession,” FYI, FDIC, March 23, 

2006, http://www.fdic.gov/bank/analytical/fyi/2006/032306fyi.html. 18 The text of the Financial Institutions Reform, Recovery and Enforcement Act of 1989 is available at http://www.fdic.gov/regulations/ 

laws/important/. 

19 For FDIC-insured institutions, annual CRE loan growth in 1991 and 

1992 fell by -2 percent and -3 percent, respectively, while U.S. Treasuries held by these institutions increased by 31 percent and 24 

percent in the same periods. 

20 CMBS existed for some time before the early 1990s, but their importance as financial intermediaries grew at the end of the last cycle. 

21 Many FDIC-insured institutions now serve as “conduits” to the CMBS 

market; the incentive is the fee income generated by the transaction. 

Chart 1 

The Growing CMBS Market Improved

Transparency in CRE Lending

Note: CRE = commercial real estate, CMBS = commercial mortgage-backed securities.

Sources: Capital Trust; Federal Deposit Insurance Corporation.

Total U.S. CRE Debt, 1994: $952 Billion Total U.S. CRE Debt, 2004: $2.3 Trillion 

CMBS 

5% 

Agency/ 

Government 

Pools and 

Other

22% 

Life 

Insurance 

Companies

21% Banks and 

Savings and

Loans

52% 

CMBS 

18% 

Agency/ 

Government 

Pools and Other 

20% 

Life Insurance 

Companies

11% 

Banks and 

Savings and

Loans

51% 

on prices. The solution was for the RTC to bundle 

whole loans into a package (a security) and sell shares 

(tranches) of the security to investors, with repayment 

priorities matching their risk appetites.22 

The CMBS vehicle worked well for the RTC and helped 

to restore liquidity to the strained CRE markets. In addition, “commoditization” of CRE loans occurred, because 

CRE loans earmarked for CMBS pools must be more 

uniformly underwritten to specific maturities, terms, and 

conditions to be eligible for placement in the security 

pool. Investors in CMBS pools, along with FDIC-insured 

institutions and the CRE industry, benefited from 

enhanced disclosures required for the underlying investments. As a result, the transparency that was lacking 

in Hoyt’s CRE cycle became more readily available.23 

As a liquidity provider, the CMBS market helped 

substitute for bank and thrift lending on CRE projects 

until bank and thrift lending momentum returned in 

the mid-1990s. Then in 1998, the scenario was reversed 

after a series of financial crises caused liquidity in the 

CMBS market to vanish. CMBS were shunned when 

U.S. investors responded with a “flight to quality” after 

the Asian currency crisis in 1997, the collapse of LongTerm Capital Management, and Russia’s default on its 

foreign debt in 1998. Consequently, the liquidity in the 

U.S. public capital markets “dried up,” and many 

22 Development of CMBS was an extension of the practice in which
 

residential mortgage securities were already being offered to
 

investors.
 

23 For more information on the development of the CMBS market,
 

see: Thomas Murray, “The Changing Paradigm in Commercial Real
 

Estate,” FYI, FDIC, October 28, 2003, http://www.fdic.gov/bank/
 

analytical/fyi/2003/102803fyi.html.
 

FDIC OUTLOOK 16 SUMMER 2006 
CRE Credit Expansion 

CMBS originators were left holding millions of dollars 

of CRE loans with no buyers. Nomura Securities folded 

most of its U.S. CMBS operations in 1998 for some 

time after losing almost $1 billion, and Criimi Mae, a 

provider and servicer of CMBS, filed for bankruptcy 

protection.24 

FDIC-insured institutions then accelerated CRE lending, effectively filling in some of the funding gap left 

by the retreat of the public markets.25 In characterizing 

these events, then-Federal Reserve Board Chairman 

Alan Greenspan referred to the “spare tire” effect that 

efficient financial markets possess. He noted that when 

public capital markets and FDIC-insured institutions 

can substitute for each other, recessions can be shortened and liquidity problems can be averted.26 

In addition to CMBS, REITs have returned to favor 

since the last CRE cycle. REIT market capitalization has 

expanded rapidly, from $44.3 billion in 1994 to $330.7 

billion at year-end 2005.27 Similar to the CMBS market, 

REITs provide funding for CRE projects. In addition, 

because of the public ownership of most REITs, an 

increased availability of market data enhances transparency, which facilitates the early identification of 

any supply-and-demand imbalances. REITs have been 

a favored investment class because of their superior 

returns over the past several years (see Chart 2). 

The increased transparency and liquidity associated with 

REITs and CMBS have benefited the CRE credit cycle 

and possibly contributed to a dampening in the cycle’s 

volatility. For instance, during the current CRE credit 

cycle and the business cycle of the past several years, 

FDIC-insured institutions have not suffered significant 

losses on CRE loans even though they did sustain losses 

on traditional business loans (see Chart 3).28 Further, 

24 Michael Siconolfi, “Nomura Hit by U.S. Loss of $1 Billion—Fiasco in 

Real Estate Spurs Unit’s Overhaul,” Wall Street Journal, October 20, 

1998. 

25 CRE lending at FDIC-insured institutions grew from 9.4 percent in 

1997 to 10.5 and 16.5 percent in 1998 and 1999, respectively. 

26 Alan Greenspan, “Do Efficient Financial Markets Mitigate Financial 

Crises?” (speech, Financial Markets Conference of the Federal 

Reserve Bank of Atlanta, Sea Island, Georgia, October 19, 1999), 

www.federalreserve.gov/boarddocs/Speeches/1999/19991019.htm. 27 According to data from the National Association of Real Estate 

Investment Trusts. 28 To the degree that loan losses have been avoided and property 

prices have only accelerated during this cycle, the price volatility in 

the down stage of the cycle may have been dampened. The earlier 

stage of oversupply (or contraction of demand) resulted in two of the 

four components that typically occur during the down stage of the 

CRE credit cycle—rising vacancies and falling rents. 

Chart 2 

nvestor Preference for CRE Has Been

Strongly Influenced by Its Superior Returns

Notes: Data are as of year-end except for 2006, which is as of first quarter. CRE = commercial

real estate, NAREIT = National Association of Real Estate Investment Trusts.

Sources: Federal Deposit Insurance Corporation, NAREIT, Merrill Lynch,

and Standard & Poor’s.

Annual Total End-of-Period Returns

(percent)

40

30

20

10

0

–10

–20

–30 2000 2001 2002 2003 2004 2005 2006

NAREIT

Composite

Index

Merrill Lynch

Corporate Bond

Index

S&P

500

Chart 3 

CRE Losses Barely Rose

in the Most Recent Cycle

Notes: Data are as of year-end. CRE (commercial real estate) includes construction and 

development, nonfarm nonresidential, and multifamily loans.

Source: Federal Deposit Insurance Corporation.

Median Charge-Off

(percent)

2

1.8

1.6

1.4

1.2

0.8

0.6

0.4

0.2

0 1991 1993 1995 1997 1999 2001 2003 2005

Commercial and

Industrial Loans

CRE Loans

the “tech collapse” in 2000 and the recession of 2001 

caused rapid deterioration in CRE fundamentals, with 

vacancies up and rents down. However, despite weakened fundamentals, CRE loan performance among 

FDIC-insured institutions was, and remains, strong. In 

addition, a favorable interest rate environment enabled 

landlords to remain current on mortgage payments and 

helped sustain investor demand for CRE products. 

Market Fundamentals Are Improving, 

but Risks Remain 

CRE lending can be very profitable for banks. Interest 

rates on CRE loans are often higher than those on 

other, more commoditized asset classes. In addition, 

many of these credits, particularly C&D loans, charge 

upfront fee income as well as periodic interest. Also, 

FDIC OUTLOOK 17 SUMMER 2006 
The Evolution of the Credit Cycle 

the strong local component of CRE markets can 

frequently give smaller, community institutions an 

advantage in making CRE loans. Small and mid-size 

institutions frequently can use their local knowledge 

to effectively compete with larger institutions that 

may not be as attuned to local conditions in this line 

of business.29 But this higher potential for profitability 

may come with a higher risk of loss. In 1991, following 

the significant loan portfolio expansion of the 1980s, 

the ratio of noncurrent CRE loans to total CRE loans 

was 8.2 percent; the ratio of all nonperforming loans 

to total loans was 5.2 percent.30 

Today, FDIC-insured financial institutions are exhibiting strong performance. The number of FDIC-insured 

problem institutions (those rated “4” or “5”) in the 

current CRE credit cycle has fallen to historical lows, 

and the banking industry’s ability to absorb losses is 

strong as capital levels remain historically high. 

However, much of that capital is allocated to increasing 

levels of CRE loans. FDIC-insured institutions now 

have CRE concentrations in excess of levels during the 

last CRE cycle of the late 1980s and early 1990s (see 

Chart 4, next page). In addition, robust growth in 

FDIC-insured institution C&D lending is exceeding 

prior peaks, with annual growth levels of 35 percent and 

36 percent for year-end 2005 and first quarter 2006, 

respectively. 

Sound underwriting standards can mitigate some of 

this concentration risk. However, according to each 

quarterly Federal Reserve Board Senior Loan Officer 

Opinion Survey on Bank Lending Practices between 

January 2004 and July 2005, underwriting standards 

have eased, although they are still improved from 

the last cycle. Examples of considerable loosening 

in CRE terms from the January 2006 survey include 

reductions in loan rate spreads over the cost of funds, 

increases in loan volume ceilings, and higher loanto-value ratios and maximum loan maturities.31 The 

April 2006 survey reported no net changes in CRE loan 

underwriting standards from the prior survey. 

29 From 1985 through 2003, community banks significantly increased 

their nonfarm nonresidential real estate lending as a percentage of 

their assets, from 5.9 percent to 15.2 percent. For the same group, C&D 

loans increased from 3.3 percent to 5.2 percent of total assets. For 

more information, see: Tim Critchfield et al., “The Future of Banking in 

America—Community Banks: Their Recent Past, Current Performance, 

and Future Prospects,” FDIC Banking Review 16, nos. 3 and 4 (2004), 

http://www.fdic.gov/bank/analytical/banking/2005jan/article1.html. 30 Freund, “Commercial Real Estate,” in History of the Eighties, 157. 31 Results of the Federal Reserve Board Senior Loan Officer Opinion 

Survey are available at http://www.federalreserve.gov/boarddocs/ 

snloansurvey/. 

Record low short-term interest rates during the past 

several years benefited the net cash flows of many 

CRE property landlords, as lower debt expenses offset 

declining rents. However, going forward, owners will 

have to address the effects of rising energy and insurance costs and taxes. In addition, landlords who have 

not locked in fixed rates or who need to refinance 

will have to stretch rental receipts to cover climbing 

costs of debt service in a rising-rate environment. With 

slowly improving CRE rents, a critical situation could 

occur if interest rates rise so high or so quickly that 

borrower cash flow cannot cover the increasingly expensive cost of debt. 

Even though CRE fundamentals are only beginning to 

improve in many markets, the average price per square 

foot for U.S. office properties increased almost 24 

percent between first quarter 2002 and year-end 2005. 

However, during the same period, the average office 

rent fell 10 percent. With falling rents and increasing 

sales prices, it is not surprising that average capitalization rates declined from 9 percent to 6.7 percent.32 

Buyers are willing to accept lower rates of return when 

overall interest rates are low. However, when capitalization rates are this low, should interest rates rise rapidly 

or to a relatively high level, properties could develop 

negative leverage—that is, borrowers would owe more for 

the loan than cash flow provides.33 

Moody’s Investors Service has raised concerns over 

falling debt service coverage and rising loan-to-value 

ratios in commercial mortgages underwritten in the past 

several years. It also points to a number of high-quality 

borrowers who have exercised “default options” inherent 

32 Office sales price changes and capitalization rates are derived 

from Real Capital Analytics data as of April 2006. Office rent data 

are based on information from Torto Wheaton Research. 33 For more information on current CRE risks, see: Joseph V. Rizzi, 

“Managing the Credit Cycle: A Behavioral Risk Interpretation,” 

Commercial Lending Review, January–February 2006. According to 

Rizzi, managing director at ABN AMRO Bank: “Weak risk management is masked during economic good times. We are in a benign 

credit environment characterized by low interest rates, tight spreads, 

excess liquidity and limited defaults. Markets in general and credit 

markets in particular are cyclical. Procyclical risk appetite and feedback loops underlie credit cycles. As risk appetite increases, credit 

extension expands. Investors use the increased debt capacity to 

bid asset prices higher. The higher asset prices increase collateral 

values, which supports additional credit expansion creating a virtuous credit circle with increasing liquidity. A tipping point or event 

can, however, prompt investors to adjust simultaneously their positions triggering a decline in asset prices. [The] decline can trigger a 

vicious circle leading to reduced collateral values, curtailed credit, 

declining investor demand, falling asset prices and reduced liquidity.” 

FDIC OUTLOOK 18 SUMMER 2006 
CRE Credit Expansion 

in their nonrecourse loans.34 Nonrecourse loans were 

prevalent in the last cycle, and this loan type, along 

with recourse loans with high loan-to-value ratios 

(minimal borrower equity), fail to “incentivize” borrowers to protect the underlying security. 

On a positive note, enhanced transparency during the 

current cycle has helped to reduce speculation by calling 

attention to speculation early on. Among CRE property 

types, significant speculative construction activity has 

been mostly limited to the condominium conversion 

market (see inset box, “Speculation in This Cycle Has 

Been Mostly Constrained to Condominiums,” next 

page). 

Regulators Respond to Elevated CRE Concentrations 

with Proposed Interagency Guidance 

In response to concern about the effects of higher CRE 

loan concentrations on FDIC-insured institutions, the 

FDIC, Office of the Comptroller of the Currency, Board 

of Governors of the Federal Reserve System, and Office 

of Thrift Supervision issued proposed interagency guidance for public comment in January 2006. The proposal 

states that institutions holding higher CRE concentrations (above 100 percent for the ratio of C&D loans to 

capital and above 300 percent for CRE loans to capital) 

are expected to have commensurate risk-management 

practices in place and maintain appropriate capital 

levels. The guidance reiterates best practices guidelines, 

and the regulators emphasize that the proposed guidance 

does not establish limits on individual institution CRE 

lending.35 

Comments received by the regulatory agencies indicate 

that many FDIC-insured institutions believe that they 

are adequately monitoring risks in their CRE portfolios. 

In addition, comments indicate that any increase in 

capital contributions could limit institutions’ abilities 

to make CRE loans and hurt local communities. Some 

comments state that CRE lending is one of the few 

remaining profitable areas available to smaller community institutions as they compete with larger banks.36 

34 Tad Phillip, Pamela Dent, and Paolo Obias, “U.S. CMBS and CRE 

CDO 1Q 2006 Review: Commercial Mortgage Finance Enters Uncharted 

Territory,” Structured Finance Special Report, Moody’s Investors 

Service, April 25, 2006. 

35 The proposed interagency guidance is available at 

http://www.fdic.gov/news/news/financial/2006/fil06004.html. 36 Responses received by the FDIC to the proposed CRE guidance 

are available at http://www.fdic.gov/regulations/laws/federal/2006/ 

06comcrelending.html. 

Chart 4 

High CRE Concentrations Are More

Common Now Than in the Late 1980s

Notes: Data reflect year-end totals. CRE (commercial real estate) loans are secured 

by nonfarm nonresidential properties, multifamily properties, and construction 

loans. Includes institutions insured by the Federal Savings and Loan Insurance

Corporation prior to 1989.

Source: Federal Deposit Insurance Corporation.

FDIC-Insured Institutions

(percent)

20

18

16

14

12

10

8

6

4

2

0

1987

FDIC-insured

institutions with a ratio

of CRE loans to equity

capital greater than:

1989 1991 1993 1995 1997 1999 2001 2003 2005

700%

600%

500%

400%

The CRE Cycle Continues to Evolve 

The CRE cycle has been significantly influenced by 

greater availability of market data and heightened transparency, new technological advances such as the commoditization of loans and more uniform underwriting, 

and greater integration between traditional bank and 

capital markets funding sources. As a result, and unlike 

the last CRE credit cycle, risk is more dispersed and 

shared among banks and the public equity and debt 

markets. However, even as these changes have resulted 

in more liquidity and transparency, the potential exists 

for greater market volatility driven by changes in 

investor sentiment. 

During the current cycle, landlords have benefited from 

a benign interest rate environment and heightened 

investor preference for CRE properties. However, trends 

suggest that CRE credit quality could weaken going 

forward, as underwriting standards have eased. With 

FDIC-insured institution CRE loan concentrations now 

exceeding those of the last CRE cycle, we must learn 

from the past: Relatively high CRE concentrations 

heighten an institution’s vulnerability to a range of risks, 

including rising delinquencies, defaults, and even failure. As a result, institutions’ risk-management practices 

must be assessed and revised continually to reflect 

changing market conditions. 

Thomas Murray, Senior Financial Analyst 

TMurray@fdic.gov 

The author would like to acknowledge the valuable input 

for this article provided by Steven Johnson, Senior Examination Specialist, FDIC Division of Supervision and 

Consumer Protection. 

FDIC OUTLOOK 19 SUMMER 2006 
The Evolution of the Credit Cycle 

Speculation in This Cycle Has Been Mostly Constrained to Condominiums
 

Except for robust activity in the condominium market, 

speculative construction activity has been relatively 

restrained in this credit cycle so far. This commercial 

real estate (CRE) segment now appears to be either 

entering or already in the bust phase in some metropolitan areas. Demand for hotel properties also has been 

particularly strong, with property sales for first quarter 

2006 at $9 billion—nearly twice the $5 billion in sales 

a year earlier.1 

Condominium conversions have been a popular 

investment for the past few years, particularly among 

speculators and others using innovative mortgage 

products.2 However, the period of “flipping” properties 

for quick profits is apparently nearing its end—the 

classic CRE cyclical pattern, in which profits drive 

investments and construction, has resulted in oversupply in many markets. 

According to Real Capital Analytics, of the $88.5 

billion in total apartment sales in 2005, 34 percent were 

sales of apartments for conversion to condominiums. 

However, after a near-peak in November 2005, sales fell 

for each of the next four months (see Chart).3 Condominium conversion sales have occurred in many markets 

across the country, but the Miami, Broward County, 

Palm Beach, San Diego, Orlando, and Washington, 

D.C., markets have been particularly active. More than 

60 percent of apartments sold between 2004 and 2005 in 

these metropolitan areas were for conversions.4 

New construction of condominiums also has been 

strong in these markets with anecdotal evidence emerging regarding excess supply. One suburb in the Washington, D.C., area reportedly had more than 14,000 

condominiums under construction at the beginning of 

1 Parke Chapman, “Hotel Lenders Pushing the Envelope,” National
 

Real Estate Investor, May 17, 2006.
 2 Innovative mortgages include interest-only and negative amortizing loans. For more information, see “Breaking New Ground in U.S.
 

Mortgage Lending” in this issue. 


3 The Real Capital Analytics multifamily sales statistics comprise
 

properties selling for $5 million and above.
 

4 According to Real Capital Analytics.
 

Chart 

Retraction in Sales of Condominium Conversions

Reflects Prompt Market Correction

Note: Data are from January 2003 to March 2006.

Sources: Real Capital Analytics; Federal Deposit Insurance Corporation.

Volume Price

(dollars in millions)

Number of

Properties

$5,000

$4,000

$3,000

$2,000

$1,000

$0

125

100

75

50

25

0 2003 2004 2005 2006

Price

(left axis)

Properties

(right axis)

2006, while only 4,000 units were sold in the same 

market in 2005.5 In addition, new condominium sales 

were 43 percent lower in this metro area in first quarter 

2006 than a year ago.6 There is evidence that builders 

are suing to enforce purchase contracts for condominiums that have declined in value. 

A Hanley Wood Market Intelligence report found that 

more than half the condominium purchase contracts 

had been cancelled in Fairfax County, Virginia, in 

March 2006, compared to none a year earlier.7 Reportedly, investors have withdrawn from many markets, 

because rising interest rates are limiting the profit 

potential on condominium investments. Other buyers 

are deciding not to fulfill purchase obligations because 

they can no longer afford higher interest rates on 

underlying mortgages. 

5 Sandra Fleishman, “Reports Indicate Glut of Condos in D.C. Area,”
 

Washington Post, January 31, 2006.
 6 Kirstin Downey, “Doors Close for Real Estate Speculators,”
 

Washington Post, April 22, 2006.
 7 Sandra Fleishman, “Sold—or Not: When Home Buyers Walk,”
 

Washington Post, May 6, 2006.
 

FDIC OUTLOOK 20 SUMMER 2006 
Breaking New Ground in U.S. Mortgage Lending
 

Mortgage lending activity has been expanding in the 

United States for decades. The nation has seen a 

substantial increase in homeownership in just the past 

ten years, while the recent housing boom has further 

boosted the demand for mortgage credit. A series of 

historical legislative and regulatory changes in the 1970s 

and 1980s shaped the mortgage market, transforming it 

into a more competitive marketplace. The mortgage 

market has again been transformed in recent years as 

significant product innovation by lenders has expanded 

the supply of mortgage credit to meet the rising demand. 

Despite the rapid growth in credit volumes, mortgage 

loan performance among financial institutions insured 

by the Federal Deposit Insurance Corporation (FDIC) 

is favorable at present. Nevertheless, growth has not 

come without risk. Widespread marketing of nontraditional products could be raising the risk profile of some 

mortgage lenders and consumers. Growing unease 

about risk taking by lenders and consumers recently 

led bank regulators to propose new supervisory guidelines on risks of, and disclosures for, various mortgage 

products. 

This article examines historical developments in 

mortgage loan volume and underwriting trends. It also 

assesses the significance of recent market and institutional innovations in light of historical trends, reviews 

mortgage loan performance trends, discusses the role 

of regulation, and considers the near-term outlook for 

the mortgage lending cycle. 

A Look Back 

Government involvement has played a fundamental 

role in shaping the U.S. mortgage credit market. Historical legislative reforms intended to improve housing 

affordability and increase homeownership have been an 

important factor in a strong upward trend in mortgage 

loan volume. At the same time, history shows us that 

the volume and quality of mortgage credit exhibit cyclical patterns as economic and housing cycles further 

influence credit availability and performance. For example, periods of high interest rates and inflation during 

the late 1970s and early 1980s dampened mortgage 

growth. Credit quality also deteriorated considerably 

during this time of economic stress. However, beginning 

in the late 1980s, mortgage credit volume grew significantly, and the dramatic upswing in mortgage volume 

since 2000 has been unprecedented (see Chart 1). 

The recent housing boom reflects the confluence of 

rising borrower demand, historically low interest rates, 

intense lender competition, innovations in the structure and marketing of mortgages, and an abundance of 

capital from lenders and mortgage securities investors. 

A look at historical milestones that helped define the 

current mortgage credit landscape will assist in understanding the evolution of the mortgage market. 

Impact of Legislative Reforms 

Key influences on the U.S. mortgage credit cycle 

during the past century are legislative reforms and the 

mandates of certain government and quasi-government 

institutions. For example, the establishment of the 

Federal Home Loan Bank system in 1932 and the 

Federal Housing Administration in 1937 broadened 

borrower qualifications for mortgages and paved the way 

for the modern mortgage market (see Chart 2). By the 

beginning of the 1980s, the mortgage market was delineated such that savings and loan associations (S&Ls) 

processed conventional mortgage loans, mortgage 

bankers originated government mortgage loans, and 

mortgage brokers handled the balance, including second 

mortgages and those with elevated credit risk.1 

Before 1980, institutional lenders were subject to strict 

interest rate ceilings on their deposits, established by the 

Federal Reserve’s Regulation Q. This regulation provided 

Chart 1 

Sources: Federal Reserve; Bureau of Economic Analysis; U.S. Census Bureau.

Total Mortgages Outstanding 

(in billions of 2005 dollars) 

Homeownership Rate 

(percent)

$9,000 

$8,000 

$7,000 

$6,000 

$5,000 

$4,000 

$3,000 

$2,000 

$1,000 

70 

68 

66 

64 

62 

60 

1975 1980 1985 1990 1995 2000 2005 

The Recent Boom in Credit Availability

Has Boosted Homeownership

FDIC OUTLOOK 21 SUMMER 2006 
The Evolution of the Credit Cycle 

Chart 2 

Note: GDP = gross domestic product. 

Sources: Bureau of Economic Analysis for GDP data, and Federal Reserve Board Flow of 

Funds for household and nonprofit organizations home mortgages outstanding data 

(includes loans for home equity lines of credit and home equity loans secured by junior liens). 

Outstanding Mortgages as a Share of GDP 

(percent) 

80

70

60

50

40

30

20

10

0

1954

1957

1960

19631966

1969

1972

1975

1978

1981

1984

1987

1990

1993

1996

1999

2002

2005

Historically low rates

on 30-year fixed-rate

mortgages (2003–2004)

Congress 

charters Freddie 

Mac (1970) 

Fannie Mae becomes a governmentsponsored entity; Ginnie Mae 

remains a federal agency (1968) 

Mortgages allowed to have 

variable interest rates and 

balloon payments (1982)

Tax Reform Act

of 1986 

Rapid growth in

nonprime lending

(2000–2005)

Regulation Q phased out

(1980–1986): Rapid growth in

residential mortgage

securitizations (1980s)

Key Legislation and Regulatory Reforms 

Helped Shape the Mortgage Cycle 

for higher ceilings on thrift institution deposits than on 

commercial bank deposits, securing S&Ls’ funding 

advantage.2 The late 1970s inflationary environment 

opened an unsustainable gap between income generated 

by assets and short-term funding costs, thereby undermining S&Ls’ theoretical foundation that had provided 

economic stability for them in the past. Further, as inflation soared, depositors fled from S&Ls to higher-yielding 

opportunities outside the regulated banking system. The 

resulting disintermediation helped set the stage for the 

enactment of the Depository Institutions Deregulation 

and Monetary Act of 1980, which mandated a six-year 

phase-out of the Regulation Q interest-rate ceiling and 

created the money market deposit to enable FDICinsured institutions to compete with brokerage houses for 

wholesale funds.3 Although it helped S&Ls retain 

deposits, the elimination of Regulation Q ended their 

favored status in the U.S. mortgage market.4 

The enactment of the Alternative Mortgage Transaction Parity Act in 1982 eliminated regulatory disparities 

between state- and federal-chartered mortgage banks by 

1 Alex Nackoul, “Mortgage Brokering: A Short History (part 1 of 2),”
 

Scotsman Guide Residential Edition, March 2006,
 

http://www.scotsmanguide.com/default.asp?ID=1299.
 2 R. Alton Gilbert, “Will the Removal of Regulation Q Raise Mortgage
 

Interest Rates?” Federal Reserve Bank of St. Louis, December 1981,
 

http://research.stlouisfed.org/publications/review/81/12/
 

Removal_Dec1981.pdf.
 

3 Disintermediation is an excess of withdrawals from an FDIC-insured
 

institution’s interest-bearing accounts over its deposits in these
 

accounts. It occurs when rates on competing investments, such
 

as Treasury bills or money market mutual funds, offer the investor a
 

higher return. For more information, see: FDIC, History of the Eight-


ies—Lessons for the Future (Washington, DC: FDIC, 1997),
 

http://www.fdic.gov/bank/historical/history.
 

granting state-chartered institutions the authority to 

issue alternative mortgages, including the use of variable 

interest rates and balloon payments, regardless of state 

mortgage lending laws.5 This legislation increased the 

supply of mortgage credit. The Tax Reform Act of 1986 

then stimulated demand for mortgage debt by retaining 

the deduction for home mortgage interest while eliminating the deduction for nonmortgage consumer debt, 

such as car loans and educational loans. The taxdeductible status of debt secured by homes made mortgage debt a more attractive after-tax financing option 

than nondeductible consumer debt (see inset box, 

“Substituting Mortgage Debt for Consumer Debt,” next 

page). 

Impact of Mortgage Securitizations 

Following the elimination of Regulation Q, control of 

the mortgage market shifted dramatically in the 1980s 

from savings institutions to banks and to federal 

government-sponsored enterprises (GSEs), which 

played a major role in the creation of mortgagebacked securities (MBS). These securitizations further 

opened the U.S. mortgage market to investors, introducing considerable new liquidity.6 By 2005, almost 

68 percent of home mortgage originations were securitized.7 This reliance on securitization underscores its 

importance as a risk-management tool that allows 

lenders to shift mortgage credit risk and interest rate 

risk to investors who have greater risk tolerance. 

A significant development in the mortgage securities 

market is the recent and dramatic expansion of 

“private-label” MBS, which are securitized by entities 

other than the GSEs and do not carry an explicit or 

implicit guarantee. Total outstanding private-label 

MBS represented 29 percent of total outstanding MBS 

in 2005, more than double the share in 2003.8 Of total 

private-label MBS issuance, two-thirds comprised 

4 Alan Greenspan (speech, Mortgage Markets and Economic Activity 

Conference, sponsored by America’s Community Bankers, Washington, DC, November 2, 1999). 

5 Department of the Treasury and Office of Thrift Supervision, 12 CFR 

Parts 560, 590, and 591, No. 2002-43, Alternative Mortgage Transaction 

Parity Act; Preemption. 

6 The two main GSEs, Fannie Mae and Freddie Mac, buy mortgages 

to create MBS that are then sold to investors. The GSEs help improve 

housing affordability for lower- and middle-income Americans by (1) 

allowing originators to respond more quickly to fluctuating mortgage 

demand and lower mortgage rates and (2) passing on their risk-free 

funding advantage to mortgage holders. 

7 John Bancroft, ed., Inside MBS & ABS, May 26, 2006, 

http://www.imfpubs.com. The securitization rate includes MBS securitized by the GSEs as well as by “private” entities such as banks, 

thrifts, and investment firms. 

FDIC OUTLOOK 22 SUMMER 2006 
U.S. Mortgage Lending 

Substituting Mortgage Debt for Consumer Debt
 

Consumer credit growth has historically been posi- Chart 1 

tively correlated with job growth. However, this relationship appears to have broken down in the late 1980s 

(see Chart 1). One of the factors contributing to the 

breakdown may be the phenomenon of substituting 

mortgage debt for consumer debt. This debt substitution phenomenon began 20 years ago when the Tax 

Reform Act of 1986 eliminated interest deductions on 

consumer loans but retained interest deductions on 

mortgage debt, making mortgage debt a more attractive 

source of financing. 

In recent years, the combination of low interest rates 

and rapidly appreciating housing values resulted in a 

surge of mortgage equity withdrawals. Mortgage debt 

grew by nearly $4 trillion from year-end 2000 to yearend 2005, with an estimated one-half of this growth 

resulting from the refinancing of existing mortgages.1 

Many homeowners who refinanced were able to take 

Consumer Credit Is Less Closely

Tied to Job Growth

Sources: Federal Reserve; Bureau of Economic Analysis.

Nonfarm Payroll

Year-over-Year Growth Rate

(percent)

Consumer Credit Outstanding

Year-over-Year Growth Rate

(percent)

8

6

4

2

0

–2

–4

–6

20

16

12

8

4

0

–4

1955 1965 1975 1985 1995 2005

Chart 2 advantage of the low mortgage interest rates, taking 

cash out and still reducing their monthly payments. 

A 2002 Federal Reserve survey found that approximately 25 percent of mortgage refinance funds were 

used to pay for consumer expenditures.2 The switch 

from consumer debt to mortgage debt is evident in that 

growth in home equity lines of credit (HELOCs) 

outstripped growth in credit card debt, even though the 

average interest rate for credit cards declined (see 

Chart 2). 

Although growth in HELOCs continued to outpace 

that of credit cards, HELOC growth fell from 40 

percent in 2004 to 8 percent in 2005. Rising interest 

rates and slowing home price appreciation may make 

home equity lending and cash-out refinancing less 

financially advantageous, which in turn could reinvigorate growth in other forms of consumer lending, 

such as credit cards. 

HELOCs Have Grown Faster

Than Credit Cards

Note: HELOCs = home equity lines of credit. Credit card growth includes growth in credit

card loans held by banks, securitized credit card loans, and credit card loans that were 

sold but are serviced by banks.

Sources: Federal Deposit Insurance Corporation; Federal Reserve (via Haver Analytics).

Annual Loan Growth at FDICInsured Commercial Banks

(percent)

Interest Rate

(percent)

40

30

20

10

0

–10

16

15

14

13

12

11

10 2001 2002 2003 2004 2005

Credit Card

Loan Growth

HELOC

Growth

Credit Card

Interest Rate

Lynne Montgomery, Senior Financial Analyst 

LMontgomery@fdic.gov 

1 Based on data from the Federal Reserve Board and from the
 

2001–2005 annual average “percent refinancing” share of the
 

total dollar volume of new mortgages reported by the Mortgage
 

Bankers Association.
 

2 Glenn Canner, Karen Dynan, and Wayne Passmore, “Mortgage
 

Refinancing in 2001 and Early 2002,” Federal Reserve Bulletin,
 

December 2002, http://www.federalreserve.gov/pubs/bulletin/
 

2002/1202lead.pdf. 


FDIC OUTLOOK 23 SUMMER 2006 
The Evolution of the Credit Cycle 

nonprime loans in 2005, up from 46 percent in 2003.9 

With the increased exposure to private-label MBS and 

a large share of higher-risk nontraditional mortgages 

being securitized in this sector, investors appear willing 

to assume greater risk in their search for yield. 

The legislative changes and increased use of securitization during the 1980s significantly altered the mortgage 

market by facilitating product innovation and expanding mortgage credit availability. The increased liquidity 

provided by securitization allowed lenders to offer 

credit to more borrowers, because lenders were no 

longer limited to lending on their deposit base. Lenders 

not only could increase their underwriting of traditional mortgages, but also were able to develop new 

mortgage products to appeal to borrowers seeking 

nontraditional features. 

Recent Innovations in Mortgage Products 

The U.S. mortgage market, which for decades was dominated by fixed-rate mortgages, now includes innovations 

such as nontraditional mortgages, simultaneous secondlien (or piggyback) mortgages, and no-documentation 

or low-documentation loans.10 Nontraditional mortgages 

allow borrowers to defer payment of principal and, sometimes, interest and include interest-only mortgages (IOs) 

and adjustable-rate mortgages (ARMs) with flexible 

payment options (also called pay-option ARMs, or POs). 

Although perceived as fairly new, many of these loan 

types are a repackaging of existing products, marketed 

again in the 2000s in response to growing demand. For 

example, record-high fixed rates in the late 1970s and 

early 1980s stimulated innovation in the form of various 

types of ARMs. Some of today’s pay-option ARMs are a 

reincarnation of negative amortization loans that were 

popular in the 1980s, but then fell out of favor in the 

early 1990s when rising interest rates and falling home 

prices in certain areas left some borrowers owing more 

than their homes were worth. 

Since 2003, strong home price appreciation and declining affordability have helped drive growing demand for 

8 A growing portion of total outstanding private-label MBS is held by
 

FDIC-insured institutions. These holdings accounted for 19.6 percent of
 

their total MBS holdings in 2005, up from 12.9 percent in 2003. However,
 

it may be that these institutions carry only the best-rated tranches in
 

their private-label MBS holdings and therefore have limited risk.
 

9 Bancroft, Inside MBS & ABS, April 14, 2006.
 10 For more information, see the Appendix, “Overview of Nonprime
 

Mortgage Lending and Nontraditional Mortgage Product Terms.”
 

nontraditional mortgage products that can be used to 

stretch home-buying power.11 Aided by new computer 

models and an easing in lending standards, many 

lenders have accommodated this demand by expanding 

the variety of nontraditional mortgage products offered 

while also extending loans to borrowers with less-thanstellar credit histories. As a result, by 2005, nonprime 

lending, comprised of subprime and Alt-A (low- or nodocumentation) loans, accounted for about 33 percent 

of all mortgage loan originations, up from almost 11 

percent in 2003.12 

Rapid growth also has occurred among some of the 

higher-risk mortgage alternatives within the nonprime 

arena. As recently as 2002, IOs and pay-option ARMs 

represented only 3 percent of total nonprime mortgage 

originations that were securitized. However, the IO 

share of credit to nonprime borrowers has soared 

during the past two years to 30 percent of securitized 

nonprime mortgages, while the pay-option product 

jumped to a similar share in less time (see Chart 3). 

Furthermore, the low- or no-documentation share of 

subprime lending has grown significantly since 2001, 

from about 25 percent to just over 40 percent. 

Lenders continue to diversify mortgage offerings as 

they compete to attract borrowers and accommodate 

Chart 3 

Notes: Nonprime mortgage originations data are securitized originations of Alt-A 

and subprime product. Data on nonprime mortgage originations are not fully 

available after August 2005 and are not displayed.

Source: LoanPerformance Corporation (Alt-A and B&C mortgage securities database). 

Nontraditional Products Share of 

Nonprime Originations (percent) 

Nonprime Mortgage 

Originations (dollars in billions; right axis) 

60 

50 

40 

30 

20 

10 

0

$70 

$60 

$50 

$40 

$30 

$20 

$10 

$0 Dec-01 Aug-02 Apr-03 Dec-03 Aug-04 Apr-05 Dec-05 

Nontraditional Products (left axis) 

Pay Option: Negative Amortization 

Interest Only 

Nontraditional Products Help Homebuyers

Bridge the Affordability Gap

11 For more analysis on the recent housing boom, see the FDIC’s 

FYI articles on “U.S. Home Prices: Does Bust Always Follow 

Boom?” issued February 10, 2005 (revised April 8, 2005), http:// 

www.fdic.gov/bank/analytical/fyi/2005/021005fyi.html, and May 2005, 

http://www.fdic.gov/bank/analytical/fyi/2005/050205fyi.html. 12 John Bancroft, ed., Inside Mortgage Finance, February 24, 2006, 

http://www.imfpubs.com. 

FDIC OUTLOOK 24 SUMMER 2006 
U.S. Mortgage Lending 

prospective homebuyers’ financing needs. Many banks 

now offer 40-year mortgages, which are gaining in 

popularity as an alternative to IOs and pay-option 

ARMs. The extended amortization period reduces 

monthly mortgage payments, thereby stretching a 

buyer’s purchasing power, and allows equity to build 

from the first mortgage payment. 

Risk Layering among Nontraditional Mortgage 

Products Raises Concerns 

Nontraditional loan products can be appropriate for 

financially savvy borrowers with low credit risk. Indeed, 

many of these products have been offered for years to 

such borrowers, and credit quality generally has been 

good. What has changed, however, is how these loans 

have been marketed and used in recent years. Lenders 

have targeted a wider spectrum of consumers, who 

may not fully understand the embedded risks but use 

the loans to close the affordability gap.13 

The degree to which mortgage market innovation, 

fueled by significant MBS liquidity, boosted home 

sales last year is unknown. Anecdotal evidence 

suggests that affordability and financing played a 

strong role in extending the volume component of 

the mortgage credit cycle last year. For example, 

there is a correlation between nontraditional mortgage loans and home price growth. An analysis of 

state-level data from LoanPerformance Corporation 

shows the penetration of IOs and pay-option ARMs 

for nonprime borrowers into areas with strong price 

appreciation and reveals a strong positive relationship between the concentration of such loans and 

home price growth (see Chart 4). This analysis illustrates the recent development of borrowers increasingly using IOs and pay-option ARMs to purchase 

homes they might not otherwise have been able to 

afford. A June 2006 study by Harvard’s Joint Center 

for Housing Studies also confirms this trend.14 

Analysts are concerned that higher-risk borrowers are 

more likely to be affected by a major payment shock 

during the life of their mortgage and may be more 

13 Pay-option ARMs have been offered for years primarily to meet the 

needs of borrowers with uneven income streams during the year, 

such as the self-employed or those who receive year-end bonuses. 

Some producers of nontraditional mortgage loans are marketing 

products that may not be suitable for some borrowers. Sales pitches 

appeal to a homebuyer’s affordability squeeze and highlight the 

“benefits” of the minimal payment option: greater monthly cash flow, 

maximized buying power, and the ability to afford a bigger house than 

a buyer thought possible. 

Chart 4 

Note: Data as of fourth quarter 2005.

Sources: Office of Federal Housing Enterprise Oversight; LoanPerformance Corporation

(Alt-A and B&C securities database).

Home Price Growth

(year-over-year percent change)

Interest-Only/Pay-Option Share of Nonprime Securitized Originations

Nontraditional Mortgage Products Are Most Popular

in States with the Strongest Home Price Growth

35

30

25

20

15

10

0

0% 10% 20% 30% 40% 50% 60% 70% 80%

VT

SD

IA

NY CT RI WY WV

MI

KS

KY

OH

TN

MO

IN TXNE

PA

OK

AL

MS

ME

ND LA

AK

NV

CA

CO

WA

AZ

VA

ID

OR

HI

FL

MD

MN

UT

NJ

GA MA

SC

MT NM

DC

IL

NH

NC

likely to default. Compounding this possibility is the 

fact that the increasing availability of mortgage credit 

is occurring at a time when mitigating controls on 

credit exposures have weakened. Evidence of loosening underwriting standards was noted in the Office of 

the Comptroller of the Currency’s annual survey of 

credit underwriting practices at nationally chartered 

banks.15 A telling result of the 2005 survey was the 

significant extent to which banks had relaxed underwriting standards for home equity and first mortgage 

loans (notably, the first time in the survey’s 11-year 

history that a net easing has been reported) by allowing lower minimum credit scores, reduced documentation in evaluating the applicant’s creditworthiness, 

and simultaneous second-lien mortgages. 

As a result, risk layering appears to have become more 

prevalent. For example, there is growing evidence of 

nonamortizing IOs and pay-option ARMs being made 

to borrowers with little or no documentation to verify 

income sources or financial assets (see Table). When 

one loan combines several such features, the total risk 

is heightened. The risk compounds in the case of a 

high loan-to-value ratio of a first-mortgage loan that 

is combined with a second-lien mortgage because, 

historically, as combined loan-to-value ratios rise, 

defaults have tended to rise as well. 

14 Joint Center for Housing Studies of Harvard University, The State
 

of the Nation’s Housing 2006 (Cambridge, MA: Harvard University,
 

June 2006), http://www.jchs.harvard.edu/publications/markets/
 

son2006/index.htm.
 

15 Office of the Comptroller of the Currency, “Survey of Credit
 

Underwriting Practices, 2005,” http://www.occ.treas.gov/cusurvey/
 

scup2005.pdf.
 

FDIC OUTLOOK 25 SUMMER 2006 
The Evolution of the Credit Cycle 

Table 

Recent Collateral Trends in Lending for Interest-Only and Pay-Option 

Adjustable Rate Mortgages: Combining Higher-Risk Loan Features Results 

in “Risk Layering” and Heightens the Overall Level of Credit Risk 

Year Low or No Documentationa Loan to Valueb Credit Scoreb Investor Sharec Prepayment Penaltya 

2003 53.9% 76.0 701 11.6% 50.5% 

2004 58.0% 77.1 692 12.6% 51.9% 

2005 65.7% 76.4 696 14.1% 59.2% 

a Calculated as a percentage of total interest-only or pay-option adjustable-rate mortgage originations. 

b Original combined loans to value and credit scores are weighted averages. 

c Calculated as nonowner and second home originations. 

Source: LoanPerformance Corporation (Alt-A and B&C mortgage securities database). 

Mortgage Loan Performance Trends 

Even in stressful times, mortgages have been among the 

best performing assets held by banks and thrifts. In the 

early 1990s, a time of serious dislocation in housing 

markets in California and the Northeast, FDIC-insured 

institutions reported exceptionally low net charge-off 

rates of less than 1 percent nationwide on home equity 

and residential mortgage loans compared to other loan 

types, ranging up to 12 percent for commercial and 

industrial loans. Mortgage charge-off rates barely 

budged during the 2001 recession, and large and small 

banks alike survived the recession with only a slight 

decline in credit quality. 

In recent years, the combination of strong home price 

appreciation and a low interest rate environment has 

benefited homeowners and stimulated strong mortgage 

demand. FDIC-insured institutions are reporting 

exceptionally strong asset quality, and charge-off rates 

are at historic lows. On a quarterly basis, one-to-four 

family mortgage charge-off rates are in the single digits 

(in basis points) and considerably lower than in earlier 

stress periods (see Chart 5). The loss rate also is well 

below historical averages. The same is true for home 

equity lines of credit (HELOCs), although this may in 

part reflect their rapid growth of more than 40 percent 

during 2004.16 

The sustainability of solid mortgage performance and 

historically low losses among FDIC-insured institutions 

is at the forefront of current industry analysis. How 

16 Rapid loan growth can mask increases in nonperforming loans. 

Because delinquencies or losses generally do not appear for some 

time after loans are originated, growth in the numerator of the ratio 

of nonperforming loans to total loans may show up later than growth 

in the denominator. 

Chart 5 

Source: Federal Deposit Insurance Corporation.

Quarterly Net Charge-Offs

(percent)

0.45

0.40

0.35

0.30

0.25

0.20

0.15

0.10

0.05

1991 1993 1995 1997 1999 2001 2003 2005

Home Equity Lines of Credit

1–4 Family Mortgages

Average

’91–’05

Charge-Off Rates for Mortgages and Home Equity Lines 

of Credit Remain Well Below the Long-Term Average

long can such favorable conditions last, especially in 

light of recent developments? 

There are growing signs that mortgage loan performance may have peaked. The increase in risk layering 

in residential mortgage lending as well as recent 

market and institutional developments support this 

perception. Lenders themselves exhibit modest 

concern about nontraditional mortgage loan quality, 

as reported in the Federal Reserve Board’s quarterly 

survey of senior loan officers. Almost 41 percent of 

respondents believe credit quality on nontraditional 

loans is likely to decline in 2006, compared with 12 

percent who view similar worsening in traditional 

mortgage loans.17 

17 Federal Reserve Board, Senior Loan Officer Opinion Survey on Bank 

Lending Practices, January 2006. 

FDIC OUTLOOK 26 SUMMER 2006 
U.S. Mortgage Lending 

Outlook for Nontraditional Mortgages 

The growing popularity of nontraditional products may 

have moved the mortgage credit cycle into uncharted 

territory. Industry analysts are uncertain how loans 

such as IOs and pay-option ARMs might perform in 

periods of rising rates or in stagnant housing markets. 

Recent media attention has highlighted the risk of 

payment shock when interest rates are adjusted, or 

reset, for IOs and hybrid ARM products. Despite favorable delinquency and default trends thus far, analysts 

fear that the current rising interest rate environment, 

combined with cooling home price appreciation, will 

limit borrowers’ options when they face large monthly 

payment increases. Homeowners who have not built 

up sufficient equity to either cover the cost of refinancing or pay down additional debt could face delinquency, particularly within the subprime markets.18 

A recent Fitch analysis warns that the payment shock 

associated with subprime IOs of 2005 vintage is strong 

even if rates do not rise. When rates do reset, these 

loans’ high margins and low initial rates will make the 

monthly payment increases significantly greater than 

the increase from principal. Despite favorable performance of previous years’ subprime IOs, the ratings agency 

expects subprime IO loan delinquency rates to increase, 

because those borrowers may not be able to keep up 

with payment increases, especially if the housing 

market softens.19 

Although some analysts emphasize borrowers’ susceptibility to increasing monthly payments, others foresee a 

more balanced outcome. A national analysis of mortgage payment reset undertaken by First American Real 

Estate Solutions suggests that mortgages originated or 

refinanced before 2004 have built sufficient equity as a 

result of strong home price appreciation and are not as 

likely to default.20 This study also puts the volume of 

potential loss associated with interest rate resets into 

perspective, finding that the volume of ARM defaults 

is relatively small compared to overall mortgage originations. The majority of homeowners will not be significantly adversely affected by reset. 

18 James R. Hagerty, “At the Doorstep: Millions Are Facing Monthly 

Squeeze on House Payments,” Wall Street Journal, March 11, 2006. 19 Suzanne Mistretta, “Rating Subprime RMBS Backed by InterestOnly ARMs,” Fitch Ratings Structured Finance, March 9, 2006. 20 Christopher Cagan, “Mortgage Payment Reset: The Rumor and 

the Reality,” First American Real Estate Solutions, February 8, 2006. 

Regulatory Guidance for HELOCs 

and Nontraditional Products 

To address potential concerns associated with risk 

layering and changes in mortgage lending practices, 

federal bank regulators issued guidance in May 2005 

on home equity lending and proposed guidance in 

December 2005 on nontraditional mortgages.21 

While acknowledging that nontraditional IOs and 

pay-option ARMs may benefit some borrowers, the 

proposed guidance targets lending to borrowers who 

qualify for loans according to initial minimum payments but who may have difficulty making future 

payments as a result of delayed or negative amortization. Furthermore, the proposed guidance addresses 

a number of specific issues—including product 

development, underwriting compliance, and riskmanagement functions—to help lenders and 

customers address the uncertainty raised by nontraditional mortgage products. 

Some lenders contend that the loans discussed in 

the proposed guidance are made only to borrowers 

with high credit scores and larger down payments. 

Comments also suggest that the guidance, as proposed, 

could penalize legitimate lenders and limit market 

competition.22 However, investors at a recent housing 

finance symposium did not share this view—MBS 

investors voiced concern about easing underwriting 

standards, calling them “lax” and “too lenient,” particularly in subprime markets where the weakest borrowers are choosing ARMs.23 These varied opinions aside, 

the challenges of today’s complex mortgage market 

call for an approach that encourages sound underwriting without inhibiting innovation, which regulators 

recognize has created opportunities for millions of 

homeowners. 

21 The federal bank regulatory agencies include the Office of the Comptroller of the Currency, Federal Reserve Board, FDIC, Office of Thrift
 

Supervision, and National Credit Union Administration. For the home
 

equity lending guidance, see “Credit Risk Management Guidance for
 

Home Equity Lending,” May 2005, http://www.fdic.gov/news/news/
 

press/2005/pr4405a.html. For the proposed guidance on nontraditional
 

mortgage loans, see “Interagency Guidance on Nontraditional Mortgage Products,” December 2005, http://www.fdic.gov/news/news/
 

press/2005/Guidance_on_non_traditional_mortgages.pdf.
 

22 Kenneth R. Harney, “Should Risks Beget Rules?” Washington Post,
 

April 8, 2006.
 

23 Bancroft, Inside MBS & ABS, April 7, 2006.
 

FDIC OUTLOOK 27 SUMMER 2006 
The Evolution of the Credit Cycle 

Conclusion 

The mortgage credit cycle has changed dramatically 

during the past several decades. More than other lending types, mortgage lending practices have been shaped 

by government influence and product innovation. More 

recently, rapid home price escalation has constrained 

housing affordability in many regions of the country, 

contributing to rising demand for nontraditional mortgages as borrowers try to maximize purchasing power. 

Mortgage originators have found ways to accommodate 

borrower demand, offering new mortgage products and 

extending loans further along the credit spectrum. 

These developments in the mortgage cycle have led to 

increased credit risk held by both homeowners, as they 

have sought to stretch affordability during an unprecedented housing boom, and by investors seeking yield. 

The benign credit landscape of recent years may have 

encouraged increased risk taking. 

Based on historical experience, and despite recent 

strong performance, a gradual rise in delinquency and 

foreclosure rates could occur over the next few years. 

Mortgage delinquencies are likely to increase over 

time as rising interest rates and the expiration of 

below-market teaser rates result in higher monthly 

payments for many borrowers. Some households with 

limited financial assets, lower incomes, or an inability 

to refinance due to poor credit, lack of appreciation, 

or high leverage may not be able to accommodate 

these higher payments. Finally, if a recession or other 

severe economic shock were to send local home prices 

and incomes sharply lower, or interest rates sharply 

higher, this additional stress could contribute to 

higher mortgage losses. 

However, banks and thrifts will head into the next 

phase of the mortgage credit cycle from a position of 

strength. In recent years, the industry has generated 

record earnings and reached near-record capital levels. 

Given a gradual transition to higher delinquency and 

foreclosure rates and assuming only modest potential 

declines in collateral values, it does not appear at this 

time that deteriorating mortgage credit performance 

would present unmanageable risks to most FDICinsured institutions. 

Cynthia Angell, Financial Economist 

CAngell@fdic.gov 

Clare D. Rowley, Economic Assistant 

CRowley@fdic.gov 

FDIC OUTLOOK 28 SUMMER 2006 
U.S. Mortgage Lending 

Appendix 

Overview of Nonprime Mortgage Lending 

and Nontraditional Mortgage Product Terms 

Subprime Lending 

Subprime lending refers to higher-interest loans that 

involve elevated credit risk. For example, borrowers 

with Fair Isaac and Company (FICO) credit scores 

below 620 are generally viewed as higher risk and thus 

ineligible for prime loans unless they make significant 

down payments. While many subprime borrowers score 

above this threshold, they are still considered high risk 

because of other issues regarding down payment, 

income documentation, or credit standing. Conventional and subprime loan interest rates have a typical 

spread of less than 2 percent. 

Alternative-A Mortgage 

An Alternative-A, or Alt-A, mortgage can be made to 

borrowers who have marginal to very good credit where 

traditional underwriting guidelines for standard complying loans have been expanded. Alt-A mortgages may 

include those with (1) no credit score or credit scores 

higher than subprime, (2) nonowner-occupied homes, 

(3) a loan-to-value ratio greater than 80 percent and 

no mortgage insurance, or (4) high debt-to-income 

ratios that are not considered subprime. 

Interest-Only Mortgage 

In a nontraditional, interest-only (IO) mortgage, the 

borrower is required to pay only the interest due on 

the loan for the first few years, during which time the 

rate may be fixed or fluctuate. After the IO period, 

the rate may be fixed or fluctuate based on the 

prescribed index; payments consist of both principal 

and interest. 

Payment-Option Adjustable-Rate Mortgage 

A payment-option adjustable-rate mortgage (ARM)— 

also known as a flexible-payment ARM, pay-option 

ARM, option ARM, or PO—is considered nontraditional in that it allows the borrower to choose from a 

number of payment options. For example, the borrower 

may choose either a minimum payment option each 

month based on an introductory interest rate, an IO 

payment option based on the fully indexed interest 

rate, or a fully amortizing principal-and-interest 

payment option based on a 15- or 30-year loan term 

plus any required escrow payments. The minimum 

payment option can be less than the interest accruing 

on the loan, resulting in negative amortization. The 

IO option avoids negative amortization but does not 

allow principal amortization. After a certain number of 

years, or if the loan reaches a certain negative amortization cap, the required monthly payment amount is 

refigured to require payments that will fully amortize 

the outstanding balance over the remaining loan term. 

Reduced Documentation 

A reduced-documentation loan feature is commonly 

referred to as a “low doc/no doc,” “no income/no asset,” 

“stated income,” or “stated assets” feature. When 

applied to mortgages, a lender sets reduced or minimal 

documentation standards to corroborate a borrower’s 

income and assets. 

Simultaneous Second-Lien Loan 

A simultaneous second-lien loan, also referred to as 

a “piggyback loan,” is a lending arrangement where 

either a closed-end second lien or a home equity line 

of credit is originated at the same time as the first-lien 

mortgage loan, usually taking the place of a larger 

down payment. 

Sources: FDIC; Edward M. Gramlich (speech, Financial Services 

Roundtable Annual Housing Policy Meeting, Federal Reserve, 

Chicago, Illinois, May 21, 2004); and Office of the Comptroller of the 

Currency, Federal Reserve Board, FDIC, Office of Thrift Supervision, 

and National Credit Union Administration, proposed “Interagency 

Guidance on Nontraditional Mortgage Products,” December 2005. 

FDIC OUTLOOK 29 SUMMER 2006