Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION	 SECOND QUARTER 1999 

FDIC
 

Boston
 

Region
 

Division of 

Insurance 

Daniel Frye,
 

Regional Manager
 

Norman Williams,
 

Regional Economist
 

Cameron Tabor,
 

Senior Financial
 

Analyst
 

Andrea N.
 

Vincequere,
 

Economic Analyst
 

In Focus This Quarter 

◆ Economic Conditions and Emerging Risks in Banking—This article 

provides an overview of economic conditions and banking industry trends, with a 

primary focus on potential risks to insured depository institutions. 

● Economic Developments—Low interest rates, dormant inflation, and rising 

stock markets have all contributed to a generally positive near-term outlook for 

the U.S. economy. See page 3. 

●	 Trends Affecting Banking Lines of Business—Although credit conditions 

appear strong, risks exist in the major banking lines of business.	 See page 7. 

Consumer Lending—Continued high consumer loan loss rates raise questions 

about how lenders will fare under less favorable economic circumstances. 

See page 8. 

Commercial Lending—Corporate loan growth accelerated in 1998 even as the
 

corporate sector showed signs of stress. See page 9.
 

Commercial Real Estate and Construction Lending—Selected metropolitan
 

markets are experiencing rapid commercial development despite declining
 

indicators of demand. See page 10.
 

Agricultural Lending—Falling commodity prices threaten U.S. farm operators. See page 11.
 

Funding and Interest Rate Risk—Intense competition and the changing term
 

structure of interest rates have presented challenges for banks and thrifts.
 

See page 12. 

● Indicators of Industry Performance—Weaknesses appear to be developing for 

banks with certain types of exposures, and the dispersion in performance among 

insured institutions is increasing. See page 13. 

By the Analysis Branch Staff 

Regional Perspectives 

◆ Regional Economic and Banking Conditions—Most indicators showed 

another year of steady economic growth during 1998, with only the manufacturing 

sector demonstrating some signs of weakness...During the first quarter of 1999, 

nonfarm payroll growth decelerated, while manufacturing payrolls declined from 

levels of a year ago...Strong asset quality continued to bolster insured institutions’ 

earnings in 1998; however, weaker margins arising from a prolonged refinancing 

wave are taking a toll on overall profitability. See page 16. 

◆ Insured Institutions Are Taking on More Risk as Narrowing Margins 

Squeeze Earnings—In 1998, strong performance by credit card banks, coupled 

with gains in many insured institutions’ securities portfolios, effectively masked 

a weakening earnings posture for the industry...Weaker earnings are arising 

primarily from increased loan loss provisions at larger institutions and a weaker 

net interest margin that is negatively affecting a wide range of institutions... 

Institutions affiliated with publicly traded companies are adopting higher risk profiles in response to weaker earnings growth and lagging stock price performance. 

See page 20. 

By the Boston Region Staff 

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

Insurance Corporation for the following eight geographic regions: 

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

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

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

Dallas Region (CO, NM, OK, TX)
 

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

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

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

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

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

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

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

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

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

dfrye@fdic.gov. 

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

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

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

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

the Federal Deposit Insurance Corporation. 

Chairman Donna Tanoue 

Director, Division of Insurance Arthur J. Murton 

Executive Editor George E. French 

Editors Lynn A. Nejezchleb 

Maureen E. Sweeney 

Publications Manager Teresa J. Franks 
In Focus This Quarter
 

Economic Conditions and
 

Emerging Risks in Banking
 

Periodically, the Division of Insurance assesses conditions in the economy and across the banking industry in an effort 

to evaluate the types of risks that could adversely affect the performance of insured depository institutions. The analysis that follows describes the salient aspects of this assessment by focusing on three areas: 1) developments and conditions in the U.S. and global economies; 2) trends affecting particular banking lines of business; and 3) selected 

indicators of bank performance. 

In brief, the U.S. economy continues to provide a favorable environment for the banking industry. The industry as a 

whole has exhibited strong loan growth and minimal credit losses. Nevertheless, there are areas of concern, including subprime and high loan-to-value consumer lending, higher levels of leveraged commercial lending, localized 

overbuilding of commercial real estate, and the potential for credit quality problems among agricultural banks. 

Although it is uncertain when, or even if, these concerns will ultimately affect overall industry performance, the 

potential for stress among insured institutions is being monitored. 

Economic Developments
 

Conditions Have Improved Markedly 

since Late 1998 

The U.S. economy is now in its eighth year of expansion, the longest peacetime expansion during the postWorld War II era. Although analysts raised concerns 

about the durability of the expansion amid the late-1998 

financial market turmoil, the economic outlook since 

that time has improved for a number of reasons: 1) the 

75 basis point reduction in short-term U.S. interest rates 

between September and November helped to support 

consumer spending and business investment; 2) following several quarters of decline, U.S. exports rose unexpectedly during the fourth quarter; 3) inflation remained 

dormant even though U.S. labor markets were extremely tight; and 4) equity valuations for large-cap stocks 

rebounded and erased most of the losses incurred during August and September. 

Consumer Spending and Business Investment 

Are Key to Economic Strength 

Most of the standard indicators of health for the U.S. 

economy currently register values associated with the 

best macroeconomic conditions in our history. Growth in 

real gross domestic product (GDP) was 3.9 percent for 

all of 1998—the third consecutive year in which growth 

exceeded 3.5 percent. The U.S. economy added over 3.1 

million jobs during 1998, while unemployment averaged 

just 4.5 percent, the lowest annual figure since 1969. 

Despite this robust economic activity, inflation was also 

the lowest in a generation. Consumer prices rose by just 

1.6 percent in 1998, extending a seven-year streak during which prices have risen by less than 3 percent per 

year. At the same time, strong gains in the productivity 

of U.S. workers helped real hourly earnings rise by 2.7 

percent—the best performance since 1972—while unit 

labor costs of businesses rose by only 1.9 percent. 

Growth in business investment spending, which typically peaks in the early years of an economic expansion, 

has actually accelerated during the current expansion 

(Chart 1, next page). A number of factors appear to be 

responsible for this investment boom. One is the need 

for producers to invest in new technologies in order to 

cut costs and remain competitive. Also, rising stock 

prices, low interest rates, and low yield spreads during 

the past few years have helped keep the cost of capital 

relatively low. The result has been an economic expansion in which approximately 20 percent of net growth in 

real GDP has come from investment in producers’ 

durable equipment, versus approximately 10 percent 

during the long expansions of the 1960s, 1970s, and 

1980s. Bank commercial and industrial lending has 

expanded at an average annual rate of 10.6 percent over 

the past five years, largely on the strength of business 

investment spending. 

The underlying factors that drive consumer spending 

are strong. Low unemployment and rising real incomes 

have boosted the Conference Board’s consumer confiBoston Regional Outlook 3 Second Quarter 1999 
In Focus This Quarter
 

CHART 1 

Low Interest Rates and High Stock Prices
 

Fuel Consumption and Investment
 

Personal Consumption Investment in Producers’ 

Expenditures* (%) Durable Equipment* (%) 

20 9 

15 7
 

5
 10 

3 5 

1 

0 –1 

–5 –3
 

–5
 –10 

* Annual Inflation-Adjusted Rate of Change 

Source: Bureau of Economic Analysis 

1990–91 

Recession 

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

dence index to its highest values since the late 1960s. 

Increases in new home construction reflect these favorable conditions. Almost 1.5 million new homes were 

completed during 1998—the highest level in ten 

years—while a record 4.8 million existing homes were 

sold (Chart 2). U.S. automobile sales reached 15.5 million in 1998, their best performance since 1986. Low 

interest rates also enabled a record number of homeowners to reduce their monthly interest expenses by 

refinancing their mortgages during 1998.1 

Although real disposable personal income grew by 

more than 3 percent during 1998, personal savings was 

essentially zero during the fourth quarter. This was the 

1 The Refinancing Index of the Mortgage Bankers Association posted an all-time high of 4,389 in the second week of October 1998. The 

index is scaled to a level of 100 as of the third week of March 1990. 

CHART 2 

Housing Starts and Home Sales Reflect the 

Strength of the Consumer Sector 

Sources: U.S. Census Bureau; National Association of Realtors 

2,250 

2,750 

3,250 

3,750 

4,250 

4,750 

5,250 

5,750 

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

One-Unit 

Housing 

Starts (000’s) 

550 

650 

750 

850 

950 

1,050 

1,150 

1,250 

1,350 

1,450 

1990–91 Recession 

Existing 1- to 

4-Family 

Sales (000’s) 

lowest rate of personal savings recorded in the United 

States since the Great Depression. The decline in personal savings has prompted much discussion of its causes and potential implications for the economy and for 

consumer credit quality. Most analysts have argued for 

the importance of a “wealth effect” from rising stock 

values on consumer spending.2 They note that although 

consumers are saving little out of current income, 

household wealth continues to grow rapidly, driving 

consumer spending higher. The willingness of American consumers to spend has been a prime factor in prolonging the economic expansion for the United States 

and in supporting the economies of countries around the 

world that depend on exports to the United States. This 

high degree of reliance on the U.S. consumer has led 

analysts to voice concerns that the wealth effect might 

reverse itself, leading to a sharp drop in consumer 

spending if there is a sustained stock market decline. 

Conditions Vary across Industry Sectors 

While overall conditions in the U.S. economy are good, 

certain sectors have been undergoing significant strain 

because of low commodity prices and weak foreign 

demand. 

Commodity price weakness extends across a wide range 

of items, from agricultural goods to industrial commodities to basic manufactured goods (Chart 3). 

Among agricultural commodities, grain prices have 

fallen substantially from their record-high levels of just 

three years ago, while prices for hogs and soybeans have 

also been under severe pressure. Industrial commodity 

prices have fallen sharply, with steel prices down by 

nearly 30 percent since January 1997. Certain manufactured goods show a similar pattern. The price of the 

industrial chemical benzene has fallen by 40 percent 

since January 1997, while the price of computer memory chips fell by more than 80 percent during that time. 

Oil prices decreased by nearly 50 percent between January 1997 and February 1999. Since mid-March, however, oil prices have increased as a result of agreements 

among oil producers to limit output. Analysts are uncer2 Personal savings is measured as the difference between disposable 

personal income (personal income less tax payments) and total consumption outlays. Increasing household wealth may reduce personal 

savings either through a reduction in disposable income or through 

increased consumption outlays. Tax payments resulting from capital 

gains will reduce measured disposable personal income. Increasing 

household wealth may lead to higher consumption outlays by means 

of the wealth effect. 

Boston Regional Outlook 4 Second Quarter 1999 
0 

In Focus This Quarter
 

CHART 3 

Price Weakness Extends across 

a Wide Range of Commodities 

Percent Decline in Prices from January 1997 to March 1998 

All 

commodities* Tin Steel Wheat Benzene Crude Oil 

–5 

–5.3%
 

–10
 –7.7%
 

–15
 

–20
 

–25
 

–30 –29.1%
 

–35
 

–36.2%
 –40
 

–40.6%
 –45
 

–50
 –47.4% 

* Producer Price Index (PPI)
 

Source: Journal of Commerce, Bureau of Labor Statistics
 

tain how long any reductions in output will be maintained or how much oil prices may increase during the 

next several months. 

Three trends in the global economy appear to be responsible for weak commodity prices. First, sustained low 

inflation has taken root both in developed nations and in 

many emerging economies. Low inflation has eliminated much of the speculative demand for commodities 

that was evident during the 1970s. Low inflation has 

also made it difficult for manufacturing firms to raise 

prices, while at the same time encouraging the implementation of new technologies to cut costs. Second, 

large-scale investment in plant and equipment during 

the 1990s in both developed and emerging countries has 

added vast amounts of new global manufacturing 

capacity, making industrial overcapacity a source of 

price weakness in a number of industries. Third, successive currency crises and the resulting recessions that 

have taken place in Asia, Eastern Europe, and Latin 

America have reduced global demand for commodity 

goods. Moreover, U.S. firms find that their products are 

less price competitive abroad because of the relative 

strength of the dollar. 

One reason the overall U.S. economy has proven so 

resilient in the face of weakness in the manufacturing 

sector is that firms have been able to restructure to cut 

costs and improve their market positions. Global overcapacity in industries such as oil and autos has been a 

driving force behind the record number and dollar value 

of merger deals announced during 1998. Mega-mergers 

involving Exxon-Mobil and Daimler Benz-Chrysler 

helped push the dollar volume of mergers announced in 

1998 to almost $1.2 trillion—nearly double the level 

announced in 1997 and far greater than any year during 

the “merger mania” of the 1980s (Chart 4). 

U.S. Foreign Trade Reflects Recent Turmoil 

in the Global Economy 

The U.S. economy increasingly relies on exports to fuel 

its overall growth. Between 1994 and 1997, export 

growth contributed about 1 percentage point each year 

to total net growth in real GDP. However, with the onset 

of the Asian economic crisis in 1997, the export sector 

stalled and became a drag on overall U.S. economic 

activity. During the first three quarters of 1998, exports 

decreased at an annualized rate of 4.4 percent, led by 

declines in capital goods, industrial material and supplies, and food and agricultural products. Weakness in 

exports was not limited to Asia; in fact, Canada, Mexico, and South America were also weak markets for U.S. 

goods and services during most of 1998. Declining 

goods exports and rising imports combined to push the 

U.S. balance of trade to a record deficit of $169 billion 

during 1998—a 50 percent increase from the year 

before. The trade deficit continued to increase in early 

1999. Data for January show an imbalance of nearly 

$17 billion, the largest monthly deficit ever recorded. 

Despite the weakness in foreign demand that was 

observed during much of last year, U.S. exports rose 

sharply at the end of 1998. Total exports jumped by 19.7 

percent during the fourth quarter, contributing 2.0 percent of the total 6.0 percent growth in GDP during the 

CHART 4 

0 

1,000 

2,000 

3,000 

4,000 

5,000 

6,000 

7,000 

8,000 

9,000 

0 

200 

400 

600 

800 

1,000 

1,200 

1,400 

Deal Value 

(Billions $) 

(Columns) 

Number of 

Deals (Line) 

Source: Houlihan Lokey’s Mergerstat 

Pressure to Maintain Profit Margins 

Has Led to Record Merger Activity 

Recessions 

’65 ’67 ’69 ’71 ’73 ’75 ’77 ’79 ’81 ’83 ’85 ’87 ’89 ’91 ’93 ’95 ’97 

Boston Regional Outlook 5 Second Quarter 1999 
In Focus This Quarter
 

quarter. This unexpected increase in U.S. exports 

involved nearly every region of the world except Eastern Europe. Export shipments increased across most 

product types, with the greatest increase in activity 

observed in capital goods. 

The Outlook for the Global Economy 

Remains Uncertain 

Developments during the past six 

months have resulted in an 

improved outlook for the global 

economy, but some key uncertainties remain. While the global 

financial system is more stable 

today than it was six months ago, 

some of the world’s most important economies either 

remain in recession or are experiencing slower growth. 

In this environment, the potential remains for shocks to 

arise in the global economy that could adversely affect 

the performance of the U.S. economy and the credit 

quality of insured depository institutions. 

Canada. The Canadian economy is healthier than at any 

time during the past several years. Canada’s economy is 

expected to track overall growth in the United States, in 

part because U.S. demand for goods and services is the 

principal support for Canadian exports. Canada’s relatively high dependence on weak commodity industries, 

such as metals, grains, and livestock, poses risks for 

producers and for local economies closely tied to these 

commodities. 

Mexico. Mexican GDP growth was 4.6 percent in 1998, 

reflecting relatively strong employment and wage gains, 

high levels of foreign direct investment, and robust nonoil export growth. Looking ahead, inflation remains a 

concern. At the end of 1998, the inflation rate was 18.7 

percent, up from a low of 15 percent in the middle of the 

year. The Blue Chip Economic Indicators consensus 

forecast calls for real GDP growth of 2.9 percent during 

1999, down from 4.6 percent in 1998. 

Western Europe. Europe’s problems are similar to 

those of the United States in that they stem from declining growth in manufacturing exports. Despite a 175 

basis point cut in short-term interest rates in the U.K. 

since October 1998, the Bank of England forecasts economic growth of less than 1.0 percent in 1999. In Germany, manufacturing activity has also decreased, owing 

to weakness in export markets. German GDP shrank by 

0.4 percent during the fourth quarter of 1998, while 

unemployment remains above 10 percent. In response to 

signs of growing weakness in Germany and other major 

economies in the 11-member “Euro-zone,” the European Central Bank cut short-term interest rates by 50 

basis points to 2.5 percent on April 8, 1999. 

Eastern Europe. Much of Eastern Europe is faced with 

slow growth or recession following the devaluation of 

the ruble and the default on Russian government debt in 

August 1998. The Russian economy shows few signs of 

recovery amid high inflation and halting progress in 

economic reform. Poland and Hungary, Eastern 

Europe’s engines of growth before the Russian crisis, 

are facing rising current account deficits and a slowdown in export growth. 

Asian Pacific Rim. The Japanese economy remains 

mired in a long-running recession that has resulted in a 

greater number of bankruptcies (up 17 percent in 1998), 

falling domestic demand, and pessimism among consumers and businesses alike. Japanese GDP fell by 2.8 

percent during 1998, and analysts call for a drop of 0.8 

percent in 1999. 

There are signs that the worst phase of the Asian economic crisis may have passed.3 In the Philippines, South 

Korea, Hong Kong, and Thailand, current accounts have 

moved from deficit to surplus as devalued currencies 

continue to depress imports. Foreign capital is returning 

to the region, as evidenced by the 27 percent increase in 

foreign direct investment in Korea during 1998. However, weak consumer spending remains a problem for 

the entire region, which ships fully 40 percent of all 

exports to other Asian Pacific Rim nations. 

In China, which has been relatively immune to the worst 

of the region’s economic crisis, slower growth is also 

forcing economic restructuring. With annual economic 

growth below the targeted 8 percent mark, economic 

planners have been forced to reduce production and 

close plants in the oil, steel, glass, and cement industries. Meanwhile, the government is trying to stimulate 

demand by investing in public infrastructure and by urging banks to increase lending to the private sector. 

3 See “The Asian Economic Crisis: Implications for the U.S. Economy,” Regional Outlook, Third Quarter 1998. Also available at 

http://www.fdic.gov/publish/regout/ro19983q/ny/infocus1.html. 

Boston Regional Outlook 6 Second Quarter 1999 
In Focus This Quarter
 

Latin America. With the apparent stabilization of the 

Asian economies, attention has now focused on emerging problems in Latin America. The 50 percent devaluation of the Brazilian real versus the dollar that began in 

January 1999 has depressed economic activity and 

renewed fears of inflation. Consensus estimates place 

Brazilian economic growth at negative 3.5 percent for 

1999, while short-term interest rates are likely to remain 

high (currently about 42 percent) to prevent further capital flows out of the country. 

Risks Remain despite a Positive 

U.S. Economic Outlook 

Robust economic growth, low inflation, and stable 

interest rates appear to be the most likely economic scenario for the remainder of 1999, according to the consensus forecast of the Blue Chip Economic Indicators. 

If this outlook actually comes to pass, we can expect 

that the vast majority of insured institutions will continue to enjoy moderate loan growth and generally favorable indicators of financial performance and condition. 

Despite this positive outlook, the risk remains that the 

expansion could be derailed by one of three types of 

shocks. The first would be a resurgence of inflation 

resulting from demand-induced shortages of labor or 

other key economic resources. Although inflation has 

been consistently low in recent years, investors remain 

on the lookout for any signs of higher prices. While it is 

not certain that a recession would result, it is worth noting that rising short-term interest rates in response to 

increasing inflation have preceded every recession during the past 40 years. 

The second type of shock that could end the expansion 

is a sustained period of deflation. Concern about deflation arises from the low prices many commodity producers are receiving and the effects of foreign currency 

devaluations on U.S. import prices. Although these 

trends have helped to keep U.S. inflation and interest 

rates low, at some point they could impose a heavier 

burden on U.S. businesses by shrinking revenues and 

profit margins, mirroring what has already occurred in 

some commodity-based industries.4 

The third type of shock is financial market instability. 

Consumer confidence, which has reflected recent 

increases in stock market wealth, could tumble in the 

event of a severe and prolonged decline in the stock 

market. Business investment has also depended on the 

support of strong and stable financial markets that offer 

firms access to capital on favorable terms and facilitate 

restructuring in troubled industries. A recession accompanied by financial market instability could pose a particular threat to bank loan performance because it would 

likely produce a disorderly shakeout of troubled firms 

marked by a rise in bankruptcies and loan defaults. 

4 See “How Will the Expansion End?” Regional Outlook, Second 

Quarter 1998. Also available at http://www.fdic.gov/publish/regout/ 

ro19982q/sf/infocus2.html. 

Trends Affecting Banking Lines of Business
 

Overview 

Trends in bank and thrift lines of business align closely 

with those of the economy. Most insured institutions 

have prospered during this economic expansion, as 

shown by the industry’s continuing earnings growth, 

strong capital levels, and improving or stable loan performance across most major loan categories. Likewise, 

today’s strong economy depends to a great extent on the 

continuing availability of consumer and business credit 

from banks and thrifts. Even during the closing months 

of 1998, when capital market funding sources became 

quite volatile, credit continued to flow from insured 

institutions. During that turbulent period, insured institutions may have acted as a stabilizing force for businesses, consumers, and farmers by continuing to provide credit, albeit at higher prices and with stricter 

underwriting terms in some cases. 

Although credit conditions appear strong, a number of 

insured institutions’ loan portfolios are shifting toward a 

riskier mix of credits. Underlying reasons for these 

shifts vary, but likely explanations include opportunities 

to earn higher yields and confidence about the overall 

economic outlook. The following paragraphs discuss 

credit risk trends and highlight possible areas of concern in the major lending lines of business at insured 

institutions. The influence of recent interest rate 

changes and competitive factors on asset/liability and 

credit risk management is also explored. 

Boston Regional Outlook 7 Second Quarter 1999 
In Focus This Quarter
 

Consumer Lending 

Debt Growth Sustains Consumer Spending but 

Could Contribute to Financial Strains under 

Less Favorable Economic Conditions 

Much of the strength and stability of the overall U.S. 

economy owes itself to the continuing growth in consumer spending. While higher personal incomes and 

consumer confidence are important contributing factors, lower interest rates and expanding avenues of credit access have also played key roles in supporting 

consumer spending. With mortgage debt leading the 

way, consumer loan growth rates accelerated in 1998. 

The key factor driving mortgage loan growth was lower 

interest rates, which encouraged many consumers to 

purchase homes, refinance existing mortgages, and 

consolidate their personal debts through home equity 

loans. As a result, the growth in home mortgage credit 

during 1998 reached a post-recession high of 10 percent. Other consumer loan types, such as auto and credit card debt, grew at slower but accelerating rates of 8 

percent and 5 percent, respectively. 

Nonmortgage consumer loan loss rates remain above 

previous recession levels despite the apparent strength 

of the consumer sector. Chart 5 shows that nonmortgage consumer loss rates have declined slightly from 

their peak in the fourth quarter of 1997, but remain 

above the rates experienced during the prior recession. 

The chart also shows that consumer credit loss rate 

trends are closely related to the rise in personal bankruptcy filings, which reached an all-time high of 1.4 

million in 1998.5 The good news for consumer lenders 

is that the growth rate in personal bankruptcies has 

slowed. However, this leveling off does not mean that 

consumer credit quality concerns have abated. The 

overriding concern is how personal bankruptcies and 

consumer credit losses, already at high levels, would be 

affected by less favorable economic conditions. Another concern is whether current consumer spending patterns will be supported by a new round of credit card 

growth. Since revolving credit card balances typically 

carry higher interest rates than home equity loans, this 

5 Reasons for the rise in personal bankruptcy rates are further 

explored in a series of Bank Trends articles published by the FDIC. 

See, for example, “A Time Series Model of the U.S. Personal Bankruptcy Rate, 1970-1996,” February 1998, and “The Effect of Consumer Interest Rate Deregulation on Credit Card Volumes, 

Charge-Offs, and Personal Bankruptcy Filings,” March 1998. Both 

reports can be accessed at www.fdic.gov/publish/bktrnds/index.html. 

CHART 5 

0.0 

0.5 

1.0 

1.5 

2.0 

2.5 

3.0 

1Q91 2Q92 3Q93 4Q94 1Q96 2Q97 3Q98 

0.0 

0.2 

0.4 

0.6 

0.8 

1.0 

1.2 

1.4 

Consumer Charge-Offs and Bankruptcies 

Have Leveled Off at a High Rate 

Bankruptcy Filings 

per 1,000 Population 

(Right axis) 

Sources: Administrative Office of the U.S. Courts; Federal Reserve Board 

1.6 

Consumer Loan 

Charge-Off Rate (%) 

“reloading” of credit card debt would further strain the 

financial flexibility of consumers. 

High Loan-to-Value Mortgage Products 

and Subprime Lending Transform 

Consumer Lending 

Consumer lending practices have changed significantly 

since the last recession. Because of intense competition 

and declining net interest margins, consumer lenders 

are reaching out to borrowers further down the credit 

quality spectrum and relaxing traditional collateral 

requirements. Bank supervisors have indicated that a 

growing number of insured institutions are involved in 

some form of subprime lending. Subprime loans, 

designed for borrowers with blemished or limited credit histories, can take a variety of forms, including home 

equity, automobile, and credit card loans. As compensation for increased risk, subprime loans carry higher 

interest rates than prime-rate loans and often require 

substantial collateral margins. 

Insured institutions are also embracing another relatively new consumer loan product: high loan-to-value 

(LTV) loans. High LTV loans, where the combined 

amount of senior and junior liens against a home 

exceeds its value, are usually made to borrowers with 

“clean” or unblemished credit histories. However, the 

lack of collateral protection results in much higher loss 

experience when a borrower defaults. As Chart 6 shows, 

high LTV loans have had a higher loss rate experience 

(adjusted for seasoning) than either traditional home 

equity loans or subprime loans. Moreover, the delinquency rates on recent-vintage home equity loan pools 

Boston Regional Outlook 8 Second Quarter 1999 
In Focus This Quarter
 

CHART 6 

0 

1 

2 

3 

4 

5 

6 

7 

0 2 4 6 8 10 12 14 16 18 20 22 

Months since Origination 

High LTV Mortgages* Have a Higher Loss 

Experience than Other Mortgage Types 

Charge-Off Rate (%) 

* Includes home improvement loans 

Source: Moody’s Investor Services 

High LTV 

Subprime 

Traditional 

Home Equity 

have deteriorated as high LTV loans have proliferated.6 

At the same time, recent regulatory surveys of credit 

underwriting practices show easing standards on home 

equity loans.7 The loss experience of these higher risk 

consumer products during less favorable economic circumstances is unknown and continues to be a concern. 

Commercial Lending 

Commercial Loan Performance Remains 

Strong but Corporate Financial Strains 

Are Developing 

Continued strength in the corporate sector is reflected in 

the level of corporate bankruptcy filings, which have 

declined since the middle of 1997 to just under 10,000 

in the fourth quarter of 1998. Bank losses on commercial credits remain low but did register a modest 

increase during the fourth quarter (see Chart 7). In addition to strong economic fundamentals in high tech, construction, finance, service-related, and other sectors, 

U.S. businesses have benefited from significantly lower 

interest rates and an abundant supply of credit. Credit 

access provided by banks was particularly important to 

U.S. businesses in the latter part of 1998. During this 

6 “Moody’s Home Equity Index Update.” Moody’s Investor Services, 

October 2, 1998, p. 3. 

7 For example, the Office of the Comptroller of the Currency’s “1998 

Survey of Credit Underwriting Practices” indicated that 33 percent of 

the banks offering home equity loans eased standards, compared with 

only 7 percent that tightened standards. The report is available at 

http://www.occ.treas.gov/cusurvey/scup98.pdf. 

period, sharply higher interest rate spreads on corporate 

bonds8 and commercial paper led many companies to 

tap cheaper funding sources, including existing unused 

credit and commercial paper lines held by commercial 

banks. As a result, commercial banks experienced a 15 

percent (annualized) rate of growth in fourth quarter 

1998, the highest rate of commercial loan growth in 16 

years. 

Although commercial loan loss rates are low, financial 

strains are becoming apparent among certain U.S. business sectors. Bank lending to U.S. businesses has grown 

at a faster pace than GDP during each of the past eight 

quarters. Moreover, growth in bank commercial lending 

through 1998 has come at a time when total after-tax 

U.S. corporate profits have begun to decline.9 Deteriorating profits are especially prevalent in sectors with 

exposure to weak commodity prices and slower export 

growth. For many businesses, lower profits have resulted in a reduced capacity to service outstanding debt 

obligations. For instance, a recent Bank of America 

Corporation study reported that amendments to syndicated loans in the latter half of 1998 were driven 

increasingly by borrowers seeking relief from financial 

performance-related covenants.10 Financial strains are 

8 The Merrill Lynch U.S. Investment Grade Corporate Bond Master 

Index indicates that corporate bond spreads over ten-year Treasury 

rates rose 58 percent, an increase of 63 basis points, from the end of 

July 1998 to the end of October 1998. 

9 See the Bureau of Economic Analysis Corporate Profit Index. 10 “Covenants Provide Loan Repricing Opportunity.” Bank of America 

Report, January 25, 1999. 

CHART 7 

0.0 

0.2 

0.4 

0.6 

0.8 

1.0 

1.2 

1.4 

1.6 

1.8 

2.0 

1Q91 3Q92 1Q94 3Q95 1Q97 3Q98 

Sources: U.S. Courts; Bank Call Reports 

Net Charge-Off Rate (%) Business Bankruptcies 

9,000 

10,000 

11,000 

12,000 

13,000 

14,000 

15,000 

16,000 

17,000 

18,000 

19,000 

20,000 

Domestic Commercial Loan Losses Remain Low 

and Business Bankruptcies Decline 

Boston Regional Outlook 9 Second Quarter 1999 
In Focus This Quarter
 

also reflected in the level of corporate bond defaults, 

which Standard and Poor’s reported at 48 ($10.8 billion in affected debt) in 1998, up 182 percent from 1997 

levels (up 150 percent in dollar volume terms).11 

As Debt Markets Become More Cautious, 

Syndicated Lending Shifts toward Higher 

Risk Borrowers 

Although the longer-term trend has been toward more 

aggressive corporate lending strategies, many insured 

institutions responded to the financial market turmoil in 

late 1998 with a heightened sense of caution. Recent surveys of underwriting practices conducted by the federal 

banking agencies show that many banks tightened standards in late 1998 across many product lines.12 However, 

tighter lending terms do not appear to have quelled 

either loan demand or loan production substantially. 

Syndicated lending trends suggest an increase in corporate lending risks.13 Despite the flight to quality that 

occurred in the latter part of 1998, syndicated loans to 

leveraged companies jumped 41 percent to $273 billion 

during 1998. Over the same period, nonleveraged loans 

declined 35 percent to $599 billion. Although corporate 

merger activity accounts for much of the increase in 

leveraged lending volume in 1998, some lenders appear 

to be taking advantage of the higher yields available in 

this market relative to yields on lower risk credits. The 

apparent shift toward a higher risk mix of total syndicated credit outstanding is occurring at the same time 

that corporate bond defaults for speculative grade issues 

are trending upward.14 Moreover, trends in corporate 

bond spreads and rating agency actions on corporate 

bond debt suggest a bond market that is becoming 

increasingly cautious about the outlook for U.S. businesses (see Chart 8). 

11 “Corporate Defaults Rise Sharply in 1998,” Standard & Poor’s, 

March 5, 1998. 

12 See Federal Reserve Board Senior Loan Officer Opinion Surveys 

for November 1998 and January 1999, http://www.bog.frb.fed.us/ 

boarddocs/snloansurvey/. 

13 Syndicated loans are credit facilities made to medium and large corporate borrowers by a group or syndicate of lenders. Analysts often 

segment this market into “leveraged” lending (loans to heavily indebted companies) and nonleveraged lending. 

14 Moody’s Investor Services reports that trailing 12-month default 

rates for speculative-grade issuers rose from 2.02 percent at the end 

of 1997 to 3.31 percent at year-end 1998. These default rates compare 

to an all-corporate trailing default rate of 0.68 percent in 1997 and 

1.27 percent in 1998. 

CHART 8 

0.4 

0.6 

0.8 

1.0 

1.2 

1.4 

1.6 

1.8 

2.0 

4Q93 4Q94 4Q95 4Q96 4Q97 4Q98 

–120 

–80 

–40 

0 

40 

80 

120 

160 

200 

Corporate Bond Ratings and Required 

Yields Reflect Greater Market Uncertainty 

Merrill Lynch Corporate Bond 

Master Index Spreads to Comparable

 Maturity Treasuries (bps) 

Sources: Moody’s Investor Service; Merrill Lynch 

Ratio of Corporate 

Upgrades to 

Downgrades 

Commercial Real Estate and 

Construction Lending 

Construction Loan Growth Accelerates 

as Overbuilding Pressures Increase 

in Certain Markets 

In 1998, the value of private commercial construction 

rose 4.0 percent over 1997 levels, reflecting a moderate 

slowdown in growth compared with a compounded 

average annual growth rate of 8.4 percent since 1992. In 

contrast, the pace of residential development has accelerated. The value of private residential construction rose 

11.5 percent in 1998, compared with an annual average 

growth rate of 8.0 percent since 1992. Construction 

loans at insured institutions grew 20 percent in 1998, 

the highest growth rate since 1986.15 

Although market fundamentals are strong throughout 

most major U.S. markets, some metropolitan areas 

appear to be vulnerable to an oversupply of commercial 

space. The Regional Outlook, First Quarter 1999, highlighted nine markets that may be susceptible to commercial overbuilding on the basis of the following 

factors: 1) the rapid pace of current construction activity in those markets; 2) high vacancy rates relative to 

construction in progress in some cases; 3) projections of 

rising vacancy rates by market analysts; and 4) various 

recent shifts in demand indicators. Data through June 

1998 indicate that construction activity in these markets 

15 Construction loan growth captures growth in both residential and 

nonresidential development. 

Boston Regional Outlook 10 Second Quarter 1999 
In Focus This Quarter
 

has not yet abated to reflect moderating demand levels.16 

Overbuilding concerns may be tempered to the extent 

that tighter commercial real estate lending standards 

slow the pace of development.17 

Loan Underwriting Study Reveals Sounder 

Practices Compared with the 1980s, but Intense 

Competition Forces Some Concessions on 

Pricing and Structure 

Beginning in August 1998, FDIC analysts set out to 

investigate construction loan underwriting practices in 

banks servicing various rapidly growing markets. The 

study identified several differences between today’s 

lending practices and those prevalent during the last 

cycle. Most importantly, today’s lenders are making 

credit decisions on the basis of improved appraisals, 

increased attention to project cash flows and project 

feasibility, and better market information on competing 

projects. However, intense competition has forced an 

across-the-board reduction in loan pricing margins even 

compared with margins at the height of the 1980s building boom. 

The study also identified some instances of aggressive 

loan structures, including pricing at extremely thin margins, waiving or limiting personal guarantees, waiving 

cash equity requirements, and lending on thin collateral 

margins. Borrowers who secured the most aggressive 

loan terms were typically larger developers, who presumably have the resources and financial flexibility to 

weather adverse conditions. Nevertheless, waiving personal guarantees and eliminating a borrower’s financial 

exposure to project risks are practices often cited in 

conjunction with the heavy construction loan losses 

experienced during the previous real estate downturn. 

Finally, the study found that many real estate investment 

trusts and large corporate developers have been able to 

obtain long-term unsecured financing for development 

purposes. The lack of collateral protection could make 

16 The nine markets are Atlanta, Charlotte, Dallas, Las Vegas,
 

Nashville, Orlando, Phoenix, Portland, and Salt Lake City. “Commercial Development Still Hot in Some Markets but Slower Development May Be Ahead.” Regional Outlook, First Quarter 1999,
 

www.fdic.gov/publish/regout/ro19991q/na/index.html.
 17 Consistent with commercial and industrial underwriting trends,
 

commercial real estate lenders reacted to market volatility in late
 

1998 by tightening loan terms and raising pricing margins. See, for
 

example, the Federal Reserve Board Senior Loan Officer Opinion
 

Survey for November 1998 and January 1999.
 

these loans particularly vulnerable to declining commercial real estate prices.18 

Agricultural Lending 

Farm Banks Threatened by Falling 

Commodity Prices 

Farm banks generally performed well in 1998, reporting 

a modest increase in nonperforming loans from 1.09 

percent at year-end 1997 to 1.13 percent as of year-end 

1998. Although delinquent loans rose only slightly 

in the aggregate, farm banks in some localized areas 

such as northeast North Dakota and northwest Minnesota experienced sharply higher problem loan levels 

and reduced profits in the aftermath of three consecutive years of low prices, bad weather, and crop diseaserelated problems. Moreover, recent surveys by the 

federal banking agencies, which show rising levels of 

farm carryover debt at farm banks, suggest that nonperforming loan data may understate borrower difficulties. 

During 1998, the outlook for significant portions of the 

farm sector deteriorated following a dramatic fall in 

prices for several major farm commodities. Prices for wheat, corn, 

soybeans, and hogs fell to ten-year 

lows and were below the economic breakeven cost of production for 

many producers. For areas heavily 

dependent on these commodities, 

the U.S. Department of Agriculture (USDA) projects that producers will experience 

substantial declines in net cash income from 1999 

through 2003.19 In 1999, the USDA projects farm 

income to fall 7.1 percent, to $44.6 billion, from last 

year’s level of $48 billion. 

Although current conditions have the potential to cause 

stress for substantial numbers of farm banks in certain 

regions, some significant differences exist between 

today’s circumstances and those that led to the farm 

18 Loan covenants may mitigate some of the risks of lending without 

collateral protection. Common covenants include maximum leverage 

ratios, minimum equity requirements, and limits on encumbered 

assets through recourse or cross-collateralization to third parties. 

19 A substantial portion of the USDA’s projected decline in the net 

cash income for U.S. farmers over the next five years is attributable 

to reductions in government payments to farmers. 

Boston Regional Outlook 11 Second Quarter 1999 
In Focus This Quarter
 

bank crisis of the mid-1980s. Current favorable factors 

include 1) lower debt-to-equity for farm producers; 2) 

substantially lower interest rates; 3) moderately appreciating farmland prices relative to the more rapid appreciation (and subsequent price corrections that followed) 

in the 1970s and 1980s; and 4) better underwriting practices by farm lenders. Nevertheless, if weak exports of 

farm products and low commodity prices continue for 

the remainder of this year, the condition of farmers 

could deteriorate significantly, increasing financial 

stress at insured farm banks. 

Funding and Interest Rate Risk 

Deposit Funding Becomes 

More Difficult to Obtain 

Competitive pressures in the banking industry are not 

restricted to lending. Insured institutions are also finding it difficult to attract deposits in today’s marketplace, 

largely because of the existence of higher yielding 

investment products. For example, the Investment 

Company Institute reports that net inflows into mutual 

funds have exceeded net increases in deposit accounts 

in all but three quarters since mid-1991. The fourth 

quarter of 1998 marked the sixteenth consecutive quarter that mutual fund inflows outstripped deposit increases. As deposits have become more difficult to attract, 

loan portfolios have expanded in line with the overall 

growth in the economy. As a result, institutions have 

turned increasingly to other borrowings for funding. 

These trends are captured in Chart 9, which shows that 

the ratio of bank and thrift loans to deposits reached a 

record 88 percent in December 1998. Small community 

CHART 9 

banks and thrifts (institutions with less than $1 billion in 

assets) are most affected by deposit trends, since they 

tend to rely more heavily on deposit funding than larger institutions with greater access to the capital markets. 

Interest Rate Changes Pose Asset/Liability 

Management Challenges 

Interest margin pressures are posing challenges for 

insured institutions. In addition to the effect of competitive pressures, changes in interest rates have had a substantial influence on institutions’ net interest margins. 

The flattening of the yield curve in 1998, for example, 

appears to have contributed to a decline in margins to 

their lowest levels since 1991 for both large and small 

insured institutions (see Chart 10). For insured institutions with more traditional asset/liability structures 

(longer-term asset holdings funded with shorter-term 

deposits and borrowings), a flatter yield curve results in 

lower spreads between asset yields and interest costs. 

The decline in long-term interest rates during 1998 also 

led to a record volume of mortgage refinance activity, 

as indicated by the Mortgage Bankers Association’s 

Refinancing Index.20 Among many mortgage lenders, 

the most immediate impact from this refinancing activity was the revaluation of servicing assets and lower servicing fee income. Some mortgage lenders also saw a 

significant increase in overhead as they expanded staff 

to accommodate higher loan application volumes. A 

20 This index hit its peak in mid-October and has since declined in line 

with a modest upward movement in fixed mortgage rates. 

CHART 10 

65 

70 

75 

80 

85 

90 

95 

’84 ’85 ’86 ’87 ’88 ’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 

Loans and Assets Are Growing Faster than 

Deposits at Insured Institutions 

Loans to Deposits 

Deposits to Assets 

Source: Bank Call Reports and Thrift Financial Reports 

Percent 

A Flatter Yield Curve in 1998 Placed 

Pressure on Net Interest Margins 

Sources: Federal Reserve Board; Bank Call Reports; Thrift Financial Reports 

1.0 

1.5 

2.0 

2.5 

3.0 

3.5 

4.0 

4.5 

5.0 

–50 

0 

50 

100 

150 

200 

250 

300 

350 

’84 ’85 ’86 ’87 ’88 ’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 

Assets 

< $1 Billion 

(right axis) 

10-Year Less 1-Year 

Treasury (bps) 

Mean Net Interest 

Margin (%) 

Assets 

> $1 Billion 

(right axis) 

Boston Regional Outlook 12 Second Quarter 1999 
In Focus This Quarter
 

longer-lasting impact involves the shift in borrower 

preferences toward fixed-rate mortgages. According to 

Freddie Mac, approximately 65 percent of adjustablerate mortgages refinanced in 1998 were replaced with 

30-year fixed-rate mortgages. Another 30 percent were 

refinanced into 15- and 20-year fixed-rate mortgages. 

As a result of this activity, mortgage lenders may tend 

to have a higher proportion of assets held in longer-term 

mortgage loans, leading to further margin pressures 

should interest rates rise. 

As discussed in previous sections, many insured institutions appear to be turning toward higher risk consumer 

and corporate lending strategies. Such strategic shifts 

may be at least partially in response to pressures on net 

interest margins. The search for higher yield spreads 

may also explain the continuing growth in nondeposit 

funding sources, which often take the form of complex 

obligations with embedded options that can reduce 

funding costs at the expense of additional interest rate 

risk. 

Indicators of Industry Performance
 

Market Signals for the Banking 

Industry Are Mixed 

Diminished concerns over the near-term economic outlook and reduced financial market volatility resulted in 

a sharp turnaround in investor attitudes toward banks in 

the fourth quarter of 1998. During the quarter, the SNL 

Bank Stock Index21 rose 21 percent, recovering all of 

the value it lost during the turmoil of the third quarter. 

The index has continued to rise in 1999. 

Although equity indicators have been generally positive, ratings actions in 1998 for the long-term debt of 

U.S. banks and finance companies reflect developing 

problems for certain industry segments. In sharp contrast to the previous six years, when upgrades far 

exceeded downgrades, Moody’s downgraded as many 

bank and finance company debt ratings as it upgraded 

during 1998. In the fourth quarter of 1998, Moody’s 

downgraded the long-term debt ratings of 27 bank and 

finance companies and upgraded only 15—the highest 

quarterly ratio of downgrades to upgrades since 1992. 

Downgrades during 1998 were centered in finance 

companies specializing in nonportfolio subprime lending and bank holding companies with exposure to 

emerging markets. 

Bank Performance Remains Strong but 

Earnings Variability Is Increasing 

Recent stable industry profitability in the aggregate has 

masked an increasing range of profit variability for 

individual commercial banks. Over the past six years, 

21 This index tracks the market capitalization of approximately 520 

banking companies. 

the annual aggregate return on average assets (ROA) for 

commercial banks has shown little fluctuation, ranging 

from a low of 1.15 percent in 1994 to a high of 1.24 percent in 1997.22 However, the variability in commercial 

bank profitability, as measured by the distribution of the 

industry’s ROA excluding the top and bottom 5 percent, 

has widened since 1994 (see Chart 11). For example, 

ROA for the worst 5 percent of the industry was negative 0.29 percent or less in 1998, reflecting a steady 

decline from 0.2 percent in 1995. Similarly, ROA for the 

most profitable 5 percent of commercial banks was 

above 2.16 percent, up from 1.94 percent in 1994. 

Reasons for the increasing variability of commercial 

bank ROA can be further analyzed by segregating institutions along predominant product or business lines. 

Chart 12 (next page) details the distribution of 1998 

22 FDIC Quarterly

www2.fdic.gov/qbp. 

CHART 11 

 Banking Profile, Fourth Quarter 1998, 

3.0 

’84 ’85 ’86 ’87 ’88 ’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 

Source: Bank Call Reports 

Bottom 5th Percentile 

Top 5th Percentile 

Mean 

The Range of Profitability for Commercial 

Banks Is Increasing 

Return on Asset Distribution 

–4.0 

–3.0 

–2.0 

–1.0 

0.0 

1.0 

2.0 

Boston Regional Outlook 13 Second Quarter 1999 
In Focus This Quarter
 

CHART 12 

–5% 0% 5% 10% 15% 

1998 Performance Varies by 

Business Specialization 

Return on Assets Percentage Distribution 

Agricultural 

(2,274) 

International 

(11) 

Consumer 

(211) 

Commercial 

(3,150) 

Specialized 

(621) 

Credit Card 

(68) 

Note: Group institution count is in parentheses. 

Source: Bank Call Reports (Research Information System) 

Industry Mean ROA=1.13% 

Bottom Fifth Percentile 

Top Fifth Percentile 

ROA for six selected groups of banks segregated by line 

of business concentrations. This chart reveals that bank 

performance varies considerably by business specialty. 

For example, the distribution of ROA of credit card 

lenders23 differs significantly from that of other bank 

groups, including other consumer lenders.24 Small specialized banks25 and commercial lenders26 followed 

credit card lenders as the groups with the greatest variability in profitability in 1998. Moreover, 75 percent of 

the least profitable commercial banks were members of 

small specialized or commercial groups. New banks 

have also influenced the dispersion of bank ROA. Banks 

chartered in 1997 and 1998 make up more than 60 percent of the industry’s worst performers. However, earnings variability widened in 1998 even when newer 

institutions are excluded from the analysis. 

23 Banks with at least 50 percent of managed loans in managed credit 

card receivables and at least 50 percent of managed loans in total 

managed assets. 

24 Banks with consumer loans and single-family mortgages in excess 

of 50 percent of assets that do not meet separate credit card or mortgage lending concentration thresholds. 

25 Banks with total assets less than $1 billion, and less than 40 percent 

of assets held in loans, that do not fall in other business specialties. 

Members of this group include de novo banks and more seasoned 

banks with low loan activity, such as trust companies. 

26 Banks with 25 percent or more of assets in commercial and commercial real estate loans. 

Far fewer commercial banks posted losses in 1998 than 

during the period from 1984 to 1992. Still, the number 

of unprofitable institutions appears to be rising despite 

generally favorable economic conditions. These concerns are mitigated somewhat, since today’s worstperforming institutions are generally much better 

capitalized and are burdened with fewer problem assets 

than their counterparts during the 1980s. 

Summary 

Most indicators of U.S. economic health remain robust 

in spite of the difficulties posed by low commodity 

prices and falling exports during 1998. The consensus 

forecast of leading economic analysts calls for continued growth in the U.S. economy for the rest of 1999. At 

the same time, a number of threats to this favorable outlook exist, including the possibility of higher inflation 

and higher interest rates stemming from strong economic growth. Other scenarios involve a very different 

threat—namely, price deflation brought on by global 

overcapacity and a decline in U.S. exports. Shocks that 

might arise in the foreign sector or in the financial markets, as experienced during 1998, remain a significant 

concern during 1999. Consumer spending and business 

investment seem particularly vulnerable to such shocks 

at this stage of the expansion. 

Favorable economic conditions are reflected in the overall performance of the banking industry. Still, a number 

of indicators suggest that the risk profile of some 

insured institutions is increasing. Responding to significant competitive pressures, and perhaps emboldened 

by the long duration of the current expansion, many 

institutions are expanding their involvement in higherrisk consumer loan products, such as subprime and high 

LTV loans and higher-risk leveraged commercial loans. 

The overall shift toward higher-risk credits is occurring 

despite signs of financial strain on the part of many consumers (in the form of record personal bankruptcies) 

and businesses (in the form of declining profits and 

increasing bond default rates). Credit-related concerns 

also extend to commercial real estate, where some markets are exhibiting rapid commercial real estate development at the same time that demand indicators are 

Boston Regional Outlook 14 Second Quarter 1999 
In Focus This Quarter
 

trending downward. Finally, sustained weak commodity 

prices are placing strains on farmers and could eventually lead to higher agricultural loan delinquencies. 

Bank and thrift net interest margins are being pressured 

by a flatter yield curve and heightened competition. 

Community institutions, which rely most heavily on 

interest income, are particularly vulnerable to tighter 

margins. The major concern in this area is that insured 

institutions will combat falling margins by entering into 

riskier funding and lending strategies. 

Market indicators and reported financial data reflect 

favorable industry performance as well as new sources 

of risk. Investor attitudes toward banking companies 

have improved since late 1998 because of an improved 

near-term economic outlook and a reduction in financial market volatility. However, a recent increase in 

ratings downgrades of bank and finance company longterm debt suggests growing concern over bank exposures to such areas as subprime lending and emerging 

markets. Despite relatively strong aggregate industry 

performance, profit variability among individual commercial banks has increased because of new chartering 

activity and pressures in consumer and commercial 

lending. As a result, for the first time since 1992, the 

worst performing 5 percent of all commercial banks 

were unprofitable last year. 

This article was prepared and coordinated by the staff of the Analysis Branch of the Division of Insurance. Contributions and feedback from analysts across the Division were essential to its completion. 

Maureen E. Sweeney, Associate Director 

Paul C. Bishop, Senior Financial Economist 

Richard A. Brown, Chief, Economic and Market Trends Section 

Steve Burton, Senior Banking Analyst 

Steven E. Cunningham, Chief, Financial Institutions Section 

Alan Deaton, Economic Analyst 

Diane Ellis, Senior Financial Analyst 

Jim Heil, Economic Analyst 

Brian Kenner, Financial Analyst 

Allen Puwalski, Senior Financial Analyst 

Boston Regional Outlook 15 Second Quarter 1999 
Regional Perspectives
 

Regional Perspectives
 

• The New England economy extended its expansion for another year in 1998, with most indicators showing 

gains from 1997. 

•	 Manufacturing employment was the Region’s one weak area during 1998, and some deceleration in overall 

job growth was seen during the first quarter of 1999. 

•	 Strong asset quality continues to bolster earnings; however, weaker margins arising from a prolonged refinancing wave are taking a toll on overall profitability. 

•	 Institutions affiliated with publicly traded companies are adopting higher risk profiles in response to weaker earnings growth and poor stock price performance. 

Regional Economic and Banking Conditions
 

Economic Overview of 1998 

The Boston Region experienced another year of solid 

expansion in 1998. Manufacturing was the only sector 

to show some weakness, although many of the Region’s 

states saw a net gain in factory jobs last year. The 

Region’s growth seemed likely to continue at a steady 

pace in the early months of 1999, as ongoing global 

weakness was offset by a very strong national economy. 

Employment 

Nonfarm employment rose by 2.3 percent in the Region 

during 1998, about the same pace as in 1997. All the 

New England states contributed to the overall employment advance (see Chart 1). Job growth in Massachusetts moderated slightly from the previous year, while 

Connecticut had its sixth straight year of progressively 

stronger job growth. Both Maine and New Hampshire 

had employment gains that exceeded the 2.6 percent 

national rate during 1998, although New Hampshire 

was the only state in the Region whose growth in 1998 

fell below its trend for this expansion. Vermont’s 

advance was its strongest in three years and was broadly based; Rhode Island’s gain was about the same as 

the previous year. During the first quarter of 1999, job 

growth decelerated modestly. New England nonfarm 

payrolls rose by 1.8 percent from a year earlier, with job 

growth decelerating most in the Region’s large states. 

The pattern of larger percentage gains posted by the 

northern New England states during 1998 persisted 

through the first quarter of 1999. 

As noted in last quarter’s Regional Perspectives, manufacturing is the economic sector that has been most 

affected by slackening global demand and a weakened 

trade picture. Nationally, factory payrolls rose by only 

0.3 percent last year, after rising 0.9 percent in 1997. 

They also decelerated in New England, from a gain of 

0.5 percent in 1997 to 0.3 percent in 1998. Only two of 

the Region’s states, Maine and Rhode Island, experienced actual net declines in factory sector payrolls last 

year. Both have been witnessing a flight of manufacturing jobs for several years as a result of various structural factors, which have been discussed in previous 

articles. Vermont’s strong 3.6 percent surge (about 

1,700 factory jobs) came after two years of gains under 

CHART 1 

–2 

–1 

0 

1 

2 

3 

4 

Source: Bureau of Labor Statistics 

Total Job Growth Remained Strong in 1998, 

despite a Weakened Manufacturing Sector 

Nonfarm 

Employment 

Manufacturing 

Employment

Percent Change from a Year Ago

MEMACT NH RI VT Region

Boston Regional Outlook 16	 Second Quarter 1999 
 

Regional Perspectives
 

2 percent and was spread across several industries. 

Massachusetts’ factory employment was unchanged in 

1998. Connecticut’s manufacturing sector, after losing 

jobs steadily between 1987 and 1996, added another 

year of positive growth: Connecticut factory payrolls 

rose 0.5 percent in 1997 and 0.9 percent in 1998. 

Despite the average increase for all of 1998, factory 

payrolls in the Region declined in the fourth quarter 

compared with the previous year. This trend was seen in 

all New England states except Vermont and persisted 

during the first quarter of 1999. 

Unemployment 

The labor market tightened further in 1998, as can be 

expected in a Region where job gains have been outpacing labor force growth for many years. The Region’s 

unemployment rate declined to an average of 3.5 percent last year—its lowest since 1988, just before the last 

recession. By way of comparison, the national unemployment rate averaged 4.5 percent in 1998, down from 

4.9 percent in 1997. The big story in 1998 was the dramatic plunge in Connecticut’s unemployment rate, from 

5.1 percent in 1997 to well under 4 percent last year. 

This drop put the state’s unemployment rate below the 

national average for the first time since 1995. Maine’s 

unemployment rate also dropped below the national 

average, from 5.4 percent in 1997 to 4.4 percent last 

year. Rhode Island was the only state in the Region with 

an average unemployment rate above the nation’s in 

1998—a condition that has existed in that state for eight 

of the past ten years. 

Unemployment fell steadily during 1998 for all the 

Region’s states, and year-end unemployment rates were 

far below those recorded in January and the annual 

averages reported above. This trend persisted in the 

early months of 1999; by March, seasonally adjusted 

state unemployment rates in the Region had fallen to 

between 2.8 and 3.1 percent, except for Maine, where 

the rate was 3.4 percent. Map 1 shows that despite the 

overall tightness in the labor market, some areas of 

higher unemployment remain. They are clustered in 

rural areas or those with large concentrations of basic 

manufacturing industries (such as Bristol County, 

Massachusetts) and reflect persistent economic difficulties (as in Vermont’s Northeast Kingdom and rural 

Maine) in addition to cyclical factors. 

Income 

At the time of this writing, personal income information 

was available for only the first three quarters of 1998. 

Based on that information and state population estiMAP 1 

Some Pockets of Higher Unemployment
 

Persist in the Region
 

1998 Unemployment Rates 

Below region (30 counties) 

Average (2 counties) 

Exceeds region (16 counties) 

Exceeds U.S. (19 counties) 

Source: Bureau of Labor Statistics 

mates by the New England Economic Project, the 

Region’s income per capita rose 4.5 percent from the 

same period in 1997. If this rate persisted during the 

fourth quarter, then income will have grown in 1998 by 

its slowest pace in four years. Income growth eased in 

all of the Region’s states except Vermont, where a 4.5 

percent advance handily exceeded the previous year’s 

3.8 percent gain in per capita income. The acceleration 

in Vermont’s per capita income was consistent with the 

state’s strength in nonfarm employment during 1998. 

Despite the apparent slowing of income growth last 

year, the Region’s advance still outpaced the national 

average of 4.2 percent. This made 1998 the fifth straight 

year in which the Region either matched or exceeded 

the national pace. 

Existing Home Sales and Prices 

The recent history of existing home sales in New England is spotty because of missing data for some states in 

some years. However, data on home sales in 1998 were 

available for all states (for the first time in four years). 

Home sales last year, as reported by the National Association of Realtors, tallied 230,000 across the Region, 

up from 170,000 in 1994—a compound annual average 

growth rate of 8 percent per year, versus a national pace 

of 5 percent (see Table 1, next page). Nationally, sales 

volume increased at a record pace in 1998, advancing 

14 percent from 1997. Only two states in this Region 

exceeded that pace: Sales shot up 16 percent in Maine 

Boston Regional Outlook 17 Second Quarter 1999 
1

1

Regional Perspectives
 

TABLE 1 

Existing Home Sales Posted 

Solid Gains in 1998 

PERCENTAGE CHANGE 

1997–1998 1994–1998* 

NATION 14 5 

REGION N/A 8 

CONNECTICUT 10 5 

MAINE 16 7 

MASSACHUSETTS 6 10 

NEW HAMPSHIRE N/A 14 

RHODE ISLAND 15 9 

VERMONT 4 –6 

* Compound annual rate 

Source: National Association of Realtors 

and 15 percent in Rhode Island last year. Favorable 

interest rates, continued job and income growth, a 

strong stock market and rising household wealth, and 

affordable pricing contributed to the home sales 

increases for these states and for the Region as a whole. 

Home sales rose by 6 percent last year in Massachusetts 

and by 10 percent in Connecticut. (Limited inventory in 

some areas of Massachusetts likely restrained growth in 

its home sales last year.) Sales increased 4 percent in 

Vermont, after falling for four consecutive years. Also, 

second and vacation home sales likely benefited from 

buoyant consumer confidence and the strong stock market. Although data for the intervening years are incomplete, home sales in New Hampshire rose at an average 

annual pace of 14 percent between 1994 and 1998, the 

strongest increase in the Region and far outpacing the 

national trend. 

Limited inventory (primarily in very active markets, 

such as Boston) coupled with strong demand caused 

average home prices to rise 6 percent last year across 

the Region, compared with a national increase of 5 percent. The home price index produced by the Office of 

Federal Housing Enterprise Oversight offers a fairly 

good measure of true home price appreciation. After 

nine years of lagging the national pace, New England 

home prices rose at a faster pace than the nation’s for 

the first time since 1988. The price growth gap was a far 

cry from the heady 1980s, however, when New England 

home prices were rising between 18 and 22 percent per 

year, compared with a national pace of 5 to 9 percent. 

Chart 2 shows the changes in price for the nation, 

Region, and six states during 1998 and the average pace 

for the previous four years. Clearly, the pace of price 

CHART 2 

The Region’s Home Prices Surged in 1998 

1998
 

RI
 

VT 

1994 to 1997 average 

CT 

Nation 

MA 

Region 

NH 

ME 

0 2 4 6 8 

Percent Change from a Year Ago 

Source: Office of Federal Housing Enterprise Oversight 

gains last year broke away from the trend for this expansion. The most dramatic acceleration in appreciation 

rates during 1998 occurred in Rhode Island and Connecticut. These states have lagged the rest of the Region 

during this expansion, and their housing markets have 

remained affordable throughout the current expansion. 

In Connecticut, the strength in home prices and sales 

may have been a major impetus behind a surge in new 

residential building permits. 

Residential Building Permits 

Strong demand for homes inspired developers to take 

out more permits in 1998. Across the Region, residential 

building permit issuance rose by 13 percent, compared 

with a gain of 11 percent for the nation. Last year’s gain 

was the strongest since 1992, the first year of the expansion. Nevertheless, permit volume was only 40 percent 

of the 1986 volume, when residential construction activity last peaked in the Region. Each of the New England 

states saw an increase in permit issuance last year. The 

weakest gains were in Rhode Island, where permits 

increased by only 2 percent after two years of somewhat 

sturdier advances, and in New Hampshire, where permits increased by 4 percent after 10 to 11 percent gains 

in the previous two years. The pace of 1998 advances 

was quite disparate in the Region’s largest markets. 

Massachusetts builders took out 9 percent more permits 

in 1998 than in 1997, while in Connecticut, permit 

issuance surged by 23 percent, setting a record for this 

decade (see Chart 3). Still, the volume of permits issued 

for each state was less than half the peak volume of the 

mid-1980s. Maine’s permit issuance jumped 25 percent 

(the state’s largest one-year gain during the 1990s), and 

Vermont permit issuance climbed 19 percent (after three 

years of declining volume). 

Boston Regional Outlook 18 Second Quarter 1999 
Regional Perspectives
 

CHART 3 

0 

10 

20 

30 

40 

50 

’86 ’87 ’88 ’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98* 

20 

40 

60 

80 

100 

120 

* Preliminary 

Source: U.S. Bureau of the Census 

(Residential Permits Issued, Thousands) 

’98 Housing Permits Jumped 13% Regionwide 

Region (right scale) 

Massachusetts 

Connecticut 

Banking Overview of 1998 

Profits Continue to Be Supported 

by Strong Asset Quality 

The Boston Region’s insured institutions reported 

another strong year in 1998, posting an aggregate return 

on assets (ROA) of 1.27 percent. This measure of profitability remained well above the national average (1.16 

percent) and, on a merger-adjusted basis, was in line 

with the year-earlier period (1.29 percent). Earnings 

continue to benefit from strong asset quality. The ratio 

of past-due loans to total loans has reached a historical 

low of 1.80 percent for the Region’s insured institutions, 

1.70 percent if credit card institutions are excluded. 

Restructured loans and other real estate owned have 

also retreated to levels not seen since the mid-1980s. 

Aggregate loan losses remain subdued, and consumer 

loan losses remain elevated but stable. The only other 

sector exhibiting credit quality weakness in 1998 was 

commercial and industrial (C&I) loans. Net chargeoffs rose 20 basis points, to 0.45 percent of average 

C&I loans. The increase was not followed by a commensurate increase in C&I delinquencies and was limited to the larger institutions in the Region, suggesting 

that the losses resulted from exposures to sectors hurt 

by weak international and capital markets in the second half of the year. Many of those losses were well 

publicized and included several finance companies 

involved in subprime consumer lending. For institutions with limited exposure beyond the Region, C&I 

losses remained low. 

Asset Growth Continues to 

Outstrip That of Core Deposits 

Core deposit growth remains lackluster for the Region’s 

insured institutions, up 3.5 percent on a merger-adjusted 

basis in 1998, compared with an increase of 5.2 percent 

for the nation as a whole. The Region’s larger institutions (assets greater than $1 billion) are lagging smaller 

institutions; however, their core deposit growth rate (1.3 

percent) is dampened somewhat by branch sales. Bank 

efforts to drive away unprofitable accounts may also be 

contributing to the lower rate of core deposit growth. 

While the aggregate core deposit growth rate in 1998 

was the highest since the mid-1980s, it is well below the 

rate of asset expansion (10.4 percent) and remains a 

long-term concern. As a result, the trend of increased 

reliance on noncore funding continues. Noncore funding grew 22 percent in 1998, following a 19 percent 

growth rate the prior year. Core deposits now support 

just 52 percent of the Region’s total assets, falling from 

a high of 71 percent of assets at year-end 1992. Clearly, 

the inability to grow core deposits has long-term liquidity implications. This factor is weighing heavily on net 

interest margins, as incremental asset growth is being 

supported largely by funds that are effectively priced at 

national market rates of interest. This trend will continue to hamper the industry’s ability to manage margins. 

Pace of Consolidation Remains Steady 

Merger and acquisition (M&A) activity remained 

steady in the Region. During 1998, the number of 

insured institutions declined by 18, to 434. The attrition 

rate has approximated 4 percent for the past four years, 

with the exception of 1997, when a large number of 

reorganizations resulting from the implementation of 

interstate branching pushed the level to 6 percent. M&A 

activity in early 1999 appeared to be tracking with 

recent experience; however, the recently announced 

acquisition of BankBoston by Fleet would dwarf previous merger activity in the Region on the basis of sheer 

size. If approved, the merger will affect the competitive 

landscape profoundly by bringing together the two 

largest competitors in the Region. Smaller institutions 

have demonstrated an ability to compete effectively 

with larger institutions in the past, and the planned 

branch divestitures and reorganization of the combined 

companies will create additional opportunities for other 

institutions, both existing and new. The concentration of 

market share will demand strong management to compete with the combined entity. 

Boston Regional Outlook 19 Second Quarter 1999 
Regional Perspectives
 

Five de novo institutions began operations in 1998, the 

highest level of new bank activity in the Region since 

1991. Four of them are headquartered in Connecticut, 

which produced nearly half of the Region’s new banks 

between 1984 and 1989 (39 charters) but had only five 

new bank formations between 1990 and 1997. Bank 

chartering activity generally rises in sync with local 

economic conditions, and the recent activity in Connecticut reflects the improvement and growing confidence in the state’s economy. Overall activity in the 

Region, however, remains subdued compared with the 

pace of the late 1980s. In the five years ending in 1989, 

75 institutions opened for business, including 24 in 

1987 alone. The pace of chartering activity in the 

Region today appears to reflect a more realistic assessment of the prospects for economic growth than was the 

case in the 1980s. 

Insured Institutions Are Taking on More Risk 


as Narrowing Margins Squeeze Earnings
 

Aggregate Data Are Masking a 

Weakening Earnings Posture 

In 1998, aggregate ROA at both the national and regional levels fell only 2 basis points from the year-earlier 

period; however, strong performance by credit card 

banks, primarily the result of a surge in noninterest 

income, effectively masked weakening earnings for the 

industry. The 1998 aggregate results were also bolstered 

by a greater reliance on securities gains. Excluding 

these two factors, the ratio of net operating income to 

average assets fell 5 basis points for the Region and 9 

basis points for the nation, to 1.13 percent and 1.02 percent, respectively. The weakening earnings posture 

results primarily from increased loan loss provisions at 

larger institutions and a weaker net interest margin that 

is affecting a wide range of institutions. Chart 4 sets 

forth the quarterly trend in the median ROA for the 

Region’s insured institutions as well as the level of perCHART 4 

formance for both the 25th and 75th percentiles. As the 

chart shows, the earnings engine appears to be losing 

some steam. 

Net interest margins (NIM) have come under pressure 

as a result of the general flattening of the yield curve 

that began following the last Fed tightening in March 

1997. Chart 5 shows the trend in the median NIM for 

the Region’s insured institutions on the basis of ownership structure. Publicly traded banks and thrifts, as well 

as subsidiaries of publicly traded holding companies 

(public companies), had the sharpest decline in NIM in 

recent quarters. Publicly held institutions saw a 47­

basis-point drop in median NIM, while closely held 

banks saw their median NIM fall 43 basis points. The 

median NIM fell only 25 basis points for mutually 

owned institutions (mutuals). The severity of the 

declines for the publicly held and closely held institutions relative to mutuals can be attributed largely to the 

CHART 5 

Region Institutions’ Earnings Are Slipping 

because of Narrowing Margins 

3.5 

4.0 

4.5 

5.0 

5.5 

Mutual 

Closely Held 

Publicly Held 

Source: Bank and Thrift Call Reports 

Margins Are Slipping across the Board 

Median Net Interest Margin (%) 

1Q 

’96 

3Q 

’96 

1Q 

’97 

3Q 

’97 

1Q 

’98 

3Q 

’98 

Return on Assets (%) 

1.4

1.2 

1.0 

0.8 

0.6 

0.4 

75th Percentile 

Median 

25th Percentile 

1Q 3Q 1Q 3Q 1Q 3Q 

’96 ’96 ’97 ’97 ’98 ’98 

Source: Bank and Thrift Call Reports 

Boston Regional Outlook 20 Second Quarter 1999 
Regional Perspectives
 

types of institutions in these categories. Table 2 breaks 

down the Region’s insured institutions by ownership 

structure and groups them on the basis of asset composition. As the table shows, stock-owned institutions have 

higher concentrations of commercial lending specialists 

and a lower level of residential lending specialists. 

The elevated refinancing activity of the past 18 months 

appears to have been felt more acutely by institutions 

with higher concentrations of commercial and commercial real estate loans (commercial structures). These 

types of loans were not as actively refinanced as residential loans during the refinancing waves of the early 

1990s because short-term rates remained well below 

long-term rates and there was no advantage to locking 

in a longer-term rate. During the latter half of 1998, 

however, a significant flattening of the yield curve created an extremely attractive opportunity for customers 

with floating-rate commercial structures, particularly 

those based on the prime rate, to lock in lower fixed 

rates. This shift of the yield curve also took place at a 

time when competition for commercial structures was 

intensifying. The end result was that asset yields fell 

more rapidly than the cost of funds. 

TABLE 2 

Ownership Structure Drives Strategies 

to Cope with Margin Squeeze 

The compression in margin is particularly problematic 

for public companies that are pressured by shareholders 

to maintain high returns on equity and earnings-pershare growth. Returns on equity are falling, and revenue 

growth is slowing because of declining net interest margins. Through 1997, institutions were able to bolster 

earnings through improved asset quality (low loan loss 

provisions and higher levels of earning assets) and cost 

containment, while they expanded noninterest income 

sources. Noninterest revenues continue to rise, but the 

incremental gains related to asset quality improvement 

and cost savings are diminishing. In fact, 1998 was the 

first year since 1991 that the provision for loan losses for 

the Region’s insured institutions actually exceeded the 

level of net charge-offs. Not surprisingly, bank and thrift 

stocks did not perform well in 1998. The SNL Securities 

Bank Index for all publicly traded banks rose 5.9 percent in 1998, compared with a 26.7 percent rise in the 

S&P 500. SNL’s asset size indices for all asset size categories below $10 billion actually fell an average of 5.0 

percent. Publicly traded thrifts performed even more 

Mutually Owned Institutions Are Highly Concentrated 

in Low-Risk Residential Lending 

PUBLICLY SHARE OF CLOSELY SHARE OF MUTUALLY SHARE OF SHARE OF 

GROUP HELD TOTAL % HELD TOTAL % OWNED TOTAL % TOTAL TOTAL % 

INTERNATIONAL 2 2 — — — — 2 0 

AGRICULTURE — — 1 1 — — 1 0 

CREDIT CARD 3 3 — — — — 3 1 

COMMERCIAL 47 42 40 48 22 9 109 25 

RESIDENTIAL 33 29 10 12 154 65 197 45 

CONSUMER 33 4 5 9 4 16 4 

SMALL SPECIALIST 65 8 10 10 4 24 6 

OTHER > $1B 10 9 1 0 31 7 

OTHER < $1B7 8 7 20 24 43 18 51 12 

TOTAL 112 100 83 100 239 100 434 100 

Institutions are grouped in the order presented below. When an institution first meets the definition of a grouping,
 

it is not tested further to meet subsequent grouping definitions.
 

International—Assets greater than $10 billion and foreign assets greater than 25 percent of assets.
 

Agriculture—Agriculture loans greater than or equal to 25 percent of total loans.
 

Credit Card—Total managed loans greater than 50 percent of managed assets and managed credit card loans
 

greater than 50 percent of total managed loans. 

Commercial—The sum of commercial and industrial, multifamily, and commercial real estate loans is greater than 

25 percent of assets. 

Residential—The sum of 1- to 4-family loans and mortgage-backed securities is greater than 50 percent of assets. 

Consumer—The sum of 1- to 4-family loans and consumer loans is greater than 50 percent of assets. 

Small Specialist—Assets less than $1 billion and total loans are less than 40 percent of assets. 

Other > $1B—Assets greater than $1 billion and no other criteria met. 

Other < $1B—Assets less than $1 billion and no other criteria met. 

Source: Bank and Thrift Call Reports 

Boston Regional Outlook 21 Second Quarter 1999 
Regional Perspectives
 

poorly, as indicated by the SNL Thrift Index, which registered a 13.3 percent decline for the year. Similar equity price performance persisted in early 1999. 

In addition to pressure from shareholders to improve the 

market value of the firm, executive compensation has 

become tied increasingly to the creation of shareholder 

wealth. Share price appreciation is a large consideration 

when year-end bonuses are calculated, and stock 

options in many instances can represent the lion’s share 

of total executive compensation. Furthermore, it 

appears that the internal and external pressures related 

to building shareholder value are resulting in an increasingly higher risk profile for public companies in the 

Region compared with closely held and mutually owned 

institutions. 

The most obvious difference in the risk profile of public entities is the degree of leverage employed in these 

companies. As Chart 6 shows, the aggregate Tier 1 

leverage ratio for these companies has hovered in the 7 

percent range, falling to 6.86 percent in fourth quarter 

1998, well below the levels maintained by nonpublic 

institutions. Although these levels of capital are higher 

than the 5 to 6 percent levels seen in the mid- to late 

1980s, certain regulatory changes that have become 

effective since then support the case that higher capital 

levels should be maintained. 

The prompt corrective action rules that arose from the 

enactment of the Federal Deposit Insurance Corporation 

Improvement Act (FDICIA) can result in the appointment of a receiver for insured institutions that become 

“critically undercapitalized” (tangible equity-to-asset 

ratio less than 2 percent). Before FDICIA, an institution 

CHART 6 

typically had to be insolvent before such action could be 

taken. A second, and perhaps more significant, change 

is the elimination of a large portion of the benefits 

derived from tax loss carrybacks. Before 1994, banks 

were allowed to carry back losses from bad debts for 

ten years and recapture taxes paid in those periods. The 

carryback period has been reduced to just two years. 

Paid taxes used to represent a significant source of “hidden capital” that insured institutions could draw upon to 

offset losses. The reduction in the carryback provision 

has reduced this capital cushion; in a worst-case scenario, the loss of this hidden capital must ultimately be 

absorbed by the deposit insurance funds. Recent tax 

changes allowing certain institutions to become Subchapter S Corporations (S Corps) have had a similar 

effect, although losses in these institutions will flow 

straight through to capital without the benefit of any tax 

cushion. This is not a major issue within the Region, as 

only three institutions had converted to S Corp status as 

of December 1998. This is a larger issue nationally, as 

approximately 10 percent of all insured institutions are 

now S Corps. 

Chart 7 shows the recent trend in the Tier 1 risk-based 

capital (RBC) ratio for each of the three ownership 

forms. The difference between public companies and 

the other ownership forms is significantly larger than 

that in the Tier 1 leverage ratio, suggesting that these 

institutions maintain a higher-risk asset mix than closely held banks and mutuals. Additionally, while the Tier 

1 leverage ratio has hovered around 7 percent for the 

public companies, the Tier 1 RBC ratio has fallen 

approximately 200 basis points, indicating that the asset 

mix of these institutions is steadily taking on a higher 

risk profile. 

CHART 7 

Publicly Held Institutions Operate with the
 

Greatest Degree of Leverage
 

6.5 

7.0 

7.5 

8.0 

8.5 

9.0 

9.5 

10.0 

10.5 

11.0 

11.5 

Tier 1 Leverage Ratio (%)

Mutual 

Closely Held Publicly Held 

1Q 3Q 1Q 3Q 1Q 3Q 

’96 ’96 ’97 ’97 ’98 ’98 

8 

10 

12 

14 

16 

18 

20 

Publicly Held Companies Appear to Be 

Shifting toward Higher-Risk Assets 

1Q 

’96 

3Q 

’96 

1Q 

’97 

3Q 

’97 

1Q 

’98 

3Q 

’98 

Mutual 

Closely Held 

Publicly Held

Tier 1 RBC Ratio (%) 

Source: Bank and Thrift Call Reports, Merger Adjusted Source: Bank and Thrift Call Reports, Merger Adjusted

Boston Regional Outlook 22 Second Quarter 1999 
Regional Perspectives
 

Chart 8 shows the changes in the securities portfolios of 

public companies over the past 12 quarters. There has 

been a clear shift of funds away from U.S. government 

and agency securities into corporate and foreign investments and mortgage derivatives. The shift in portfolio 

mix has prevented a steeper decline in margins but has 

introduced greater risk, in both credit and interest rate, 

to the balance sheet. There has also been a steady shift 

in the loan portfolio, away from real estate loans (primarily residential) and into the C&I and consumer sectors, both of which have been growing rapidly over the 

past two years. The combination of high operating 

leverage and strong growth in C&I loans is leading to a 

significant concentration in that sector relative to Tier 1 

capital (see Chart 9). 

CHART 8 

Summary 

It is clear that a greater level of risk is embedded in the 

balance sheets of publicly owned insured institutions. 

That risk is increasing, owing in part to efforts to mitigate earnings weakness as institutions strive to meet the 

profit expectations of shareholders. The pressure for 

profit growth will remain, particularly if bank and thrift 

stocks continue to languish in comparison with other 

stock groups. Management’s challenge will be to 

respond to the pressure in a prudent manner without 

compromising safety and soundness. 

Boston Region Staff 

Source: Bank and Thrift Call Reports, Merger Adjusted 

1Q 

’96 

3Q 

’96 

1Q 

’97 

3Q 

’97 

1Q 

’98 

3Q 

’98 

10 

20 

30 

40 

50 

60 Closely Held 

Mutual 

Publicly Held 

Publicly Held Firms Have the Lowest Share of 

Low-Risk Government Securities... 

U.S. Treasuries and Agencies

as a % of Securities Portfolios 70 

5 

10 

15 

20 

25 

30 

35 

40 Mortgage-Backed Securities 

(pass-throughs) 

U.S. Treasuries 

& Agencies 

Corporate & Foreign 

Source: Bank and Thrift Call Reports, Merger Adjusted (Publicly Held Only) 

Mortgage-Backed 

Securities (other) 

...While They Continue to Increase 

Exposure to Higher-Risk Assets 

% of Securities Portfolio 

1Q 

’96 

3Q 

’96 

1Q 

’97 

3Q 

’97 

1Q 

’98 

3Q 

’98 

CHART 9 

50 

100 

150 

200 

250 

300 

Commercial & Industrial 

Consumer 

Commercial 

Real Estate 

Publicly Held Companies Are Increasing

 Commercial Loan Concentrations... 

Residential Real Estate 

Source: Bank and Thrift Call Reports, Merger Adjusted (Publicly Held) Loans as a % of Tier 1 Capital

1Q 

’96 

3Q 

’96 

1Q 

’97 

3Q 

’97 

1Q 

’98 

3Q 

’98 

Source: Bank and Thrift Call Reports, Merger Adjusted (Closely Held and Mutuals) 

1Q 

’96 

3Q 

’96 

1Q 

’97 

3Q 

’97 

1Q 

’98 

3Q 

’98 

20 

40 

60 

80 

100 

120 

140 

325 

350 

375 

400 

425 

450 

475 

...But Mutual and Closely Held Companies 

Remain Focused on Residential Loans 

Commercial & 

Consumer (L) Industrial (L)

Commercial Real Estate (L) 

Residential Real Estate (R)

Loans as a % of Tier 1 Capital 

Boston Regional Outlook 23 Second Quarter 1999 
✁
 

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