Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION THIRD QUARTER 2002 

FDIC
 

Memphis
 

Edition
 

Division of
 

Insurance
 

and Research
 

Gary L. Beasley,
 

Regional Manager
 

Harry W. John,
 

Regional Economist
 

Robert L. Burns,
 

Senior Financial
 

Analyst
 

F. Miguel Hasty,
 

Financial Analyst
 

Regional Perspectives 

◆ Economic and Banking Conditions—The Region’s economy appears poised 

for growth in the second half of 2002, with indications of improved employment 

conditions in the important manufacturing and distribution sectors. Banking 

conditions improved in early 2002, as credit quality stabilized and earnings 

increased as a result of stronger net interest margins. See page 3. 

By Harry W. John and Robert L. Burns 

◆ Market Risk Rises in Investment Portfolios—Dramatic changes during 2001 

and early 2002 in the composition of community bank securities portfolios likely 

increased market risk. Now may be an opportune time for managers to review 

investment strategies and portfolio holdings to ensure compliance with boardapproved tolerances for sensitivity to changing interest rates. See page 5. 

By Robert L. Burns 

In Focus This Quarter 

◆ The Road to Recovery for Commercial Credit Quality: Not without a Few 

Hurdles Ahead—The recession that began in March 2001 has been especially 

hard on the corporate sector. Banks that made loans to affected firms felt the 

immediate effects of the recession through rising problem commercial loans. 

Large banks took the brunt of this commercial credit deterioration, as indicated 

by a somewhat larger uptick in problem commercial loans among large banks 

compared with smaller banks. This credit deterioration was more apparent 

at banks that participated in loan syndications, one of the financing vehicles 

available primarily to large corporate customers. Various indicators pointing 

toward economic recovery, as well as an apparent decline in rating downgrades 

and default rates among corporate bond issuers in recent weeks, suggest that 

improvement in commercial credit quality may be just ahead. This recovery, however, faces a few hurdles, including continued high leverage, weak earnings, and 

prospects for a more difficult funding environment, particularly for speculativegrade corporations with maturing debt. See page 10. 

By Cecilia Lee Barry, Senior Financial Analyst 

A Publication of the Division of Insurance and Research 
The Regional 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. It is produced for the following eight geographic regions: 

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

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

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

Dallas Region (CO, NM, OK, TX)
 

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

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

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

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

The first and third quarter issues of the Regional Outlook feature in-depth coverage of the economy and the banking industry in each Region and consist of a national edition and eight regional editions. The second and fourth quarter issues are a single national edition that provides an overview 

of economic and banking risks and discusses how these risks relate to insured institutions in each 

FDIC Region. These issues tell the national story and, at the same time, alert the reader to specific 

trends and developments at the regional level. 

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

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

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

For more information or to provide comments or suggestions about the Memphis Region’s 

Regional Outlook, please call Gary Beasley at (901) 821-5234 or send an e-mail to gbeasley@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 Donald E. Powell 

Director, Division of Insurance Arthur J. Murton 

and Research 

Executive Editor George E. French 

Writer/Editor Kim E. Lowry 

Editors Lynn A. Nejezchleb 

Maureen E. Sweeney 

Richard A. Brown 

Ronald L. Spieker 

Publications Manager Teresa J. Franks 
Regional Perspectives
 

Regional Perspectives 

Regional Economic and Banking Conditions 

•	 Although employment growth remained stagnant in early 2002,1 the Region’s economy appears primed 

for growth in the second half of 2002. Leading indicators suggest that job formation in the beleaguered 

manufacturing sector could improve soon. 

• Banks and thrifts in the Region reported stable credit quality in early 2002 and stronger earnings 

performance as a result of higher net interest margins. 

The Regional Economy Is Likely to Improve 

as the Manufacturing Sector Appears Poised 

fora Rebound 

The Region’s economic downturn, which began in late 

2000, stemmed from a severe contraction in manufacturing that subsequently spread to other sectors. Slowing demand for goods led manufacturers to reduce 

capital investment in new equipment and ultimately 

precipitated layoffs and plant closings. As shown in 

Chart 1, regional job cuts in the sector significantly 

exceeded losses experienced during previous manufacturing slumps in 1990–1991 and 1995–1996. 

The Region’s manufacturing sector began to strengthen in early 2002 as manufacturers continued to pare 

CHART 1 

bloated inventories, and new orders for goods 

climbed. But despite rising production, many manufacturers hesitated to expand payrolls without evidence of a sustained rebound in demand for goods. 

Instead, they increased existing employees’ hours to 

achieve higher production levels (see Chart 1). However, a natural limit exists on the expanded use of 

existing employees. When this limit is reached, 

manufacturers must hire new employees (or rehire 

displaced employees) before production levels can 

increase. As shown in Chart 1, in the past, spikes in 

average hours worked among manufacturing employees have preceded stabilizing employment conditions. The current rebound in average hours worked 

suggests that area manufacturers may soon expand 

payrolls to meet increasing demand.2 

Memphis Region Manufacturing Sector Employment Appears Poised for Rebound 

Note: “Months of Job Losses” is the total number of months in which the MSAs lost jobs, irrespective of when they started losing them. 

Source: Bureau of Labor Statistics, Haver Analytics Year-over-year percentage change in employment (bars)

Year-over-year percentage change 

in average weekly hours (line) 

–6 

–4 

–2 

0 

2 

4 

Previous spikes in average weekly hours have preceded improvement in manufacturing employment 

The current jump in average weekly hours 

worked suggests a potential near-term 

rebound in manufacturing employment. 

–8 

–6 

–4 

–2 

0 

2 

4 

Dec 

’89 

Jun 

’90 

Dec 

’90 

Jun 

’91 

Dec 

’91 

Jun 

’92 

Dec 

’92 

Jun 

’93 

Dec 

’93 

Jun 

’94 

Dec 

’94 

Jun 

’95 

Dec 

’95 

Jun 

’96 

Dec 

’96 

Jun 

’97 

Dec 

’97 

Jun 

’98 

Dec 

’98 

Jun 

’99 

Dec 

’99 

Jun 

’00 

Dec 

’00 

Jun 

’01 

Dec 

’01 

1 Memphis Region payroll employment fell 0.2 percent in first quarter 

2002, compared with a decline of 0.1 percent in first quarter 2001. 

The nation reported a year-over-year payroll employment decline of 

1.0 percent in first quarter 2002, compared with growth of 1.2 percent 

during the same period in 2001. 

2 As discussed in previous articles, not all of the Region’s manufacturing sector is likely to expand with an economic recovery. Because of 

long-term structural changes, recent job losses in certain industries, 

such as textiles and apparel, are unlikely to be reversed. 

Memphis Regional Outlook 3	 Third Quarter 2002 
Regional Perspectives
 

Any improvement in manufacturing, which comprises 

almost 18 percent of total regional employment, likely 

would spill over into other areas of the economy. The 

transportation/distribution sector, another important 

segment of regional payrolls, also began to recover from 

a slump associated with the national downturn. Shipments and travel have begun to increase, which could 

lead to expanded payrolls in the sector. 

Banking Conditions Improved in Early 2002 

Banks and thrifts in the Region reported stronger earnings performance, while credit quality was largely 

unchanged in first quarter 2002. Some weaknesses 

remain, however, as many institutions continue to grapple 

with credit quality concerns that linger from the prolonged downturn during late 2000 and throughout 2001. 

Credit quality indicators were mixed in first quarter 2002 

but showed initial signs of improvement. Loan loss rates 

were down from levels reported during 2001, although 

they were high relative to longer-term trends, as many 

banks and thrifts continued to identify and address problem credits. The past-due and nonaccrual loan ratio fell 

modestly, as shown in Table 1, signaling that credit problems for most of the Region’s banks and thrifts may have 

peaked for this cycle. Institutions with weak underwriting 

practices or those operating in particularly hard-hit areas 

of the Region, however, may continue to experience high 

loan delinquencies and loan loss rates. 

Earnings performance improved in early 2002, with 

approximately 60 percent of the Region’s banks and 

thrifts reporting higher returns on assets compared with 

TABLE 1 

Loan Delinquency Ratios Declined 

Regionwide in Early 2002 

MEDIAN PDNA LOAN RATIO 

MAR-2002 DEC-2001 

MEMPHIS REGION 

ARKANSAS 

LOUISIANA 

KENTUCKY 

TENNESSEE 

MISSISSIPPI 

2.65 

2.88 

2.30 

2.51 

2.84 

3.50 

2.84 

3.17 

2.47 

2.64 

3.02 

3.65 

Note: PDNA = Past-due and nonaccrual
 

Source: Bank and Thrift Call Reports
 

one year ago. The higher returns, reported by both large 

institutions and community institutions, were driven by 

stronger net interest margins. Wider margins were primarily the result of a favorable interest rate environment, particularly the steepness of the yield curve. 

Many bank and thrift managers in the Region have 

made asset allocation decisions that take advantage 

of the steep yield curve. As discussed in Regional 

Perspectives, Memphis Regional Outlook, first quarter 

2002, some of these strategies could make an institution’s earnings more vulnerable to any rise in interest 

rates. See Community Banks Report Increased 

Market Risk in Investment Portfolios, which follows, 

elsewhere in this publication for a discussion of how 

such strategies have affected securities holdings at 

many of the Region’s insured institutions. 

Harry W. John, Regional Economist 

Robert L. Burns, Senior Financial Analyst 

Memphis Regional Outlook 4 Third Quarter 2002 
Regional Perspectives
 

Community Banks Report Increased Market Risk in Investment Portfolios 

• Faced with weak loan demand, many managers of insured financial institutions have tried to boost revenues 

from securities portfolios. 

• Investment alternatives in the current interest rate environment require managers to weigh the pursuit of 

higher yields in the short term against the potential adverse effects such strategies could have on future 

earnings. 

Although economic conditions improved, loan growth 

among the Region’s banks and thrifts remained weak in 

late 2001 and early 2002, prompting many insured financial institutions to buy loans in the form of mortgagebacked and mortgage derivative securities. Similarly, 

some institutions sought higher yields by investing in 

longer-term securities or those with complex embedded 

options. These strategies helped institutions preserve or 

improve net interest margins in the current interest rate 

environment, but they added to investment portfolio market risk. For many insured institutions, the increase in 

investment portfolio market risk is a well-understood 

component of a sound overall asset/liability management 

strategy. For others, however, the increase in market risk 

may result from a simple pursuit of higher yields without 

adequate prepurchase investment analysis. Managers 

focused on such short-term results could impair the future 

earnings potential and economic value of their institutions. 

quarters was modest, the fact that median loan balances at community banks and thrifts declined 

undoubtedly had a significant influence on financial 

institution asset allocation decisions. 

With flat loan demand, community banks and thrifts 

shifted funds into investment portfolios during the 

second half of 2001 and early 2002.3 This growth in 

securities among the Region’s community banks and 

thrifts reverses the trend of growing loan-to-asset 

ratios and steadily declining investment portfolios 

during the early 1990s. In community bank securities 

portfolios, mortgage-related securities (mortgagebacked and mortgage derivative securities) were the 

preferred investment choice during 2001 and early 

2002. 

CHART 1 

With Anemic Loan Growth, Banks and Thrifts 

Turn to Securities 

Weak economic conditions led to slowing loan growth 

in 2001 and early 2002. During 2001, median loan 

growth among established community banks and 

thrifts,1 adjusted for merger activity, was 4.3 percent, 

less than half the rate reported in the previous year. 

Large institutions reported an even more pronounced 

drop in loan growth. The most dramatic slowing 

occurred in fourth quarter 2001 and first quarter 2002, 

as loan volumes at established community institutions 

declined (see Chart 1).2 While the decline in both 

Loan Growth Stalled among Community Banks 

and Thrifts as Economic Conditions Weakened 

Source: Bank and Thrift Call Reports Growth Rate (%) 

–2 

0 

2 

4 

6 

8 

10 

12 

14 

16 Annualized Quarterly 

Loan Growth (bars) 

Year-over-Year 

Memphis Region 

Employment 

Growth 

(line) 

Jun 

’99 

Sep 

’99 

Dec 

’99 

Mar 

’00 

Jun 

’00 

Sep 

’00 

Dec 

’00 

Mar 

’01 

Jun 

’01 

Sep 

’01 

Dec 

’01 

Mar 

’02 

1 Established community institutions are banks and thrifts with less 

than $1 billion in total assets in operation for more than three years 

during the period reviewed. 

2 The loan growth trends in Chart 1 follow expected seasonal borrowing patterns, primarily affecting agricultural and construction lending, 

that typically result in stronger loan growth in the second and third 

quarters. A comparison of quarterly loan growth ratios with the ratios 

reported during the same period in the previous year, however, confirms a significant slowdown in loan growth throughout 2001 and 

during the first quarter of 2002. 

3 Securities as a percentage of aggregate assets among the Region’s 

community banks and thrifts increased modestly in third quarter 2001. 

In fourth quarter 2001, securities portfolios jumped from 21.3 percent 

of aggregate assets to 22.5 percent, a significant shift in balance sheet 

composition in a single quarter. Securities portfolios increased again 

in first quarter 2002, to 23.0 percent of aggregate assets. The previous 

period of sustained growth for more than two consecutive quarters in 

securities relative to total assets was in 1992. 

Memphis Regional Outlook 5 Third Quarter 2002 
Regional Perspectives
 

Mortgage-Related Securities Return to Favor 

During 2001, aggregate holdings of mortgage-related 

securities among the Region’s community banks grew 

by a remarkable 59 percent. As a result, mortgagerelated securities as a share of total assets increased 

sharply (see Chart 2). Similarly, the share of the investment portfolio comprising mortgage-related securities 

surged from 18.6 percent on December 31, 2000, to 

28.2 percent on March 31, 2002.4 

This dramatic shift in investment portfolio composition was facilitated by a number of factors. As noted 

earlier, loan growth slowed significantly during 2001. 

At the same time, deposit inflows at many community 

banks increased as consumers, shaken by weaknesses 

in the stock market, sought a safe haven for their 

money. Also, the sharp decline in interest rates during 

2001 led to the exercise of embedded call features and 

prepayment options, which resulted in significant 

asset turnover at many banks. Consequently, banks 

found themselves with considerable funds to invest in 

2001. 

Mortgage-related securities became a popular investment choice for community banks because of yield.5 

Yields improved compared with most other investment 

alternatives during this period because of the increasing 

risk premium associated with the inherent optionality of 

mortgage-related securities (discussed below). Spreads 

over funding costs also widened considerably (see 

Chart 3). The difference between current coupon 

15-year mortgage rates and six-month certificate of 

deposit rates climbed from approximately 75 basis 

points at year-end 2000 to more than 450 basis points 

by year-end 2001. The steepening of the yield curve 

that occurred throughout 2001 was the primary factor 

driving this increase. 

While the higher yields available on mortgage-related 

securities make them attractive investments in the current environment, these securities introduce additional 

portfolio management complexity, primarily in the 

form of increased optionality. When interest rates 

4 This reverses a long-term trend, dating from the early 1990s, of declining mortgage-related securities balances relative to total securities. 

5 Also noteworthy, mortgage-related securities became more abundant 

during this period. An active housing market and record refinancing 

activity led to a high volume of mortgage originations and subsequent 

securitizations, making ample mortgage-related securities available for 

purchase. 

CHART 2 

Mortgage-Related Securities Holdings 

Climbed among the Region’s Community 

Banks during 2001 

Source: Bank Call Reports Mortgage-Related Securities/Total Assets (%)

Mar 

’94 

Sep 

’94 

Mar 

’95 

Sep 

’95 

Mar 

’96 

Sep 

’96 

Mar 

’97 

Sep 

’97 

Mar 

’98 

Sep 

’98 

Mar 

’99 

Sep 

’99 

Community Banks 

Large Banks 

Mar 

’00 

Sep 

’00 

2 

4 

6 

8 

10 

12 

14 

Mar 

’01 

Sep 

’01 

Mar 

’02 

decline, mortgage holders prepay existing loans and 

refinance at lower rates. The cash passes through to the 

bondholder, who must then reinvest the funds in a 

lower interest rate environment. Conversely, rising 

interest rates trigger a slowdown in refinancing activity 

and, consequently, a reduction in pass-through payments on mortgage-related securities, effectively 

lengthening the reinvestment horizon for these securities and locking in below-market returns for an extended period. It is this potential for ongoing contraction or 

extension of the life of the bond that causes the price of 

mortgage-related securities to be more sensitive to 

changes in interest rates than many other investment 

alternatives.6 

In mortgage-backed securities portfolios,7 community 

banks invested more heavily in bonds with longer 

reinvestment horizons, either maturity or earliest 

repricing opportunity (see Chart 4). This trend reflects 

not only bank purchasing preferences but also 

changes in mortgage origination patterns that favor 

longer-term fixed-rate mortgages over adjustable rate 

6 Not all mortgage-related securities exhibit the same degree of 

increased optionality. Certain mortgage derivative securities, for 

example, are structured to reduce cash flow variability, and therefore 

price sensitivity, by shifting cash flows among various classes of 

bonds that are all collateralized by the same underlying mortgages. 

7 Information collected on mortgage derivative securities in Bank Call 

Reports is based on the average life of the security rather than on 

maturity or next repricing opportunity. While the average life is a more 

meaningful measure of a bond’s reinvestment horizon, average life 

calculations change from quarter to quarter, potentially changing 

dramatically during periods of rapid interest rate movement such as 

that experienced during 2001, and therefore do not provide a useful 

gauge of investment purchase decisions. Thus, only mortgage-backed 

securities are discussed here. 

Memphis Regional Outlook 6 Third Quarter 2002 
Regional Perspectives
 

CHART 3 CHART 4 

Mortgage Product Spreads over Funding Costs Mortgage-Backed Securities Maturity/Repricing 

Make Mortgage-Related Securities Intervals Extended during 2001 and Early 2002 

Attractive Investments 100

Interest Rate 

2 

3 

4 

5 

6 

7 

8 

9 15-Year Fixed-Rate 

Mortgage 

6-Month 

Certificate of Deposit 

Percent of Mortgage-Backed Securities

80 

60 

40 

20 

0 

25.6 

12.2 

24.2 

38.0 

Less than 

1 Year 

1 to 5 

Years 

5 to 15 

Years 

More than 

15 Years 

16.6 

10.8 

33.9 

38.8 

1 

0 

Jan May Sep Jan May Sep Jan May Sep Jan May Sep Jan 

’98 ’98 ’98 ’99 ’99 ’99 ’00 ’00 ’00 ’01 ’01 ’01 ’02 Dec ’00 Maturity/Repricing Mar ’02 

Interval 

Source: Federal Mortgage Acceptance Corporation, Federal Reserve Board 

mortgages (ARMs).8 While the stated maturity of 

mortgage-related securities does not provide an appropriate measure of the expected repayment of principal 

on the bond, the shift from an ARM-based product to a 

fixed-rate product suggests an increase in the cash flow 

variability and price volatility of mortgage-related 

securities portfolios. 

Market Risks Climb for Other Community 

Bank Investment Holdings 

Although mortgage-related securities have gained favor 

in recent quarters, other securities, such as U.S. government, agency, and municipal bonds, continue to comprise the bulk of the investment portfolio for most 

community banks. Some institutions appear to have 

elected to accept increased market risk in these segments 

of investment portfolios by extending reinvestment 

horizons and purchasing structured notes. 

Extended Reinvestment Horizons: The steep yield 

curve during 2001 and early 2002 offered considerable 

incentive for banks to invest in securities with longer 

maturities or repricing intervals in return for higher 

yields (see Regional Perspectives, Regional Outlook, 

first quarter 2002, for a more detailed discussion of the 

yield curve shifts and resulting incentives for asset 

8 The underlying collateral for the shorter-term mortgage-backed securities shown in Chart 4 is primarily ARMs. With historically low interest 

rates prevailing throughout much of 2001, consumers migrated from 

ARMs to longer-term fixed-rate mortgages. The limited availability of 

ARMs available for securitization likely influenced the shift by community banks to longer-term fixed-rate mortgage pass-through products. 

Source: Bank Call Reports 

extension). Non-mortgage-related securities maturing 

or repricing in less than one year declined from almost 

20 percent of all non-mortgage-related securities at 

year-end 2000 to under 15 percent by early 2002. Community banks primarily shifted these funds into intermediate investments maturing or repricing in the 

next three to five years. Longer-term investments also 

increased somewhat, with the percentage of nonmortgage-related securities maturing in over five years 

inching up from 34.8 percent to 36.1 percent during 

this period. While the aggregate shift to intermediate 

and longer-term reinvestment horizons has not been 

extreme, it adds to the growing market risk apparent in 

many community bank investment portfolios. 

Structured Notes: Structured notes frequently contain complex embedded options that often significantly increase the cash flow variability and price volatility 

of these instruments. While the reported volume of 

these securities9 comprises only a small portion of 

total securities, the level has grown in recent quarters. 

The number of community banks reporting a significant portion of investment portfolios in structured 

notes (at least 10 percent of total securities) has 

climbed from 3 institutions at year-end 2000 to 32 

institutions in early 2002. 

9 The reported volume of structured note holdings has increased from 

0.6 percent of aggregate securities holdings at year-end 2000 to 1.1 

percent by first quarter 2002, with only 20 percent of community 

banks in the Region reporting any holdings of structured notes in early 

2002. Structured notes are reported only as a memorandum item in 

Bank Call Reports and are frequently not readily identified by bank 

investment portfolio management reports. As a result, the volume of 

structured notes held may be underreported. 

Memphis Regional Outlook 7 Third Quarter 2002 
Regional Perspectives
 

Most Institutions That Have Invested Heavily 

in Mortgage-Related Securities Accepted 

Increased Market Risk Elsewhere 

in Investment Portfolios 

Table 1 compares selected investment portfolio information for a group of banks that reported a substantial 

increase in mortgage-related securities during 200110 

and all other community banks in the Memphis Region. 

As the table shows, banks that significantly increased 

mortgage-related securities holdings exhibited additional market risk factors than were reported by other 

community banks. 

Both groups of banks began with similar concentrations in mortgage-related securities—at just under 19 

percent of total investment portfolios. This suggests 

that banks subsequently investing heavily in mortgagerelated securities were not predisposed to do so; the 

investment portfolios of these banks were not previously disproportionately weighted toward mortgagerelated securities. As these banks shifted portfolios, 

they also extended the maturity and repricing intervals 

on mortgage-related securities to a greater extent than 

did other community banks, further adding to cash flow 

variability and price volatility. 

Furthermore, banks that invested heavily in mortgagerelated securities reported a more significant increase in 

TABLE 1 

Excerpt from Office of
 

the Comptroller of the
 

Currency Bulletin 2002–19 on
 

investment portfolio practices,
 

issued May 22, 2002
 

“For investors trying to enhance yield, a steeply 

sloping yield curve provides an incentive to extend 

maturities. The current yield curve environment is 

similar to the one that prevailed during 1993, when 

banks faced a similar dilemma concerning how to 

replace the yields on called/prepaid assets. At that 

time, some banks made the mistake of investing a 

disproportionate amount of funds within a short 

time period and locked in a large volume of earning 

assets at a cyclical low point in yields. Then, as 

now, many banks chased yields to avoid investing 

excess liquidity at very low overnight rates.” 

non-mortgage-related securities with longer-term 

investment horizons. The ratio of non-mortgage-related 

securities maturing or repricing in over five years as a 

percentage of all such securities at these banks 

increased by 420 basis points, compared with a 100­

basis-point increase in this ratio at other community 

banks in the Region. These institutions also reported a 

Community Banks Reporting a Significant Increase in Mortgage-Related 

Securities Also Exhibited Other Indications of Increased 

Investment Portfolio Market Risk 

SAMPLE REPORTING SIGNIFICANT INCREASE = 141 BANKS BANKS REPORTING OTHER COMMUNITY 

SIGNIFICANT INCREASES BANKS IN THE 

OTHER COMMUNITY BANKS = 668 BANKS IN MRS HOLDINGS MEMPHIS REGION 

PERCENT DEC-00 MAR-02 DEC-00 MAR-02 

MRS/TOTAL SECURITIES 18.6 45.9 18.7 22.9 

MORTGAGE-BACKED SECURITIES MATURING IN 

OVER 5 YEARS/MORTGAGE-BACKED SECURITIES 58.8 74.0 62.3 71.9 

NON-MORTGAGE SECURITIES MATURING IN OVER 

5 YEARS/NON-MORTGAGE SECURITIES 40.3 44.5 33.3 34.3 

STRUCTURED NOTES/NON-MORTGAGE SECURITIES 0.7 2.2 0.7 1.3 

Notes: MRS = mortgage-related securities. A significant increase in MRS is defined as an increase in MRS equivalent 

to 5 percent of total assets during 2001. 

Source: Bank Call Reports 

10 Defined as an increase in mortgage-related securities equivalent 

to 5 percent or more of total assets during 2001. 

Memphis Regional Outlook 8 Third Quarter 2002 
Regional Perspectives
 

Large Banks in the Region
 

Have Followed a Different
 

Investment Strategy
 

Large banks headquartered in the Memphis Region 

have not reported a significant increase in 

mortgage-related securities holdings. In aggregate, 

such investments increased modestly, from 10.1 

percent of assets at year-end 2000 to 10.8 percent 

by first quarter 2002. This situation contrasts with 

the substantial increase in mortgage-related assets 

reported by community banks during this period. 

As shown in Chart 2, large banks reported a sharp 

increase in mortgage-related securities in late 1998, 

when credit concerns led to a brief pullback in loan 

exposure at many larger institutions. But why the 

difference in investment strategies at large banks in 

late 1998 compared with today? The shape of the 

yield curve and expectations concerning future 

interest rates likely played a role in such decisions. 

At the end of third quarter 1998, the yield curve 

was relatively flat, with only a 45-basis-point 

spread between short-term and long-term rates, 

suggesting limited expectations for higher interest 

rates. In early 2002, the yield curve was steep, with 

a 400-basis-point spread between short- and longterm rates. 

Consistent with limited increases in mortgagerelated securities, large banks contracted nonmortgage-related securities reinvestment horizons 

in recent quarters. In aggregate, non-mortgagerelated securities holdings among large banks with 

a maturity or earliest repricing opportunity exceeding five years declined from 41.4 percent of all 

such securities at year-end 2000 to 32.3 percent by 

first quarter 2002. In general terms, this decline 

has served to reduce the sensitivity of large bank 

investment portfolio earnings to potential adverse 

effects from rising interest rates. 

Some large banks may be inclined to reduce market risk in investment portfolios to compensate for 

the sensitivity of certain other revenue sources to 

rising interest rates. For example, large institutions 

concerned about a potentially lower volume of 

origination fees from mortgage banking activities 

in a climate of rising interest rates may try to 

reduce the potential effects of higher rates on 

securities portfolio earnings. 

greater increase in structured note holdings during the 

period, although both groups of banks held similar 

levels of structured notes at year-end 2000. 

Changes in investment portfolios should be measured as 

part of an institution’s overall asset allocation and 

funding structure, as higher market risk in investment 

portfolios can be offset elsewhere on the balance sheet. 

However, the significant and rapid shifts in portfolio 

composition reported by many of these banks suggest 

that 

•	 these institutions may have significantly increased 

investment portfolio risk tolerances, or 

•	 yield considerations have assumed increased significance for these institutions, underscoring the need 

for thorough prepurchase analysis. 

Conclusion 

A shift into mortgage-related securities, longer-term 

securities, or securities with complex embedded options 

does not represent an inappropriate or undesirable strategy. In the current interest rate environment, such a 

strategy can translate into improved returns. However, 

better returns are often achieved only through the 

acceptance of increased risk, which must be well understood and properly managed. 

With credit concerns understandably paramount for 

most bankers and regulators during 2001 and early 

2002, attention to investment portfolios may have 

waned. Now may be an opportune time for bank and 

thrift managers to review investment strategies and 

securities portfolios to ensure that current holdings and 

future purchases are within board-approved tolerances 

for sensitivity to changes in interest rates. 

Robert Burns, CFA, CPA 

Senior Financial Analyst 

Memphis Regional Outlook 9	 Third Quarter 2002 
In Focus This Quarter
 

The Road to Recovery for Commercial Credit Quality:
 

Not without a Few Hurdles Ahead
 

Introduction 

The banking industry as a whole has performed well in 

recent years, despite increasing loan delinquencies, 

notably in commercial credits. Although the extent of 

commercial loan deterioration has not reached levels 

experienced in the early 1990s, it nonetheless warrants 

scrutiny. With a variety of economic indicators pointing 

toward recovery, the volume of problem commercial 

loans held by insured institutions could plateau during 

2002. Many banks tightened business loan underwriting 

standards beginning in early 2000, a trend that should 

contribute to an eventual turnaround in commercial loan 

quality. Nevertheless, several factors could delay this 

improvement. Corporate profitability has yet to recover 

fully, and many firms continue to operate with significant financial leverage. Highly leveraged firms are 

especially vulnerable to declining revenues, which 

reduce the cash flow available to service debt obligations. More significantly, lower investor tolerance for 

risk has created a far less hospitable financing market 

for speculative-grade firms, possibly straining liquidity 

and increasing the likelihood that these companies 

could default as debts mature. 

Commercial Credit Deterioration Should 

Subside with the Economic Recovery 

While the banking industry has fared well through the 

latest recession, it did not escape the effects of the troubled corporate sector. Large banks (those with assets 

greater than $1 billion), in particular, have seen a significant rise in noncurrent commercial and industrial 

(C&I) loan and loss rates.1 While total C&I loans represented 25 percent of all outstanding loans held by all 

insured commercial banks as of March 31, 2002, net 

C&I loan losses comprised 32 percent of all loan 

losses. In first quarter 2002, noncurrent C&I loans 

reached 2.6 percent of outstanding loans (2.8 percent 

for large banks), the highest level since fourth quarter 

1993. The four-quarter moving average C&I loss rate 

also rose among small and large banks; however, the 

rate of increase for large banks was significantly higher, 

as shown in Chart 1. 

1 Noncurrent loans are defined as loans 90 or more days past due or 

on nonaccrual status. 

CHART 1 

Large Banks Experience a Rapid Rise in 

Commercial and Industrial Loan Loss Rates 

Source: Bank Call Reports, FDIC Research Information System 

Large banks 

(> $1 billion in assets)

Four-Quarter Moving Average Commercial

and Industrial Loss Rates (%)

Small banks 

(< $1 billion in assets) 

0.0 

0.2 

0.4 

0.6 

0.8 

1.0 

1.2 

1.4 

1.6 

1.8 

2.0 

2.2 

1Q90 3Q91 1Q93 3Q94 1Q96 3Q97 1Q99 3Q00 1Q02 

Improving economic conditions and tighter underwriting standards suggest that commercial credit quality 

should improve. A range of indicators suggests that economic recovery is under way, albeit more slowly than 

some expected earlier this year. The housing sector 

remains robust, job conditions have stabilized, and real 

gross domestic product (GDP) grew 5.0 percent in first 

quarter 2002. Although GDP grew at a slower pace of 

1.1 percent in second quarter 2002, business equipment 

spending increased 2.9 percent, in contrast to a decrease 

of 2.7 percent in first quarter 2002. Also, the manufacturing sector began to show signs of recovery with the 

Institute for Supply Management (ISM) index for 

manufacturing reaching 56.2 and 50.5 in June and July 

2002, respectively. The ISM index has remained above 

50, which signals an economic expansion, for the six 

consecutive months since February 2002. Also, the 

index of coincident indicators, a gauge of current economic activity, rose 0.3 percent in June 2002. Furthermore, a survey of 50 leading corporate economists by 

Blue Chip Economic Indicators shows that analysts 

expect the U.S. economy to grow at a rate of 3.3 percent 

in third quarter 2002.2 

Recent changes in underwriting standards also bode 

well for credit quality at commercial banks. The Federal 

2 Blue Chip Economic Indicators, July 2002. Also see Regional 

Outlook, Second Quarter 2002, “Back to the Future: How This 

Downturn Compares to Past Recessions.” See http://www.fdic.gov/ 

bank/analytical/regional/ro20022q/na/index.html. 

Memphis Regional Outlook 10 Third Quarter 2002 
In Focus This Quarter
 

Reserve Board’s Senior Loan Officer Opinion Survey 

on Bank Lending Practices, which focuses on 

changes in the supply of and demand for bank loans to 

businesses and households over the previous three 

months, has shown consistent tightening of business 

loan standards during the past two years. The April 

2002 survey indicated some further tightening of standards, but the percentage of banks reporting this tightening has declined since the January survey, consistent 

with the anticipation of a continued economic 

rebound.3 Since credit quality typically lags the business cycle, near-term recovery appears more likely, 

provided the economy continues to improve. This 

recovery in commercial credit quality, however, is not 

without a few hurdles ahead. 

High Default Rates, Rating Downgrades, 

and Bankruptcies Persist 

While the U.S. economy is showing signs of recovery 

and underwriting standards have tightened, corporate 

credit quality could continue to be affected by several 

adverse trends. The number of bankruptcies filed by 

public companies this year is on pace to challenge 

the record set in 2001.4 Furthermore, default rates for 

CHART 2 

Current U.S. Corporate Credit Deterioration Is 

U.S. speculative-grade corporate bond issuers remained 

high at 10.3 percent in June 2002, and the high ratio of 

corporate rating downgrades to upgrades indicates continuing weakness in the corporate sector (see Chart 2).5 

The main reasons for rating downgrades have been poor 

profitability and high leverage. 

Corporate Profitability Remains Fragile 

Corporate profitability has been depressed since first 

quarter 2001 (see Chart 3). However, this trend is improving slowly in 2002. U.S. corporate profits rose during 

second quarter 2002 for the first time in five quarters.6 

However, the rate of recovery is not expected to be strong 

in 2002, as some 93 companies in the Standard & Poor’s 

500 have announced that third quarter earnings will be 

less than expected, more than twice the number of companies that have announced they will beat estimates.7 In 

fact, earnings forecasts have been revised downward 

consistently for the past several months, and analysts 

have warned recently that earnings estimates for the 

second half of 2002 are likely to be reduced. The bright 

spot in earnings continues to be the consumer sector, 

with automobile manufacturers and certain retail areas 

posting strong sales. The worst-performing sectors on a 

CHART 3 

Corporate Profits Remained Depressed 

Approaching Early 1990s Levels 

0 

1 

2 

3 

4 

5 

6 

7 

8 

9 

10 

11 

0.0 

0.5 

1.0 

1.5 

2.0 

2.5 

3.0 

3.5 

4.0 

4.5 

5.0 

Percent Ratio 

Bank commercial and 

industrial noncurrent 

rate (left scale) 

U.S. speculative-grade bond 

issuer default rate (left scale) 

U.S. Corporate bond ratings downgrades 

to upgrades (right scale) 

1988 1990 1992 1994 1996 1998 2000 1Q02 

Year-over-year growth in net income from

continuing operations for all S&P 500 firms (%)

35 

25 

15 

5 

–5 

–15 

–25 

through the First Quarter of 2002 

1997 1998 1999 2000 2001 2002 

Sources: Moody’s, Bank Call Reports, FDIC Research Information System 

3 Senior Loan Officer Opinion Survey on Bank Lending Practices, 

The Federal Reserve Board, April 2002. The survey reported that the 

percentage of domestic banks that reported tightened standards on 

C&I loans to large and middle-market firms (annual sales of at least 

$50 million) since the January survey declined to 25 percent from 

45 percent. The percentage of domestic banks that report tightened 

standards on business loans to small firms declined more, from 42 

percent in January to 15 percent in April. 

4 Bankruptcydata.com reports that 257 publicly traded companies 

filed for bankruptcy in 2001, while 114 companies had filed by 

June 30, 2002. 

Source: Standard & Poor’s 

5 In the first half of 2002, Moody’s downgraded 262 companies and 

upgraded 59, producing a downgrades to upgrades ratio of 4.4:1. 

6 On a year-over-year basis, 371 companies in the Standard & Poor’s 

500 Index that reported earnings through July 26, 2002, posted 

profits. 

7 Danielle Sessa, “U.S. Stocks Slide as Johnson & Johnson, Pepsi 

Shares Tumble,” Bloomberg.com, July 19, 2002. 

Memphis Regional Outlook 11 Third Quarter 2002 
In Focus This Quarter
 

year-over-year basis appear to be energy, transportation, 

utilities, capital goods, and communications services.8 

The latest recession was driven primarily by the sharp 

decline in the demand for capital goods. With the slow 

economic recovery, businesses have continued to limit 

capital spending. The rate of recovery for corporate profitability will depend in large part on how soon and to 

what extent businesses resume spending. 

The prospect of slow earnings growth could be particularly problematic for many highly leveraged corporations. Debt levels relative to cash flow have been 

rising because of anemic earnings (see Chart 4). Negative earnings news also comes at a time when several 

well-publicized accounting irregularities have shaken 

investors’ confidence in corporate earnings reports. A 

Huron Consulting Group study of financial restatements indicates that during the past five calendar 

years, the number of restated financial statements filed 

by public companies has grown from approximately 

120 in 1997 to 270 in 2001.9 The number of restatements continued to grow in 2001, despite a reduction in 

the number of public companies. That study found that 

CHART 4 

the largest source of restatements relates to how companies recognize revenue. With depressed corporate 

profits and diminishing investor confidence, some 

firms with debts maturing in the near term may have 

difficulty refinancing. 

Firms with Maturing Debts Could Face 

a Critical Period in the Near Term 

Moody’s estimates that $141 billion worth of U.S. 

speculative-grade corporate bonds and rated bank debt 

will come due over the next three years: $27 billion 

(19 percent) in 2002, $54 billion (38 percent) in 2003, 

and $60 billion (43 percent) in 2004.10 To put these 

numbers into perspective, total U.S. corporate bond 

defaults were $115 billion in all of 2001, of which 

95 percent of those defaulting were speculative-grade 

borrowers. Although Moody’s expects the bulk of 

high-yield debt maturing in 2002 to be refinanced 

despite unfavorable market conditions, concern exists 

about the large percentage of issues rated B1 or lower 

that will come due in 2003 and 2004 (see Chart 5).11 

CHART 5 

Corporate Debt Continues to Rise 

Relative to Cash Flows 

Source: Federal Reserve Board Ratio of nonfarm, nonfinancial debt to cash flow 

3.5 

4.0 

4.5 

5.0 

5.5 

6.0 

1975 1978 1981 1984 1987 1990 1993 1996 1999 1Q02 

Forty-Seven Percent of U.S. Speculative-Grade
 

Bonds and Bank Debt Maturing in 2003–2004
 

Are Rated B1 or Lower
 

Ba1 to Ba3 

53% 

B1 to B3 

36% 

Caa1 or lower 

11% 

Source: Moody’s 

8 Charles L. Hill, et al., This Week in Earnings, Thomson First Call, 

July 22, 2002. 

9 A Study of Restatement Matters, for the five years ended December 

31, 2001, Huron Consulting Group, June 2002. This study excluded 

restatements caused by changes in accounting principles and 

nonfinancial-related restatements. 

10 Tom Marshella, et al., “Refunding Risk for U.S. Speculative Grade 

Borrowers, 2002–2004,” Global Credit Research, Moody’s Investors 

Service, December 2001. Figures related to refunding risk presented 

throughout this article are taken from Moody’s refunding risk studies, 

conducted annually since November 1998. 

11 Speculative-grade debt ratings assigned by Moody’s in the order of 

declining credit quality are as follows: Ba, B, Caa, Ca, and C. 

Moody’s also applies numerical modifiers 1, 2, and 3 in each generic 

rating classification. The modifier 1 indicates that the obligation 

ranks in the higher end of its generic rating category, while the 

modifier 3 indicates a ranking in the lower end of that generic rating 

category. 

Memphis Regional Outlook 12 Third Quarter 2002 
In Focus This Quarter
 

Credit deterioration of bank loans is similar to the cur- TABLE 1 

rent trend in corporate bonds. Migration of maturing 

loans into lower grade categories has accelerated in 

recent years (see Chart 6). This ratings decay reflects 

the borrowers’ deteriorated financial condition and the 

effects of liberal underwriting conditions from 1996 to 

1998, when speculative-grade originations were more 

common. For example, the 1999 and 2000 refunding 

risk studies conducted by Moody’s noted that 16 percent 

and 17 percent, respectively, of all rated bank loans 

maturing in 2002 were rated B1 or lower. The trend 

worsened significantly in 2001, when the study noted 

that 39 percent of bank loans maturing in 2002 were 

rated B1 or lower. When firms have to refinance lowgrade debts in today’s environment, they may face 

additional pressure on earnings and liquidity. 

Loss Severity Has Increased 

with Higher Default Rates 

Moody’s credit ratings reflect the likelihood of default 

and the severity of loss given default. As a result, the 

migration of maturing bonds and loans into lower 

grades implies a greater risk of default or increased loss 

severity upon default, or perhaps both. Moody’s notes, 

as part of its 15th annual study of global corporate 

defaults and ratings performance, that average recovery 

rates fell for the third straight year in 2001.12 The recovery rate has deteriorated for all levels of security and 

CHART 6 

The Proportion of Maturing Bank Loans Rated
 

B1 or Lower Is Increasing
 30 

Ba 25 

Average Speculative-Grade 

Recovery Rates in 2001 Show a 

Declining Trend in Nearly All Levels 

of Security and Subordination 

AVERAGE
 

RECOVERY
 

PER $100
 

1982– 

SENIORITY/SECURITY 2000 2001 

SENIOR SECURED BANK LOAN $67.06 $54.68 

EQUIPMENT TRUST $64.65 NA 

SENIOR SECURED BONDS $52.09 $58.00 

SENIOR UNSECURED BONDS $43.82 $36.20 

SENIOR SUBORDINATED BONDS $34.59 $19.90 

SUBORDINATED BONDS $31.83 $16.45 

JUNIOR SUBORDINATED BONDS $22.48 NA 

Note: NA=not available 

Source: Moody’s 

subordination except for senior secured bonds (see 

Table 1). 

Higher-Risk Borrowers Pay High Premiums 

A speculative-grade company refinancing debt today 

will face a much higher price, in terms of spreads over 

a cost of funds index or risk-free instruments, compared to several years ago. Yield spreads between 

investment-grade and speculative-grade bonds have 

widened significantly since early 2000 (see Chart 7), in 

part because of lower investor tolerance for risk, rising 

CHART 7 

$ Billions 

20 

15 

10 

5 

0 

B1 or Lower 

2002 2003 2004 

Credit Costs for Higher-Risk Borrowers Rose 

Dramatically in Recent Years 

Sources: Merrill Lynch Bond Global Bond Indices, Federal Reserve Board Basis point spread over ten-year constant-maturity Treasuries

Investment-grade bonds 

High-yield bonds 

0 

100 

200 

300 

400 

500 

600 

700 

800 

900 

1000 

Jun 

’98 

Dec 

’98 

Jun 

’99 

Dec 

’99 

Jun 

’00 

Dec 

’00 

Jun 

’01 

Dec 

’01 

Jun 

’02 

Source: Moody’s 

12 David Hamilton, et al., “Default & Recovery Rates of Corporate 

Bond Issuers: A Statistical Review of Moody’s Ratings Performance 

1970–2001,” Global Credit Research, Moody’s Investors Service, 

February 2002. The recovery rate is defined as the secondary market 

price of the defaulted instrument approximately one month after the 

time of default. 

Memphis Regional Outlook 13 Third Quarter 2002 
In Focus This Quarter
 

defaults, and weakening corporate cash flows. After 

narrowing a bit in first quarter 2002, spreads have 

widened again on renewed concerns about accounting 

irregularities and the realization that the economic 

recovery may come at a slower pace than anticipated. 

Lower investor tolerance for risk has affected not only 

speculative-grade borrowers but also some investmentgrade borrowers. For example, the commercial paper 

(CP) market, which many investment-grade borrowers 

have used as a cheap source of funding, is no longer 

readily available to all investment-grade borrowers.13 

Drawn-Down Commercial Paper Back-up Lines 

Heighten Commercial Bank Exposure14 

Since its peak at the end of 2000, the CP market for 

domestic nonfinancial companies has shrunk by almost 

50 percent (see Chart 8). A reduction in the need for 

working capital and heavy refinancing activity have 

contributed to this contraction. However, the record 

number of downgrades among issuers of CP in 2001 

also contributed to this decline. Money market funds 

cannot hold more than 5 percent of assets in CP graded 

less than A1/P1/F1.15 Thus, the recent flux of downgrades effectively squeezed some issuers out of this 

market and forced them to refinance with fixed-rate 

bonds.16 Also, fears of deteriorating credit quality have 

shut some investment-grade companies out of the CP 

market. Since the collapse of Enron, investors have been 

reluctant to hold the debt of certain companies. Some of 

these companies reported accounting irregularities, and 

the restatement of financial statements revealed previously hidden losses. In some cases, issuers that were not 

involved with accounting irregularities were forced to 

draw on bank credit lines when they were unable to roll 

over their CP because of the lack of demand or extreme13 Commercial paper is short-term promissory notes issued by large 

firms, generally maturing in nine months or less. It is an important 

source of short-term funding for corporations that need a steady 

stream of working capital. 

14 A CP back-up line is a commitment to provide a liquidity support 

for a company’s CP program. It is typically a revolving credit, a 

364-day facility. The rationale is that the borrower does not intend 

to use the back-up line, which generally costs more than issuing 

CP, unless the CP cannot be rolled over or repaid. 

15 The CP market can be divided into three tiers: Tier 1 (A1/P1/F1 or 

better), Tier 2 (A2/P2/F2), and Tier 3 (A3/P3/F3). The first two 

groups make up the bulk of the market. The first rating refers to a 

rating assigned by Standard & Poor’s, while the second and third 

reflect ratings assigned by Moody’s and Fitch, respectively. 

16 Moody’s Investors Service, Moody’s Credit Perspectives, December 

31, 2001. Moody’s downgraded 38 commercial paper programs from 

P1 in 2001. 

CHART 8 

Domestic Nonfinancial Commercial Paper 

Outstandings Have Declined amid Investors’ 

Jitters about Credit Quality 

Source: Federal Reserve Board (Haver Analytics) $ Billions 

100 

150 

200 

250 

300 

350 

2Q95 2Q96 2Q97 2Q98 2Q99 2Q00 2Q01 2Q02 

ly high rates demanded by investors. When a CP issuer 

draws down on the back-up line, rating agencies often 

view this as a weakness in the company’s liquidity, and 

a rating downgrade can occur. In turn, lower ratings lead 

to higher funding costs for the borrowers. 

The steepness of the current yield curve also results in 

significantly higher refinancing costs for investmentgrade corporations that no longer have access to shortterm funding through the CP market. As these 

companies are forced to borrow longer term, they face 

higher refinancing costs in the long-term end of the 

current yield curve.17 For example, if a Tier 1 corporation formerly issuing 90-day CP was forced to issue 

ten-year fixed-term debt in mid-July 2002, the cost 

would have been almost 350 basis points higher than 

issuing 90-day CP. 

Using back-up lines of credit when companies cannot 

roll over maturing CP has become expensive for some 

issuers. Bankers are realizing that initial pricing does 

not reflect the risk inherent in drawn-down lines. As a 

result, bankers have started to impose high utilization 

premiums on BBB-rated CP back-up lines. Also, borrowers recently have been seeking term-out options, 

another sign that refunding risk is a concern.18 Recent 

transactions reported by Loan Pricing Corporation 

show that some investment-grade companies are seek17Bloomberg Fair Market Sector Curves, July 5, 2002. The spread
 

between 60-day and five-year Treasury instruments was nearly 300
 

basis points. 


18 Once the back-up line has been drawn down, the borrower again has
 

to repay or roll over the debt. A revolving facility can be “termed out”
 

so that it becomes an installment loan with a much longer maturity,
 

such as three to five years. Such an option, however, can be costly.
 

Memphis Regional Outlook 14 Third Quarter 2002 
In Focus This Quarter
 

ing term-out options even at a fee of 200 basis points. 

The higher premiums demanded reflect both the volatility in the market and deteriorating credit quality indicated by high default rates and rating downgrades in 

recent quarters. 

Conclusion 

During the boom times of the late 1990s, corporations 

enjoyed an abundance of liquidity sources and easy 

access to capital. Many corporations used debt to 

finance business expansions, and rolling over maturing 

debt was not a significant concern. Recently, however, 

stock prices have been declining and investors have 

been concerned about the possibility of more corporate 

financial restatements. In this environment, highly 

leveraged borrowers worry about maturing debts and 

refunding risk implications. Lenders are demanding 

higher spreads because of the volatile financial markets 

and the deteriorated financial condition and debt ratings 

of many borrowers. In general, firms seeking to roll 

over maturing debt clearly face a less hospitable financing market today. With corporate profitability not yet 

strong, highly leveraged companies may find it increasingly difficult to meet debt service requirements and 

loan covenants. Despite these hurdles, the economy 

appears to be improving, and more companies are 

beginning to report higher earnings. With an economic 

recovery and tighter underwriting standards, the deterioration in commercial credit quality should stabilize 

and turn around. 

Cecilia Lee Barry, Senior Financial Analyst 

Memphis Regional Outlook 15 Third Quarter 2002 
✁
 

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