Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION	 THIRD QUARTER 2002 

In Focus This Quarter 

FDIC 

National ◆ The Road to Recovery for Commercial Credit Quality: Not without a Few Edition	 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. Boston 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 3. Division of 

San 

Francisco Kansas 

City 

Dallas 

Memphis 

Atlanta 

New 

York 

Chicago 

Insurance
 

and Research
 

Regional Perspectives 

◆ Atlanta—Rate/volume analysis suggests that community banks were exposed to heightened interest rate 

risk during 2001. A rapidly changing yield curve contributed to increased optionality in the loan portfolio, 

and low short-term rates made repricing of liabilities 

difficult. See page 9. 

◆ Boston—The effects of the recession varied widely 

across the New England states. The Region’s insured 

institutions remained healthy overall but showed elevated credit and earnings risk. See page 10. 

◆ Chicago—Most community institutions have 

weathered the recession fairly well, although moderate 

credit quality deterioration was widespread and risk 

management became more of a challenge. See page 11. 

◆ Dallas—The 2002 farm bill is a major departure 

from the market-oriented approach of the 1996 FAIR 

Act and continues a high level of government payments 

to the agricultural sector. See page 12. 

By Cecilia Lee Barry, Senior Financial Analyst 

◆ Kansas City—While many observers believe that 

Internet technology may enhance the economic viability 

of rural areas, others suggest that it could increase 

the ability of larger banks to compete in these areas. 

See page 13. 

◆ Memphis—Weaker loan demand in late 2001 and 

early 2002 prompted many of the Region’s banks 

and thrifts to seek improved revenues from securities 

portfolios, often through the acceptance of increased 

market risk. See page 14. 

◆ New York—The characteristics of the recent recession and the economic profiles of the Region’s major 

metropolitan areas help explain differences in employment trends, banking performance, and prospects for 

economic recovery. See page 15. 

◆ San Francisco—Insured institutions have fared 

better in the recent recession than during the 1990–1991 

downturn, despite recurring challenges from weak 

commercial real estate markets and a large share of 

newly chartered banks, as well as new risks from 

subprime lending. See page 16. 

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 National Edition of Regional 

Outlook, please call Lynn Nejezchleb at (202) 898-3898 or send an e-mail to lnejezchleb@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 
In Focus This Quarter 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. 

Regional Outlook—National Edition 3 Third Quarter 2002 
In Focus This Quarter 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. 

Regional Outlook—National Edition 4 Third Quarter 2002 
In Focus This Quarter 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. 

Regional Outlook—National Edition 5 Third Quarter 2002 
In Focus This Quarter 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. 

Regional Outlook—National Edition 6 Third Quarter 2002 
In Focus This Quarter 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.
 

Regional Outlook—National Edition 7 Third Quarter 2002 
In Focus This Quarter 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 

Regional Outlook—National Edition 8 Third Quarter 2002 
Regional Perspectives
 

Atlanta Regional Perspectives
 

Economic conditions have contributed to a rapidly 

changing interest rate environment that has been 

challenging for many community banks in the 

Atlanta Region as net interest margins (NIMs) 

shrank. The steepening and downward twist in the 

yield curve in 2001 contributed to an increase in optionality risk, which limited the effectiveness of interest rate 

risk (IRR) modeling techniques. As an alternative 

method for assessing exposure to IRR in 2001, an interest rate/volume analysis was used to identify the degree 

of sensitivity to a changing rate environment of community bank net interest income (NII) and the NIM. 

The NIM and NII among many of the Region’s community banks declined during 2001. The NIM decline was 

systemic; 80 percent of community banks reported margin compression. More important, however, NII 

declined among 41 percent of the Region’s community 

banks; this subset also exhibited a comparatively 

higher risk profile, as suggested by higher 

past-due loan and charge-off levels and lower 

rates of return on assets. The results of the 

rate/volume analysis suggest that the Region’s 

community banks were exposed to a significant amount of IRR during 2001. Some institutions may have assumed more credit risk to 

compensate for a lower NIM. 

Responses by certain of the Region’s community 

banks to lower NII and margin pressures in 2001 

may lead to earnings pressure or heightened liquidity risk if robust economic growth prompts an 

increase in interest rates. The appeal of nonbank 

investment alternatives has diminished, contributing to 

a re-intermediation of funds. The permanence of these 

flows is open to debate, however, and liquidity risk 

could arise if these funding sources are short-lived. 

Extension risk is an increase in the duration of an asset 

as a result of a rise in interest rates. Community banks 

have increased holdings of low-rate long-term assets 

significantly, potentially heightening extension risk 

going forward. 

During 2001, the unprecedented decline in interest 

rates, the dramatic steepening of the yield curve, and 

the resulting increase in optionality risk limited the 

effectiveness of many IRR models. Unsophisticated 

sensitivity models that assess IRR from a large parallel 

shift in the yield curve were ineffective in 2001. Even 

more sophisticated historical Value at Risk (VAR) models, the most frequently used of the VAR models, probably did not include enough abnormal events (large 

market fluctuations). As a result, most IRR models 

underestimated the degree of IRR. 

IRR modeling may be challenging going forward. Continued slow economic growth, which restrains rates 

from rising, would likely benefit community bank 

NIMs. But stronger economic growth, higher inflation, 

or a rapid decline in the relative value of the U.S. dollar 

could lead to an increase in short-term rates. The timing 

of such increases could have different effects on various 

types of insured institutions. A rapid rise in short-term 

rates, paired with a flattening yield curve, 

would likely be disadvantageous to 

most insured institutions. Such a 

rapid rise in interest rates could 

extend asset durations. Given the 

various paths in which interest rates 

may move, IRR managers should use 

an interest rate forecast that is consistent with an institution’s overall strategic 

planning process. For example, if loan volume is expected to grow robustly because of 

an economic rebound, short-term rates will 

likely rise as the economy expands. Under 

this scenario, it would be inconsistent to 

use a constant interest rate forecast in 

IRR models. 

Bank managers’ attempts to mitigate the negative 

effects of IRR in 2001 may lead to unexpected challenges. In the case of insured institutions that have 

relied on significant loan growth (particularly in the 

real estate loan portfolio) to offset NIM compression, 

credit risk could arise if slow or negative economic 

growth contributes to a decline in real estate absorption 

rates. On the other hand, robust economic growth that 

leads to higher interest rates could pressure earnings 

because of longer asset durations. A lesser concern 

would be an increase in liquidity risk if nonbank investment alternatives become more attractive. Another concern in 2001 is that many banks may not adequately 

consider embedded options when pricing loans. 

Insured institutions that may be most vulnerable to an 

increasing rate environment are those that experienced 

the greatest drop in NII during 2001. Most of these 

institutions are community banks headquartered in 

urban areas, primarily in Florida, Virginia, Georgia, 

and Alabama. 

Regional Outlook—National Edition 9 Third Quarter 2002 
Regional Perspectives Regional Perspectives
 

Boston Regional Perspectives
 

Individual states’ performances differed during this 

recession. The performance of the Region’s six state 

economies through this business cycle has differed from 

their performance during the early 1990s recession, 

when most of them experienced significant deterioration relative to the nation. The difference this time is that 

the national recession’s adverse impact was amplified 

only in those states more dependent on technology 

employment, business investment demand, and spending linked to stock market wealth effects. 

Massachusetts and Vermont economies face the 

greatest challenges. Between January 2001 and June 

2002, the weakest labor markets of all the Region’s 

states were in Massachusetts and Vermont. Employment trends in these two states appear likely to continue deteriorating, whereas employment among the 

other four states apparently stabilized during the 

first half of 2002. 

Robust economic growth in Massachusetts 

during the late 1990s strongly reflected the 

influence of a booming demand for technology products and services and an extremely 

strong equities market. The absence of these 

economic catalysts has amplified the state’s 

recent downturn. In addition, with a continued 

malaise in the national economy a distinct possibility, the state’s economic growth may be subdued this year. The continued economic weakness in 

Vermont reflects the impact of poor conditions nationally in overall business investment, high-end retailing, and 

tourism—key drivers of business and consumer sales in 

the Vermont economy. 

Maine and Rhode Island: No booms, but no busts, 

either. In contrast, Maine and Rhode Island appear 

to have escaped the adverse effects of the recession 

because they do not have significant concentrations in 

information technology (IT) and financial services 

employment, nor are they characterized by sizable concentrations of high-worth households. Their economies 

were not characterized by “boom” conditions during the 

late 1990s. In addition, long-running consolidation in 

recession-sensitive industries such as manufacturing has 

limited the fallout from the recent national recession. 

The Region’s insured institutions weathered the 

recession, but credit and earnings risks remain. The 

recent economic downturn appears to have had limited 

effects on the Region’s insured institutions thus far. For 

example, the boost in net interest margins late in 2001 

and early 2002 from cheaper funding sources helped 

insured institutions remain profitable. But other measures of banking performance, particularly loan growth 

rates, reflect the recent economic slowdown in some 

cases. 

Consumer loan growth (excluding credit card loans) 

decelerated sharply at the end of 2000, ultimately turning negative for insured institutions in those New England states first affected by the recent recession, such 

as Connecticut and Massachusetts. Banks and thrifts 

in other states, such as New Hampshire, that 

have been hit harder by the recent downturn in 

IT employment, continued to post respectable 

consumer loan growth until late last year; 

however, loan growth has also turned negative for insured institutions in these states. 

Unlike consumer lending, state-level commercial loan trends appear less closely linked 

to local economic trends. Part of the disconnect 

may be due to the fact that local commercial 

credit demand has not been driven by firms that 

have weakened most during this downturn, such 

as those in the IT and manufacturing sectors. 

Combined construction and development, commercial 

real estate, and multifamily real estate loan portfolios 

have continued to grow modestly among insured institutions in all the Region’s states, even though weak conditions overall continue in the Region’s major office 

markets. These markets are more likely to have their 

funding met by public capital market vehicles, such as 

real estate investment trusts (REITs), than by locally 

based small and mid-size banks. 

Past-due loan levels and charge-offs among the 

Region’s insured institutions remain modest. However, 

the full effect of the recession may not yet have 

appeared in loan performance data. Also, with deteriorating consumer lending conditions and generally 

sluggish demand for business credit in recent quarters, 

insured institutions may find it harder to increase revenues until the economy returns to a stronger footing. 

Over the near term, these trends may become particularly evident in states such as Vermont or Massachusetts, where economic growth is expected to remain 

sluggish. 

Regional Outlook—National Edition 10 Third Quarter 2002 
Regional Perspectives
 

Chicago Regional Perspectives
 

To date, the financial health of the Region’s community banks and thrifts1 has not been significantly 

strained by the 2001 recession. Profitability, measured 

by return on assets, held close to 1 percent, and increases 

in past-due and nonaccrual loans have been moderate. 

Behind the moderate changes in broad measures of 

performance, however, is an increase in the number 

of institutions rated as weak (i.e., having composite 

CAMELS ratings of 3, 4, or 5).2 Asset quality and 

management rating trends are major contributors to 

the rising number of weak-rated institutions. On the 

positive side, the current percentage of weak institutions 

(7.6 percent) is less than half that in the early 1990s, 

suggesting that industry conditions are healthier thus far 

than at the end of the previous recession. 

Although a variety of economic indicators suggests that 

a cyclical recovery began in early 2002, output and 

employment levels in many sectors remain lower than 

before the recession. In this environment of modest 

cyclical improvement, accompanied by stock market 

turmoil, many businesses and households remain vulnerable to financial strains. Household income, for 

example, is not likely to grow noticeably until employment levels start to rise. Meanwhile, the cushioning 

effect of last year’s decline in interest rates, cut in 

personal income taxes, modest inflation, and falling 

energy prices may be waning. 

Loan portfolios reflect changing conditions. Although 

loan quality deteriorated across most business lines in 

the year ending first quarter 2002, there is considerable 

variation in how portfolio segments fared. Although 

commercial and industrial (C&I) portfolios among the 

Region’s community banks are exhibiting some deterioration, they are performing modestly better than those 

held by community banks nationwide. Credit quality 

deterioration in commercial real estate (CRE) portfolios 

has been modest, but rising vacancy rates and significant amounts of space available for sublease in many of 

the Region’s metropolitan areas may foreshadow further 

weakness. 

1 Banks and thrifts with less than $1 billion in assets, excluding
 

de novo and specialty institutions.
 

2 Composite CAMELS ratings reflect examiners’ evaluations of
 

institutions’ capital, asset quality, management, earnings, liquidity,
 

and sensitivity to market risk.
 

One- to four-family residential and consumer loans 

held by the Region’s banks and thrifts declined in the 

year ending first quarter 2002. Some households that 

refinanced their debt likely did so with larger or out-ofregion lenders. Nonbank lenders also are attracting 

some business that might have gone to community 

institutions a decade ago. Furthermore, insured institutions themselves may contribute to shrinking mortgage 

and consumer portfolios by adopting strategies to originate such loans but not hold them. The risk associated 

with one- to four-family mortgage lending traditionally 

has been less than for most 

other loan categories. The 

credit risk associated with 

this portfolio may have 

risen, however, reflecting 

structural changes in the 

mortgage business during 

the 1990s. In fact, one- to 

four-family mortgage lending 

is the only major loan category 

held by the Region’s community banks that exhibits a higher percentage of delinquencies 

than the percentage during the 

1990–1991 recession. 

As the economy recovers, challenges remain. The 

Region’s insured institutions appear to be weathering the 

impacts of the 2001 recession fairly well, but challenges 

remain. They include an expected increase in interest 

rates and flattening of the yield curve; structural 

changes and competitive forces in the financial services 

industry; and more traditional concerns, such as ensuring adequate risk management and other internal controls and routines. 

Meanwhile, credit quality problems may linger as 

household and business stresses from the recession are 

resolved and commercial real estate markets adjust to 

imbalances. In this environment, insured institutions at 

some point will need to shift gears from asset-liability 

management strategies that worked well when shortterm interest rates were low and falling to strategies 

more suitable in a rising rate environment. The recent 

well-publicized accounting and management lapses at 

some major corporations underscore the importance of 

continually verifying the effectiveness of internal routines and controls, accounting practices, and adherence 

to board policies. 

Regional Outlook—National Edition 11 Third Quarter 2002 
Regional Perspectives
 

Dallas Regional Perspectives
 

The 2002 farm bill is a major departure from the 

market-oriented approach of the 1996 Federal Agriculture Improvement and Reform (FAIR) Act, which 

was designed to reduce payments to the farm sector 

by decoupling payments from production. The 2002 

farm bill makes no pretense of reducing government 

expenditures and seeks to provide a farm safety net at a 

relatively higher cost. This change in approach coincides with several other developments, such as major 

drought conditions and global overproduction at a time 

of declining demand, that portend even higher government outlays. As a result, the newly enacted farm bill 

continues the trend toward a high level of government 

payments to the agricultural sector. In fact, the bill 

increases spending for commodity support programs by 

$31.2 billion (compared with the amount legislated in 

FAIR) over the next six years. 

The 2002 farm bill may contribute to 

excess production of certain commodities 

and, as a result, continue to depress 

prices. As producers attempt to maximize 

benefits under the farm bill, supply 

and demand forces could become 

artificially constrained. Consequently, 

consideration of production costs and 

commodity price levels could become 

secondary to concerns about subsidy benefits. 

As a result, production of certain crops could 

expand at the same time prices are falling. 

Provisions of the 2002 farm bill could have unintended consequences. Some analysts suggest that farm 

subsidy payments may slow the growth of some rural 

communities by artificially inflating land prices and 

diverting capital away from businesses. At the same time 

government payments are inflating farmland values, 

insured financial institutions have increased lending 

secured by farm real estate. If the level of government 

payments declines at some point in the future and 

commodity prices remain weak, rural land values likely 

would be subject to downward price pressure. Subsequently, lenders’ collateral and producers’ equity and 

borrowing capacity would be adversely affected. 

Enactment of the 2002 farm bill could complicate 

future international trade negotiations because the 

legislation represents a shift away from a free marketoriented farm policy. The new farm bill follows closely 

on the heels of the U.S. decision to impose tariffs on steel 

and lumber imports. As a result, many countries are 

appealing for relief to the World Trade Organization and 

have threatened to respond with tariffs on U.S. goods. 

Trade disputes could slow or set back negotiations as the 

U.S. economy struggles to recover. 

Relatively high levels of government payments to 

farmers help explain why the Region’s agricultural 

banks have continued to perform well despite low 

commodity prices. During the past five years (coinciding with enactment of FAIR in 1996), when commodity 

prices have been at historically low levels, the return on 

assets for the Region’s agricultural banks has remained 

relatively stable, averaging a strong 1.28 percent, compared with 1.18 percent for other agricultural banks 

nationwide and 0.94 percent for small nonagricultural 

banks nationwide. In addition to relatively high levels of 

government payments, Dallas Region agricultural banks 

have benefited from lower funding costs because they 

hold a greater percentage of noninterest deposits than 

do agricultural banks outside the Region. 

Dallas Region agricultural banks also 

have reported a declining share of agricultural loans during the past ten years. 

In part, this is because large insured institutions (assets greater than $1 billion) are 

holding an increasing share of total farm 

debt—35 percent of total agricultural loans 

as of year-end 2001, up from 22 percent ten 

years earlier. Small insured institutions now hold 

only 29 percent of total agricultural loans, down from 53 

percent during the same period. In addition, agricultural 

banks in the Dallas Region have reported increasing loanto-asset ratios; the greatest increase has occurred among 

loans secured by farmland. If government payments have 

artificially inflated land prices, collateral margins may be 

squeezed if subsidy levels decline. 

The enactment of the 2002 farm bill alleviated producers’ uncertainty about the future of government payment 

programs. If producers plant more acreage in crops 

expected to receive the highest level of subsidies, the 

cost of the farm bill could exceed expectations, as was 

the case with the FAIR Act. Moreover, agricultural 

producers and their communities could become increasingly dependent on farm payments, potentially causing 

problems for agricultural lenders should payment levels 

decline in the future at the same time commodity prices 

are low. 

Regional Outlook—National Edition 12 Third Quarter 2002 
Regional Perspectives
 

Kansas City Regional Perspectives
 

Will communications technology be the salvation of 

rural communities? Many observers believe emerging 

telecommunications technology, including the Internet, 

may provide the means to maintain or restore the vitality of many of America’s rural areas. According to this 

line of thinking, improved telecommunications will 

improve the quality of life in sparsely populated areas 

and allow rural businesses to compete more effectively 

over wider areas. Closer analysis suggests, however, that 

while there is some truth to these beliefs, Internet technology may prove to be less than a “magic bullet” to 

revitalize rural economies. 

Access to the Internet has diffused rapidly in rural 

America, closely tracking national trends. According to 

surveys conducted by the U.S. Census Bureau in September 2001, access to the Internet in rural households 

is only slightly less than that in urban households. 

Communications-related improvements substantially 

reduce historical incentives to locate firms in urban 

areas. The advantages traditionally associated with rural 

areas will loom larger in the decision about where to 

locate a business: lower labor and land costs and less 

stringent environmental regulations. 

Those who are more dubious of the benefits of modern 

telecommunications to rural areas see the technology as 

a “bridge to” rural areas, opening local businesses to 

competition. The Internet may enhance 

urban firms’ access to rural consumers, 

because telecommunications are more 

likely to be used to reach into the rural 

community customer base from outside. 

When the Internet offers rural customers 

more choices, they may be less likely to 

bring their business to local merchants. 

What does this situation imply for 

community banks? Community banks 

have embraced Internet technology rapidly. A series of annual surveys of community bank presidents by a major accounting firm 

found that the proportion of banks with a website 

increased from 29 percent in 1998 to 75 percent in 

November 2001. More significant, 43 percent of the 

community banks surveyed had some transactional 

capabilities in 2001, and 77 percent expected such 

capability by 2003. 

Certainly, the Internet provides rural banks with many of 

the advantages ascribed to other rural businesses, including the ability to employ telecommuters, use outsourcing services more efficiently, and buy inputs, including 

deposits, more competitively. Community banks may be 

able to use the Internet to reduce unit costs of delivering 

many services while continuing to provide the personalized attention to their customers that is their comparative 

advantage over larger institutions. 

But the development of Internet technology may allow 

the largest banks headquartered in urban areas to pursue 

a “less than a branch” strategy in rural areas. As more 

rural customers become conversant with using the Internet for commercial transactions, large banks may have 

greater opportunities to gain business in rural areas. 

Conclusion: Technology is a two-edged sword. Evidence indicates that the diffusion of the Internet may be 

a double-edged sword for the rural economy: It can be 

expected to increase the efficiency and market reach of 

many rural businesses, but it may also expose 

these businesses to competitors that can 

now reach more easily into the rural community, perhaps providing services more 

cheaply than rural businesses can. Rural 

banks may also find the Internet to be a 

mixed blessing: While the Internet may 

enable them to improve operational efficiency and extend market reach, the technology may also provide a means for 

large banks and other financial services 

providers to compete more aggressively 

in rural areas. 

Regional Outlook—National Edition 13 Third Quarter 2002 
Regional Perspectives
 

Memphis Regional Perspectives
 

The Memphis Region economy has stabilized and 

appears poised for growth. Rising factory orders and 

an increase in average employee hours worked in the 

beleaguered manufacturing sector indicate a likely 

rebound in employment in the second half of 2002. The 

transportation/distribution sector, which is also important to the Region’s employment base, is showing signs 

of recovery, with increased air and ground shipment 

activity. Improvement in manufacturing and transportation/distribution employment should spill over into 

other sectors of the Region’s economy. 

Bank and thrift credit quality deterioration abated 

and earnings performance improved in early 2002. 

Loan loss rates were down from prior levels but 

remained high. Past-due and nonaccrual loans fell 

modestly, signaling that credit problems, at least in the 

aggregate, may have peaked for this cycle. Stronger 

earnings in first quarter 2002 were driven by 

increased net margins resulting from a favorable 

interest rate environment. 

Insured financial institutions continued to face difficult asset allocation decisions, however. Loan 

demand in early 2002 remained 

weak, and loan balances fell among 

the Region’s community banks and 

thrifts for the second consecutive 

quarter. Throughout 2001 and in 

early 2002, deposit inflows at many 

community banks increased as consumers, 

shaken by weaknesses in the stock market, sought a 

safe haven for their money. The sharp decline in interest rates during 2001 led to the exercise of embedded 

call features and prepayment options, resulting in considerable asset turnover. Consequently, banks found 

themselves with excess funds to invest in 2001 and 

early 2002. 

Many banks chose to invest heavily in mortgage-related 

securities during recent periods, in effect purchasing 

loans to compensate for weak local loan demand. 

Aggregate holdings of mortgage-related securities 

among the Region’s community banks grew by a 

remarkable 59 percent in 2001. The share of investment 

portfolios composed of mortgage-related securities 

surged from 18.8 percent on December 31, 2000, to 28.2 

percent on March 31, 2002. The popularity of these 

investments is a function of higher yields. Because of 

the increasing risk premium associated with the inherent 

optionality, mortgage-related securities yields improved 

compared with yields on most other investment alternatives during this period. 

Similarly, some institutions sought higher yields by 

investing in longer-term securities or those with complex 

embedded options. Although mortgage-related securities 

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 elected to accept 

increased market risk in these segments of their investment portfolios by extending reinvestment horizons and 

purchasing structured notes. While the 

aggregate changes in these investments 

have not been as extreme as the shift into 

mortgage-related securities, the changes 

added to the growing market risk 

apparent in many community bank 

investment portfolios. 

These strategies not only helped institutions preserve 

or improve net interest margins in the current 

interest rate environment but also contributed to 

heightened market risk in investment portfolios. A 

shift into mortgage-related securities, longer-term 

securities, or securities with complex embedded 

options is not an inappropriate or undesirable strategy. 

For many insured financial institutions, this increase 

in investment portfolio market risk represents a wellunderstood component of a sound overall asset/liability 

management strategy. For others, however, the significant and rapid shift in portfolio composition may result 

from a simple pursuit of higher yields. 

Bank and thrift managers should review investment 

strategies and securities portfolios to ensure that 

current holdings and future purchases fit within 

board-approved tolerances for sensitivity to changes 

in interest rates. With credit concerns understandably 

paramount for most bankers and regulators during 

2001 and in early 2002, attention to investment portfolios may have waned. 

Regional Outlook—National Edition 14 Third Quarter 2002 
Regional Perspectives
 

New York Regional Perspectives
 

Different MSAs weathered the recession differently. 

A political axiom states that “where you stand depends 

on where you sit.” Similarly, your view of the economy may depend largely on the location of your 

window. The Region’s largest metropolitan 

statistical areas (MSAs) weathered this 

recession differently, and the timing of 

the recoveries may vary—a reflection of the disparate economic and 

industrial makeup of these MSAs.1 

The Region’s MSAs that lost jobs 

early in this downturn, such as BuffaloNiagara Falls, Rochester, Syracuse, BergenPassaic, Newark, and Scranton-Wilkes-Barre, 

generally are more dependent on manufacturing jobs 

than the nation is. Credit quality weakened for institutions headquartered in some of these MSAs to a greater 

extent than in the Region and the nation. Trends in 

the manufacturing sector will influence the recovery 

in these MSAs. Analysis of the Institute for Supply 

Management’s (ISM) manufacturing index shows a 

lag of 6 to 12 months at the national level between the 

manufacturing index and the employment index.2 The 

lag tends to increase when the economy is on the 

upswing because employers hesitate to add workers 

until they are confident that the recovery “has legs.” 

The overall manufacturing index turned positive in 

February 2002, suggesting that employment growth 

may be months away. 

Job losses in New York City also occurred early in this 

downturn and accelerated after September 11. However, the preponderance of job losses occurred in 

the city’s financial, insurance, and real estate and 

services sectors. Despite early entrance into this recession and relatively high job losses, credit quality 

for insured institutions in the New York City area 

remained favorable through first quarter 2002. New 

1 For the purposes of this analysis, the Region’s MSAs are categorized 

into three groups: MSAs that experienced job losses early in this business cycle, MSAs whose economies were more directly affected by 

the events of September 11, and MSAs that experienced minimal or no 

job losses. Analysis was limited to MSAs with a labor force of at least 

200,000 and at least six insured institutions with total assets less than 

$10 billion, excluding credit card banks. Twenty-one of the Region’s 

45 MSAs met these criteria as of March 31, 2002. Employment data 

are through May 2002. 

2 The ISM manufacturing index measures the overall health of the 

nation’s manufacturing index and has several components, including 

new orders, shipments, and employment. 

York City’s recovery will be closely linked to conditions in the financial services sector. 

Six of the Region’s 21 major MSAs arguably were 

pulled into recession by September 11. Institutions in 

these MSAs reported higher past-due ratios at yearend 2001, consistent with the economic decline following September 11. Economic recovery for 

these MSAs is likely to be on par with that of 

the nation, reflecting their highly diversified job 

base. Average employment changes in this MSA 

group correlate at a 98.3 percent rate with the United 

States, reinforcing the expectation that the economic 

recovery of this MSA group will track the nation’s.3 

Eight of the Region’s MSAs experienced minimal or 

no job losses between March 2001 and May 2002. The 

primary commonality among these MSAs is the relatively high growth in government and service sector 

jobs, particularly in the health care industry. Not surprisingly, credit quality reported by insured institutions 

headquartered in these MSAs has been more favorable 

during this economic downturn than that reported by 

institutions in the Region’s other MSAs. The recovery 

apparently is further along in these MSAs; however, it 

likely will take time for any economic recovery to be 

reflected in insured institution credit quality trends. 

After declining in the second half of 2001, profitability 

among the Region’s large banks increased in first 

quarter 2002.4 Most of the Region’s large banks reported 

stable or moderately increasing net interest margins in 

first quarter 2002 compared with the previous quarter. 

Large banks’ average cost of funds, which is highly 

sensitive to changes in short-term interest rates, reached 

the lowest recorded level at approximately 2 percent 

in first quarter 2002.5 Profitability also was aided by 

a moderate increase in noninterest income, although 

certain business lines did better than others. Profitability among the Region’s large banks also increased 

because problem loan costs abated in first quarter 2002. 

Nonetheless, loan delinquency6 and charge-off rates 

remained elevated in first quarter 2002, a situation that 

could require additions to loan loss reserves. 

3 Correlation between January 2000 and April 2002.
 4 Large banks are defined as institutions with total assets greater than
 

$25 billion, excluding credit card banks. Median figures are used
 

unless otherwise noted.
 

5 Data available from first quarter 1984.
 

6 Loans 30 days or more past due or in nonaccrual status.
 

Regional Outlook—National Edition 15 Third Quarter 2002 
Regional Perspectives
 

San Francisco Regional Perspectives
 

The Region’s insured institutions have fared better 

in the recent recession than during the 1990–1991 

downturn. The confluence of events that led to the last 

banking crisis, most of which predated the 1990–1991 

recession, did not play out in the same way during the 

current cycle. Troubled and failed insured institutions 

were far fewer in number as of first quarter 2002 than 

during the early 1990s, and a repeat of the last banking 

crisis is not anticipated. Nevertheless, the recent downturn has had mild adverse effects on credit quality 

among the Region’s insured institutions. In addition, the 

recent slowdown was more economically and geographically widespread than the 1990–1991 recession, and the 

banking industry remains vulnerable to some recurring 

as well as new risks. 

The recent downturn has been more geographically 

widespread than the prior recession. The adverse 

effects of the 1990–1991 economic downturn primarily 

were focused on defense and lumber-related employment in Southern California and Oregon. In contrast, 

the effects of the recent downturn were felt across the 

more geographically dispersed high-tech manufacturing, business services, and tourism sectors. Through 

March 2002, 7 of the Region’s 11 states reported yearover-year job losses, in part because of weakness in 

these important industries. 

Rapidly increasing commercial real estate (CRE) 

vacancy rates have been a common theme in both 

recessions, although reasons for supply and demand 

imbalances differ. During the 1990–1991 recession, 

buildup of excess space was associated with national tax 

law changes and regional overbuilding. In contrast, current CRE imbalances relate to unrealistic estimates of 

future demand, fueled by an expanding high-tech industry and free-flowing venture capital. The boom and bust 

environment in some of the Region’s high-tech centers 

has led to problems in the office and industrial subsectors in particular. 

During the 1990–1991 downturn, soft CRE markets, 

weak underwriting standards, and high CRE loan1 

concentrations contributed to severe asset quality 

problems among the Region’s insured institutions, 

especially those based in Southern California and 

1 CRE loans include commercial credits secured by multifamily, 

nonfarm-nonresidential, or construction projects. 

Arizona. Improvements in underwriting and appraisal 

standards likely will forestall a repeat of the CRE loan 

problems of the early 1990s. Nevertheless, most of the 

Region’s insured institutions reported high CRE loan 

exposures as of first quarter 2002. In particular, insured 

commercial banks headquartered in most of the Region’s 

states report higher construction loan concentrations 

now than during the early 1990s. 

Brisk bank chartering activity in the ten years before 

both recessions, which contributed to the magnitude 

of failures during the early 1990s, remains a key 

concern. The recent downturn was the first economic 

contraction experienced by nearly 30 percent of the 

Region’s community institutions. During the 1990– 

1991 recession, newly chartered2 institutions headquartered within the Region were primarily between three 

and ten years old, an age group that experienced high 

average annual failure rates during the early 1990s. 

Currently, a larger proportion of the Region’s newly 

chartered institutions are less than three years old. 

Although relatively strong capital positions might help 

to mitigate the effects of the business cycle on these 

very young institutions, the high proportion of institutions less than three years old is a concern because 

these institutions have relatively untested risk management practices. 

Since the last recession, several of the Region’s 

insured institutions have pursued concentrated consumer3 and subprime lending niches, often 

using non-recession–tested credit scoring 

models to achieve large, high-yielding 

loan portfolios. The Region’s 

concentrated consumer and subprime lenders reported weakened 

asset quality as of first quarter 

2002, and they experienced higher 

loan loss rates during the recent 

recession than during the 1990–1991 

downturn. Credit quality problems 

among subprime loan securitizers could 

have an adverse effect on residual interest valuations 

and limit these institutions’ access to capital markets. 

2 Newly chartered institutions are defined as insured institutions in 

operation less than ten years with assets of less than $1 billion. 

3 Concentrated consumer lenders are defined as insured institutions 

with credit card and other non-real estate–secured consumer loans 

exceeding 25 percent of total assets. 

Regional Outlook—National Edition 16 Third Quarter 2002 



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