Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION THIRD QUARTER 2002 

FDIC
 

Dallas 


Region
 

Division of
 

Insurance
 

and Research
 

Alan C. Bush,
 

Regional Manager
 

Adrian R. Sanchez,
 

Regional Economist
 

Jeffrey A. Ayres,
 

Senior Financial
 

Analyst
 

Stephen L. Kiser,
 

Regional Economist
 

Regional Perspectives 

◆ In a departure from the market-oriented approach that characterized the 

1996 FAIR Act, the 2002 farm bill continues to provide significant subsidies to 

producers. 

◆ Agricultural producers and their communities could become increasingly 

dependent on government payments, potentially causing problems for agricultural lenders should payment levels decline at some point in the future at 

the same time commodity prices are low. 

◆ Relatively high levels of government payments to farmers help explain how 

the Region’s agricultural banks have continued to perform well despite low 

commodity prices. See page 3. 

By the Dallas Region Staff 

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 8. 

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 Dallas Region’s Regional 

Outlook, please call Alan Bush at (972) 761-2072 or send an e-mail to abush@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 

Implications of the 2002 Farm Bill for Agricultural 


Farm Policy, Producers, and Lenders
 

Overview 

The 2002 Farm Security and Rural Investment Act, 

signed into law on May 13, 2002, ended the prolonged 

farm policy debate and the uncertainty of many producers and their lenders about the nature and level of 

government payments. The legislation allocates $190 

billion over ten years and differs markedly from the 

previous farm bill (the Federal Agriculture Improvement and Reform Act of 1996 [FAIR]), which was 

intended to promote a free-market approach. Provisions of FAIR ended a history of acreage restrictions 

that controlled the supply of commodities when production outstripped demand. FAIR removed these 

acreage restrictions to allow producers to react to market signals when they decide what crops to plant. FAIR 

Total Government Expenditures Will Rise 

under Provisions of the 2002 Farm Bill 

The new farm bill increases spending for commodity 

support programs during the next six years by $31.2 billion over the amount legislated in FAIR, of which $24.4 

billion will be targeted at traditional program crops 

(corn, wheat, soybeans, and cotton). The bill provides 

for income support to producers through three main 

provisions: direct payments, counter-cyclical income 

support payments, and loan deficiency payments. 

Direct payments will serve the same purpose as the production flexibility contract (PFC) payments introduced 

in FAIR. PFC payments were fixed payments based on 

a particular farm’s historical acreage and yield; they 

were intended to ease producers’ transition to a freealso established transition payments to help
 market approach.
 

offset the cost of changing crops or to allow
 

farmers to exit the agricultural industry.
 In addition to direct payments, the 2002 law 

also introduces a counter-cyclical income 

The 2002 farm bill is a major departure from support payment program intended to supthe market-oriented approach of FAIR. In port and stabilize farm income when comprinciple, FAIR was designed to reduce payments to the 

farm sector by decoupling payments from production 

and providing transition payments to aid in a new 

market-based approach. In fact, government expenditures have increased markedly since FAIR was enacted in 

1996. The 2002 farm bill makes no pretense of reducing 

government expenditures, and it 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 new 

farm bill continues the trend toward a high level of 

government payments to the agricultural sector. 

The existence and level of government subsidies may 

determine whether many farmers remain profitable. 

Therefore it is critical that farmers and their lenders be 

aware of and understand the provisions and long-term 

implications of the new farm legislation. This article 

discusses the major components of the 2002 farm legislation and their potential economic effects on the 

Region’s producers and agricultural banks. 

modity prices are low (below target prices). These 

payments are counter-cyclical because the payments 

will increase as commodity prices fall. These payments 

also are intended to alleviate the need for ad hoc federal emergency assistance, which became a major source 

of unplanned spending under FAIR. 

Both direct and counter-cyclical payments under the 

2002 legislation will be influenced by incentives that 

were in place under FAIR. These incentives prompted 

many producers to plant crops that received higher subsidy payments, primarily cotton and soybeans. Consequently, total planted acreage increased for crops that 

received the highest subsidy levels. Under the 2002 legislation, producers can reestablish their “base acres” 

based on their past four years of production. Base acres 

are used to calculate direct and counter-cyclical payments. The increased acreages brought about by provisions of FAIR will likely result in higher subsidies 

going forward under the new legislation. 

The 2002 legislation also raises loan rates used to determine floor prices for loan deficiency payments for 

Dallas Regional Outlook 3 Third Quarter 2002 
Regional Perspectives
 

wheat, feed grains, and upland cotton. The difference CHART 1 

between these loan rates and current cash prices would 

result in large subsidy payments. Consequently, if prices 

fall below current levels, subsidies will increase further, 

and these outlays could deplete appropriated funds 

sooner than projected. 

The 2002 legislation strengthens three other programs: 

conservation programs, value-added agricultural grants, 

and Farm Service Agency (FSA) loan programs. Conservation and grant programs fund conservation initiatives (significantly expanded under this legislation) and 

establish agricultural cooperatives that allow producers 

to stabilize farm income. The bill also increases benefits under the FSA loan guarantee programs—for example, waiving eligibility time limits on direct and 

guaranteed farm operating loans; increasing the number 

Relatively High Levels of Government Payments 

Have Contributed to an Increase in Planted Cotton 

Acres as Prices Decline 

Source: U.S. Department of Agriculture/National Agricultural Statistical Service Cotton acres planted (millions) Price per pound 

12.0 

12.5 

13.0 

13.5 

14.0 

14.5 

15.0 

15.5 

16.0 

1997 1998 1999 2000 2001 

0.30 

0.35 

0.40 

0.45 

0.50 

0.55 

0.60 

0.65 

Planted cotton acres (left) (solid) 0.70

Cotton price per pound (right) (dotted) 

of producers who qualify for FSA emergency financ- CHART 2 

ing; and increasing and making permanent interest rate Commodity Prices Have Suffered from assistance for guaranteed loans. In addition, the bill Overproduction and a Strong U.S. Dollar streamlines application documentation procedures. 

110 Corn 

Wheat 100

Commodity Price Index, annualized

monthly cash prices, 1997=100 

Soybeans 

Provisions of the New Farm Bill Are Expected to Cotton

Prompt Producers to Continue High Production 

of Specific Commodities 

Provisions of the 2002 farm bill may contribute to 

excess production of certain commodities and, as a 

result, continue to depress prices. As producers attempt 

90 

80 

70 

60 

50 

40 to maximize benefits under the farm bill, supply and 1997 1998 1999 2000 2001 2002 

April demand forces could become artificially constrained. Source: Haver Analytics/Wall Street Journal Consequently, production costs and commodity price 

levels could become secondary to concerns about sub­ stantially, from $7.3 billion in 1996 to $22.8 billion in sidy benefits. As a result, production of certain crops 2000 (the 2000 figure included $8.4 billion in ad hoc could expand at the same time prices are falling, as was emergency assistance). the case after the enactment of FAIR.
 

As mentioned earlier, after FAIR was enacted in 1996,
 

producers responded to the expected payment levels by 

increasing production of certain crops that garnered the 

greatest subsidies, rather than following market signals. 

Cotton is a good example. As cotton prices fell 31 cents 

per pound (47 percent), cotton acreage increased by 

almost 2 million acres (13.7 percent) following enactment of FAIR (see Chart 1). During 2001, cotton prices 

averaged 35 cents per pound, 37 cents below the breakeven price. Although prices for all four commodities— 

corn, wheat, soybeans, and cotton—have declined since 

FAIR was implemented, cotton prices have declined the 

most (see Chart 2). As a result of increased production 

and declining prices, government payments rose subThe 2002 Farm Bill Will Boost Farm Income 

but May Have Other Consequences as Well 

U.S. Department of Agriculture (USDA) analysts say 

that provisions of the 2002 farm bill will increase farm 

income, but there may be other consequences as well. A 

USDA analysis found that producers would be expected 

to respond not only to market prices, but also to expectations of how the programs may change in the future. 

Direct payments resemble and replace PFC (Production Flexibility Contract) payments which led to 

higher crop production. Since producers have the 

Dallas Regional Outlook 4 Third Quarter 2002 
Regional Perspectives
 

option of updating base payment acres in 2002 from 

1996 levels and the addition of soybeans to this 

payment scheme, farmers may have an incentive to 

continue producing crops and/or to expand production in order to maintain a production history in 

anticipation of future government payments.1 

The expectation of pending legislation can dramatically 

affect producers’ planting decisions. For example, an 

amendment to cap payments, proposed by Senator 

Charles E. Grassley of Iowa, which was adopted by the 

Senate but failed in conference committee, could have 

resulted in lost payments to an estimated 50 percent of 

cotton producers.2 This amendment was debated when 

producers were making 2002 planting decisions. As a 

result of producers’ reaction to this anticipated amendment, the number of acres planted in cotton is projected 

to decline by 12 percent during the 2002 crop year. Even 

though the legislation was enacted without the caps, 

members of the Senate Appropriations Committee are 

continuing to debate payment caps as this article is 

being written. If Congress decided to implement payment caps through the appropriations process, producers 

still could face substantially reduced payments on certain commodities. Moreover, the recent enactment of 

trade promotion authority could contribute to a reduction in government subsidies to U.S. agriculture; the 

Bush administration has indicated its desire to lower 

agricultural subsidies worldwide as part of the World 

Trade Organization negotiations.3 

Some analysts suggest that government farm payments 

may slow the growth of rural communities in certain 

cases, by artificially inflating land prices and diverting 

capital away from businesses.4 A USDA/Economic 

Research Service report attributes $62 billion of U.S. 

farmland values to payments from the FAIR farm commodity programs.5 Alternative uses for these agricultural lands—residential, commercial, or industrial—might 

have promoted local economic diversification and faster 

growth. However, such efforts were constrained, at least 

1 USDA/Economic Research Service (ERS), Farm Bill 2002: Analysis of 

Selected Provisions: Counter-Cyclical Payments, www.ers.usda.gov/ 

Features/farmbill/analysis/countercyclicalpayments2002act.htm. 

2 Agricultural and Food Policy Center, “Farm Level Comparison of 

H.R. 2646 and S. 1731,” Working Paper 02-4, March 2002, p. 5.
 3 Washington Post, “WTO Negotiations May Hold Key to Bush’s
 

Legacy on Free Trade,” July 28, 2002. Section A, page A06.
 

4 USDA/ERS, “How Important Are Farm Payments to the Rural Economy?” Agricultural Outlook, October 2000.
 5 USDA/ERS, “Higher Cropland Value From Farm Program
 

Payments: Who Gains?” Agricultural Outlook, November 2001.
 

in part, by the fact that farmland values were supported 

by relatively high levels of government payments. 

At the same time that government payments are artificially inflating farmland values, insured financial institutions have increased lending secured by farm real 

estate. Insured institutions nationwide reported a 90 percent increase in farmland loans for the ten-year period 

ending March 31, 2002, in contrast to 68 percent growth 

for all real estate loans. If the level of government payments declines at some point, and if commodity prices 

remain weak, rural land values likely would be subject 

to downward price pressure. The result would be an 

adverse effect on lenders’ collateral and producers’ 

equity and borrowing capacity. 

Provisions of the 2002 farm bill also could complicate 

future international trade negotiations. Because the legislation represents a shift away from a free marketoriented farm policy, many global trading partners are 

criticizing the United States for what could be characterized as a protectionist strategy. The farm bill follows 

closely on the heels of tariffs imposed 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. 

Of particular interest to the Dallas Region are discussions about the creation of a Free Trade Area of the 

Americas. The proposed Free Trade Area would function much the way the NAFTA agreement does, but it 

would expand the trading partners to North, South, and 

Central America. In 2001, a little more than 50 percent 

($39.7 billion) of Dallas Region exports were destined 

for nations in the proposed Free Trade Area of the Americas, compared with 41.7 percent ($272.1 billion) for the 

rest of the nation. Together with recently imposed tariffs 

on lumber and steel imports, current U.S. farm policy 

could complicate the completion of the Free Trade Area 

of the Americas agreement. 

The Dallas Region’s Dependence on 

Government Payments Has Grown but Still 

Remains below the National Average 

As a share of net farm income, the Dallas Region’s 

dependence on government payments grew from almost 

30 percent in 1996 to 43.2 percent in 2000. This increase 

is attributable primarily to the heavily subsidized cotton 

Dallas Regional Outlook 5 Third Quarter 2002 
Regional Perspectives
 

industry, which plays a substantial role in Dallas Region 

agriculture. Although significant, the share of Dallas 

Region farm income attributed to government payments 

remains below that of the nation because of the predominance in the Region of livestock production, which 

does not receive government payments. Specifically, 

69 percent of the Region’s agricultural cash receipts 

are derived from livestock products, compared with 51 

percent for the nation. 

The livestock sector is not without its problems. Severe 

drought has led to poor grazing conditions this year. 

Consequently, many producers are liquidating herds, 

placing downward pressure on livestock prices. Cattle 

(feeder) prices declined about 18 percent from April 

2001 to June 2002. Higher cattle prices have shielded 

the Region from losses caused by low bulk commodity 

prices during the past four years, and any further decline 

in livestock prices could have a particularly adverse 

effect on the Region’s agricultural economy. 

The Region’s Agricultural Banks Continue 

to Perform Well despite Troubled Agricultural 

Sector Fundamentals 

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. The average return on assets (ROA) was 1.31 

percent for Dallas Region agricultural banks in first 

quarter 2002, compared with 1.23 percent for all other 

agricultural banks nationwide and 0.90 percent for 

nonagricultural banks that hold less than $100 million 

TABLE 1 

in assets (small banks).6 During the past five years 

(coinciding with enactment of FAIR), at a time when 

commodity prices have been at historically low levels, 

the ROA for the Region’s agricultural banks has 

remained relatively stable, averaging a strong 1.28 percent, compared with 1.18 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 these institutions hold 

a greater percentage of noninterest deposits than agricultural banks outside the Region. Additionally, the 

Region has the highest percentage of agricultural banks 

electing Subchapter S tax status (47 percent), boosting 

the aggregate ROA relative to other parts of the nation. 

The influence of the Subchapter S status does not 

entirely explain the performance of the Region’s agricultural banks. Pretax ROA shows that the Region’s 

agricultural banks have outperformed agricultural 

banks outside the Region and small nonagricultural 

banks nationwide during the past four years. While the 

Region’s agricultural banks reported higher past-due 

and charge-off rates during the past five years, they also 

reported a higher loan loss reserve to total loan ratio 

than their peers (see Table 1). 

A review of examination ratings shows that as of 

December 31, 2001, 6.3 percent of the Region’s agricultural banks were classified as “weak” (composite 

examination rating of 3, 4, or 5), the lowest level since 

1995. While this percentage is slightly higher than 

that for all U.S. agricultural banks, it is lower than the 

Statistics of Agricultural Banks Compare Favorably to Other Small Banks 

FIVE-YEAR AVERAGE 

U.S. DALLAS REGION OTHER SMALL 

AGRICULTURAL AGRICULTURAL NONAGRICULTURAL 

BANKS (%) BANKS (%) BANKS (%) 

RETURN ON ASSETS 1.18 1.28 0.94 

LEVERAGE RATIO 10.26 10.36 11.01 

PAST-DUE RATIO 2.38 2.97 2.67 

CHARGE-OFF RATIO 0.25 0.40 0.32 

LOAN LOSS RESERVE TO TOTAL LOANS 1.52 1.56 1.25 

Source: Bank and Thrift Call Reports, annual results 1997–2001 

6 Small banks are useful for comparison purposes because agricultural banks tend to be relatively small institutions, with 84 percent holding less 

than $100 million in assets. 

Dallas Regional Outlook 6 Third Quarter 2002 
Regional Perspectives
 

10.0 percent reported for all nonagricultural small 

banks nationwide. 

Loan Exposure Has Risen among the Region’s 

Agricultural Banks 

Nationwide, the average agricultural bank loan-to-asset 

ratio increased from 48 percent at year-end 1991 to 61 

percent ten years later. Concurrently, agricultural loans 

as a percentage of total loans fell nationally from 46 

percent to 43 percent. Dallas Region agricultural banks 

also reported increasing loan-to-asset ratios and a 

declining share of agricultural loans during this period. 

This situation can be attributed, in part, to the fact that 

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 ten years ago. 

As large banks take on more agricultural loan volume, 

Dallas Region agricultural banks are diversifying into 

other loan types, primarily real estate. Real estate loans 

represented 40 percent of total loans as of year-end 

2001, up from 29 percent ten years earlier. Singlefamily residential mortgages represent the largest single 

real estate category; however, loans secured by farmland sustained the largest increase among the Region’s 

agricultural banks during this period.7 If government 

farm payments have inflated land prices, collateral 

7 Dallas Region farmland loans increased (as a percentage of total 

loans) by 4.5 percentage points during this ten-year period, while agriculture production loans decreased by 10.4 percentage points, causing 

the overall agriculture exposure to decrease to 41 percent of total 

loans, down from 47 percent ten years earlier. 

For more information on specific provisions 

of the 2002 farm bill, refer to these resources. 

Farm Bill Frequently Asked Questions 

www.fsa.usda.gov/pas/farmbill/fbfaqhome.asp 

USDA 2002 Farm Bill Glossary of Terms: 

www.ers.usda.gov/features/farmbill/ 

2002glossary.htm 

USDA 2002 Farm Bill Page 

www.usda.gov/farmbill/index.html 

The Agricultural and Food Policy Center: 

Base and Yield Update Option Analyzer 

www.afpc.tamu.edu/models/bya/ 

margins may be squeezed if subsidy levels decline—as 

would happen, for example, if payment caps were 

implemented. 

Summary 

The enactment of the 2002 farm bill alleviated producers’ uncertainty about the future of government payment programs. If producers plant more acreage in 

crops that are expected to receive the highest level of 

subsidies, the cost of the farm bill could exceed expectations, as was the case with FAIR. Moreover, agricultural producers and their communities could become 

increasingly dependent on farm payments, potentially 

causing problems for agricultural lenders if payment 

levels should decline in the future at the same time 

commodity prices are low. 

Dallas Region Staff 

Dallas Regional Outlook 7 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. 

Dallas Regional Outlook 8 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. 

Dallas Regional Outlook 9 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. 

Dallas Regional Outlook 10 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. 

Dallas Regional Outlook 11 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.
 

Dallas Regional Outlook 12 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 

Dallas Regional Outlook 13 Third Quarter 2002 


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