Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION SECOND QUARTER 1998 

FDIC
 

Dallas
 

Region
 

Division of
 

Insurance
 

Alan C. Bush,
 

Regional Manager
 

Adrian R. Sanchez,
 

Regional Economist
 

Jeffrey A. Ayres,
 

Financial Analyst
 

In Focus This Quarter 

◆ Gain-on-Sale Accounting Can Result in Unstable Capital Ratios and Volatile Earnings—The accounting for transferring and servicing financial assets causes asset sellers, particularly high-growth lenders, to recognize significant noncash income related to retained economic interests in the sold 

assets. This is true whether a company securitizes its own assets or sells its assets as 

a conduit to another securitizer. Values are often driven by management assumptions about future performance of the sold assets. Major writedowns of gain-on-sale 

assets by some finance and mortgage companies underscore the importance of careful scrutiny of these assumptions by banks and their supervisors. See page 3. 

By Allen Puwalski 

◆ How Will the Expansion End?—Analysts are now focusing on when 

and how the current expansion will end. Although no one can accurately predict 

when a recession will begin, two possible scenarios have emerged. Each scenario has 

important implications for lenders as they prepare for the possibility of slower economic growth or recession. See page 7. 

By Paul C. Bishop 

◆ Trends Affecting the Allowance for Loan and Lease Losses— 

In today’s environment, in which loan availability is abundant, growth is strong, and 

competition is fierce, some industry leaders and regulators have expressed concern 

about the loosening of underwriting standards and greater risk in bank loan portfolios. At the same time, the allowance for loan and lease losses (ALLL) relative to 

total loans at many insured institutions is declining. As the economic expansion 

reaches an advanced age, an important question for insured institutions is whether 

their ALLLs adequately reflect the risks associated with changing industry practices. See page 11. 

By Andrea Bazemore 

Regular Features 

◆ Regional Economy—The Asian economic crisis could result in slower 

export growth in 1998, particularly for the Region’s producers of livestock and feed 

grains...the glut of worldwide oil supplies may keep crude oil prices below $20 a 

barrel this year...economic growth in the Region is expected to slow somewhat from 

its 1997 pace. See page 16. 

By Adrian Rangel Sanchez 

◆ Regional Banking—Insured institutions in the Dallas Region continue to 

report strong performance...trends in agriculture are presenting challenges to producers and their lenders...tumbling oil prices rekindle concerns about energyrelated lending, especially for areas that have concentrations of marginal wells. 

See page 22. 

By Alan C. Bush, Jeffrey A. Ayres 

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

Insurance Corporation for the following eight geographic regions: 

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

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

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

Dallas Region (CO, NM, OK, TX)
 

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

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

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

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

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

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

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

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

Director, Division of Insurance Arthur J. Murton 

Editor George E. French 

Assistant Editors Gary L. Beasley 

Jack M.W. Phelps 

Publications Manager Teresa J. Franks 
In Focus This Quarter
 

Gain-on-Sale Accounting Can Result in Unstable
 

Capital Ratios and Volatile Earnings 


•	 Gains generated from asset sales under SFAS 125 

rely on management assumptions about the lifetime performance of the assets sold and may not 

materialize in cash if the assumptions prove 

incorrect. 

•	 Gain-on-sale accounting has been most significant to securitizers, but nonsecuritizers can and 

do retain economic interests that give rise to significant gain-on-sale assets. 

•	 Finance companies seeking to shift attention from 

gain-on-sale assumptions may find willing bank 

correspondents. 

•	 The rating services have modified capital and 

earnings analysis in order to lessen what they consider distortions caused by SFAS 125. 

Statement of Financial Accounting Standards No. 125 

(SFAS 125),Accounting for Transfers and Servicing of 

Financial Assets and Extinguishing of Liabilities, 

causes asset sellers, particularly high-growth lenders, to 

recognize significant noncash income. Applying SFAS 

125, which became effective on January 1, 1997, can 

give rise to significant noncash gains and related assets 

if an economic interest is retained in assets sold. The 

value of retained interests in assets sold is quantified on 

the basis of management’s assumptions about future 

charge-off rates, repayment rates, and the rate used to 

discount the expected cash flows from the loans sold. 

Because the value of these assets changes when actual 

performance deviates from the assumptions, the quality 

of earnings, capital, and liquidity for a lender that relies 

significantly on gains on sale must be considered carefully. 

The recent writedowns of interest-only (IO) assets by a 

few major finance companies have led to a higher level 

of scrutiny of companies whose financial statements are 

influenced significantly by gain-on-sale accounting. 

The Securities and Exchange Commission has recently 

increased its scrutiny of publicly traded companies that 

use gain-on-sale accounting, and it may soon require 

assumptions regarding defaults, prepayments, and discount rates to be disclosed in financial statements. The 

same companies that enjoyed soaring stock performance thanks to high earnings growth caused by gainon-sale accounting have seen their stock values tumble 

as they have had to write down their gain-on-salerelated assets. 

Several major credit rating companies have recognized 

the significant effect of gain-on-sale accounting under 

SFAS 125 on interpreting financial statements. These 

companies have issued comments or reports dealing 

with SFAS 125’s effect on the quality of earnings and 

capital of the companies they rate and how they adjust 

their analysis as a result. The consensus of these papers 

is that gain-on-sale accounting for companies that securitize often results in significantly higher reported earnings and equity compared to balance sheet 

lenders—without, in many cases, materially changing 

the underlying economics or credit risk to the originator 

of the assets.1 Generally, the rating services have modified capital and earnings analysis in order to lessen 

what they consider distortions caused by SFAS 125. 

There Are Risks Associated with Gain-on-Sale 

Accounting 

The asset booked in connection with an SFAS 125 loan 

sale is an IO strip that represents the present value of 

future excess spread cash flows generated by the transferred assets. Generally, asset-backed securitizations, 

including some classified as mortgage-backed securities, are structured so that each month the expected cash 

flows from the underlying assets will be sufficient to 

pay the investor coupon, the trust expenses, the servicing fee, and net charge-offs. The cash flow that the 

underlying assets will generate each month cannot be 

known with certainty because the underlying asset may 

allow for variable principal payments (e.g., credit card 

accounts), or the borrowers may default. Securitizations 

are structured so that there is enough cushion between 

the expected cash flows and the required payments and 

1 Duff & Phelps Credit Rating Company, “Securitization and Corporate Credit Risk.” Special Report Financial Services Industry, July 

1997; T. E. Foley and M. R. Foley. “Alternative Financial Ratios for 

the Effects of Securitization Tools for Analysis.” Moody’s Special 

Comment, September 1997; H. L. Moehlman, R. W. Merrit, and N. E. 

Stroker. “Capital Implications of Securitization and Effect of SFAS 

125.” Fitch Research, September 16, 1997. 

Dallas Regional Outlook 3	 Second Quarter 1998 
In Focus This Quarter
 

expected charge-offs to absorb fluctuations in actual 

cash flows and actual charge-offs. This cushion is 

excess spread. As actual cash flows vary from projections, so does the excess spread generated. 

According to SFAS 125, when a company sells assets 

and retains the right to future excess spread cash flows, 

the calculation of the gain on the sale includes the capitalization of this right. In many transactions, the gain 

on sale consists entirely of the fair value of the IO strip 

that represents this right—none of which is necessarily 

received in cash. In addition, with many transactions, 

cash receipt is further delayed while cash flows go to 

fund the spread account, which is analogous to an internal loan loss reserve. 

SFAS 125 states that quoted market prices in active 

markets are the best evidence of fair value and should 

be used whenever available. Although there have been 

some sales of these IO strips, the number of sales is not 

yet sufficient to constitute an active market. When market prices are not available, SFAS 125 states that the 

estimate of fair value should be based on the best information available. In practice, fair value of the excess 

spread is determined by present valuing the expected 

cash flows using a discounted cash flow model. 

The value of the right to future cash flows is determined 

on the basis of management’s assumptions about the 

charge-off rate, the average life of loans, and the rate 

used to discount the cash flows. These input assumptions drive the model results and, therefore, the magnitude of the gain. The stability of the value of the IO will 

depend greatly on the extent to which the input assumptions accurately describe the pool performance over the 

life of the transferred assets. Changes in economic or 

market conditions that were not anticipated in the initial 

cash-flow assumptions will likely cause the pool of 

loans to perform differently than initially projected. 

Gain-on-sale accounting is significant to securitizers. 

To illustrate the significance of the IO account to a 

securitizer’s reported income, consider one major subprime lender. During fiscal year 1997, this company’s 

IO asset grew by over $141 million. Despite a $28 million writedown of the IO asset, the net growth of the 

asset constituted over half of total revenue and over 

eight times net income. The revaluation of the IO was 

necessitated by higher-than-expected prepayment rates. 

Current market conditions were not anticipated by 

many companies that benefited from high earnings 

related to gain-on-sale accounting. Several other major 

securitizers have reduced the carrying value of their IO 

assets in the face of either rising charge-off rates or 

higher prepayment rates. Writing down an IO strip 

largely represents a company’s admission that it will not 

generate on a cash basis income that was booked previously. 

Chart 1 displays the cumulative charge-off rates by vintage for Moody’s index of home equity loan securitizations. The index consists mostly of prime mortgages, so 

the loss rates are still low. However, the rising trend in 

losses is noteworthy and reflects the growing influence 

of subprime securitizations on the index and the related 

decline in underwriting standards as competition has 

increased in this market. Loans originated in 1995 and 

1996 are causing progressively larger and earlier losses. 

After 21 months of seasoning, the cumulative loss rate 

on loans originated in 1996 is .17 percent—almost six 

times the loss rate experienced by the 1994-originated 

cohort at the same age. Despite the continued low loss 

rates for the home equity market in general, subprime 

lenders are experiencing accelerated loss rates that are 

eroding the value of their interests in excess spreads. 

There may be a tendency for management to base 

assumptions about expected loss rates on loans sold 

solely on past experience with similar loans. Such an 

approach may not capture changes in market conditions 

and trends. For example, the Moody’s data demonstrate 

that loss rates on home equity loans, including first 

liens, have been trending upward rapidly. This trend 

implies that when estimating loss rates, management 

should consider the potential for changes in market conCHART 1 

Vintage Analysis of Home Equity Loan 

Securitizations 

Source: Moody’s Investor Services 

0.00 

0.05 

0.10 

0.15 

0.20 

1 3 5 7 9 11 13 15 17 19 21 

Cumulative 

Loss (%) 

1994 

1995 

1996 

Months 

Dallas Regional Outlook 4 Second Quarter 1998 
In Focus This Quarter
 

ditions over the life of the sold assets as well as the past 

performance of similar assets. 

Like loss rates, prepayment rates have risen substantially in the subprime mortgage market. Several factors 

have contributed to the rise. One factor is the trend 

toward higher loan-to-value (LTV) loans in the mortgage market, which has allowed borrowers to obtain 

additional cash from their homes without waiting to pay 

down principal. Mortgage bankers report the tendency 

of some subprime borrowers, often debt consolidators, 

to maintain outstanding balances at the highest possible 

LTV. With maximum LTV ceilings rising, debt consolidators can refinance home equity loans without having 

to amortize existing debt. 

Another important factor contributing to rising prepayment rates is competition among lenders for volume 

growth. To continue to grow volume, lenders have been 

sacrificing margins on loans to offer a better rate to borrowers. When estimating prepayment rates for subprime 

borrowers, it has been normal to expect that they would 

need to improve their credit rating, or “credit cure,” 

before they would find it economical to refinance. Stiff 

competition for volume has allowed borrowers to find 

better rates without credit curing and has stimulated 

them to refinance prior to the time estimated at origination. Falling interest rates and a relatively flat yield 

curve are likely to increase prepayment rates. 

In standard finance theory, uncertainty about the future 

level of losses and prepayment rates is compensated for 

by discounting the cash flows at a higher rate. Some 

analysts advocate using a discount rate similar to the 

required rate of return for equity investments. Faced 

with changing conditions, one large finance company 

that specializes in high LTV lending announced in 

December 1997 that it was increasing the discount rate 

it uses to value new IO strips from 12.5 percent to 33 

percent. 

The IO Strip Asset Is Growing at Insured 

Depository Institutions 

As of December 31, 1997, only 30 institutions reported 

this IO asset at more than 5 percent of tier 1 capital. 

However, some institutions have booked gains that 

should have given rise to a call-reportable IO strip but 

did not properly report the assets. Therefore, the current 

reporting may understate the prevalence of the asset. 

Furthermore, the recent attention to gain-on-sale 

accounting from the public equity markets has at least a 

few large finance and mortgage companies seeking 

business strategies that shed IO strip-related volatility 

from their financial statements. One such strategy 

already in use is to leave the economic interest in excess 

spread with the correspondents that originate the loans. 

This is done as follows: The correspondent originates 

loans for purchase by a finance company. The finance 

company pays par for the loans, and instead of being 

paid an origination fee or a premium for the loans, the 

seller retains the right to excess spread generated over 

the life of the loan. The seller books a gain and an IO 

asset that capitalizes this right to receive future cash 

flows. The nature of the IO asset is exactly the same 

whether it arises directly from a securitization or from a 

sale of loans to a securitizer. If this strategy is used 

widely by finance and mortgage companies, then IO 

strips are likely to grow among institutions that originate loans for sale to these companies (see Chart 2). 

For insured depository institutions, the capital effects of 

SFAS 125 need to be evaluated carefully. Analysis of the 

financial statements and leverage ratios of insured institutions should consider fully issues related to the quality of earnings and the stability of capital posed by the 

volatility of the IO strip. Insured institutions that engage 

in significant asset sales while retaining economic interests that give rise to SFAS 125–related assets are subject 

to distortions similar to those of nonbank financial 

companies. 

The activity of originating and selling loans and booking associated gains can lead to capital ratios that 

CHART 2 

IO Strip Is Growing at Insured Institutions 

Source: Bank & Thrift Call Reports 

0.00 

0.50 

1.00 

1.50 

2.00 

2.50 

3.00 

1Q97 2Q97 3Q97 4Q97 

$Billion 

120 

130 

140 

150 

160 

Number of Institutions 

Number of Institutions 

IO Strip 

Dallas Regional Outlook 5 Second Quarter 1998 
In Focus This Quarter
 

appear high by traditional bank standards. For several 

reasons, the leverage ratio can appear particularly high. 

First, although the asset may be more volatile than 

mortgage serving rights, there is no limit to the amount 

of IO strip that a bank can include in tier 1 capital. Second, the amount of IO strip booked increases capital by 

a gain on the net of the tax effect. The extent to which 

the amount remains in capital depends, of course, on the 

institution’s dividend policy. Third, the denominator of 

the leverage ratio is reduced by the sale because the 

loans are no longer assets of the bank. The cumulative 

result can be a significant boost to the leverage ratio. 

Several insured institutions report an IO strip at greater 

than 25 percent of tier 1 capital. For an institution whose 

primary line of business is originating and selling subprime mortgages, the asset can quickly reach a level 

exceeding tier 1 capital. In a little more than a year of 

originating and selling subprime mortgages to a major 

securitizer, one institution has amassed IO assets that it 

has valued at more than 150 percent of tier 1 capital. 

The institutions that have concentrations of 25 percent 

or more of tier 1 capital in IO assets have a median 

leverage ratio of about 11 percent. In contrast, the median equity capital ratio for nonbank mortgage securitizers tracked by SNL DataSource is about 30 percent. 

Public debt markets or banks that lend to these finance 

companies appear to require significantly higher capital 

levels than regulatory minimums required for banks. 

The potential for growth of the IO 

strip asset at insured institutions 

seems strong. In some circumstances, minimum capital standards for banks may require 

significantly less capital for IO 

asset exposure than the public 

equity markets. Perhaps more 

important, the quick rise of the significance of gain-onsale accounting to the mortgage and consumer credit 

markets exemplifies the speed with which exposure to 

risk can be acquired through the securitization market. 

Strong demand for asset-backed securities coupled with 

changing accounting emphases, which in this case favor 

asset sellers, can lead quickly to substantial exposures. 

Allen Puwalski, Senior Financial Analyst 

Risk-Based Capital (RBC) Treatment of the Gain-on-Sale–Related IO Asset 

If the IO asset derives from excess spread that absorbs tions does not necessarily preclude subprime mortcharge-offs from the sold assets, then the IO strip con- gages in general from receiving the reduced risk 

stitutes recourse from the sold assets for RBC pur- weighting. Although the capital standards require that 

poses. RBC standards require capital to be held mortgages be prudently underwritten to qualify for 

against this exposure. In general, the capital require- the 50 percent risk weighting, it is not entirely clear 

ment for this exposure is the amount of capital that how the term “prudently underwritten” applies to subwould have been required for the assets had they not prime mortgages. A higher expected loss rate alone 

been sold. If the sold assets are one- to four-family may be insufficient cause for presuming that the 

residential mortgages, they may receive a 50 percent mortgages are not prudently underwritten. 

risk weighting. Subprime mortgages are not necessarily precluded from receiving this weighting. The rationale for reducing the capital requirement for 

traditional one- to four-family mortgage lending is 

In order to apply the 50 percent risk weighting, the related to the maturity of the market and consistently 

capital standards require that one- to four-family res- low loss rates. As noted above, the subprime mortgage 

idential mortgages be fully secured and prudently market is changing rapidly, and loss rates can be much 

underwritten. The “fully secured” requirement pre- higher than in traditional mortgage lending. Accordcludes high-LTV loans with LTV ratios of greater ingly, bank managements need to be aware of the 

than 100 percent from receiving reduced capital potential volatility and risks associated with gain-onrequirements, but the language of the RBC regula- sale assets associated with subprime mortgages. 

Dallas Regional Outlook 6 Second Quarter 1998 
In Focus This Quarter
 

How Will the Expansion End?
 

•	 Despite a very low unemployment rate and high 

industry capacity utilization, inflation has been 

unusually subdued during this expansion, with 

price declines in some sectors. 

•	 After seven years of expansion, most analysts 

expect the economy’s growth to slow in the coming 

months. 

•	 The last seven expansions have ended with an 

inflation-driven increase in short-term interest 

rates; in contrast, some analysts believe that the 

next recession will be caused by a period of falling 

prices for commodities, finished goods, and perhaps wages. 

•	 Insured institutions that base lending and strategic decisions on assumptions of continued robust 

economic growth should scrutinize and test those 

decisions against possible adverse change in economic conditions. 

The current economic expansion is the third longest on 

record since World War II. Since mid-1991, when the 

expansion began, more than 15 million new jobs have 

been created and inflation-adjusted gross domestic 

product (GDP) has increased by nearly 20 percent. In 

fact, the unemployment rate reached a 24-year low 

when it fell to 4.6 percent in November 1997 and again 

in February 1998. At the same time, inflation has 

remained unusually low, at only 2.3 percent during 

1997. 

Analysts are now focusing on when and under what circumstances the current expansion will end. While no 

one can accurately predict when the expansion will end, 

two related but competing theories about how it will end 

have emerged in recent months. The first and more 

familiar scenario occurs when the Federal Reserve 

increases short-term interest rates to prevent a rapid 

increase in inflation caused by an overheating economy. 

The second scenario, a deflation-induced contraction, is 

less familiar in the context of recent recessions. This 

scenario posits a period of falling prices for commodities, finished goods, and, under the most severe circumstances, even wages. 

Whatever the cause of the next downturn, its effects are 

likely to be important for the performance of lenders. 

During the 1990–91 recession, for example, the widespread deterioration of economic conditions was 

reflected in a number of indicators: Inflation-adjusted 

GDP fell by 2 percent; the number of business failures 

rose by nearly 40 percent; unemployment increased by 

more than 40 percent to 9.8 million; the unemployment 

rate peaked at more than 7 percent; single-family housing starts fell by almost 22 percent; and the bank card 

delinquency rate increased from 2.4 percent to 3.3 percent. This experience suggests that no matter what triggers the next downturn, dramatic adverse changes in the 

drivers of bank performance will likely result. 

How Have Economic Expansions 

Usually Ended? 

Although to some extent each business cycle is unique, 

virtually all of the post–World War II expansions have 

shown a similar characteristic: Toward the end of the 

expansion, inflation has accelerated. As the economy 

expands, the prices of inputs, including the wages of 

workers, are bid up as firms compete for resources to 

meet demand. The overall inflation rate will rise if 

prices increase across a large number of industries. Left 

unchecked, an increase in the overall price level may 

itself feed back into the labor market through demands 

for higher wages. 

By raising short-term interest rates, the Federal Reserve 

can limit what might otherwise lead to a rapid increase 

in both wages and prices. Higher interest rates will 

reduce sales of capital goods, housing, and consumer 

durables, the demand for which is very sensitive to the 

level of interest rates. One reflection of this sensitivity 

is the changing pattern of loan growth over the business 

cycle. During periods of expansion, the demand for 

loans grows rapidly as businesses and households borrow to finance purchases of capital goods and consumer 

durables. If short-term interest rates are increased in 

response to inflationary pressures, loan growth will 

slow as businesses and consumers reduce their demand 

for loans. If interest rates continue to increase, loan 

growth may decline as it has done before and during 

each recession. The cyclical movement of loan growth 

(with vertical bars indicating periods of recession) is 

shown in Chart 1 (next page). 

Looking more closely at short-term interest rates, Chart 

2 (next page) illustrates the federal funds rate during the 

Dallas Regional Outlook 7	 Second Quarter 1998 
In Focus This Quarter
 

CHART 1	 expansion began. During the expansion between 1975 

and 1980, for example, the inflation rate was nearly 12 Commercial Bank Loan Growth percent at the start of the expansion but fell to just over during the Business Cycle 6 percent after four quarters. Inflation remained at 

approximately 6 percent until the twelfth quarter of the 

–5 

0 

5 

10 

15 

20 

25 

1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 

Percent Change—Year Ago 

expansion, after which it accelerated to more than 12 

percent by the end of the 20-quarter expansion. 

The current inflation trend differs from previous expansions in two ways. First, by the later stages of previous 

expansions, inflation was accelerating (see Chart 3). In 

contrast, there are few signs of accelerating consumer 

price inflation during the current expansion. In fact, it 

appears that the rate of inflation is declining; the United 

States has experienced disinflation.1 Second, among 

Source: Federal Reserve 

last seven business cycles. While an increase in shortterm interest rates has preceded each recession, it 

should be noted that an increase in rates is not sufficient 

to induce a recession. An increase in rates in 1984 was 

followed by a period of rapid growth that lasted until 

1990. More recently, the increase in rates during 1994 

was accompanied by a slowdown in the economy, but 

not a recession. 

What Is Different about Inflation 

during This Expansion? 

With history as a guide, one would expect inflation to 

rise as the current expansion matures. Chart 3 illustrates 

consumer price inflation during the four longest postwar expansions, including the current one. The chart 

shows the inflation rate at various points after the 

CHART 2 

expansions that have lasted more than 20 quarters, the 

current rate of inflation is one of the lowest since World 

War II. Consumer inflation is both decreasing and low 

by historical standards. 

What Are the Two Views about 

Future Inflation? 

Two views have developed about how the current 

expansion will end. The debate, couched in terms of the 

expected rate of future inflation, is of more than academic concern. The Federal Reserve’s decision about 

1 In popular discussions of inflation rates and the price level, terminology is sometimes used loosely. To clarify, a declining rate of inflation, properly described as disinflation, means that prices are 

increasing at a progressively slower rate over time. Deflation is 

defined as a generally falling price level or, equivalently, a negative 

inflation rate. 

CHART 3 

Federal Funds Rate and Recent 

Recessions 

0 

5 

10 

15 

20 

1955 1959 1963 1967 1971 1975 1979 1983 1987 1991 1995 

Federal Funds Rate (percent) 

Source: Federal Reserve 

Consumer Price Inflation during Four Longest 

Postwar Expansions 

0 

2 

4 

6 

8 

10 

12 

14 

0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 32 34 

Quarters after Start of Expansion 

Percent 

1975–1980 

1982–1990 

1961–1969 

1991–present 

Note: Prices exclude food and energy 

Source: Bureau of Labor Statistics 

Dallas Regional Outlook 8	 Second Quarter 1998 
In Focus This Quarter
 

whether to change short-term interest rates may be 

influenced by arguments on either side of the debate. 

The Traditional View 

Although inflation has been tame during this expansion, 

adherents of the traditional view believe that impending 

inflation still poses a danger to the longevity of the 

expansion. Evidence cited to support this view includes 

a very low unemployment rate and rising inflationadjusted wages. The reasons for the low inflation rate 

include low energy prices, inexpensive imports, and 

brisk domestic and international competition. These 

factors have delayed the onset of inflationary pressures, 

but they will not remain favorable indefinitely. The 

underlying dynamics have not changed significantly 

from those that led to rising inflation during every other 

recent economic expansion. This is also the view of the 

Federal Reserve Open Market Committee, as stated in 

the minutes of its November 12, 1997, meeting: 

The reasons for the relative quiescence of inflation 

were not fully understood, but they undoubtedly 

included a number of special factors...the risks 

remained in the direction of rising price inflation 

though the extent and timing of that outcome were 

subject to considerable debate. 

—Federal Reserve Bulletin, February 1998, p. 104 

The Deflation View 

Alternatively, some analysts suggest that a recession 

may be brought about by a period of deflation. Advocates of this scenario base their view on the unusually 

low and falling inflation rate in the United States, even 

after seven years of economic expansion. They also suggest that the national economy of the 1990s is markedly different from that of the 1970s and 1980s. Intense 

global competition is now the norm and not the exception. Worker productivity growth is believed to be higher than the official data show, meaning that wage 

growth will not translate as readily as before into price 

increases. The U.S. economy is more prone to a period 

of falling prices than at any time in the recent past, especially in view of decreasing rates of inflation and deflationary forces originating from the ongoing Asian 

financial crisis. 

What Does the Evidence Show? 

Because determining economic policy is necessarily a 

forward-looking process, policymakers look at many 

indicators to determine the likely future course of inflation. A brief review of some of the more popular indicators reveals contradictory readings that can support 

either the inflation or deflation scenario. 

Wage Growth 

The national unemployment rate is currently very low, 

signaling that labor markets are near capacity in terms 

of their ability to create new jobs. The nation’s unemployment rate was below 5 percent for nine months during 1997. This rate has been well below what many 

analysts thought possible without a sharp rise in inflation. As labor market conditions have tightened, wage 

growth has increased. Since 1993 the rate of growth has 

been on a steady upward trend, from a low of just over 

2 percent to about 4 percent in the first quarter of 1998. 

Capacity Utilization 

Capacity utilization, the percentage of industrial capacity that is currently in use, has risen since early 1997. 

Utilization has been around 83 percent since mid-1997, 

a threshold rate that has traditionally signaled impending inflationary pressures at factories, mines, and utilities. 

Commodity Prices 

Many commodities, such as metals, crude oil, and 

unprocessed food products, have exhibited weak prices 

during the past several months. Between mid-1996 and 

early 1998, the Knight-Ridder Commodity Research 

Board Price Index fell by more than 15 percent. Key to 

the decline was a 35 percent decrease in crude oil 

prices. 

Finished Goods Prices 

Since the data show that both labor and physical capital 

are at high rates of utilization, the traditional inflation 

scenario suggests that there will be increasing price 

pressures. In the manufacturing sector, such price pressures would likely show up first in the prices of goods 

as they leave the factory. The price of finished goods 

rose by only 0.4 percent during 1997, however. On a 

monthly basis, prices declined during eight months in 

1997. 

Service Sector Prices 

The service sector accounts for a growing portion of all 

output and employment in the U.S. economy. Labor 

costs generally account for a much higher percentage of 

input costs in the service sector than in the manufacturDallas Regional Outlook 9 Second Quarter 1998 
In Focus This Quarter
 

ing industries. Additionally, many service industries 

operate in local markets and are insulated from national or global competition. Consequently, inflation rates 

in the service sector are generally higher than in the 

goods sector. Service sector inflation has, however, 

been on a downward trend, falling from 5.5 percent in 

1990 to 3.1 percent in 1997. 

Import Prices 

Since early 1996, import prices have fallen precipitously. The decline is due in part to the rising value of the 

dollar, which has reduced the cost of imports. Nonpetroleum import prices have fallen by 5 percent since 

early 1996. Within that group, capital goods prices have 

decreased by 12 percent over the same period. 

One factor that will continue to put downward pressure 

on prices is the turmoil in Asian markets. Asian 

exporters are now much more competitive with the rest 

of the world, following the drop in the value of their currencies. Consequently, U.S. firms that compete with 

Asian producers will be under greater pressure to cut 

prices. At the same time, reduced Asian demand for 

U.S. exports could lead to a ballooning trade deficit and 

a softening of export prices. In January 1998, for example, the United States reported a record-breaking trade 

deficit of $12 billion, caused in part by slower export 

growth. 

From this brief review, it is apparent that signs of 

impending inflation are at best mixed. Clearly, U.S. 

labor markets are at or near full effective capacity, and 

the utilization of factories and physical capital is also 

very high. There is little evidence that these factors are 

causing an increase in prices at either the producer or 

consumer levels. 

How Will the Expansion End? 

Although no one can accurately determine when the 

expansion will end, most analysts are predicting slower 

economic growth in the second half of 1998. Indicators 

such as the unemployment rate suggest that growth will 

be limited by the availability of labor needed to produce 

an increasing supply of goods and services. Weak or 

declining output prices in some sectors could act as a 

further constraint on economic growth. 

Among economists, the traditional view that the expansion will end following a rise in inflation and an 

increase in short-term interest rates appears to be the 

more prevalent view. Nevertheless, the possibility that 

the next economic downturn might be triggered by the 

ripple effects of declining output prices should not be 

dismissed, especially in light of the potentially adverse 

and less familiar risks associated with deflation. What is 

clear for insured institutions is that at this stage of the 

economic expansion, lending and strategic decisions 

predicated on an assumption of continued robust economic growth should be carefully scrutinized and considered in light of a possible deterioration of economic 

conditions. 

Paul C. Bishop, Economist 

Why Might Deflation 


Be a Concern?
 

The most significant difference between the inflation and deflation scenarios is reflected in the 

response of financial markets. One of the consequences of inflation is that a dollar in the future is 

of less value than today’s dollar. In a deflationary 

environment, the opposite is true—a dollar in the 

future will buy more goods and services than a dollar today. 

In a deflation scenario, debtors would see the real 

value of their financial obligations rise and might 

therefore be hesitant to borrow. A fixed monthly 

mortgage payment, for example, would be paid 

back with increasingly valuable dollars over time. 

Asset values could fall, especially since the purchase of an asset, such as a house, would require 

inflation-adjusted debt repayments that increase 

through time. Likewise, consumer credit debt obligations, such as payments on outstanding credit 

card balances, would become increasingly onerous. 

For households already experiencing credit problems, the prospect of a period of sustained deflation 

would worsen their financial position. At the very 

least, deterioration in credit quality would be 

expected, along with an increase in the number of 

business and personal bankruptcies. 

Dallas Regional Outlook 10 Second Quarter 1998 
In Focus This Quarter
 

Trends Affecting the Allowance for
 

Loan and Lease Losses
 

•	 Allowance for loan and lease loss (ALLL) levels 

are declining relative to total loans. 

•	 Some industry leaders and regulators have 

expressed concern about the loosening of underwriting standards and greater risk in bank loan 

portfolios. 

•	 Significant growth in riskier loan types calls 

attention to the need to scrutinize closely the adequacy of the allowance. 

Weakening underwriting standards and significant 

growth in riskier loan types have increased the risk 

exposures of some insured institutions to an economic 

downturn. Meanwhile, the ALLL relative to total loans 

has declined in recent years. This article provides information on trends in the ALLL over time and by loan 

type and discusses the factors analysts consider when 

evaluating the adequacy of the ALLL. Special attention 

is given to issues related to the volatility of loan losses 

and the composition of the loan portfolio. 

Historical Perspective on the Allowance 

for Loan and Lease Losses 

The nation is currently witnessing one of the longest 

economic expansions since World War II. It is to be 

expected that some institutions will reduce their ALLL 

CHART 1 

coverage during periods of improved economic conditions. However, in the current environment—in which 

loan availability is abundant, growth is strong, and competition is fierce—some industry leaders and regulators 

have expressed concern about the loosening of underwriting standards and greater risk in bank loan portfolios. At the same time, the ALLL relative to total loans 

for commercial banks has declined to the lowest point in 

a decade (see Chart 1). This allowance ratio has diminished because commercial banks’ loan loss provisions 

have not kept pace with new loan growth. In some 

cases, banks have determined that their allowances are 

higher than necessary and have taken negative loan loss 

provisions, which are credited back to income. 

This decline in reserve coverage has been broad based, 

with the exception of credit card specialists. Commercial banks with concentrations in commercial lending 

and large multinational banks have significantly 

reduced the level of reserves to total loans in recent 

years. Table 1 (next page) shows that since 1993, ALLL 

ratios at both commercial lending banks and multinational banks have declined 31 percent. Moreover, commercial lending banks with assets exceeding $10 billion 

have reduced ALLL ratios by slightly over 37 percent, 

or 98 basis points, over the same period. 

The low level of nonperforming and charged-off loans, 

coupled with prevailing favorable economic conditions, 

is doubtless a significant factor in the reduction of 

Dallas Regional Outlook 11 Second Quarter 1998 

Commercial Bank Reserves at Lowest Point in a Decade 

Source: FDIC Historical Statistics on Banking, National Bureau of Economic Research, Inc. 

1965 1967 1969 1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 

0.0 

0.5 

1.0 

1.5 

2.0 

2.5 

3.0 

% of Loans

Current 

Expansion 

Recessionary 

periods 
In Focus This Quarter
 

TABLE 1 

Commercial Bank Allowance for Loan and Lease Losses to 

Total Loans by Lender Type 

TYPE OF LENDER 

NUMBER OF 

BANKS 

ASSETS 

($BILLIONS) 1997 1996 1995 1994 1993 

MULTINATIONAL 

COMMERCIAL 

CREDIT CARD 

MORTGAGE 

AGRICULTURAL 

11 

3,207 

67 

286 

2,373 

$1,383 

$1,915 

$202 

$120 

$120 

2.14 

1.63 

4.21 

1.26 

1.53 

2.25 

1.71 

3.48 

1.45 

1.66 

2.55 

1.90 

3.21 

1.45 

1.69 

2.83 

2.16 

2.89 

1.69 

1.75 

3.10 

2.37 

3.35 

1.87 

1.83 

Definitions for lender types by order of priority: Multinational—assets >$10 billion and foreign assets >25% of 

assets; Commercial—C&I plus CRE loans >50% of assets; Credit Card—credit card loans >50% of assets; Mortgage— 

1- to 4-family mortgages and mortgage-backed securities >50% of assets; Agricultural—agricultural production and 

agricultural real-estate loans >25% of total loans. 

Source: Bank Call Reports 

ALLL levels. Asset quality indicators such as nonperforming loans and loan loss rates are at historically 

favorable levels. At year-end 1997, the banking industry’s nonperforming loans were just under 1 percent of 

total loans, the lowest in 13 years. The industry’s loan 

charge-off rates (with the exception of consumer loans) 

are also at historical lows. (See the Regional Outlook, 

first quarter 1997, for a detailed discussion of consumer 

loan losses.) However, even with the problems in consumer lending, the banking industry’s aggregate loan 

loss rate is down significantly from levels in the early 

1990s (see Chart 2). 

As the economic expansion reaches an advanced age, 

an important question for insured institutions is 

whether their ALLLs adequately reflect the risks assoCHART 2 

Source: Bank Call Reports 

Asset Quality Indicators Are at Historically 

Favorable Levels 

0.0% 

0.5% 

1.0% 

1.5% 

2.0% 

1985 1987 1989 1991 1993 1995 1997

0.0 

0.5 

1.0 

1.5 

2.0 

2.5 

3.0 

3.5 

4.0 

Charge-off 

Rates 

Nonperforming 

Loan Rates 

% of Total Loans 

ciated with changing industry practices. Insured institutions could experience strains on profitability and capital if allowance levels are inadequate. Given changing 

underwriting trends and loan delinquency patterns, a 

related question is whether reliance on past loss experience in setting the allowance will be an adequate measure for current losses. 

Trends in Underwriting Prompt 

Regulatory Cautions 

Over the past year, various underwriting and lending 

practices surveys by the FDIC, the Office of the Comptroller of the Currency (OCC), and the Federal Reserve 

have noted easing of terms and weakening underwriting 

standards on loans, especially in commercial loan portfolios. It is important to note that, in 1997, nearly twothirds of the commercial banking industry’s loan growth 

was centered in the commercial real estate (CRE) and 

commercial and industrial (C&I) loan categories 

(Chart 3). 

In the FDIC’s Report on Underwriting Practices for 

April 1997 through September 1997, examiners noted 

“above-average” risk in current underwriting practices 

for new loans at almost 10 percent of the 1,233 FDICsupervised institutions examined. Of the institutions 

with above-average risk, 12 percent did not adjust pricing for loan risk. Examiners noted that several of the 

852 institutions examined that were making business 

loans had poor underwriting standards, including lack 

of documentation of the borrower’s financial strength 

Dallas Regional Outlook 12 Second Quarter 1998 
In Focus This Quarter
 

(21 percent) and poor and unpredictable loan repayment 

sources (14 percent). Also, of the 571 institutions 

specifically involved in asset-based business lending, 

20 percent often failed to monitor collateral. Furthermore, 20 percent of the 398 institutions examined that 

were actively engaged in construction lending repeatedly failed to consider alternative repayment sources, and 

29 percent often funded speculative projects. In contrast, just one year earlier, in the Report on Underwriting Practices for April 1996 through September 1996, 

examiners reported that only 11 percent of the institutions examined that were actively engaged in construction lending often funded speculative projects. 

The Federal Reserve’s Senior Loan Officer Opinion 

Survey for November 1997 and February 1998 both 

indicated some easing of commercial business lending 

terms and standards. Also, the OCC’s 1997 Survey of 

Credit Underwriting Practices stated that the level of 

inherent credit risk continues to increase for components of both commercial and consumer loan portfolios. 

These underwriting trends have resulted in increased 

risk profiles for some insured institutions, while ALLL 

ratios at some institutions continue to decline. 

In August 1997, the OCC issued an Advisory Letter 

voicing its concern about declining allowance levels in 

commercial banks. The OCC cited as primary concerns 

the apparent increases in credit risk reported by examiners, such as weakening underwriting trends in the syndicated loan market, easing of other commercial 

underwriting standards, and consumer lending delinquency and charge-off trends. Moreover, the OCC 

found that some banks were using flawed reserve 

CHART 3 

Loan Growth in 1997 Centered in
 

Commercial Loans
 

% of Total Loan Growth 

–30 

–20 

–10 

0 

10 

20 

30 

40 

50 

60 

70 

80 

Commercial

Consumer

Residential

Mortgages

CRE 

C&I 

Other 

Note: Percent of all loan growth for commercial banks in 1997 

Source: Bank Call Reports 

methodologies for estimating loan loss rates, including 

an overreliance on historical loss rates. 

Factors Affecting Adequacy 

of the ALLL 

In using offsite data to assess allowance adequacy, analysts consider financial ratios such as the allowance to 

total loans, reserve coverage (allowance to nonperforming loans), loan loss provisions to charge-offs, and loan 

delinquency levels. These ratios are evaluated against 

historical benchmarks. At the same time, however, analysts supplement the analysis with consideration of the 

potential effects of current industry trends. For example, the banking industry is currently witnessing higher 

than normal losses in consumer lending spurred by 

increased bankruptcy filings and the migration of loans 

from current to charged off without intervening delinquencies. An institution that has a sizable consumer 

loan portfolio may therefore need to attach more weight 

to recent loan loss data in setting the allowance, since 

historical trends may not adequately reflect reserving 

needs. 

Insured institutions exhibit different management and 

portfolio characteristics that significantly influence the 

level of the allowance. These characteristics include the 

diversification of a loan portfolio (diversification by 

borrower, loan type, geography, or industry), the history and recent trends of credit losses, management’s 

practices in the recognition of losses, trends in past-due 

and nonperforming loans, underwriting practices, and 

economic conditions. 

New techniques continue to be developed to improve 

the reliability of allowance estimates. Management 

information systems, which enable the collection of 

more refined historical data, coupled with the application of statistical techniques, are helping some institutions formulate more statistically reasoned allowance 

estimates. Loan management tools such as credit scoring systems, risk rating systems, and consideration of 

economic cycles in the review of historical loss and 

delinquency data all are aiding bankers in the reserving 

process. While these new techniques provide more analytically defensible estimates, they do not diminish the 

role of judgment in assessing ALLL adequacy. 

The role of judgment in setting the ALLL is underscored by the volatility of loan losses over time. 

Dallas Regional Outlook 13 Second Quarter 1998 
In Focus This Quarter
 

CHART 4 

Historically, Commercial Loan Loss Rates Have Been Higher and More Volatile 

than Mortgage Loss Rates 

Source: Bank Call Reports 

0.0 

0.2 

0.4 

0.6 

0.8 

1.0 

1.2 

1.4 

1.6 

1991 1992 1993 1994 1995 1996 1997 

Loan Loss Rates (%)

Commercial Real Estate Loans 

Commercial & Industrial Loans 

Residential Mortgages 

“Volatility” in this context refers to the degree to which 

loan losses have diverged or might diverge from the 

long-run averages. Volatility in loan losses can result 

from changes in the business cycle, local economic 

events, and major one-time events. For example, a bank 

relying on a historic average loan loss calculation to 

derive its reserve level could find itself underreserved if 

it does not adjust its historical loss rates for deteriorating economic conditions and suddenly incurs greater 

loan losses than it had anticipated simply on the basis of 

past performance. 

Generally, different types of loans experience varying 

loan loss rates because of the inherently different risks 

and varying levels of volatility within each type. Chart 

4 shows that commercial loans, such as commercial and 

industrial loans and commercial real estate, historically 

have had greater losses than residential loans. Furthermore, the loss rates on commercial loans have not only 

been higher, they have been more volatile over the 

years, while average losses on mortgage loans have varied little. 

Volatility in loan losses is determined not only by economic events but also by banks’ willingness to take risk. 

Banks that adopt more liberal underwriting policies and 

high loan growth objectives may experience greater 

loan default risk and greater volatility in loan loss rates 

than suggested by their own past experience. For example, Chart 4 shows that mortgage lending has had low 

and stable loss rates on average. The recent growth in 

subprime and high loan-to-value mortgage lending, 

however, may result in increased volatility and losses 

for some lenders going forward. 

All of these factors suggest that ALLLs would be 

expected to vary considerably both over time and across 

loan types. Table 2 shows that this has been the case. 

The ALLL is reported as a single line item on the Call 

Report. This makes it difficult to estimate how much of 

the ALLL is attributable to a particular loan type or to 

compare allowance levels for banks with significantly 

different loan portfolios. Table 2 shows the results of a 

statistical regression estimation of commercial bank 

allowance allocations across the various loan types for 

TABLE 2 

ALLL Allocations Have Varied over Time and by Loan Type 

(Commercial Banks under $1 Billion)* 

LOAN TYPE 1997 (%) 1996 (%) 1995 (%) 1994 (%) 1993 (%) 1992 (%) 1991 (%) 

C&I 

CRE 

MORTGAGES 

CREDIT CARDS 

1.71 

1.44 

0.92 

4.47 

1.85 

1.54 

1.00 

4.42 

1.87 

1.77 

1.05 

3.32 

2.06 

1.83 

1.19 

3.11 

2.14 

1.97 

1.22 

3.20 

2.29 

2.02 

1.07 

3.29 

2.45 

1.99 

0.91 

3.59 

* Estimated regression results 

Source: Bank Call Reports 

Dallas Regional Outlook 14 Second Quarter 1998 
In Focus This Quarter
 

1991 through 1997 for commercial banks with under $1 

billion in assets. Not surprisingly, CRE and C&I loans 

received relatively higher allowance allocations than 

residential mortgage loans, indicating that banks saw 

greater risk in these loan types. Also, credit card loans 

consistently received higher allocations than the other 

loan categories, and the allocations have increased in 

recent years owing to the increased delinquencies and 

charge-offs in this area. 

Conclusions 

The adequacy of the ALLL is measured not only relative to historical loan loss experience but also relative to 

current conditions that may cause losses to differ from 

past experience. Increased losses could result from 

adverse economic developments, from changes in 

banks’ appetite for taking risk, or 

both. In this regard, reported weakening in underwriting standards is 

increasing some banks’ risk exposure to an economic downturn. 

Institutions with high concentrations in riskier loans, significant 

growth in riskier loans, or weaknesses in underwriting may be most at risk. Especially 

for such institutions, the adequacy of the ALLL and its 

methodologies merits close scrutiny. 

Andrea Bazemore, Banking Analyst 

Dallas Regional Outlook 15 Second Quarter 1998 
Regular Features	 Regional Economy
 

Surpluses and Waning Demand Weigh Heavily
 

on Area Agriculture and Oil in 1998
 

•	 Primarily as a result of Asia’s economic crisis, agricultural exports in livestock products and feed grains 

throughout the Region are almost certain to decline in the face of softening worldwide demand. 

•	 Analysts expect the glut of worldwide oil supplies to keep crude oil prices well below $20 a barrel throughout much of this year. Oil companies, oil service firms, independent refiners, and marginal well owners will 

be affected. 

•	 State personal income growth throughout the Region surpassed that of the nation as a whole. However, per 

capita personal income continues to lag behind the national average. 

•	 Although opportunities for further loan growth may continue to exist, some caution is warranted as tight 

labor markets, a possibly prolonged weakness in the oil patch, and the full impact of the Asian economic 

crisis—which has yet to be felt—may result in substantially slower growth in the second half of 1998. 

Regional Farmers and Ranchers Feel Some 

Discomfort from Asian Crisis 

Although the causes and effects of the Asian economic 

crisis have been well chronicled with respect to U.S. 

economic growth and manufacturing, less has been 

written about its probable impact on U.S. agriculture. 

The crisis is expected to result in slower world economic growth, undermining what had been a favorable environment for U.S. agricultural exports. Economists from 

the U.S. Department of Agriculture (USDA) project 

world economic growth of 2.5 percent this year, down 

from 3.1 percent in 1997. 

The Extent of the Problem: The five most troubled 

Asian economies—Indonesia, Malaysia, the Philippines, South Korea, and Thailand—account for 12 percent of U.S. farm exports. Japan and Taiwan account for 

TABLE 1 

an additional 25 percent. The total value of U.S. agricultural exports to Asia in 1997 was approximately $24 

billion, or 41 percent of the total value of U.S. agricultural products sent overseas. Agricultural exports are a 

large component of farm income, representing about 30 

percent of farm cash receipts. The USDA estimates that 

U.S. farm exports worldwide may be 3 to 6 percent 

lower over the next two years than would have been the 

case if these five countries had maintained their prior 

rapid growth. Table 1 lists cash receipts, net farm 

income, and agricultural exports for each of the 

Region’s four states in 1996. 

The devaluation of these nations’ currencies has 

reduced their purchasing power substantially. The volume of U.S. agricultural exports began to fall late last 

year and may continue to do so through this year and 

possibly into early 1999. 

Dallas Region Agriculture at a Glance, 1996 

NET FARM AGRICULTURAL 

CASH RECEIPTS % OF INCOME % OF EXPORTS % OF 

STATE ($ MILLIONS) U.S. TOTAL ($ MILLIONS) U.S. TOTAL ($ MILLIONS) U.S. TOTAL 

COLORADO $4,229 2.1 $844 1.6 $1,099 1.8 

NEW MEXICO 1,709 0.8 363 0.7 75 0.1 

OKLAHOMA 3,566 1.8 551 1.1 475 0.8 

TEXAS 13,053 6.5 2,573 4.9 3,566 6.0 

TOTAL $22,557 11.2 $4,331 8.3 $5,215 8.7 

Source: U.S. Department of Agriculture 

Dallas Regional Outlook 16	 Second Quarter 1998 
an-91

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Regular Features	 Regional Economy
 

U.S. agricultural exports have averaged between $50 

and $60 billion throughout the 1990s. In the most recent 

year for which data are available (1996), agricultural 

exports from the Dallas Region totaled $5.2 billion, or 

about 9 percent of the U.S. total. Chart 1 shows that 

livestock, cotton, feed grain, and wheat accounted for 

60 percent of the Region’s agricultural exports in 1996. 

Agricultural exports from the United States and the 

Dallas Region are expected to be negatively affected by 

the Asian economic crisis for the following reasons: 

•	 The previously fast-growing Asian economies were 

the primary source of the most rapid growth for U.S. 

farm exports. 

•	 Meats are extremely price sensitive and are considered luxury items by Asians. Consumers there are 

likely either to do without or to substitute local meat 

products for U.S. beef and pork. 

•	 U.S. farm exports to Japan will likely continue to fall 

as a result of the yen’s depreciation against the U.S. 

dollar, which was occurring even before the financial 

crisis began in Southeast Asia. 

What the Effects Will Be: The immediate effect of the 

Asian crisis will be to price U.S. agricultural products 

relatively higher than Asian domestic goods, while 

making farm exports from these same Asian countries 

more price competitive with U.S. farm products both 

here and in other third-country markets. The following 

is a brief summary of the outlook for several of the 

Region’s major exports: 

CHART 1

 Livestock and Cotton Were the Region’s Two
 

Largest Agricultural Exports in 1996
 

•	 Beef. Both the weakening Asian demand for beef and 

a record supply of competing meats (poultry and 

pork) have pushed cattle prices downward in early 

1998 compared with early 1997 (see Chart 2). However, as ranchers continue to liquidate their herds 

throughout the year, cattle prices by fourth quarter 

1998 are expected to be above their year-ago levels. 

Producers will have to increase the efficiency of their 

meat operations, including processing and marketing, to maintain profitability. Continued consolidation of firms within the meat industry is expected as 

more efficient firms acquire or eliminate less efficient firms. 

•	 Cotton. High U.S. and world production of cotton, 

high carryover stocks, and lackluster Asian demand 

will likely cause cotton prices to fall in 1998. 

According to the USDA, however, greater use of the 

U.S. government’s export guarantee program will 

help support sales volume at last year’s level. 

•	 Feed grain. Asian livestock operators are heavy 

importers of U.S. feed grains. Their reduced purchasing power, however, has caused them to switch 

to cheaper substitutes, which could exert downward 

pressure on prices and U.S. exports. 

•	 Wheat. Wheat exports are expected to be well below 

the average for the 1990s. U.S. stocks are relatively 

unchanged, and USDA economists predict that 

prices are likely to remain near their 1997 average if 

the Asian crisis is moderate and of short duration. 

CHART 2 

Weak Asian Demand and Competing Meat
 

Supplies Have Pushed Beef Cattle Prices
 

Downward in Early 1998
 

Livestock 

Other 20%

33% 

Wheat 

12% 

$80 

$75 

$70 

$65 

$60 

$55 

Beef Cattle Prices 

$ per Hundredweight

Cotton 

15% 

Hideskins 

7% 

Feed Grain $50 

13% 

Source: U.S. Department of Agriculture	 Source: U.S. Department of Agriculture, National Agricultural Statistics Service 

Dallas Regional Outlook 17	 Second Quarter 1998 
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Regular Features Regional Economy
 

On a Positive Note: Not all the news will be bad in CHART 3 

1998. Stable to declining prices for many major U.S. Oil Prices Have Fallen by More Than commodities should allow U.S. consumers to purchase 

more food with a smaller share of disposable income. One-Third since January 1997 

USDA economists are forecasting that food prices will 

$15 

$16 

$17 

$18 

$19 

$20 

$21 

$22 

$23 West Texas Intermediate (Cushing); Domestic Spot Market 

$ per Barrel 

increase 2.6 percent on average in 1998. In addition, the 

USDA forecasts that farm production expenses will 

decline this year for only the second time in this decade. 

Falling energy prices, lower pesticide costs, and stable 

interest rates are the main factors behind the decline in 

farm expenses. 

Moreover, local economists are hoping Mexico’s strong 

economy will help offset Asia’s weakening economies. 

The USDA is projecting a 14 percent increase in U.S. 

agricultural exports to Mexico after 1997’s record volume. 

Implications: The price outlook for major crops and 

livestock products (e.g., beef, cotton, and wheat) are 

stable to slightly down, although prices could be greatly undermined if economic conditions in Asia deteriorate any further. Consequently, agricultural lenders may 

wish to allow for the possibility that commodity prices 

could soften more than expected. Moreover, reductions 

in farm exports and prices are likely to have repercussions on the demand for farm equipment and machinery 

as well as on the local economy. 

What a Difference a Year Makes 

In January 1997, a barrel of West Texas Intermediate 

(Cushing)1 crude oil fetched about $25 in the domestic 

spot market. As of February 1998, oil prices had fallen 

below $15 a barrel. Thus, in 13 months, oil prices 

declined by more than one-third, with much of the 

decline occurring since fall 1997 (see Chart 3). 

Oil prices have been under downward pressure from a 

variety of sources. First and foremost, the Organization 

of Petroleum Exporting Countries (OPEC), in its 

1 The wellhead price is a daily posted price received by producers. This 

price differs from the price listed in the Wall Street Journal, which 

reports the West Texas Intermediate (WTI) (Cushing) spot price for 

the following month’s futures price. For example, the average WTI 

(Cushing) price for March was $15.02 and represents the average 

April delivery futures price. Accordingly, expectations of price movement through the contract delivery date as well as transportation and 

tariff costs are considered in the WTI (Cushing) spot price but are not 

included in the wellhead price received by producers. 

Sources: The Wall Street Journal; Haver Analytics 

November 1997 meeting, voted to raise the production 

quotas of its members by 10 percent. OPEC is currently producing approximately 27.5 million barrels of oil 

per day, or about 40 percent of the world’s output. This 

increase comes at a time when non-OPEC nations (e.g., 

Mexico) are already boosting their production. 

Second, Iraq has resumed exporting its oil under strict 

United Nations guidelines imposed after the 1991 Persian Gulf war. Under the terms of those guidelines, Iraq 

is allowed to export oil for the sole purpose of raising 

currency to purchase food and medical supplies. Analysts believe Iraqi production will add approximately 1 

million barrels of oil output a day to the world supply. 

Third, the Asian economic crisis is causing nations there 

to reduce their growth estimates for 1998 and cut back 

on production in key industries, many of which consume large quantities of oil and gas-related energy. Asia 

accounts for more than a quarter of the world’s oil consumption, with 15 percent of world oil demand originating from the most troubled Asian nations. Until 

recently, industrial oil demand in the Asian region grew 

8 percent annually, but analysts are expecting a gain of 

only 1 percent this year. 

The combination of increased oil supplies and reduced 

oil demand have contributed to a buildup of inventories 

and downward pressure on oil prices. The capacity utilization rate of refineries is currently at 95 percent, its 

highest level in 20 years. New strides in technology— 

which allow companies to find and produce more oil 

cheaply—and the continued operation of refineries at 

high rates have contributed substantially to the present 

Dallas Regional Outlook 18 Second Quarter 1998 
Regular Features Regional Economy
 

oil glut. According to the U.S. Department of Energy, 

the cost of finding oil around the world dropped nearly 

30 percent between 1990 and 1996. Some industry analysts are predicting that by summer, oil prices will have 

begun to settle somewhere between $15 and $17 a barrel, where they are expected to remain for the balance of 

the year. 

The Good News: Weak oil prices will help restrain 

inflation by holding down the energy component of the 

price index. Already January’s consumer price index, 

although flat overall, revealed a 2.4 percent decline in 

energy prices, with a 3.5 percent decline in petroleum 

product prices alone. Chart 4 shows the close relationship between oil price movements and the producer 

price index, excluding food, for the previous ten years. 

Downstream producers such as pharmaceutical companies, plastics manufacturers, and electric utilities will 

benefit from lower energy costs. End users like the airline and trucking industries, homeowners, and drivers 

will also benefit from lower prices on oil-based products. Inflation-adjusted gasoline prices are at their lowest level since the early 1970s. 

The Bad News: Oil analysts argue that if prices stay at 

$15 a barrel or less, more and more oil companies will 

trim their capital expenditure budgets in 1998. If this 

occurs, the downturn in crude oil prices would have its 

greatest impact on the industry’s exploration segment, 

followed by eventual declines in the sale and manufacture of oilfield equipment and, ultimately, a reduction in 

oil services. 

Some oil companies have already announced plans to 

slash their capital expenditures budget for 1998, and 

CHART 4

industry analysts believe that widespread cutbacks in 

drilling activity may follow. Moreover, some projects 

may be delayed or pulled off production. Owners of 

marginal or “stripper” wells—wells that typically produce 15 barrels of oil a day or less—may be especially 

hard hit. If crude oil prices stay below $15 a barrel for 

an extended period, many of these wells could be 

plugged and abandoned. 

Profits and earnings have come under pressure. Refiners’ crack spread—the difference between the price they 

pay for crude and the spot price of gasoline—fell from 

an average of $4 during the first nine months of 1997 to 

$1.70 in early March 1998, according to Vector Associates, a consulting firm to the energy industry. The combination of lower oil prices and lower refining margins 

has caused energy analysts to cut their earnings estimate 

for the industry in 1998 and 1999—in some cases by as 

much as 20 percent below 1997 results. 

Many oil companies can still show a profit at $14 a barrel, but they may have difficulty maintaining stable cash 

flows and earnings streams. Smaller, highly leveraged 

companies may be forced to sell off their properties or 

be acquired by larger companies. Oil prices below $15 

a barrel could touch off another wave of mergers in the 

industry, particularly among oil service companies 

looking to offer integrated services. 

Implications: Analysts expect oil prices to remain 

below $20 a barrel throughout 1998. As a result, oil 

companies may need to readjust their balance sheets to 

reflect the diminished value of their undeveloped assets 

(oil reserves). This downward adjustment in asset values could hinder the ability of oil companies to raise 

 Oil Prices and Inflation Track Closely 

Sources: U.S. Bureau of Labor Statistics; the Wall Street Journal 

− 4 

− 2 

0 

2 

4 

6 

8 

10 

12 

1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 

Percent Change from a Year Ago 

0 

5 

10 

15 

20 

25 

30 

35 

40 

$ per Barrel 

West Texas Intermediate Crude (Cushing) 

(right axis) 

Producer Price Index, Excluding Food (left axis) 

Dallas Regional Outlook 19 Second Quarter 1998 
Regular Features Regional Economy
 

funding by either bank borrowing or the equities market. Banks look to oil reserves as collateral, and their 

expected drop in value may put a damper on the aggressive lending to the industry that occurred when crude oil 

was priced at $20 a barrel. 

Despite diversification, the oil industry is still heavily 

concentrated in the Region. Sustained oil prices at $15 

a barrel would probably result in the slowing of employment growth in the Region in line with overall U.S. 

employment growth. Also, slower job growth may cause 

ripple effects in other sectors of the economy, resulting, 

for example, in less demand for housing and office 

space. 

Personal Income Growth Exceeds 

the National Rate 

Despite softening in agriculture and energy, the 

Region’s economic performance remained fairly robust 

in 1997. Third-quarter personal income figures for 1997 

revealed that the Dallas Region’s economy outperformed the rest of the United States (see Chart 5). Total 

personal income—the total income received by households from employment, self-employment, investments, 

and transfer payments—is a coincident indicator when 

adjusted for inflation—a useful measure of current economic conditions in the Region. 

Chart 5 shows the Region surpassing the United States 

in personal income growth during this expansion. Leading the Region with gains of roughly 7 percent in 1997 

were Texas and Colorado. Oklahoma and New Mexico are projected to finish the year with personal income 

growth of about 5.5 percent and 5 percent, respectively, 

while the United States as a whole finished 1997 with a 

personal income gain of 5.6 percent. Colorado, Oklahoma, and Texas all ranked among the top 12 states in 

annualized personal income growth in the third quarter 

of 1997. 

With the exception of New Mexico, strong state 

economies, robust employment gains, and gradually rising wages have contributed to the Region’s better-thanaverage income growth. In particular, Texas and 

Colorado—states where wages and salaries account for 

about 69 to 70 percent of total personal income—have 

benefited from strong job growth and tight labor markets. Both states achieved 20-year lows in unemployment in December 1997. Moreover, the run-up in the 

stock market over the past three years has been a substantial source of growth in dividends and interest 

income for both states. 

As measured by industry earnings, the major contributors to income growth in the Region in 1997 were services, durable goods manufacturing, trade, and finance. 

The weakest areas (below-average contributions to 

earnings) were concentrated in mining, nondurable 

goods manufacturing, communications, and the federal 

government. 

Finally, despite the Region’s rapid growth in personal 

income during this decade, three of its four states (the 

exception being Colorado) continued to rank among the 

lowest in per capita personal income—a common measure of relative prosperity—in 1996. New Mexico, with 

CHART 5 

Personal Income Growth in the Dallas Region Has Outpaced 

the United States in This Expansion 

9 

Percent Change

from a Year Ago 

8 

7 

6 

5 

4 

3 

Dallas Region 

United States 

1Q922Q923Q924Q921Q932Q933Q934Q931Q942Q943Q944Q941Q952Q953Q954Q951Q962Q963Q964Q961Q972Q973Q97 

Source: U.S. Department of Commerce, Bureau of Economic Analysis 

Dallas Regional Outlook 20 Second Quarter 1998 
Regular Features Regional Economy
 

a per capita income of $18,400, ranks forty-eighth in 

the nation, ahead of only Mississippi and West Virginia. 

Oklahoma ranks forty-fifth ($19,350) and Texas thirtyninth ($20,400). Only Colorado, with a per capita 

income of $25,400, is above the national average of 

$24,600. It ranks thirteenth among the 50 states. 

Implications: The continuing strong growth trend in 

personal income may portend continued strength in the 

Region’s economy and vigorous growth in bank loans. 

Although job growth in the Region is expected to moderate in 1998, analysts expect income growth for individual states to continue to advance within a 5 to 7 

percent range for another year, surpassing forecasts for 

national personal income growth. 

Income growth drives consumer spending, which typically makes up two-thirds of gross regional product. For 

now, consumption growth should remain strong. In the 

current low-inflation environment, consumers will have 

greater purchasing power, and that should boost spending. Households may take the opportunity to acquire 

more housing, nondurable and durable goods, and services, while at the same time paying down debt and 

replenishing savings. 

Although opportunities for further consumer loan 

growth may continue to exist, some caution is warranted, as tight labor markets, a possibly prolonged weakness in the oil patch, and the full impact of the Asian 

economic crisis—which has yet to be felt—may result 

in substantially slower growth in the second half of 

1998. 

Adrian Rangel Sanchez, Regional Economist 

Dallas Regional Outlook 21 Second Quarter 1998 
Regular Features	 Regional Banking
 

Current Regional Banking Conditions
 

•	 The Region’s insured institutions continue to report strong earnings and asset quality despite a decline in 

tier 1 capital ratios at large institutions. 

•	 Trends in agriculture may present challenges to the Region’s agricultural lenders. 

•	 Although oil and gas do not dominate the Region’s economy to the same extent as in the past, their influence 

is still important to many insured institutions. 

Banks and thrifts in the Dallas Region continue to enjoy 

strong economic conditions, favorable profitability and 

capital ratios, and low nonperforming asset ratios (see 

Chart 1). During the fourth quarter 1997, the Dallas 

Region’s institutions: 

•	 improved aggregate return on assets to 1.26 percent; 

•	 maintained total past-due loans at 2.35 percent, compared with a national level of 2.27 percent; and 

•	 sustained a decline of 40 basis points in the aggregate leverage capital ratio to 7.65 percent, driven by 

asset growth at large banks. 

As discussed in past Dallas Regional Outlook issues, 

small banks dominate the Region’s population more so 

than in other FDIC Regions. Nonetheless, the asset size 

of some of the largest banks heavily influences the 

Region’s profile. For example, the Region’s assets grew 

$14.6 billion, or 4 percent, in the fourth quarter of 1997; 

all but $837 million of this asset growth occurred 

among the ten largest banks in the Region, which hold 

CHART 1 

Dallas Region Institutions Show 

Financial Strength 

Source: Bank and Thrift Call Reports 

0 

2 

4 

6 

8 

10 

Return 

on Assets 

Net Interest 

Margin 

Past Due 

and 

Noncurrent 

Loans 

Leverage 

Ratio 

12/95 

Percent of 12/97

Assets 

12/96 

United States 

12/97 

$165 billion, or 44 percent, of its assets. This rapid asset 

growth outpaced earnings retention and caused an 

aggregate decrease in the tier 1 leverage ratio of 40 

basis points to 7.65 percent for all institutions during 

fourth quarter 1997. However, for all institutions 

excluding the ten largest, the same capital measure averaged a much higher 8.57 percent and declined only 14 

basis points during fourth quarter 1997. 

The return on assets (ROA) for these two groups of 

banks is very similar, but over a period of time, the 

group that excludes the largest banks has had a higher 

net interest margin, lower overhead, and lower noninterest income. This group of banks relies more on traditional bank lending than the Region’s largest banks, 

which are continuing to develop noninterest income as 

a core element of their revenue stream. 

Two topics addressed in this issue’s Regional Economy—oil and agriculture—are particularly relevant to 

this Region. While issues that are currently unfolding in 

these industries are driven largely by macroeconomic 

trends, each has the potential to affect banks in this 

Region. For many banks in the Dallas Region—particularly smaller or rural banks—these two industries are 

the primary economic drivers for their trade area and 

thus may be more vulnerable to the events now taking 

place. The remainder of this article will address possible risks financial institutions face with regard to these 

two industries. 

Agriculture Is Key 

Agriculture is an important sector of the Dallas Region’s 

economy. According to the U.S. Department of Agriculture (USDA), agricultural cash receipts for the Region’s 

four states totaled $22.5 billion during 1996 and 

accounted for 11.2 percent of the nation’s total. This total 

reflects only direct farm cash receipts and does not 

Dallas Regional Outlook 22	 Second Quarter 1998 
Regular Features Regional Banking
 

include downstream components (processing, transportation, wholesale, retail, related finance activities, 

etc.). Texas agriculture, which generated close to $15 

billion in cash receipts in 1997, is estimated by the Texas 

A&M Department of Economics Agricultural Extension Service to add $50 billion to the state’s economy 

when support businesses are considered. 

Agricultural Banks in the Dallas Region 

Are Influential 

In the Dallas Region, 374 banks are classified as “agricultural banks,” with combined assets of $20 billion. 

Agricultural banks are banks in which agricultural real 

estate and operating farm loans exceed 25 percent of 

total bank loans. In highly concentrated agricultural 

areas, the influence of agriculture reaches far beyond 

the credit quality of farm loans. For banks in these communities, agriculture affects all loan types, other 

sources of the bank’s revenue stream, and the stability 

of its deposit base. One way to identify banks that may 

be particularly sensitive to trends in agriculture is to 

identify which counties have more than 25 percent of 

total bank loans outstanding in agriculture. There are 

138 such counties in the Dallas Region; these serve as 

headquarters for 332 banks, 55 of which do not meet the 

agricultural bank criteria (see Chart 2). In this article, 

these counties are referred to as agricultural counties. In 

this group, 43 counties have 50 percent or more of their 

loans directly invested in agriculture. 

TABLE 1 

CHART 2 

The Bulk of the Region’s Agricultural Loans Are
 

Concentrated in Western Oklahoma, Northern
 

Texas, and Eastern Colorado
 

Percentage of Agricultural Loans 

to Total Loans, by County 

Over 50% (43 counties) 

25 to 50% (95 counties) 

Under 25% (289 counties) 

Source: Bank and Thrift Call Reports 

Both groups of banks that encompass agricultural lending report high capital ratios, an ROA above the national average, and low levels of past-due loans. See Table 1 

for a comparison of all agricultural banks, banks in agricultural counties, and other banks in the Region that are 

not heavily exposed to agricultural lending and that 

Agriculture Banks and Counties Show Greater Reliance on Traditional Lending 

NON-AG BANKS 

AG BANKS* AG COUNTIES** < $100 MILLION 

NUMBER OF INSTITUTIONS 374 332 730 

TOTAL ASSETS ($ MILLIONS) $19,999 $16,867 $35,024 

AVERAGE ASSET SIZE ($ MILLIONS) $53 $50 $48 

NET INTEREST MARGIN 4.49 4.44 5.05 

NONINTEREST INCOME/EARNING ASSETS 0.78 0.76 1.30 

NONINTEREST EXPENSE/EARNING ASSETS 3.15 3.14 4.17 

RETURN ON ASSETS 1.29 1.27 1.28 

CHARGE-OFF RATE 0.37 0.40 0.33 

TOTAL PAST-DUE RATIO 3.17 3.06 2.94 

TIER 1 LEVERAGE RATIO 10.59 10.74 9.63 

LOAN-TO-DEPOSIT RATIO 56.86 56.01 60.84 

* Ag banks are banks in which agricultural loans exceed 25 percent of total loans. 

** Ag counties are defined as counties where agriculture loans exceed 25 percent of total loans. 

Source: Bank and Thrift Call Reports 

Dallas Regional Outlook 23 Second Quarter 1998 
Regular Features Regional Banking
 

have total assets under $100 million. Because the average asset size of an agricultural bank is $53 million, 

comparisons were limited to nonagricultural banks with 

less than $100 million in assets. 

Distinctions between agricultural banks and nonagricultural 

banks with assets under $100 

million are evident in the earning components and the leverage capital ratios. While the 

ROA is similar for these two 

groups of banks, agricultural 

banks show a greater reliance on traditional lending 

than nonagricultural banks under $100 million do. Agricultural banks have both lower overhead and lower noninterest income. They also have a narrower net interest 

margin, possibly reflecting the competitive pressures in 

agricultural lending, particularly from point-of-sale 

vendor financing and agency-sponsored financing that 

use lower cost wholesale funding. Higher leverage capital ratios for agricultural banks may reflect in part their 

geographic concentration of credit. 

Agricultural Issues of Interest to Farm and 

Ranch Lenders Are Many 

Several significant changes or events taking place in the 

agricultural sector could have a direct or indirect effect 

on banks in the Dallas Region. These changes are likely to increase certain risk factors for agricultural 

producers and their lenders. Consequently, measuring 

and managing these risks is becoming increasingly 

complex, particularly for the smaller producers and 

lenders with limited resources. A summary of these 

issues follows. 

Waning Demand Amid Strong Harvest Expectations: Principally as a result of the weak Asian 

economies, previous expectations of strong global 

demand have been reduced. Concurrently, principal 

grain and cotton crops are expected to be larger than 

previously estimated. Consequently, many crop prices 

have been under heavy downward pressure. For example, from year-end 1996 to February 1998, average 

prices for cotton have fallen 10 percent; wheat and corn, 

23 percent; and cattle—the largest agricultural commodity by dollar value in the Region—9 percent. 

Despite what is expected to be a significant decrease in 

Asian demand for cattle this year, ongoing efforts on the 

part of domestic producers to reduce the aggregate herd 

population have led the USDA to project a mild price 

increase in cattle prices by year-end 1998. 

Changed Government Policy: The Federal Agricultural Improvement and Reform Act of 1996 delinked 

income support payments from farm prices by providing for seven annual fixed but declining “production 

flexibility contract payments.” In sharp contrast to previous policy, registered producers receive fixed payments regardless of current prices or what they planted. 

Two of the most important aspects of this bill for farmers and their credit providers are the eventual elimination of government support payments (in 2003) and the 

fact that planting decisions will be guided by market 

forces rather than government. The increasing complexity of farming operations may require bankers to act as 

advisers and intermediaries for futures contracts and 

other hedging alternatives. 

Crop Alternatives and New Growth Areas: Given 

fluctuations in crop prices, many farmers are electing to 

plant different crops than they have traditionally planted. While this capability allows producers to make market-based decisions, many agricultural economists 

believe it also increases commodity price risk. Accordingly, producers and their lenders will face increased 

risks from both pricing volatility and venturing into new 

types of crops. 

Significant growth in hog production in the southeastern section of Colorado and the panhandles of Texas 

and Oklahoma have brought new lending opportunities 

as well as new risks to participating lenders. A major 

hog processing plant in Guymon, Oklahoma, is now in 

its fourth year and is producing up to 4 million hogs 

annually. Another hog processing plant of the same 

capacity reportedly may be established in the Texas panhandle or central Kansas. While this activity is adding 

to economic growth, it is not without controversy. Environmental concerns are growing over the smell and the 

pollution of underground water tables associated with 

such enterprises. Oklahoma’s governor and several legislative leaders have endorsed a one-year moratorium 

on large hog operations. Additionally, the average price 

of hogs has declined 38 percent between year-end 1996 

and February 1998. Producers, some of them new to 

hog production, face growing risks from weakened 

demand, falling prices, and political and regulatory 

pressures. These issues merit the continued attention of 

lenders to this industry. 

Dallas Regional Outlook 24 Second Quarter 1998 
Regular Features Regional Banking
 

Demographic Trends and Increased Competition: 

The dynamics of the financial marketplace and demographic trends in rural areas could add up to increased 

pressure on small agricultural banks. Nontraditional 

capital providers—such as point-of-sale financing subsidiaries of large agriculture venders—are taking market share from traditional lenders. Meanwhile, the 

average farm size slowly continues to increase, and the 

number of small producers is declining, eroding the 

customer base for small rural banks. While current 

agricultural conditions have been very favorable and 

agricultural banks, as a group, have benefited, the confluence of increased competition and an eroding customer base presents some long-term challenges for 

these banks. In particular, efforts to sustain new loan 

generation could put pressure on loan pricing, underwriting standards, or both. 

Oil’s Influence Is Still Widely Felt 

in the Dallas Region 

Historically, the oil industry has been very important to 

the Dallas Region. The energy-related booms and busts 

of the 1970s and 1980s were a principal contributor to 

the crises that shook the Region’s banking industry. 

Today, the states of the Dallas Region are more diversiTABLE 2 

fied than they were in the 1980s, and banks do not have 

the degree of exposure to energy lending they once had. 

Nevertheless, oil’s influence is still widely felt. In 

aggregate, the Region accounts for 30 percent of the 

nation’s oil production and 46 percent of its gas production. Table 2 shows where each state in the Region 

stands in terms of oil and gas production, as well as 

employment. Texas far exceeds the other states in 

production and employment, but Oklahoma and New 

Mexico’s production levels are more significant in 

terms of the industry’s contribution to their respective 

gross state products. 

The upward trend in oil prices during 1996 and 1997 

stimulated increased drilling activity, employment 

growth in the petroleum industry, and energy-related 

lending. Overall, the increased oil and gas activity has 

been a significant contributor to the Region’s strong 

economic showing in both those years. Recently, however, crude oil prices have tumbled, and the industry’s 

economic significance to the Region rekindles concerns 

about oil and gas lending and risks to banks in areas that 

rely heavily on that industry. 

The falling prices witnessed over recent months affect 

all segments of the oil industry. Historically, falling oil 

prices have been a benefit to “downstream” firms that 

Oil Impact in the Dallas Region 

75 

% OF 

UNITED NEW UNITED 

STATES COLORADO MEXICO OKLAHOMA TEXAS REGION STATES 

OIL PRODUCTION 

(THOUSANDS OF BARRELS) 2,361,915 24,954 64,477 85,379 543,342 718,152 30 

GAS PRODUCTION 

(THOUSANDS MCF) 19,915,409 528,965 1,646,492 1,815,370 5,162,501 9,153,328 46 

OIL RANK 11 8 6 1 

GAS RANK 9 4 3 2 

STRIPPER % 18 21 21 25 

EMPLOYMENT 

(IN THOUSANDS) 

EXTRACTION 310 8 10 30 149 196 

REFINING 125 1 1 4 25 31 

TRANSPORTATION 162 2 2 7 28 39 24 

WHOLESALE 162 2 2 4 16 24 15 

RETAIL 665 11 6 9 34 60 9 

TOTAL 1,424 24 19 53 253 349 25 

AVERAGE COST TO 

DRILL ONE WELL ($000) $513 $287 $406 $492 $538 

Circled numbers represent significant positions relative to other Regions or States. 

Source: Independent Producers Association of America (IPAA) 1997 Oil and Gas Information 

63 

25 

Dallas Regional Outlook 25 Second Quarter 1998 
Regular Features Regional Banking
 

refine crude oil into usable products. However, slower 

worldwide economic growth, slack demand for heating 

oil, and abundant supplies of gasoline have caused 

prices for those petroleum-based products to fall, 

squeezing profit margins. Oil and gas firms are expected to cut capital spending budgets, employment growth 

could slow, and job layoffs could occur. Drilling and 

extraction activities are likely to be the first and most 

affected segment of the industry. As shown in Table 2, 

the Region accounts for 63 percent of the nation’s oil 

and gas extraction employment. Because of their heavy 

concentration of oil production, Oklahoma and Texas 

stand to be more adversely affected by problems in the 

petroleum industry than other areas of the country. 

Most affected by the oil price decline are marginal 

wells—commonly referred to as “stripper” wells—that 

produce less than 15 barrels of oil a day. With higher 

overhead and a lower revenue base, these wells are the 

first to pierce break-even points in a declining price 

environment. As of 1996, there were almost 69,000 producing stripper wells in Oklahoma, accounting for 75 

percent of the state’s oil production. While Texas has 

over 113,000 producing stripper wells, they account for 

only 25 percent of the state’s total production. By comparison, national oil production from stripper wells is 

only 18 percent. 

While the recent oil price decline is a serious issue for 

all industry participants throughout the Region, Oklahoma appears to be particularly vulnerable because of 

its high rate of oil and gas employment and the extremely high percentage of its oil production that comes from 

stripper wells. Chart 3 shows the leading oil producing 

counties in Oklahoma. There, 35 of 77 counties produce 

500,000 or more barrels of oil annually. Small communities with high oil production are more likely to rely on 

that single industry, and thus be more vulnerable. Of 

these high-producing counties in Oklahoma, 28 have 

populations under 50,000. 

Different Grades of Oil Mean Different Prices 

Different grades of oil vary significantly, as do their 

prices. For example, the average spot price of West 

Texas Intermediate (WTI) (Cushing) crude was $12.758 

a barrel as of March 1998, while the average price of 

West Texas Sour was only $9.758 because of its lower 

quality. The wellhead price is a daily posted price 

received by producers. This price differs from the price 

listed in the Wall Street Journal, which reports the WTI 

CHART 3 

Oil Production Is Still Key to Oklahoma 

Oklahoma Oil Production by County 

(1996 barrels of crude oil)
 

Over 1,000,000 (22 counties)
 

500,000 to 1,000,000 (13 counties)
 

Under 500,000 (42 counties)
 

Source: Oklahoma Corporation Commission, Oil and Gas Conservation Division, 

Statistical Department 

(Cushing) spot price for the following month’s futures 

price. For example, the average WTI (Cushing) price for 

March was $15.02, which represents the average April 

delivery futures price. Accordingly, expectations of 

price movement through the contract delivery date as 

well as transportation and tariff costs are considered in 

the WTI (Cushing) spot price but are not included in the 

wellhead price received by producers. Even with 

improving efficiency gained through new technologies, 

the current environment of low prices is below many 

producers’ break-even points, especially those with 

lower-grade, small-producing wells. Consequently, 

many producers are shutting down their wells, and others are curtailing their capital spending programs. In 

some cases, producers are just walking away from wells 

to avoid the high cost of capping them. 

There are 178 banks headquartered in Oklahoma’s high 

oil-producing counties (annual production greater than 

500,000 barrels). At year-end 1997, these banks held 

$23.5 billion in assets, or 58 percent of Oklahoma’s 

banking assets. Financial ratios for these banks,1 including tier 1 leverage ratio, ROA, charge-off rates, and 

past-due ratios, are very similar to those for the Region. 

Call Report information does not segregate oil and gas 

lending data; however, FDIC Division of Supervision 

staff report very little direct lending to oil production 

companies by banks in the high oil-producing areas of 

Texas and Oklahoma. Rather, small bank lending exposure to the oil industry is reportedly geared more toward 

1 Aggregated data for financial ratio calculation excludes one large 

institution that reported significant losses in 1997. Exclusion of this 

institution eliminates the non-energy-related losses that would otherwise distort the data. 

Dallas Regional Outlook 26 Second Quarter 1998 
Regular Features Regional Banking
 

petroleum service companies. The Independent Producers Association of America (IPAA) indicates that 

bank lending to independent producers is increasing. 

According to IPAA, “bank participation has increased 

significantly in financing of independent projects. It 

grew by six percentage points from the 1994 Profile 

survey and has nearly tripled from the 1992 Profile survey.” In 1996, bank financing accounted for 26 percent 

of capital sources for independent producers, second only to 

internally generated financing 

(34 percent). This information 

does not include lending 

activities to the large oil conglomerates that are also borrowing from insured institutions. These large companies are typically borrowing 

from the large regional banks and money center banks 

or going directly to the capital markets for their funding. 

While direct energy lending from smaller institutions 

may not be substantial, many borrowers from these oilbased communities rely on the industry to support their 

debts, either directly through their employment or indirectly through the economic and commercial vitality of 

the community. 

Implications: An extended period of weak oil prices— 

below $15 a barrel—would put a strain on energy producers and energy-dependent areas. Banks may feel 

this strain directly in their oil and gas lending, which 

has reportedly seen rapid growth over the past four 

years. Banks in areas that are dependent on the industry 

may be affected negatively as well if oil-related firms 

curtail employment and capital spending. Income from 

royalties used to support consumer debts also may be 

curtailed, and many of the high oil-producing areas, 

particularly in western Oklahoma, the Texas panhandle, 

and the high plains, are large agricultural production 

areas as well. As discussed earlier in this article, agriculture too is facing changes that may present challenges to producers and their lenders. Combined, oil 

and agriculture are the major economic underpinnings 

for large parts of these areas. The confluence of 

changes in agriculture with the strain that the oil and 

gas industry is undergoing poses risks and challenges 

that warrant the continued attention of both bankers and 

their supervisors. 

Alan C. Bush, Regional Manager 

Jeffrey A. Ayres, Financial Analyst 

Additional Sources of Information 

“Banking Problems in the Southwest” in Brian 

Lamm and John O’Keefe, History of the Eighties, 

Lessons for the Future, Volume 1. Washington, 

D.C.: FDIC, 1997. 

Department of Energy (www.fe.doe.gov) 

Energy Information Administration (www.eia. 

doe.gov) 

Independent Petroleum Association of America 

(IPAA) (www.ipaa.org) 

Dallas Regional Outlook 27 Second Quarter 1998 
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