Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION FIRST QUARTER 2002 

FDIC
 

Memphis
 

Region
 

Division of
 

Insurance
 

Gary L. Beasley,
 

Regional Manager
 

Harry W. John,
 

Regional Economist
 

Robert L. Burns,
 

Senior Financial
 

Analyst
 

F. Miguel Hasty,
 

Financial Analyst
 

Regional Perspectives 

◆ Credit Quality Remains a Concern, Particularly in Areas Dependent on Manufacturing Employment—The Memphis Region underperformed the national economy 

in 2001 because of a heavy reliance on a weak manufacturing sector. As a result, banks 

and thrifts in the Region reported greater credit quality deterioration than was experienced in many other areas of the country. Furthermore, because of structural and cyclical changes, the Region’s manufacturing sector may be slow to recover when the nation’s 

economy begins to improve. See page 3. 

By F. Miguel Hasty and Harry W. John 

◆ Further Earnings Pressure Could Result If Interest Rates Rise—Net interest 

margins have fallen sharply from levels reported one year ago, largely because of 

changes in interest rates. The potential for continuing interest rate volatility, this time in 

a rising rate environment, suggests that sound asset/liability management will be particularly critical to future earnings performance. See page 6. 

By Robert L. Burns 

In Focus This Quarter 

◆ Housing Market Has Held Up Well in This Recession, but Some Issues Raise 

Concern—Recent trends in mortgage underwriting are of particular interest, as an 

estimated $2 trillion in mortgage debt, approximately one-third of the total outstanding, 

was underwritten during 2001. Nonconstruction residential mortgages traditionally 

have represented one of the better-performing loan classes during prior downturns. The 

level of credit risk, however, may be higher this time around because the mortgage lending business has changed since the last downturn. This article examines these changes, 

including increased involvement by insured institutions in the higher-risk subprime 

credit market, the acceptance of higher initial leverage on home purchases, and greater 

use of automated underwriting and collateral valuation processes, which have not been 

recession-tested. 

◆ Home price softening could have an adverse effect on residential construction and 

development (C&D) and mortgage portfolios. In the aggregate, the level of risk appears 

modest. However, insured institutions with significant C&D loan exposures in markets 

that experienced ongoing residential construction during 2001, despite slowing local 

economies, are at higher risk. Weakening home prices could hurt loan quality in selected markets. The San Francisco Bay area stands out as a place to watch in this regard. 

See page 11. 

By Scott Hughes, Regional Economist 

Judy Plock, Senior Financial Analyst 

Joan Schneider, Regional Economist 

Norm Williams, Regional Economist 

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

Insurance Corporation as an information source on banking and economic issues for insured 

financial institutions and financial institution regulators. It is produced for the following eight 

geographic regions: 

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

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

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

Dallas Region (CO, NM, OK, TX)
 

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

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

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

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

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

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

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

trends and developments at the regional level. 

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

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

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

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

Outlook, please call Gary Beasley at (901) 821-5234 or send an e-mail to gbeasley@fdic.gov. 

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

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

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

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

the Federal Deposit Insurance Corporation. 

Chairman Donald E. Powell 

Director, Division of Insurance Arthur J. Murton 

Executive Editor George E. French 

Writer/Editor Kim E. Lowry 

Editors Lynn A. Nejezchleb 

Maureen E. Sweeney 

Richard A. Brown 

Ronald L. Spieker 

Publications Manager Teresa J. Franks 
Regional Perspectives
 

Regional Perspectives
 

• The Memphis Region’s economy underperformed the national economy during the current downturn 

because of heavy reliance on a weak manufacturing sector. 

•	 Banks and thrifts headquartered in areas with significant employment concentrations in the manufacturing 

sector have reported the greatest increase in loan delinquencies. 

•	 The Region’s manufacturing sector may be slow to recover when the nation’s economy begins to improve. 

Credit Quality Remains a Concern,
 

Particularly in Areas Dependent on Manufacturing
 

The Midsouth economy entered a period of economic 

decline well ahead of the national recession and underperformed the national economy in 2001. Unlike in the 

1990 to 1991 recession, the Region’s economy seems 

unlikely to outperform the nation when the economy 

recovers. The primary reason for the relative weakness 

is the significant concentration in manufacturing 

employment and the specific mix of industries, which 

has been discussed in depth in previous Regional Perspectives articles. As a result of this specific economic 

weakness, banks and thrifts in the Region faced greater 

credit quality deterioration than that experienced in 

many other areas of the country. Not surprisingly, banks 

and thrifts operating in those parts of the Midsouth with 

the highest exposure to the manufacturing sector reported the most significant drop in credit quality. 

Weakened Credit Conditions Are More 

Pronounced in Areas with Manufacturing 

Employment Concentrations 

The nation’s economic downturn in 2001 was preceded 

by weakness in the manufacturing sector that contributed to reduced capital investment in new plants and 

equipment, slowed production, and precipitate eventual 

layoffs and plant closings. The effects of this slowdown 

were most pronounced in Midwestern and Midsouthern 

states, which have a higher concentration of manufacturing employment. 

Credit quality at insured institutions also has been disproportionately affected. Credit quality declined 

throughout the Region during 2001, but the deterioration 

was more pronounced at insured institutions operating in 

counties dependent on manufacturing employment. 

Small community banks and thrifts operating in counties 

with high manufacturing employment concentrations1 

reported past-due loans at 3.6 percent of total loans as of 

September 30, 2001, up 65 basis points from one year 

earlier. By comparison, insured institutions operating in 

counties with lower manufacturing employment concentrations reported past-due loans at 2.9 percent of total 

loans, up 36 basis points from one year earlier. 

Certain Sectors Led the Region’s 

Manufacturing Downturn 

The Region’s apparel, automotive parts, furniture and 

fixtures, and lumber industries were among the sectors 

most affected by the overall slump in manufacturing. 

Louisiana, with a lower overall manufacturing concentration and more limited exposure to these specific sectors than other states in the Region, experienced only 

moderate layoffs. Arkansas and Mississippi, whose 

economies are dominated by small manufacturing 

plants in these sectors, experienced larger declines in 

payrolls and numerous plant closures. While Kentucky 

and Tennessee have significant exposure to these sectors, job losses were moderated by continuing strength 

in automobile production, which constitutes a significant share of these states’ manufacturing payrolls. 

Throughout much of the 1990s, the low-tech and laborintensive textile and apparel sector experienced problems. 

1 Counties with high manufacturing employment concentrations are 

defined as those with 17 percent or more of total employment in 

manufacturing-related jobs. With 54 percent of all small community 

banks (less than $250 million in assets) operating in these areas, this 

level identifies those counties with manufacturing concentrations 

greater than the regional concentration. 

Memphis Regional Outlook 3	 First Quarter 2002 
Regional Perspectives
 

Lower-priced imports of apparel products from Central 

Asia and Latin America undercut domestic pricing, 

forcing many apparel companies to streamline costs by 

cutting jobs and relocating plants to overseas locations. 

In large part, these job losses represent a structural 

decline rather than a cyclical contraction. Thus, these 

jobs are unlikely to return with an economic recovery. 

Although automobile production held up well in 2001, 

many automobile parts producers and suppliers suffered. 

These companies faced growing competition from 

abroad, bloated inventories, and pressure from automobile makers to cut prices, forcing many suppliers to 

reduce costs, which necessitated layoffs and some plant 

closings. Exacerbating the effects of these layoffs, many 

of the Region’s automotive part suppliers are located in 

rural counties where other employment opportunities are 

limited. These job losses can be characterized as both 

cyclical (reduced demand, inventory adjustments) and 

structural (foreign competition, pricing pressures). 

While most of these jobs are expected to return with an 

economic recovery, some may be permanently lost. 

Employment in the lumber and wood products, paper 

and allied products, and furniture and fixture industries 

weakened because of a variety of factors, including 

moderating construction and stiff competition from 

imported lumber and wood products. Numerous lumber 

and paper mills were shut down, and many furniture 

companies reduced payrolls and closed plants. 

Insured Institution Credit Quality Deteriorated 

in Most Areas with Significant Manufacturing 

Employment Concentrations 

Most geographic areas with high manufacturing 

employment concentrations experienced adverse economic conditions during 2001 (see Map 1). These weak 

economic conditions appear to have contributed to 

deteriorating loan portfolio conditions among small 

community banks headquartered in these areas.2 

Northwest Tennessee is an example of how a slowing 

economy can contribute to stress on bank and thrift 

loan portfolios. Not only does the area have a high 

2 Not all areas have been affected to the same degree. Northwest 

Arkansas is dominated by the food products industry, which remained 

strong despite the national economic slowdown. The area also is 

helped by the presence of large nonmanufacturing employers, such as 

Wal-Mart, Inc., and the University of Arkansas. 

concentration in overall manufacturing employment, but 

over one-third of this employment is in the weak automobile parts suppliers sector, primarily rubber parts and 

supplies. With rising layoffs and high unemployment, 

northwest Tennessee’s economy is the weakest of the 

Region’s manufacturing pockets. These trends may 

explain why the aggregate past-due ratio among small 

community banks and thrifts in the area rose 127 basis 

points from one year ago to 4.36 percent by thirdquarter 2001. This level of past-due loans, as well as the 

rate of increase, is the highest among the geographic 

areas shown on the table that accompanies Map 1. 

Some of the Region’s Manufacturing Distress 

May Linger into the Recovery 

The Region’s economic recovery will likely be affected 

by continuing weakness in the manufacturing sector. 

By year-end 2001, national manufacturing activity 

improved.3 The Region’s manufacturing problems, however, include both structural changes and cyclical 

changes. For example, job losses in the apparel sector, 

which are likely to continue, appear to be permanent. 

While automotive production remained strong in 2001 

and offset some weakness in other sectors, sales are 

expected to slow. Production volume (distinct from 

industry profitability) remained stable largely because 

of strong incentives, such as rebates and zero percent 

financing. The possibility that these incentives pulled 

automobile sales in 2001 from future sales and an 

increasing global overcapacity could contribute to a 

slowdown in demand, leading to reduced automobile 

production.4 In January 2002, Ford Motor Company 

announced restructuring plans that will result in up to 

35,000 job cuts and five plant closures. General Motors 

also announced plans to reduce employment levels. 

F. Miguel Hasty, Financial Analyst 

Harry W. John, Regional Economist 

3 The Institute of Supply Management reported that its index of 

manufacturing activity rose to 48.2 in December 2001 from 44.5 the 

previous month. In the same period, the new orders component rose 

from 48.8 to 54.9; this was the largest increase in the overall index 

and indicates a favorable outlook. 

4 Production levels may experience a temporary boost in early 2002, 

as automobile producers may need to return depleted inventories to 

normal levels. 

Memphis Regional Outlook 4 First Quarter 2002 
Regional Perspectives
 

MAP 1 

Manufacturing Employment Concentration 

Northwest 

Arkansas 

South 

Arkansas 

Northeast 

Arkansas 

S. Central 

Tennessee 

East 

Tennessee 

East Central 

Kentucky 

Northern 

Kentucky 

East Mississippi 

NW 

Tennessee 

Central 

Tennessee 

Share of total employment in 

manufacturing 

(as of September 2000) 

0 percent to 14 percent 

14 percent to 17 percent 

17 percent to 25 percent 

25 percent to 56 percent 

TABLE 1 

Insured Institutions in Many Areas with Concentrations in Manufacturing 

Employment Report Some Credit Quality Weakening 

MANUFAC­ TURING 

CONCEN­ REGIONAL AREA TRATION (%) 

EMPLOY­ UNEMPLOY­ PAST-DUE 

MENT MENT NUMBER RATIO 

SUB-SECTOR (OCT 2001, (OCT 2001, OF BANKS 3Q2001 PAST-DUE RATIO 

CONCENTRATIONS* YOY,%) YOY,%) IN AREA (%) YEAR-AGO CHANGE 

NORTHWEST TENNESSEE 31.3 

EAST MISSISSIPPI 31.2 

SOUTH CENTRAL 31.6 

TENNESSEE 

EAST TENNESSEE** 31.2 

CENTRAL TENNESSEE 30.1 

SOUTH ARKANSAS 26.5 

NORTHEAST ARKANSAS 25.6 

EAST CENTRAL 26.0 

KENTUCKY 

NORTHERN KENTUCKY 29.6 

NORTHWEST ARKANSAS 25.0 

RUBBER PRODUCTS –1.8 7.5 17 4.36 UP 127 BASIS POINTS 

METAL PRODUCTS 

FURNITURE AND 

FIXTURES –1.4 6.1 27 3.65 UP 80 BASIS POINTS 

FOOD PRODUCTS 

TRANSPORTATION 0.5 5.2 24 3.65 UP 43 BASIS POINTS 

INDUSTRIAL 

MACHINERY 

CHEMICALS 0.0 4.5 14 3.56 DOWN 3 BASIS POINTS 

FURNITURE AND 

FIXTURES 

TRANSPORTATION 0.4 5.2 28 3.35 UP 79 BASIS POINTS 

FURNITURE AND 

FIXTURES 

FOOD PRODUCTS 0.8 4.3 51 3.33 UP 59 BASIS POINTS 

LUMBER 

TRANSPORTATION –1.4 6.1 20 3.18 UP 99 BASIS POINTS 

ELECTRONICS 

TRANSPORTATION –1.5 6.2 26 3.09 UP 68 BASIS POINTS 

ELECTRONICS 

TRANSPORTATION –0.3 4.4 32 3.00 UP 85 BASIS POINTS 

PRINTING 

RUBBER PRODUCTS 3.8 2.3 32 2.86 UP 31 BASIS POINTS 

METAL PRODUCTS 

NOTES: *The two largest manufacturing concentrations are listed for each Regional Area. There may be other
 

important sectors. YOY=Year over Year.
 

**East Tennessee's economy has experienced a steady decline in chemical sector jobs since the mid-1990s because of
 

cost cutting and restructuring at Eastman Chemical Corp., but employment in this sector has recently stabilized.
 

This has led to stability in bank and thrift past-due ratios.
 

Sources: Bureau of Labor Statistics, Bank and Thrift Call Reports
 

Memphis Regional Outlook 5 First Quarter 2002 
Regional Perspectives
 

Further Earnings Pressure Could Result if Interest Rates Rise
 

• Most banks and thrifts in the Region experienced considerable net interest margin compression during the 

preceding year, largely because of interest rate volatility. 

•	 As the yield curve steepened during 2001, many insured institutions extended asset maturities and repricing intervals in an effort to mitigate margin erosion. Combined with a modest shortening of liability maturities, this asset extension likely increased the vulnerability of earnings performance to rising interest rates. 

• The apparent increase in interest rate risk exposure and the growing likelihood of rising interest rates underscore the importance of sound asset/liability management policies, models, and strategies. 

Declining net interest margins (NIMs) combined with 

rising provisions to the allowance for loan and lease 

losses led to lower returns on assets and returns on equity for most banks and thrifts in the Memphis Region 

during 2001. The effect of changing interest rates 

appears to have been the primary factor contributing to 

the sharp decline in margins.1 Banks and thrifts faced 

compelling incentives to add to interest rate risk exposures in 2001, including 

•	 the need to mitigate margin erosion, 

•	 rapid balance sheet turnover, and 

•a progressive steepening of the yield curve throughout the year. 

The current steepness of the yield curve indicates that 

most market participants expect interest rates, particularly short-term rates, to rise. Rising short-term rates are 

likely to adversely affect already depressed margins. 

The extent of this drain on an institution’s earnings perMargins Have Contracted Significantly 

NIMs at most community banks and thrifts2 in the 

Region have steadily declined since the mid-1990s, as 

shown in Chart 1. This long-term trend has largely 

resulted from intense competitive pressures that affected both loan pricing and funding costs. Competition for 

dwindling deposit growth in the late 1990s also contributed to a significant shift to wholesale funding 

sources and a subsequent incremental increase in funding costs at many institutions. This steady decline in 

margins occurred despite growth in loan-to-asset levels 

during the period that improved earning asset yields. 

During 2000, NIMs were further hampered by the flattening and eventual inversion of the yield curve. In late 

CHART 1 

Community Bank NIMs in the Region Fall 

4.90 Community Banks 

4.70

Median Net Interest Margin

formance will be largely influenced by current asset/ 

liability management strategies. Managers must carefully weigh the trade-off of extending assets in an effort to 

improve margins with the potential adverse effects such 

asset extension could have on future earnings during a 

period of rising interest rates. 

4.50 

4.30 

4.10 

3.90 

Large Banks 3.70 

3.50 

Sep Sep Sep Sep Sep Sep Sep Sep Sep Sep Sep 

’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00 ’01 

Source: Bank and Thrift Call Reports 1 Bank and thrift NIMs are affected by a multitude of factors, including competitive pressures, the level of interest rates and the shape of 

the yield curve, the mix of earning assets and funding sources, and the 

level of nonperforming assets. To some extent, changes in all of these 2 Community banks and thrifts are defined as those with less than 

factors placed downward pressure on margins during the preceding $1 billion in total assets that are not credit card lenders or specialty 

year. institutions such as trust banks. 

Memphis Regional Outlook 6	 First Quarter 2002 
Regional Perspectives
 

CHART 2 

Community Bank NIMs in Recent Quarters Were Affected by Interest Rate Changes 

Aggregate Net Interest Margin (right axis) 

Basis Point Spread between 3-Month Treasury 

Bills and 10-Year Treasury Notes (left axis) 

Net Interest Margin 

3.5 

3.7 

3.9 

4.1 

4.3 

4.5 

4.7 

–100 

–50 

0 

50 

100 

150 

200 

250 

Dec 

’00 

8.62 

4.54 

4.08 

5.11 

5.90 

–0.79 

Mar 

’01 

8.44 

4.42 

4.02 

4.92 

4.29 

0.63 

Jun 

’01 

8.22 

4.18 

4.04 

5.51 

3.66 

1.75 

Sep 

’01 

7.96 

3.87 

4.09 

4.59 

2.37 

2.22 

Aggregate Bank Earnings Performance Measures 

Dec Mar Jun Sep 

’99 ’00 ’00 ’00 

Yield on Assets 

Cost of Funds 

NIM 

Interest Rates
 

10 Years
 

3 Months
 

Spread 

8.24 

3.88 

4.36 

6.44 

5.33 

1.11 

8.21 

3.94 

4.28 

6.00 

5.87 

0.13 

8.42 

4.13 

4.29 

6.03 

5.85 

0.18 

1999, the Federal Reserve Board began to raise shortterm interest rates in an effort to slow what appeared to 

be an overheating economy. As the yield curve flattened 

during 2000, bank and thrift NIMs were adversely 

affected, as shown in Chart 2. In fourth-quarter 2000, 

the cost of funds increased while the yield on earning 

assets declined (see table that accompanies Chart 2).3 

A slowdown in loan growth, consistent with weakening 

economic conditions in the Region, and a dip in loan-toasset levels also hurt margins in fourth-quarter 2000 and 

first-quarter 2001. At the same time loan growth slowed, 

deposit flows increased, leaving banks with excess 

funds that were generally invested in lower-yielding 

Federal Funds sold positions.4 

Throughout 2001, interest rates declined sharply and the 

yield curve gradually steepened. The positive benefits 

of a steeper yield curve have been slow to accrue to 

3 The cost of funds for insured institutions is typically aligned with the 

short end of the curve because of the short-term nature of most funding sources. Conversely, yields on earning assets are often more closely associated with the intermediate and long end of the yield curve. 4 Federal Funds sold positions at community banks in the Memphis 

Region climbed from 2.1 percent of total aggregate assets on September 30, 2000, to 4.99 percent of total aggregate assets by March 31, 

2001. 

8.74 

4.48 

4.26 

5.80 

6.21 

–0.41 

Source: Bank and Thrift Call Reports 

most insured institutions. Banks and thrifts have been 

unable to lower funding costs commensurate with the 

steep reductions in asset yields because of high volumes 

of asset prepayments and calls (discussed below). 

Dramatic Asset Turnover Occurred in 2001, 

with Mortgage-Related Assets Most Affected 

Falling interest rates in 2001 induced many borrowers and 

bond issuers to refinance debt. Often, insured institutions 

preferred to voluntarily rework loans to a lower interest 

rate rather than potentially lose the borrowing relationship. Within securities portfolios, embedded call features 

and prepayment options were exercised. These refinancings and prepayments resulted in the reinvestment of a 

substantial volume of assets at lower interest rates. 

The decline in mortgage rates during 2001 led to a 

tremendous increase in mortgage refinancings (see Chart 

3, next page), eclipsing the activity during the last refinancing wave in 1998. The boom in mortgage lending 

undoubtedly contributed to increased fee generation for 

underwriters but threatened margins at institutions with 

considerable mortgage exposure because they were 

unable to reprice liabilities as rapidly as loans refinanced 

to lower interest rates. The refinancing wave also affected 

Memphis Regional Outlook 7 First Quarter 2002 
Regional Perspectives
 

insured institutions with substantial holdings of mortgage-backed securities (MBS) and mortgage derivative 

securities (MDS), as these securities, particularly the former, experienced accelerating prepayment rates. 

The mortgage refinancing wave also added to many 

institutions’ exposure to rising interest rates because of 

changes in product type. As shown in Chart 3, mortgage 

holders increasingly opted for fixed-rate rather than 

adjustable-rate mortgages. To the extent that these 

longer-term fixed-rate mortgages were retained in bank 

and thrift portfolios or indirectly purchased in the form 

of MBSs (see inset box), asset maturities and repricing 

intervals extended. 

Most Banks Reported Limited Asset Extension 

as of September 30, 2001, but the Incentive to 

Extend Intensified in the Fourth Quarter 

During the first nine months of 2001, most community 

banks5 reported a modest elongation of asset maturities. 

The level of long-term assets (assets with more than 

five years until maturity or repricing) held by all community banks in the Region rose from 15.8 percent of 

total assets at year-end 2000 to 16.4 percent as of September 30, 2001. 

Although community banks in aggregate reported only a 

limited increase in long-term asset levels during the first 

nine months of 2000, one group of banks, those with low 

loan-to-asset ratios,6 incurred greater asset extension. 

Long-term asset levels among this group increased from 

CHART 3 

Source: Mortgage Bankers Association of America 

Households Refinanced into Fixed Rate 

Mortgages during 2001 

Refinancing Index

Percentage of Applications in ARM Products 

ARM Product/Applications 

Refinancing 

Index 10 

30 

0 

5 

15 

20 

25 

35 

’91 ’93 ’95 ’97 ’99 ’01

0 

500 

1,000 

1,500 

2,000 

2,500 

3,000 

3,500 

5 Asset maturity data are not available for thrifts. 

Market Risk in Investment
 

Portfolios Increases
 

Mortgage-backed securities return to favor. Aggregate 

MBS and MDS holdings at community banks grew an 

unprecedented 44 percent during the first nine months 

of 2001 (59 percent annualized growth rate), rising 

from 18.4 percent of total securities at the beginning of 

the year to 26.8 percent by the end of the third quarter. 

This reverses a long-term trend of declining MBS and 

MDS balances dating from the mid-1990s. While the 

higher yields available on such instruments make them 

attractive in the current environment, MBSs and MDSs 

introduce additional portfolio management complexity, 

primarily in the form of increased optionality. Rising 

interest rates would likely trigger a slowdown in refinancing activity and, consequently, an extension of the 

weighted average lives of these securities, locking in 

suddenly below-market yields on these investments for 

a prolonged period. 

Investment portfolio maturity/repricing intervals 

extend. This extension occurred in both traditional 

fixed income securities (Treasury, agency, municipal, 

and corporate bonds) and MBSs. Significant call volume on traditional securities and prepayments on previously held MBSs caused extensive turnover in 

investment portfolios, allowing management the opportunity to restructure portfolios. The restructuring 

through the first nine months of 2001 reflects the decisions of many portfolio managers to pick up yield by 

extending maturities/repricing intervals. 

less than 20 percent of total assets at year-end 2000 to 

22.5 percent as of September 30, 2001. These banks 

appear to have faced greater margin pressures because of 

low loan volume potentially resulting from lower demand 

in their trade areas. As a result, managers at many of 

these banks likely attempted to stem margin compression 

by moving farther out on the yield curve. 

The asset extension that occurred during the first nine 

months of 2001 could continue at some institutions, as 

a potential “rate trap” developed in late 2001. The yield 

curve steepened considerably in the weeks just before 

September 30 and in the remaining months of 2001. 

This provided additional incentive for banks to invest in 

longer-term instruments. Short-term rates (3-, 6-, and 

6 The threshold used for this analysis was a 60 percent loan-to-asset 

ratio. As of September 30, 2001, 269 nonspecialty community banks 

in the Memphis Region—over one-third of the Region’s community 

banks—met this definition. 

Memphis Regional Outlook 8 First Quarter 2002 
Regional Perspectives
 

12-month rates) dropped by 140 to 170 basis points 

from August 31 to December 30. By comparison, longterm rates (10- and 30-year rates) rose slightly during 

this period. By year-end 2001, managers faced the alternatives of investing short term at less than 2 percent or 

picking up 250 to 300 basis points by investing in intermediate- or long-term loans or securities. 

Changing Deposit Trends Shorten Liabilities 

Even as assets extended during the first nine months of 

2001, depositors migrated to shorter-term products, 

leading to a modest contraction in liability maturities 

and repricing intervals. This change in customer preferences included an increase in aggregate balances of 

money market demand accounts and savings accounts 

(as a share of total deposits) and an increase in certificates of deposit with maturities of one year or less compared with longer maturity times. 

Many banks appear to be using longer-term wholesale 

funding to offset shortening deposit maturities.7 But as 

other borrowings represent less than 5 percent of aggregate liabilities among the Region’s community banks, 

this strategy seems unlikely to completely mitigate 

increasing price sensitivity resulting from changes elsewhere on the balance sheet. 

7 Call report information on other borrowing, such as Federal Home 

Loan Bank advances, is based solely on maturity with no consideration of repricing intervals. Therefore, it is possible that maturities 

were extended to provide a longer-term funding source but that the 

borrowings are repriceable in shorter periods. 

Interest Rate Risk Management Will Likely 

Become More Complex and Important in 2002 

The need for additional attention to interest rate risk 

considerations was demonstrated by the margin compression that occurred in late 2000 and early 2001. For 

many institutions, falling margins may have been 

largely unavoidable, but in some cases the decline also 

may have been largely unanticipated. Many asset/ 

liability management models were unable to measure 

the potential adverse effects of the nonparallel shift 

and inversion of the yield curve in 2000. Likewise, 

many models were not sufficiently dynamic to accurately gauge the level of asset turnover that accompanied the dramatic decline in interest rates during 2001. 

As a result, asset/liability management strategies that 

were implemented based on the results of these tools 

may have fallen short of their goals. 

The potential for continuing interest rate volatility, 

this time in a rising rate environment, suggests that 

sound asset/liability management policies and practices will be particularly critical to future earning performance. At a minimum, managers should ensure 

that measurement processes provide for an accurate 

assessment of the effects of changing interest rates on 

performance and that their institutions are operating 

within sound risk tolerances established by policy or 

board direction. 

Robert L. Burns, Senior Financial Analyst 

Memphis Regional Outlook 9 First Quarter 2002 

In Focus This Quarter
 

Housing Market Has Held Up Well in This 


Recession, but Some Issues Raise Concern
 

Trends in housing markets are important performance 

drivers for many FDIC-insured institutions. The health of 

residential markets can affect the credit quality of residential mortgage loans, home equity loans, and loans to 

finance residential construction and is linked indirectly to 

the performance of other types of consumer and smallbusiness debt. Further, an estimated $2 trillion in mortgage debt, approximately one-third of the mortgage 

market, was underwritten during 2001, with 56 percent of 

this activity in refinancing transactions.1 This activity 

makes recent trends in underwriting of particular interest. 

An ancillary issue for many mortgage lenders, interest 

rate risk, is not addressed in this article.2 

The U.S. economy entered a recession in March 2001, 

and the question arises as to how consumer creditworthiness, housing values, and recent mortgage-lending 

practices will fare during this downturn. Developments 

contributing to increased credit risk include higher consumer debt burdens, looser mortgage loan underwriting 

standards, and the emergence of subprime mortgage 

lending as a significant line of business for some banks. 

Mitigating this risk has been the steady appreciation of 

home prices, which have shown signs of softening in 

some markets but not to the extent seen at a comparable 

stage in previous recessions. 

Home price weakness may be more pronounced in 2002 

as the effects of the recession take hold, but in the 

authors’ judgment, systemic weakness in home prices is 

unlikely, absent a deep and long recession. Adverse mortgage lending trends are not expected to threaten the capital or earnings of the vast majority of insured 

institutions. Nonconstruction residential mortgages, even 

during the most pronounced periods of stress in the 1980s 

and early 1990s, remained the best-performing loan 

class, especially for lenders specializing in residential 

real estate; and, historically, these mortgages have been 

1 Mortgage Market Forecast, www.mbaa.org/marketdata/forecasts/,
 

January 2002.
 

2 For a discussion of this issue, see “Regional Perspectives,” Boston
 

and Chicago Regions, Regional Outlook, First Quarter 2002.
 

one of the lowest credit-risk loan types for all manner of 

insured institutions.3 

That said, however, there are pockets of risk for 

insured institutions. There is evidence that borrowers 

with weak credit may be experiencing greater repayment difficulties, elevating the risks faced by subprime 

mortgage lenders. Further, a slump in residential real 

estate markets could be especially detrimental to 

insured institutions with significant exposures to 

housing construction because projects might not sell at 

projected asking prices or as quickly as anticipated. 

Finally, in specific markets where housing prices may 

have achieved unsustainable levels, some increase in 

housing-related credit quality problems can be expected, and in this regard, the San Francisco Bay area 

stands out as a place to watch. 

The Recession Thus Far Has Had 

a Minimal Impact on Mortgage 

Delinquencies at Insured Institutions 

Despite three quarters of recession, most housing indicators remained quite healthy this past year relative to 

trends seen in past recessions. For example, new and 

existing home sales both set records during the year, 

while new home construction failed to decline, an 

occurrence not seen in the past six recessions. Another indicator, year-over-year growth in existing home 

prices—as measured by either the Office of Federal 

Housing Enterprise Oversight (OFHEO) repeat sales 

price index or the National Association of Realtors 

(NAR) median single-family price statistic—showed 

deceleration but remained well above trends seen at 

similar points in past recessions. This behavior partly 

reflected the early robustness of household income in 

the face of recession and relatively low fixed mortgage 

rates during 2001, which helped to counter some of the 

3 See “Region’s Insured Institutions Exhibit Lower Risk Profile than 

the Nation’s, Appendix: Risk-Weighting Methodology,” Table A in 

Boston Region, Regional Outlook, First-Quarter 2000. 

Memphis Regional Outlook 11 First Quarter 2002 
In Focus This Quarter
 

CHART 1 CHART 2 

Through September 2001, Mortgage-


Related Delinquencies Remained Modest
 

Although the Much Larger Market for 

Existing Homes Has Held Up, New Home 

Prices Are Under Pressure 

Percentage Change from

Prior Year 

Sources: Census (new), National Association of Realtors (Existing) 

Existing 

New 

–10 

–5 

0 

5 

10 

15 

20 

,

79 ,81 ,83 ,85 ,87 ,89 ,91 ,93 ,95 ,97 ,99 ,

01 

Percentage 

30+ Days Past Due 

0 

2 

4 

6 

8 

10 

12 

,

91 ,93 ,95 ,97 ,99 Sep ,

01 

0 

1 

2 

3 

4 

5 

6 

Percentage 

30+ Days Past Due 

95th Percentiles (R) 

mortgages equity lines 

75th Percentiles (L) 

NOTE: Sample consists of banks with at least $1 million in equity lines 

or mortgages that are also at least 5 percent of bank's Tier 1 capital. 

Source: Bank and Thrift Call Reports 

initial adverse effects of the recession on housing 

demand. 

One sign of potential weakness appeared late in 2001 

in the modest year-over-year decline in median prices 

of new single-family homes (see Chart 1). Because 

existing home sales outnumber new home sales roughly fivefold, price trends in the latter are generally not 

predictive of prices for the much larger existing home 

market.4 However, as discussed later in this article, 

adverse pricing trends in the new home segment do 

raise concerns for residential developers and insured 

institutions that finance residential construction. 

The steady increase in prices of existing homes depicted in Chart 1 masks considerable regional variation. 

As detailed later in this article, home price growth 

began to weaken in 2001 in a number of metropolitan 

statistical areas (MSAs). While there is no clear common denominator among the markets in which this 

occurred, a number of these markets had both extremely rapid home price growth in the recent past and significant slowdowns in employment growth or outright 

contractions in employment last year. 

Credit quality indicators for insured institutions’ mortgage loans have shown only preliminary signs of 

weakness thus far. Through the first nine months of 

2001, insured institutions showed negligible advances 

in median past-due ratios for mortgages and equity 

4 Existing home prices are also more reflective than new home prices 

of trends in broader economic indicators, such as aggregate per capita personal income. 

lines of credit, although continued strong mortgage 

origination activity in 2001 may have masked (in the 

aggregate) developing credit problems for more seasoned mortgage loans. For institutions that held at 

least $1 million in residential mortgages or home equity lines of credit and whose exposures comprised at 

least 5 percent of Tier 1 capital, some modest deterioration is evident in the worst-performing mortgages 

and home equity lines since 1999, as seen in Chart 2.5 

Even if this recession lingers, worsens, or both, residential mortgage lending (nonconstruction and development-related) likely poses only modest risk to most 

insured institutions’ earnings and capital, since it has 

held up better in prior recessions than other loan types. 

What Are the Risks Facing Housing 

Lenders in 2002 and Beyond? 

In an environment of significantly slower economic 

growth than prevailed during the 1990s, can the 

strength of housing prices and the relatively benign 

credit quality environment for housing lenders be 

expected to continue? The answer will depend on the 

interplay of economic conditions and lenders’ risk profiles. In the remainder of this article, we discuss the 

gradual increase in the risk profile for insured mortgage lenders that appears to have occurred during the 

5 It is interesting to examine the (adverse) tail of the credit quality distribution when looking at residential mortgage trends, as average and 

median past-due ratios move little and are typically very low—thus, 

only the highest 25th and 5th percentiles of past-due ratios are presented in Chart 2. 

Memphis Regional Outlook 12 First Quarter 2002 
, UT

Miami– 

y, NY

Phoenix, AZ

, NV–AZ 

, MO–IL 

Tucson, AZ

Oklahoma City

, NY

, OK 

Kansas City

Tulsa, OK

, MO–KS

, NC–SC 

mingham, AL

, TN-AR–MS

Honolulu, HI

, SC 

Entire Nation

, FL

e City

alo

ville

 Lauderdale

Alban

Buff

 Louis

Green

egas

lotte

Salt Lak

Memphis

Las V

Char

St.

Bir

Ft.

In Focus This Quarter
 

1990s, as well as some cyclical risks to their performance that may exist as the recession plays out. 

Evolving Lending Practices Have Increased 

the Risk Profile for Mortgage Lenders 

Although history suggests that residential mortgage 

defaults will be relatively low even in a recession, 

changes in the mortgage market since the 1990–1991 

recession could affect mortgage performance during the 

present downturn. Many underwriting changes over the 

past decade have been driven in part by the growing 

importance of the secondary market for mortgage debt, 

and of Fannie Mae and Freddie Mac in particular. In 

1980, federal and related agencies had direct or indirect 

interests in approximately 17 percent of all mortgage 

debt.6 By 2000, their share of the mortgage market had 

increased to roughly 41 percent. Insured bank and thrift 

mortgage exposures grew over the same period, but, as 

a share of direct mortgage debt, bank and thrift mortgage holdings decreased from 59 to 35 percent. These 

trends notwithstanding, insured institutions still provide 

substantial funding, directly or indirectly, to the housing 

market: as of September 30, 2001, 1 to 4 family mortgage loans and mortgage-backed securities held by 

insured institutions aggregated $2.3 trillion, up 37 percent from five years earlier. 

Although an active secondary mortgage market has 

broadened homeownership, improved mortgage loan liquidity, and allowed insured institutions to allay credit 

risk, it has also heightened market competition and transformed the lending process. In presecondary market 

CHART 3 

1993 2000 

days, lenders largely had to retain originated mortgages 

in their own portfolios. Consequently, only lenders with 

ready funding sources (such as banks, thrifts, and insurance and finance companies) were able to compete in the 

mortgage markets. The advent of the secondary market 

enlarged the pool of available funding and permitted both 

insured institutions and other originators to transfer their 

mortgage business readily into entities such as mortgage 

pools and trusts. Consequently, many new players, 

including on-line and brick-and-mortar mortgage brokers, have entered the mortgage origination market. 

The resulting robust mortgage loan competition, combined with Internet-based consumer research tools, has 

led to considerable commodification of the mortgage 

market. Rather than competing on the basis of traditional 

relationships, lenders’ market shares are increasingly 

driven by price. For smaller savings institutions that focus 

heavily on residential mortgage underwriting, this issue 

has likely elevated business risk. Heightened competition 

has caused some loosening of mortgage underwriting 

standards and pushed lenders to use technology to expedite and streamline the underwriting process. Consequently, credit-scoring mechanisms and automated 

valuation techniques currently in place have not been 

tested through a full credit cycle. Because pricing competition has pressured margins, some mortgage lenders 

have pursued subprime or high loan-to-value (HLTV) 

mortgages. The ability of insured institutions to mitigate 

subprime losses through an economic downturn is untested to a large extent as well—finance companies dominated the high-risk mortgage market in past recessions. 

High Loan-to-Purchase Price Ratios Are Increasingly Common in Some Metro Areas 

Percentage of Mortgages with Loan-toPurchase Price Ratios Exceeding 90 Percent 

60 

40 

20 

0 

Source: Federal Housing Finance Board 

6 These interests include residential, commercial, and farm real estate debts held directly by, or held in mortgage pools or trusts issued by, federal 

and related agencies. Source: Table 1186, Statistical Abstract of the United States: 2001, page 733. 

Memphis Regional Outlook 13 First Quarter 2002 
In Focus This Quarter
 

In general, mortgage underwriting standards have loosened industrywide over the past decade. For instance, 

lenders have increasingly accepted higher loan-topurchase price (LTPP) ratios for purchase money mortgages.7 According to the Federal Housing Finance 

Board, LTPP ratios are high and have risen in several 

metropolitan areas over the past seven years (see Chart 3). 

Between 1993 and 2000, the Honolulu, Tulsa, and Tucson markets exhibited the largest increases in mortgages 

with LTPP ratios exceeding 90 percent. 

Although lenders often mitigate the risk of loss associated with low downpayments by requiring private mortgage 

insurance (PMI), recently the mortgage industry has 

allowed borrowers to avoid purchasing PMI. In particular, 

“piggyback” financing has made homeownership 

increasingly possible for households that cannot afford 

the traditional 20 percent down payment or do not wish to 

pay for PMI. With piggyback financing, the borrower 

often arranges a conforming 80 percent LTPP first mortgage and finances a portion of the remaining 20 percent 

with a concurrent second mortgage on the property (e.g., 

“80-10-10”). This type of transaction has become popular 

because interest paid on the (albeit more expensive) second mortgage is tax-deductible, whereas PMI premiums 

are not. Thus, piggyback financing is probably most 

attractive to individuals in higher-cost/tax areas or higher 

tax brackets, such as those in the Northeast and California. This trend effectively shifts the first loss position 

on all low down payment loans to the lender that 

retains the junior position. These institutions are, of 

course, compensated for some of this risk with the 

higher interest rates charged on the piggyback portion 

of these mortgages. 

Competitive factors have prompted the industry to 

enhance underwriting automation. As part of the push, 

credit scoring has become a routine part of the credit 

analysis process, and, increasingly, lenders are using 

automated valuation models (AVMs) to determine collateral coverage. However, credit scoring and collateral valuation models have been in popular use only 

since the 1990–1991 recession; consequently, their 

predictive ability in a downturn is uncertain. Although 

some have touted AVMs as the answer to appraisal 

fraud, the ability of statistical models to simulate the 

qualitative judgments considered critical to traditional 

appraisals is unknown. Paper appraisals reportedly 

7 Purchase money mortgages are loans extended solely for the initial 

purchase of a home. Statistics on loan-to-value ratios for supplemental home equity loans/lines (e.g., piggyback or “80-10-10” financing), as well as refinanced mortgages, are not readily available. 

continue to dominate the industry; however, recently, 

the two largest government-sponsored enterprises have 

begun accepting AVMs in lieu of standard appraisals 

for loans under $275,000.8 For lenders that specialize 

in HLTV mortgages, there is less room for error with 

AVMs. 

Cyclical Weakness Is Already Apparent 

in Subprime Mortgage Lending 

Historically, certain insured institutions have made 

mortgage loans with narrow collateral margins or to 

borrowers with limited or blemished credit histories. 

However, significant entry by FDIC-insured institutions into mortgage lending to borrowers with weak or 

marginal credit, as a targeted line of business, generally has occurred only since the early 1990s. These 

“subprime” mortgages are neither defined nor reported on Bank Call Reports. As a result, gauging the 

extent of bank involvement in subprime lending at any 

point in time is difficult. However, the FDIC estimates 

that fewer than 1 percent of all insured institutions 

have significant subprime residential mortgage exposures. Nevertheless, according to some measures, subprime mortgages as a share of total mortgage 

originations peaked at 13 percent in early 2000, before 

moderating somewhat during the first three quarters of 

last year.9 Thus, a much larger number of institutions 

probably have some limited involvement in subprime 

mortgage lending. A survey by the Minneapolis Federal Reserve Bank found that 29 percent of banks in 

the Minneapolis District offered loans to low-credit 

quality consumer borrowers in 1999.10 

Subprime mortgage loan performance appears to have 

deteriorated notably during 2001. One source of support for this observation comes from delinquency 

trends on Federal Housing Agency (FHA)-insured 

mortgages, which are often granted to first-time homebuyers with troubled credit histories and borrowers 

with low down payments. The Mortgage Bankers 

Association reports that while the national delinquency rate on conventional mortgages rose 58 basis points 

in the year ending third-quarter 2001, the delinquency 

rate on FHA mortgages shot up by 234 basis points, to 

11.4 percent (see Chart 4). This growing gap between 

8 “Automated Appraisals Require Caution by Lenders,” American 

Banker, October 10, 2001. 9 Based on dollar volumes, data from Inside Mortgage Finance Publications, Bethesda, MD. 

10 Ron Feldman and Jason Schmidt, “Why All Concerns About Subprime Lending Are Not Created Equal,” Fedgazette, Minneapolis 

Federal Reserve, July 1999. 

Memphis Regional Outlook 14 First Quarter 2002 
In Focus This Quarter
 

CHART 4 

Recent Mortgage Delinquencies for HigherRisk Loans Reached All-Time Highs 

Percentage of Mortgages

30+ Days Past Due

FHA 

Conventional 

,

79 ,81 ,83 ,85 ,87 ,89 ,91 ,93 ,95 ,97 ,99 ,01 

0 

2 

4 

6 

8 

10 

12 

Source: Mortgage Bankers Association 

delinquency rates on conventional and governmentinsured mortgages suggests that marginal and subprime borrowers are facing growing repayment 

difficulties. 

A database of more than 6.5 million subprime loans 

tracked by Loan Performance Corporation (formerly 

Mortgage Information Corporation) reported similar 

trends. The nationwide third quarter 2001 ratio of seriously delinquent subprime mortgages was 7.3 percent, up 

from 5.5 percent one year earlier.11 Moreover, subprime 

delinquencies significantly exceeded those found among 

prime mortgages, as just under 0.5 percent of conventional prime mortgages were seriously delinquent.12 Also 

of possible concern are vintage data trends, which show 

how pools of primary and junior-lien subprime mortgages perform over time. Mortgages originated in 2000 

are performing poorly in relation to previous years’ vintages.13 This simply could reflect the impact of the current 

recession. Alternatively, Loan Performance Corporation 

analysts have suggested that the 2001 refinancing boom 

might have created some adverse selection in mortgage 

pools originated during the relatively higher interest rate 

environment of late 1999 and early 2000.14 Because high11 The Market Pulse, Loan Performance Corporation (formerly Mortgage Information Corporation), Winter 2001 and Fall 2001. 

12 The Market Pulse, Loan Performance Corporation, Fall 2001. 13 Per Loan Performance Corporation delinquency data, subprime primary mortgages originated in 2000 displayed higher delinquency 

ratios for their age compared with similarly seasoned subprime loans 

originated in 1996, 1997, 1998, or 1999. Moody’s second-quarter 

2001 Home Equity Index Update found the same to be true of subprime home equity loans. 

14 “Another Look at the 2000 Book,” The Market Pulse, Loan Performance Corporation (formerly Mortgage Information Corporation), 

Winter 2001. 

er-coupon and variable-rate loans comprised a significant 

share of mortgage originations during that period, overall 

prepayment rates on the 2000 vintage might have been 

unusually high during 2001. Consequently, the best-quality loans in the 2000 pool might have refinanced, leaving 

loans of lesser credit quality behind and elevating the 

residual delinquency experience in that pool. 

Given these trends, an important issue for subprime 

lenders is their ability to anticipate and plan for the 

impact of an economic slump on their operations. Some 

institutions clearly adopt subprime lending as part of an 

overall business strategy, setting up monitoring and collection departments geared to dealing with such loans. 

Among large, national lenders, for example, one institution that makes 5 to 10 percent of its loans to subprime 

borrowers recently provided additional resources to its 

loan services and default management departments. This 

action followed a period when one-third of its increase in 

nonperforming single-family mortgage loans was associated with loans to subprime borrowers.15 

C&D Lending Risks May Be Elevated in MSAs 

with Potential Supply/Demand Imbalances 

Historically, lending to finance housing construction is 

riskier than mortgage lending on existing structures. 

Insured institutions report construction and development 

(C&D) lending in a single category that includes both 

commercial and residential construction. While it is thus 

impossible to ascertain from quarterly call reports the 

extent of bank involvement in financing housing construction, anecdotal evidence suggests that, although 

smaller insured institutions engage to some degree in 

commercial property development, their C&D lending 

largely finances single-family construction. If markets 

with an oversupply of housing see weaker economic performance, insured institutions engaged in financing residential real estate development may be at risk. This could 

result in an increase in C&D loan delinquencies, losses, 

and other-real-estate-owned (OREO). 

Demand for housing can be affected by two distinct 

trends: secular, or longer term; and cyclical, or shorter 

term. Over the long term, demographic trends, such as 

population growth rates and concentrations of households by age cohort, can affect overall demand for housing, as well as the types of homes demanded. Demand in 

local housing markets also can be affected by more cyclical factors such as recent changes in economic 

15 Calmetta Coleman, “Default Worries on Home Loans Escalate as 

Lenders Report Delinquency,” Wall Street Journal, October 29, 2001. 

Memphis Regional Outlook 15 First Quarter 2002 
In Focus This Quarter
 

conditions, including interest rates. New supply of homes 

in local housing markets is produced in response to perceived or estimated future demand. Correct interpretation 

of market and economic signals is critical to the success 

of builders in metropolitan areas; however, this activity is complicated by the lags associated with developing, permitting, and constructing properties. The effect 

of overestimating future demand could be multiplied if 

several builders inaccurately gauge changes in 

demand. Consequently, a construction market with 

numerous smaller developers, such as Atlanta, may 

see amplified swings in construction activity and may 

experience excess supply during certain periods. 

Although conceptually straightforward, measuring the 

balance between housing demand and supply is challenging, particularly at lower geographic levels. Shortcomings in data availability, quality, and timeliness 

can limit the effectiveness of this type of analysis. As 

already mentioned, some insight about current housing 

market conditions in specific metropolitan areas may 

be gained by analyzing both secular and cyclical 

trends. However, given the onset of recession last year, 

the role of cyclical factors is of prime concern at this 

time. 

To measure the cyclical aspect of the relationship 

between a market’s supply and demand, some analysts 

rely heavily on the concept of employment-driven 

demand.16 Such analysis involves tracking a demand/ 

supply ratio based on employment growth and permit 

issuance. Areas where permitting activity continues to 

accelerate while employment levels decrease may produce an increasing imbalance in the local housing 

market.17 

Using a simplified version of employment-driven 

demand, we identified a number of metropolitan areas 

as being at risk for a rising imbalance in their housing 

markets (see Chart 5), the largest of which are Chicago, Greensboro (NC), Minneapolis, Phoenix, Portland (OR-WA), St. Louis, and, most notably, Atlanta. 

These markets are displaying signs that residential 

16 For example, see www.myersgroup.com. 17 This approach, although more reflective of recent economic events 

than perhaps more secular measures, is not without its drawbacks. For 

example, employment data from the Bureau of Labor Statistics’ establishment survey are frequently revised, and, consequently, employment-driven demand may need to be reexamined. 

CHART 5 

–120 

–100 

–80 

–60 

–40 

–20 

20 

40 

60 

(5,000) (2,500) 2,500 5,000 

December 2001 Year-to-Date Permits 

(Year-Ago Change) 

December 2001 Employment

(Year-Ago Change, Thousands) 

Sources: Bureau of Labor Statistics, U.S. Census Bureau (Haver Analytics) 

Some Larger MSAs Continued to See 

Permit Growth during 2001, despite 

Declining Employment 

0 

Greensboro, 

Minneapolis, 

& St. Louis 

Chicago 

Atlanta 

Portland, OR–WA 

Phoenix 

construction activity may not be responding in kind to 

local economies that have started to contract during 

this recession. Further, Phoenix, Portland, and Atlanta 

were identified previously as banking markets exhibiting elevated risk profiles.18 

Chart 6 displays the level (y axis) and trend (x axis) in 

C&D lending exposures for the top 25 MSAs by median C&D concentration as a share of assets.19 It is 

apparent that some markets identified in Chart 5 as 

having significant banking exposure to C&D lending 

also may have a cyclical imbalance in home building. 

Atlanta, for example, demonstrates one of the highest 

exposures, with a ratio of median C&D to total assets 

of 17 percent in third-quarter 2001, a roughly 100­

basis-point increase from year-end 2000. In other 

words, while employment-driven demand has softened 

in the metropolitan area, single-family construction 

activity has continued, and community bank lenders 

may have increased their level of residential financing 

commitments. 

Cyclical Risks May Be Developing 

with Respect to Home Prices 

Popular comparisons have been made recently 

between the healthy run-up in housing prices during 

18 See “In Focus This Quarter,” Regional Outlook, Fourth-Quarter 

2001. 

19 We considered only MSAs that had at least six locally headquartered community banks that engaged in C&D lending activity and 

then charted the top 25 MSAs ranked by September 2001 median 

C&D/assets. 

Memphis Regional Outlook 16 First Quarter 2002 
In Focus This Quarter
 

CHART 6 

Some Banking Markets Are Seeing Rising Construction and Development (C&D) 

Exposure Coupled with Potentially Growing Supply/Demand Imbalances 

Sources: Bank Call Reports, Bureau of Labor Statistics, U.S. Census Bureau (Haver Analytics) Median C&D Loans-to-Assets (Third-Quarter 2001, %) 

0 

5 

10 

15 

20 

25 

30 

Change in Median C&D Loans-to-Assets 

(Percentage Point Change, from Fourth-Quarter 2000 to Third-Quarter 2001) 

–2 0 2 4 6 8 10 

Salt Lake City 

Atlanta Provo-Orem, UT 

Stockton, CA 

Greensboro 

Portland, OR–WA 

Phoenix 

MSAs with declining employment

 but rising permitting during 2001 

the past several years and the technology stock-fed 

speculative “bubble” in equity prices that persisted 

through early 2000. The subsequent bursting of this 

bubble and the resulting economic distress have raised 

concerns of a sequel featuring housing prices. 

According to the OFHEO repeat sales price index, 

there has never been an instance of outright declines in 

aggregate U.S. existing home prices.20 However, home 

prices do exhibit strong cyclical tendencies, with the 

rate of appreciation slowing during national recessions. In addition, there have been some decidedly 

CHART 7 

negative episodes during the past few decades in various metropolitan markets. At the national level, existing-home price growth historically has followed trends 

in population-adjusted personal income growth,21 and 

some have pointed to a growing imbalance between 

the two as a sign that home prices may weaken as the 

effects of the recession take hold (see Chart 7). 

Given that home price bubbles have occurred in the 

past, most notably in Texas, California, and the Northeast during the 1980s, and that their ultimate deflation 

MAP 1 

Change on Year Ago (%) Note: E=estimate 

Sources: OFHEO, U.S. Census Bureau 

The Widening Gap between Home Price and 

Income Growth Has Raised Some Concern 

Per Capita Income 

Home Price Index 

’85 ’87 ’91 ’93 ’97 ’01E ’89 ’95 ’99 

0 

2 

4 

6 

8 

10 

Drops in Affordability since the Mid-1990s
 

Are Most Prevalent in California 


and the Northeast
 

Top 10 percent of
 

MSAs ranked by decline
 

in affordability index, 1996
 

to 2001 (through June)
 

NOTE: Anchorage, AK, is included, but not shown. 

Source: Economy.com 

20 According to the National Association of Realtors’ U.S. median price, a few episodes of price declines (on a quarterly, year-ago basis) are present in the time series—specifically first- and second-quarter 1989; fourth-quarter 1990; and first-quarter 1993—only the 1990 episode occurred
 

during a recession. Also, as shown in Chart 1, U.S. median new home prices have experienced meaningful declines.
 21 This relationship is generally true at the metropolitan level as well.
 

Memphis Regional Outlook 17 First Quarter 2002 
In Focus This Quarter
 

resulted in significant negative fallout for these areas’ 

economies and insured institutions, it is useful to look 

at these historical examples as a potential “worst-case” 

scenario (with very low probability) for residential 

real estate markets during the current recession. It is 

unlikely that significant, systemic risks from home 

price bubbles have arisen yet for residential lenders. 

Of course, this situation could change if the current 

recession deepens or is protracted, or if growth during 

the subsequent recovery is anemic. Further, national 

trends can obscure dramatic variations in local markets, and a handful of MSAs today are coming off several years of rapid home price growth and falling 

affordability. These markets, and the residential lenders 

targeting them, may be more at risk as local economic 

growth falters. 

Map 1 shows markets that have seen the most significant reductions in affordability (sharp price gains) 

during the past several years. Not surprisingly, many 

of them—namely larger cities in California and the 

Northeast—are those that historically have seen the 

biggest swings in prices and a penchant for speculative 

excess. 

In markets with rapidly declining affordability, credit 

risk arises from the increasing likelihood that new 

borrowers will commit a greater share of household 

financial resources to meet monthly payments. Credit 

problems could become more readily apparent given 

any subsequent disruptions to employment or income 

in these markets—especially among households with 

limited wealth or that require multiple job holders to 

meet mortgage payments. These risks may be amplified by the increased underwriting of HLTV and subprime mortgages during the past decade. 

Disruptions to aggregate household liquidity from lost 

employment or decreased income can result in rising 

mortgage delinquencies. With respect to foreclosures, 

however, some research has suggested that the decline 

in prices relative to the balance owed on the mortgage 

(rising loan-to-value ratio) is the most significant factor.22 Even in instances of prolonged job/income loss, 

owners with positive equity are likely able to sell their 

22 For instance, “Mortgage Default Risk and Real Estate Prices: The 

Use of Index-Based Futures and Options in Real Estate,” Case, 

Shiller, & Weiss, NBER Working Paper #5078, NBER, April 1995, 

finds this to be the case, while citing past work that identified the link 

between rising LTVs and foreclosure rates. 

CHART 8 

Rising Foreclosure Rates Followed Falling 

Home Prices in New England a Decade Ago 

Sources: OFHEO (prices), Mortgage Bankers Association (foreclosures) 

Annual Home Price Change (%) 

’79 ’84 ’89 ’94 ’99 

Inverse 

Price (R) 

Foreclosure (L) 

–20 

–10 

0 

10 

20 

30 

Foreclosure Started

(% of Existing Loans) 

0.00 

0.10 

0.20 

0.30 

0.40 

0.50 

homes profitably, thus avoiding foreclosure. Chart 8 

shows the strong relationship between declining home 

prices and increasing foreclosure rates in New England a decade ago (the chart plots the inverse price 

change in order to emphasize the relationship).23 

The data available through late 2001 were mixed with 

respect to home resale price trends at the MSA level. 

On the one hand, while existing home prices as measured by the OFHEO home price index showed no 

markets with year-over-year price declines in fourthquarter 2001, NAR’s median resale price metric did 

show about a dozen markets with year-over-year 

declines, none exceeding four percent. A deceleration 

in year-over-year home price growth was evident for 

many markets (and the nation) using either measure. It 

should be noted that the OFHEO data do not include 

sales of high-priced homes and are less influenced by 

changes in the mix of homes sold than are average and 

median prices;24 this issue is more meaningful in the 

nation’s most expensive markets, such as MSAs in the 

23 In states where dominant metro areas have seen large price declines 

in past years, such as Massachusetts, this relationship is more pronounced than in larger states or the nation as a whole. For example, 

the two-decade correlation between foreclosures started and price 

change is –78 percent in Massachusetts versus roughly –60 percent in 

both California and the nation. 

24 Data are obtained from aggregating repeat sales or refinancings of 

the same properties over time and using statistical methods to calculate an overall rate of home price appreciation for each market. Sampled properties are confined to those whose mortgages are 

“conventional” and do not exceed a conforming loan limit (set at 

$275,000 in 2001) required for securitization through Fannie Mae and 

Freddie Mac. For more information, see www.ofheo.gov/house/. 

Memphis Regional Outlook 18 First Quarter 2002 
In Focus This Quarter
 

TABLE 1 

As Recession Evolved, Home Price Appreciation Waned through 2001 

...Further Deceleration in Growth (or Declines) May Be Possible in 2002 

ANNUAL PERCENT CHANGES 

MSAS RANKED 

BY DECELERATION 

IN HOME PRICE INDEX 

FROM 1Q01 TO 4Q01 

OFHEO HOME PRICE INDEX 

NONFARM 

EMPLOYMENT 

1998– 

2000 1Q01 2Q01 3Q01 4Q01 

1998– 

2000 2001 

UNITED STATES 6.3 9.6 9.1 8.8 6.9 2.4 0.3 

SAN JOSE CA PMSA 17.7 24.4 16.9 8.4 0.6 3.4 –0.4 

SANTA CRUZ-WATSONVILLE CA 

PMSA 16.8 25.7 17.3 11.9 5.9 N/A N/A 

SAN FRANCISCO CA PMSA 16.5 19.4 13.9 9.1 3.5 3.3 1.3 

SALINAS CA MSA 13.7 24.3 22.4 19.0 9.4 3.3 0.9 

SANTA ROSA CA PMSA 14.8 22.7 19.6 13.6 8.6 4.1 1.6 

OAKLAND CA PMSA 14.7 22.3 18.0 14.1 8.2 3.4 2.0 

AUSTIN-SAN MARCOS TX MSA 9.4 15.2 12.1 7.7 5.0 5.9 2.1 

MERCED CA MSA 6.4 24.6 21.8 17.3 15.7 N/A N/A 

JAMESTOWN NY MSA 4.9 9.9 0.8 7.4 1.6 N/A N/A 

STOCKTON-LODI CA MSA 9.0 22.8 25.2 20.6 14.9 3.7 3.0 

WHEELING WV-OH MSA 4.1 10.8 7.7 11.7 3.7 1.1 –0.5 

GOLDSBORO NC MSA 4.0 7.9 3.2 1.6 0.9 N/A N/A 

CUMBERLAND MD-WV MSA 2.7 8.6 8.4 8.1 1.8 N/A N/A 

LEWISTON-AUBURN ME NECMA 4.2 14.0 8.6 10.1 7.1 4.4 –0.4 

BANGOR ME NECMA 3.7 13.2 7.4 9.3 6.5 N/A N/A 

FARGO-MOORHEAD ND-MN MSA 4.0 11.1 6.5 5.4 4.6 2.1 –0.3 

BARNSTABLE-YARMOUTH MA 

NECMA 12.8 17.6 14.5 14.6 12.5 3.9 1.3 

PINE BLUFF AR MSA 2.2 6.6 9.7 5.0 0.3 0.8 –1.7 

DUBUQUE IA MSA 3.9 8.8 6.0 6.9 2.5 1.1 –0.6 

BOULDER-LONGMONT CO PMSA 10.9 14.6 11.7 11.7 8.3 5.1 3.2 

DENVER CO PMSA 11.1 13.7 11.8 10.9 7.9 3.8 2.3 

UTICA-ROME NY MSA 3.5 14.6 9.5 8.4 9.1 2.4 0.1 

VALLEJO-FAIRFIELD-NAPA CA PMSA 11.8 20.0 19.1 16.6 14.7 4.7 2.8 

BRYAN-COLLEGE STATION TX MSA 4.8 11.1 2.1 5.6 5.8 4.0 0.7 

SAN DIEGO CA MSA 11.8 15.6 13.8 12.9 10.4 4.3 2.7 

SAN LUIS OBISPO-ATASCADERO­ PASO ROBLES CA MSA 11.4 19.2 18.0 17.8 14.2 N/A N/A 

TUCSON AZ MSA 3.3 8.6 8.0 6.8 3.6 3.5 0.8 

JERSEY CITY NJ PMSA 8.0 11.1 17.6 13.7 6.2 2.1 2.7 

CLARKSVILLE-HOPKINSVILLE TNKY MSA 3.3 9.1 4.2 6.5 4.2 N/A N/A 

RAPID CITY SD MSA 6.2 8.9 9.3 7.7 4.1 3.1 0.1 

LA CROSSE WI-MN MSA 5.7 7.4 5.8 5.1 2.6 2.3 1.0 

ST. CLOUD MN MSA 6.9 10.4 8.5 9.4 5.7 3.8 1.4 

Sources: Office of Federal Housing Enterprise Oversight (OFHEO), Bureau of Labor Statistics 

Memphis Regional Outlook 19 First Quarter 2002 
 

In Focus This Quarter
 

San Francisco Bay Area25 and parts of the Northeast, 

since prices for high-end homes (typically financed by 

jumbo mortgages) may be more volatile over the economic cycle. 

Table 1 lists markets whose 2001 deceleration in home 

price growth was in the top 10 percent of the more 

than 300 metro areas for which the OFHEO statistic is 

available. The table also provides (where available) 

each MSA’s recent employment trend as an indicator 

of overall economic conditions. These markets may yet 

see even more pronounced deceleration in home price 

growth or even declines in home prices this year (as 

may others not shown). This possibility will be determined for the most part by the performance of each market’s local economy. 

The metro areas in the table are 

ordered by the magnitude of their 

deceleration in home price growth 

over the initial quarters of this recession. As a result, the marked deceleration in year-over-year price 

growth in the recently overheated 

San Francisco Bay Area puts many of its MSAs near the 

top of the list. In the table, San Jose, San Francisco, 

Oakland, Denver, and San Diego also previously were 

identified as banking markets with elevated risk profiles.26 For some of the smaller MSAs in Table 1 with 

more volatile appreciation rates, such as Utica and 

Fargo, comparisons of recent price trends are more 

appropriate using the 1998–2000 average as a benchmark, as these markets experienced pronounced spikes in 

year-ago price growth during first-quarter 2001. 

It is hard to generalize about which markets will see the 

most pronounced home price weakness as the recession 

continues. However, certain markets have shown a tendency in the past to be driven to a greater degree by speculative, rather than fundamental, factors. These markets 

are more likely to see significant downward corrections 

in price when economic activity falls for a prolonged 

period or by a sufficient magnitude. One study from the 

mid-1990s found, in comparing 14 cities in the Northeast and West with 16 inland cities, that while both 

groups tended to respond similarly to local and national 

25 As considered here, this includes the following MSAs: San Jose,
 

Santa Cruz-Watsonville, San Francisco, Santa Rosa, Oakland, Salinas, and Vallejo-Fairfield-Napa.
 

26 See “In Focus This Quarter,” Regional Outlook, Fourth Quarter
 

2001.
 

economic forces (fundamental, or “equilibrium,” price 

drivers), prices in the former group tended to be influenced to a greater degree by speculative, or “disequilibrium,” variables, including recent trends in price 

appreciation.27 Cities along the nation’s coasts also have 

tended to see the most significant price swings over the 

past 20 years. 

History also provides some insights into the nature and 

extent of any price declines in markets where economic 

conditions deteriorate. A study of two significant examples, Boston and Los Angeles in the 1980s and early 

1990s, concluded that declines differed by property type 

(i.e., condos versus single-family) and price class (i.e., 

high-end versus entry-level).28 This dispersion in price 

declines arose from differing rates of appreciation (properties that experienced the greatest inflation during the 

boom saw the largest deflation) and from the nature of 

each city’s economic decline, which differed according to 

concentrations of job losses by industry and wage type, 

underlying demographic factors, and housing supply 

trends. 

Looking at recent developments, it seems that the greatest near-term risk of a significant downward adjustment 

in housing prices is in the San Francisco Bay area. In 

recent years, this area witnessed double-digit home price 

appreciation that exceeded growth in per capita income 

by a wide margin. A recent analysis from the University 

of California-Berkeley’s Haas School of Business forecast that prices in the Bay Area housing market will 

decline by 15 percent overall (and by 30 percent for luxury homes) by the time the local economy’s recession 

ends late this year.29 Meanwhile, the larger MSAs in 

Southern California have not seen as significant a disparity between home price appreciation and personal 

income growth during this cycle as during the 1980s. 

Also in contrast to the 1980s, New England (and the 

Northeast generally) has seen little speculative purchase 

or construction activity in recent years, which should 

help to mitigate any price weakness through the current 

recession in these markets.30 

27 Jesse M. Abraham and Patric H. Hendershott, “Bubbles in Metropolitan Housing Markets,” Working Paper #4774, NBER, June 1994. 

28 Karl E. Case and Robert J. Shiller, “A Decade of Boom and Bust in 

the Prices of Single-Family Homes: Boston and Los Angeles, 1983 to 

1993,” New England Economic Review, March/April 1994. 29 David Goll, “Bay Area Housing Market Will Remain Slow,” East 

Bay Business Times, January 23, 2002. 30 “Regional Perspectives,” Boston Region, Regional Outlook, First 

Quarter 2002. 

Memphis Regional Outlook 20 First Quarter 2002 
In Focus This Quarter
 

Conclusion 

Home prices are holding up in most markets, and, generally, permanent residential mortgages have fared 

well in prior recessions. However, history might 

understate credit risks for insured institutions during 

this cycle because the mortgage lending business has 

changed since the last recession. Chief among these 

changes are robust mortgage market competition, 

which has contributed to narrower collateral margins; 

increased reliance on underwriting automation; and 

expanded involvement in the subprime credit market. 

In addition, residential C&D lenders in certain markets might be particularly vulnerable, since C&D credits typically undergo higher loss rates and some areas 

are experiencing continued construction despite a 

cyclical slowdown (as measured by employment 

trends). Permanent mortgage lenders in certain areas, 

such as the San Francisco Bay area, could also face 

higher loss rates and foreclosures going forward, as the 

current economic weakness places downward pressure 

on home prices and dampens the ability of households 

to meet mortgage payments. 

Scott Hughes, Regional Economist 

Judy Plock, Senior Financial Analyst 

Joan Schneider, Regional Economist 

Norm Williams, Regional Economist 

Memphis Regional Outlook 21 First Quarter 2002 


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