Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION	 SECOND QUARTER 1999 

FDIC
 

Chicago
 

Region
 

Division of
 

Insurance
 

Suzannah L. Susser,
 

Regional Manager
 

Joan D. Schneider,
 

Regional Economist
 

Michael Anas,
 

Senior Financial
 

Analyst
 

Ronald W. Sims, II,
 

Financial Analyst
 

In Focus This Quarter 

◆ Economic Conditions and Emerging Risks in Banking—This article 

provides an overview of economic conditions and banking industry trends, with a 

primary focus on potential risks to insured depository institutions. 

● Economic Developments—Low interest rates, dormant inflation, and rising 

stock markets have all contributed to a generally positive near-term outlook for 

the U.S. economy. See page 3. 

●	 Trends Affecting Banking Lines of Business—Although credit conditions 

appear strong, risks exist in the major banking lines of business.	 See page 7. 

Consumer Lending—Continued high consumer loan loss rates raise questions 

about how lenders will fare under less favorable economic circumstances. 

See page 8. 

Commercial Lending—Corporate loan growth accelerated in 1998 even as the
 

corporate sector showed signs of stress. See page 9.
 

Commercial Real Estate and Construction Lending—Selected metropolitan
 

markets are experiencing rapid commercial development despite declining
 

indicators of demand. See page 10.
 

Agricultural Lending—Falling commodity prices threaten U.S. farm operators. See page 11.
 

Funding and Interest Rate Risk—Intense competition and the changing term
 

structure of interest rates have presented challenges for banks and thrifts.
 

See page 12. 

● Indicators of Industry Performance—Weaknesses appear to be developing for 

banks with certain types of exposures, and the dispersion in performance among 

insured institutions is increasing. See page 13. 

By the Analysis Branch Staff 

Regional Perspectives 

◆ Economic and Banking Conditions—While the Region’s economy 

remains healthy, some indicators suggest that its recent robust growth may be difficult to sustain. The industrial sector, in particular, is showing signs of declining 

vigor. While unemployment remains low, job growth is slowing unevenly across the 

Region. Banks and thrifts reported generally healthy financial conditions in the 

fourth quarter, but aggregate results reflect a modest decline in some performance 

measures. See page 16. 

◆ Weak Agricultural Conditions Continue to Warrant Attention—Ongoing weakness in commodity prices, declining farmland values in specific areas, and 

emerging repayment problems pose risks to insured institutions active in agricultural lending.Agricultural banks with significant concentrations of credit in areas where 

farmland values are declining may be particularly exposed. See page 19. 

◆ New Law Allows Cancellation of Private Mortgage Insurance and Imposes Requirements on Mortgage Lenders—The Homeowners’ Protection 

Act of 1998, which becomes effective on July 29, 1999, is intended to prevent consumers from paying more private mortgage insurance premiums than necessary and 

to facilitate the cancellation of such insurance. Failure to meet the Act’s requirements may expose insured institutions to potential liabilities. See page 21. 

By the Chicago Region Staff 

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, AZ, CA, FJ, 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 Chicago 

Region’s Regional Outlook, please call Suzannah Susser at (312) 382-6543 or send an e-mail to 

ssusser@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 

Executive Editor George E. French 

Editors Lynn A. Nejezchleb 

Maureen E. Sweeney 

Publications Manager Teresa J. Franks 
In Focus This Quarter
 

Economic Conditions and
 

Emerging Risks in Banking
 

Periodically, the Division of Insurance assesses conditions in the economy and across the banking industry in an effort 

to evaluate the types of risks that could adversely affect the performance of insured depository institutions. The analysis that follows describes the salient aspects of this assessment by focusing on three areas: 1) developments and conditions in the U.S. and global economies; 2) trends affecting particular banking lines of business; and 3) selected 

indicators of bank performance. 

In brief, the U.S. economy continues to provide a favorable environment for the banking industry. The industry as a 

whole has exhibited strong loan growth and minimal credit losses. Nevertheless, there are areas of concern, including subprime and high loan-to-value consumer lending, higher levels of leveraged commercial lending, localized 

overbuilding of commercial real estate, and the potential for credit quality problems among agricultural banks. 

Although it is uncertain when, or even if, these concerns will ultimately affect overall industry performance, the 

potential for stress among insured institutions is being monitored. 

Economic Developments
 

Conditions Have Improved Markedly 

since Late 1998 

The U.S. economy is now in its eighth year of expansion, the longest peacetime expansion during the postWorld War II era. Although analysts raised concerns 

about the durability of the expansion amid the late-1998 

financial market turmoil, the economic outlook since 

that time has improved for a number of reasons: 1) the 

75 basis point reduction in short-term U.S. interest rates 

between September and November helped to support 

consumer spending and business investment; 2) following several quarters of decline, U.S. exports rose unexpectedly during the fourth quarter; 3) inflation remained 

dormant even though U.S. labor markets were extremely tight; and 4) equity valuations for large-cap stocks 

rebounded and erased most of the losses incurred during August and September. 

Consumer Spending and Business Investment 

Are Key to Economic Strength 

Most of the standard indicators of health for the U.S. 

economy currently register values associated with the 

best macroeconomic conditions in our history. Growth in 

real gross domestic product (GDP) was 3.9 percent for 

all of 1998—the third consecutive year in which growth 

exceeded 3.5 percent. The U.S. economy added over 3.1 

million jobs during 1998, while unemployment averaged 

just 4.5 percent, the lowest annual figure since 1969. 

Despite this robust economic activity, inflation was also 

the lowest in a generation. Consumer prices rose by just 

1.6 percent in 1998, extending a seven-year streak during which prices have risen by less than 3 percent per 

year. At the same time, strong gains in the productivity 

of U.S. workers helped real hourly earnings rise by 2.7 

percent—the best performance since 1972—while unit 

labor costs of businesses rose by only 1.9 percent. 

Growth in business investment spending, which typically peaks in the early years of an economic expansion, 

has actually accelerated during the current expansion 

(Chart 1, next page). A number of factors appear to be 

responsible for this investment boom. One is the need 

for producers to invest in new technologies in order to 

cut costs and remain competitive. Also, rising stock 

prices, low interest rates, and low yield spreads during 

the past few years have helped keep the cost of capital 

relatively low. The result has been an economic expansion in which approximately 20 percent of net growth in 

real GDP has come from investment in producers’ 

durable equipment, versus approximately 10 percent 

during the long expansions of the 1960s, 1970s, and 

1980s. Bank commercial and industrial lending has 

expanded at an average annual rate of 10.6 percent over 

the past five years, largely on the strength of business 

investment spending. 

The underlying factors that drive consumer spending 

are strong. Low unemployment and rising real incomes 

have boosted the Conference Board’s consumer confiChicago Regional Outlook 3 Second Quarter 1999 
In Focus This Quarter
 

CHART 1 

Low Interest Rates and High Stock Prices
 

Fuel Consumption and Investment
 

Personal Consumption Investment in Producers’ 

Expenditures* (%) Durable Equipment* (%) 

20 9 

15 7
 

5
 10 

3 5 

1 

0 –1 

–5 –3
 

–5
 –10 

* Annual Inflation-Adjusted Rate of Change 

Source: Bureau of Economic Analysis 

1990–91 

Recession 

’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 

dence index to its highest values since the late 1960s. 

Increases in new home construction reflect these favorable conditions. Almost 1.5 million new homes were 

completed during 1998—the highest level in ten 

years—while a record 4.8 million existing homes were 

sold (Chart 2). U.S. automobile sales reached 15.5 million in 1998, their best performance since 1986. Low 

interest rates also enabled a record number of homeowners to reduce their monthly interest expenses by 

refinancing their mortgages during 1998.1 

Although real disposable personal income grew by 

more than 3 percent during 1998, personal savings was 

essentially zero during the fourth quarter. This was the 

1 The Refinancing Index of the Mortgage Bankers Association posted an all-time high of 4,389 in the second week of October 1998. The 

index is scaled to a level of 100 as of the third week of March 1990. 

CHART 2 

Housing Starts and Home Sales Reflect the 

Strength of the Consumer Sector 

Sources: U.S. Census Bureau; National Association of Realtors 

2,250 

2,750 

3,250 

3,750 

4,250 

4,750 

5,250 

5,750 

’86 ’87 ’88 ’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 

One-Unit 

Housing 

Starts (000’s) 

550 

650 

750 

850 

950 

1,050 

1,150 

1,250 

1,350 

1,450 

1990–91 Recession 

Existing 1- to 

4-Family 

Sales (000’s) 

lowest rate of personal savings recorded in the United 

States since the Great Depression. The decline in personal savings has prompted much discussion of its causes and potential implications for the economy and for 

consumer credit quality. Most analysts have argued for 

the importance of a “wealth effect” from rising stock 

values on consumer spending.2 They note that although 

consumers are saving little out of current income, 

household wealth continues to grow rapidly, driving 

consumer spending higher. The willingness of American consumers to spend has been a prime factor in prolonging the economic expansion for the United States 

and in supporting the economies of countries around the 

world that depend on exports to the United States. This 

high degree of reliance on the U.S. consumer has led 

analysts to voice concerns that the wealth effect might 

reverse itself, leading to a sharp drop in consumer 

spending if there is a sustained stock market decline. 

Conditions Vary across Industry Sectors 

While overall conditions in the U.S. economy are good, 

certain sectors have been undergoing significant strain 

because of low commodity prices and weak foreign 

demand. 

Commodity price weakness extends across a wide range 

of items, from agricultural goods to industrial commodities to basic manufactured goods (Chart 3). 

Among agricultural commodities, grain prices have 

fallen substantially from their record-high levels of just 

three years ago, while prices for hogs and soybeans have 

also been under severe pressure. Industrial commodity 

prices have fallen sharply, with steel prices down by 

nearly 30 percent since January 1997. Certain manufactured goods show a similar pattern. The price of the 

industrial chemical benzene has fallen by 40 percent 

since January 1997, while the price of computer memory chips fell by more than 80 percent during that time. 

Oil prices decreased by nearly 50 percent between January 1997 and February 1999. Since mid-March, however, oil prices have increased as a result of agreements 

among oil producers to limit output. Analysts are uncer2 Personal savings is measured as the difference between disposable 

personal income (personal income less tax payments) and total consumption outlays. Increasing household wealth may reduce personal 

savings either through a reduction in disposable income or through 

increased consumption outlays. Tax payments resulting from capital 

gains will reduce measured disposable personal income. Increasing 

household wealth may lead to higher consumption outlays by means 

of the wealth effect. 

Chicago Regional Outlook 4 Second Quarter 1999 
0 

In Focus This Quarter
 

CHART 3 

Price Weakness Extends across 

a Wide Range of Commodities 

Percent Decline in Prices from January 1997 to March 1998 

All 

commodities* Tin Steel Wheat Benzene Crude Oil 

–5 

–5.3%
 

–10
 –7.7%
 

–15
 

–20
 

–25
 

–30 –29.1%
 

–35
 

–36.2%
 –40
 

–40.6%
 –45
 

–50
 –47.4% 

* Producer Price Index (PPI)
 

Source: Journal of Commerce, Bureau of Labor Statistics
 

tain how long any reductions in output will be maintained or how much oil prices may increase during the 

next several months. 

Three trends in the global economy appear to be responsible for weak commodity prices. First, sustained low 

inflation has taken root both in developed nations and in 

many emerging economies. Low inflation has eliminated much of the speculative demand for commodities 

that was evident during the 1970s. Low inflation has 

also made it difficult for manufacturing firms to raise 

prices, while at the same time encouraging the implementation of new technologies to cut costs. Second, 

large-scale investment in plant and equipment during 

the 1990s in both developed and emerging countries has 

added vast amounts of new global manufacturing 

capacity, making industrial overcapacity a source of 

price weakness in a number of industries. Third, successive currency crises and the resulting recessions that 

have taken place in Asia, Eastern Europe, and Latin 

America have reduced global demand for commodity 

goods. Moreover, U.S. firms find that their products are 

less price competitive abroad because of the relative 

strength of the dollar. 

One reason the overall U.S. economy has proven so 

resilient in the face of weakness in the manufacturing 

sector is that firms have been able to restructure to cut 

costs and improve their market positions. Global overcapacity in industries such as oil and autos has been a 

driving force behind the record number and dollar value 

of merger deals announced during 1998. Mega-mergers 

involving Exxon-Mobil and Daimler Benz-Chrysler 

helped push the dollar volume of mergers announced in 

1998 to almost $1.2 trillion—nearly double the level 

announced in 1997 and far greater than any year during 

the “merger mania” of the 1980s (Chart 4). 

U.S. Foreign Trade Reflects Recent Turmoil 

in the Global Economy 

The U.S. economy increasingly relies on exports to fuel 

its overall growth. Between 1994 and 1997, export 

growth contributed about 1 percentage point each year 

to total net growth in real GDP. However, with the onset 

of the Asian economic crisis in 1997, the export sector 

stalled and became a drag on overall U.S. economic 

activity. During the first three quarters of 1998, exports 

decreased at an annualized rate of 4.4 percent, led by 

declines in capital goods, industrial material and supplies, and food and agricultural products. Weakness in 

exports was not limited to Asia; in fact, Canada, Mexico, and South America were also weak markets for U.S. 

goods and services during most of 1998. Declining 

goods exports and rising imports combined to push the 

U.S. balance of trade to a record deficit of $169 billion 

during 1998—a 50 percent increase from the year 

before. The trade deficit continued to increase in early 

1999. Data for January show an imbalance of nearly 

$17 billion, the largest monthly deficit ever recorded. 

Despite the weakness in foreign demand that was 

observed during much of last year, U.S. exports rose 

sharply at the end of 1998. Total exports jumped by 19.7 

percent during the fourth quarter, contributing 2.0 percent of the total 6.0 percent growth in GDP during the 

CHART 4 

0 

1,000 

2,000 

3,000 

4,000 

5,000 

6,000 

7,000 

8,000 

9,000 

0 

200 

400 

600 

800 

1,000 

1,200 

1,400 

Deal Value 

(Billions $) 

(Columns) 

Number of 

Deals (Line) 

Source: Houlihan Lokey’s Mergerstat 

Pressure to Maintain Profit Margins 

Has Led to Record Merger Activity 

Recessions 

’65 ’67 ’69 ’71 ’73 ’75 ’77 ’79 ’81 ’83 ’85 ’87 ’89 ’91 ’93 ’95 ’97 

Chicago Regional Outlook 5 Second Quarter 1999 
In Focus This Quarter
 

quarter. This unexpected increase in U.S. exports 

involved nearly every region of the world except Eastern Europe. Export shipments increased across most 

product types, with the greatest increase in activity 

observed in capital goods. 

The Outlook for the Global Economy 

Remains Uncertain 

Developments during the past six 

months have resulted in an 

improved outlook for the global 

economy, but some key uncertainties remain. While the global 

financial system is more stable 

today than it was six months ago, 

some of the world’s most important economies either 

remain in recession or are experiencing slower growth. 

In this environment, the potential remains for shocks to 

arise in the global economy that could adversely affect 

the performance of the U.S. economy and the credit 

quality of insured depository institutions. 

Canada. The Canadian economy is healthier than at any 

time during the past several years. Canada’s economy is 

expected to track overall growth in the United States, in 

part because U.S. demand for goods and services is the 

principal support for Canadian exports. Canada’s relatively high dependence on weak commodity industries, 

such as metals, grains, and livestock, poses risks for 

producers and for local economies closely tied to these 

commodities. 

Mexico. Mexican GDP growth was 4.6 percent in 1998, 

reflecting relatively strong employment and wage gains, 

high levels of foreign direct investment, and robust nonoil export growth. Looking ahead, inflation remains a 

concern. At the end of 1998, the inflation rate was 18.7 

percent, up from a low of 15 percent in the middle of the 

year. The Blue Chip Economic Indicators consensus 

forecast calls for real GDP growth of 2.9 percent during 

1999, down from 4.6 percent in 1998. 

Western Europe. Europe’s problems are similar to 

those of the United States in that they stem from declining growth in manufacturing exports. Despite a 175 

basis point cut in short-term interest rates in the U.K. 

since October 1998, the Bank of England forecasts economic growth of less than 1.0 percent in 1999. In Germany, manufacturing activity has also decreased, owing 

to weakness in export markets. German GDP shrank by 

0.4 percent during the fourth quarter of 1998, while 

unemployment remains above 10 percent. In response to 

signs of growing weakness in Germany and other major 

economies in the 11-member “Euro-zone,” the European Central Bank cut short-term interest rates by 50 

basis points to 2.5 percent on April 8, 1999. 

Eastern Europe. Much of Eastern Europe is faced with 

slow growth or recession following the devaluation of 

the ruble and the default on Russian government debt in 

August 1998. The Russian economy shows few signs of 

recovery amid high inflation and halting progress in 

economic reform. Poland and Hungary, Eastern 

Europe’s engines of growth before the Russian crisis, 

are facing rising current account deficits and a slowdown in export growth. 

Asian Pacific Rim. The Japanese economy remains 

mired in a long-running recession that has resulted in a 

greater number of bankruptcies (up 17 percent in 1998), 

falling domestic demand, and pessimism among consumers and businesses alike. Japanese GDP fell by 2.8 

percent during 1998, and analysts call for a drop of 0.8 

percent in 1999. 

There are signs that the worst phase of the Asian economic crisis may have passed.3 In the Philippines, South 

Korea, Hong Kong, and Thailand, current accounts have 

moved from deficit to surplus as devalued currencies 

continue to depress imports. Foreign capital is returning 

to the region, as evidenced by the 27 percent increase in 

foreign direct investment in Korea during 1998. However, weak consumer spending remains a problem for 

the entire region, which ships fully 40 percent of all 

exports to other Asian Pacific Rim nations. 

In China, which has been relatively immune to the worst 

of the region’s economic crisis, slower growth is also 

forcing economic restructuring. With annual economic 

growth below the targeted 8 percent mark, economic 

planners have been forced to reduce production and 

close plants in the oil, steel, glass, and cement industries. Meanwhile, the government is trying to stimulate 

demand by investing in public infrastructure and by urging banks to increase lending to the private sector. 

3 See “The Asian Economic Crisis: Implications for the U.S. Economy,” Regional Outlook, Third Quarter 1998. Also available at 

http://www.fdic.gov/publish/regout/ro19983q/ny/infocus1.html. 

Chicago Regional Outlook 6 Second Quarter 1999 
In Focus This Quarter
 

Latin America. With the apparent stabilization of the 

Asian economies, attention has now focused on emerging problems in Latin America. The 50 percent devaluation of the Brazilian real versus the dollar that began in 

January 1999 has depressed economic activity and 

renewed fears of inflation. Consensus estimates place 

Brazilian economic growth at negative 3.5 percent for 

1999, while short-term interest rates are likely to remain 

high (currently about 42 percent) to prevent further capital flows out of the country. 

Risks Remain despite a Positive 

U.S. Economic Outlook 

Robust economic growth, low inflation, and stable 

interest rates appear to be the most likely economic scenario for the remainder of 1999, according to the consensus forecast of the Blue Chip Economic Indicators. 

If this outlook actually comes to pass, we can expect 

that the vast majority of insured institutions will continue to enjoy moderate loan growth and generally favorable indicators of financial performance and condition. 

Despite this positive outlook, the risk remains that the 

expansion could be derailed by one of three types of 

shocks. The first would be a resurgence of inflation 

resulting from demand-induced shortages of labor or 

other key economic resources. Although inflation has 

been consistently low in recent years, investors remain 

on the lookout for any signs of higher prices. While it is 

not certain that a recession would result, it is worth noting that rising short-term interest rates in response to 

increasing inflation have preceded every recession during the past 40 years. 

The second type of shock that could end the expansion 

is a sustained period of deflation. Concern about deflation arises from the low prices many commodity producers are receiving and the effects of foreign currency 

devaluations on U.S. import prices. Although these 

trends have helped to keep U.S. inflation and interest 

rates low, at some point they could impose a heavier 

burden on U.S. businesses by shrinking revenues and 

profit margins, mirroring what has already occurred in 

some commodity-based industries.4 

The third type of shock is financial market instability. 

Consumer confidence, which has reflected recent 

increases in stock market wealth, could tumble in the 

event of a severe and prolonged decline in the stock 

market. Business investment has also depended on the 

support of strong and stable financial markets that offer 

firms access to capital on favorable terms and facilitate 

restructuring in troubled industries. A recession accompanied by financial market instability could pose a particular threat to bank loan performance because it would 

likely produce a disorderly shakeout of troubled firms 

marked by a rise in bankruptcies and loan defaults. 

4 See “How Will the Expansion End?” Regional Outlook, Second 

Quarter 1998. Also available at http://www.fdic.gov/publish/regout/ 

ro19982q/sf/infocus2.html. 

Trends Affecting Banking Lines of Business
 

Overview 

Trends in bank and thrift lines of business align closely 

with those of the economy. Most insured institutions 

have prospered during this economic expansion, as 

shown by the industry’s continuing earnings growth, 

strong capital levels, and improving or stable loan performance across most major loan categories. Likewise, 

today’s strong economy depends to a great extent on the 

continuing availability of consumer and business credit 

from banks and thrifts. Even during the closing months 

of 1998, when capital market funding sources became 

quite volatile, credit continued to flow from insured 

institutions. During that turbulent period, insured institutions may have acted as a stabilizing force for businesses, consumers, and farmers by continuing to provide credit, albeit at higher prices and with stricter 

underwriting terms in some cases. 

Although credit conditions appear strong, a number of 

insured institutions’ loan portfolios are shifting toward a 

riskier mix of credits. Underlying reasons for these 

shifts vary, but likely explanations include opportunities 

to earn higher yields and confidence about the overall 

economic outlook. The following paragraphs discuss 

credit risk trends and highlight possible areas of concern in the major lending lines of business at insured 

institutions. The influence of recent interest rate 

changes and competitive factors on asset/liability and 

credit risk management is also explored. 

Chicago Regional Outlook 7 Second Quarter 1999 
In Focus This Quarter
 

Consumer Lending 

Debt Growth Sustains Consumer Spending but 

Could Contribute to Financial Strains under 

Less Favorable Economic Conditions 

Much of the strength and stability of the overall U.S. 

economy owes itself to the continuing growth in consumer spending. While higher personal incomes and 

consumer confidence are important contributing factors, lower interest rates and expanding avenues of credit access have also played key roles in supporting 

consumer spending. With mortgage debt leading the 

way, consumer loan growth rates accelerated in 1998. 

The key factor driving mortgage loan growth was lower 

interest rates, which encouraged many consumers to 

purchase homes, refinance existing mortgages, and 

consolidate their personal debts through home equity 

loans. As a result, the growth in home mortgage credit 

during 1998 reached a post-recession high of 10 percent. Other consumer loan types, such as auto and credit card debt, grew at slower but accelerating rates of 8 

percent and 5 percent, respectively. 

Nonmortgage consumer loan loss rates remain above 

previous recession levels despite the apparent strength 

of the consumer sector. Chart 5 shows that nonmortgage consumer loss rates have declined slightly from 

their peak in the fourth quarter of 1997, but remain 

above the rates experienced during the prior recession. 

The chart also shows that consumer credit loss rate 

trends are closely related to the rise in personal bankruptcy filings, which reached an all-time high of 1.4 

million in 1998.5 The good news for consumer lenders 

is that the growth rate in personal bankruptcies has 

slowed. However, this leveling off does not mean that 

consumer credit quality concerns have abated. The 

overriding concern is how personal bankruptcies and 

consumer credit losses, already at high levels, would be 

affected by less favorable economic conditions. Another concern is whether current consumer spending patterns will be supported by a new round of credit card 

growth. Since revolving credit card balances typically 

carry higher interest rates than home equity loans, this 

5 Reasons for the rise in personal bankruptcy rates are further 

explored in a series of Bank Trends articles published by the FDIC. 

See, for example, “A Time Series Model of the U.S. Personal Bankruptcy Rate, 1970-1996,” February 1998, and “The Effect of Consumer Interest Rate Deregulation on Credit Card Volumes, 

Charge-Offs, and Personal Bankruptcy Filings,” March 1998. Both 

reports can be accessed at www.fdic.gov/publish/bktrnds/index.html. 

CHART 5 

0.0 

0.5 

1.0 

1.5 

2.0 

2.5 

3.0 

1Q91 2Q92 3Q93 4Q94 1Q96 2Q97 3Q98 

0.0 

0.2 

0.4 

0.6 

0.8 

1.0 

1.2 

1.4 

Consumer Charge-Offs and Bankruptcies 

Have Leveled Off at a High Rate 

Bankruptcy Filings 

per 1,000 Population 

(Right axis) 

Sources: Administrative Office of the U.S. Courts; Federal Reserve Board 

1.6 

Consumer Loan 

Charge-Off Rate (%) 

“reloading” of credit card debt would further strain the 

financial flexibility of consumers. 

High Loan-to-Value Mortgage Products 

and Subprime Lending Transform 

Consumer Lending 

Consumer lending practices have changed significantly 

since the last recession. Because of intense competition 

and declining net interest margins, consumer lenders 

are reaching out to borrowers further down the credit 

quality spectrum and relaxing traditional collateral 

requirements. Bank supervisors have indicated that a 

growing number of insured institutions are involved in 

some form of subprime lending. Subprime loans, 

designed for borrowers with blemished or limited credit histories, can take a variety of forms, including home 

equity, automobile, and credit card loans. As compensation for increased risk, subprime loans carry higher 

interest rates than prime-rate loans and often require 

substantial collateral margins. 

Insured institutions are also embracing another relatively new consumer loan product: high loan-to-value 

(LTV) loans. High LTV loans, where the combined 

amount of senior and junior liens against a home 

exceeds its value, are usually made to borrowers with 

“clean” or unblemished credit histories. However, the 

lack of collateral protection results in much higher loss 

experience when a borrower defaults. As Chart 6 shows, 

high LTV loans have had a higher loss rate experience 

(adjusted for seasoning) than either traditional home 

equity loans or subprime loans. Moreover, the delinquency rates on recent-vintage home equity loan pools 

Chicago Regional Outlook 8 Second Quarter 1999 
In Focus This Quarter
 

CHART 6 

0 

1 

2 

3 

4 

5 

6 

7 

0 2 4 6 8 10 12 14 16 18 20 22 

Months since Origination 

High LTV Mortgages* Have a Higher Loss 

Experience than Other Mortgage Types 

Charge-Off Rate (%) 

* Includes home improvement loans 

Source: Moody’s Investor Services 

High LTV 

Subprime 

Traditional 

Home Equity 

have deteriorated as high LTV loans have proliferated.6 

At the same time, recent regulatory surveys of credit 

underwriting practices show easing standards on home 

equity loans.7 The loss experience of these higher risk 

consumer products during less favorable economic circumstances is unknown and continues to be a concern. 

Commercial Lending 

Commercial Loan Performance Remains 

Strong but Corporate Financial Strains 

Are Developing 

Continued strength in the corporate sector is reflected in 

the level of corporate bankruptcy filings, which have 

declined since the middle of 1997 to just under 10,000 

in the fourth quarter of 1998. Bank losses on commercial credits remain low but did register a modest 

increase during the fourth quarter (see Chart 7). In addition to strong economic fundamentals in high tech, construction, finance, service-related, and other sectors, 

U.S. businesses have benefited from significantly lower 

interest rates and an abundant supply of credit. Credit 

access provided by banks was particularly important to 

U.S. businesses in the latter part of 1998. During this 

6 “Moody’s Home Equity Index Update.” Moody’s Investor Services, 

October 2, 1998, p. 3. 

7 For example, the Office of the Comptroller of the Currency’s “1998 

Survey of Credit Underwriting Practices” indicated that 33 percent of 

the banks offering home equity loans eased standards, compared with 

only 7 percent that tightened standards. The report is available at 

http://www.occ.treas.gov/cusurvey/scup98.pdf. 

period, sharply higher interest rate spreads on corporate 

bonds8 and commercial paper led many companies to 

tap cheaper funding sources, including existing unused 

credit and commercial paper lines held by commercial 

banks. As a result, commercial banks experienced a 15 

percent (annualized) rate of growth in fourth quarter 

1998, the highest rate of commercial loan growth in 16 

years. 

Although commercial loan loss rates are low, financial 

strains are becoming apparent among certain U.S. business sectors. Bank lending to U.S. businesses has grown 

at a faster pace than GDP during each of the past eight 

quarters. Moreover, growth in bank commercial lending 

through 1998 has come at a time when total after-tax 

U.S. corporate profits have begun to decline.9 Deteriorating profits are especially prevalent in sectors with 

exposure to weak commodity prices and slower export 

growth. For many businesses, lower profits have resulted in a reduced capacity to service outstanding debt 

obligations. For instance, a recent Bank of America 

Corporation study reported that amendments to syndicated loans in the latter half of 1998 were driven 

increasingly by borrowers seeking relief from financial 

performance-related covenants.10 Financial strains are 

8 The Merrill Lynch U.S. Investment Grade Corporate Bond Master 

Index indicates that corporate bond spreads over ten-year Treasury 

rates rose 58 percent, an increase of 63 basis points, from the end of 

July 1998 to the end of October 1998. 

9 See the Bureau of Economic Analysis Corporate Profit Index. 10 “Covenants Provide Loan Repricing Opportunity.” Bank of America 

Report, January 25, 1999. 

CHART 7 

0.0 

0.2 

0.4 

0.6 

0.8 

1.0 

1.2 

1.4 

1.6 

1.8 

2.0 

1Q91 3Q92 1Q94 3Q95 1Q97 3Q98 

Sources: U.S. Courts; Bank Call Reports 

Net Charge-Off Rate (%) Business Bankruptcies 

9,000 

10,000 

11,000 

12,000 

13,000 

14,000 

15,000 

16,000 

17,000 

18,000 

19,000 

20,000 

Domestic Commercial Loan Losses Remain Low 

and Business Bankruptcies Decline 

Chicago Regional Outlook 9 Second Quarter 1999 
In Focus This Quarter
 

also reflected in the level of corporate bond defaults, 

which Standard and Poor’s reported at 48 ($10.8 billion in affected debt) in 1998, up 182 percent from 1997 

levels (up 150 percent in dollar volume terms).11 

As Debt Markets Become More Cautious, 

Syndicated Lending Shifts toward Higher 

Risk Borrowers 

Although the longer-term trend has been toward more 

aggressive corporate lending strategies, many insured 

institutions responded to the financial market turmoil in 

late 1998 with a heightened sense of caution. Recent surveys of underwriting practices conducted by the federal 

banking agencies show that many banks tightened standards in late 1998 across many product lines.12 However, 

tighter lending terms do not appear to have quelled 

either loan demand or loan production substantially. 

Syndicated lending trends suggest an increase in corporate lending risks.13 Despite the flight to quality that 

occurred in the latter part of 1998, syndicated loans to 

leveraged companies jumped 41 percent to $273 billion 

during 1998. Over the same period, nonleveraged loans 

declined 35 percent to $599 billion. Although corporate 

merger activity accounts for much of the increase in 

leveraged lending volume in 1998, some lenders appear 

to be taking advantage of the higher yields available in 

this market relative to yields on lower risk credits. The 

apparent shift toward a higher risk mix of total syndicated credit outstanding is occurring at the same time 

that corporate bond defaults for speculative grade issues 

are trending upward.14 Moreover, trends in corporate 

bond spreads and rating agency actions on corporate 

bond debt suggest a bond market that is becoming 

increasingly cautious about the outlook for U.S. businesses (see Chart 8). 

11 “Corporate Defaults Rise Sharply in 1998,” Standard & Poor’s, 

March 5, 1998. 

12 See Federal Reserve Board Senior Loan Officer Opinion Surveys 

for November 1998 and January 1999, http://www.bog.frb.fed.us/ 

boarddocs/snloansurvey/. 

13 Syndicated loans are credit facilities made to medium and large corporate borrowers by a group or syndicate of lenders. Analysts often 

segment this market into “leveraged” lending (loans to heavily indebted companies) and nonleveraged lending. 

14 Moody’s Investor Services reports that trailing 12-month default 

rates for speculative-grade issuers rose from 2.02 percent at the end 

of 1997 to 3.31 percent at year-end 1998. These default rates compare 

to an all-corporate trailing default rate of 0.68 percent in 1997 and 

1.27 percent in 1998. 

CHART 8 

0.4 

0.6 

0.8 

1.0 

1.2 

1.4 

1.6 

1.8 

2.0 

4Q93 4Q94 4Q95 4Q96 4Q97 4Q98 

–120 

–80 

–40 

0 

40 

80 

120 

160 

200 

Corporate Bond Ratings and Required 

Yields Reflect Greater Market Uncertainty 

Merrill Lynch Corporate Bond 

Master Index Spreads to Comparable

 Maturity Treasuries (bps) 

Sources: Moody’s Investor Service; Merrill Lynch 

Ratio of Corporate 

Upgrades to 

Downgrades 

Commercial Real Estate and 

Construction Lending 

Construction Loan Growth Accelerates 

as Overbuilding Pressures Increase 

in Certain Markets 

In 1998, the value of private commercial construction 

rose 4.0 percent over 1997 levels, reflecting a moderate 

slowdown in growth compared with a compounded 

average annual growth rate of 8.4 percent since 1992. In 

contrast, the pace of residential development has accelerated. The value of private residential construction rose 

11.5 percent in 1998, compared with an annual average 

growth rate of 8.0 percent since 1992. Construction 

loans at insured institutions grew 20 percent in 1998, 

the highest growth rate since 1986.15 

Although market fundamentals are strong throughout 

most major U.S. markets, some metropolitan areas 

appear to be vulnerable to an oversupply of commercial 

space. The Regional Outlook, First Quarter 1999, highlighted nine markets that may be susceptible to commercial overbuilding on the basis of the following 

factors: 1) the rapid pace of current construction activity in those markets; 2) high vacancy rates relative to 

construction in progress in some cases; 3) projections of 

rising vacancy rates by market analysts; and 4) various 

recent shifts in demand indicators. Data through June 

1998 indicate that construction activity in these markets 

15 Construction loan growth captures growth in both residential and 

nonresidential development. 

Chicago Regional Outlook 10 Second Quarter 1999 
In Focus This Quarter
 

has not yet abated to reflect moderating demand levels.16 

Overbuilding concerns may be tempered to the extent 

that tighter commercial real estate lending standards 

slow the pace of development.17 

Loan Underwriting Study Reveals Sounder 

Practices Compared with the 1980s, but Intense 

Competition Forces Some Concessions on 

Pricing and Structure 

Beginning in August 1998, FDIC analysts set out to 

investigate construction loan underwriting practices in 

banks servicing various rapidly growing markets. The 

study identified several differences between today’s 

lending practices and those prevalent during the last 

cycle. Most importantly, today’s lenders are making 

credit decisions on the basis of improved appraisals, 

increased attention to project cash flows and project 

feasibility, and better market information on competing 

projects. However, intense competition has forced an 

across-the-board reduction in loan pricing margins even 

compared with margins at the height of the 1980s building boom. 

The study also identified some instances of aggressive 

loan structures, including pricing at extremely thin margins, waiving or limiting personal guarantees, waiving 

cash equity requirements, and lending on thin collateral 

margins. Borrowers who secured the most aggressive 

loan terms were typically larger developers, who presumably have the resources and financial flexibility to 

weather adverse conditions. Nevertheless, waiving personal guarantees and eliminating a borrower’s financial 

exposure to project risks are practices often cited in 

conjunction with the heavy construction loan losses 

experienced during the previous real estate downturn. 

Finally, the study found that many real estate investment 

trusts and large corporate developers have been able to 

obtain long-term unsecured financing for development 

purposes. The lack of collateral protection could make 

16 The nine markets are Atlanta, Charlotte, Dallas, Las Vegas,
 

Nashville, Orlando, Phoenix, Portland, and Salt Lake City. “Commercial Development Still Hot in Some Markets but Slower Development May Be Ahead.” Regional Outlook, First Quarter 1999,
 

www.fdic.gov/publish/regout/ro19991q/na/index.html.
 17 Consistent with commercial and industrial underwriting trends,
 

commercial real estate lenders reacted to market volatility in late
 

1998 by tightening loan terms and raising pricing margins. See, for
 

example, the Federal Reserve Board Senior Loan Officer Opinion
 

Survey for November 1998 and January 1999.
 

these loans particularly vulnerable to declining commercial real estate prices.18 

Agricultural Lending 

Farm Banks Threatened by Falling 

Commodity Prices 

Farm banks generally performed well in 1998, reporting 

a modest increase in nonperforming loans from 1.09 

percent at year-end 1997 to 1.13 percent as of year-end 

1998. Although delinquent loans rose only slightly 

in the aggregate, farm banks in some localized areas 

such as northeast North Dakota and northwest Minnesota experienced sharply higher problem loan levels 

and reduced profits in the aftermath of three consecutive years of low prices, bad weather, and crop diseaserelated problems. Moreover, recent surveys by the 

federal banking agencies, which show rising levels of 

farm carryover debt at farm banks, suggest that nonperforming loan data may understate borrower difficulties. 

During 1998, the outlook for significant portions of the 

farm sector deteriorated following a dramatic fall in 

prices for several major farm commodities. Prices for wheat, corn, 

soybeans, and hogs fell to ten-year 

lows and were below the economic breakeven cost of production for 

many producers. For areas heavily 

dependent on these commodities, 

the U.S. Department of Agriculture (USDA) projects that producers will experience 

substantial declines in net cash income from 1999 

through 2003.19 In 1999, the USDA projects farm 

income to fall 7.1 percent, to $44.6 billion, from last 

year’s level of $48 billion. 

Although current conditions have the potential to cause 

stress for substantial numbers of farm banks in certain 

regions, some significant differences exist between 

today’s circumstances and those that led to the farm 

18 Loan covenants may mitigate some of the risks of lending without 

collateral protection. Common covenants include maximum leverage 

ratios, minimum equity requirements, and limits on encumbered 

assets through recourse or cross-collateralization to third parties. 

19 A substantial portion of the USDA’s projected decline in the net 

cash income for U.S. farmers over the next five years is attributable 

to reductions in government payments to farmers. 

Chicago Regional Outlook 11 Second Quarter 1999 
In Focus This Quarter
 

bank crisis of the mid-1980s. Current favorable factors 

include 1) lower debt-to-equity for farm producers; 2) 

substantially lower interest rates; 3) moderately appreciating farmland prices relative to the more rapid appreciation (and subsequent price corrections that followed) 

in the 1970s and 1980s; and 4) better underwriting practices by farm lenders. Nevertheless, if weak exports of 

farm products and low commodity prices continue for 

the remainder of this year, the condition of farmers 

could deteriorate significantly, increasing financial 

stress at insured farm banks. 

Funding and Interest Rate Risk 

Deposit Funding Becomes 

More Difficult to Obtain 

Competitive pressures in the banking industry are not 

restricted to lending. Insured institutions are also finding it difficult to attract deposits in today’s marketplace, 

largely because of the existence of higher yielding 

investment products. For example, the Investment 

Company Institute reports that net inflows into mutual 

funds have exceeded net increases in deposit accounts 

in all but three quarters since mid-1991. The fourth 

quarter of 1998 marked the sixteenth consecutive quarter that mutual fund inflows outstripped deposit increases. As deposits have become more difficult to attract, 

loan portfolios have expanded in line with the overall 

growth in the economy. As a result, institutions have 

turned increasingly to other borrowings for funding. 

These trends are captured in Chart 9, which shows that 

the ratio of bank and thrift loans to deposits reached a 

record 88 percent in December 1998. Small community 

CHART 9 

banks and thrifts (institutions with less than $1 billion in 

assets) are most affected by deposit trends, since they 

tend to rely more heavily on deposit funding than larger institutions with greater access to the capital markets. 

Interest Rate Changes Pose Asset/Liability 

Management Challenges 

Interest margin pressures are posing challenges for 

insured institutions. In addition to the effect of competitive pressures, changes in interest rates have had a substantial influence on institutions’ net interest margins. 

The flattening of the yield curve in 1998, for example, 

appears to have contributed to a decline in margins to 

their lowest levels since 1991 for both large and small 

insured institutions (see Chart 10). For insured institutions with more traditional asset/liability structures 

(longer-term asset holdings funded with shorter-term 

deposits and borrowings), a flatter yield curve results in 

lower spreads between asset yields and interest costs. 

The decline in long-term interest rates during 1998 also 

led to a record volume of mortgage refinance activity, 

as indicated by the Mortgage Bankers Association’s 

Refinancing Index.20 Among many mortgage lenders, 

the most immediate impact from this refinancing activity was the revaluation of servicing assets and lower servicing fee income. Some mortgage lenders also saw a 

significant increase in overhead as they expanded staff 

to accommodate higher loan application volumes. A 

20 This index hit its peak in mid-October and has since declined in line 

with a modest upward movement in fixed mortgage rates. 

CHART 10 

65 

70 

75 

80 

85 

90 

95 

’84 ’85 ’86 ’87 ’88 ’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 

Loans and Assets Are Growing Faster than 

Deposits at Insured Institutions 

Loans to Deposits 

Deposits to Assets 

Source: Bank Call Reports and Thrift Financial Reports 

Percent 

A Flatter Yield Curve in 1998 Placed 

Pressure on Net Interest Margins 

Sources: Federal Reserve Board; Bank Call Reports; Thrift Financial Reports 

1.0 

1.5 

2.0 

2.5 

3.0 

3.5 

4.0 

4.5 

5.0 

–50 

0 

50 

100 

150 

200 

250 

300 

350 

’84 ’85 ’86 ’87 ’88 ’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 

Assets 

< $1 Billion 

(right axis) 

10-Year Less 1-Year 

Treasury (bps) 

Mean Net Interest 

Margin (%) 

Assets 

> $1 Billion 

(right axis) 

Chicago Regional Outlook 12 Second Quarter 1999 
In Focus This Quarter
 

longer-lasting impact involves the shift in borrower 

preferences toward fixed-rate mortgages. According to 

Freddie Mac, approximately 65 percent of adjustablerate mortgages refinanced in 1998 were replaced with 

30-year fixed-rate mortgages. Another 30 percent were 

refinanced into 15- and 20-year fixed-rate mortgages. 

As a result of this activity, mortgage lenders may tend 

to have a higher proportion of assets held in longer-term 

mortgage loans, leading to further margin pressures 

should interest rates rise. 

As discussed in previous sections, many insured institutions appear to be turning toward higher risk consumer 

and corporate lending strategies. Such strategic shifts 

may be at least partially in response to pressures on net 

interest margins. The search for higher yield spreads 

may also explain the continuing growth in nondeposit 

funding sources, which often take the form of complex 

obligations with embedded options that can reduce 

funding costs at the expense of additional interest rate 

risk. 

Indicators of Industry Performance
 

Market Signals for the Banking 

Industry Are Mixed 

Diminished concerns over the near-term economic outlook and reduced financial market volatility resulted in 

a sharp turnaround in investor attitudes toward banks in 

the fourth quarter of 1998. During the quarter, the SNL 

Bank Stock Index21 rose 21 percent, recovering all of 

the value it lost during the turmoil of the third quarter. 

The index has continued to rise in 1999. 

Although equity indicators have been generally positive, ratings actions in 1998 for the long-term debt of 

U.S. banks and finance companies reflect developing 

problems for certain industry segments. In sharp contrast to the previous six years, when upgrades far 

exceeded downgrades, Moody’s downgraded as many 

bank and finance company debt ratings as it upgraded 

during 1998. In the fourth quarter of 1998, Moody’s 

downgraded the long-term debt ratings of 27 bank and 

finance companies and upgraded only 15—the highest 

quarterly ratio of downgrades to upgrades since 1992. 

Downgrades during 1998 were centered in finance 

companies specializing in nonportfolio subprime lending and bank holding companies with exposure to 

emerging markets. 

Bank Performance Remains Strong but 

Earnings Variability Is Increasing 

Recent stable industry profitability in the aggregate has 

masked an increasing range of profit variability for 

individual commercial banks. Over the past six years, 

21 This index tracks the market capitalization of approximately 520 

banking companies. 

the annual aggregate return on average assets (ROA) for 

commercial banks has shown little fluctuation, ranging 

from a low of 1.15 percent in 1994 to a high of 1.24 percent in 1997.22 However, the variability in commercial 

bank profitability, as measured by the distribution of the 

industry’s ROA excluding the top and bottom 5 percent, 

has widened since 1994 (see Chart 11). For example, 

ROA for the worst 5 percent of the industry was negative 0.29 percent or less in 1998, reflecting a steady 

decline from 0.2 percent in 1995. Similarly, ROA for the 

most profitable 5 percent of commercial banks was 

above 2.16 percent, up from 1.94 percent in 1994. 

Reasons for the increasing variability of commercial 

bank ROA can be further analyzed by segregating institutions along predominant product or business lines. 

Chart 12 (next page) details the distribution of 1998 

22 FDIC Quarterly

www2.fdic.gov/qbp. 

CHART 11 

 Banking Profile, Fourth Quarter 1998, 

3.0 

’84 ’85 ’86 ’87 ’88 ’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 

Source: Bank Call Reports 

Bottom 5th Percentile 

Top 5th Percentile 

Mean 

The Range of Profitability for Commercial 

Banks Is Increasing 

Return on Asset Distribution 

–4.0 

–3.0 

–2.0 

–1.0 

0.0 

1.0 

2.0 

Chicago Regional Outlook 13 Second Quarter 1999 
In Focus This Quarter
 

CHART 12 

–5% 0% 5% 10% 15% 

1998 Performance Varies by 

Business Specialization 

Return on Assets Percentage Distribution 

Agricultural 

(2,274) 

International 

(11) 

Consumer 

(211) 

Commercial 

(3,150) 

Specialized 

(621) 

Credit Card 

(68) 

Note: Group institution count is in parentheses. 

Source: Bank Call Reports (Research Information System) 

Industry Mean ROA=1.13% 

Bottom Fifth Percentile 

Top Fifth Percentile 

ROA for six selected groups of banks segregated by line 

of business concentrations. This chart reveals that bank 

performance varies considerably by business specialty. 

For example, the distribution of ROA of credit card 

lenders23 differs significantly from that of other bank 

groups, including other consumer lenders.24 Small specialized banks25 and commercial lenders26 followed 

credit card lenders as the groups with the greatest variability in profitability in 1998. Moreover, 75 percent of 

the least profitable commercial banks were members of 

small specialized or commercial groups. New banks 

have also influenced the dispersion of bank ROA. Banks 

chartered in 1997 and 1998 make up more than 60 percent of the industry’s worst performers. However, earnings variability widened in 1998 even when newer 

institutions are excluded from the analysis. 

23 Banks with at least 50 percent of managed loans in managed credit 

card receivables and at least 50 percent of managed loans in total 

managed assets. 

24 Banks with consumer loans and single-family mortgages in excess 

of 50 percent of assets that do not meet separate credit card or mortgage lending concentration thresholds. 

25 Banks with total assets less than $1 billion, and less than 40 percent 

of assets held in loans, that do not fall in other business specialties. 

Members of this group include de novo banks and more seasoned 

banks with low loan activity, such as trust companies. 

26 Banks with 25 percent or more of assets in commercial and commercial real estate loans. 

Far fewer commercial banks posted losses in 1998 than 

during the period from 1984 to 1992. Still, the number 

of unprofitable institutions appears to be rising despite 

generally favorable economic conditions. These concerns are mitigated somewhat, since today’s worstperforming institutions are generally much better 

capitalized and are burdened with fewer problem assets 

than their counterparts during the 1980s. 

Summary 

Most indicators of U.S. economic health remain robust 

in spite of the difficulties posed by low commodity 

prices and falling exports during 1998. The consensus 

forecast of leading economic analysts calls for continued growth in the U.S. economy for the rest of 1999. At 

the same time, a number of threats to this favorable outlook exist, including the possibility of higher inflation 

and higher interest rates stemming from strong economic growth. Other scenarios involve a very different 

threat—namely, price deflation brought on by global 

overcapacity and a decline in U.S. exports. Shocks that 

might arise in the foreign sector or in the financial markets, as experienced during 1998, remain a significant 

concern during 1999. Consumer spending and business 

investment seem particularly vulnerable to such shocks 

at this stage of the expansion. 

Favorable economic conditions are reflected in the overall performance of the banking industry. Still, a number 

of indicators suggest that the risk profile of some 

insured institutions is increasing. Responding to significant competitive pressures, and perhaps emboldened 

by the long duration of the current expansion, many 

institutions are expanding their involvement in higherrisk consumer loan products, such as subprime and high 

LTV loans and higher-risk leveraged commercial loans. 

The overall shift toward higher-risk credits is occurring 

despite signs of financial strain on the part of many consumers (in the form of record personal bankruptcies) 

and businesses (in the form of declining profits and 

increasing bond default rates). Credit-related concerns 

also extend to commercial real estate, where some markets are exhibiting rapid commercial real estate development at the same time that demand indicators are 

Chicago Regional Outlook 14 Second Quarter 1999 
In Focus This Quarter
 

trending downward. Finally, sustained weak commodity 

prices are placing strains on farmers and could eventually lead to higher agricultural loan delinquencies. 

Bank and thrift net interest margins are being pressured 

by a flatter yield curve and heightened competition. 

Community institutions, which rely most heavily on 

interest income, are particularly vulnerable to tighter 

margins. The major concern in this area is that insured 

institutions will combat falling margins by entering into 

riskier funding and lending strategies. 

Market indicators and reported financial data reflect 

favorable industry performance as well as new sources 

of risk. Investor attitudes toward banking companies 

have improved since late 1998 because of an improved 

near-term economic outlook and a reduction in financial market volatility. However, a recent increase in 

ratings downgrades of bank and finance company longterm debt suggests growing concern over bank exposures to such areas as subprime lending and emerging 

markets. Despite relatively strong aggregate industry 

performance, profit variability among individual commercial banks has increased because of new chartering 

activity and pressures in consumer and commercial 

lending. As a result, for the first time since 1992, the 

worst performing 5 percent of all commercial banks 

were unprofitable last year. 

This article was prepared and coordinated by the staff of the Analysis Branch of the Division of Insurance. Contributions and feedback from analysts across the Division were essential to its completion. 

Maureen E. Sweeney, Associate Director 

Paul C. Bishop, Senior Financial Economist 

Richard A. Brown, Chief, Economic and Market Trends Section 

Steve Burton, Senior Banking Analyst 

Steven E. Cunningham, Chief, Financial Institutions Section 

Alan Deaton, Economic Analyst 

Diane Ellis, Senior Financial Analyst 

Jim Heil, Economic Analyst 

Brian Kenner, Financial Analyst 

Allen Puwalski, Senior Financial Analyst 

Chicago Regional Outlook 15 Second Quarter 1999 
Regional Perspectives
 

Regional Perspectives
 

• While the Region’s economy remains healthy, some indicators suggest that its recent robust growth may be 

difficult to sustain in the coming quarters. 

•	 The Region’s banks and thrifts reported generally healthy financial conditions, but aggregate results reflect 

some moderation in recent performance trends. 

•	 Ongoing weakness in commodity prices, declining farmland values in specific areas, and emerging repayment problems continue to warrant attention in the agricultural sector. 

•	 A new law allows cancellation of private mortgage insurance and imposes requirements on mortgage 

lenders. 

Regional Economic and Banking Conditions
 

The Region’s Economy Reflects Crosscurrents 

The current economic expansion entered its ninth year 

in March 1999, making it the second longest expansion 

in the past 50 years. Yet, as typically happens in an 

aging expansion, some indicators suggest that the 

Region’s robust economic health may be difficult to 

sustain in the coming quarters. For example, the shrinking pool of workers available for hire is a factor behind 

slower job gains. Current indicators do not suggest that 

a recession is imminent, and the level of economic 

activity could remain fairly high for some time. However, additional improvements—such as significantly 

lower unemployment rates or an increase in hiring by 

manufacturers—may be both small and hard to achieve. 

In addition, sustained weakness in commodity prices 

may hurt communities in the Region that depend heavily on earnings from corn, soybean, and small hog 

operations. 

Industrial Sector Experiences Declining Vigor. While 

some important manufacturing industries, like motor 

vehicles, continue to post strong sales, overall growth in 

the industrial sector is slowing. The Midwest Manufacturing Index (MMI), calculated by the Federal Reserve 

Bank of Chicago, demonstrates that a slowdown is 

under way in the broader manufacturing sector (see 

Chart 1). This index, based on 16 manufacturing industries important in the Region, has expanded at a rate of 

only 2.1 percent annually since mid-1998. This pace is 

considerably slower than during the 23 months ending 

in May 1998, when, at its slowest, the MMI index 

expanded by 3.7 percent annually (relative to the same 

month a year earlier). 

Part of the current slowdown can be attributed to 

strikes against the General Motors Corporation (GM) 

in the summer of 1998. However, weakness exists in 

other sectors as well. The steel and farm equipment 

industries have experienced sharp output declines 

recently, while production of chemicals and of paper 

and related products has fallen, although less sharply. 

At the same time, the food processing industry, fabricated metals firms, and producers of industrial and 

electrical machinery and equipment experienced continued, but slower, growth. Although tight labor markets and low unemployment have enabled some laid-off 

workers to find replacement jobs, communities with a 

heavy exposure to affected industries likely will experience some weakening of activity in the retail, service, 

and other sectors as well. 

CHART 1 

Growth Slows for Both Midwest Manufacturing 

Index and Region’s Manufacturing Employment Percent Change from Year Earlier 

Sources: Bureau of Labor Statistics and Federal Reserve Bank of Chicago, via 

Haver Analytics, Inc. 

4Q 

’83 

2Q 

’85 

4Q 

’86 

2Q 

’88 

4Q 

’89 

2Q 

’91 

4Q 

’92 

2Q 

’94 

4Q 

’95 

2Q 

’97 

4Q 

’98 

–10 

–5 

0 

5 

10 

15 

20 

Midwest Manufacturing 

Index 

Region’s Manufacturing 

Employment 

Chicago Regional Outlook 16	 Second Quarter 1999 
Regional Perspectives
 

Peaks in the MMI’s growth rate typically precede those 

in the Region’s manufacturing employment (see Chart 

1). Following this pattern, manufacturing job growth 

peaked in early 1998, about ten months after growth in 

the MMI peaked. The recent sustained slowing in the 

MMI’s growth rate suggests that factory employment 

growth likely will remain tepid through mid-1999, at 

least. 

As growth in the industrial sector has slowed, so too has 

growth in household and business incomes. Household 

income rose about 4.5 percent in the Chicago Region 

last year—about eight-tenths of a percentage point 

slower than in 1997. If stock prices fall dramatically or 

interest rates rise while income growth slows, a slump 

in consumer confidence and a curtailment of households’ willingness and ability to spend freely could follow. Such events, in turn, could weaken the current 

expansion’s viability. 

Although regional data are not available for business 

profits, the marginal gain in operating profits at the 

national level at year-end 1998 likely was mirrored by 

many firms in the Region. Among producers of nondurable goods such as chemicals, rubber and plastics, 

paper products, and food, fourth-quarter profits nationally were 37 percent lower than at year-end 1997, the 

first significant decline since 1992. Durable-goods 

firms—those producing metal products, vehicles, 

equipment and machinery, for example—saw operating 

profits pick up at year-end after midyear declines. However, the quarterly pattern partly reflects the impact of 

strikes against GM. When average profits in 1998 for 

durable-goods manufacturers are compared with those 

in 1997, a slim gain of 1 percent was realized. Reduced 

profitability has contributed to an increase in job layoff 

announcements since mid-1998. It also may serve as a 

warning sign that some business borrowers’ repayment 

abilities could be coming under pressure. 

CHART 2 

Distribution of Counties’ Employment 

Growth Shifted in 1998 

Source: Bureau of Labor Statistics, via Haver Analytics, Inc. 

0 

50 

100 

150 

200 

Falling 0% to 1.99% 2% to 4% Over 4% 

Pace of Employment Growth (relative to four quarters earlier) 

Number of Counties 

1997:Q4 

1998:Q4 

Job Growth Is Uneven across the Region. Since 

midyear 1998, the Region’s unemployment rate has hovered around 3.9 percent, about half a percentage point 

lower than the national rate. Low unemployment is one 

factor behind the temperate job growth of 1.8 percent in 

1997 and 1.9 percent in 1998. Another is the recent 

reduction in employment by manufacturing firms, especially among durable-goods producers, which is illustrated in Table 1. 

Although the recent pace of job growth has been fairly 

stable for the Region as a whole, the pace has been 

uneven across its counties as well as across its industries. During 1997, for example, employment growth 

was 2 percent or higher in nearly half of the 437 counties in the Region, as shown by the dark bars in Chart 2. 

In contrast, this share fell to only 24 percent, or 103 

counties, in 1998 (see light bars in Chart 2). 

The most dramatic shift in job growth among counties 

took place in Michigan and partly reflects the strikes 

TABLE 1 

Manufacturing Job Loss Occurred in Four of the Region’s States 

(Thousands of Jobs, March 1998 to March 1999) 

REGION IL IN MI OH WI 

ALL MANUFACTURING –33.1 –5.5 1.4 –9.6 –14.8 –4.6 

DURABLE-GOODS SECTOR –29.0 –5.3 0.5 –9.4 –11.5 –3.3 

NONDURABLE-GOODS SECTOR –4.1 –0.2 0.9 –0.2 –3.3 –1.3 

ADDENDUM: MARCH 1999 99.2% 99.4% 100.2% 99.0% 98.7% 99.3% 

MANUFACTURING EMPLOYMENT 

AS PERCENTAGE OF MARCH 

1998 LEVEL 

Source: Bureau of Labor Statistics, via Haver Analytics, Inc. 

Chicago Regional Outlook 17 Second Quarter 1999 
Regional Perspectives
 

MAP 1 

Slowdown in Job Growth Is Widespread 

Employment Growth Employment Growth 

1996:Q4 to 1997:Q4 1997:Q4 to 1998:Q4 

Falling (106) Falling (124)

0% to 1.99% (116) 0% to 1.99% (210)

2% to 4% (116) 2% to 4% (74)

Over 4% (99) Over 4% (29) 

Note: The darker the shading, the weaker the job growth. Figures in parentheses reflect number of counties in the range. 

Source: Bureau of Labor Statistics, via Haver Analytics, Inc. 

against GM and their spillover effects on GM suppliers 

and various communities. Only 10 of 83 counties in the 

state had sluggish or no growth in 1997 (see Map 1, left) 

but 60 counties were in this situation in 1998 (see Map 

1, right). Ohio posted the second biggest shift, with 76 

percent of its 88 counties experiencing sluggish job 

growth or decline in late 1998, up from 41 percent a 

year earlier. These developments suggest that slower 

economic growth is affecting an increasing number of 

communities, even though job growth in the Region as a 

whole remains fairly steady. 

Housing Activity Remains Robust. New residential 

construction and home resales continue to be buoyed by 

low unemployment, favorable interest rates, and households’ rising net worth from appreciation of real estate 

and financial assets. Residential construction permits in 

the Region jumped by 12 percent in 1998. Home resales 

TABLE 2 

Residential Housing Rebounded 

(Percent Change from 

1997:Q4 TO 1998:Q4) 

IL IN MI OH WI 

SINGLE-FAMILY 

PERMITS 10.5 12.8 9.8 14.2 15.6 

RESALES OF HOMES, 

CONDOS, AND CO-OPS 15.8 13.8 8.5 10.3 10.9 

Sources: Bureau of the Census and National 

Association of Realtors, via Haver Analytics, Inc. 

also rose by 12 percent, and the median sales price rose 

by nearly 8 percent. The sustained strength in residential construction and sales is generating spillover 

demand for home furnishings, appliances, landscaping, 

and the like, all of which contribute to a community’s 

economic health. Only Michigan fell short of posting 

double-digit growth in both permits for new singlefamily homes and home resales in 1998 (see Table 2). 

The widespread weakening in job growth in the state 

may have contributed to the relatively weaker performance of its housing market. 

Associated with these developments, 1- to 4-family 

mortgages held by insured institutions in the Region 

rose by 5.6 percent ($10.8 billion) between year-ends 

1997 and 1998. Reflecting a sharp shift in borrower 

preference, long-term, fixed-rate mortgages at the 

Chicago Region’s banks accounted for 66 percent of 

total mortgages at year-end 1998, up from 56 percent a 

year earlier. This shift likely is challenging some institutions’ ability to manage their asset-liability mix and 

interest rate exposure. 

Bank and Thrift Performance 

Results Moderate 

The Region’s banks and thrifts reported generally 

healthy financial conditions in the fourth quarter of 1998 

(see Chart 3). However, aggregate results reflect a modest decline in some key performance measures. 

Chicago Regional Outlook 18 Second Quarter 1999 
Regional Perspectives
 

CHART 3 

Chicago Region Institutions Report
 

Moderating Performance
 

12 

10 

8 

6 

4 

2 

0 

Tier 1 Risk- Return on Net Interest Past-Due 

Based Capital Assets Margin Loans 

Source: Bank and Thrift Call Reports, December 31, 1998 

1996 

1997 

1998

Percent of Assets 

The Region’s banks reported a return on assets (ROA) 

ratio of 1.08 percent for the year ending December 31, 

1998, down from 1.38 percent a year earlier. The decline 

in aggregate performance was driven chiefly by a narrowing net interest margin (NIM). The aggregate NIM 

among the Region’s banks fell to 3.96 percent at yearend from 4.24 percent a year earlier. A decline of 50 

basis points in the yield on earning assets more than 

offset a decline of 23 basis points in the cost of funds. 

Compression in the NIM over the year was most prevalent in the Region’s largest (total assets greater than 

$10 billion) and smallest (total assets under $100 million) banks, where, in aggregate, interest spreads 

declined 30 and 28 basis points, respectively. Noninterest income continues to bolster net income for many 

insured institutions; however, an increase in the aggregate level of noninterest income in the fourth quarter 

was offset by a larger increase in noninterest expenses. 

On the whole, banks continue to report relatively high 

capital ratios; however, aggregate Tier 1 and total riskbased capital ratios at year-end were at their lowest levels since 1990 and 1991, respectively. 

Aggregate performance of the Region’s thrifts improved 

over the previous year. The Region’s thrifts reported an 

average ROA of 0.83 percent at year-end, compared 

with 0.65 percent the previous year. An increase in the 

level of noninterest income offset a slight decline in the 

net interest income. 

Weak Agricultural Conditions Continue to Warrant Attention
 

Farmers, in general, were in good financial condition 

before last year, and many have the financial flexibility 

to withstand a period of poor agricultural conditions. 

However, the wherewithal of some farmers may be tested this year, as the United States Department of Agriculture (USDA) forecasts continued low commodity 

prices in 1999. According to USDA forecasts, prices of 

corn and soybeans, two field crops especially important 

to Illinois and Indiana, are expected to decline by as 

much as 20 percent from last year. 

The dairy sector, which was one of the strongest farm 

sectors in 1998, stumbled earlier this year when the 

basic formula price for milk took a steep and unexpected decline. The decline in milk prices was due to better 

weather conditions, herd expansion, and higher milk 

output, which have eliminated shortages. The USDA is 

projecting milk prices to rebound as the year unfolds, 

and prices are expected to average between those seen 

in 1997 and 1998. As a result, returns for dairy farmers 

may be lower in 1999 than in 1998. 

Insured institutions in the Chicago Region reported 

total outstanding agricultural loans (agricultural production loans plus loans secured by farmland) equaling 

$13.0 billion as of year-end 1998. Nearly 70 percent, or 

1,419 insured institutions, in the Region hold some 

agricultural loans. Most agricultural financing is held 

by larger, diversified financial institutions, which held 

agricultural loans totaling $8.7 billion, or 67 percent of 

total outstanding agricultural loans in the Region. 

Because their loan portfolios are often quite diversified, 

these institutions may be able to withstand some deterioration in the agricultural segment without significant 

damage to their overall portfolio quality or earnings. 

The Region’s 348 agricultural banks1 held $4.3 billion in 

agricultural loans, with almost 63 percent of this amount 

held by Illinois’ 241 agricultural banks. The average 

1 An agricultural bank is defined as any institution where the sum of 

agricultural production loans and loans secured by farmland exceeds 

25 percent of total loans. 

Chicago Regional Outlook 19 Second Quarter 1999 
Regional Perspectives 

agricultural bank had total assets of $58.8 million. More 

than 180 agricultural banks, with total assets of $11.1 

billion, reported farm loan exposures over 200 percent 

of Tier 1 capital (see Table 3). In aggregate, agricultural 

banks headquartered in counties in central and northwestern Illinois and in the western corridor of Wisconsin have particularly high agricultural loan exposures 

relative to capital (see Map 2). 

As a group, agricultural banks thus far have maintained 

profitability despite competitive pressures and 

depressed crop prices. Agricultural banks in the Region 

reported an ROA of 0.97 percent in the fourth quarter of 

1998. The IR aggregate NIM was 3.89 percent, compared with 4.06 percent at small nonfarm banks.2 The 

narrower margin may reflect the strong competition 

agricultural banks face from nonbank competitors. 

However, the trend in agricultural banks’ NIM does not 

indicate any significant margin erosion over the past 12 

quarters. 

Agricultural banks continue to report high capital levels 

and few credit quality problems as of year-end 1998. 

The average core capital (leverage) ratio for agricultural banks of 10.67 percent has been stable over the past 

12 quarters. Net loan charge-offs have been relatively 

static on a year-over-year basis as well. Total past-due 

loan levels rose to 2.27 percent of total loans from 2.03 

percent a year earlier but have remained within a fairly 

narrow range over the past 12 quarters. 

2 A small nonfarm bank is defined as any institution with total assets 

less than $100 million that does not meet the definition of an agricultural bank. 

TABLE 3 

Some Agricultural Banks Have
 

Significant Exposure of Capital
 

AGRICULTURAL 

LOANS TO NUMBER OF TOTAL ASSETS
 

TIER 1 CAPITAL
 BANKS ($ MILLIONS) 

OVER 300% 54 3,230 

200 TO 300% 128 7,880 

100 TO 200% 139 7,825 

UNDER 100% 27 1,362 

TOTAL 348 20,297 

Source: Bank and Thrift Call Reports, 


December 31, 1998
 

MAP 2 

Agricultural Banks’ Loan Concentrations
 

Are Highest in Illinois
 

Agricultural Loans as a
 

Percentage of Risk-


Based Capital by
 

County
 

Greater than 300% 

200 to 300% 

100 to 200% 

Less than 100% 

Source: Bank and Thrift Call Reports, December 31, 1998 

Typically, financial institutions do not immediately 

show the effects of one year, or even two consecutive 

years, of poor agricultural conditions. For farm borrowers who experience difficulties because of a poor crop 

year or low prices, loans are often “carried over” into 

operating loans for the subsequent year or are restructured to reflect “current” status. As a result, current 

reported measurements of asset quality might not reveal 

a rising risk profile in agricultural loan portfolios. As 

evidence, results from a February 1999 survey by the 

Federal Reserve Bank of Chicago reveal that farm loan 

repayments declined for the seventh consecutive quarter, with the index reaching its lowest point since 1985. 

Bankers in Illinois and Indiana were among those who 

reported the greatest weakness in repayments. Weaker 

repayments could be an indication that past-due and 

nonperforming loan data may understate farm borrowers’ difficulties. 

Given the heightened risk in the agricultural sector, 

growth in the allowance for loan losses among the 

Region’s 348 agricultural banks did exceed agricultural 

loan growth during the year ending December 31, 1998. 

However, among the 87 agricultural banks in the highest quartile for agricultural loan growth over the past 

year, a small number reported a decline in reserve balances over the same period and maintained a reserve to 

total loan ratio that was less than the median for all agricultural banks. 

Chicago Regional Outlook 20 Second Quarter 1999 
Regional Perspectives
 

Continued low commodity prices may impede farmers’ 

ability to demonstrate adequate cash flow for both current operating and carried-over loans. Inadequate cash 

flow may force banks to base lending decisions on the 

value of available farm collateral, like land and machinery. A survey by the Federal Reserve Bank of Chicago 

indicates that the depressed agricultural economy has 

begun putting downward pressure on land prices in 

selected areas. Bankers in Illinois reported an annual 

decline in farmland values of 4 percent in 1998, with 

central Illinois values down by 8 percent. As a whole, 

bankers in Indiana reported no change in farmland values in 1998; however, those in northern Indiana reported a slight decline of 1 percent. Institutions making 

lending decisions based on the value of farmland in 

these areas are most at risk for potential asset quality 

problems should cash flow difficulties combine with 

declining farmland values. 

Ongoing weakness in commodity prices, emerging 

repayment problems, and declining farmland values in 

specific areas pose risks to insured institutions active in 

agricultural lending. Agricultural banks with significant 

concentrations of credit located in areas where farmland 

values are declining may be particularly exposed. Prudent risk management among agricultural lenders will 

become increasingly important if weak agricultural conditions persist. Farm lenders will have to determine 

whether individual farmers have sufficient financial 

cushion to withstand a prolonged period of low commodity prices, continue to monitor cash flow, and avoid 

overreliance on land or equipment collateral. In addition, 

bankers need to ensure that reserve balances reflect all 

significant factors that affect repayment and estimated 

credit losses, including continuing weakness in the agricultural sector. In a broader context, lenders should consider the wider economic effect of weak farm conditions 

on the local community and commercial borrowers. 

New Law Allows Cancellation of Private Mortgage Insurance and
 

Imposes Requirements on Mortgage Lenders
 

The Homeowners’ Protection Act of 1998, which 

becomes effective on July 29, 1999, was intended to 

prevent consumers from paying more private mortgage 

insurance (PMI) premiums than necessary and to facilitate the cancellation of such insurance when predefined 

equity levels are reached. The key provisions of the Act 

generally require financial institutions and other mortgage holders to terminate PMI when a mortgage 

reaches a loan-to-value ratio of 78 percent. Furthermore, borrowers may request termination of PMI when 

a mortgage reaches a loan-to-value ratio of 80 percent. 

Loan-to-value calculations are based on the value of the 

residential real estate at the time of loan origination. 

The automatic cancellation provisions apply only to 

loans made after July 29, 1999. 

The Act also contains provisions regarding initial and 

annual disclosures that inform borrowers of their right 

to cancel PMI and the procedures for doing so. Terms of 

the disclosures depend on whether the loan has a fixed 

or adjustable rate and whether the borrower or lender 

pays the insurance. For loans made before the July 29, 

1999, effective date, servicers must notify borrowers 

that they may request cancellation and must provide 

contact information. 

Increases in property value do not have to be considered 

in determining when PMI termination is allowed or 

mandatory. Prepayments, however, must be considered 

for borrower-initiated cancellations of insurance. Generally, insurance must be cancelled at a borrower’s 

request if 

•	 the loan-to-value ratio is less than 80 percent, 

•	 the loan has not been more than 30 days past due in 

the past 12 months or more than 60 days past due in 

the past 24 months, and 

•	 the property value has not declined from its original 

value. 

Mortgage lenders, servicers, or insurers found in violation of the law will be liable to the borrower for actual 

damages, cost of the action, reasonable attorney fees, 

and statutory damages up to $2,000 per individual. The 

Act limits class action lawsuits for the same violation 

to the lesser of $500,000 or 1 percent of the liable 

party’s net worth. The reputational risk for noncompliance may prove greater than any legal or monetary 

penalties. Mortgage lenders and servicers should 

ensure that requisite systems are in place to meet the 

Act’s requirements and to minimize potential liabilities 

for noncompliance. 

Chicago Region Staff 

Chicago Regional Outlook 21	 Second Quarter 1999 
Regional Perspectives
 

References 

Federal Reserve Bank of Chicago, Changes in Farmland 

Values are Mixed Across the District, Ag Letter, 

Number 1903, February 1999, http://www.FRBCHI. 

org. 

The Homeowners’ Protection Act of 1998. U.S. Public 

Law 105-216. 105th Cong., 2d sess., 6 August 1998. 

http://thomas.loc.gov/ 

Chicago Regional Outlook 22 Second Quarter 1999 
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