Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION FIRST QUARTER 2001 

FDIC
 

National
 

Edition
 

Boston 

Chicago 

New 

York 

Atlanta 

Memphis 

Kansas 

City 

San Francisco 

Dallas 

Division of
 

Insurance
 

In Focus This Quarter 

◆ Credit Problems for U.S. Businesses Continue to Rise—Commercial 

loan quality indicators of insured banks have steadily worsened since 1998. Factors 

contributing to this deterioration include rising financial leverage in the corporate 

sector as well as weaknesses within certain domestic industries. Many market 

observers also have attributed the increase in problem commercial loans to a 

heightened appetite for risk and relaxed underwriting standards from 1996 to 1999. 

The apparent softening in economic conditions in recent months reduces prospects 

that business loan quality will improve any time soon. In the meantime, lenders, 

analysts, and supervisors continue to pay close attention to U.S. business lending 

conditions. See page 4. 

◆ Outlook for Three Industries Facing Uncertainty—Industries as 

diverse as telecommunications, health care, and textiles have been experiencing 

problems, despite the economic expansion that began nine years ago. Although the 

sources of their difficulties are quite different, these industries share some common 

concerns and challenges. Fierce competition characterizes their operating environment. Armed with a better grasp of the origins of stress in these industries, we will 

have a better basis for understanding the lending risks associated with a changing 

policy and economic environment in the years to come. See page 12. 

By the Division of Insurance Staff 

Regional Perspectives 

◆ Atlanta—Nearly one-fourth of the 

counties in the Atlanta Region report 

employment concentrations in industries that, according to an analysis of 

economic indicators, could be more vulnerable in the event of an economic 

downturn. See page 22. 

◆ Boston—Commercial loans as a percentage of the total portfolio of the 

Region’s commercial banks rose steeply 

in the past three years, suggesting an 

increased risk profile. See page 23. 

◆ Chicago—Slower economic growth 

and rising exposure to traditionally 

higher-risk loan types suggest that the 

credit risk profile of the Region’s 

insured institutions has increased. See 

page 24. 

◆ Dallas—Increasing oil prices have 

contributed significantly to the Region’s 

boom-and-bust periods. However, as the 

local economies continue to diversify, 

the benefits of rising oil prices will 

diminish over time. See page 25. 

◆ Kansas City—A review of community banks prior to the 1980s agricultural 

crisis shows that the relationship 

between the loan-to-asset ratio and the 

net interest margin frequently was an 

indicator of increased potential for failure. See page 26. 

◆ Memphis—In an increasingly competitive environment, a slowing economy 

will challenge the Region’s insured institutions to meet earnings expectations 

and maintain sound asset quality. See 

page 27. 

◆ New York—As the economy has 

slowed, the Region’s community banks 

have reported a shift into traditionally 

higher-risk, higher-yielding loan categories. See page 28. 

◆ San Francisco—Slowing in the 

Region’s economy could limit consumers’ financial flexibility, contribute 

to higher personal bankruptcy rates, 

and adversely affect subprime and specialty credit card lenders. See page 29. 

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)
 

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

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

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

more information or to provide comments or suggestions about the National Edition of Regional 

Outlook, please call Lynn Nejezchleb at (202) 898-3898 or send an e-mail to lnejezchleb@fdic.gov. 

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

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

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

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

the Federal Deposit Insurance Corporation. 

Chairman Donna Tanoue 

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 
 

 

 

Letter from the Executive Editor
 

To the Reader: 

The goal of the Regional Outlook is to provide useful risk-related information to bankers, banking agency staff, and 

other interested readers. To do this more effectively, the second quarter 2001 edition will have a new look. We will 

publish a single national edition that will provide an overview of economic and banking risks and discussions of these 

risks as they relate to insured institutions in each FDIC Region. We will tell the national story and, at the same time, 

alert the reader to specific trends and developments at the regional level. 

After considering our experience with this new format, we may adopt it permanently for the second and fourth quarters of each year. The first and third quarter editions will continue to feature in-depth coverage of the economy and 

banking industry in each Region. Trying new formats will help us find the right balance between regional coverage 

of specific topics and analysis of economic and banking issues that cut across regional lines. 

After you have read the next edition of the Regional Outlook, we would like to hear from you. Does this new 

approach provide a more effective vehicle for reporting on banking and economic trends? What other suggestions do 

you have for improving our presentation of risk-related information? Call us with your comments at (877) 275-3342 

or (800) 925-4618 (TDD) or e-mail them to lnejezchleb@fdic.gov. 

Sincerely, 

George E. French
 

Executive Editor 


Regional Outlook—National Edition 3 First Quarter 2001
 
In Focus This Quarter
 

Credit Problems for U.S. Businesses 


Continue to Increase
 

•	 Commercial credit quality trends have been slipping since 1998, despite generally favorable U.S. 

business conditions. 

•	 The recent economic slowdown, coupled with 

tighter credit conditions, points to continued deterioration in business credit quality over the coming months. 

•	 Trends in bond defaults, syndicated lending, corporate profitability, and expected default levels 

reveal a number of industry sectors that pose a 

heightened degree of risk to lenders. 

Introduction 

Continuing increases in problem commercial loans have 

focused the spotlight on business lending conditions. 

On September 30, 2000, commercial banks reported the 

highest relative level of noncurrent1 commercial 

loans—at 1.52 percent of total commercial loans— 

since third quarter 1994. In fact, commercial banks have 

been reporting steadily higher rates of noncurrent 

domestic commercial loans since the second quarter of 

1999. The first quarter 2000 edition of Regional Outlook identified several factors contributing to the 

decline in business credit quality despite the strong economic indicators then in place. These factors, which are 

still relevant today, include the rise in financial leverage 

for domestic corporations, greater investment risk 

appetite and looser underwriting standards from 1996 to 

1999, and increasing financial stress within various 

industry sectors. More recently, an apparent slowdown 

in economic growth increases prospects for further 

deterioration in business credit conditions. 

Large Banks Experience a Reversal 

in Commercial Credit Quality Trends 

Through much of the 1990s, a sustained period of economic growth produced improving commercial loan 

credit quality indicators for insured commercial banks. 

This trend reversed itself in 1998, when banks began 

1 Nonaccrual loans plus loans 90 days or more delinquent. 

experiencing a steady rise in nonperforming and delinquent commercial loans. While the initial catalyst for 

this reversal was related mainly to events abroad,2 a 

slowing domestic economy has since taken center stage 

as the underlying driving force behind worsening commercial credit quality trends. 

As of September 30, 2000, noncurrent commercial and 

industrial (C&I) loans held by commercial banks stood 

at $15.6 billion, a 46 percent increase over the previous 

year. Roughly 97 percent of this increase is attributable 

to the rise in nonaccrual and delinquent credit to U.S. 

domiciled borrowers. Net C&I loan loss rates are also 

rising. Through the first three quarters of 2000, annualized C&I loan loss rates reached 0.64 percent, up from 

0.58 percent in 1999. The last time banks saw C&I loss 

rates this high was in 1993 (0.74 percent). 

Larger banks, which have the greatest exposures to 

large- and middle-market corporate credits, have been 

hardest hit by the turnaround in business credit conditions. As shown in Chart 1, banks with over $1 billion 

in assets have experienced most of the recent deterioration in C&I noncurrent loan rates. Since the fourth 

quarter of 1997, the noncurrent C&I loan rate of large 

CHART 1 

Noncurrent Loan Rates
 

Are Rising at Larger Banks
 

Percentage of C&I loans on nonaccrual
 

and 90 days or more past-due 5.2 

4.8 

4.4 

4.0 

3.6 

3.2 

2.8 

2.4 

2.0 

1.6 

1.2 

0.8 

0.4 

4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 

Small Banks 

(< $1 billion in assets) 

Large Banks 

(> $1 billion in assets) 

’88 ’90 ’91 ’92 ’93 ’95 ’96 ’97 ’98 ’00 

Source: Bank Call Reports 

2 Significant events that contributed to higher levels of problem foreign loans in 1998 include the collapse of Asian currency exchange 

rates and default by the Russian government on its sovereign debts. 

Some domestic industries that were highly dependent on exports 

(steel, for example) were also adversely affected by these events. 

Regional Outlook—National Edition 4	 First Quarter 2001
 
In Focus This Quarter
 

banks has increased from 0.74 percent to 1.50 percent. 

Over the same period, noncurrent C&I loan rates at 

small banks were unchanged at 1.64 percent. While the 

increase in noncurrent loan rates at larger banks is significant, these higher rates remain well below those that 

preceded the 1990 to 1991 recession, when noncurrent 

loan rates at large banks were in the 3.40 percent to 3.60 

percent range. 

Much of the recent deterioration in banks’ business 

credit quality is attributable to the seasoning of credits 

underwritten during a period of relaxed lending standards. Each of the three bank supervisory agencies has 

recognized and warned about the potential impact of 

loosened loan underwriting standards in the event of a 

slowdown in the economy. For example, just over a year 

ago, the Office of the Comptroller of the Currency 

(OCC) issued a warning to banks about the “...cumulative effect of the past four years of easing standards...” 

for commercial loans.3 The shift toward more liberal 

credit standards from 1996 to 1999 was fueled by various factors, including a robust economy, intense competition to originate syndicated credits, and an increased 

appetite for risk. During this period, a number of banks 

moved aggressively into non-investment-grade lending to 

combat narrowing interest margins and declining investment-grade yields. According to a recent Standard & 

Poor’s commentary, several banks have acknowledged 

the role of 1997 and 1998 vintage credits in producing 

higher levels of problem loans.4 

Business Loan Performance Is Not Likely 

to Improve Any Time Soon 

Prospects for any near-term reversal in deteriorating 

commercial loan trends are dimming as signs of slower 

economic growth and tighter credit conditions emerge. 

Economic indicators suggest an aging economic expansion that is losing momentum. In third quarter 2000, the 

U.S. economy recorded its 39th consecutive quarter of 

growth. However, real gross domestic product growth 

for the third quarter was only 2.2 percent, well below 

the previous quarter’s growth of 5.6 percent and below 

the 4.9 percent average quarterly growth rate during the 

past eight quarters. Corporate earnings also appear to be 

slowing. Annualized corporate profit growth in the third 

3 Office of the Comptroller of the Currency Press Release. October 5,
 

1999.
 

4 July 20, 2000. “U.S. Bank Loan Portfolios Reflect Rise in Corporate
 

Bond Defaults.” Standard & Poor’s Commentary.
 

quarter slowed to 5.1 percent, down from a 15.6 percent 

annualized growth rate in second quarter 2000 and a 

10.4 percent average growth rate over the past eight 

quarters.5 Corporate earnings are widely anticipated to 

slow even further based on the number of companies 

that have warned of profits falling below expectations 

in the fourth quarter.6 

Prospects for slower economic growth prompted the 

Federal Reserve to lower its target for the federal funds 

rate (the rate charged on overnight lending) by 1/2 percentage point to 6 percent on January 3, 2000. This cut 

follows a 175-basis-point increase in the targeted federal funds rate since the end of June 1999. Although higher interest rates have undoubtedly raised borrowing 

costs for U.S. corporations, business borrowing rates— 

even before the Federal Reserve cut interest rates in January 2001—are well below those prevalent during much 

of the 1980s (see Chart 2, next page). Moreover, 

changes in rates have been far less volatile in the latter 

part of the 1990s than they were during the 1980s and 

early 1990s. 

Tolerance for risk on the part of investors and lenders is 

waning. In a November 2000 survey of underwriting 

practices, the Federal Reserve Board noted that 44 percent of U.S. banks tightened credit terms for large- and 

middle-market borrowers in the past three months, the 

highest incidence of tightening since fourth quarter 

1990. This tightening of credit terms is primarily in 

response to economic concerns, industry-specific problems, and a lower tolerance for risk. Banks appear to be 

especially apprehensive about taking on additional 

credit risk related to merger and acquisition financing 

deals, new borrowing prospects, and specific industry 

segments such as health care, movie theaters, and communications.7 

Tighter credit terms by banks will have the greatest 

impact on high-risk companies, which have fewer 

financing options in an environment of slumping bond 

and stock prices. Moreover, there appears to be a significant increase in the volume of maturing debt that 

could be forced into default if capital market or bank 

5 These figures are taken from the U.S. Department of Commerce’s 

statistics on corporate profits with inventory valuation adjustments. 

6 According to First Call/Thomson Financial, 505 companies released 

warnings that fourth quarter 2000 earnings would fall below expectations, up 96 percent from the 257 companies with negative profit 

warnings for fourth quarter 1999. 

7 See the Federal Reserve Board’s November 2000 Senior Loan Officer Opinion Survey on Bank Lending Practices. 

Regional Outlook—National Edition 5 First Quarter 2001
 
 

In Focus This Quarter
 

CHART 2 

Business Borrowing Rates Have Risen but Are Less Volatile than in Past Cycles 

Percent 

1Q82 3Q83 1Q85 3Q86 1Q88 3Q89 1Q91 3Q92 1Q94 3Q95 1Q97 3Q98 1Q00 

Note: LIBOR = London Interbank Offer Rate 

Sources: Federal Reserve Board, Moody's, FT London Interbank 

3-Month LIBOR 

Moody’s Baa Average Yield 

Prime Rate 

0 

2 

4 

6 

8 

10 

12 

14 

16 

18 

funding is not available. According to Moody’s, some 

$108 billion of rated speculative-grade corporate debt 

held by banks matures over the next three years, a 40 

percent increase over year-earlier levels. 

Higher-risk companies also have a lower capacity to 

absorb the cost of higher interest rates. Yet many companies with debt maturing in the near term will likely be 

forced to pay higher risk premiums than in the past. For 

example, Moody’s notes that in November 2000, 

speculative-grade bond yield spreads over seven-year 

Treasuries reached their widest level since February 

1991, at 771 basis points.8 Chart 3 illustrates further how 

credit spreads between just-investment-grade bond 

issues and near-investment-grade bond issues have 

widened considerably compared with spreads between 

lower-investment-grade bond issues since the beginning 

of 2000. Some of the most significant increases in credit spreads have been observed in the high-yield telecommunications sector, where credit spreads over seven-year 

Treasuries widened by 688 basis points in 2000.9 

The effects of tighter credit conditions and a reduced 

appetite for risk are beginning to emerge in loan origination volumes. According to Loan Pricing Corporation, originations of highly leveraged loans10 through 

8 December 2000. Moody’s Leveraged Finance Commentary. 

9 Merrill Lynch Global Bond composites. Issues facing the telecommunications industry are explored further in the article entitled 

“Three Industries Navigating in a Competitively Charged Environment” in this issue of the Regional Outlook. 10 Loan Pricing Corporation defines highly leveraged loan transactions as those carrying interest rates of 250 basis points or more over 

the London Interbank Offer Rate (LIBOR). 

the first three quarters of 2000 fell to $117 billion from 

$140 billion for the same period in 1999. 

Corporate bond trends provide further evidence of 

financial stress in the domestic market and suggest 

more near-term deterioration in problem business 

loans. Corporate bond default rates have climbed significantly since 1997 (see Chart 4). Through November 2000, trailing 12-month default rates on 

speculative-grade corporate bonds reached 6.8 percent, up from 3.5 percent at the end of 1998. Higher 

default rates have been accompanied by an accelerated 

pace of negative ratings revisions, which, according to 

Moody’s, reached a rate of 3.2 speculative-grade 

downgrades for every speculative-grade upgrade 

through the first 11 months of 2000.11 More signifiCHART 3 

Credit Risk Premiums for High-Yield 

Bond Issues Have Increased Sharply 

Basis Point Yield Spread Between 

220 

200 

180 

160 

140 

120 

100 

80 

60 

40 

20 

0 

A-rated and 

BBB-rated bonds 

BBB-rated and 

BB-rated bonds 

Jan Mar May Jul Sep Nov Jan Mar May Jul Sep Nov 

’99 ’99 ’99 ’99 ’99 ’99 ’00 ’00 ’00 ’00 ’00 ’00 

Source: Merrill Lynch 

11 See Moody’s Credit Perspectives, December 4, 2000. 

Regional Outlook—National Edition 6 First Quarter 2001
 
In Focus This Quarter
 

cant, Moody’s projects that speculative-grade corporate bond defaults will continue to move higher to 9.1 

percent over the coming year. Given a fairly strong 

correlation between speculative bond default rates and 

banks’ noncurrent loan rates, these projections suggest 

a continuing rise in the relative level of problem commercial loans.12 

Loan Default Risk Is Rising 

in a Number of Industry Sectors 

Evidence from Corporate Bond Defaults 

Corporate bond defaults provide clues as to which 

industries may experience a higher rate of defaults. 

Chart 4 shows the historical trend in speculative-grade 

bond defaults since 1988. The initial upward spike in 

default rates in 1998 was largely the result of events 

abroad, when 74, or 59 percent, of 126 defaulted issues 

were attributed to foreign-domiciled issues.13 In 1999, 

the distribution of defaults shifted decidedly toward 

domestic issues, with U.S. firms accounting for 99, or 

67 percent, of 147 defaults. Of the U.S.-domiciled 

defaults in 1999, 64 percent were related to industrial 

CHART 4 

sectors, with concentrations in price-sensitive commodity and trade-dependent sectors such as oil and gas, 

shipping, and steel. Other domestic sectors that experienced a noteworthy rise in defaulted issues in 1999 were 

telecommunications and health care. Year-to-date 2000 

defaults continue to be dominated by U.S. firms.14 

According to Moody’s, year-to-date defaulted bond 

issues have been concentrated in health care; telecommunications; and textiles, leather, and apparel.15 

Evidence from Syndicated Loan Trends 

Past growth in syndicated loans may be another indicator of default risk. Many lenders appeared to increase 

their appetite for risk from 1996 through 1999, judging 

by the growth in leveraged loan and highly leveraged 

loan volumes during this period (see Chart 5, next 

page).16 Because rapid loan growth can be an indicator 

of aggressive risk taking, it is important to review some 

significant borrowing industries that experienced rapid 

credit growth from 1996 to 2000. It is also worthwhile 

to review industries where higher-risk (high-yield) borrowing accounted for a substantial proportion of syndicated loan transactions. 

Pace of Speculative Bond Defaults Expected to Rise Significantly 

Bond Rating Downgrades to Upgrades (right axis) 

Trailing 12-Month Speculative-Grade Bond Default Rate 

Bank C&I Noncurrent Rate Projected 

Default and Noncurrent Loan Rate (%) Bond Downgrades to Upgrades 

0 

1 

2 

3 

4 

5 

6 

0 

1 

2 

3 

4 

5 

6 

7 

8 

9 

10 

11 

’88 ’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 3Q’00 3Q’01 

YTD* 

* Bond default rates through November 30, 2000 

Sources: Moody’s, Call Reports 

12 There is a strong correlation between historical speculative-grade corporate bond defaults and noncurrent loan rates. The correlation coefficient 

between these two variables for the period 1984 to the present is 0.67. 

13 Indonesia alone accounted for 32 defaulted issues in 1998, and sovereign issuers accounted for 36 percent of defaulted debt volume. Historical 

Default Rates of Corporate Bond Issuers, 1998. Moody’s Investor Service. 14 Historical Default Rates of Corporate Bond Issuers, 1999. Moody’s Investor Service. 15 Moody’s Credit Perspectives, December 11, 2000. Issues facing the health care and textile industries are explored further in the article entitled 

“Three Industries Navigating in a Competitively Charged Environment” in this issue of the Regional Outlook. 16 Loan Pricing Corporation defines leveraged transactions as those that carry interest rate spreads of 150 basis points or more over LIBOR and 

highly leveraged transactions as those that carry spreads of 250 basis points or more over LIBOR. Because these definitions are spread-driven, the 

rise in the proportion of higher-yield issuance is attributable in part to a general increase in credit spreads. This was the case particularly during 

the 1998 period, when credit spreads rose significantly. 

Regional Outlook—National Edition 7 First Quarter 2001
 
In Focus This Quarter
 

CHART 5 

Source: Loan Pricing Corporation 

High-Yield Loan Syndications More 

Prevalent from 1996 through 1999 

Leverage Lending to Total 

Syndicated Lending (%) 

Syndicated Loan 

Originations ($ billions) 

High-Yield Leverage Lending 

to Total Syndicated 

Lending (left scale) 

0 

5 

10 

15 

20 

25 

30 

35 

0 

200 

400 

600 

800 

1,000 

1,200 

’90 ’91 ’93 ’95 ’97 ’99 ’92 ’94 ’96 ’98 ’00

Table 1 lists selected industries17 that accounted for a 

significant proportion of syndicated loan volumes from 

1996 to 2000, according to Thomson Financial Securities Data. Industries that experienced some of the most 

rapid growth rates in syndicated loan volumes during 

that time include utilities, telecommunications, and real 

estate investment trusts (REITs). Industries that recorded a particularly significant proportion of high-yield 

TABLE 1 

transactions during that period include real estate and 

construction, REITs, health care, and entertainment/ 

lodging/leisure. 

Evidence from Corporate Profit Trends 

Industry sector earnings trends may also be an indicator 

of industry default risk, because higher defaults are 

more likely in sectors with weak earnings. As noted 

above, profit growth rates of domestic firms appear to 

be decelerating following two years of strong earnings 

growth overall. Rapid growth in previous quarters 

appears to have been driven in large part by high-tech 

and related sectors, such as electronic equipment and 

communications. These sectors have to a large extent 

overshadowed noteworthy declines in profit growth in 

other sectors, such as metals, chemical production, 

medical services, property casualty insurance, apparel 

and textiles, manufactured housing, agriculture, transportation, and wholesale trade (see Table 2). 

Evidence from Credit Risk Models 

Credit default models have proliferated in recent years 

because of advances in technology, data availability, and 

financial theory. One such model is KMV LLC’s CredHistorical U.S. Syndicated Loan Trends 

Help Identify Possible Sources of Industry Credit Risks 

1996 TO 2000 

SHARE OF AVG. ANNUAL 2000 

1996 TO 2000 ISSUANCE ISSUANCE HY AS A % 

ISSUANCE GROWTH GROWTH 1996 TO 2000 

INDUSTRY (%) (%) (%) ISSUANCE 

WHOLESALE AND RETAIL TRADE 7.8 –2 –12 34 

ELECTRIC, GAS AND SANITARY 

UTILITIES 6.5 34 15 19 

TELECOMMUNICATIONS 5.4 28 54 29 

NONDEPOSITORY INVESTMENT 

COMPANIES 5.2 19 24 33 

OIL AND GAS 4.1 23 83 18 

SECURITIES BROKERS/DEALERS 3.7 15 13 4 

ENTERTAINMENT/LEISURE/LODGING 3.3 5 31 42 

REAL ESTATE INVESTMENT TRUST 2.7 27 25 49 

HEALTH CARE 2.6 –4 –41 44 

REAL ESTATE AND CONSTRUCTION 2.5 25 46 50 

Note: HY (high-yield) issuance includes deals priced at 125 basis points or more over LIBOR. 

Source: Thomson Financial Securities Data 

17 This list is taken from a group of 50 sectors defined using Standard Industrial Codes (SICs). Only industries that accounted for more than 2 percent of 1996 to 2000 origination volumes were considered for inclusion. 

Regional Outlook—National Edition 8 First Quarter 2001
 
In Focus This Quarter
 

it Monitor®. This model, which uses publicly available 

information to estimate the likelihood of default for 

individual firms, is widely used by lenders to monitor 

and evaluate obligor risk and credit risk trends. While it 

is not the only model available, the KMV model can be 

applied consistently and easily to the analysis of industry sector credit risk across a broad range of industry 

groupings. 

In brief, the KMV model uses options-pricing theory to 

derive market-based expected default probabilities or 

an expected default frequency (EDFTM).18 The model 

relies mainly on three pieces of information: (1) a 

firm’s asset market value; (2) the volatility of a firm’s 

asset market values; and (3) the firm’s capital structure 

or financial leverage. Although EDFTM scores are company-specific, median industry expected default probTABLE 2 

abilities can be constructed and compared across 

industries and across time to discern relative rankings 

of industry risk and industry risk trends. These median 

EDFTM scores also can be mapped to other default measurement scales, such as external rating agency ratings, 

based on individual EDFTM scores of firms with rated 

debt. 

Since the second quarter of 1998, median EDFTM scores 

have risen significantly across a wide range of U.S. nonfinancial industry sectors (see Chart 6, next page). The 

service and trade sector includes the greatest proportion 

of firms with high default risk. The median probability 

of default for the manufacturing sector firms is lower, 

but it is rising and roughly equaled that of Standard & 

Poor’s BB-grade (sub-investment-grade) obligors as of 

December 2000. 

Various Industries Have Exhibited Negative Profitability Trends 

ANNUAL GROWTH IN NET INCOME 

1998 1996 TO 1999 1994 TO 1999 

INDUSTRY TO 1999 (%) AVERAGE (%) AVERAGE (%) 

STEEL –1,237.9 –428.6 –187.4 

COPPER –80.7 –65.5 13.2 

INTERNET –43.2 –42.7 –35.5 

TIRES AND RUBBER –81.9 –28.6 –12.7 

ALUMINUM –13.2 –13.9 156.4 

CHEMICALS –38.1 –3.9 18.4 

MEDICAL SERVICES AND 

INFORMATION SYSTEMS –48.2 –2.5 44.8 

PROPERTY CASUALTY INSURANCE –3.9 –2.0 3.8 

RECREATIONAL GOODS AND SERVICES .5 2.5 17.1 

APPAREL AND TEXTILES 2.5 10.4 3.3 

MANUFACTURED HOUSING AND 

RECREATIONAL VEHICLES –9.8 11.7 27.3 

AGRICULTURE –1.3 12.3 4.6 

WHOLESALE TRADE –8.8 13.7 13.7 

CEMENT AND AGGREGATES 1.2 21.6 60.5 

OILFIELD SERVICES AND PRODUCTION –373.7 39.9 19.3 

AIRLINES AND FREIGHT –13.2 1,085.5 666.5 

ALL CORPORATE PROFITS (WITH 

INVENTORY VALUATION AND CAPITAL 

CONSUMPTION ADJ.) 5.0 4.4 13.6 

Sources: Economy.com Precis Reports; U.S. Department of Commerce, Survey of Business Conditions 

18 Typically expressed as the probability of default over the coming year. 

Regional Outlook—National Edition 9 First Quarter 2001
 
 

In Focus This Quarter
 

Although no one factor can explain the rise in expected CHART 6 

default measures for U.S. nonfinancial firms, rising 

financial leverage is clearly a major determinant. U.S. 

corporate debt burdens continue to rise in conjunction 

with the longest-running economic expansion in U.S. 

history. The debt-to-net-worth ratio (book value) of 

nonfarm, nonfinancial businesses rose to 83 percent in 

the second quarter of 2000, up from 72 percent at yearend 1996. Although these figures remain below the relative debt levels experienced in the late 1980s and early 

1990s,19 U.S. businesses are nevertheless becoming 

increasingly vulnerable to rising credit costs and disruptions in credit availability. Higher asset value volatility20 has also played a role in rising EDFTM scores, 

which, as in any options-based credit risk model, leads 

to a greater likelihood of default. 

Default Risk Is Rising Broadly 

among U.S. Nonfinancial Firms 

Source: Credit MonitorTM ©2000, KMV LLC, all rights reserved 

3Q 

’00 

1Q 

’96 

3Q 

’96 

3Q 

’97 

1Q 

’99 

3Q 

’98 

3Q 

’99 

1Q 

’00 

1Q 

’97 

1Q 

’98 

0.0 

1.0 

2.0 

3.0 

4.0 

5.0 

6.0 

7.0 

Service & Trade 

Manufacturing 

One-Year EDFTM in Percent

Comparative Median EDFTM 

of S&P Bonds Rated BB 

(as of December 2000) 

Chart 7 shows eight of the highest-risk industries in 

terms of changes in median EDFTM scores over the past 

two years. These industries were drawn from a list of 50 

financial and nonfinancial sectors segregated by Standard Industrial Codes (SICs). For each of these 50 sectors, median EDFTM scores were determined for 

December 2000 and compared with median EDFTM 

scores for the same sector in December 1998. Consistent with general industry observations, entertainment 

and leisure, health care, and telecommunications are 

among the sectors where default risk has risen most significantly over the past two years. 

CHART 7 

While Chart 7 illustrates sectors undergoing financial 

stress, it does not provide information on the relative 

importance of these sectors to lenders. Thomson 

Financial Securities Data provides information on the 

volumes of syndicated loan originations by banks and 

nonbanks. Matching industry-expected default trends 

with syndicated loan origination trends by industry is 

one way to determine the relative importance of higherrisk industry credit exposures.21 

Chart 8 shows median EDFTM and syndicated loan origination pairs for selected industries during the past three 

Industries That Experienced the Greatest Increase 

in Expected Default Risk over the Past Two Years 

Median Expected Default

Frequency (EDFTM) in Percent 14

12 

10 

8 

6 

4 

2 

0 

December 1998

 December 2000 

Comparative Median EDFTM 

of S&P Bonds Rated BB 

(as of December 2000) 

Entertainment Health Wholesale Apparel Business Agriculture Telecom Retail 

& Leisure Care Trade & Textile Services 

Source: Credit MonitorTM ©2000, KMV LLC, all rights reserved 

19 The debt-to-net worth ratio for U.S. nonfarm, nonfinancial businesses averaged slightly under 87 percent from 1988 to 1992. 

20 Implicit in changes in stock prices. 

21 Syndicated loan originations are an imperfect measure of actual loan exposures in the financial industry. For example, it is not possible to determine the level of outstanding exposures simply by summing up origination levels from year to year, because payments on long-term debt are not 

considered. Moreover, a substantial volume of debt represents revolving lines of credit where credit exposures roll over on a periodic basis. Nevertheless, trends in originations do contain some information on the relative level of industry exposures, because they show which industries are 

borrowing more or less during any given year. 

Regional Outlook—National Edition 10 First Quarter 2001
 
In Focus This Quarter
 

years. Of the industries shown, the telecommunications 

industry appears to present the greatest degree of risk, 

given a nearly $50 billion increase in loan volumes from 

1998 to 2000, coupled with a 170 percent increase in 

median expected default levels over the same period. In 

contrast, loans to securities brokers and dealers can be 

considered relatively less risky—despite a $17 billion 

rise in originations from 1998 to 2000—because of a 

fairly modest rise in median expected defaults. It is also 

interesting to contrast the health care and entertainment 

and leisure sectors. Firms in both sectors have experienced a dramatic rise in expected defaults. However, 

since 1998, Thomson Financial Securities Data shows a 

significant curtailment in lending to health care companies, while entertainment and leisure originations have 

held steady over the same period. Because banks appear 

to be reducing credit exposures to health care firms, 

banks should eventually see a decline in the level of 

defaulting debt related to this sector. 

Chart 8 illustrates how U.S. syndicated loan issuance 

and expected default measures can be linked to produce 

a better sense of risk-weighted industry exposure volumes held by lenders. On the basis of this type of analysis, producing a list of industry sectors that appear to 

pose the greatest degree of syndicated loan default risk 

is relatively straightforward. Perhaps not surprisingly, 

industries such as telecommunications, wholesale and 

retail trade, entertainment and leisure, health care, and 

apparel and textiles rank high in terms of risk-weighted 

industry credit exposures using this analysis.22 

Conclusion
 

Many U.S. banks are experiencing deterioration in business loan quality measures. The adverse effects of higher interest rates, a tightening of credit terms, slowing 

profit growth, and industry sector weaknesses are the 

primary contributing factors to this deterioration. Several indicators—including a projected increase in corporate bond default rates, rising expected default trends 

in certain industry sectors, and evidence of lax underwriting practices in previous periods—suggest that 

banks could experience substantial further deterioration 

in business loan quality in the near term. 

Although worsening business loan quality is a concern, these negative trends must be put into perspective. In relative terms, current indicators of business 

loan problems do not approach the experience of 

banks during the last economic downturn of the early 

1990s. Moreover, continued strong earnings and capital provide a significant buffer for banks to weather 

the effects of higher levels of nonperforming business 

loans and business loan losses. Nevertheless, the 

prospect of a slowdown in the economy raises concerns about the possible severity of commercial loan 

problems, a situation that will undoubtedly be watched 

closely by both banks and bank supervisors in the 

coming months. 

Steven Burton, Senior Banking Analyst 

CHART 8 Median EDFTM in Percent 

Expected Default Data Can Be Used to Risk-Weight Industry Credit Risk 

Sources: Credit MonitorTM ©2000, KMV LLC, all rights reserved; Securities Data Corporation 

Health Care 

Syndicated Loan Originations by Industry Sector ($ Billions) 

0 

2 

4 

6 

8 

10 

12 

14 Entertainment & Leisure 

Wholesale Distributors 

Telecommunications 

Securities Brokers & Dealers 

0 20 40 60 80 100 

2000 

1999 1998 

Legend: 

2000 Originations and Dec. ’00 EDFTM 

1999 Originations and Dec. ’99 EDFTM 

1998 Originations and Dec. ’98 EDFTM 

22 Fifty sectors, grouped by SIC codes, were considered. 

Regional Outlook—National Edition 11 First Quarter 2001
 
In Focus This Quarter
 

Three Industries Navigating 


in a Competitively Charged Environment
 

The rising tide of a booming economy in the United 

States has lifted the boats of a broad spectrum of industries over the past nine years. Some industries, however, 

have fallen on hard times despite continued economic 

expansion. These industries represent a broad crosssection of the economy. Problems in these industries were 

precipitated by diverse factors, reflecting the differences 

among sectors in industries ranging from old economy 

(such as textiles) to services (such as health care) to those 

on the horizon (such as telecommunications). 

These industries will navigate in turbulent waters over 

the next few years. All three face an uncertain economic outlook, changing public policies that can influence 

their operating environment, and fierce competition. 

The importance of these industries to the U.S. economy 

varies based on employment. The telecommunications 

industry accounts for about 1.4 million jobs, or 0.85 

percent of total U.S. employment.1 Health care, on the 

other hand, contributes over 11 million jobs, or 7 percent of total employment. Textile industry employment 

has been falling steadily for many years and is now 

under 550,000, accounting for less than 0.40 percent of 

total U.S. employment. 

As diverse as these industries are, a common denominator exists. Intense competition characterizes their 

operating environment, leaving little room for strategic 

missteps. Indeed, there have been reports that these 

industries have been significant contributors to the 

recent rise in problem bank loans. 

With a better grasp of the origins of stress in these 

industries comes a basis for understanding the lending 

risks associated with a changing policy and economic 

environment in the years to come. The following discussion describes trends and developments contributing 

to stress in these industries and looks at the near- and 

long-term outlook. Our discussion also looks at the 

implications for the insured institutions lending to the 

telecommunications, health care, and textiles industries. 

1 Source: Economy.com. Includes employment in telecommunications 

services, telecommunications equipment manufacturing, and cable 

television. 

Telecommunications 

The telecommunications sector consists of several 

industry subsectors, including telecommunications services, cable television, and telecommunications equipment, all of which are facing significant challenges. 

Telecommunications Services 

Rapid growth in the telecommunications services 

industry has been fueled by strong domestic consumer 

demand. However, the pace of consumption of telecommunications services has slowed in recent months. This 

sector has experienced booming growth in revenues 

from computer network access since 1998, while local 

and long distance revenues have grown at a much more 

moderate pace (see Chart 1). 

Rapid change and intense competition characterize the 

industry environment. Long distance businesses, in particular, have experienced fierce competition, resulting 

in severe pricing pressures. Competitors include both 

established and new wireline long distance providers, as 

well as wireless services. Local telephone companies, 

however, have fared well in recent years, as residences 

and small businesses have added phone lines to accommodate the growing demand for Internet access. However, as high-speed DSL and cable Internet access 

become more readily available, the demand for additional telephone lines may diminish, cutting into a 

lucrative source of revenue for local phone companies. 

Capital spending by telecommunications services companies has soared in recent years, although it was 

expected to level off in 2000 in response to higher interest rates and reduced earnings growth. Nevertheless, 

high levels of telecommunications equipment investment are expected to continue for the foreseeable future, 

as telecom service firms require additional equipment 

upgrades to accommodate increased network traffic and 

wireless applications (see Chart 2). 

Cable TV 

Cable TV is another important component of the 

telecommunications services industry. According to 

Economy.com, “among the current technologies available, cable is viewed as the leading option for delivering 

Regional Outlook—National Edition 12 First Quarter 2001
 
In Focus This Quarter
 

CHART 1 

* Forecast 

Source: Economy.com 

Growth in Telecom Services’ Network Access Revenues Soared in Recent Years 

Annual % Change in Residential

Service Revenues

Residential—Local Residential—Long Distance 

Residential—Network Access 

0 

5 

10 

15 

20 

25 

30 

35 

40 

45 

50 

55 

60 

65 

’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00* 

video, telephony, entertainment, and computing services to households and businesses.”2 Cable TV sales 

revenue has grown more than 19 percent a year since 

1995. In spite of this stellar revenue growth, most cable 

companies are not earning a profit because of the high 

levels of capital investment required. 

Telecommunications Equipment 

The telecommunications equipment industry is growing 

rapidly, as telecom service providers rush to upgrade 

infrastructure to enhance their offerings of high-speed 

broadband services. Telecommunications service 

providers are not only upgrading fiber optic and cable 

line networks; they are rapidly upgrading antiquated 

circuit-switched networks to more efficient packetswitch networks. However, the growth in revenues and 

profits was expected to moderate in 2000 because of 

higher interest rates and slower growth in the domestic 

economy (see Chart 3, next page). 

The wireless phone industry also has experienced problems since late 2000. The major mobile phone companies have missed earnings projections, casting doubt on 

the growth potential of the industry. Much is riding on 

the development of third-generation (3G) wireless technology, which is expected to allow wireless access to the 

Internet, transmission of video and other images, and 

videoconferencing—all from a handheld mobile phone. 

Although huge amounts of money are being invested to 

develop 3G technology, it is unclear what applications 

will generate the demand to make the investments profitable. 

CHART 2 

90,000 

80,000 

70,000 

(In $ millions)

60,000 

50,000 

40,000 

30,000 

20,000 

10,000 

0 

Telecom Services’ Capital Spending Growth Soars 

’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00* 

* Forecast 

Source: Economy.com 

2 September 2000. Economy.com, Precis: Industry: Cable TV. 

Regional Outlook—National Edition 13 First Quarter 2001
 
In Focus This Quarter
 

CHART 3 

Telecom Equipment Sales Revenue 

Moderates in 2000 

* Forecast 

Source: Economy.com Annual % Change in Telecom Equipment Sales Revenue 

0 

5 

10 

15 

20 

25 

30 

’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00* 

Outlook 

The telecommunications industry has been badly battered in both equity and bond markets in the past several months. A spate of bad news has resulted in sharply 

lower stock prices and higher costs in debt markets. As 

a result, the availability of financing for some higherrisk firms is now questionable. Investors are concerned 

about the prospect of slowing wireless subscriber 

growth, continuing capital expenditures, intense competition, and the rapid rise in telecom debt3 (see Chart 4). 

The long-term outlook for the telecommunications services industry is positive. The emergence of highmargin technologies and continued growth in wireless 

subscriber rates should enhance profitability in the 

future. Consumers and businesses are also expected to 

CHART 4 

spend an increasing share of their incomes on telecom 

services. Nevertheless, strong competition, huge investments in equipment upgrades, and rapidly changing 

technology will force firms to be nimble and innovative. 

The long-term outlook for the telecommunications 

equipment industry is positive, as the demand for data, 

Internet, and wireless services continues to grow 

strongly. Nevertheless, individual firms in the industry 

face a highly competitive environment and rapidly 

changing technology. 

Cable TV’s long-term outlook is also positive because 

of growing advertising sales and technological developments that should allow cable firms to offer a broader 

array of services. Still, the competitive environment is 

fierce. In addition to competing with a host of “traditional” telecommunications firms, cable firms must 

contend with satellite TV providers, which are partnering with major firms to offer sophisticated communications and entertainment services. 

Implications for Banks 

The most important characteristics of the telecom 

industry with respect to lending risks are its highly competitive environment and its pace of technological 

change. These characteristics suggest that the mediumto long-term outlook for a particular credit may not be 

well represented by current conditions. The success of 

telecom firms will be based on management’s ability to 

adapt to change and compete with a fluid set of competitors. 

Source: Standard & Poor's Compustat 

Growth in Telecom Debt since 1995 Dwarfs Other Sectors’ Debt Growth 

Telecom Industries 

Percent Change in Debt

(1995–1999) 

Radio/Tel. Broadcast/

Commun. Equip.

Basic Materials

ConsumerCyclical

Consumer

Staples

Health Care

Energy

Capital Goods

Technology

Communication

Services

Utilities 

Transportation

Radiotelephone

(Wireless)

Telephone,

Except Wireless

Cable and Other

Pay TV Services 

0 

50 

100 

150 

200 

250 

300 

350 

400 

450 

500 

3 Solomon, Deborah, and Nicole Harris. October 18, 2000. “Talks on Merger By AT&T Wireless Face Investor Static.” Wall Street Journal. 

Regional Outlook—National Edition 14 First Quarter 2001
 
 

In Focus This Quarter
 

CHART 5 

HMO Enrollment Rose Sharply through 1998 

as Employers Sought to Contain Health Care Costs 

HMO Enrollment as a

Percentage of Population 

’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00* 

0 

5 

10 

15 

20 

25 

30 

35 

* Forecast 

Sources: Economy.com, Interstudy 

With both equity and bond markets turning against the 

telecommunications industry, cash-hungry telecom 

firms may have difficulty obtaining financing. This 

could pose a serious risk for banks with a significant 

exposure to telecom start-ups without a major partner or 

an investor sponsor. 

The high capital requirements and financial leverage of 

many telecommunications firms complicate these lending risks. Some of these firms are borrowing heavily to 

put into place an infrastructure to accommodate a 

demand for services that is yet to come on-stream, 

meaning that the payback on this investment may not 

occur for a number of years. 

Health Care 

Industry trends such as declining hospital occupancy 

rates and rising outpatient visits to hospitals, intense 

competition, and the unexpected results of new 

Medicare policy combined to put the health care industry in difficult financial straits during the past few 

years. However, subsequent industry consolidation and 

streamlining and revised Medicare rules have helped to 

stabilize prospects for many health care providers. 

Recent Trends and Developments 

The health care industry has been suffering since the 

implementation of the Balanced Budget Act of 1997 

(BBA), which cut Medicare payments much more than 

expected. However, two subsequent bills were passed to 

“give back” a portion of the Medicare payment cuts 

implemented in the BBA. The Balanced Budget Refinement Act of 1999 should restore some $16 billion of the 

cuts to health care facilities over five years.4 Also, the 

recently passed Benefits Improvement and Protection 

Act of 2000 (BIPA) will restore about $35 billion in 

benefits to the industry over the next five years. BIPA 

will provide the greatest benefit to hospitals, managed 

care plans, nursing homes, and home health agencies. 

The health care industry’s financial situation has stabilized somewhat in the past year because of widespread 

consolidation of hospitals and other health care 

providers. This has helped the industry reach greater 

levels of efficiency as well as improved bargaining 

power in negotiations with managed care organizations. 

Notwithstanding these favorable developments, other 

trends continue to pose serious challenges to many 

firms. Higher labor costs, continued HMO penetration, 

breakthrough pharmaceutical therapies resulting in 

reduced demand for services, and increased outpatient 

volumes have buffeted many health care facilities (see 

Chart 5 and Chart 6, next page). 

Higher-Risk Sectors 

A better understanding of risks and trends in health care 

can be gained by discussing its specific sectors. We 

have segregated these sectors based on the results of an 

option-pricing model of firm default risk. These models 

estimate the probability that the market value of a firm’s 

assets will fall below a level that would trigger default. 

Firms that have low stock prices, volatile stock prices, 

or high debt levels will tend to be flagged as having 

high default risk by such models. 

4 June 15, 2000. Healthcare: Facilities. Standard & Poor’s Industry 

Surveys. 

Regional Outlook—National Edition 15 First Quarter 2001
 
In Focus This Quarter
 

CHART 6	 Health care industry subsectors have been grouped into 

three categories: higher risk, moderate risk, and lower Outpatient Visits to Hospitals Grow Steadily risk, which refer to the degree of default risk relative to 

700 other subsectors in the industry. The estimated default 

Outpatient Visits to Hospitals

(millions) 

600 

500 

400 

300 

200 

100 

0 

’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00* 

* Forecast 

risk across these subsectors varies substantially. The 

highest-risk health care sectors include Offices of Medical Doctors; Skilled Nursing Care Facilities; Home 

Health Care Services; Specialized Outpatient Facilities, 

NEC; and Health Services (see Chart 7). 

Offices of Medical Doctors are largely physicians’ 

practice management firms. These firms acquire a practice of physicians based on a multiple of the practice’s 

discounted cash flow. The multiple can be several times 

the practice’s asset value at the time of purchase. However, these firms have had difficulty achieving profitability because of legal restrictions on referrals among 

affiliated groups of physicians, as well as the reluctance 

of physicians to submit their medical practice to the criteria of cost control.6 Total liabilities in this sector have 

grown rapidly over the past few years. 

Skilled Nursing Care Facilities’ earnings have been 

hurt badly by the BBA. However, they stand to benefit 

from the Medicare “giveback” provided by the recently 

enacted BIPA, which seeks to rectify the deeper-thanexpected cuts in funding resulting from the BBA. 

Skilled nursing care facilities’ performance has also 

been adversely affected by (1) declining occupancy 

Sources: Economy.com, Morgan Quinto 

One such model that is readily available is Credit MonitorTM, which was developed by KMV LLC.5 We stratify 

health care sectors based on their median one-year 

default probability as estimated by expected default frequenciesTM (EDFsTM) generated by Credit MonitorTM. 

Sectors identified in this article as higher-risk sectors, 

therefore, are those with a relatively high percentage of 

firms with low stock prices, volatile stock prices, or 

high debt levels. Readers are cautioned that the risk profile of a specific company may be very different from 

the sector risk profiles described here. 

CHART 7 

Estimated Default Risk Varies Widely among Health Care Subsectors, December 2000 

Median Expected Default

FrequencyTM (EDFTM)

in Percent 

Source: Credit MonitorTM ©2001, KMV LLC, all rights reserved 

Comparative Median EDFTM 

of S&P Bonds Rated BB 

(as of December 2000) 

0 

2 

4 

6 

8 

10 

12 

14 

16 

18 

20 

22 

8011: 

Doctors 

Offices 

8051: 

Skilled 

Nursing 

8082: 

Home 

Health Care 

8093: 

Spec. 

Outpatient, 

NEC 

8000: 

Health 

Services 

8071: 

Medical 

Labs 

8060: 

Hospitals 

6324: 

HMOs 

8090: 

Misc. Health 

Services 

8062: 

Med. & 

Surgical 

Hospitals 

5 Credit MonitorTM’s Expected Default FrequencyTM (EDFTM) estimates the probability of default within one year. KMV LLC’s proprietary calculation for EDFTM is based on (1) the current market value of the firm, (2) the structure of the firm’s current obligations, and (3) the vulnerabiltiy of 

the firm to large changes in market value measured in terms of asset volatility. EDFsTM are one of many potential measures of industry risk, and 

their use in this article should not be construed as an endorsement by the FDIC or Credit MonitorTM. 6 Gruehn, Charles. April 2000. Healthcare Industry Manual. Federal Reserve Bank of Atlanta. 

Regional Outlook—National Edition 16	 First Quarter 2001
 
 

In Focus This Quarter
 

rates caused at least partly by increased competition 

from lower-acuity facilities such as assisted living facilities; (2) rising labor and legal costs; and (3) surging 

debt service costs. Many of these firms are experiencing severe financial stress. The stressed facilities have 

registered negative net income for the past year or so, as 

well as burgeoning debt levels. The high debt levels are 

the result of acquisitions of ancillary support services 

that in many cases are not generating adequate cash 

flow because of the BBA.7 Most of these firms have 

seen their interest coverage ratios decline sharply over 

the past few years. 

Home Health Care Services focus primarily on respiratory therapy programs and intravenous and infusion 

services. The industry is undergoing financial stress as 

a result of the Health Care Financing Administration’s 

implementation of a prospective payment system that 

reduced reimbursements on respiratory therapy and 

infusion therapy. 

Specialty Outpatient Facilities, NEC are primarily 

engaged in outpatient care of a specialized nature, such 

as alcohol and drug treatment and birth control/family 

planning. They have permanent facilities and medical 

staff to provide diagnosis, treatment, or both for patients 

who are ambulatory and do not require inpatient care. 

Many of the firms in this sector have experienced a rising debt burden over the past few years, pushing default 

risk to higher levels. 

Health Services firms are engaged primarily in furnishing medical, surgical, and other health services. Firms 

listed in this broad category rather than more specific categories include companies providing dental services, 

laser eye correction, and physical and occupational therapy. Many publicly traded firms in this category have 

experienced sharply rising liabilities over the past three to 

four years. 

Moderate-Risk Sectors 

Moderate-risk health care sectors include medical laboratories, hospitals, and HMOs. 

Medical Laboratories provide professional analytic or 

diagnostic services to the medical profession or to the 

patient as prescribed by a physician. Companies with 

diverse financial performance and risk of default are 

included in this sector. A number of medical laborato7 Ibid. 

ries have registered deteriorating interest coverage 

ratios in the past year or two. 

Hospitals, as defined for these purposes, are specialty 

hospitals. They are primarily engaged in providing diagnostic services, treatment, and other hospital services 

for specialized categories of patients. Only eight publicly traded firms are listed in this category. They are 

involved in providing specialized hospital care such as 

rehabilitation, diabetes treatment, and drug and substance abuse treatment. 

Hospital and Medical Service Plans (HMOs) are primarily engaged in providing hospital, medical, and 

other health services to subscribers or members in 

accordance with prearranged agreements or service 

plans. Generally, these service plans provide benefits to 

subscribers or members in return for specified subscription charges. Also included in this industry are separate HMOs that provide medical insurance. After 

several years of intense competition among HMOs, 

which restricted premium-rate hikes when medical 

costs were rising sharply, HMOs began to pursue a more 

aggressive approach toward price increases. This new 

approach has improved the near- and intermediate-term 

outlook for this sector. Yet, the prospect of the passage 

of a Patients’ Bill of Rights suggests that rising costs 

could be an issue for HMOs in the future. As an industry, HMOs are highly concentrated, with the top 10 

HMOs accounting for nearly two-thirds of total HMO 

enrollment in the United States.8 

Lower-Risk Sectors 

The lowest-risk sectors in the health care industry 

include miscellaneous health and allied services, and 

general medical and surgical hospitals. Many of these 

firms have an estimated default risk that puts them in 

speculative credit risk categories in spite of the fact that 

they are considered lower risk compared with other 

health care sectors. 

Miscellaneous Health and Allied Services firms are 

involved in providing kidney or renal dialysis services 

and outpatient care of a specialized nature, such as alcohol and drug treatment and birth control/family planning. Some firms are engaged in providing health and 

allied services such as blood banks, blood donor stations, childbirth preparation classes, medical photography and art, and oxygen tent services. 

8 August 31, 2000. Healthcare: Managed Care. Standard & Poor’s 

Industry Surveys. 

Regional Outlook—National Edition 17 First Quarter 2001
 
 

In Focus This Quarter
 

General Medical and Surgical Hospitals provide general medical and surgical diagnostic and treatment services, other hospital services, and continuing nursing 

services. They have an organized medical staff, inpatient beds, and equipment and facilities to provide complete health care. According to a study conducted by 

HCIA-Sachs and Ernst & Young, “The BBA created the 

greatest financial instability that hospitals have experienced since the creation of Medicare in 1965. Yet the 

most severe reductions have just begun to impact hospitals, and will continue to do so through 2002. The 

recently enacted Balanced Budget Refinement Act provides little sustained relief to the industry, and significant financial problems are likely to remain.”9 The study 

also indicates that smaller hospitals (fewer than 100 

beds) are in the “greatest financial jeopardy.” The recent 

enactment of BIPA will help to stabilize the finances of 

hospitals over the next several years. However, other 

trends adversely affecting hospitals include as much as 

40 percent estimated excess capacity, rising labor costs, 

a severe shortage of nurses, continued HMO penetration, breakthrough pharmaceutical therapies, and 

increased outpatient volumes (see Charts 5, 6, and 8). 

Outlook 

The outlook for the health care industry has improved 

substantially in the past year. Industry consolidation and 

legislation to give back some of the Medicare cuts 

implemented in the Balanced Budget Act of 1997 have 

gone a long way to stabilize health care providers’ 

financial prospects, particularly those of hospitals and 

nursing homes. 

The passage of a Patients’ Bill of Rights in 2001 could 

also strengthen the hand of health care providers relative to HMOs. Such a bill could contain provisions that 

would weaken the position of managed care organizations to contain costs and negotiate with health service 

providers. 

Longer term, the demographic trends are positive, with 

the population aging and life expectancy increasing. 

The result should be a growing demand for health care 

services in the future. On the negative side, however, the 

current trends toward greater use of outpatient procedures and drug therapies will dampen the demand for 

inpatient hospital services. 

9 HCIA-Sachs, LLC, and Ernst & Young, LLP. May 1, 2000. The 

Financial State of Hospitals: Post-BBA and Post-BBRA. 

CHART 8 

Hospital Occupancy Rate 

Continues Steady Decline 

Hospital Occupancy Rate

(percent) 

* Forecast 

Sources: Economy.com, Morgan Quinto 

52 

54 

56 

58 

60 

62 

64 

66 

’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00* 

Implications for Banks 

The opportunities for financing health care firms will 

continue to grow into the future. Recent experience has 

shown that the financial performance of many health 

care providers is profoundly influenced by changes in 

Medicare policy. As Medicare expenditures grow to 

occupy a greater and greater place in the federal budget, 

Medicare policy will be scrutinized to an unprecedented degree, magnifying the importance of understanding 

the policy risk associated with health care lending. 

Powerful demographic trends should lead to the growth 

in demand for many health care services over the next 

10 to 20 years. For example, demand for nursing homes 

and assisted living facilities will increase sharply as 

baby boomers reach old age. However, regional supply 

and demand for these services can get out of balance as 

providers add facilities to meet demand. Monitoring 

local demand and supply trends is an important part of 

assessing the credit risks in these loans. 

Textiles 

The textile industry has been plagued by excess capacity, fierce competition from cheaper imports, and sagging textile prices. The result was a sharp drop in 

industry profits in 1999 and continued weakness in 

2000. 

Recent Trends and Developments 

The textile industry is a mature industry that by a number of measures has been declining. Intense competition 

from low-cost imports has taken its toll on domestic 

Regional Outlook—National Edition 18 First Quarter 2001
 
 

In Focus This Quarter
 

textile businesses. Since 1995, textile imports have 

increased nearly 50 percent while exports have grown 

just under 10 percent. A strong dollar should help textile imports continue to outpace exports. As a result of 

industry consolidation and the movement of many operations offshore, textile employment has continued to 

fall steadily. Textile employment has dropped from 

663,000 in 1995 to an estimated 544,000 in 2000.10 

Closely linked to all these trends, labor productivity in
 

the textile industry is low relative to the average for 

other manufacturing industries because of low output 

prices and a heavier reliance on labor in the production 

process. 

The Department of Commerce reports that the industry’s profit as a percentage of sales declined from 3.2 

percent in 1998 to just 1.3 percent in 1999 (see Chart 

9).11 Also, drought in the South has had an adverse effect 

on textile manufacturing firms, as these firms use a 

large amount of water in bleaching and dyeing fabric.12 

Because of improving global demand and plant closings 

in the United States, many analysts believe textile prices 

have now reached a low point. Indeed, data for 2000 

show a slight increase and some firming of prices in the 

first three quarters of the year (see Chart 10, next page). 

Nevertheless, the profit picture seems to have weakened 

further in 2000 because of an increase in nonoperating 

expenses. 

Publicly traded firms in the textile industry can be separated into six major categories: knitting mills, textile 

mill products, broadwoven fabric mills–cotton, broadwoven fabric mills–manmade fiber/silk, carpets/rugs, 

and miscellaneous fabricated textile products. The 

default risk characteristics of these sectors vary significantly as measured by the median EDFTM. 

Higher-Risk Sectors 

The higher-risk sectors include knitting mills, Broadwoven Fabric Mills–Cotton, and Textile Mill Products 

(see Chart 11, next page). 

10 Economy.com. November 2000. Apparel and Textiles, Precis Industry. 

11 Office of Textiles and Apparel, U.S. Dept. of Commerce. September 6, 2000. Current Situation in the U.S. Textile, Apparel, and Manmade Fiber Industries. 12 Kilman, Scott, and Amy Merrick. July 25, 2000. “Drought in the 

South Crimps Economy in Region.” Wall Street Journal. 

CHART 9 

Textile Industry Profits as a 

Percentage of Sales Fall in 1999 

4.0 

3.5 

3.0 

’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 

Percent 2.5 

2.0 

1.5 

1.0 

0.5 

0 

Source: U.S. Dept. of Commerce, Current Situation in the U.S. Textile,
 

Apparel, and Manmade Fiber Industries, September 6, 2000
 

Knitting Mills are engaged in knitting, dyeing, and finishing hosiery, stockings, outerwear, underwear, and 

other products from yarn or knitted fabrics. Two public 

firms in this industry accounted for 66 percent of the 

sector’s 1999 sales. Three out of eight firms in this sector reported net losses and six out of eight reported 

declining sales in 1999. The trends are similar in 2000 

based on incomplete available data. 

Broadwoven Fabric Mills–Cotton are engaged primarily in weaving fabrics more than 12 inches in width, 

wholly or chiefly by weight of cotton. One dominant 

firm accounted for nearly 38 percent of the sales of all 

publicly traded firms in this sector in 1999. The performance of firms in this sector was mixed in 1999. Six out 

of nine of these firms recorded negative net income in 

1999. Two companies reported a sizable increase in 

1999 net income. Incomplete 2000 results suggest that 

six firms are in the black, leaving just three with negative net income. 

Textile Mill Products is a broad category that includes 

establishments engaged in performing any of the following operations: (1) preparation of fiber and subsequent manufacturing of yarn, thread, braids, twine, and 

cordage; (2) manufacturing broadwoven fabrics, narrow 

woven fabrics, knit fabrics, and carpets and rugs from 

yarn; (3) dyeing and finishing fiber, yarn, fabrics, and 

knit apparel; (4) coating, waterproofing, or otherwise 

treating fabrics; (5) the integrated manufacture of knit 

apparel and other finished articles from yarn; and (6) 

the manufacture of felt goods, lace goods, nonwoven 

fabrics, and miscellaneous textiles. Two firms dominate 

this sector. Together, they accounted for over 60 percent 

of the sector’s sales in 1999 (considering publicly traded 

Regional Outlook—National Edition 19 First Quarter 2001
 
In Focus This Quarter
 

CHART 10 

Textile Prices Begin to Recover in 2000 

Producer Price Index

for Textile Mill Products

(NSA, Dec 1984=100) 

Source: Bureau of Labor Statistics 

113 

114 

115 

116 

117 

118 

119 

120 

’95 ’96 ’97 ’98 ’99 ’00 

firms only). Net income for both firms was off sharply 

in 1999. Still, some companies registered net income 

gains in 1999, building on several years of growth in net 

earnings. Although the 2000 data are incomplete, most 

firms in this sector have reported weak earnings. 

Indeed, several firms have reported more quarters of 

negative than positive net income. 

Moderate-Risk Sectors 

The moderate default risk sectors include Miscellaneous Fabricated Textile Products and Broadwoven Fabric Mills–Manmade Fiber/Silk. 

Miscellaneous Fabricated Textile Products includes 

businesses primarily involved in manufacturing curtains 

and draperies, house furnishings, textile bags, and canvas 

and related products; performing pleating, decorative and 

novelty stitching, and tucking for the trade; manufacturCHART 11 

ing automotive trimmings, apparel findings, and related 

products; Schiffli machine embroideries; and manufacturing fabricated textile products, not elsewhere classified. Net income for three out of the five publicly traded 

firms in this sector was negative in 1999. Two of those 

firms have experienced losses for at least two years’ running. Most of these firms reported negative net income 

through the first two or three quarters of 2000. The three 

largest firms’ total debt has grown considerably over the 

past few years. The increase is related primarily to 

financing acquisitions. 

Broadwoven Fabric Mills–Manmade Fiber/Silk are 

engaged in weaving fabrics more than 12 inches in 

width using primarily silk and manmade fibers, including glass. Net income for each of the six publicly traded firms in this category was down in 1999—in most 

cases down sharply. Earnings for most of these firms 

Estimated Default Risk in Textile Industry Subsectors, December 2000 

Median Expected Default

FrequencyTM (EDFTM)

in Percent 

Source: Credit MonitorTM ©2001, KMV LLC, all rights reserved 

2 

4 

6 

8 

10 

12 

14 

16 

18 

20 

22 

0 

Comparative Median EDFTM 

of S&P Bonds Rated BB 

(as of December 2000) 

2250: 

Knitting Mills 

2211: Brdwoven 

Fabric Mill, Cotton 

2200: 

Textile Mill 

Products 

2390: 

Misc Fabricated 

Textile Pds 

2221: 

Brdwovn Fabric 

Manmade, Silk 

2273: 

Carpets 

and Rugs 

Regional Outlook—National Edition 20 First Quarter 2001
 
 

 

 

In Focus This Quarter
 

appear to have continued to deteriorate in 2000. Interest 

coverage ratios for several firms were down in 1999 and 

2000 because of lower income, higher liabilities in 

some cases, and higher interest rates. 

Lower-Risk Sector 

Manufacturers of carpets and rugs represent the only 

lower-risk sector in the textile industry. 

Carpets/Rugs businesses are involved in manufacturing woven, tufted, and other carpets and rugs. This sector, as a group, experienced strong income growth in 

1999. Only one out of six publicly traded firms failed to 

make a profit in 1999, and several firms reported sizable profit increases. Available 2000 data suggest that 

each of these firms will have generated positive earnings. Two firms dominate the carpet and rug sector, 

accounting for about 65 percent of 1999 sales for the 

group. Carpet and rug manufacturing is capital and 

research intensive, which gives the U.S.-based firms a 

comparative advantage over overseas companies, which 

do not have the same level of access to capital markets 

and an educated workforce. 

Outlook 

Some positive factors could temper the adversity being 

experienced by the U.S. textile industry. Low fiber costs 

and an improved trade situation with Asia should 

strengthen the textile industry in the future. Labor productivity has been rising slowly, as firms continue to 

invest in labor-saving computer technology and equipment. The industry is pursuing various strategies to 

remain competitive, including consolidations and mergers and setting up operations in Mexico.13 Nevertheless, 

the current slowdown in the U.S. economy and the 

increased risk of an actual recession has posed challenges for the textile industry. 

Another concern for U.S. producers is trade liberalization and its effect on textile imports. The normalization 

of trade relations with China and the elimination of 

import quotas by 2005 according to the World Trade 

Organization (WTO) Agreement on Textiles and Clothing could lead to even greater imports. 

Implications for Banks 

Banks lending to textile firms face an array of risks 

emanating from the economic environment in which 

these firms operate. These risks include the ebb and 

flow of demand associated with the business cycle of 

the U.S. and world economies; the exchange rate of the 

U.S. dollar, which affects the competitiveness of domestically produced textile products; and the prices of both 

inputs and textile products. U.S. trade policy will also 

have a profound impact on the competitive environment 

in which domestic textile firms operate. Banks need to 

monitor these developments carefully. 

Concentration risk can be a significant issue for some 

banks. Textile mill employment is highly concentrated 

geographically. About 72 percent of all textile mill jobs 

are located in five southeastern states (North Carolina, 

Georgia, South Carolina, Alabama, and Virginia). 

Almost 29 percent of these jobs are in North Carolina 

alone. Another 18 percent are in Georgia. Even within 

these states, textile employment can be regionally concentrated, introducing concentration risk to banks with 

significant exposures to local textile firms. This risk is 

measured in terms of not only the volume of textile 

loans in the portfolio but also the spillover effects that 

plant layoffs can have in the community.14 

In an increasingly global market, credit risk in textiles 

will depend on decisions about production processes 

and intercompany linkages. For example, capitalintensive domestic producers may be in a better position 

to compete with offshore firms with greater access to 

cheap labor resources. Some textile firms may be able 

to enhance profitability and control risk by entering into 

partnerships with domestic and overseas organizations. 

Stephen Gabriel, Financial Economist 

13 Reichard, Robert. January 2000. “New Year Offers Problems and 14 See “Regional Economy,” Atlanta Regional Outlook, second quarOpportunities,” Textile World. ter 1998. 

Regional Outlook—National Edition 21 First Quarter 2001
 
 

 

Regional Perspectives
 

Atlanta Regional Perspectives
 

Despite nearly a decade of economic expansion, 

growth has not been uniform. Some financially 

stressed industries may be more vulnerable to an economic downturn or increasing global competition. Others may be undergoing a structural transformation that 

has constrained growth. Evidence of particular industries coming under pressure may be reflected by the fact 

that default rates on speculative bonds have been 

increasing. By comparing data from three industry 

analysis providers—KMV Corporation, Standard & 

Poor’s (S&P), and Morningstar—we identified seven 

industries that are important in the Atlanta Region and 

that appear vulnerable in the event of an economic 

downturn: health care; wholesale trade; restaurants; 

apparel, footwear, and textiles; agriculture; construction; and retail. 

One approach to quantifying industry risk is the use 

of the KMV Corporation’s Expected Default Frequency (EDFTM) for publicly traded firms. This 

approach was referred to in the In Focus segment of 

Regional Outlook, third quarter 1999. KMV Credit 

Monitor® uses information from a firm’s equity prices 

and financial statements to derive the EDFTM, which is 

the probability that the firm will default within a oneyear period. The primary determinants of a firm’s likelihood of default are asset value, volatility of the asset 

value, and degree of financial leverage. We then 

assume that issues facing publicly traded firms also 

exist for privately held firms in the same industry segment. This approach allows us to use median industry 

EDFsTM as an indication of an industry’s relative risk in 

the Atlanta Region. Data from S&P’s Monthly Investment Review (December 2000) and industry stock performance (as of December 12, 2000) from Morningstar 

also were used to develop comparable industry risk 

rankings. 

The majority of the workforce in nearly one-fourth 

of all counties in the Atlanta Region is employed in 

the stressed industries we identified through the use 

of data supplied by KMV Corporation, Morningstar, 

and S&P. Rural areas tend to have the highest exposure 

to these industry concentrations and therefore may be 

disproportionately affected should an economic downturn occur. Lower managed-care payments, a critical 

nursing shortage, and federal reimbursement cuts are 

generating considerable pressure on the health care services industry. Industry vulnerability, however, may be 

more pronounced in Florida, home to nearly 40 percent 

of the Region’s medical services employment. Retailers 

are increasingly concerned that higher energy costs, a 

changing interest rate environment, weakening consumer confidence, and lower stock returns could curtail 

consumer spending and narrow profit margins. Certain 

areas in the Region may be more vulnerable to overbuilding after nearly a decade of economic growth that 

has stimulated demand for residential and commercial 

construction activity, particularly in rapidly growing 

metropolitan areas. 

The Atlanta Region’s banking industry could be 

affected by further stress in the indusindustries have difficulty meeting 

tries identified in this article. Indirectly, layoffs could result from 

deteriorating conditions in markets 

served by stressed industries. Layoffs 

could negatively affect consumers’ ability to meet debt 

obligations and, ultimately, 

could affect credit quality. 

Insured financial institutions also could experience 

a decline in asset quality if 

these 

financial obligations. 

Regional Outlook—National Edition 22 First Quarter 2001
 
Regional Perspectives
 

Boston Regional Perspectives
 

New England experienced slower economic growth 

during 2000, but the economy remained healthy 

overall. Total nonfarm employment gains continued to 

lag the national average, while the Region’s unemployment rate remained well below average. Per capita personal income growth in the Region again outpaced that 

of the nation, as it has since 1992, while personal bankruptcy filings continued to move lower through the third 

quarter of 2000. Home sales and construction showed 

signs of cooling during the past year, but price appreciation in most major metropolitan markets continued to 

exceed the national pace. The rate 

of increase in home prices has 

been accelerating in smaller, 

more remote metropolitan 

areas in the Region as well 

during the past few years. 

The condition of Boston 

Region insured institutions remains stable. Excluding credit card specialists, the 

aggregate return on assets for the 

Region was 1.26 percent as of 

September 30, 2000, an increase 

of 6 basis points from a year ago. 

However, net interest margins continued to decline, with the largest institutions leading the 

trend. Loan growth among the Region’s small and 

medium-size institutions continued to be robust, particularly in the commercial, commercial real estate, construction and development, and consumer sectors. This 

loan growth helped maintain low past-due loan ratios. 

Loan composition in the Region’s banks reflects a 

continued shift into traditionally higher-risk loan 

categories. Commercial loans are typically higher risk 

than traditional real estate loans, both commercial and 

residential. As of September 30, 2000, the Region’s 

institutions, on an aggregate basis, reported the highest 

ratio of commercial loans to total loans in the past 11 

years. Commercial loans as a percentage of the total 

portfolio at the Region’s commercial banks rose steeply 

in the past three years. The Region’s savings institutions 

also are shifting into a higher concentration of commercial loans, although at a slower pace than commercial 

banks. While concentrations are below the national 

average, the change reflects an increasing risk profile 

for the Region’s banks. 

The pace of loans migrating to nonperforming status 

has increased. On an aggregate level, the Region’s 

insured institutions show favorable and historically low 

past-due loan levels. While the larger institutions’ 

aggregate past-due ratios are beginning to increase 

slightly, primarily because of rising levels of problem 

commercial loans, overall, past-due ratios are being 

diluted by robust commercial loan growth. New loan 

volume is masking the migration of previously booked 

loans to past-due status. The aggregate ratios continued 

to fall for the Region’s smaller institutions and remained 

low compared with the national average. However, 

migration analysis indicates that the rate at which seasoned commercial loans are becoming past due began 

increasing in 1998; if new loans were not being booked, 

the past-due ratios would be increasing. 

Regional Outlook—National Edition 23 First Quarter 2001
 
Regional Perspectives
 

Chicago Regional Perspectives
 

Transition to slower economic growth triggers some 

imbalances. It is unclear whether the deceleration in 

growth that began midyear 2000 represents a temporary 

pause after rapid gains in early 2000; a “soft landing” to 

sustained, moderate growth; or something more severe. 

On the positive side, the level of economic activity 

remained high in early 2001, even though growth was 

slowing in some key sectors. Moreover, lower interest 

rates may temper disruptions that typically accompany 

a significant slowing of economic growth. 

Of importance to the Chicago Region is the fact that 

motor vehicle sales nationally during fourth quarter 

2000 were relatively high, although they were 11 percent lower than during the first quarter. As a result, 

inventories were high and production was curtailed 

early in 2001. Similarly, permits for single-family houses in the Region are relatively high but trending down. 

Meanwhile, the Region’s private-sector job growth 

slowed to around 0.6 percent at year-end, the slowest 

since early 1992. 

Transitions to slower growth, by themselves, often generate short-term imbalances as firms and households 

adjust to changing conditions with a lag. Firms’ earnings and repayment abilities may be reduced, while 

households relying on the continuance of income 

growth and asset appreciation may face challenges as 

labor or financial market conditions soften. Historical 

experience suggests that credit quality problems start 

appearing during transitions to significantly slower economic growth, not just when a recession takes hold. For 

example, the percentage of problem consumer loans 

started to rise a year before the beginning of the last 

recession in mid-1990. In contrast, the percentage of 

past-due and nonaccrual commercial and industrial 

(C&I) loans increased only slightly before the beginning of the last recession but then rose quickly. 

Exposure to credit risk is rising. C&I credit quality 

warrants monitoring in light of the Region’s insured 

institutions’ rising exposure to C&I loans. In addition, 

historical experience shows that C&I charge-off rates 

tend to be higher than for many other loan categories. 

Although the strongest C&I loan growth has occurred 

among the Region’s largest institutions, increased C&I 

exposure is evident at some community institutions as 

well. 

Thirty-nine percent of the Region’s institutions held 

C&I loans equal to 100 percent or more of Tier 1 capital on September 30, 2000, compared with 34 percent 

five years earlier. Furthermore, these institutions 

increased in relative importance from 66 percent of the 

Region’s total assets in 1995 to 75 percent in 2000. 

Thus, the Region’s exposure to C&I loans has increased. 

In general, asset 

quality indicators for 

community banks and thrifts (insured institutions holding assets less than $1 billion) appear favorable; however, certain trends are worth noting. During the past five 

years, the percentage of community institutions with 

significant exposures to commercial real estate and C&I 

lending has risen as loan-to-asset levels have increased. 

Despite this rising exposure to credit risk, the 1.09 percent aggregate allowance for loan losses on September 

30, 2000, was almost unchanged from 1.10 percent ten 

years earlier. However, aggregate capital levels have 

increased substantially during the same period, providing an additional cushion should weaker economic conditions contribute to declining loan quality. 

In aggregate, the Region’s large institutions (with assets 

of $1 billion or more) reported that C&I loan growth 

accelerated to 16 percent for the 12 months ending September 30, 2000, the largest gain in five years. Meanwhile, these institutions also experienced declining 

reserve coverage of nonperforming loans.1 Even though 

large insured institutions have been increasing allowance 

for loan and lease loss levels, such increases have not 

kept pace with growth in total nonperforming loans, 

which has been driven higher by nonperforming C&I 

loans. As of 

September 30, 

2000, 1.23 percent of aggregate C&I loans 

held by large 

institutions were 

nonperforming, a 

41-basis-point 

increase over two 

years. 

1 Nonperforming loans are either delinquent at least 90 days or in 

nonaccrual status. 

Regional Outlook—National Edition 24 First Quarter 2001
 
Regional Perspectives
 

Dallas Regional Perspectives
 

Oil and gas is an important industry in the Dallas 

Region. The Region produced more than 715 million 

barrels of crude oil in 1997, employing 206,000 workers in the oil and gas extraction industry. Rising oil 

prices played a key role in the Region’s booming economy during the 1970s, and declining oil prices contributed to the recessions of 1982 and 1986. 

Oil prices increased threefold from January 

1999 to October 2000. Contributing factors to 

higher U.S. oil prices include low inventories, 

a booming global economy, reductions in oil exploration budgets, 

industrywide consolidation, lack 

of qualified personnel, and outdated delivery systems. 

Potential direction of oil prices 

in the near term. 

likely to remain high through midyear 

Oil prices are 

2001 because few oil-producing countries are able to increase production substantially. As a 

result, supplies are unlikely to rise to a level that would 

push down oil prices. In the interim, prices will be 

extremely volatile, as oil markets remain vulnerable to 

disruptions and cold weather. 

Vulnerability of the U.S. economy to higher oil 

prices. Surging energy prices were a contributing factor 

in three of the past four recessions (1973–75, 1980, 

1990–91). However, the U.S. economy is better able to 

handle an oil price shock today than it was 20 years ago. 

For example, technology has allowed many industries to 

become more efficient users of oil. 

Effects of higher oil prices on the Dallas Region. The 

benefits from higher oil prices have diminished somewhat as the oil and gas industry has gradually declined 

in importance during the past two decades. At the same 

time, the high-tech, construction, and financial services 

sectors have grown in importance. 

The impact of higher oil prices has not been widespread. Rather, the effects are more specific to consumers of petroleum products. Corporate profitability 

has eroded in energy-intensive industries such as transportation, textiles, lumber, paper, chemicals, rubber and 

plastics, and steel. Higher gasoline and heating oil 

prices have reduced consumers’ real income and displaced demand for other goods and services. 

Effects of higher oil prices on energy lending and 

Dallas Region insured institutions. During the 1980s, 

the relationship among the oil and gas industry, the 

Region’s economy, and the fortunes of banks was a 

more direct one. Today the relationship is not as clearcut, as the Region’s economies, particularly in Colorado and Texas, are increasingly diversified. 

Moreover, the degree of economic diversification has 

varied by area, and, as a result, the effects of rising oil 

prices will vary by area as well. 

Oil and Gas as a Share of the U.S. and Dallas Region
 

Economies Has Declined Precipitously since the Early 1980s
 

Oil and Gas Share of

Gross Product (percent)

35 

30 

25 

20 

15 

10 

5 

0 

8.1% 

4.3% 

29.7% 

8.7% 

27.4% 

11.2% 

1981 

27.6% 

12.0% 

1998 

10.1% 

6.1% 

Colorado New Mexico Oklahoma Texas United States 

Note: Industries totaling oil and gas production include oil and gas extraction; the manufacturing industries of chemicals, petroleum, and plastics; and the utility industries of
 

oil, gas, and sanitary services.
 

Source: U.S. Bureau of Economic Analysis (Haver Analytics)
 

Regional Outlook—National Edition 25 First Quarter 2001
 
Regional Perspectives 

Kansas City Regional Perspectives 

The Kansas City Regional Outlook, first quarter 

2001, discusses the strong positive correlation 

between an insured institution’s loan-to-asset (LTA) 

ratio and net interest margin (NIM). However, some 

banks in the Kansas City Region diverged from this 

relationship in 1999, reporting high LTA ratios and low 

NIMs, or low LTA ratios and high NIMs. 

Chart 1 plots the Region’s community banks by reported 1999 LTA ratios and NIMs and segments the middle 

quintile. In general, this scatterplot shows that higher 

LTA ratios correspond with higher NIMs and vice 

versa. However, the chart also shows unexpected relationships: some banks report low LTA ratios but high 

NIMs, or high LTA ratios but low NIMs. 

The LTA/NIM relationship is an indicator of 

increased vulnerability to an economic downturn, 

CHART 1 

A Scatterplot Shows the Positive Relationship 

between LTA Ratios and Net Interest Margins 

Each Dot Represents One Community Bank 

6.0 

st

5.5 

ere

Margin (NIM)5.0 

Int

4.5 

Net

4.0 

3.5

Percent 

3.0 

2.5 Middle LTA Middle NIM 

2.0 Quintile Quintile 

30% 40% 50% 60% 70% 80% 90% 

Loan-to-Asset (LTA) Ratio 

Source: Bank Call Reports, Community Banks, 1999 

particularly for banks with higher LTA ratios. Our 

analysis ranks each quadrant’s relative risk profile using 

loan levels and composition, growth, and leverage performance variables that 

are largely responsible 

for the variance among 

the quadrants. 

This analysis suggests 

that the two groups 

of banks characterized by higher LTA 

ratios may be somewhat 

more vulnerable during 

an economic downturn 

than banks with low loan 

levels. Moreover, given similar LTA ratios, banks with 

higher NIMs are more vulnerable than banks with lower 

NIMs. 

Analysis of insured institutions in the Kansas City 

Region during the 1980s agricultural crisis supports 

these results and shows that among banks reporting 

higher LTA ratios, those with high NIMs experienced a 

significantly higher potential for failure than those with 

lower NIMs. In the case of banks reporting lower LTA 

ratios, the NIM level did not result in material differences in failure rates. 

Although not predictive of community bank failure 

rates, the results of our analysis suggest that banks 

reporting high LTA ratios and high NIMs appear to have 

a higher risk profile than banks reporting low LTA 

ratios and low NIMs. 

Regional Outlook—National Edition 26 First Quarter 2001
 
Regional Perspectives
 

Memphis Regional Perspectives
 

As the economic expansion reaches a historic tenyear anniversary, there are signs of weakening. The 

nation’s gross domestic product, the sum of all goods 

and services produced, continued to grow, but at a substantially slower rate than in previous periods. The 

Memphis Region experienced moderating economic 

growth consistent with that of the nation in the third 

quarter of 2000. Sluggish durable goods sales and 

growing inventories, particularly in the automobile 

industry, led to some temporary plant closures and layoffs. As a result, the Region’s employment growth 

trailed the nation’s for the eighth consecutive quarter. 

Competitive pressures continue to drive bank credit 

exposure. Despite the economic slowdown during the 

third quarter of 2000, banks and thrifts in the Memphis 

Region reported increasing credit exposure, with 

insured institutions’ aggregate loan-to-asset (LTA) ratio 

reaching a historical high 

in third quarter 2000. Loan 

growth is concentrated in 

traditionally higher-risk 

loan types. Pressured by rising competition, banks and 

thrifts have appeared willing to 

accept greater levels of credit risk to 

improve asset yields and maintain net 

interest margins (NIMs). 

These trends are most evident in the Region’s metropolitan areas. During the past three years, funding costs 

among the Region’s metropolitan banks have increased at 

a faster rate than for rural banks. In response, many 

insured institutions operating in the Region’s metropolitan areas have tapped into relatively strong loan demand 

to bolster sagging NIMs. Although insured institutions 

operating in the Region’s metropolitan areas historically 

have reported LTA ratios well below national levels, 

recent loan growth has reversed this trend, and regional 

levels are now higher (see Chart 1). 

Within the Region, banks in the Memphis metropolitan area have reported the greatest increase in funding costs. In 1997, Memphis banks reported aggregate 

funding costs well below the median reported for all metropolitan markets nationally. Since that time, however, 

relative funding costs have climbed sharply and are now 

higher than those in 96 percent of metropolitan areas. 

Economic prosperity in the Memphis area throughout 

much of the 1990s encouraged the formation of new 

CHART 1 

Notes: MSA = metropolitan statistical area 

Includes banks with less than $1 billion in total assets in operation for three 

years or longer and with at least 10 percent of total assets in loans; third 

quarter ratios are reported for each year shown. 

Source: Bank Call Reports 

Loan Levels at Metropolitan Area Banks Have 

Climbed Sharply during This Expansion 

Loans as Percentage

of Total Assets 

’74 ’76 ’78 ’80 ’82 ’84 ’86 ’88 ’90 ’92 ’94 ’96 ’98 ’00 

Banks in the 

Nation’s MSAs 

Banks in the 

Region’s MSAs 

45 

50 

55 

60 

65 

70 

insured institutions; 12 new banks have opened in Memphis since 1991, with 9 opening during the past three 

years. The significant number of new insured institutions 

striving to grow market share is likely a major factor driving the increase in relative funding costs. 

Community banks in the Memphis market have 

responded to rising relative funding costs by focusing 

on asset yields and accepting higher inherent credit risk. 

In the past three years, loans have climbed from 60.5 

percent of total assets to 67.8 percent. In addition, banks 

have participated in the robust real estate market by 

accepting significantly higher concentrations in commercial real estate loans. 

Insured institutions in other metropolitan areas in the 

Region, including Lexington, Louisville, and 

Nashville, also face high or rising relative funding costs. 

These banks have generally followed a similar strategy 

of increasing loan levels or migrating into traditionally 

higher-risk loan types, although not to the extent of 

Memphis banks. Nashville banks will likely experience 

further competitive pressures in the near term, as the city 

is reporting considerable new bank activity. 

How will banks respond to competition in a slowing 

economy? In an environment of slower economic 

growth, the effects of intense competition on earnings in 

certain markets may become more apparent. If loan 

demand softens with slowing economic conditions, 

banks in these markets likely will face difficult strategic 

decisions that could affect asset quality, earnings performance, or market share. 

Regional Outlook—National Edition 27 First Quarter 2001
 
Regional Perspectives
 

New York Regional Perspectives
 

After a record nine years of economic expansion, 

growth in the Region’s economy slowed as 2000 came 

to a close. The Region enjoyed strong productivity, high 

levels of household income, and generally favorable 

commercial real estate (CRE) conditions during the past 

few years. However, slower job and income growth suggest that the Region’s economy will slow further in 

2001. Job growth declined because of tight labor markets, which have been constrained by limited population 

growth in some of the Region’s states and slower growth 

in the manufacturing and financial services sectors. The 

Region’s housing sector also may be softening, evidenced by declining sales volume in some of the 

Region’s larger cities. 

The Region’s economy may be more vulnerable to 

certain economic risks than the nation’s, particularly weakness in the capital markets. Wall Street and 

many ancillary businesses represent a significant portion of the Region’s economy. Furthermore, higher business costs, prevalent in many of the Region’s larger 

cities, also could make the Region more susceptible to a 

slowing economy. In addition, geographic areas that are 

experiencing higher labor and real estate costs or a 

greater reliance on oil products could be more vulnerable as companies downsize or relocate to contain costs. 

The Region’s insured institutions reported slightly 

lower profitability for the nine months ending September 30, 2000, than a year ago. The Region’s banks 

have benefited from the nation’s long economic expansion, experiencing strong loan demand and favorable 

credit quality. However, competition for bank products 

and services is becoming increasingly aggressive 

among bank and nonbank providers. Furthermore, 

because loan demand has outpaced core deposit growth, 

the Region’s banks have increased their reliance on noncore funding, which has constrained net interest margins (NIMs) and heightened liquidity risk at some 

institutions. Higher short-term interest rates compared 

with a year ago contributed to increased funding costs, 

which further pressured NIMs at all banks. 

The Region’s large banks1 reported a continued weakening of commercial and industrial (C&I) credit quality. Although well below levels reached toward the end 

1 Insured institutions with assets greater than $25 billion. 

of the 1980s business cycle, the median C&I past-due 

ratio reported by large banks reached the highest level 

since 1993. Moreover, an increase nationwide in the 

number of criticized Shared National Credits, higher 

corporate bond defaults, and an increased proportion of 

bond rating downgrades to upgrades suggest that large 

banks’ C&I credit quality may weaken further. 

Community banks2 reported strong loan growth and 

increased concentrations in traditionally higher risk 

loan categories. Much as banks did during the 1980s, 

today’s community banks have increased loan portfolios 

to meet customers’ financing needs. Recent loan growth 

has been focused on commercial lending,3 a typically 

higher-yielding, higher-risk lending segment. While 

commercial loan growth suggests an elevated 

credit risk profile, community banks’ margins have not increased consistent 

with the traditional risk-reward 

tradeoff. Increased competition 

and a flat yield curve have pressured community banks’ margins. 

Furthermore, while favorable 

credit quality has aided profitability, there are signs that credit quality may be peaking. 

Similar to the 1980s experience, new bank formation 

in the Region increased during the 1990s economic 

expansion. However, compared with their 1980s peers, 

the credit risk profile of today’s new banks appears to 

be increasing. As of September 30, 2000, the percentage 

of new banks in the Region slightly exceeded the level 

achieved at the height of the 1980s expansion. While the 

Region’s percentage of new banks is equivalent to the 

national average, some of the Region’s metropolitan statistical areas (MSAs) are home to a greater percentage 

of new banks. Strong economic conditions, high personal income levels, and bank consolidation have contributed to new bank formation. The Region’s current 

crop of new banks reported a higher concentration of 

CRE loans than their 1980s peers. Furthermore, some 

of the Region’s MSAs with a greater percentage of new 

banks also have exposure to troubled industries, including the manufacturing and high-tech sectors. 

2 Insured institutions with assets less than $1 billion.
 

3 Includes commercial, commercial real estate, and construction and
 

development loans.
 

Regional Outlook—National Edition 28 First Quarter 2001
 
Regional Perspectives
 

San Francisco Regional Perspectives
 

Although the San Francisco Region’s employment 

growth rate exceeded the nation’s during third quarter 2000, lower corporate profits, increased industry 

layoffs, and higher personal bankruptcy levels in 

some states suggest the potential for economic slowing. Several of the Region’s leading personal computer 

companies, including Intel and Apple Computer, issued 

earnings warnings because of weakness in demand late 

in 2000. Also, layoffs among the Region’s Internet companies accelerated through year-end. Finally, annualized 

data for the first nine months of 2000 show higher personal bankruptcy filing rates in some of the Region’s 

states, compared with the national average. 

Weakness in the Region’s economy has not significantly affected the area’s insured institutions, which 

reported solid performance through third-quarter 

2000. The median return on assets increased 

because of a widening net interest margin, 

from 1.08 percent to 1.15 percent, largely 

despite increased funding costs. Insured 

institutions offset these higher 

costs by increasing the proportion of assets invested in higher-yielding commercial real 

estate loans. Also, some signs 

of asset quality and liquidity deterioration emerged. For example, median 

delinquency levels for commercial 

and industrial loans in some states 

increased, particularly at community 

banks. Furthermore, loan growth outpaced core deposit 

formation and increased banks’ reliance on noncore 

funding sources. 

Although the Region’s insured institutions reported 

relatively strong conditions through third-quarter 

2000, further economic softening may weaken credit 

quality, especially at institutions with large unsecured or subprime consumer loan portfolios. Nearly 

all institutions in the Region held some consumer loans 

as of September 30, 2000; however, subprime and specialty credit card lenders managed the majority of the 

Region’s consumer loan portfolio. These lenders reported relatively strong performance; however, increased 

bankruptcy filings, high household consumption, and 

elevated debt burdens may indicate potential for future 

consumer credit weakness. 

Five of the Region’s 11 states reported personal bankruptcy filing rates that exceeded the national average 

as of third-quarter 2000. Moreover, filing rates in 

Utah and Oregon continued to rise, contrary to the 

nationwide decline. Hawaii, which experienced a period of economic softness during the second half of the 

1990s, reported the Region’s largest increase in bankruptcy filing rates. The current level and trend of bankruptcy rates are important because of the historical 

correlation with consumer credit losses. In addition, 

with the exception of Hawaii, bankruptcy rates 

increased between 1995 and 1998 in several states 

despite the strong economic expansion. The moderation in filing rates in 1999 and 2000 in some states may 

largely be a result of additional household leverage, 

specifically mortgage refinancing, rather than an actual improvement in consumers’ financial positions. 

Household asset appreciation has contributed to 

higher consumer spending in recent years. Rising 

stock prices and rapid home price appreciation allowed 

consumers to spend more than their disposable income. 

In the second half of the 1990s, stock ownership and the 

value of equity holdings increased, providing consumers with access to funds through liquidation of these 

assets. Furthermore, home prices in several of the 

Region’s metropolitan areas have increased recently, 

enabling consumers to borrow against the equity in their 

homes. 

Widespread credit availability and a prolonged period of excellent economic conditions likely contributed to increased debt service levels among 

consumers. Nationwide, debt service payments in second-quarter 2000 were at the highest level since late 

1987. These trends could disproportionately affect consumers with annual incomes below $10,000 because of 

the use of credit card debt. Surveyed consumers in this 

income bracket nearly tripled credit card balances held 

between 1989 and 1998. 

The Region’s consumer lenders are likely to be challenged by deterioration in the Region’s consumer 

sector. An economic downturn could result in increased 

job losses and reduced stock market and home values. 

Consequently, consumers in the Region may find it 

more difficult to liquidate or leverage assets to service 

debts, and bankruptcy rates could rise. Increasing 

delinquency and charge-off rates spurred by these 

trends would particularly affect subprime and credit 

card niche lenders, because these institutions typically 

experience relatively higher proportions of past-due 

consumer loans and consumer credit losses, even in a 

strong economic environment. 

Regional Outlook—National Edition 29 First Quarter 2001
 
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