Outlook
 

WINTER 2003 

In Focus This Quarter 

Causes and Implications of Recent Interest Rate Volatility—Longterm interest rates took a roller coaster ride during the summer of 2003. The 

ten-year constant maturity treasury yield plummeted to a 45-year low on June 

13, only to reverse course sharply over the next 45 days. This level of volatility is unusual by historical standards. Typically, such a sharp rise in interest 

rates is accompanied by strengthening economic data and accelerating inflation. While the emerging economic data were modestly positive over the 

summer, inflation continued to decelerate from already-low levels. 

The short time frame for such a wide interest rate swing was also unusual, 

given the absence of major events or economic shocks during this period. 

Clearly, underlying fundamentals cannot explain fully such an abrupt movement in interest rates. So what caused this 

volatility? The blame probably can be laid at the feet of a “perfect storm” of related factors. The combination of mortgagerelated hedging activity, deflation worries, and a rising federal budget deficit, among other factors, likely played a role. This 

article explores several possible catalysts of the recent increase in interest rate volatility and evaluates the likelihood that a 

more volatile interest rate environment may persist in the foreseeable future. See page 3. 

By Maureen Raymond, Senior Financial Economist 

Atlanta—The housing sector is a key earnings driver 

for many of the Region’s commercial banks, and recent 

increases in residential mortgage rates could challenge 

revenue streams. See page 10. 

Chicago—The Chicago metro area economy and banking 

market are large and diverse. Its economy has underperformed that of the nation in recent years, and competition 

for the retail banking business is strong and intensifying. 

See page 14. 

Dallas—Strong demand and tight supplies are keeping 

natural gas prices high, benefiting gas producers in the 

Region but hindering farmers and manufacturers who rely 

heavily on consumption of natural gas. See page 18. 

Kansas City—Drought in the Region’s western states 

significantly reduced 2002 net farm income. Farm banks 

based in areas of persistent drought are now reporting rising 

delinquencies and increased levels of carryover debt. 

See page 21. 

New York—A steeper yield curve historically has been 

positive for bank margins, but the recent rise in interest 

rates may challenge banks in the Region that hold high 

concentrations of long-term assets. See page 25. 

San Francisco—Record levels of mortgage prepayments 

have reduced mortgage-servicing asset values. Interest rate 

increases may boost servicing values but could heighten 

levels of extension and credit risk. See page 29. 

By Regional Operations Staff 

Regional Perspectives 

San 

Francisco 

Kansas 

City 

Dallas Atlanta 

New 

York 

Chicago 

A PUBLICATION OF THE DIVISION OF INSURANCE AND RESEARCH 
The FDIC Outlook is published quarterly by the Division of Insurance and Research of the Federal Deposit 

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

institutions and financial institution regulators. It is produced for the following six geographic regions: 

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

Jack M. Phelps, Regional Manager, 678-916-2295 

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

David Van Vickle, Regional Manager, 312-382-7551 

Dallas Region (AK, CO, LA, MS, NM, OK, TN, TX) 

Midsouth: Gary Beasley, Regional Manager, 901-821-5234 

Southwest: Alan Bush, Regional Manager, 972-761-2072 

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

John Anderlik, Regional Manager, 816-234-8198 

New York Region (CT, DC, DE, MA, MD, ME, NH, NJ, NY, PA, PR, RI, VI, VT) 

Mid-Atlantic: Kathy Kalser, Regional Manager, 917-320-2650 

New England: Paul Driscoll, Regional Manager, 781-794-5502 

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

Catherine Phillips-Olsen, Regional Manager, 415-808-8158 

The FDIC Outlook provides an overview of economic and banking risks and discusses how these risks relate 

to insured institutions nationally and in each FDIC region. 

Single copy subscriptions of the FDIC 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 FDIC 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 FDIC Outlook, please call Rae-Ann Miller at 202-898-8523 or 

send an e-mail to rmiller@fdic.gov. 

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

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

of this publication was obtained from publicly available sources that are considered reliable. However, the 

use of this information does not constitute an endorsement of its accuracy by the Federal Deposit Insurance 

Corporation. 

Chairman Donald E. Powell 

Director, Division of Insurance 

and Research 

Arthur J. Murton 

Executive Editor Maureen E. Sweeney 

Managing Editor Kim E. Lowry 

Editors Rae-Ann Miller 

Richard A. Brown 

Ronald L. Spieker 

Publications Manager Teresa J. Franks 
In Focus This Quarter 

Causes and Implications of Recent Interest Rate
 

Volatility 

Long-term interest rates took a roller coaster ride 

during the summer of 2003. The ten-year constant 

maturity treasury yield plummeted to a 45-year low on 

June 13, only to reverse course sharply over the next 45 

days (Chart 1). This level of volatility is unusual by 

historical standards. Typically, such a sharp rise in interest rates is accompanied by strengthening economic 

data and accelerating inflation. While the emerging 

economic data were modestly positive over the summer, 

inflation continued to decelerate from already-low 

levels. 

The short time frame for such a wide interest rate swing 

was also unusual, given the absence of major events or 

economic shocks during this period. Clearly, underlying 

fundamentals cannot explain fully such an abrupt 

movement in interest rates. So what caused this volatility? The blame probably can be laid at the feet of a 

“perfect storm” of related factors. The combination of 

deflation worries, mortgage-related hedging activity, 

and a rising federal budget deficit, among other factors, 

likely played a role. This article explores several possible catalysts of the recent increase in interest rate 

volatility and evaluates the likelihood that a more 

volatile interest rate environment may persist in the 

foreseeable future. 

Chart 1 

Putting Recent Volatility in Context 

Before exploring the factors leading to the recent 

increase in interest rate volatility, it is useful to put it 

into historical context. As measured by a simple ratio 

of the standard deviation of the ten-year yield over its 

mean, interest rate volatility during the first nine 

months of 2003 was erratic, ranging from 0.01 to .67, 

compared with 1999 through 2002, when volatility had 

a much narrower range, between .01 and 0.36.1 Previous periods of high volatility typically have been associated with periods of high inflation, such as that 

following the second oil shock in 1979 or the 1981– 

1982 recession. Certain one-time events, such as the 

1987 stock market crash, also appear to be related to 

increased volatility (see Chart 2, next page). 

Deflation Concerns May Have 

Boosted Interest Rate Volatility 

A key difference between the recent economic environment and periods around previous recessions is the 

historically low levels of inflation and interest rates. In 

fact, “core inflation,” as measured by the consumer 

price index less food and energy, has fallen continuously, from 2.8 percent in December 2001 to 1.2 

Yield 

4/1/03 4/30/03 5/29/03 6/26/03 7/25/03 8/22/03 

Note: GSE = Government sponsored entity. 

May: Deflation concerns 

send yields lower 

5/6/03: Fed says economic 

risks weighted toward 

weakness 

7/15/03: Greenspan’s congressional 

testimony indicates unconventional 

monetary policy unlikely 

July to August: GSE hedging 

drives bond market lower, 

amplifying interest rate 

movements 

6/25/03: Fed cuts target 

funds rate by only 25 bps; 

market expected 50 bps 

6/2/03: Greenspan leaves 

door open for rate cut 

7/15/03: White House estimates budget 

deficit to reach $455 billion 

4.6 Many Factors Contribute to Heightened Interest Rate Volatility 

4.4 

4.2 

4.0 

3.8 

3.6 

3.4 

3.2 

3.0 

1 Interest rate volatility is calculated by taking a moving 20-day standard deviation of the ten-year Treasury Note’s constant maturity yield divided 

by the 20-day moving average of that yield. Adjusting volatility for the underlying level of interest rates is indicated by historical evidence 

suggesting that high-yield periods are apt to witness larger daily deviations than low-yield periods. 

FDIC OUTLOOK 3 WINTER 2003 
In Focus This Quarter 

Chart 2 

Increased Volatility of Ten-Year Treasury Notes 

0.08 

0.07 

0.06 

Volatility Ratio 0.05 

0.04 

0.03 

0.02 

0.01 

0 

1979 1985 1991 1997 2003 

Note: Interest rate volatility is calculated by taking a moving 20-day standard deviation of the ten-year Treasury Note’s constant maturity yield divided by the 20-day moving average of that 

yield.
 

Source: Bloomberg, FDIC.
 

percent in September 2003, leading to concerns about 

outright deflation, or a decline in the overall price 

level. With economic activity running below its potential for the past two years and historically low rates of 

capacity utilization in key industry sectors, core 

consumer price inflation has decelerated (see Chart 3). 

Typically, disinflation occurs during a recession, as 

sales drop and retailers are unable to pass on higher 

prices to customers; however, the low initial rate of 

inflation and the fact that inflation, as measured, may 

be overstated lead to expressions of concern about the 

risks of deflation on the part of the Federal Deposit 

Insurance Corporation, the Federal Reserve, and 

private-sector analysts. 

In the absence of actual deflation, it is important to 

note that policymakers’ emphasis on this scenario arose 

from its potentially severe effects on financial instituChart 3 

tions and economic activity. The Federal Reserve 

acknowledged in the official statement after its May 6, 

2003, Federal Open Market Committee (FOMC) meeting that “the probability of an unwelcome substantial 

fall in inflation, though minor, exceeds that of a pickup 

in inflation from its already low level. The FOMC 

believes that, taken together, the balance of risks to 

achieving its goals is weighted toward weakness over 

the foreseeable future.” This statement was the first to 

assess the risks of economic growth and inflation separately. Previous FOMC statements had characterized 

the balance of risks as being in the direction of either 

economic weakness (low inflation) or excessive inflation (strong growth). This was the first time that the 

Fed explicitly recognized that price changes could have 

upside or downside risks, depending on varying conditions of the real economy. 

Disinflation and “Zero Bound” Concerns Intensify Interest Rate Volatility 

9 

8 

Fed funds target rate 

YOY change in core CPI 

Jan 1990 Jun 1994 Nov 1998 Apr 2003 

Notes: YOY = year-over-year; CPI = consumer price index; shaded areas are recession bands. 

FDIC OUTLOOK 4 WINTER 2003 

7 

6 

5 

4 

3 

2 

1 

0 

Percentage 
7 

6 

5 

4 

3 

2 

1 

In Focus This Quarter 

Chart 4 

Interest Rate Volatility Has Increased around FOMC Meetings 

0.08 

01/03/00 08/14/00 03/28/01 11/09/01 06/26/02 02/10/03 09/22/03

Previous federal funds target floor 

of 3 percent set in 1991–92 recession 

1 

2 

3 

4 

5 

6 

7

Federal Funds Target Rate Percentage

(bars)

1. November 6, 2001—Fed cuts more than

0.07 expected, citing “heightened 

uncertainty.” 0.06 2. March 19, 2002—Fed holds, saying Volatility Ratio* (line) 

“expansion uncertain...risks balanced.” 

3. November 6, 2002—Fed cuts 50 basis 

points, citing “heightened geopolitical 

risks.” 

4. March 18, 2003—Iraq War; Fed holds as 

it cannot “usefully characterize risks.” 

0.05 

0.04 

0.03 

0.02 5. 	May 6, 2003—Fed holds on risk “of an 

unwelcome substantial fall in inflation.” 

6. June 25, 2003—Fed cuts 25 basis points; 

market expected 50 basis points. 

0.01 

0 0 7. July 15, 2003—In Semi-annual Monetary 

Policy Report to Congress, Fed indicates 

“situations requiring special policy *Interest rate volatility is calculated by taking a moving 20-day standard deviation of the ten-year Treausry Note’s constant maturity yield divided 

by the 20-day moving average of that yield. 

Source: Haver Analytics/Bloomberg; FDIC. 

Further, the fact that nominal interest rates cannot 

actions most unlikely.” 

stated that “Given the now highly stimulative stance of 

practically be set below zero caused certain Federal 

Reserve officials to give public voice to contingency 

plans in the event the so-called “zero bound” was 

reached.2 Certain Federal Reserve officials indicated in 

widely publicized speeches that in order to gain additional monetary policy traction after the federal funds 

target rate reached zero, the FOMC might orchestrate 

purchases of long-dated Treasury notes to “buy down” 

the long end of the yield curve. Although these discussions clearly were couched in hypothetical language, 

some bond traders appear to have taken speculative 

positions in anticipation of such a move. In fact, since 

the federal funds target rate breached 3 percent, the 

interest rate floor during the 1991–1992 recession, 

volatility appears to have risen in conjunction with 

FOMC meetings (see Chart 4). 

A meaningful turning point in the bond market was 

reached on June 25, when the FOMC announced a 25 

basis point cut in the federal funds target rate instead of 

the 50 basis point cut that many market analysts had 

been anticipating. It was at this point that bond yields 

began to rise rapidly, as traders who were betting on 

lower long-term interest rates moved to liquidate their 

positions. Since then, heightened interest rate volatility 

seems to have accompanied the market’s anticipation of 

several FOMC meetings. In the aftermath of the June 

25 announcement, statements of Federal Reserve officials no longer referred to the purchase of long-term 

Treasuries to ward off deflation. Chairman Greenspan’s 

July 15 semiannual monetary policy report to Congress 

2 Ben S. Bernanke, “Deflation: Making Sure ‘It’ Doesn’t Happen 

Here,” remarks before the National Economists Club, Washington, 

DC, November 21, 2002. 

monetary and fiscal policy and well-anchored inflation 

expectations, the Committee concluded that economic 

fundamentals are such that situations requiring special 

policy actions are most unlikely to arise.” 

However, while the Federal Reserve may no longer be 

considering implementing unconventional monetary 

policy to ward off deflation, it appears that short-term 

interest rates could remain unchanged until the U.S. 

economic recovery develops more fully. According to 

the statements following the FOMC meetings in 

August, September, and October, “policy accommodation can be maintained for a considerable period.” This 

statement seems to have had the desired effect of 

convincing markets that the Fed is serious about staying accommodative until its “predominant concern” 

about a further fall in inflation has been reduced. With 

the large output gap and overcapacity, the economy can 

grow for some time above trend before the excess 

capacity is worked off and disinflation ceases to be the 

predominant concern. But how long is a “considerable” 

period? As long as markets continue to speculate on 

this issue, interest rates are likely to remain volatile. 

Such a position was articulated recently by Federal 

Reserve Bank of Kansas City President Thomas 

Hoenig, who indicated that the Fed should begin to 

consider changing interest rates “once the economy 

achieves sustainable growth with increases in employment and with upward pressure on prices.”3 Most 

analysts expect that the FOMC will maintain a highly 

accommodative policy stance until significant job 

3 Bloomberg. ”Hoenig Says 4% Growth Needed to Boost Jobs.” 

October 7, 2003. 

FDIC OUTLOOK 5	 WINTER 2003 
In Focus This Quarter 

growth and accelerating inflation become sustained 

trends. Still, as the market grapples with the question 

of what exactly is an “accommodative policy,” high 

interest rate volatility will likely persist. 

Mortgage Hedging Amplifies 

Long-Term Yield Movements 

According to some analysts, another significant contributor to increased interest rate volatility over the summer 

was the reaction of large holders of mortgage-related 

assets, such as Fannie Mae and Freddie Mac, to rising 

interest rates. These companies, along with other large 

holders of mortgage assets, engage in a risk management 

technique known as dynamic hedging. 

Hedging mortgage-related assets is complicated by the 

fact that the timing of future cash flows can only be 

estimated. The timing of cash flows will change as 

more or fewer mortgage holders decide to prepay their 

mortgages—a unique feature to this type of debt instrument. This characteristic requires that hedge positions 

be adjusted as the estimates of the timing of future cash 

flows change. The adjustment process is referred to as 

dynamic hedging. 

For those homeowners not seeking to liquidate equity, 

the most important factor governing individuals’ decisions to refinance a mortgage is the rate on the mortgage held relative to one that is potentially available. 

The persistence of low mortgage rates over roughly the 

past two years led to record levels of refinancing and a 

steady increase in home ownership. This boom in mortgage originations ultimately resulted in a significant 

increase in outstanding mortgages and a mortgage 

market dominated by loans that were originated at rates 

close to record lows. Another factor of this boom is 

that the holdings of mortgage-related assets have 

become more concentrated at fewer, larger companies.4 

In mid-June 2003, when mortgage rates began rising 

from 45-year lows, estimates of the rate at which mortgage holders will prepay their debts fell dramatically. 

As mortgage rates rise and expected prepayments slow, 

4 Since 1998, outstanding mortgage-related debt has expanded more 

than 10 percent a year. As of June 2003, mortgage securities pools 

issued by government-sponsored housing enterprises such as Fannie 

Mae and Freddie Mac totaled $3.2 trillion. Mortgage debt, which 

accounts for 58 percent of gross domestic product, has reached $6.6 

trillion. The derivative positions needed to hedge the prepayment and 

interest rate risk of these portfolios are massive. 

dynamic hedging strategies require that hedges be 

adjusted to match new expectations about the timing of 

future cash flows. As the expected return of mortgage 

principal moves further into the future, hedge positions 

are adjusted to compensate. Prepayment estimates, and 

therefore the expected timing of future cash flows, 

changed dramatically in mid-June, and large holders of 

mortgage-related assets moved in concert to adjust 

hedge positions. 

Although maintaining dynamic hedging strategies is 

complex, involving swaps, futures, and cash market 

purchase and sales, the theoretical relationship to 

interest rate volatility can be illustrated by the following example.5 To offset the increasing exposure to 

rising rates caused by a slower return of principal, a 

hedger can sell Treasury securities. The decreased 

demand for Treasury securities embodied by these sales 

puts downward pressure on their value and pushes 

Treasury yields higher. The increased volatility of Treasury rates in this example is caused by the fact that 

rising rates motivated the sale of securities, and the sale 

of the securities itself pushes rates still higher. When 

these conditions reverse and interest rates fall, dynamic 

mortgage hedgers buy Treasuries, pushing prices up and 

supporting the downward momentum in interest rates. 

According to a Federal Reserve study, similar behavior 

among large mortgage asset holders has been enough to 

amplify movements in Treasury market yields (see 

Chart 5, next page). The study finds the magnitude of 

this effect to be an increase in interest rate volatility of 

between 16 and 30 percent.6 

Rising Federal Budget Deficits Also May Be 

Affecting Interest Rate Volatility 

Another factor influencing the interest rate outlook 

and, possibly, adding to the recent interest rate volatility is the growing size of projected federal budget 

deficits. A combination of factors—including the costs 

of the wars in Afghanistan and Iraq, the 2001 and 2003 

tax cut packages, and the revenue shortfall associated 

with the 2001 recession and declining equity prices— 

turned a $255 billion federal budget surplus in 2000 

into a projected $480 billion deficit in 2004. The result 

5 See International Monetary Fund, Global Financial Stability Report,
 

World Economic and Financial Surveys. Washington, DC: September
 

2003.
 

6 Robert Perli and Brian Sack, “Does Mortgage Hedging Amplify
 

Movements in Long-term Interest Rates?” Washington, DC: Federal
 

Reserve Board, August 2003.
 

FDIC OUTLOOK 6 WINTER 2003 
In Focus This Quarter 

Chart 5 

0.08 

Refinancing Exacerbates Interest Rate Volatility 

Shaded areas indicate 

periods of pronounced

refinancing activity. 

7/23/01 5/7/02 2/18/03 

10-year interest 

rate volatility 

1/3/00 10/11/00 

0.06 

0.04 

0.02 

0 

Source: Mortgage Bankers Association, Bloomberg. 

σ(20-day M.A. 10-year Yield)/

μ(20-day MA 10-year Yield) 

has been a dramatic increase in the issuance of Treasury 

debt. In 2000, net retirement of debt by the Treasury 

was $296 billion, compared with a net issuance of 

government debt of $258 billion in 2002. 

While it is clear that the federal government’s demand 

for credit has risen dramatically, the effect of this 

increased demand on long-term interest rates is not 

clear. Leading economists and scholars assert that 

increases in future deficits raise long-term interest rates. 

Professor Martin Feldstein of Harvard University, 

former chairman of the Council of Economic Advisors 

under President Reagan, explains this concept as 

follows: “An anticipated future budget deficit means a 

smaller amount of funds at that future date to finance 

investment in plant and equipment. Restricting that 

investment will require a higher real rate of interest. 

Similarly, the anticipated budget deficit means that 

individuals will have to be offered a higher yield in the 

future to induce them to hold the larger amount of 

government debt in their portfolios. Both of these 

effects raise the expected future interest rate and therefore...they raise the current long-term rate as well.”7 

Key policymakers also have asserted that higher budget 

deficits cause interest rates to rise. Even the current 

chairman of the Council of Economic Advisors, 

Gregory Mankiw, stated recently that “the budget 

deficit is a cause for concern...it could push up interest 

rates. But at the moment high interest rates are not the 

U.S. economy’s main problem. Indeed interest rates are 

7 Martin S. Feldstein, “The Budget Deficits and the Dollar,” NBER 

Macroeconomic Annual 1986, edited by Stanley Fischer, Cambridge, 

MA: MIT Press, 1986. 

very low.”8 Finally, Alan Greenspan argued last year 

that “some of the firmness in long-term interest rates 

probably is the consequence of the fall of projected 

budget surpluses and the implied less-rapid paydowns 

of Treasury debt.”9 

The widening federal government deficit, and the 

increased demand for funding it entails, raises concerns 

about crowding out private investment (see Chart 6, 

next page). However, given the relatively weak growth 

in U.S. investment spending in recent years and the 

still historically low level of interest rates, it is not clear 

that increased government demand for credit has yet 

had a meaningful effect on interest rates. As investment spending recovers and the overall demand for 

credit rises, upward pressure may be applied to interest 

rates. As markets try to decipher this impact on interest 

rates, volatility may heighten. 

Large Foreign Purchases of 

Treasuries Add to Interest Rate Concerns 

The effect of budget deficits on interest rates presumably would be even more substantial if the United 

States did not have access to international capital 

markets. The reduction in national savings from budget 

deficits manifests itself in both lower domestic investment and more borrowing from abroad. The mirror 

image of a reduction in net foreign investment is an 

8 Gregory Mankiw, “Deficits could increase rates,” Reuters, 


October 6 , 2003.
 

9 Alan Greenspan, “The Economy,” Remarks at the Bay Area Council
 

Conference, San Francisco, January 11, 2002.
 

FDIC OUTLOOK 7 WINTER 2003 
In Focus This Quarter 

Chart 6 

Increased Government Borrowing May Crowd Out Private Sector 

Source: FDIC, based on Flow of Funds data. Annual Net Lending (borrowing) by Other Sectors ($ Billions) 

Government Households Nonfinancial Business Domestic Financial Sector Foreign Sector

‘80 ‘81 ‘82 ‘83 ‘84 ‘85 ‘86 ‘87 ‘88 ‘89 ‘90 ‘91 ‘92 ‘93 ‘94 ‘95 ‘96 ‘97 ‘98 ‘99 ‘00 ‘01 ‘02 

–1,500 

–1,000 

–500 

0 

500 

1,000 

1,500 

expansion in the current account.10 If the United States 

imports more goods and services than it exports or has 

a current account deficit, then it must be selling assets 

or borrowing the difference from abroad. The United 

States has a very large current account deficit, requiring 

it to borrow from abroad on a massive scale. The shortfall or current account deficit was about $139 billion in 

second quarter 2003 alone, about 5 percent of gross 

domestic product (see Chart 7). The United States 

needs to attract more than $2 billion in foreign capital 

every working day just to finance the current account 

deficit. To the extent these foreign inflows are invested 

in U.S Treasury debt, interest rates are reduced. Large 

shifts in foreign holdings of U.S. Treasury debt or speculation regarding shifts or the rate of net new purchases 

could elevate interest rate volatility. The heavy reliance 

on, and the volatile nature of, international capital may 

raise interest rate volatility. 

Many of this nation’s trading partners, particularly in 

Asia, currently run bilateral trade surpluses with the 

United States. As they recycle dollars gained in the sale 

of exports, they typically purchase U.S. Treasury or 

other lower-risk debt. In addition, after a decade of 

economic stagnation, Japan continues to follow a 

policy of intervention in the exchange rate market to 

limit yen appreciation and thereby encourage Japanese 

exports. To implement this policy, the Bank of Japan 

has sold yen and bought dollar-denominated assets, 

such as U.S. Treasury and agency securities. From Janu10 The current account is equal to net exports (exports minus imports) 

of goods and services plus net factor income (interest payments 

received from abroad minus interest payments made to foreigners 

from abroad) plus net unilateral transfers (such as direct foreign aid 

payments). 

ary through July 2003 alone, Japan sold about 9.03 trillion yen (U.S. $80.5 billion) and purchased U.S. Treasuries. Japan is the largest foreign holder of U.S. 

Treasury notes and bonds, with $444 billion out of the 

$1.39 trillion held abroad as of July 2003. The total 

amount of Treasury securities outstanding is about $3.5 

trillion, so foreign holdings account for about 40 

percent of all Treasury debt outstanding. 

China is also a large purchaser of U.S. Treasury and 

agency securities. As it recycles its current account 

surplus with the United States, China needs large 

dollar reserves in order to maintain the yuan’s dollar 

peg against speculative attacks and maintain a currency 

exchange rate peg of 8.3 yuan per dollar. According to 

the U.S. Treasury, China is the third largest owner of 

U.S. Treasury bonds, and these holdings surged 23 

Chart 7 

U.S. Current Account Deficit Deteriorates 

Source: Bureau of Economic Analysis. Current account as a percentage of gross domestic product 

–6 

–5 

–4 

–3 

–2 

–1 

0 

1 

1983 1988 1993 1998 2003 

FDIC OUTLOOK 8 WINTER 2003 
In Focus This Quarter 

Chart 8 Conclusion 

Large Japanese and Chinese Foreign Holdings
 

Could Contribute to Interest Rate Volatilty
 

Treasury Holdings U.S. 

($ Billions) 

1,400 

1,200 

1,000 

800 

600 

400 

200 

0 

Other foreign holdings 

China Japan 

1996 1998 2001 2003 

Source: U.S. Treasury. 

percent to $126 billion through the fall of 2003 (see 

Chart 8). 

Some economists argue that there is a risk, although 

small, that if Japan and China ever sold their large 

Treasury holdings it could cause havoc in the U.S. 

Treasury market, forcing yields even higher. Volatility 

could increase should any shift take the form of an 

abrupt shock, rather than a gradual change in investment strategies. An immediate floating of the Chinese 

yuan, for example, might engender such a shock. If 

these nations scaled back their demand for U.S. Treasuries, interest rates could rise. How abruptly rates 

would rise would depend on the nature of the event. 

However, it is not clear whether instigating such instability in international currency and bond markets 

would be advantageous for any of the parties involved. 

It is most unlikely that either China or Japan would sell 

their large holdings of Treasuries, considering the negative consequences of such a move on their economies 

and export markets. 

Several factors contributed to the 2003 episode of 

heightened long-term interest rate volatility. These 

included deflation worries, mortgage-hedging activity 

by large holders of mortgage-backed securities, budget 

deficit concerns, and increased foreign buying of U.S. 

Treasury debt. The key question is whether these 

factors will prove to be one-time shocks or permanent 

fixtures of the interest rate environment going forward. 

To the extent that deflation concerns fade as the economy gains traction and generates new jobs and inflation 

pressures build, this factor should fall by the wayside. 

However, until we reach that stage in the recovery, and 

markets continue to speculate on when the Federal 

Reserve will move from an accommodative stance, 

volatility may persist. Still, other factors may add to 

interest rate volatility over the next several years. The 

ever-expanding mortgage-backed securities market and 

the concentration of holdings at large agencies will 

likely persist as a potential catalyst of interest rate 

volatility. Interest in U.S. securities by nations that 

either run bilateral trade surpluses with the United 

States or need to invest dollars acquired through 

currency management activities likely will remain a 

source of potential volatility. This source may become 

more pronounced should China choose to float its 

currency abruptly, or should Japan cease its recent 

efforts to weaken an appreciating yen. Finally, the 

growing budget deficit may cause uncertainty about the 

future course of interest rates and thus may add to 

volatility whenever budget estimates are revised or 

developments occur that may affect the outlook for the 

federal pocketbook. 

Maureen Raymond, Senior Financial Economist 

FDIC OUTLOOK 9 WINTER 2003 
Regional Perspectives 

Atlanta Regional Perspectives
 

How Might a Slowdown in the Housing Industry 

Affect Bank Earnings? 

Despite the recent recession and 

subsequent weak recovery, the nation’s 

Atlanta Region, homebuilding increased 

unlike during past downturns. In the 

ued to add to the nation’s housing stock, 

housing industry has remained 

resilient. Fueled by 30-yearlow mortgage rates and the 

perceived lack of investment alternatives such as 

the equity markets, demand 

for housing soared. Developers, in response, continmore rapidly than in the rest of the nation. Low 

mortgage rates and continuing home price appreciation 

also have contributed to a boom in cash-out refinancings, which moderated the severity of the recent recession by supporting consumer spending. By third quarter 

2003, however, higher long-term interest rates may 

portend a slowdown in the housing industry. 

The Atlanta Region’s banking and thrift industry also 

has performed well during the past several quarters, in 

large part thanks to record earnings generated by 

funding the construction, purchase, and refinancing 

of housing. However, recent evidence may point 

Chart 1 

toward a weaker housing market going forward. This 

article discusses the implications of a slowdown in 

the recent housing boom on the earnings performance of insured financial institutions based in the 

Atlanta Region. 

Interest Rates and Housing Trends 

Interest Rates Play an Important Role in Shaping 

the Health of the Housing Industry 

Historically, levels and changes in mortgage rates have 

been key factors in determining trends in the construction, purchase, and refinancing of housing. Typically, as 

long-term interest rates decline, housing affordability 

increases, enabling more people to buy homes. Between 

2001 and early 2003, sustained declines in mortgage 

rates more than offset lower personal income growth 

associated with the recent recession and supported 

affordability at record levels.1 In response to continued 

growth in demand, residential permit issuance and 

housing starts increased. Low mortgage rates also energized mortgage refinancing activity (see Chart 1), 

which helped homeowners consolidate debt. In addition, continuing home price appreciation allowed 

borrowers to tap equity that, in turn, helped support 

consumption nationally and mitigated the lingering 

effects of the recent recession. 

Declining Long-Term Interest Rates Energized Mortgage 

Refinancing Activity across the Nation 

Refinancing Index: Mortgage

Loan Applications

(holiday adjusted 3/16/90 = 100)

Ten-Year Treasury Note Yield at Constant

Maturity (inverted scale percentage) 

Sources: Board of Governors of the Federal Reserve System; Mortgage Bankers Association of America (Haver Analytics). 

1,000 

2,000 

3,000 

4,000 

5,000 

6,000 

7,000 

8,000 

9,000 

10,000 

– 

Jan ’00 Jul ’00 Jan ’01 Jul ’01 Jan ’02 Jul ’02 Jan ’03 Jul ’03 

3.0 

3.5 

4.0 

4.5 

5.0 

5.5 

6.0 

6.5 

7.0 

Refinancing Index 

Interest Rates 

1 Some evidence suggests that demand for housing also has been strengthened by the apparent lack of investment alternatives in the wake of 

equity market declines. Affordability measures the ability of a household to qualify for an 80 percent mortgage on a median-priced existing singlefamily home; affordability is a function of income and interest rates. 

FDIC OUTLOOK 10 WINTER 2003 
Regional Perspectives 

The Recent Rise in Long-term Rates Chart 2 

Is Affecting the Housing Sector 

Mid-year 2003 may have heralded a change in the The Recent Rise in Mortgage Rates May Dampen

Home Sales Nationwide interest rate environment as mortgage rates rose more 7,400 5.0

Southeast 30-Year Fixed Interest Rates 

(inverted scale percentage)

New and Existing Home Sales


(000s, seasonally adjusted annual rates)


Home Sales-Mortgage Rates 

Correlation (1/90–7/03) = –0.79 

Home Sales 

Mortgage Rates 

than 100 basis points between June and August, the 

most rapid increase in nearly a decade. In some 

respects, the immediate impact of rising rates on housing markets was positive, as developers, homebuyers, 

and homeowners rushed to lock rates before rates rose 

further. Subsequently, housing starts and home sales 

surged to record levels, and mortgage applications 

continued to increase. In contrast, however, the 

number of mortgage refinancing applications immedi5.5 

7,000 6.0 

6.5 

6,600 

7.0 

7.5 6,200 

8.0 

5,800 8.5 

Jun Dec Jun Dec Jun Dec Jun ately fell, and, by late August 2003, purchase applica­ ’00 ’00 ’01 ’01 ’02 ’02 ’03 

tions also started to decline. 

Continued Increases in Mortgage Rates 

Could Affect Housing Markets Adversely 

History has shown an inverse relationship between 

long-term interest rates and growth in the housing 

market (see Chart 2). If mortgage rates continue to 

climb and the economy fails to post higher growth 

rates, housing affordability likely will suffer. Recent 

declines in purchase mortgage applications may 

portend a slowdown in home sales. Similarly, softer 

demand in the wake of mortgage rate increases could 

constrain rates of home price appreciation, which has 

minimized declines in household net worth following 

the downturn in the stock market during the three 

years.2 Housing has represented a key area of support 

for a weak recovery in recent quarters; should this 

industry slow in response to rising interest rates, the 

prospects for the nation’s economic growth could dim 

somewhat. 

Implications for the Atlanta 

Region Banking Industry 

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

(Haver Analytics). 

lending (REL)4 rose from 38 percent at year-end 1998 

to 49 percent at year-end 2002. Although community 

banks nationwide have placed more reliance on REL, 

the Atlanta Region is home to a disproportionate share 

of these institutions. The Region is home to 13 percent 

of all community banks nationwide; however, 22 

percent (146 banks) of the community banks that are 

ranked in the 90th percentile for REL income to gross 

revenue are based in the Atlanta Region.5 Moreover, 

several metropolitan statistical areas (MSAs) that are 

home to a significant share of banks with relatively 

high levels of REL income also are located in the 

Region. For example, the average ratio of REL income 

to gross revenue reported by community banks based in 

the West Palm Beach-Boca Raton MSA is 63 percent, 

which exceeds the national 90th percentile. Other 

areas where REL income has increased sharply since 

1998, or where at least three of the community banks 

are in the 90th percentile, include the Naples, Fort 

Lauderdale, Sarasota-Bradenton, Atlanta, Tampa-St. 

Petersburg-Clearwater, and Jacksonville, Florida, 

MSAs (see Chart 3). 

Despite the relatively weak economic recovery, community banks3 headquartered in the Atlanta Region have 

reported strong earnings growth during the past several 

years, driven primarily by increased income from residential real estate mortgage and refinancing activity. As 

a percentage of gross revenue, income from real estate 

2 Thomas A. Fogarty, “Mortgage rate rise may slow home price
 

growth,” USA Today, August 20, 2003.
 3 Community banks hold assets less than $1 billion and exclude de
 

novos, specialty institutions, and thrifts.
 

Many of the community banks based in the Atlanta 

Region actively support the production of housing. 

The Region’s top earnings performers reported an 

average construction and development (C&D) loan 

exposure of 9.6 percent of assets, while some of the 

community banks with lower levels of earnings 

reported C&D loan-to-asset ratios of 6 percent or 

4 REL consist of all income received from real estate lending activities.
 

5 The 90th percentile consists of banks that have an REL-to-grossincome ratio of at least 61 percent.
 

FDIC OUTLOOK 11 WINTER 2003 
Regional Perspectives 

Chart 3 

Income from Real Estate Lending Has Increased as a Share of Gross Revenue among 

Insured Institutions in the Atlanta Region 

Number of banks in national 90th percentile where real estate lending 

income is 61percent or more of gross revenue 

1998 

2002

Average Real Estate Loan Income/

Gross Revenue (percentage) 

0 

10 

20 

30 

40 

50 

60 

70 4 6 3 8 

19 11 3 146 

669 

West Palm Naples Ft. Lauderdale Sarasota Atlanta Tampa Jacksonville Atlanta Region Nation 

Beach 

Note: Only Metropolitan Statistical Areas with at least 50 percent of gross revenue from real estate lending and a minimum of three banks in the 90th percentile are shown. 

Source: Bank and Thrift Call Reports, December 31. 

less.6,7 Among insured institutions based in the 

Region, this loan segment has grown by almost 200 

basis points during the past two years and, by year-end 

2002, comprised an average 7.6 percent of assets, up 

from 5.7 percent at year-end 2000. Given the recent 

rise in intermediate- and long-term interest rates and 

its potential adverse effects on the housing sector, the 

top performers may encounter an earnings challenge 

should housing absorption slow. 

In addition to residential lending exposures for housing production and permanent financing, community 

banks headquartered in the Atlanta Region have 

exposure to the housing market through holdings of 

mortgage-backed securities (MBS). After reporting a 

relatively low level of MBS holdings at year-end 2000, 

community banks grew MBS holdings to 5 percent of 

assets at year-end 2002. These securities also generated about 5 percent of gross revenue during 2002. 

The positively sloped yield curve during the past 

several quarters increased the attractiveness of MBS, 

giving community banks an opportunity to pick up 

yield. However, the increased yield did not come 

without additional risks. The increase in MBS holdings may lead to a heightened level of interest rate 

risk. Further, the sharp upward movement in the 

intermediate- and long-term rates during June 2003 

likely will reduce the market value of many MBS. 

As a result, investment portfolios that are heavily 

6 Top performers are community banks ranking in the 90th percentile 

as measured by pretax net income to gross revenue percentage. 

7 Poorer performers are community banks ranking in the 10th 

percentile as measured by pretax net income to gross revenue 

percentage. 

weighted toward holdings of MBS likely would swing 

from appreciation to depreciation. 

During the past few years, growth has occurred in other 

components of gross revenue among the Atlanta 

Region’s community banks, potentially softening the 

blow to earnings if the housing market cools. Income 

in categories such as interest on treasury and municipal 

bonds, deposit service charges, and other noninterest 

income, including automated teller machine and 

check-printing fees, has grown during the past two 

years. Revenue growth from these sources has helped 

offset declining income from all other loan categories, 

including commercial and industrial (C&I) and individual loans. 

Many industry observers are hopeful that C&I lending 

will expand as the economy improves and business 

investment revives. Income from C&I lending is 

expected to replace income lost from the anticipated 

slowdown in housing. The recent Senior Loan Officer 

survey of major commercial bank lenders conducted by 

the Federal Reserve Board found that most respondents have stopped tightening lending standards for 

small and large business credits, and that interest rate 

spreads on C&I loans have declined for the first time 

since 1998.8 Although this anecdotal information is 

consistent with the supposition that C&I lending will 

rebound, history and recent data might suggest otherwise. Coming out of the 1990/1991 recession, a 

substantial lag occurred before business lending started 

to grow, as C&I lending did not rebound until late 

8 Kent Hoover, “Business loan demand drops at banks,” American 

City Business Journals, August 25, 2003. 

FDIC OUTLOOK 12 WINTER 2003 
Regional Perspectives 

1994.9 Currently, many corporations are hoarding cash 

and likely will tap this source before borrowing to 

finance expansion. Also, the expected rebound in business investment spending may not be as robust as forecast. Overcapacity still exists in many industries, and 

many firms are using improved cash flow to pay down 

debt.10 Ultimately, the revenue outlook for community 

banks in the Atlanta Region looks particularly 

challenging should housing-related activities slow without an ample pickup in business lending. 

Jack Phelps, CFA, Regional Manager 

Scott Hughes, Regional Economist 

Ronald Sims, II, CFA, Senior Financial Analyst 

Pamela Stallings, Senior Financial Analyst 

9 “Marinac’s Weekly Musings,” FIG Partners, LLC, September 15, 2003. 10 Matt Krantz, “Recovering companies reducing debt loads; capital 

spending takes a back seat,” USA Today, September 25, 2003. 

FDIC OUTLOOK 13 WINTER 2003 
Regional Perspectives 

Chicago Regional Perspectives
 

The Chicago metro area’s economy is the largest in the 

nation. Like other markets, it has experienced weakness 

in recent years. In addition, the sizable banking sector 

is highly competitive and likely to become more so in 

the near future, as numerous banking organizations 

have announced plans to enter or expand operations 

within the Chicago market. 

Increased competition could 

pressure loan and deposit pricing, affecting overall earnings 

performance. This article 

examines important economic 

trends, the Chicago banking 

environment, and prospects for 

heightened competition in the 

Region’s largest market. 

The Chicago Metro Area’s Economy Is 

Underperforming That of the Nation 

The Chicago metro area’s economy is one of the largest 

and most diverse in the nation. While weakness in one 

sector often can be mitigated by strength in another, its 

overall economic performance recently has been 

subpar, in part owing to the following trends. 

Employment Trends Remain Weak 

As of mid-2003, the Chicago labor market continued 

to shed more jobs and recorded a higher unemployment 

rate than the nation. Job losses in the Chicago metropolitan statistical area (MSA) have been concentrated 

in the manufacturing sector, which represents 12 

percent of total employment and is one of the higherpaying employment sectors. More recently, state 

government employment also has contracted sharply, 

as budget cuts have hampered this traditionally more 

stable economic sector. 

The Chicago Office Market Remains under Pressure 

The Chicago office market, like that of most metro 

areas, has weakened in recent years (see Chart 1). The 

office market has undergone two consecutive years of 

negative net absorption, declining starts, and falling 

rents. Although much of the new planned downtown 

office space in the Chicago MSA appears to be heavily 

preleased, filling vacated space may be difficult should 

the absorption of new space be the result of tenants 

Chart 1 

The Chicago MSA’s Office Market 

Fundamentals Have Been Weak 

Note: MSA = Metropolitan Statistical Area. 

Source: Property & Portfolio Research, Inc. (1Q2003). 

1998 1999 2000 2001 2002 2003 

(forecast) 

(000 square feet) Percent

Net Absorptions (left axis) 

Net Completions (left axis) 

Vacancy Rate (right axis) 

0 

2 

4 

6 

8 

10 

12 

14 

16 

18 

–8,000 

–6,000 

–4,000 

–2,000 

0 

2,000 

4,000 

6,000 

8,000 

relocating, rather than expanding.1 The suburban office 

market has performed worse, and vacancy rates exceed 

those of the downtown area. 

The health of the commercial real estate (CRE) sector 

in the Chicago MSA is important, given the high CRE 

exposure reported by insured institutions based in this 

market.2 However, the vast majority of insured institutions in the Chicago market are not heavily exposed to 

construction and development lending, often the riskiest form of CRE. And while suburban office market 

fundamentals have weakened, this segment is but one 

among many subcategories of nonresidential real estate 

lending. Nevertheless, recent office market trends illustrate that prudent management of CRE lending 

programs warrants continuous monitoring. 

The Residential Real Estate Sector May Be 

Softening 

Housing affordability in the Chicago MSA is relatively 

low compared with the rest of the Midwest. In recent 

years, home price appreciation has been strong and 

has outstripped income growth; these trends could 

dampen future rates of appreciation. Mortgage rates 

also have trended higher recently, further constraining 

housing affordability. While the housing market 

1 Preleasing data are available from Property & Portfolio Research,
 

Inc., first quarter 2003, p. 2.
 2 Insured institutions headquartered in the Chicago MSA maintained 


a median level of CRE to Tier 1 capital of 292 percent as of June 30,
 

2003, compared with 237 percent for all other MSAs in the nation.
 

FDIC OUTLOOK 14 WINTER 2003 
Regional Perspectives 

currently does not represent a serious concern for the 

health of the Chicago economy, local consumers may 

not be able to continue to rely on growth in home 

equity as a source of financial strength. While past-due 

first mortgages held by community institutions based 

in the Chicago market have risen recently, past-due 

and nonaccrual rates remain favorable compared with 

those of other MSAs.3 

The Delayed Expansion of O’Hare International 

Airport May Hamper Future Growth 

The planned expansion of O’Hare has been delayed 

owing to the weak financial condition of major airlines 

and reevaluation of the hub model.4 This expansion is 

important to the growth prospects of international business, transportation, and Chicago’s standing as a 

tourism center.5 

The Chicago Banking Market Traditionally 

Has Been Highly Competitive 

The presence of many insured institutions and a relatively high number of banking branches has made 

Chicago one of the nation’s most competitive banking 

markets. Two hundred seventy-six insured institutions 

maintain headquarters in the Chicago MSA, more than 

twice that of the second-place market. In addition, 35 

insured institutions headquartered elsewhere maintain 

branches in the Chicago metro area. With several large 

institutions headquartered in Chicago as well, the 

Chicago market ranks third in the nation in total assets. 

Limits on branching in Illinois that existed for many 

years contributed to the current competitive climate. 

Some legislators were concerned that branching by 

larger institutions would hurt the area’s community 

banks.6 As a result, the Chicago market is highly fragmented and is not dominated by a small group of financial institutions, as is the case in many other markets 

(see Chart 2). 

The presence of newer institutions also can fuel competition. Among the nation’s larger banking markets, the 

3 Community institutions are defined as those that hold less than $1
 

billion in assets, excluding institutions established within the past
 

three years and specialty banks (e.g., credit card lenders).
 

4 The hub model routes much of an airline’s traffic through a central
 

point.
 

5 Economy.com, June 2003, Chicago Prècis.
 6 Illinois law restricted bank branching until 1993. “In Chicago, Expansion a Step-by-Step Process,” American Banker, September 5, 2002.
 

Chart 2 

The Chicago Deposit Market Is Large, Highly 

Fragmented, and Home to Many Insured Institutions 

Sources: Summary of Deposits, June 2002; FDIC's Research and Information 

System, June 30, 2003. 

Note: Fifteen largest markets shown, based on number of institutions 

headquartered there. Institutions Headquartered in Each MSA 

Herfindahl Index (measure of market's concentration of deposits) 

Least 

Concentrated 

Most 

Concentrated 

Size of bubble denotes volume 

Chicago of insured deposits

New York 

0 500 1,000 1,500 2,000 2,500 

0 

50 

100 

150 

200 

250 

300 

350 

number of newer institutions in the Chicago MSA has 

been second only to Atlanta during the past several 

years.7 Newer institutions often focus on building 

market share in the first few years of operation, a strategy that can place competitive pressure on prices and 

services in a given market, as established institutions 

seek to retain customers. 

Banking Performance Reveals 

Some Competitive Pressures 

Strong competition can affect loan and deposit pricing, 

which flows through to net interest margins (NIMs). 

Community banks in the Chicago metro area report 

lower NIMs than the nation’s other 14 largest banking 

markets.8 In a continuation of a long-term trend, 

median year-to-date annualized NIMs as of June 30, 

2003, were 3.80 percent, compared with 3.98 percent 

for the largest banking markets combined (see Chart 3). 

Some of this gap in NIMs may occur because community institutions in other large markets have larger 

shares of nonresidential real estate and construction 

and development lending, which tend to be higheryielding loan segments. However, competition is likely 

a factor in lower asset yields in the Chicago banking 

market as well. A closer look at asset yields among 

community banks reveals that the spread between those 

in the 90th percentile and the median has widened in 

7 Institutions less than three years old in markets that are headquarters to at least 50 insured institutions.
 

8 The 15 largest markets are determined by the number of insured
 

institutions headquartered in the MSA. These markets are Chicago;
 

Boston; Minneapolis; Atlanta; Philadelphia; Kansas City; New York;
 

Los Angeles; St. Louis; Dallas; Baltimore; Cincinnati; Washington,
 

D.C.; Denver; and Houston.
 

FDIC OUTLOOK 15 WINTER 2003 
Regional Perspectives 

Chart 3 

Chicago Net Interest Margins Remain 

below Those of Other Large MSAs 

Other large MSAs (median NIM) 

Notes: MSA = Metropolitan Statistical Area. NIM = net interest margin. 

2003 margins shown through June 30. 

Source: Bank and Thrift Call Reports for community institutions in the Chicago MSA. Percentage of Average Earning Assets 

20032002200120001999199819971996199519941993 

3.0 

3.2 

3.4 

3.6 

3.8 

4.0 

4.2 

4.4 

4.6 

4.8 

5.0 

Chicago MSA (median NIM) 

the Chicago market, while it has narrowed among 

banks in other large MSAs. Evidence suggests that 

increases in nonresidential lending have contributed to 

the relatively higher yields for institutions in the 90th 

percentile. For some, however, higher asset yields may 

be the result of favorable loan pricing—a result of finding niches in a market large enough to afford many 

lending opportunities. 

Chicago community banks report funding costs that 

are in line with those in other large MSAs and have 

tracked very closely with other large markets during the 

past decade.9 Deposit pricing may become more of an 

issue if retail banking competition intensifies as 

expected. 

Competition in the Retail Banking 

Arena Is Increasing 

The Chicago banking market appeals to many institutions based outside the area. A recent article stated, 

“the joke in the Chicago banking community is that 

there are not enough street corners to accommodate all 

the bank branches that out-of-towners want to open up 

in their city.”10 The market is large, not dominated by 

any one player, and represents a potential growth 

opportunity for some institutions. At $93 million, the 

Chicago market ranks 15th among MSAs nationally for 

deposits per branch, a situation likely resulting from its 

highly concentrated population and relatively high 

per capita income. Competitors may be drawn to the 

Chicago market in part because of the high level of 

9 Markets where at least 50 community institutions are headquartered.
 

10 “Windy city’s bank scene about to become ‘it’ spot,” US Banker,
 

July 2003, p. 12.
 

deposits per branch; lower cost outlays associated with 

certain branch types, such as supermarket branches; 

and reasonable funding costs relative to other large 

markets. 

Recent announcements by banking organizations headquartered outside the Chicago metro area suggest that 

growth plans are on a fast track. Bank of America, 

Washington Mutual, Fifth Third, National City, and 

others have announced plans that would add 250 to 

350 branches to the 2,164 already in the Chicago 

banking market.11 Bank of America reentered Chicago 

with a retail branch in January 2003 and has plans for 

30 more by the end 2004.12 Bank of America expects 

much of the initial deposit growth in Chicago to come 

from its large private banking customer base. Washington Mutual Inc. (Wamu), one of the largest mortgage 

lenders in the country, has established a presence in the 

Chicago market and has been adding branches aggressively. In June 2003, the company opened 28 branches, 

with plans for 70 by year-end. Many of Wamu’s new 

customers previously had relationships with established 

banks in the area.13 Bank One, which currently has the 

largest share of deposits in the Chicago MSA, has 

begun adding branches; 13 are planned for 2003 and 15 

for 2004.14 Bank One has introduced free checking and 

eliminated teller fees to encourage customers to use its 

branches. 

De novo branching is likely to segment a highly fragmented market further. Some insured institutions may 

rely on de novo branching until acquisition targets 

become available. Others may be content with the 

growth that they can obtain through de novo branching, particularly in the faster-growing outlying areas of 

the Chicago market, rather than trying to expand 

market share downtown. Gaining substantial market 

share likely would challenge any newcomer to the 

Chicago banking market. Establishing a sizable market 

share quickly would require multiple acquisitions. Yet 

such acquisitions often cause customers to migrate 

toward community banks, as some perceive that larger 

institutions fail to maintain existing customer services. 

11 Ibid.
 

12 Ibid.
 

13 “Signs of Life, A few gutsy companies think now is the time to
 

grow,” Business Week, July 14, 2003.
 14 Ibid.
 

FDIC OUTLOOK 16 WINTER 2003 
Regional Perspectives 

Competition May Affect Fee Income 

and Loan Product Offerings 

Increased competition can affect more than loan and 

deposit pricing. With many institutions focusing more 

on retail banking, Chicago-area institutions could 

experience other costs. Many insured institutions have 

offset compressed margins in recent years by bolstering 

noninterest income. Often, this noninterest income 

growth has been generated by higher fees, such as automatic teller machine charges. This option may be less 

viable as institutions try to gain or maintain market 

share. In addition, as large banks more aggressively 

pursue market share, community banks’ more profitable 

business lines may come under pressure. For instance, 

some large institutions are automating small business 

lending, traditionally a niche for smaller institutions. 

This situation could heighten competition for certain 

community banks. 

Strong Competition Is Expected to Continue, 

but Insured Institutions Can Succeed 

The Chicago banking environment has been fragmented and highly competitive for a long time. 

Although pockets of economic weakness exist, this 

diverse economy has proven fairly resilient, and insured 

institutions have continued to perform well. With 

competition in retail banking expected to increase, 

margins are likely to remain under pressure. Nevertheless, effectively managed insured institutions should be 

able to continue to capitalize on the opportunities 

available in such a large and diverse market. 

Mike Anas, Senior Financial Analyst 

FDIC OUTLOOK 17 WINTER 2003 
Regional Perspectives 

Dallas Regional Perspectives
 

Rising Natural Gas Prices Pose Opportunities and 

Challenges for the Dallas Region 

Overview: Natural gas prices are expected to remain 

high—the result of rapidly growing demand and tight gas 

supplies. Residential and commercial users will be 

affected; however, industrial users are expected to bear the 

brunt of higher prices. Overall, the effects of higher natural 

gas prices on the U.S. and Dallas Region economies likely 

will be relatively modest during 2003 and 2004, with a 

slight dampening effect on overall economic growth. Higher 

prices will affect certain key industries in the Dallas Region. 

Upstream industries, such as oil and gas extraction and 

oilfield services, are expected to benefit most from higher 

natural gas prices. However, downstream industries, such 

as petrochemical companies, and indirect users, such as the 

manufacturing and agricultural sectors, will be adversely 

affected as operating costs rise, plants are shuttered, and 

operations are moved overseas.1 

Natural gas prices have risen significantly since 

2000. Natural gas prices in the United States have 

risen from an average of $2.20 per million British thermal units (mmbtu) between 1993 and 1999 to an average of $4.20 since 2000 (see Chart 1). Moreover, on an 

energy equivalent basis, prices for natural gas have been 

as high as those for crude oil during 2003, which has 

not been the case historically. The near doubling of 

natural gas prices is the result of increasing production 

failing to keep pace with soaring consumption. The 

supply and demand imbalance has also contributed to 

heightened price volatility, as wide price swings have 

occurred in response to small demand shifts because of 

the relatively tight supply of natural gas.2 

Shifts in demand can be attributed, at least in part, to 

broad weather-related temperature swings, enactment 

of environmental legislation, the housing boom of the 

past decade, the proliferation of new gas-fired electrical 

plants, and the downturn and subsequent weak recovery in the national economy. Meanwhile, natural gas 

supplies are not keeping pace with increasing demand. 

Maturing gas wells and more rapid depletion rates, 

1 For purposes of this article, the term “upstream” refers to the oil and 

gas extractive and oilfield services industries, and “downstream” 

refers to industrial users of natural gas in the production process. 

2 The coefficient of variation (a measure of relative price volatility) of 

natural gas prices was 25 percent from 1994 through 1999; however, 

that figure has jumped to 39 percent since 2000. 

increasing 

price volatility 

(which has 

limited the 

attractiveness of new 

capital investment), 

and limited accesses to 

world natural gas 

supplies have hindered 

producers’ ability to satisfy demand. 

High natural gas prices likely will dampen U.S. 

economic growth. Recent economic indicators point 

toward a U.S. recovery that is gaining momentum. A 

rebounding economy is likely to increase demand for 

natural gas, placing further upward pressure on prices. 

Historically, demand for natural gas has correlated 

strongly with economic growth.3 A sustained period of 

higher natural gas prices would be expected to dampen 

U.S. economic growth slightly. Consumers would be 

forced to spend more on energy, leaving less for discretionary spending. Given the recent near doubling of 

natural gas prices, real U.S. gross domestic product 

growth during 2003 and 2004 could be constrained by 

25 to 50 basis points.4 The worst of the fallout from 

higher natural gas prices would be expected during the 

remainder of this year and early in 2004. 

Chart 1 

Natural Gas Prices Have Trended Upward since 

Late 2001 but Have Exhibited Heightened Volatility Henry Hub ($ per mmbtu) Note: mmbtu = million British thermal units 

Sources: Wall Street Journal (Haver Analytics); author's calculations. 

Mean price $2.20 

1993–1999 

Mean price $4.20 

2000–2003 

–

 1

 2

 3

 4

 5

 6

 7

 8

 9

 10 

Nov ’93

May ’94

Nov ’94

May ’95

Nov ’95

May ’96

Nov ’96

May ’97

Nov ’97

May ’98

Nov ’98

May ’99

Nov ’99

May ’00

Nov ’00

May ’01

Nov ’01

May ’02

Nov ’02

May ’03 

3 Standard & Poor’s Industry Surveys: Natural Gas, May 15, 2003. 

4 The Dismal Scientist from Economy.com, “Macroeconomics of 

Natural Gas,” by Mark Zandi, June 17, 2003, and The Kiplinger Letter: 

Forecasts for Management Decision-Making, Vol. 80, No. 2, July 3, 

2003. 

FDIC OUTLOOK 18 WINTER 2003 
 

Regional Perspectives 

Higher natural gas prices will benefit the natural gas 

industry, but create problems for industrial users. 

The oil and gas extraction industry and oilfield service 

firms (upstream industries), concentrated in the Dallas 

Region (see Map 1), have benefited the most from 

higher natural gas prices. One industry forecast 

predicts double-digit increases in revenue growth for 

the natural gas industry in 2003.5 Indeed, employment 

in these sectors has stabilized and even expanded in 

some areas. However, future job gains may be modest 

because of cost-cutting measures and efficient use of 

new technology. 

Industrial users of natural gas (downstream industries), 

such as manufacturing and agricultural producers, have 

been affected adversely by higher prices (see Map 1). 

This category of users represented 35 percent of U.S. 

natural gas consumption in 2002.6 Natural gas accounts 

for at least 30 percent of all energy used in most industries; however, the bulk of consumption is in the chemical and petroleum manufacturing industries. The 

chemical industry’s bottom line, in particular, has been 

hurt significantly this year by higher natural gas prices.7 

Furthermore, high prices have prompted natural gasintensive industries to scale back operations and 

employment, transfer production overseas, and shutter 

plants. Businesses can choose to pass higher costs on to 

customers, switch to cheaper alternative fuels, reduce 

other production costs, or absorb the higher costs. 

However, manufacturers typically have not been able to 

pass on these higher costs because of competition and 

excess capacity that have limited their pricing power.8 

The Dallas Region economy will benefit and be challenged by higher prices for natural gas. Natural gas 

producers that benefit from higher prices are concentrated in Texas, Louisiana, New Mexico, Oklahoma, 

and Colorado. The Region produces more than half 

the nation’s natural gas, but accounts for only one-third 

of its consumption. Because higher natural gas prices 

are a boon to upstream producers that drill and produce 

natural gas, higher industry incomes should benefit the 

regional economy overall. 

5 Economy.com, U.S. Industry Outlook, October 23, 2003.
 6 See the Energy Information Administration website, http://www.eia.
 

doe.gov.
 

7 Thaddeus Herrick, “Natural-Gas Prices Rock U.S.’s Chemical Industry,” Wall Street Journal, June 18, 2003.
 8 Fifteen counties that are home to 34 banks are characterized by high
 

employment concentrations in both oil and gas extraction and the
 

chemical or petroleum products manufacturing industries. These
 

counties were removed from our analysis for purposes of comparison. 


Map 1 

Upstream and Downstream Industries Are

 Located throughout the Dallas Region 

Counties in dark blue represent large concentrations of oil and gas extraction
 

employment (upstream industries) that are three times the state’s share
 

of total jobs in that industry.
 

Counties in light blue represent large concentrations of chemical and
 

petroleum product manufacturing employment (downstream industries)
 

that are three times the state’s share of total jobs in that industry.
 

Sources: Bureau of Labor Statistics; author’s calculations. 

However, high prices are expected to hurt several key 

manufacturing industries in the Dallas Region because 

of their significant use of natural gas. Almost half the 

nation’s industrial gas usage occurs in the Dallas Region, 

with Texas and Louisiana representing almost 40 

percent of the total.9 Specifically, the Gulf Coast area 

has the greatest direct exposure to higher prices because 

of the abundance of energy firms and petrochemical 

and chemical plants that rely heavily on natural gas. 

Arkansas, Mississippi, and Tennessee—states with 

significant shares of employment in the manufacturing 

sector—also are exposed to higher natural gas prices 

because of the energy-intensive nature of certain industries, such as fertilizer, plastics, paper, automobiles, 

steel, cement, glass, and food processing. 

Higher gas prices could affect insured institutions. 

Economic conditions would be expected to rebound in 

areas in where drilling activity is on the rise; as a 

result, loan demand could increase among banks based 

in these areas. Although Call Report data do not indicate whether banks are participating in financing for 

drilling activity, anecdotal reports suggest that smaller 

banks have started or are expanding lending for energy 

projects.10 Some of this lending activity is attributed to 

an increase in energy operations spurred by higher 

prices, as well as community banks looking for niche 

9 JPMorgan Securities Inc., Office of the Chief Economist, “Global
 

Issues: Energy and the Recovery,” July 8, 2003.
 

10 John Reosti, “Small Lenders Finding Room in Energy Biz,” 


American Banker, August 28, 2003, p.1.
 

FDIC OUTLOOK 19 WINTER 2003 
Regional Perspectives 

Table 1 

Banks Based in “Downstream Counties” Have Performed More Poorly 

than Banks Based in “Upstream Counties” 

2Q03 

Number Total Median Past- Median Return 

Sector(s) in Counties with at of Number Assets Due Ratio (%) on Assets (%) 

Least 3 Times Total Employment Counties of Banks ($ Billion) 2Q03 2Q02 2Q03 2Q02 

Oil and gas extraction (upstream) 75 121 20.7 2.19 2.10 1.26 1.26 

Chemical and allied products with 

petroleum and coal products 

(downstream) 65 176 24.6 2.53 2.38 1.06 1.16 

Source: Bank and Thrift Call Reports. 

opportunities in smaller energy credits. However, 

heightened price volatility, the need for greater levels 

of capital investment, and the specific skills required to 

conduct drilling activities heighten the complexity of 

this type of lending. 

The chemical and petrochemical refining areas on the 

Louisiana and Texas coastlines, and in areas with high 

shares of employment in the manufacturing and farming sectors, would be disproportionately hurt by higher 

gas prices. Should these industries be forced to scale 

back operations and lay off workers, individual and 

commercial borrowers may find it more difficult to 

remain current on their debts. As a result, insured institutions based in these areas could be challenged by 

declining loan demand and weakening credit quality. 

As shown in Table 1, banks headquartered in counties 

with large employment concentrations in upstream 

industries (“upstream counties”) are performing better 

than banks based in counties with significant concentrations of employment in downstream industries 

(“downstream counties”). Insured institutions based in 

downstream counties report a lower median return on 

assets and higher past-due ratios. Obviously, there are a 

variety of factors that affect the performance and 

condition of institutions in these areas, and many of 

these factors take time to work through the balance 

sheets of individual institutions. Given the price 

volatility of natural gas and the heavy exposure to gas 

prices, it would be reasonable to expect that gas prices 

are one of the reasons for the differences between the 

upstream and downstream counties. Should natural gas 

prices remain high for a sustained period, the significance to institutions in downstream counties could 

increase because it will affect employment and profitability of firms that depend on natural gas. 

Dallas Staff 

FDIC OUTLOOK 20 WINTER 2003 
 

 

Regional Perspectives 

Kansas City Regional Perspectives
 

Drought conditions remain a significant issue 

in the Kansas City Region, with implications 

for the Region’s economy and insured institutions. This article describes the effects of 

drought conditions on the Region’s cattle 

and crop producers and assesses their effects 

on farm bank credit quality. 

Drought Continues to Stress Much of the 

Western Part of the Kansas City Region 

Nearly half the nation experienced severe drought 

conditions during spring and summer 2002. The 

hardest-hit parts of the Kansas City Region were much 

of western South Dakota, a large portion of Nebraska, 

and northwestern Kansas. The duration and intensity 

of the drought devastated much of the pastureland in 

these areas and severely damaged wheat, corn, and 

soybean production. Crop yields dropped significantly, 

and many cattle producers were forced to liquidate 

some or all of their herds because of a lack of forage. 

Rainfall in the spring and early summer of 2003 helped 

alleviate the situation throughout much of the Region. 

However, the hot, dry weather pattern that characterized late July and August further eroded topsoil moisture 

conditions. As a result, almost the entire Region is now 

experiencing at least moderate agricultural drought 

conditions (see Map 1), and certain areas have been 

subject to more long-term stress (see Map 2). In areas of 

Map 1 

U.S. Drought Monitor, September 16, 2003 

DO Abnormally Dry Drought Impact Types:
 

D1 Drought—Moderate
 A = Agricultural (crops, pastures, D2 Drought—Severe grasslands)
 D3 Drought—Extreme W = Hydrological (water)
 D4 Drought—Exceptional No type = both impacts
 

Delineates dominant impacts 

Note: The Drought Monitor focuses on broad-scale conditions. Local conditions may vary. 

Source: U.S. Drought Monitor, http://drought.unl.edu/dm. 

persistent drought, farm bank performance has begun to deteriorate. 

The Region’s Economy Was Affected 

Adversely by the 2002 Drought 

The 2002 drought caused sharp 

declines in prices and rising feed costs 

that hurt cattle industry revenues 

throughout the Region. Faced with 

a shortage of feed and water, many 

cattle producers liquidated herds, 

resulting in a precipitous drop in cattle prices and 

producer revenues. The Nebraska Choice Steer Price 

declined 20 percent from $79 per hundredweight in 

first quarter 2001 to a four-year low of $63 per hundredweight in third quarter 2002.1 

Map 2 

Persistent Drought Conditions Continue 

in Western Kansas City Region 

Dark blue-shaded areas indicate at least moderate drought 

conditions in 2002 and 2003, as well as 2001 and/or 2000. 

Light blue-shaded areas are counties with at least moderate drought 

conditions in the past two years, but not in 2000 and 2001. 

Source: U.S. Drought Monitor, http://drought.uml.edu/dm. 

1 Livestock Price Outlook, July 2003, Table 5. Purdue University and 

University of Illinois, http://www.farmdoc.uiuc.edu/marketing/ 

livestockoutlook/07003cattle/0703cattle_text.html. 

FDIC OUTLOOK 21 WINTER 2003 
Regional Perspectives 

Table 1 

The Region’s Western States Experienced Higher Acreage 

Abandonment and Lower Crop Yields in 2002 

Wheat Corn 

STATE 

Planted 

Acres Regional 

(000s) Share 

Percent Historic 

Abandoned1 Abandon 

2002 Rate 

Yield Historic 

(bu/acre) Yield2 

Planted 

Acres Regional 

(000s) Share 

Percent Historic 

Abandoned1 Abandon 

2002 Rate 

Yield Historic 

(bu/acre) Yield2 

Kansas 

Nebraska 

North Dakota 

South Dakota 

9,600 36% 

1,650 6% 

9,080 34% 

3,030 12% 

16 8% 

8 7% 

13 5% 

46 12% 

33 44 

32 41 

27 30 

26 37 

3,250 8% 

8,400 21% 

1,230 3% 

4,400 11% 

23 7% 

13 4% 

19 18% 

27 10% 

116 138 

128 138 

115 110 

95 110 

23,360 89% 18 7% 30 37 17,280 44% 19 7% 117 130 

Iowa 20 0% 20 18% 50 46 12,300 31% 3 2% 165 144 

Minnesota 2,040 8% 10 3% 34 41 7,200 18% 7 8% 157 142 

Missouri 900 3% 16 9% 45 51 2,800 7% 4 4% 105 120 

2,960 11% 12 5% 37 44 22,300 56% 4 4% 155 141 

Source: Various USDA commodity reports. 

1 The term ‘abandon’ is used to signify that the crop was not harvested for grain as intended. Wheat producers typically let cattle forage on abandoned wheat acreage, and corn producers 

harvest abandoned corn as silage for livestock. 

2 Historic abandon rate and historic yield rate based on five-year averages 1997 through 2001. 

Many crop producers in Kansas, Nebraska, and the 

Dakotas also were affected adversely by drought conditions. Persistent drought contributed to declining 

production, particularly in areas without irrigation. 

Producers of wheat and corn were forced to abandon 

historically high acreage because of crop failures, and 

yields on harvested acres were low (see Table 1). 

Reduced crop yields resulted in rising commodity 

prices, which minimized some of the production loss, 

but these price increases were offset somewhat by a 

decline in government subsidies. 

Because of extremely low commodity prices, government subsidies to the Region’s farmers averaged $8.7 

billion, or 96 percent of net farm income, from 1999 

through 2001. However, when commodity prices 

improved in 2002, rising above target prices established 

in the 2002 Farm Bill, farmers received significantly 

lower subsidies. The level of government payments to 

the Kansas City Region declined to $3.2 billion, or 62 

percent of net farm income, in 2002. No consensus 

exists as to whether higher commodity prices helped 

increase net farm income for successful producers 

during 2002. A study conducted by the Food and Agricultural Policy Research Institute suggests that, in the 

aggregate, the loss of subsidies can outweigh the benefits of moderate gains in commodity prices.2 Farmers 

2 See Patrick Westhoff, “Income and Risk in Today’s Agriculture,” 

presentation to the National Agricultural Credit Committee meeting, 

Chicago, Illinois, September 2003, http://www.fapri.missouri.edu/ 

FAPRI_Publications.html. 

who experienced low yields not only benefited little 

from higher commodity prices, but also received less 

government assistance. As for the cattle industry, the 

2002 Farm Bill does not include subsidies for cattle 

farmers, and producers received only $250 million in 

assistance as part of the disaster bill enacted in 2003.3 

When government payments are excluded, the Region’s 

net farm income was $2 billion in 2002, double the 

2001 figure and the third consecutive increase since 

1999. However, when government payments are 

included, net farm income declined by almost half, 

from $9 billion in 2001 to $5.2 billion in 2002. 

Farm Bank Loan Portfolios Are Now Showing the 

Effects of the Drought 

A considerable lag typically exists between the time 

serious problems occur in the agricultural industry and 

the time farm banks report weakening credit quality, in 

large part because of “carryover debt.” Farm revenues 

generally are volatile, as they are subject to swings in 

production levels and prices. Therefore, it is not 

uncommon for borrowers to carry over operating loans 

to the next season, pledging equity in real estate and 

3 Cattle producers are eligible for an aggregate $250 million in assistance under the Livestock Assistance Program authorized by the 

Agricultural Assistance Act of 2003. 

FDIC OUTLOOK 22 WINTER 2003 
Regional Perspectives 

Chart 1 

Source: Bank Call Reports, farm banks in Kansas City Region. 

Loan Delinquencies Are Rising Faster at Farm Banks in Areas of Prolonged Drought 

Proportion of Farm Banks (%) 

0 

10 

20 

30 

40 

50 

Total Past-Due Loan Ratio (%) 

March 2003 

0 2 4 6 8 10 More 

Total Past-Due Loan Ratio (%) 

March 2002 

Areas of Prolonged 

Drought (solid line) 

0 2 4 6 8 10 More 

0 

10 

20 

30 

40 

50 

March 2001 

Total Past-Due Loan Ratio (%) 

Areas Largely Unaffected by 

Drought (dashed line) 

0 2 4 6 8 10 More 

0 

10 

20 

30 

40 

50 

machinery to shore up collateral margins. Federal 

Deposit Insurance Corporation (FDIC) examiners 

began observing rising levels of carryover debt among 

borrowers in the Kansas City Region in 1998 as a result 

of declining commodity prices. Between 1998 and 

2002, one-quarter to one-half of FDIC examinations 

of farm banks indicated increasing levels of carryover 

debt; a much smaller percentage reported declining 

levels of carryover debt.4 

Many agricultural borrowers in the Kansas City Region 

have been under stress since 1999, when prices for 

corn, wheat, and soybeans declined substantially. Many 

farm operations would have failed had it not been for 

the high government assistance to farmers. Although 

the payments prevented widespread farm failures, net 

farm income remained under pressure, and farm banks 

continued to work out repayment arrangements with 

agricultural borrowers. 

Delinquency data are beginning to show some deterioration in credit quality. Farm banks based in areas of 

persistent drought (shaded areas in Map 2) have 

reported higher delinquency levels than those based 

in areas largely unaffected by persistent drought 

(unshaded areas in Map 2) (see Chart 1). The share 

of farm banks in persistent drought areas with delinquency ratios of at least 8 percent was 17.1 percent 

in 2001and 16.9 percent in 2002, nearly twice that of 

farm banks in areas largely unaffected by persistent 

drought. Although farm banks in both areas reported 

4 Reports on Underwriting Practices, Kansas City Region. These 

reports aggregate safety and soundness loan underwriting survey 

results in six-month periods ending March 31 and September 30. 

rising delinquency levels in March 2003, the increase 

was larger for those based in areas characterized by 

persistent drought. The difference was even greater 

among farm banks based in the dark-shaded counties 

of Map 2, areas under the most persistent drought 

conditions. An extremely high 41 percent of those 

institutions reported loan delinquency ratios of at least 

8 percent as of March 31, 2003. 

The greater increase in loan delinquencies among farm 

banks based in the hardest-hit areas (some of the most 

rural and agriculturally dependent parts of the Region) 

has occurred not only because these areas have suffered 

from repeated years of poor yields, but because these 

banks tend to hold higher concentrations of direct agricultural credits. In March 2003, farm banks based in 

dark-shaded areas of Map 2 reported a median agricultural production loan concentration of 40 percent, 

versus 28 percent for farm banks in lightly shaded areas 

and 25 percent for farm banks in nonshaded areas. As 

a result, the effects of poor production are exacerbated 

among farm banks based in drought-persistent areas. 

Owing to their reliance on the agricultural sector, farm 

banks in the persistent drought areas find it difficult to 

shift concentrations away from agricultural lending. 

Farm banks in less rural areas have been more successful at diversifying exposures and have scaled back 

concentrations in agricultural loans. Moreover, 

although all farm banks have reported rising exposures 

in loans secured by farmland, this is occurring for 

different reasons. Banks based in the less rural areas 

could be experiencing increased demand for hobby 

farms and rural estate living. However, among banks 

based in the more rural areas, the increase in loans 

FDIC OUTLOOK 23 WINTER 2003 
Regional Perspectives 

secured by farmland is probably attributable to 

increases in carryover debt. 

The Agricultural Outlook Remains Mixed 

Prospects for many cattle producers are much improved 

over 2002. Smaller herds and lower levels of imports 

from Canada have contributed to higher prices.5 

Revenues of cattle producers are expected to grow overall; however, producers who were forced to liquidate 

herds will face higher prices to rebuild them. 

The outlook for crop production is mixed. Winter 

wheat production has increased, and prices are up as 

well. Estimates for spring wheat production also are 

favorable. However, the late summer drought is 

expected to have an adverse effect on corn and soybean 

yields. Although production should improve from 2002 

levels, it could remain well below historical averages in 

the most drought-stricken areas. 

Not All the News Is Bad 

for the Region’s Farm Banks 

Credit quality appears to be eroding somewhat among 

the Region’s farm banks, particularly those in the areas 

hit hardest by drought. However, there is positive news. 

Capital protection and loan loss reserve coverage 

remain high among the Region’s farm banks, even in 

areas significantly hurt by the drought. Farm banks 

headquartered in areas of the most persistent drought 

reported a median leverage capital ratio of 10.0 percent 

as of June 30, 2003, down slightly from recent years, 

but well above levels during the 1980s agricultural crisis 

and the 1988 drought. Moreover, these banks reported 

a historically high ratio of median loan loss reserves to 

total loans of 1.8 percent. In addition, farm real estate 

prices remain stable or have risen in many areas, 

providing ongoing collateral protection. 

Still, the effects of drought remain a critical issue for 

farm banks headquartered in the Kansas City Region. 

A high 18.4 percent of farm banks based in the areas 

of most persistent drought are rated 3, 4, or 5 for asset 

quality, compared with 10.1 percent of farm banks in 

areas largely unaffected by persistent drought. 

The FDIC continues to monitor drought conditions 

closely, engaging in outreach activities with bankers, 

other regulators, and trade groups, and, as needed 

updating bank management on farm lending best practices. For example, FDIC staff from the Kansas City 

Region hosted roundtable discussions on agricultural 

trends and conditions in Grand Island, Nebraska, and 

Hays, Kansas, on May 21 and May 22, 2003, respectively. These outreach events helped the Region 

develop a best practices document entitled, “Effective 

Strategies for Managing Agricultural Credit Risk.” The 

Region provided copies of this document to all state 

nonmember banks located in the drought areas of 

Nebraska and western Kansas.6 

Richard D. Cofer, Jr. 

Senior Financial Analyst 

5 In May 2003, Canada reported an incident of bovine spongiform 

encephalopathy (BSE, or “mad cow disease”). In response, the 

United States, the primary importer of Canadian cattle, temporarily 

banned Canadian cattle imports. The United States imported 1.7 

million head of cattle from Canada in 2002. Source: USDA Back­ 6 Interested parties may request a copy of this document by submit- grounder, report updated July 10, 2003. ting an e-mail to Assistant Regional Director Pamela Farwig at http://www.usda.gov/news/releases/2003/05/bg0166.html. PFarwig@FDIC.gov. 

FDIC OUTLOOK 24 WINTER 2003 
Regional Perspectives 

New York Regional Perspectives
 

Dramatic Changes in the Yield Curve Have 

Implications for Bank Margins and Interest Rate 

Risk Management 

Generally, a steep yield curve benefits the net 

interest margins (NIMs) of insured institutions because the asset yields of many 

banks are based on intermediate- and 

long-term market interest rates, and costs 

of funds are based on short-term rates. 

The shape of the yield curve is particularly important to community banks, especially residential mortgage lenders, because these 

banks typically “fund short and lend long.” In other 

words, the NIMs of these institutions depend on the 

spread between short- and long-term rates. Additionally, community bank earnings rely more on margin 

revenue than do the earnings of larger, more diversified 

insured financial institutions that generate higher 

volumes of noninterest income (see inset box for more 

detail on the Region’s large banks).1 

The steepness of the 

yield curve that developed in third quarter 

2003 generally is considered a 

positive sign for the banking industry; a steep yield curve typically 

portends economic growth and 

provides an opportunity for some 

banks to increase margins. However, a 

steep yield curve also likely will challenge 

certain insured institutions. Residential 

lenders, which generally hold higher concentrations of long-term assets, may experience 

margin pressure, as a greater percentage of their 

assets may be locked in at below-market rates. Also, 

banks that increased concentrations of long-term securities before the rise in interest rates may experience a 

decline in the value of securities portfolios and a reduction in gains on the sale of securities. This article 

examines the effects of recent interest rate changes on 

the operations of the Region’s community banks and 

identifies banking industry and market conditions that 

likely will affect interest rate risk management. 

An Increase in Securities Gains and a Decline in Problem Loan Costs Have
 

Helped to Offset Margin Compression among the Region’s Large Banks
 

Large institutions based in the New York Region Large banks based in the Region reported a drop in 

reported a decline in the NIM in second quarter 2003.2 problem loan costs in second quarter 2003 compared 

Falling market interest rates contributed to lower asset with a year ago. Loan delinquency and charge-off rates 

yields, but reductions in funding costs decelerated as declined, and a reduction in provisions for loan losses 

short-term rates neared record lows. Similar to the reflected expectations of continued moderation in probRegion’s community banks, deposit costs may have lems associated with large corporate loans and improveapproached a floor. Large bank securities gains increased ment in overall credit quality. Although corporate 

in second quarter 2003 as the value of fixed-income credit quality may weaken if the economic recovery 

investment portfolios rose with the significant decline stalls, the review of large syndicated bank loans 

in long-term interest rates. Nonetheless, securities gains conducted by federal banking regulators in 2003 showed 

likely will dissipate in coming quarters, reflecting the that credit quality weakness has moderated. For infordramatic rise in long-term rates in third quarter 2003. mation on the interagency Shared National Credit 

review, see the interagency September 2003 press 

release “Bank Regulators’ Data Show Stabilization in 

Credit Quality.”3 

2 “Large institutions” are defined as insured institutions that hold 

more than $10 billion in assets. This definition does not include 

credit card banks. 3 http://www.fdic.gov/news/press/2003/pr 8903.html 

1 Data in this article refer to community banks unless otherwise noted. “Community banks” are defined as insured institutions that hold less than 

$10 billion in assets. This definition does not include credit card banks and banks less than three years old. 

FDIC OUTLOOK 25 WINTER 2003 
Regional Perspectives 

A Look Back: Flattening in the Yield Curve during 

2002 and the First Half of 2003 Contributed to 

Margin Compression 

During the year ending second quarter 2003 long-term 

interest rates dropped significantly, in large part because 

of concerns about the prospects for U.S. economic 

growth and expectations that the Federal Reserve 

would cut interest rates further. The decline in longterm rates contributed to flattening in the yield curve. 

In June 2003, mortgage rates fell to 45-year lows, and 

loan refinancing activity exploded. The Mortgage 

Bankers Association Refinancing Index reached the 

highest point on record, doubling since the beginning 

of the year.4 Loan demand and mortgage origination 

income increased for many banks, though asset yields 

contracted as loans were made at low rates. As a result, 

the median asset yield for community banks based in 

the Region declined 94 basis points from mid-2002 

through mid-2003. 

Bank funding costs also declined with overall interest 

rate movements, but not as dramatically as asset yields. 

The latest cut in the federal funds rate in June 2003 

helped to reduce funding costs for the Region’s insured 

institutions in second quarter 2003 to an all-time low.5 

However, the decline in funding costs decelerated as 

short-term interest rates neared record lows. Deposit 

costs approached a floor, indicating that banks faced 

some competitive resistance to lowering deposit rates 

further. The median cost of funds reported by the 

Region’s insured institutions declined 62 basis points 

during the year ending second quarter 2003, a less 

significant drop than the 94 basis point decline in asset 

yield. Consequently, the median NIM reported by the 

Region’s insured institutions has declined sharply for 

four consecutive quarters, hitting a 12-year low of 3.63 

percent in second quarter 2003 (see Chart 1). 

A Look Ahead: The Steeper Yield Curve Likely Will 

Bolster Bank Margins, but the Recent Significant 

Rise in Long-Term Interest Rates Is Expected to 

Challenge Some Banks 

The yield curve steepened significantly in third quarter 2003 as confidence in the nation’s economic 

4 Mortgage Bankers Association of America via Haver Analytics. Data
 

available from January 1990.
 

5 Bank and Thrift Call Reports. Median cost of funds data are available from first quarter 1984.
 

Chart 1 

Flattening Yield Curve Contributed to NIM 

Compression in Mid-2003; However, Yield 

Curve Has Since Steepened 

Notes: NIM = net interest margin. “Yield Curve” is the difference between the yield on 

ten-year and three-month U.S. Treasury securities. Shaded line represents the average 

for 3Q03. 

Sources: Federal Reserve Board; Bank and Thrift Call Reports. 

Yield Curve (basis points) 

(left axis) NIM (%) 

(right axis) 

2Q00 4Q00 2Q01 4Q01 2Q02 4Q02 2Q03 

3.30 

3.50 

3.70 

3.90 

4.10 

–100 

0 

100 

200 

300 

400 

recovery grew. Expectations for further rate cuts 

waned, and investors sold long-term U.S. Treasury 

securities, driving down prices and increasing yields. 

The 112 basis point increase in the average ten-year 

U.S. Treasury yield during July and August represented the largest increase for a two-month period 

since January and February 1980. A steep yield curve 

and economic growth typically provide opportunity 

for banks to grow NIMs. However, among some of 

the Region’s community banks, NIMs may weaken 

and securities gains may dissipate. 

Banks Holding High Levels of Long-Term Assets 

May Experience Weaker NIMs 

Rising interest rates may pressure the margins of a 

greater percentage of banks based in the New York 

Region compared with elsewhere in the country 

because of the Region’s higher concentration of residential lenders. Residential lenders, which typically 

hold relatively high concentrations of long-term assets, 

comprise one-third of insured institutions headquartered in the Region, compared with less than 10 

percent in the rest of the nation.6 Generally, these 

banks will have greater shares of assets locked into 

lower rates and will be less able to reprice assets 

upward as market rates increase. The median level of 

long-term assets to earnings assets for the Region’s 

banks is double that of the nation. The median level of 

long-term assets among the Region’s residential lenders 

6 “Residential lenders” are defined in this article as insured institutions that hold less than $10 billion in assets and at least 50 percent of 

assets in one- to four-family residential loans or mortgage-backed 

securities. This definition does not include banks less than three 

years old. 

FDIC OUTLOOK 26 WINTER 2003 
Regional Perspectives 

also is higher than that of residential lenders nationwide (see Chart 2). 

Nevertheless, although higher than the nation’s, 

concentrations of long-term assets reported by the 

Region’s banks have remained stable, despite record 

refinancing activity and borrowers’ preference for longterm, fixed-rate mortgages during the 2002–2003 refinancing wave. This stability likely results from a 

significant degree of refinancing activity within existing 

long-term categories; that is, refinancing between 15­

and 30-year mortgages. In addition, banks have implemented strategies to mitigate the risk of holding longterm loans, for example, selling loans in the secondary 

market. Furthermore, the Region’s banks have 

increased concentrations of longer-term liabilities, 

probably to match long-term asset concentrations and 

lock in longer-term funding at record low interest rates. 

Time deposits, which constitute more than one-third of 

the funding for the Region’s banks, have lengthened in 

maturity or repricing structure. The median percentage 

of time deposits maturing or repricing beyond one year 

has increased from 27 percent to 34 percent during the 

past year.7 

Securities Gains May Dissipate Following the 

Significant Rise in Long-Term Interest Rates 

Securities gains, which benefited from declining interest rates in 2002 and the first half of 2003, boosted the 

overall net income of the Region’s insured institutions 

during the past year (see Chart 3). However, such gains 

likely will dissipate following the significant rise in 

Chart 2 

long-term rates in third quarter 2003. In particular, 

banks that increased holdings of longer-term securities 

just before the sharp rise in rates may experience depreciation in this portfolio segment, precluding any potential boost to future earnings from securities gains. 

An increasing percentage of banks in the New York 

Region grew concentrations of long-term securities in 

the first half of 2003 compared with a year ago. Fiftytwo percent of banks increased concentrations of securities maturing or repricing in more than five years 

during the first half of 2003, compared with 41 percent 

of banks a year earlier. These banks may have to decide 

whether to reduce holdings of long-term, depreciated 

securities in favor of higher-yielding investments, 

emphasizing the need for strong interest rate risk 

measurement and management practices. 

Dramatic Yield Curve Changes Heighten the 

Importance of Interest Rate Risk Management 

The wide fluctuation in interest rates during the past 

year has created a dynamic interest rate risk (IRR) 

management environment. Banks have been challenged to evaluate the reasonableness and accuracy 

of IRR management models under a wide range of 

interest rate scenarios. Management has had the 

opportunity to assess how well these models have 

accommodated significant reductions in short-term 

rates followed by a sharp drop and subsequent rapid 

rise in long-term rates. Dramatic changes in interest 

Chart 3 

Securities Gains Bolstered Income as Interest 

Rates Dropped during 2002 and Early 2003 

Source: Bank and Thrift Call Reports. 

Net Income to Average Assets 

(%) (left axis) Ten-Year U.S. Treasury Yield 

(%) (right axis) 

0 

3Q00 4Q00 1Q01 2Q01 3Q01 4Q01 1Q02 2Q02 3Q02 4Q02 1Q03 2Q03 

1.2 

0.6 

0.7 

0.8 

0.9 

1 

1.1 

2 

4 

6 

Operating Income Securities Gains 

Long-Term Asset Levels among the Region’s 

Banks Exceed Those for Banks in the Rest of 

the Nation 

Source: Bank Call Reports. 

Notes: Thrift institutions are excluded because of differences in data collected. LTA 

are assets that mature or reprice in more than five years. Median data displayed. LTA-to-Earning Assets (%) 

All Community Banks Residential Lenders 

0 

10 

20 

30 

40 

50 

60 New York Region 

Rest of the Nation 

7 Asset and liability maturity/repricing data exclude thrift institutions because of differences in the data. 

FDIC OUTLOOK 27 WINTER 2003 
Regional Perspectives 

rates heighten the importance of prudent asset and management identify ways to enhance IRR measureliability management practices, such as ensuring that ment systems. 

fluctuations in the NIM and investment portfolio 

depreciation levels remain within established limits Robert M. DiChiara 

and policy guidelines. Ultimately, comparing the Senior Financial Analyst output of IRR models with actual results can help 

FDIC OUTLOOK 28 WINTER 2003 
Regional Perspectives 

San Francisco Regional Perspectives
 

Low Interest Rates Have Benefited Insured Institutions Based in the San Francisco 

the Region’s Economy and Insured Region Hold Relatively High Concentrations of 

Institutions Mortgage-Related Assets 

Economic conditions in the San Francisco Banks and thrifts headquartered in the 

Region, like those in the nation, have been Region are heavily involved in mortgage 

sluggish; employment growth during second servicing and hold shares of mortgagequarter 2003 was flat compared with one related assets that exceed the national averyear ago. However, interest rates, at a age, increasing their sensitivity to interest rate 

four-decade low, mitigated the effects of volatility. As of June 30, 2003, insured institutions 

weak job growth and boosted the Region’s 

housing sector. During the first half of 2003, the 

volume of residential building permits in Hawaii, 

Wyoming, and California increased year-over-year at 

more than five times the national rate. Low interest 

rates and relatively high rates of home price appreciation have allowed homeowners to take cash out when 

refinancing, bolstering consumer spending and lowering 

monthly debt service levels. The rate of home price 

appreciation across the Region during the year ending 

June 30, 2003, was strongest in California, Hawaii, and 

Nevada. 

Insured institutions headquartered in the San Francisco Region continued to perform well despite weak 

economic conditions. Credit quality was favorable as 

median past-due ratios declined year-over-year across 

major loan categories and remained well below 

national levels.1 Lower interest rates benefited asset 

quality and augmented earnings in two ways. First, 

lower rates contributed to higher securities prices, 

allowing approximately one-third of the insured institutions based in the Region to recognize securities 

gains in the first half of 2003. Second, the record 

number of mortgage refinancings boosted fee income. 

Although banks and thrifts based in the Region have 

benefited from low interest rates, institutions with 

significant mortgage lending and mortgage servicing 

operations have faced challenges created by the record 

level of prepayments. This article examines these challenges, focusing on the potential for heightened levels 

of credit and extension risk. 

1 The median past-due ratio reported by insured institutions based in 

the San Francisco Region as of June 30, 2003, was 1.11 percent, 

compared with 1.83 percent for the nation. 

based in the Region held 40 percent of all one- to 

four-family mortgages serviced for others by institutions nationwide, in part because institutions based 

in the Region hold the two largest servicing portfolios. 

As of June 30, 2003, mortgage-related assets represented 45 percent of the assets held by the Region’s 

banks and thrifts, significantly above the 33 percent for 

institutions nationwide. These assets are concentrated 

in banks and thrifts headquartered in California and 

Washington. Interest rate declines during the previous 

three years have driven refinancings to all-time highs, 

resulting in record prepayments of existing mortgages 

and reducing the value of mortgage-servicing assets 

(MSAs). 

Record High Prepayment Speeds Occurred 

Nationwide, and Studies Indicate Significant 

Differences in Prepayment Speeds among the 

Region’s States 

The significant decline in interest rates during the past 

three years triggered a record wave of mortgage loan 

originations, resulting in historically high levels of 

prepayments.2 In August 2003, Economy.com forecast 

that the dollar volume of annual originations would 

triple from 2000 to 2003. Prepayment speeds for individual states differ from national averages, in part 

because of differences in rates of home price appreciation, personal income per capita levels, and percentages 

of adjustable-rate mortgages (see Chart 1).3 

2 The 30-year constant maturity treasury (CMT) rate fell one-third from
 

January 2000 to June 2003.
 

3 Kurt van Kuller, Prepayments Fastest in CA, MA, and Midwest,
 

Merrill Lynch Global Securities Research & Economics Group, Municipal Credit Research, pp. 1–13, July 25, 2003.
 

FDIC OUTLOOK 29 WINTER 2003 
Regional Perspectives 

Chart 1 

California and Washington Prepayment Speeds Are Higher than the National Average 

Prepayment speed relative to the nation

Percent 

130 

120 

110 

100 

90 

80 

70 

60 

126% 

Nation 

101% 97% 

94% 

89% 85% 

73% 

68% 65% 

California Washington Arizona Utah Nevada Oregon Hawaii Idaho Montana 

Notes: The prepayment speed ratio is relative to the national average in terms of the constant prepayment rate for the six months ended June 30, 2003, using weighted Fannie Mae and Freddie
 

Mac cohort data. That is, loans in Arizona prepaid at 97 percent of the national average rate. The Montana ratio uses only Fannie Mae data. Alaska and Wyoming did not meet the mortgage
 

prepayment volume cutoff.
 

Sources: Merrill Lynch; Freddie Mac; Fannie Mae.
 

Differences in prepayment speeds may affect the valuation of MSAs that are concentrated in a specific 

geographic area. During the first half of 2003, insured 

institutions based in California and Washington posted 

the highest prepayment speeds in the Region and 

ranked second and twelfth nationally. In particular, the 

rate of home price appreciation in California has 

exceeded the national average significantly, both yearover-year and over the previous five years. In addition, 

banks and thrifts based in California hold the Region’s 

highest share of adjustable-rate mortgages (ARMs). In 

contrast, institutions in Idaho and Montana reported 

the lowest prepayment speeds in the Region, with per 

capita income, rates of home price appreciation, and 

shares of ARMs lower than the national averages. 

These differences in prepayment speeds may contribute 

to certain mortgage pools generating actual cash flows 

that differ from projected cash flows, which were based 

on national prepayment speeds. Nationwide, recordhigh prepayment speeds have had an adverse effect on 

the value of MSAs. The value of assets that are related 

to mortgages held by banks and thrifts headquartered in 

states with relatively high prepayment levels may be 

impaired further. 

Writedowns of Mortgage-Servicing Assets 

Are on the Increase in the Region 

Mortgage-servicing asset values are based on the underlying portfolio of mortgages serviced. As those mortgages prepay, especially at higher speeds than originally 

estimated, the value of the MSA must be written down 

to correspond with the shrinking pool of serviced mortgages.4 Many insured institutions based in the San 

Francisco Region that service one-to-four family mortgages have written down the value of MSAs. The 

number of banks and thrifts in the Region that reported 

one-time MSA writedowns in excess of mortgageservicing fee income more than doubled from 2001 to 

June 30, 2003.5 During the same period, the book value 

of these assets declined almost 40 percent. Accelerated 

mortgage prepayments also have reduced the value and 

marketability of older servicing portfolios. 

Higher Interest Rates May Increase the Value of 

Mortgage Servicing but Also May Heighten 

Extension and Credit Risk 

Although long-term interest rates declined to historically low levels during second quarter 2003, rates rose 

sharply in third quarter 2003. Rate increases have positive implications for MSA valuations. However, rising 

rates also may challenge earnings and asset quality, 

particularly for the Region’s mortgage servicers. First, 

the large volume of new mortgages extended at low 

interest rates may contribute to margin compression 

going forward. Second, default rates may increase on 

adjustable-rate mortgages as the interest rate ratchets 

4 For details on the valuation of mortgage servicing assets, refer to 

the FFIEC Interagency Advisory on Mortgage Banking Activities dated 

February 25, 2003 (http://www.fdic.gov/news/news/financial/2003/ 

fil0315.html). 

5 For the year ending December 31, 2001, 13 percent of insured institutions in the San Francisco Region reported one-time MSA writedowns in excess of mortgage-servicing fee income; this number 

increased to 29 percent for the six months ending June 30, 2003. 

FDIC OUTLOOK 30 WINTER 2003 
May-02

May-03

-03

Jun-02 Jul-02

Aug-02 Sep-02 Oct-02

Nov-02 Dec-02 Jan-03

Jun-03 Jul-03

Aug-03 

-03

Feb-03 MarApr

Regional Perspectives 

Chart 2	 inated, low-rate mortgages likely will prepay more 

slowly. As a result, mortgage lenders could be saddled Changes in Prepayments Drive Market Valuations with asset yields that do not increase commensurately for Mortgage-Servicing Assets with funding costs as rates rise, compressing net interest 

5.0 0 margins. Also, the unintended consequences of hedging 

interest rate risk (IRR) increases the complexity of IRR 

management. An August 2003 Federal Reserve study 

found that hedging mortgage-backed securities by 

buying or selling U.S. Treasury securities resulted in 

greater rate swings.10 In addition, when MSAs were 

hedged with mortgage loans, the sharp rise in interest 

rates caused the duration of these assets and the hedge 

to extend significantly.11

30-Year Conforming Mortgage Generic

Servicing Asset (price multiple)

Refinancing Index (inverted scale)

3.0 

Refinancing

 application index

(right axis) 

Servicing value 

(left axis)	 

5,000 

1,000 4.5 

2,000 4.0 

3,000 3.5 

4,000 

2.5 6,000 

2.0 7,000 

1.5 8,000 

1.0 9,000

The level of credit risk also could increase as interest 

Sources: Mortgage Industry Advisory Company; Mortgage Bankers Association of America. 

upward, potentially making monthly payments unaffordable for some borrowers. 

Further interest rate increases likely will ease mortgageservicing price pressures and improve the marketability 

of these portfolios. Data from the Mortgage Industry 

Advisory Company suggest that the increase in longterm interest rates and declining mortgage refinancing 

activity during third quarter 2003 had an immediate, 

positive impact on servicing asset values (see Chart 2).6 

As these values increase, insured institutions based in 

the Region may be able to recapture some of the losses 

on mortgage servicing assets that were recognized in 

prior quarters.7 However, the increase in value of MSAs 

linked to recently originated, relatively low-yielding 

rates move higher, both on seasoned and newly originated loans. ARM default rates may climb as monthly 

mortgage payments increase. Data from the Mortgage 

Bankers Association of America show that ARMs tend 

to become more popular than fixed-rate mortgages as 

rates rise and refinancing activity declines (see Chart 

3). This is particularly true in the San Francisco 

Region, where many metro areas, including Los Angeles, Phoenix, San Diego, San Francisco, and Seattle, 

ranked in the top ten nationally in terms of the share 

of variable-rate mortgages originated during 2002. 

Historically, when demand for mortgages was curbed 

sharply by rising interest rates, loans originated in these 

periods have performed poorly. Lenders may be tempted 

Chart 3 

Refinancings Dropped in Third 

Quarter 2003, as the Share of Adjustable-Rate 

Mortgages (ARMs) Increased 

Source: Mortgage Bankers Association of America. Mortgage Refinancings as a Percentage of Originations

ARMs as a Percentage of Originations

Refinancings (%) 

ARMs (%) 

0 

10 

20 

30 

40 

50 

60 

70 

80 

0 

5 

10 

15 

20 

25 

30 

35 

40 

45 

50 

1991199219931994199519961997199819992000200120022003 

mortgages could be limited.8 

Although rising interest rates may benefit mortgageservicing asset values, earnings concerns may emerge, 

particularly for servicers of one-to-four family mortgages.9 Extension risk may heighten because newly orig6 This is based on the value of “Generic Servicing Assets,” which are 

proxy mortgage-servicing assets created by the Mortgage Industry 

Advisory Company. For more detailed information, refer to 

http://www.servicing.com/miac/introtoGSAs.html. 7 The ability of insured institutions to recapture prior losses is 

governed by Financial Accounting Standard (FAS) 133. FAS 133 allows 

insured institutions to recapture temporary impairment on mortgageservicing assets. 

8 Melanie Harwood, “The Mortgage Servicing Shuffle: What to Do 

When Values Weaken,” Community Banker, pp.18–22, December 2002. 

The article quotes the chief executive officer of a mortgage brokerage firm saying that investors would prefer mortgage-servicing 

assets linked to mortgages with higher interest rates. 

9 As of June 30, 2003, 96 insured institutions based in the San Francisco Region reported MSAs. 

10 Roberto Perli and Brian Sack, “Does Mortgage Hedging Amplify 

Movements in Long-term Interest Rates?” Federal Reserve, pp. 1–19, 

August 2003. 

11 “Analyst Roundtable: What Will Fill Revenue Void as Refi Business 

Wanes?” American Banker, August 28, 2003. 

FDIC OUTLOOK 31 WINTER 2003 
Regional Perspectives 

to relax underwriting standards as they face pressure to 

keep loan origination volume at high levels.12 

Conclusion 

The recent low interest rate environment boosted the 

San Francisco Region’s lackluster economy, particularly 

the housing sector. However, the record wave of mortgage refinancings adversely affected earnings and 

12 Mortgage Market Trends, Office of Thrift Supervision Research & 

Analysis Directorate 3 (3), November 1999. The Office of Thrift Supervision cites a similar period of reduced origination activity in 1995 

after a refinancing boom. Mortgages originated during that period 

have performed poorly, suggesting an easing in underwriting standards in an attempt to maintain origination volume. 

prompted many of the Region’s insured institutions to 

write down the value of mortgage-servicing assets. Now 

that rates have started to move up, the value of these 

assets could increase. At the same time, banks and 

thrifts with significant mortgage banking operations 

may be vulnerable to earnings pressures and asset 

quality concerns going forward. 

Robert E. Basinger, Senior Financial Analyst 

John A. Roberts, Regional Economist 

FDIC OUTLOOK 32 WINTER 2003 
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