Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION FIRST QUARTER 2002 

FDIC
 

Chicago
 

Region
 

Division of
 

Insurance
 

Suzannah L. Susser,
 

Regional Manager
 

Joan D. Schneider,
 

Regional Economist
 

Michael Anas,
 

Senior Financial
 

Analyst
 

Ronald W. Sims II,
 

Financial Analyst
 

Regional Perspectives 

◆ The current recession and aftermath of the September 11 attacks triggered 

sharp cutbacks in the Region’s economic activity and employment—In contrast 

with most prior recessions, deterioration in the Region’s labor markets has 

not been more severe than that of the nation. This situation reflects, in part, 

the fact that the current economic slump extends beyond the manufacturing 

industries that are concentrated in the Region. 

◆ As economic weakness became more evident in 2001, the Federal Reserve 

lowered its target short-term interest rate by 475 basis points—Lower interest 

rates stimulated the refinancing of business and household debt and helped sustain demand in some key sectors of the Region, especially motor vehicles and 

residential real estate. 

◆ Rapidly falling interest rates improved insured institution net interest margins 

and affected asset and liability management—Loan and deposit customers’ preferences have changed, and bankers now face a new environment for asset and 

liability management. How insured institutions manage these changes will 

determine future exposure to rising short-term rates or a flattening of the yield 

curve. See page 3. 

By the Chicago Region Staff 

In Focus This Quarter 

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

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

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

was underwritten during 2001. Nonconstruction residential mortgages traditionally 

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

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

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

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

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

recession-tested. 

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

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

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

that experienced ongoing residential construction during 2001, despite slowing local 

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

See page 11. 

By Scott Hughes, Regional Economist 

Judy Plock, Senior Financial Analyst 

Joan Schneider, Regional Economist 

Norm Williams, Regional Economist 

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

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

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

geographic regions: 

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

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

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

Dallas Region (CO, NM, OK, TX)
 

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

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

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

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

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

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

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

trends and developments at the regional level. 

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

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

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

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

Outlook, please call Suzannah Susser at (312) 382-6543 or send an e-mail to ssusser@fdic.gov. 

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

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

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

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

the Federal Deposit Insurance Corporation. 

Chairman Donald E. Powell 

Director, Division of Insurance Arthur J. Murton 

Executive Editor George E. French 

Writer/Editor Kim E. Lowry 

Editors Lynn A. Nejezchleb 

Maureen E. Sweeney 

Richard A. Brown 

Ronald L. Spieker 

Publications Manager Teresa J. Franks 
Regional Perspectives
 

Regional Perspectives
 

•	 The current recession and the economic effects of September 11 have triggered sharp job cutbacks. In 

December 2001, the Region’s total employment was 1 percent lower than it had been a year earlier, with 

manufacturing employment 5 percent lower. 

•	 The Federal Reserve lowered the interest rate on federal funds by 475 basis points during 2001 as signs of 

economic weakness grew. Lower interest rates stimulated the refinancing of business and household debt 

and helped sustain demand in some sectors, especially motor vehicles and residential real estate. 

•	 The speed of change in short-term interest rates and the shift to a steeply sloped yield curve have affected 

the asset and liability sides of many banks’ balance sheets. As a result, net interest margins improved slightly 

in the past two quarters, but bankers face a new environment for asset and liability management. 

Region’s Economic and Banking Conditions 

Recession Keenly Felt in the Chicago Region 

The adverse effects of the recession that began in April 

2001 are being compounded by the aftermath of the 

events of September 11, 2001. The Chicago Region’s 

unemployment rate of 5.4 percent in December 2001 

was noticeably higher than the 3.8 to 4.0 percent range 

of 1998 through 2000. However, in contrast with some 

previous cyclical contractions, the recent increase in 

the Region’s unemployment rate and the percentage 

drop in employment were not dramatically worse than 

those of the nation. 

The relatively comparable performance of the Chicago 

Region reflects the fact that the current slump involves 

some industry sectors that are not heavily concentrated in the Region, such as computers, aircraft, hightechnology equipment, and tourism. Even so, output of 

such traditionally cyclical industries as motor vehicles, 

industrial machinery and equipment, and metals—all 

heavily represented in the Region—also is declining 

sharply. Consequently, employers in the Region have 

curtailed production significantly, and year-end 2001 

employment in the Region was 1 percent lower than 

employment a year earlier, with manufacturing 

employment 5 percent lower. 

Net job losses in the Region amounted to 225,000 in 

the year ending December 2001. Employment growth 

of 9,000 workers in the construction industry was overwhelmed by the loss of 217,000 jobs in the manufacturing sector. These losses were concentrated among 

producers of transportation equipment (–38,500), primary and fabricated metals (–50,700), industrial 

machinery and equipment (–43,100), and electronic 

and electrical equipment (–26,800). Elimination of 

an additional 33,500 jobs by providers of business 

services reflects, in part, the softness in manufacturing, as these companies provide such ancillary services to manufacturers as security, data processing, 

payroll services, and deliveries. Likewise, the fact that 

there are 22,600 fewer jobs in wholesale trade in the 

Region likely reflects the lack of demand for these 

services during a period of declining manufacturing 

activity. 

Despite widespread evidence of economic weakness 

through the summer of 2001, the national economic 

decline before September 11 was sufficiently mild that 

it might not have reached recessionary proportions. 

Indeed, production and job cutbacks needed to reduce 

unplanned inventory accumulation were well under 

way among producers of motor vehicles and parts and 

in some other sectors. For others, however, significant 

inventory overhang remained a problem. 

The nature and sources of economic difficulties 

expanded suddenly after mid-September as travel, 

tourism and lodging, and many other service industries—which are typically less sensitive to economic 

cycles than manufacturing—weakened significantly. 

Thus, the harshest effects of September 11 may be felt 

outside the Region. However, to the extent that the 

aftermath of September 11 also may trigger a sharp 

Chicago Regional Outlook 3	 First Quarter 2002 
Regional Perspectives
 

reduction in business and household spending for 

goods, manufacturers may need to trim inventories 

further, prompting additional cutbacks in production 

and jobs. 

This second wave of adversity added to the severity and 

areas of weakness in the U.S. economy and affected the 

nature and timing of when the economic slump might 

end. Even if production cutbacks wind down in the first 

half of 2002, for example, the potential impact of a 

rebound in manufacturing activity may be tempered 

by continuing adjustments in the service-producing 

sectors. In this way, the current situation parallels conditions following the 1990–1991 recession. Then, the 

recovery from a traditional inventory cycle was tempered by the restructuring under way among some 

major industries, as vulnerable firms were no longer 

able to delay the downsizing needed to enhance their 

viability. 

With respect to the cyclical contraction now under way, 

the decline in production of motor vehicles and parts 

approximates previous downturns in terms of severity 

(see top panel of Chart 1). However, the recent weakness has been more prolonged and is not showing a 

quick rebound. Various incentives offered by manufacturers in late 2001 pushed sales to record levels in the 

fourth quarter. Because these promotions dramatically 

lowered inventories, production of vehicles and parts 

rose by more than 4 percent in November and again in 

December, boosting year-end output to the highest 

level since July. Looking ahead, however, any production and employment rebound during 2002 may be 

muted because the recent incentives not only advanced 

into 2001 some purchases that would have occurred in 

2002 but also reduced producers’ profitability. At one 

firm, for example, the “cost” of incentives in 2001 

amounted to 16 percent of revenues, up from 11 percent the prior year, and incentives contributed to projections of an annual net loss for the company.1 

Similarly, contraction in the steel sector has been prolonged relative to the last recession (see middle panel 

of Chart 1). This development reflects not only the 

slump in domestic demand but also longer-term structural adjustments in the industry and the ready availability and competitive pricing of product from abroad. 

1 Hakim, Danny, December 17, 2001. “Automakers’ Big Sales Now 

May Cut Business Next Year,” New York Times. 

CHART 1 

KEY SECTORS IN REGION EXPERIENCE 

SIGNIFICANT DECLINES 

–25 

–15 

–5 

5 

15 

25 

35 

Jan 

,

89 

Jan 

,

91 

Percent Change in Auto Sector 

Index from a Year Earlier 

Jan 

,

93 

Jan 

,

95 

Jan 

,

97 

Jan 

,

99 

Jan 

,

01 

Auto Sector Activity 

(Transportation Equipment Plus Rubber 

and Miscellaneous Plastic Products) 

Source: Federal Reserve Bank of Chicago 

Steel Sector Activity 

(Primary Metal and Fabricated Metal Industries) 

Percent Change in Steel Sector 

Index from a Year Earlier 

–25 

–15 

–5 

5 

15 

25 

35 

Jan 

,

89 

Jan 

,

91 

Jan 

,

93 

Jan 

,

95 

Jan 

,

97 

Jan 

,

99 

Jan 

,

01 

Source: Federal Reserve Bank of Chicago 

Machinery Sector Activity 

(Industrial Machinery and Equipment, Electronic 

and Electric Equipment, Instruments 

and Related Products)

Percent Change in Machinery Sector

Index from a Year Earlier 

Jan 

,

89 

Jan 

,

91 

Jan 

,

93 

Jan 

,

95 

Jan 

,

97 

Jan 

,

99 

Jan 

,

01 

Source: Federal Reserve Bank of Chicago 

–25 

–15 

–5 

15 

25 

35 

5 

Chicago Regional Outlook 4 First Quarter 2002 
Regional Perspectives
 

The viability of some domestic steel producers and 

fabricators was weakened several years ago when economic activity in Asia plummeted, many currencies 

were devalued relative to the U.S. dollar, and some 

product was dumped in the United States. Moreover, 

some steel producers in this Region are losing business 

to newer facilities elsewhere in the country that tend to 

operate with lower cost structures. More than 25 U.S. 

steel companies have filed for bankruptcy since 1998; 

about half of them are no longer in operation. 

An unusual characteristic of this recession is that a 

slump in the business equipment and machinery sector 

occurred slightly before a downturn in output of consumer goods, in contrast with the typical sequence in 

recessions. The current contraction in this sector is 

more severe than in the last recession (see bottom 

panel of Chart 1) but not worse than in the previous 

two. This sector likely will remain weak until the manufacturing sector as a whole utilizes existing plant and 

equipment more fully than the 73 percent utilization 

rate of late 2001. 

Outside the manufacturing sector, a parallel with the last 

recession is the Federal Reserve’s significant lowering 

of short-term interest rates as signs of economic weakness intensified. In turn, favorable financing terms 

helped sustain relatively high demand for some interestsensitive sectors such as homes and motor vehicles. 

Lower interest rates also helped lower the financing 

costs faced by businesses and households, enhancing 

borrowers’ ability to remain current on existing debts 

despite slower growth in income or profits. Even so, 

corporate bankruptcies have risen noticeably in the past 

year, and signs of repayment problems are appearing 

among households as well. Should new federal farm 

legislation significantly reduce government payments to 

farmers, which are a major source of income in some 

agricultural communities, signs of stress also might 

become evident among small farmers. 

Rapidly Falling Interest Rates Have Affected Net Interest 


Margins and Asset and Liability Management Choices
 

During the past ten years, insured institution net interest margins (NIMs) have been shrinking. This margin 

compression has been the consequence of structural 

changes within the banking industry, largely the result 

of significant competition for both loans and deposits. 

Throughout 2001, however, short-term interest rates 

fell significantly,2 and the yield curve, previously 

inverted, is now steep and upward sloping. Generally, 

a steep yield curve is perceived as beneficial for the 

banking industry, as many institutions have liabilities 

of shorter duration than the earning assets. However, 

the rapid change in the yield curve in 2001 contributed 

to many sudden changes. Refinancing activity has 

surged, customers’ loan and deposit preferences have 

changed, and bank management teams now are faced 

with substantially different asset and liability management decisions than those they faced a year ago. The 

discussion below explores recent NIM trends, the 

banking markets or types of institutions that have 

been affected most significantly, and the effect that 

2 In 2001, the target federal funds rate was reduced 11 times, for a 

total of 475 basis points. 

higher short-term rates could have on insured institutions if the economy rebounds in 2002. 

Margin Compression Has 

Abated in Recent Quarters 

The last major steepening of the yield curve occurred 

in the early 1990s, was fairly gradual, and corresponded with rising NIMs. Similarly, significant short-term 

interest rate reductions in 2001 appear to have helped 

improve margins in recent quarters (see Chart 2, next 

page). However, the swift nature of recent rate reductions may lead to a muted positive impact and could 

prove adverse to some insured institutions that were 

not adequately hedged against a rapid decline in shortterm rates and a steepening yield curve. Although the 

full effects of the 2001 changing interest rate environment have yet to be felt, a review of the driving forces 

of NIM already reveals changing strategies among 

both insured financial institutions and their customers. 

The restructuring that is taking place will affect 

insured institution interest rate risk positions and, 

therefore, future NIM trends. 

Chicago Regional Outlook 5 First Quarter 2002 
ight axis)

Refinancing Index

(left axis)

Regional Perspectives
 

CHART 2 

The Last Major Yield Curve Steepening Was Gradual and Corresponded to Higher Margins 

30-Year U.S. Treasury Rate— 

3-Month T-Bill Rate 

(left axis) 

Net Interest Margin 

(quarterly annualized) 

(right axis) 

Percentage Points 

-1.0 

0.0 

1.0 

2.0 

3.0 

4.0 

5.0 

3.4 

3.6 

3.8 

4 

4.2 

4.4 

4.6 

Percentage Points 

3Q84

2Q85

1Q86

4Q86

3Q87

2Q88

1Q89

4Q89

3Q90

2Q91

1Q92

4Q92

3Q93

2Q94

1Q95

4Q95

3Q96

2Q97

1Q98

4Q98

3Q99

2Q00

1Q01 

Source: Bank and Thrift Call Reports for Chicago Region Community Institutions, Excluding De Novos and Specialty Banks, Federal Reserve Board 

“The Asset Side” 

As short and intermediate rates have fallen, so have 

asset yields. Since 1998, median asset yields peaked in 

fourth-quarter 2000 at 8.15 percent and have since 

declined to 7.56 percent for third-quarter 2001.3 

The softening economy has hampered loan originations 

because of both declining loan demand and tighter 

underwriting. As a result, institutions will have a more 

difficult time bolstering asset yields by increasing loanto-asset ratios. In fact, Chicago Region commercial 

banks are reporting higher levels of federal funds sold 

and securities purchased under agreements to resell, 

indicating that recent deposit inflows have not been 

absorbed by loan demand. These highly liquid but lowCHART 3 

yielding assets hit bottom in second-quarter 2000 at 

1.57 percent of assets and rose to 3.21 percent as of 

third-quarter 2001. Modest loan demand, should it persist, could constrain recent NIM improvements. 

Falling Mortgage Rates Led to a Surge 

in Refinancing Activity and a Borrower 

Preference for Fixed-Rate Mortgages 

A surge in mortgage refinancing activity (see Chart 3) 

has been fueled by low mortgage rates and steadily 

increasing home values in the Midwest. The increase in 

mortgage origination activity has been a boon for many 

lenders, enabling them to generate more fee income. 

Refinancing Activity and Shares of Fixed-Rate Mortgages Climbed Nationwide in 2001 

Fixed-Rate Percentage 

(r

Refinancing Index (applications)

3/16/90=10

Percent 

60 

65 

70 

75 

80 

85 

90 

95 

Source: Mortgage Bankers Association via Haver Analytics 

0 

500 

1,000 

1,500 

2,000 

2,500 

3,000 

3,500 

4,000 

4,500 

5,000 

Jan ,

92 

Jun ,

92 

Nov ,

92

Apr ,

93

Sep ,

93 

Feb ,

94 

Jul ,

94

Dec ,

94 

May ,

95

Oct ,

95

Mar ,

96 

Aug ,

96 

Jan ,

97 

Jun ,

97 

Nov ,

97

Apr ,

98

Sep ,

98 

Feb ,

99 

Jul ,

99

Dec ,

99 

May ,

00

Oct ,

00

Mar ,

01 

Aug ,

01 

3 Unless noted otherwise, insured institution data refer to institutions headquartered in the Chicago Region with less than $1 billion in assets, 

excluding de novos and specialty banks. The term “commercial banks” will be used to denote thrift data is not included. 

Chicago Regional Outlook 6 First Quarter 2002 
Regional Perspectives
 

Mortgage Lenders Are Highly More problematic, however, could be the rapid return of 

principal funds to banks and thrifts and how those funds 

are then reinvested. The Mortgage Bankers Association 

(MBA) forecasts4 that mortgage originations will start 

to subside, yet refinancing activity is expected to remain high, accounting for 67 percent and 55 percent of 

mortgage originations in fourth-quarter 2001 and firstquarter 2002, respectively. 

Because low interest rates are available, borrowers have 

shown, and are expected to continue to show, a preference 

for fixed-rate mortgages with longer duration. The MBA 

anticipates that adjustable-rate mortgage loans will comprise only 13 percent of mortgage loan originations in 

2002, well below the 24 percent level seen in 2000. 

How margins ultimately will be affected by refinancing 

activity will be a function of the migration of mortgages 

from short term to longer term, management decisions 

on which loans to retain or sell, and competitive pressures on pricing power. Insured institutions holding 

higher percentages of long-term loans may begin to see 

margin improvement, but possibly at the risk of margin 

exposure to higher short-term rates. Fortunately, liquid 

mortgage markets give institutions flexibility in dealing 

with high volumes of mortgage lending activity. Chicago Region commercial banks have not reported a significant lengthening of maturities in one- to four-family 

mortgage portfolios; however, those institutions more 

heavily focused on residential lending5 have seen a 

marked increase in one- to four-family loans maturing 

or repricing in greater than 15 years.6 

Commercial Loan Refinancings Have 

Margin and Asset Quality Implications 

Commercial-oriented loans also are subject to refinancing activity. Commercial lenders in the Region have seen 

the biggest year-over-year and quarter-to-quarter declines 

in asset yields, largely because of softer commercial loan 

demand; however, refinancings also likely contributed to 

these declines. Given a soft economy, creditworthy borrowers are at a premium, and savvy borrowers are likely 

4 Mortgage Bankers Association of America, Mortgage Finance Forecasts, November 14, 2001. 5 Residential real estate lenders have more than 50 percent of assets in 

the sum of one- to four-family loans and mortgage-backed securities. 

6 As of December 31, 2000, 21 percent of one- to four-family mortgage loans matured or repriced in over 15 years, versus 25 percent as 

of September 30, 2001. This is approximately double the level of 

long-term mortgages held by community banks in the Region. 

Sensitive to Interest Rate Fluctuations 

A review of median NIMs across different institution 

types reveals that this year’s interest rate cuts have not 

halted NIM compression for residential real estate 

lenders (as well as those that hold significant 

mortgage-backed securities portfolios). Mortgage 

lenders typically have lower spreads based on lower 

credit risk profiles; therefore, interest rate declines 

tend to have a more significant impact on them than on 

other groups. Other bank groupings also are experiencing the longer-term structural margin compression 

but have performed slightly better during the past two 

quarters. 

Mortgage lenders in the Region hold the highest percentage of long-term assets, and during the past two 

quarters, the group’s long-term asset ratio increased 

appreciably,7 unlike that of non-mortgage lenders. 

Mortgage lenders’ long-term assets increased from 

37.9 percent to 40.9 percent of assets from March 31, 

2001, to September 30, 2001. Under the current scenario, mortgage lenders could experience significantly 

mismatched asset/liability positions. 

In addition to dealing with the substantial optionality 

inherent in mortgage lending, mortgage lenders have 

the highest median quarterly annualized cost of funds, 

at 4.29 percent. This group has experienced the most 

modest decline in median cost of funds during the past 

year, at only 33 basis points. In contrast, the Region’s 

commercial lenders8 saw a more substantial 65-basispoint decline in cost of funds during the same period. 

7 Long-term asset information is available only for Call Report 

filers. 

8 Commercial lenders are defined as holding more than 25 percent of assets in the sum of commercial and industrial and 

commercial real estate lending. 

to seek interest rate concessions. If lenders balk, the better customers can pay off their loans early by obtaining 

new funds elsewhere at a lower market rate. As a result, 

commercial lenders are sometimes faced with the unappealing choice of accepting lower loan yields or potentially losing prime borrowers. 

Securities Compose a Smaller Portion of Assets 

but Have Heightened Interest Rate Sensitivity 

Long-term margin pressures and the increased availability of off-balance-sheet liquidity sources have led many 

Chicago Regional Outlook 7 First Quarter 2002 
Regional Perspectives
 

of the Region’s commercial banks to hold a smaller proportion of marketable securities. At year-end 1998, the 

Region’s commercial banks had an aggregate securitiesto-assets ratio of 25.5 percent, compared with 21.5 percent as of September 30, 2001. Generally speaking, 

holding smaller securities portfolios and retaining more 

loans will serve to augment NIMs. 

Within securities portfolios, Chicago Region commercial 

banks have been opting to hold significantly fewer U.S. 

Treasury securities and more U.S. agency and mortgagebacked securities. These instruments provide slightly 

higher yields while continuing to meet liquidity needs. 

Even before the recent steepening of the yield curve, the 

Region’s banks had been opting for investments with 

maturities or earliest repricing dates further into the 

future. Mortgage pass-throughs with maturities over 15 

years (compared with those with shorter maturities) have 

increased as a percentage of that category in the past few 

years, as have “other debt” securities with 5- to 15-year 

maturities. As of December 31, 1998, 34 percent of mortgage pass-throughs had maturities or repricing dates over 

15 years, and now 49 percent do. Although these trends 

also are contributing to margin improvement, holding 

securities portfolios with extended maturity or repricing 

dates heightens potential market value fluctuations associated with changes in interest rates. 

“The Liability Side” 

The increased use of noncore funding has been one of the 

key trends contributing to narrowing NIMs. While there 

are exceptions, noncore funding sources tend to be more 

expensive than core funds. However, the differences in 

costs become less meaningful during a period of rapidly 

falling rates. During such times, the structure of a bank’s 

liabilities and its management of interest rate risk become 

the paramount factors affecting NIM trends. Given the 

availability of many funding sources, such as Federal 

Home Loan Bank borrowings and brokered deposits, 

banks have a variety of options for structuring the liability side of their balance sheets. Therefore, some banks 

with a significant amount of short-term noncore funding 

may have benefited greatly from the recent drop in rates. 

Conversely, those that locked in rates, have more longerterm funding sources, or faced significant competitive 

pressure for core funds may not have experienced the 

same benefit to their funding costs. 

CHART 4 

Sources: Bank and Thrift Call Reports for community institutions in the Chicago 

Region, excluding de novos and specialty banks, Federal Reserve Board 

3/31/01

6/30/01

9/30/01

12/31/00

3/31/00

6/30/00

9/30/00

12/31/99

3/31/99

6/30/99

9/30/99

12/31/98 

Percent 

1 

2 

3 

4 

5 

6 

7 Two-Year 

U.S. Treasury Rate 

Median Cost of Funding 

Earning Assets 

Core Funding Costs May 

Not Drop Much More 

Funding Cost Improvements May Be Muted 

It takes time for liabilities to reprice after market rates 

shift; the result is a lag between rate reductions and the 

full effect of cost improvements (see Chart 4). Median 

funding costs during the past three years peaked in 

December 2000 at 4.39 percent and fell steadily to 3.79 

percent as of September 2001, a much smaller decline 

than that of the two-year U.S. Treasury rate. Some funding cost “stickiness” may be expected because banks 

may be unwilling to jeopardize deposit relationships by 

lowering deposit rates even further. The total expected 

decline in funding costs may be relatively small, given 

that rates are already so low and that banks may not 

have much pricing power. 

Institutions with pressured margins may perceive an 

incentive to utilize shorter-term wholesale funding if 

they fear deposit runoff that might occur if deposit 

interest rates were lowered further. Lower-cost wholesale funding could be used in the short term to augment margins. However, such a strategy may be 

short-sighted for institutions whose customer base is 

ultimately the foundation of franchise value. Jeopardizing those relationships could adversely affect the 

ability to generate high-yielding loans and manage 

deposit rates upward on a lagged basis when the economy rebounds. 

Chicago Regional Outlook 8 First Quarter 2002 
Regional Perspectives
 

Many Banks Seek Longer-Term Funding, 

while Many Retail Customers Migrate 

toward Short-Term Instruments 

Recent changes in the Region’s liability structure have 

implications for interest rate sensitivity going forward. 

Although noncore funding use continues to rise in the 

Region, the bulk of assets are funded with core funds. 

Chief among these are time deposits, such as certificates 

of deposit (CDs). Many depositors appear reluctant to 

invest in long-term time deposits in the current interest 

rate environment. For commercial banks, retail customer 

preference now seems to be toward shorter-term time 

deposits as well as nonmaturity money market deposit 

accounts (MMDA) and savings accounts. During the past 

year, the percentage of CDs maturing within one year has 

been increasing,9 as has the amount of MMDA and savings accounts, albeit more modestly. 

Where management has the most control over funding 

maturities, such as with brokered deposits and Federal 

Home Loan Bank (FHLB) borrowings, there has been a 

move toward longer-term maturities. The ratio of other 

borrowings10 to assets has pulled back slightly this year, 

CHART 5 

with aggregate FHLB borrowings to assets holding 

steady at 4.7 percent of assets during the past three 

quarters; however, the median percentage of FHLB borrowings maturing within one year has fallen to 19 percent 

from 25 percent over the same period.11 The use of brokered deposits is relatively modest in the region, but 

aggregate maturities are increasingly longer term. 

Margin Levels and Trends Vary 

among the Region’s MSAs 

Insured institutions in all but three metropolitan statistical areas (MSAs)12 in the Region experienced declines 

in median year-to-date annualized NIMs during the 

year ended September 30, 2001. The most significant 

decline13 in median NIM occurred in the Cincinnati 

banking market, where it dropped 47 basis points to 

2.85 percent.14 Banking markets in Detroit, Peoria, and 

Davenport experienced similar declines, albeit from 

higher levels. In Detroit, declines may not be as significant, as initial margins were much higher. Contributing 

to margin compression among banks in the Detroit 

MSA are rising nonaccrual levels, repricing of 

Net Interest Margins Vary across the Region’s Metropolitan Statistical Areas (MSAs) 

Cost of Funding Earning Assets (%) 4.6 

4.4 

4.2 

4.0 

3.8 

3.6 

3.4 

3.2 

3.0 

Ann Arbor 

Champaign 

Chicago 

Cincinnati 

Cleveland 

Columbus

 Davenport

 Dayton-Springfield 

Decatur 

Detroit 

Duluth-Superior 

Ft. Wayne 

Gary 

Grand Rapids 

Indianapolis 

La Crosse 

Madison 

Mansfield 

Milwaukee 

Peoria 

Rockford 

St Louis 

Springfield 

Lower Margins 

Higher Margins 

7.2 7.4 7.6 7.8 8.0 8.2 8.4 8.6 8.8 

Asset Yields (%)
 

Source: Bank and Thrift Call Reports for community institutions, excluding de novos and specialty banks, as of September 30, 2001.
 

Note: Median year-to-date annualized values shown.
 

9 Short-term CDs have increased as a percentage of total time deposits, with the median level increasing from 73.7 percent as of June 30, 2000, to 

77.1 percent as of September 30, 2001.
 10 The primary components of other borrowings are federal funds sold, securities sold under agreements to repurchase, demand notes issued to the
 

U.S. Treasury and other borrowed money, and obligations under capitalized leases.
 11 Although maturity information is available for FHLB borrowings, repricing information is not, which prevents a determination on their potential impact on margins.
 

12 Among MSAs with at least ten nonspecialty institutions (excluding de novos) with assets of less than $1 billion.
 

13 Based on median NIMs through September 30, 2001 (year-to-date, annualized).
 

14 Excludes institutions in the Cincinnati MSA but not headquartered in Ohio or Indiana.
 

Chicago Regional Outlook 9 First Quarter 2002 
Regional Perspectives
 

commercial loans, and significant use of longer-term 

noncore funding. 

Although insured institutions operating in most MSAs 

have lower margins than they did a year ago, much of 

the disparity in asset yields and funding costs exists 

among the Region’s larger banking markets (see Chart 5, 

previous page). Markets such as Cincinnati, Davenport, 

Peoria, and Dayton-Springfield tend to have relatively 

higher funding costs and lower asset yields than other 

markets in the Region, which may be evidence of 

competitive pressures in these markets. Relatively low 

loan-to-asset levels and low asset yields among 

insured institutions in the St. Louis and Davenport 

MSAs indicate modest loan demand, perhaps leading 

to pricing pressures. 

The Sharp Decline in Interest Rates 

in 2001 May Have Left Some Institutions 

Exposed to Rising Rates 

Some groups of institutions are not seeing and may not 

see the enhancement to NIMs that lower interest rates 

traditionally are thought to cause. Institutions seeking to 

maximize current margins by increasing long-term, 

fixed-rate assets and shifting toward earlier repricing 

and shorter-term liabilities may be vulnerable during a 

rising interest rate environment. For instance, banks that 

had shifted toward shorter-term wholesale funding are 

reaping benefits now. However, should loan demand 

pick up and interest rates rise, many of these institutions 

may be particularly hard hit by higher funding costs and 

an inability to capitalize on increasing loan demand by 

tapping into deposit relationships. 

Although many of the determinants of NIM trends in 

the aggregate have been explored, prudent interest rate 

risk decisions can be made only by reviewing the totality of an individual institution’s rate-sensitive assets 

and liabilities. To that end, bank management teams 

now can review how well interest rate risk management systems performed during a period of substantial 

interest rate changes. Management also has the opportunity to ensure that institutions are well positioned for 

possibly higher interest rates or significant, nonparallel shifts in interest rates, such as those seen in 2001. 

Now is the time for management to prepare for a rising 

rate environment. 

By the Chicago Region Staff 

Chicago Regional Outlook 10 First Quarter 2002 
In Focus This Quarter
 

Housing Market Has Held Up Well in This 


Recession, but Some Issues Raise Concern
 

Trends in housing markets are important performance 

drivers for many FDIC-insured institutions. The health of 

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

finance residential construction and is linked indirectly to 

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

market, was underwritten during 2001, with 56 percent of 

this activity in refinancing transactions.1 This activity 

makes recent trends in underwriting of particular interest. 

An ancillary issue for many mortgage lenders, interest 

rate risk, is not addressed in this article.2 

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

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

practices will fare during this downturn. Developments 

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

standards, and the emergence of subprime mortgage 

lending as a significant line of business for some banks. 

Mitigating this risk has been the steady appreciation of 

home prices, which have shown signs of softening in 

some markets but not to the extent seen at a comparable 

stage in previous recessions. 

Home price weakness may be more pronounced in 2002 

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

authors’ judgment, systemic weakness in home prices is 

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

institutions. Nonconstruction residential mortgages, even 

during the most pronounced periods of stress in the 1980s 

and early 1990s, remained the best-performing loan 

class, especially for lenders specializing in residential 

real estate; and, historically, these mortgages have been 

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

January 2002.
 

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

and Chicago Regions, Regional Outlook, First Quarter 2002.
 

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

insured institutions.3 

That said, however, there are pockets of risk for 

insured institutions. There is evidence that borrowers 

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

mortgage lenders. Further, a slump in residential real 

estate markets could be especially detrimental to 

insured institutions with significant exposures to 

housing construction because projects might not sell at 

projected asking prices or as quickly as anticipated. 

Finally, in specific markets where housing prices may 

have achieved unsustainable levels, some increase in 

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

stands out as a place to watch. 

The Recession Thus Far Has Had 

a Minimal Impact on Mortgage 

Delinquencies at Insured Institutions 

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

trends seen in past recessions. For example, new and 

existing home sales both set records during the year, 

while new home construction failed to decline, an 

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

prices—as measured by either the Office of Federal 

Housing Enterprise Oversight (OFHEO) repeat sales 

price index or the National Association of Realtors 

(NAR) median single-family price statistic—showed 

deceleration but remained well above trends seen at 

similar points in past recessions. This behavior partly 

reflected the early robustness of household income in 

the face of recession and relatively low fixed mortgage 

rates during 2001, which helped to counter some of the 

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

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

Boston Region, Regional Outlook, First-Quarter 2000. 

Chicago Regional Outlook 11 First Quarter 2002 
In Focus This Quarter
 

CHART 1 CHART 2 

Through September 2001, Mortgage-


Related Delinquencies Remained Modest
 

Although the Much Larger Market for 

Existing Homes Has Held Up, New Home 

Prices Are Under Pressure 

Percentage Change from

Prior Year 

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

Existing 

New 

–10 

–5 

0 

5 

10 

15 

20 

,

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

01 

Percentage 

30+ Days Past Due 

0 

2 

4 

6 

8 

10 

12 

,

91 ,93 ,95 ,97 ,99 Sep ,

01 

0 

1 

2 

3 

4 

5 

6 

Percentage 

30+ Days Past Due 

95th Percentiles (R) 

mortgages equity lines 

75th Percentiles (L) 

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

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

Source: Bank and Thrift Call Reports 

initial adverse effects of the recession on housing 

demand. 

One sign of potential weakness appeared late in 2001 

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

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

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

predictive of prices for the much larger existing home 

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

adverse pricing trends in the new home segment do 

raise concerns for residential developers and insured 

institutions that finance residential construction. 

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

As detailed later in this article, home price growth 

began to weaken in 2001 in a number of metropolitan 

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

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

contractions in employment last year. 

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

weakness thus far. Through the first nine months of 

2001, insured institutions showed negligible advances 

in median past-due ratios for mortgages and equity 

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

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

lines of credit, although continued strong mortgage 

origination activity in 2001 may have masked (in the 

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

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

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

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

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

insured institutions’ earnings and capital, since it has 

held up better in prior recessions than other loan types. 

What Are the Risks Facing Housing 

Lenders in 2002 and Beyond? 

In an environment of significantly slower economic 

growth than prevailed during the 1990s, can the 

strength of housing prices and the relatively benign 

credit quality environment for housing lenders be 

expected to continue? The answer will depend on the 

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

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

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

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

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

Chicago Regional Outlook 12 First Quarter 2002 
, UT

Miami– 

y, NY

Phoenix, AZ

, NV–AZ 

, MO–IL 

Tucson, AZ

Oklahoma City

, NY

, OK 

Kansas City

Tulsa, OK

, MO–KS

, NC–SC 

mingham, AL

, TN-AR–MS

Honolulu, HI

, SC 

Entire Nation

, FL

e City

alo

ville

 Lauderdale

Alban

Buff

 Louis

Green

egas

lotte

Salt Lak

Memphis

Las V

Char

St.

Bir

Ft.

In Focus This Quarter
 

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

Evolving Lending Practices Have Increased 

the Risk Profile for Mortgage Lenders 

Although history suggests that residential mortgage 

defaults will be relatively low even in a recession, 

changes in the mortgage market since the 1990–1991 

recession could affect mortgage performance during the 

present downturn. Many underwriting changes over the 

past decade have been driven in part by the growing 

importance of the secondary market for mortgage debt, 

and of Fannie Mae and Freddie Mac in particular. In 

1980, federal and related agencies had direct or indirect 

interests in approximately 17 percent of all mortgage 

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

increased to roughly 41 percent. Insured bank and thrift 

mortgage exposures grew over the same period, but, as 

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

trends notwithstanding, insured institutions still provide 

substantial funding, directly or indirectly, to the housing 

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

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

Although an active secondary mortgage market has 

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

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

CHART 3 

1993 2000 

days, lenders largely had to retain originated mortgages 

in their own portfolios. Consequently, only lenders with 

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

mortgage markets. The advent of the secondary market 

enlarged the pool of available funding and permitted both 

insured institutions and other originators to transfer their 

mortgage business readily into entities such as mortgage 

pools and trusts. Consequently, many new players, 

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

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

led to considerable commodification of the mortgage 

market. Rather than competing on the basis of traditional 

relationships, lenders’ market shares are increasingly 

driven by price. For smaller savings institutions that focus 

heavily on residential mortgage underwriting, this issue 

has likely elevated business risk. Heightened competition 

has caused some loosening of mortgage underwriting 

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

valuation techniques currently in place have not been 

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

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

mortgages. The ability of insured institutions to mitigate 

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

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

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

60 

40 

20 

0 

Source: Federal Housing Finance Board 

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

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

Chicago Regional Outlook 13 First Quarter 2002 
In Focus This Quarter
 

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

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

Board, LTPP ratios are high and have risen in several 

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

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

with LTPP ratios exceeding 90 percent. 

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

insurance (PMI), recently the mortgage industry has 

allowed borrowers to avoid purchasing PMI. In particular, 

“piggyback” financing has made homeownership 

increasingly possible for households that cannot afford 

the traditional 20 percent down payment or do not wish to 

pay for PMI. With piggyback financing, the borrower 

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

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

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

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

are not. Thus, piggyback financing is probably most 

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

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

on all low down payment loans to the lender that 

retains the junior position. These institutions are, of 

course, compensated for some of this risk with the 

higher interest rates charged on the piggyback portion 

of these mortgages. 

Competitive factors have prompted the industry to 

enhance underwriting automation. As part of the push, 

credit scoring has become a routine part of the credit 

analysis process, and, increasingly, lenders are using 

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

since the 1990–1991 recession; consequently, their 

predictive ability in a downturn is uncertain. Although 

some have touted AVMs as the answer to appraisal 

fraud, the ability of statistical models to simulate the 

qualitative judgments considered critical to traditional 

appraisals is unknown. Paper appraisals reportedly 

7 Purchase money mortgages are loans extended solely for the initial 

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

continue to dominate the industry; however, recently, 

the two largest government-sponsored enterprises have 

begun accepting AVMs in lieu of standard appraisals 

for loans under $275,000.8 For lenders that specialize 

in HLTV mortgages, there is less room for error with 

AVMs. 

Cyclical Weakness Is Already Apparent 

in Subprime Mortgage Lending 

Historically, certain insured institutions have made 

mortgage loans with narrow collateral margins or to 

borrowers with limited or blemished credit histories. 

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

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

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

extent of bank involvement in subprime lending at any 

point in time is difficult. However, the FDIC estimates 

that fewer than 1 percent of all insured institutions 

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

originations peaked at 13 percent in early 2000, before 

moderating somewhat during the first three quarters of 

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

probably have some limited involvement in subprime 

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

the Minneapolis District offered loans to low-credit 

quality consumer borrowers in 1999.10 

Subprime mortgage loan performance appears to have 

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

trends on Federal Housing Agency (FHA)-insured 

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

with low down payments. The Mortgage Bankers 

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

in the year ending third-quarter 2001, the delinquency 

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

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

8 “Automated Appraisals Require Caution by Lenders,” American 

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

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

Federal Reserve, July 1999. 

Chicago Regional Outlook 14 First Quarter 2002 
In Focus This Quarter
 

CHART 4 

Recent Mortgage Delinquencies for HigherRisk Loans Reached All-Time Highs 

Percentage of Mortgages

30+ Days Past Due

FHA 

Conventional 

,

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

0 

2 

4 

6 

8 

10 

12 

Source: Mortgage Bankers Association 

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

difficulties. 

A database of more than 6.5 million subprime loans 

tracked by Loan Performance Corporation (formerly 

Mortgage Information Corporation) reported similar 

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

from 5.5 percent one year earlier.11 Moreover, subprime 

delinquencies significantly exceeded those found among 

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

of possible concern are vintage data trends, which show 

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

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

recession. Alternatively, Loan Performance Corporation 

analysts have suggested that the 2001 refinancing boom 

might have created some adverse selection in mortgage 

pools originated during the relatively higher interest rate 

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

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

ratios for their age compared with similarly seasoned subprime loans 

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

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

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

Winter 2001. 

er-coupon and variable-rate loans comprised a significant 

share of mortgage originations during that period, overall 

prepayment rates on the 2000 vintage might have been 

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

loans of lesser credit quality behind and elevating the 

residual delinquency experience in that pool. 

Given these trends, an important issue for subprime 

lenders is their ability to anticipate and plan for the 

impact of an economic slump on their operations. Some 

institutions clearly adopt subprime lending as part of an 

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

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

borrowers recently provided additional resources to its 

loan services and default management departments. This 

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

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

C&D Lending Risks May Be Elevated in MSAs 

with Potential Supply/Demand Imbalances 

Historically, lending to finance housing construction is 

riskier than mortgage lending on existing structures. 

Insured institutions report construction and development 

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

commercial and residential construction. While it is thus 

impossible to ascertain from quarterly call reports the 

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

smaller insured institutions engage to some degree in 

commercial property development, their C&D lending 

largely finances single-family construction. If markets 

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

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

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

Demand for housing can be affected by two distinct 

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

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

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

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

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

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

Chicago Regional Outlook 15 First Quarter 2002 
In Focus This Quarter
 

conditions, including interest rates. New supply of homes 

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

of market and economic signals is critical to the success 

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

of overestimating future demand could be multiplied if 

several builders inaccurately gauge changes in 

demand. Consequently, a construction market with 

numerous smaller developers, such as Atlanta, may 

see amplified swings in construction activity and may 

experience excess supply during certain periods. 

Although conceptually straightforward, measuring the 

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

can limit the effectiveness of this type of analysis. As 

already mentioned, some insight about current housing 

market conditions in specific metropolitan areas may 

be gained by analyzing both secular and cyclical 

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

the role of cyclical factors is of prime concern at this 

time. 

To measure the cyclical aspect of the relationship 

between a market’s supply and demand, some analysts 

rely heavily on the concept of employment-driven 

demand.16 Such analysis involves tracking a demand/ 

supply ratio based on employment growth and permit 

issuance. Areas where permitting activity continues to 

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

market.17 

Using a simplified version of employment-driven 

demand, we identified a number of metropolitan areas 

as being at risk for a rising imbalance in their housing 

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

These markets are displaying signs that residential 

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

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

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

CHART 5 

–120 

–100 

–80 

–60 

–40 

–20 

20 

40 

60 

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

December 2001 Year-to-Date Permits 

(Year-Ago Change) 

December 2001 Employment

(Year-Ago Change, Thousands) 

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

Some Larger MSAs Continued to See 

Permit Growth during 2001, despite 

Declining Employment 

0 

Greensboro, 

Minneapolis, 

& St. Louis 

Chicago 

Atlanta 

Portland, OR–WA 

Phoenix 

construction activity may not be responding in kind to 

local economies that have started to contract during 

this recession. Further, Phoenix, Portland, and Atlanta 

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

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

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

apparent that some markets identified in Chart 5 as 

having significant banking exposure to C&D lending 

also may have a cyclical imbalance in home building. 

Atlanta, for example, demonstrates one of the highest 

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

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

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

words, while employment-driven demand has softened 

in the metropolitan area, single-family construction 

activity has continued, and community bank lenders 

may have increased their level of residential financing 

commitments. 

Cyclical Risks May Be Developing 

with Respect to Home Prices 

Popular comparisons have been made recently 

between the healthy run-up in housing prices during 

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

2001. 

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

then charted the top 25 MSAs ranked by September 2001 median 

C&D/assets. 

Chicago Regional Outlook 16 First Quarter 2002 
In Focus This Quarter
 

CHART 6 

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

Exposure Coupled with Potentially Growing Supply/Demand Imbalances 

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

0 

5 

10 

15 

20 

25 

30 

Change in Median C&D Loans-to-Assets 

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

–2 0 2 4 6 8 10 

Salt Lake City 

Atlanta Provo-Orem, UT 

Stockton, CA 

Greensboro 

Portland, OR–WA 

Phoenix 

MSAs with declining employment

 but rising permitting during 2001 

the past several years and the technology stock-fed 

speculative “bubble” in equity prices that persisted 

through early 2000. The subsequent bursting of this 

bubble and the resulting economic distress have raised 

concerns of a sequel featuring housing prices. 

According to the OFHEO repeat sales price index, 

there has never been an instance of outright declines in 

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

prices do exhibit strong cyclical tendencies, with the 

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

CHART 7 

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

in population-adjusted personal income growth,21 and 

some have pointed to a growing imbalance between 

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

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

Given that home price bubbles have occurred in the 

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

MAP 1 

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

Sources: OFHEO, U.S. Census Bureau 

The Widening Gap between Home Price and 

Income Growth Has Raised Some Concern 

Per Capita Income 

Home Price Index 

’85 ’87 ’91 ’93 ’97 ’01E ’89 ’95 ’99 

0 

2 

4 

6 

8 

10 

Drops in Affordability since the Mid-1990s
 

Are Most Prevalent in California 


and the Northeast
 

Top 10 percent of
 

MSAs ranked by decline
 

in affordability index, 1996
 

to 2001 (through June)
 

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

Source: Economy.com 

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

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

Chicago Regional Outlook 17 First Quarter 2002 
In Focus This Quarter
 

resulted in significant negative fallout for these areas’ 

economies and insured institutions, it is useful to look 

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

scenario (with very low probability) for residential 

real estate markets during the current recession. It is 

unlikely that significant, systemic risks from home 

price bubbles have arisen yet for residential lenders. 

Of course, this situation could change if the current 

recession deepens or is protracted, or if growth during 

the subsequent recovery is anemic. Further, national 

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

affordability. These markets, and the residential lenders 

targeting them, may be more at risk as local economic 

growth falters. 

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

during the past several years. Not surprisingly, many 

of them—namely larger cities in California and the 

Northeast—are those that historically have seen the 

biggest swings in prices and a penchant for speculative 

excess. 

In markets with rapidly declining affordability, credit 

risk arises from the increasing likelihood that new 

borrowers will commit a greater share of household 

financial resources to meet monthly payments. Credit 

problems could become more readily apparent given 

any subsequent disruptions to employment or income 

in these markets—especially among households with 

limited wealth or that require multiple job holders to 

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

Disruptions to aggregate household liquidity from lost 

employment or decreased income can result in rising 

mortgage delinquencies. With respect to foreclosures, 

however, some research has suggested that the decline 

in prices relative to the balance owed on the mortgage 

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

owners with positive equity are likely able to sell their 

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

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

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

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

between rising LTVs and foreclosure rates. 

CHART 8 

Rising Foreclosure Rates Followed Falling 

Home Prices in New England a Decade Ago 

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

Annual Home Price Change (%) 

’79 ’84 ’89 ’94 ’99 

Inverse 

Price (R) 

Foreclosure (L) 

–20 

–10 

0 

10 

20 

30 

Foreclosure Started

(% of Existing Loans) 

0.00 

0.10 

0.20 

0.30 

0.40 

0.50 

homes profitably, thus avoiding foreclosure. Chart 8 

shows the strong relationship between declining home 

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

change in order to emphasize the relationship).23 

The data available through late 2001 were mixed with 

respect to home resale price trends at the MSA level. 

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

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

show about a dozen markets with year-over-year 

declines, none exceeding four percent. A deceleration 

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

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

should be noted that the OFHEO data do not include 

sales of high-priced homes and are less influenced by 

changes in the mix of homes sold than are average and 

median prices;24 this issue is more meaningful in the 

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

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

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

the two-decade correlation between foreclosures started and price 

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

both California and the nation. 

24 Data are obtained from aggregating repeat sales or refinancings of 

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

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

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

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

Chicago Regional Outlook 18 First Quarter 2002 
In Focus This Quarter
 

TABLE 1 

As Recession Evolved, Home Price Appreciation Waned through 2001 

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

ANNUAL PERCENT CHANGES 

MSAS RANKED 

BY DECELERATION 

IN HOME PRICE INDEX 

FROM 1Q01 TO 4Q01 

OFHEO HOME PRICE INDEX 

NONFARM 

EMPLOYMENT 

1998– 

2000 1Q01 2Q01 3Q01 4Q01 

1998– 

2000 2001 

UNITED STATES 6.3 9.6 9.1 8.8 6.9 2.4 0.3 

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

SANTA CRUZ-WATSONVILLE CA 

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

SAN FRANCISCO CA PMSA 16.5 19.4 13.9 9.1 3.5 3.3 1.3 

SALINAS CA MSA 13.7 24.3 22.4 19.0 9.4 3.3 0.9 

SANTA ROSA CA PMSA 14.8 22.7 19.6 13.6 8.6 4.1 1.6 

OAKLAND CA PMSA 14.7 22.3 18.0 14.1 8.2 3.4 2.0 

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

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

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

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

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

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

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

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

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

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

BARNSTABLE-YARMOUTH MA 

NECMA 12.8 17.6 14.5 14.6 12.5 3.9 1.3 

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

DUBUQUE IA MSA 3.9 8.8 6.0 6.9 2.5 1.1 –0.6 

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

DENVER CO PMSA 11.1 13.7 11.8 10.9 7.9 3.8 2.3 

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

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

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

SAN DIEGO CA MSA 11.8 15.6 13.8 12.9 10.4 4.3 2.7 

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

TUCSON AZ MSA 3.3 8.6 8.0 6.8 3.6 3.5 0.8 

JERSEY CITY NJ PMSA 8.0 11.1 17.6 13.7 6.2 2.1 2.7 

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

RAPID CITY SD MSA 6.2 8.9 9.3 7.7 4.1 3.1 0.1 

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

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

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

Chicago Regional Outlook 19 First Quarter 2002 
 

In Focus This Quarter
 

San Francisco Bay Area25 and parts of the Northeast, 

since prices for high-end homes (typically financed by 

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

Table 1 lists markets whose 2001 deceleration in home 

price growth was in the top 10 percent of the more 

than 300 metro areas for which the OFHEO statistic is 

available. The table also provides (where available) 

each MSA’s recent employment trend as an indicator 

of overall economic conditions. These markets may yet 

see even more pronounced deceleration in home price 

growth or even declines in home prices this year (as 

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

The metro areas in the table are 

ordered by the magnitude of their 

deceleration in home price growth 

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

growth in the recently overheated 

San Francisco Bay Area puts many of its MSAs near the 

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

Oakland, Denver, and San Diego also previously were 

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

more volatile appreciation rates, such as Utica and 

Fargo, comparisons of recent price trends are more 

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

year-ago price growth during first-quarter 2001. 

It is hard to generalize about which markets will see the 

most pronounced home price weakness as the recession 

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

are more likely to see significant downward corrections 

in price when economic activity falls for a prolonged 

period or by a sufficient magnitude. One study from the 

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

groups tended to respond similarly to local and national 

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

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

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

2001.
 

economic forces (fundamental, or “equilibrium,” price 

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

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

tended to see the most significant price swings over the 

past 20 years. 

History also provides some insights into the nature and 

extent of any price declines in markets where economic 

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

1990s, concluded that declines differed by property type 

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

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

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

boom saw the largest deflation) and from the nature of 

each city’s economic decline, which differed according to 

concentrations of job losses by industry and wage type, 

underlying demographic factors, and housing supply 

trends. 

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

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

recent years, this area witnessed double-digit home price 

appreciation that exceeded growth in per capita income 

by a wide margin. A recent analysis from the University 

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

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

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

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

income growth during this cycle as during the 1980s. 

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

Northeast generally) has seen little speculative purchase 

or construction activity in recent years, which should 

help to mitigate any price weakness through the current 

recession in these markets.30 

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

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

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

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

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

Quarter 2002. 

Chicago Regional Outlook 20 First Quarter 2002 
In Focus This Quarter
 

Conclusion 

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

well in prior recessions. However, history might 

understate credit risks for insured institutions during 

this cycle because the mortgage lending business has 

changed since the last recession. Chief among these 

changes are robust mortgage market competition, 

which has contributed to narrower collateral margins; 

increased reliance on underwriting automation; and 

expanded involvement in the subprime credit market. 

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

are experiencing continued construction despite a 

cyclical slowdown (as measured by employment 

trends). Permanent mortgage lenders in certain areas, 

such as the San Francisco Bay area, could also face 

higher loss rates and foreclosures going forward, as the 

current economic weakness places downward pressure 

on home prices and dampens the ability of households 

to meet mortgage payments. 

Scott Hughes, Regional Economist 

Judy Plock, Senior Financial Analyst 

Joan Schneider, Regional Economist 

Norm Williams, Regional Economist 

Chicago Regional Outlook 21 First Quarter 2002 


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