Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION FIRST QUARTER 1999 

FDIC
 

San Francisco
 

Region
 

Division of
 

Insurance
 

Catherine I.
 

Phillips-Olsen,
 

Regional Manager
 

Gary C. Zimmerman,
 

Regional Economist
 

Millen L. Simpson,
 

Financial Analyst
 

In Focus This Quarter 

◆ High Loan-to-Value Lending: A New Frontier in Home Equity Lending—High loan-to-value home equity loans have grown in popularity as consumers 

have sought ways to consolidate credit card debt and lenders have sought ways to 

deal with declining profit margins on traditional home equity loans. High loan-tovalue loans pose unique risks for lenders because of their hybrid nature: they combine characteristics of both a secured home equity loan and an unsecured consumer 

loan. Losses on such loans are increasing rapidly, and the current rate of loss raises 

concern about how these loans might perform in an economic recession. See page 4. 

By Diane Ellis 

◆ Commercial Development Still Hot in Many Major Markets, but 

Slower Growth May Be Ahead—Following the experience of the 1980s, the 

threat of an oversupply of commercial real estate is watched with keen interest by 

market participants and observers alike. This article highlights nine metropolitan 

areas that may be vulnerable to overbuilding based on the rapid pace of development occurring within those markets, various indicators of current and prospective 

demand, and projections by credible industry analysts. These concerns could be 

mitigated to the extent that reduced credit availability within the capital markets 

leads to a slowing in construction activity. See page 11. 

By Steven Burton 

◆ Recent Trends in Syndicated Lending—A strong U.S. economy, intensifying lender competition, and increasing marketability of bank loans have driven 

record volumes of syndicated lending in the 1990s. These factors led to several years 

of liberalized underwriting in the syndicated market. While evidence suggests that 

some banks have tightened standards and terms for loans to large commercial borrowers, market developments and underwriting trends over the past several years 

have implications for credit quality, earnings, and liquidity at institutions that hold 

or originate syndicated loans. See page 19. 

By Steven E. Cunningham, Ronald L. Spieker 

Regional Perspectives 

◆ Several of the Region’s Metropolitan Areas May Be Vulnerable to 

Overbuilding as a Result of Rapid Commercial Real Estate Development—Rapid commercial real estate development in Las Vegas and Phoenix continues unabated, raising concerns about overbuilding...Slowing economies in Salt 

Lake City and Portland may be a sign that the recent strong growth in commercial 

real estate development may be subsiding...Most community banks with construction loan concentrations are now located outside of California...In particular, Salt 

Lake City, Las Vegas, and Portland community banks as a group have much higher construction loan exposure than their community bank peers in other markets. 

See page 25. 

By the San Francisco Region Staff 

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

Insurance Corporation for the following eight geographic regions: 

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

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

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

Dallas Region (CO, NM, OK, TX)
 

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

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

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

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

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

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

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

publish/regout. For more information or to provide comments or suggestions about the San Francisco Region’s Regional Outlook, please call Catherine I. Phillips-Olsen at (415) 974-4247 or send 

an e-mail to cphillips-olsen@fdic.gov. 

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

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

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

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

the Federal Deposit Insurance Corporation. 

Chairman Donna Tanoue 

Director, Division of Insurance Arthur J. Murton 

Executive Editor George E. French 

Editors Lynn A. Nejezchleb 

Maureen E. Sweeney 

Publications Manager Teresa J. Franks 
From the Editor
 

The National Edition of the
 

Regional Outlook is now available
 

To the Reader: 

I am pleased to announce the first publication of the Regional Outlook National Edition. Since its 

inception, the Regional Outlook has been published quarterly in eight separate volumes that were 

tailored specifically for each FDIC Region. This format was ideal for the reader who wanted 

detailed analysis of a specific Region. 

Beginning this quarter, the FDIC will publish in a single volume the highlights of our Regional 

analysis of trends affecting FDIC-insured institutions across the United States. The eight 

unabridged Regional editions will continue to be published for readers who want more detailed 

information about trends in their Regions. All editions will continue to offer the In Focus series of 

articles on trends affecting the risk exposures of FDIC-insured institutions. 

For example, this quarter the In Focus series highlights important trends affecting commercial 

lenders and consumer lenders. The Regional Perspectives articles explore in more detail how these 

and other trends may affect FDIC-insured institutions around the United States. 

Both the Regional and National editions are available by subscription or on the FDIC’s website at 

www.fdic.gov. As always, we welcome your comments on the content or format of this publication. 

Please refer to the back cover and inside the front cover for information about how to subscribe or 

comment. 

Sincerely, 

George French 

Executive Editor 
In Focus This Quarter
 

High Loan-to-Value Lending:
 

A New Frontier in Home Equity Lending
 

•	 High loan-to-value (HLTV) loans are typically 

junior liens on owner-occupied single-family residences, but there is limited collateral protection 

because the combined loan amounts often exceed 

the value of the home. 

•	 Nonbank, specialty lenders have dominated this 

line of business, and their growth has been fueled 

by strong demand for asset-backed securities collateralized by HLTV loans. 

•	 Insured depository institution involvement in 

HLTV lending has been increasing, and opportunities for further involvement opened up when 

market turmoil resulted in a contraction of HLTV 

specialists. 

•	 HLTV lending involves unique risks because it 

combines characteristics of both secured home 

equity lending and unsecured consumer lending. 

Just a few years ago, it would have been difficult to 

imagine a mainstream lender writing a home equity 

loan in excess of the equity that the consumer had in his 

or her home. However, intense competition and declining profit margins in traditional home equity lending 

have lenders looking to boost volume and profits by 

relaxing underwriting standards. At the same time, consumers are signaling their desire to transfer their credit 

card balances to lower-costing home equity loans. 

These trends have given lenders, including insured 

depository institutions, the impetus to enter the HLTV 

home equity market. Furthermore, new opportunities 

have opened up for insured depository institutions to get 

involved in HLTV lending as a result of turmoil in the 

equity and asset-backed securities market, which resulted in a severe liquidity crisis that effectively sidelined 

many HLTV specialists. 

HLTV Lending Taps Consumers’ Desire to Shift 

Credit Card Debt into Home Equity Loans 

For the better part of the 1990s, credit card lending was 

dubbed the Wild West of consumer credit. This title 

was earned, in part, by lenders’ aggressive marketing 

and solicitation of their cards and consumers’ willingness to push their holdings of credit card debt to record 

high levels. After several years of double-digit growth 

in credit card outstandings, the growth has slowed. 

However, this slowdown does not necessarily mean that 

the Wild West has been tamed. In fact, home equity 

lenders are blazing new frontiers in consumer credit. 

Chart 1 shows that the originations of home equity 

loans for asset-backed securitizations have surpassed 

the originations of credit card loans over the past two 

years. 

It could be said that the home equity industry owes its 

resurgence to the boom in credit card lending that preceded it, because today’s home equity borrowers primarily use these loans to consolidate their outstanding 

debt. A survey by the Consumer Bankers Association 

found that, whereas in 1991 home improvement was the 

primary reason for taking out a home equity loan, debt 

consolidation is now the primary reason, with 40 percent of borrowers using a home equity loan for this purpose in 1997. This shift also is evidenced by another 

recent survey by Brittain Associates, Inc., which estimated that during a 24-month period ending June 1998, 

4.2 million households converted $26 billion in credit 

card debt to home equity mortgage debt. Given the high 

levels of credit card debt on households’ balance sheets, 

it should be no surprise that consumers with other borrowing options are looking for ways to consolidate their 

debt and reduce their borrowing costs. 

CHART 1 

Originations of Home Equity Loans Have 

Surpassed Originations of Credit Card 

Loans in the Past Two Years 

Source: Inside MBS & ABS 

1995 1996 1997 9 mos. 1998 

Credit Card 

Home Equity 

$ Billions 

70 

60 

50 

40 

30 

20 

10 

0 

San Francisco Regional Outlook 4	 First Quarter 1999 
In Focus This Quarter
 

HLTV Loans Are Hybrid Loans 

HLTV loans are considered hybrid loans and can be 

thought of as a marriage between secured lending and 

unsecured credit card loans. HLTV loans are typically 

junior liens on owner-occupied single-family residences 

where the combined loan amounts exceed the value of 

the home—sometimes by as much as 125 to 150 percent. Some lenders also make HLTV first mortgages, 

which enable consumers to finance their down payment 

and closing costs and consolidate other debts. 

In return for pledging their home as collateral, borrowers are charged lower rates of interest than on unsecured 

consumer loans. Even at 125 to 150 percent loan-tovalue, the rates on HLTV loans generally are lower than 

credit card loans. In 1997, the average rate on an HLTV 

was 13 to 14 percent, whereas the average rate on a 

credit card loan was 16 percent. Because HLTV loans 

carry lower interest rates and are long-term loans (15 to 

30 years), the monthly payment on one is often considerably less than the total monthly payments on the loans 

that were paid off in the consolidation. 

HLTV loans also appeal to consumers because they can 

benefit from the tax deductibility on a portion of their 

interest payments. Current IRS rules allow interest to 

be deducted on that portion of the loan that is equal to 

Typical HLTV 


Borrower Characteristics
 

Annual Income $60,000 

Job Tenure 5 years 

Age Late thirties 

FICO Score 680 

Outstanding Nonmortgage Debt $20,000 

First Mortgage Amount $110,000 

Property Value $130,000 

Typical HLTV 

Loan Characteristics 

Amount $30,000 

Contract Interest Rate 13 to 14% 

Term 25 years 

Loan to Value 110% 

Notes: HLTV = high loan-to-value; FICO = Fair, Isaac Company 

Source: General Accounting Office, based on interviews with 

public and private officials 

or less than the value of the home at the time the loan 

is closed. 

The primary disadvantage of converting unsecured 

credit card and other consumer debt to an HLTV loan 

is that in the event of default, the borrower could lose 

his or her home. However, many consumers burdened 

by the high cost of unsecured consumer debt apparently have viewed the chance to lower their monthly payments as worth the risk. HLTV loans have been 

particularly popular in California, where property 

value declines in the early 1990s left homeowners with 

little or no equity in their homes. The inset box shows 

the typical characteristics of an HLTV loan and an 

HLTV borrower. 

Underwriting of HLTV Loans Emphasizes 

the Borrower’s Credit Quality 

Because of their limited or nonexistent collateral protection, HLTV loans typically are considered unsecured 

loans and the emphasis in underwriting is on the borrower’s credit quality rather than on collateral value. 

Large HLTV lenders use credit scoring to underwrite 

their loans, and a major component of their scoring is a 

credit bureau or Fair, Isaac Company (FICO) score. 

Other important factors are the borrower’s debt-toincome ratio, mortgage credit history, consumer credit 

history, bankruptcies, foreclosures, notice of defaults, 

deeds in lieu of foreclosure, and repossessions. 

HLTV loans are not necessarily subprime loans; the 

term “subprime” refers to the credit quality of the borrower rather than the margin of collateral protection. 

Instead, many lenders assert that HLTV loans are made 

to “prime” borrowers and can point to the fact that 

FICO scores on HLTV loans have been rising, averaging approximately 689 in 1998. Scores above 680 are 

generally associated with “A” credit quality; however, 

the average ignores the fact that major HLTV lenders 

allow FICO scores to go much lower, typically as low as 

620.1 Standard & Poor’s recently reported that performance problems clearly exist on loans for which the 

borrower’s FICO score is below 650.2 

1 H.T. Katz and G.T. Costello, Fitch IBCA Credit Rating Company.
 

“Securitization of 125 LTV Mortgages.” Structured Finance Special
 

Report, March 4, 1998. Underwriting guidelines summary matrices
 

are provided for seven large HLTV lenders.
 

2 “High LTV Security Performance Expected to Improve as FICO
 

Scores Rise and FHA Title 1 Loans Disappear.” Inside MBS & ABS,
 

November 13, 1998, p. 9.
 

San Francisco Regional Outlook 5 First Quarter 1999 
In Focus This Quarter
 

TABLE 1 

HLTV Underwriting Guidelines 

QUALIFYING PARAMETERS A+ A B+ B C+ 

FICO SCORE 700+ 680–699 660–679 640–659 629–639 

MORTGAGE HISTORY (PAST 12 MONTHS) 1X30* 1X30 1X30 1X30 1X30 

BANKRUPTCY (YEARS SINCE DISCHARGE) 3 3 3 5 5 

MAXIMUM DEBT TO INCOME (%) 50 50 45 45 40 

MAXIMUM LOAN TO VALUE 125 125 125 125 125 

MAXIMUM CASHOUT $35,000 $25,000 $15,000 $5,000 $1,000 

MAXIMUM LOAN AMOUNT $100,000 $75,000 $65,000 $45,000 $30,000 

* Number of times delinquent multiplied by days delinquent. 

Note: HLTV = High loan-to-value; FICO = Fair, Isaac Company. 

Source: The 10K filing of a major HLTV lender. 

The agencies that rate asset-backed securities collateralized by HLTV loans offer another perspective on the 

credit quality of HLTV borrowers. Moody’s has 

described HLTV borrowers as in the “A–” to “B” 

grades, and Standard & Poor’s has characterized the 

loans as “A–” to “B+” in terms of credit quality. Any 

grade below A can be considered subprime. Indeed, 

according to Mortgage Information Corp., the bulk of 

subprime mortgage activity occurs in the A– category. 

However, some analysts have preferred to characterize 

HLTV borrowers as squarely in between the subprime 

and prime designations. 

Whatever the label given to the quality of borrowers, 

they typically have a large amount of high-cost revolving debt, and converting this debt into a second lien on 

their home is an attractive alternative. They also might 

have some degree of poor credit performance. Table 1 

shows the underwriting criteria used by one of the 

largest HLTV lenders. Because underwriting classification systems are not uniformly applied among 

HLTV lenders, this table should be viewed only as a 

guide. 

Fueled by Easy Access to Capital, 

HLTV Loans Have Grown Rapidly 

On the basis of the volume of loans securitized, the 

HLTV loan market has expanded rapidly over the past 

several years (see Chart 2). Originations have grown 

from $1 billion in 1995 to $8 billion in 1997 and are 

expected to be around $12 billion in 1998. 

Nonbank, specialty finance companies presently dominate the HLTV market, and their easy access to capital 

CHART 2 

High Loan-to-Value Mortgage Production
 

Has Grown Rapidly
 

$ Billions 

14 

12 

10 

8 

6 

4 

2 

0 

1995 1996 1997 1998 (Est.) 

Source: General Accounting Office 

has been an important factor behind their growth. These 

specialists depend on their ability to securitize the loans 

and sell them in the asset-backed securities market. 

Strong investor demand for all kinds of asset-backed 

securities has allowed HLTV lenders to raise a substantial amount of funding without a strong degree of corporate credit quality. However, their reliance on the 

asset-backed securities market to fund operations 

exposes them to liquidity risk if demand for these securities declines. 

A healthy initial public offering market also has fueled 

the growth of these specialty lenders, and gain-on-sale 

accounting has allowed lenders to establish an earnings 

track record and attract debt and equity investors. Gainon-sale accounting requires securitizers to calculate and 

record a gain on sale from securitizations; however, the 

use of gain-on-sale accounting exposes lenders to prepayment risk. If the securitized loans prepay at a faster 

San Francisco Regional Outlook 6 First Quarter 1999 
In Focus This Quarter
 

rate than the assumption used to calculate the gain, the 

company could be forced to take a write-down, which 

can affect earnings, liquidity, and capitalization. Institutions that invest in securities collateralized by HLTV 

loans also are exposed to prepayment risk. (For more 

information on gain-on-sale accounting, see “Gain-onSale Accounting Can Result in Unstable Capital Ratios 

and Volatile Earnings” in Regional Outlook, second 

quarter 1998.) 

In addition to the easy access to capital, favorable economic conditions also have encouraged HLTV lending. 

The long economic expansion has brought about the 

return of home price appreciation to nearly all parts of 

the country, which has encouraged HLTV lending 

because rising home values serve to reduce lender and 

investor exposure fairly quickly. The median sales price 

of existing single-family residences has increased an 

average of 4.39 percent per year since 1995, according 

to the National Association of Realtors. 

Market Turmoil Hit HLTV Specialty 

Lenders Hard 

The market volatility that began last summer illustrated the importance of liquidity risk and prepayment 

risk. HLTV specialists were faced with a liquidity 

crunch when they were hit hard in the equity downturn, 

in many cases significantly harder than the general 

market. Investors retreated from HLTV lenders and 

their asset-backed securities, in part as a result of a 

“flight to quality” as the Asian crisis spilled over into 

other global markets. A core of investors participating 

in the HLTV market also exited the market when prepayments occurred at faster rates than anticipated, 

largely a result of lower market interest rates, and 

forced lenders to take write-downs of interest-only 

residuals. Another factor in the investor retreat from 

this market was the growing skepticism concerning the 

performance of HLTV loans during an economic 

downturn. 

When investor demand for asset-backed securities dried 

up, HLTV lenders were unable to securitize their loans 

profitably. This situation created a severe liquidity crisis 

for specialty lenders who relied heavily upon this source 

of funding. As a result, some lenders were forced to put 

themselves up for sale, and others were forced to undergo massive restructuring. 

HLTV Lending Presents Unique Risks 

to Home Equity Lenders 

In addition to the risks associated with the securitization 

of HLTV loans (liquidity and prepayment risk), HLTV 

lending poses some unique risks for lenders who hold 

these loans in their portfolio, service them, or guaranty 

the performance of asset-backed securities. Because 

HLTV loans are a relatively new product, their credit 

risk is untested and could be affected by the following 

factors: 

•	 Increased rate of default. Data on the performance 

of HLTV loans are limited; however, the loss potential is starting to become visible when vintage analysis is performed. Chart 3, next page, shows that when 

recent vintages are adjusted for seasoning, chargeoff rates on HLTV loans are increasing at a rapid 

rate. Both the severity and frequency of default are 

much higher than for traditional A-quality home 

equity loans and are even higher than subprime home 

equity loans. The fact that charge-offs are higher 

than subprime loans suggests that the credit quality 

of HLTV borrowers is not too different from subprime borrowers and that when default occurs, the 

loss is more severe because of the lack of collateral 

protection. Lenders who do not accurately forecast 

the magnitude and costs of default associated with 

HLTV loans, or who make underwriting mistakes, 

might find that this line of business is not as profitable as anticipated. 

Lenders that rapidly increase HLTV exposures 

might consider the use of vintage analysis, also 

called “static pool” analysis, as a means of evaluating loan portfolio performance. This technique is 

effective when there is rapid growth, which can 

make it more difficult to accurately track delinquency and default trends when only an average delinquency or default ratio is calculated. Refer to 

“Subprime Lending: A Time for Caution” in 

Regional Outlook, third quarter 1997, for additional discussion on vintage analysis. 

•	 Untested performance in a recession. HLTV lending has existed for only a few years and has yet to be 

tested by economic recession. The rapid rise in 

charge-offs on HLTV loans has occurred in a relatively robust economic environment, and the losses 

during an economic downturn could be considerably 

San Francisco Regional Outlook 7	 First Quarter 1999 
In Focus This Quarter
 

higher than anticipated. Moody’s has asserted that 

losses will mimic those of credit cards, and losses on 

credit card loans are usually higher than other consumer mortgage-related products. 

HLTV lenders’ heavy reliance on credit-scoring 

models raises further questions about how these 

loans might perform in a recession because these 

models are largely unproven in a recession as well. 

To improve the accuracy of credit-scoring models 

and the model’s ability to appropriately price the risk 

assumed, lenders can continually test and refine 

credit-scoring models to ensure that actual performance approximates projections. 

Changes in the borrower’s financial condition present a 

greater risk to HLTV lenders than in other types of 

secured lending, which introduces additional credit 

risks. In the event of default, the lender is likely to suffer a complete loss because foreclosure is probably 

infeasible and the size of HLTV loans is much larger 

than other types of unsecured or partially secured loans. 

Therefore, adverse changes in the borrower’s financial 

condition are very important and can be affected by the 

following factors: 

•	 Debt reloading. The primary reason consumers take 

out an HLTV loan is to consolidate credit card and 

other high-cost consumer debt. However, lenders 

cannot prevent HLTV borrowers from running up 

additional credit card debt after the loan is made. 

Consequently, these loans might serve to only postpone or amplify credit problems. A recent survey by 

CHART 3 

Brittain Associates, Inc., indicates that a large percentage of borrowers who take out home equity 

loans proceed to run up credit card debt shortly 

thereafter. Their survey of over 6,000 borrowers who 

used home equity loans to consolidate their debts 

revealed that only 30 percent of those borrowers 

remained free of credit card debt one year later. 

•	 Long-term exposure. Consumer loans typically 

have been made on a short-term basis; however, 

HLTV loans are made for terms up to 30 years. 

Therefore, the credit quality on an HLTV loan is 

more vulnerable to catastrophic events such as borrower job loss, illness, or divorce. Furthermore, the 

term of these loans far exceeds the predictive power 

of FICO scores, which have proven to be predictive 

for about a two-year period according to Moody’s. 

Because of their fixed terms and limited collateral protection, there are some unique operational risks associated with servicing and collecting an HLTV loan. 

Servicing and collecting an HLTV loan differs somewhat from servicing and collecting both secured lending and credit card lending because of the following 

factors: 

•	 Limited default remedies. The servicing and collecting of HLTV loans are complicated by the fact 

that the threat of foreclosure is not as severe as in traditional secured lending. According to Moody’s, 

HLTV lenders must adopt a collection strategy similar to credit card lenders that will require early intervention and the ability to “talk” the borrower into 

CHART 4 

Note: HLTV = high loan-to-value 

Source: Moody’s Investor Services 

Charge-Offs Are Rising More Rapidly on HLTV 

Loans Than for Any Other Type of Home Equity 

Loan (1996 and 1997 Origination Years); ... 

2 3 4 5 6 7 8 9 10 11 12 13 1415 16 17 18 19 

HLTV 

Home Equity Index 

Composite 

Subprime 

Traditional Home Equity 

Charge-Off Rate (%) 

10 0 

1 

2 

3 

4 

5 

6 

7 

Months of Seasoning 

Note: HLTV = high loan-to-value 

Source: Moody’s Investor Services 

...However, Delinquency Rates on HLTV Loans 

Are Lower Than on Subprime Loans Because 

Loans Are Charged Off Sooner 

(1996 and 1997 Origination Years) 

4567 8 9 10 11 12 13 14 15 16 17 18 19 20 

Months of Seasoning 

Subprime 60 Plus Delinquency Rate 

HLTV 60 Plus 

Delinquency Rate 

HLTV Annualized 

Charge-Off Rate 

Subprime Annualized

 Charge-Off Rate 

Delinquency Rate (%) 

321 0 

2 

4 

6 

8 

10 

12 

14 

San Francisco Regional Outlook 8	 First Quarter 1999 
In Focus This Quarter
 

making a payment without resorting to foreclosure. 

However, unlike credit card lenders, HLTV lenders 

have less flexibility in collection because lines cannot be adjusted and interest rates cannot be raised. 

The different demands for servicing and collecting 

these loans, compared with traditional and subprime 

home equity loans, could strain institutions that do 

not have an adequate investment or expertise in collecting these loans. 

According to Moody’s, HLTV lenders generally 

write off their loans as a loss once they become 180 

days delinquent. In contrast, subprime lenders go 

through a lengthy foreclosure procedure. The speedier resolution of HLTV loans is reflected in a lower 

level of delinquencies in HLTV portfolios compared 

with subprime portfolios (see Chart 4, previous 

page). 

•	 Limited borrower flexibility and motivation. After 

a borrower has taken out an HLTV loan, opportunities to refinance are limited, and selling the home 

often is not feasible because of the large amount of 

cash needed at closing. As a result, counseling borrowers might prove to be harder than in credit card 

lending. Also, with negative equity in their homes, 

borrowers might have less incentive and ability to 

work with the lender to bring the loan current than to 

allow foreclosure. 

Insured Depository Institution Involvement 

in HLTV Lending Is Increasing 

Insured depository institution involvement in HLTV 

lending reportedly has been growing. Their precise 

involvement is difficult to quantify because these loans 

are not delineated in bank or thrift Call Reports. However, one indication of their growing involvement is 

cited in the Consumer Bankers Association 1998 home 

equity loan study. Twenty-five percent of respondents to 

its survey offered home equity loans with loan-tovalues in excess of 100 percent, up from only 5.8 percent one year earlier. 

Banks and thrifts can become involved in HLTV lending by using a variety of strategies. They can lend 

directly to HLTV borrowers or purchase HLTV loans 

from loan brokers and hold them in portfolio. Institutions also can originate the loans and securitize them or 

sell them to another company that will securitize them. 

A more indirect way for insured depository institutions 

to get involved in this market is to lend to HLTV specialty lenders in the form of warehouse lines. Institutions also can service HLTV loans or invest in 

asset-backed securities secured by HLTV loans. 

In light of the contraction of HLTV specialists, the 

question arises as to whether banks will view this as an 

opportunity to further expand their presence in HLTV 

lending, given that consumer demand for these products 

is still strong. Recent press reports indicate that this is 

happening, as some insured depository institutions 

recently have piloted HLTV lending programs by buying loans and keeping them in portfolio.3 Another way 

that banks have recently become involved in HLTV 

lending is by investing in HLTV specialists. Many 

HLTV specialists have been looking for opportunities to 

affiliate with firms that have plentiful and stable 

sources of liquidity (“deep pockets”), and insured 

depository institutions have been viewed as ideal candidates. Several of the largest HLTV specialists have an 

insured depository institution as an affiliate. 

Insured Depository Institutions Are Subject 

to Real Estate Lending Standards 

Unlike many of the specialty finance companies, 

insured depository institutions are subject to regulations 

prescribed by the federal supervisory agencies. In 1992, 

the federal banking and thrift supervisory agencies 

finalized a uniform regulation and interagency guidelines for real estate. The regulation, in part, requires 

institutions to adopt and maintain written policies that 

establish appropriate limits and standards for all real 

estate loans, including HLTV loans. When a bank 

adopts a policy, the regulation requires consideration of 

the Interagency Guidelines for Real Estate Lending 

Policies. These guidelines state that institutions should 

establish their own internal loan-to-value limits for real 

estate loans; however, they also indicate that the internal 

limits should not exceed 90 percent on a home equity 

loan.4 The guidelines recognize that it might be appro3 Timmons, H. “Banks Poised to Move in as High-LTV Lenders Fall.”
 

American Banker, October 28, 1998.
 4 The guidelines state, “A loan-to-value limit has not been established
 

for permanent mortgage or home equity loans on owner-occupied,
 

1- to 4-family residential property. However, for any such loan with a
 

loan-to-value ratio that equals or exceeds 90 percent at origination, an
 

institution should require appropriate credit enhancement in the form
 

of either mortgage insurance or readily marketable collateral.”
 

San Francisco Regional Outlook 9	 First Quarter 1999 
In Focus This Quarter
 

priate to deviate from these guidelines and state that 

loans made in exception to these guidelines should be 

identified in the institution’s records and reported to the 

board of directors at least quarterly. Furthermore, the 

guidelines state that the aggregate amount of all loans in 

excess of the supervisory loan-to-value limits should 

not exceed 100 percent of total capital. 

Competition from HLTV Loans Is Driving 

a Loosening in Underwriting on Other 

Home Equity Loans 

Even for insured depository institutions not directly 

involved in the HLTV market, the competition posed 

by this product already is evident in the underwriting 

of other types of home equity products. The Office of 

the Comptroller of the Currency reported in its latest 

survey of the 77 largest national banks in the country 

that underwriting on home equity loans has been loosening for three years, a time period that corresponds 

with the life of the HLTV market. They reported that 

in 1998, the percentage of banks tightening standards 

on credit card loans is nearly matched by the percentage of banks loosening their underwriting standards on 

home equity loans. Competition was cited as the primary reason for loosening home equity standards, and 

an easing of collateral requirements was the primary 

method. 

Conclusion 

HLTV lending has provided a new option for consumers to work their way out from under burdensome 

credit card debt. It also has provided lenders with a new 

and potentially profitable line of business. Insured 

depository institution involvement in this line of business is growing and could continue to grow, especially 

if liquidity problems that have affected HLTV specialists continue. As with any line of business, success is 

dependent upon understanding the particular nature of 

the HLTV business and making the appropriate commitment of resources and expertise. With HLTV lending, there are unique risks involved because of the 

compound nature of these loans, which contain characteristics of both a secured home equity loan and an 

unsecured consumer loan. The risks involved in HLTV 

lending are further heightened by the fact that the performance of these loans is largely untested in an 

adverse economic environment. 

Diane Ellis, Senior Financial Analyst 

San Francisco Regional Outlook 10 First Quarter 1999 
In Focus This Quarter
 

Commercial Development Still Hot in Many Major
 

Markets, but Slower Growth May Be Ahead1
 

•	 Oversupply within commercial real estate markets typically arises from the difficulty developers 

face in accurately predicting future demand for a 

given project, particularly when projections are 

based on temporary or unsustainable increases in 

demand. Easy access to investment capital in the 

form of lower borrowing rates or relaxed underwriting standards can exacerbate the overproduction of space. 

•	 This analysis identifies nine major metropolitan 

markets believed to be vulnerable to broad-based 

overbuilding.2 This vulnerability stems from rapid 

ongoing development across multiple property 

types, which threatens to outpace absorption or 

demand levels over the next one to two years. 

Overbuilding concerns are heightened by cyclical 

and secular demographic and economic trends 

that portend lower demand for commercial space. 

•	 Trends in the capital markets may have tempered 

the appetite for further development in some 

rapidly expanding metro areas. Should such 

trends continue, construction activity could moderate, thereby mitigating some of the overbuilding 

concerns expressed in this article. 

Since the boom development years of the 1980s, and the 

bust that followed, the financial community has devoted 

considerable resources to analyzing commercial real 

estate trends. The primary purpose of these efforts is to 

detect, as early as possible, warning signs of potential 

imbalances between supply and demand. The markets 

highlighted in this article are considered vulnerable to 

possible overbuilding on the basis of various early 

warning signs. Each of these markets is experiencing 

rapid commercial real estate development across multi1 In fall 1998, the FDIC’s Division of Insurance published a report ranking the risk of overbuilding within major metropolitan markets (see 

“Ranking the Risk of Overbuilding in Commercial Real Estate Markets,” Bank Trends, October 1998). This paper, which was based mainly on market information as of year-end 1997, highlighted six major 

metropolitan areas where the rapid pace of current construction activities raised concerns over the potential for broad-based overbuilding. 

2 “Broad-based overbuilding” signifies potential overbuilding in two 

or more of five property types: office, industrial, retail, apartment, 

and hotel. 

ple property types. In addition, each market exhibits one 

or more of the following characteristics: high vacancy 

rates relative to the pace of development, declining 

employment growth trends, declining in-migration 

trends, projected increases in vacancy rates by credible 

industry experts, and significant dependence on industry sectors vulnerable to either weak Asian markets or a 

slowing domestic economy. 

The term “vulnerable” is used here to signify a potential, as opposed to a certain, outcome. In previous cyclical downturns, falling commercial real estate values 

were preceded by economic events that resulted in lower 

demand: Declining energy prices preceded the mid1980s decline in Southwestern real estate markets; 

weaknesses in the financial sector preceded the late 

1980s decline in Northwestern real estate markets; and 

sharp defense cutbacks preceded the early 1990s 

decline in Southern California real estate markets. It 

remains to be seen whether weakening Asian markets or 

prospects for slower economic growth serve as catalysts 

for slower commercial real estate demand in the current 

cycle. Whatever the catalyst, markets most affected by a 

downturn in real estate values will be those in which 

optimistic expectations, the basis for current construction activity, fall farthest from the mark. 

Why Do Markets Become Overbuilt? 

Commercial property developers often face substantial 

lags between a project’s conception and its completion: 

The longer the construction period, the greater the 

uncertainty surrounding demand projections. These 

risks can be largely mitigated if the developer enters 

into presale contracts or preleasing agreements with 

financially sound parties prior to breaking ground on 

construction. However, it is not unusual in rapidly 

developing and highly competitive markets for developers to anticipate or “speculate” what demand levels 

will be, based on current trends. If the market in question is experiencing a period of temporary or unsustainable growth (a “boom” period, for example), then 

projections may lead to an overly optimistic outlook 

for future demand, particularly when forecasts are 

weighted heavily toward recent rental, sales, and 

demographic trends. Projection error also arises from 

San Francisco Regional Outlook 11	 First Quarter 1999 
In Focus This Quarter
 

the failure to consider competitors’ planned development activities. 

If a developer’s demand projections fail to materialize, 

the result is an overhang of commercial property 

beyond what the market can absorb during a reasonable 

time frame. Easy access to investment capital can exacerbate overproduction of space by reducing or eliminating incentives to make reasoned and prudent 

investment decisions. Excessive leverage, where the 

developer has little personal capital at risk on a particular project, is a familiar example often associated with 

the excessive development of the 1980s. Loan pricing 

that fails to adequately account for the risks involved in 

a construction project is another example of how 

financing incentives could lead to imprudent development decisions. 

Ranking the Risks of Overbuilding 

The October 1998 Bank Trends (see footnote 1) study 

employed a three-step process to rank the vulnerability 

of markets to possible overbuilding. First, major metropolitan markets were ranked in terms of current construction activity3 relative to existing space for each of 

five property types: office, industrial, retail, apartment, 

and hotel. Second, relative construction activity was 

compared with current vacancy rates to assess the competitive pressures faced by newly developed projects. 

Third, market-related research was reviewed to determine which markets analysts considered candidates for 

possible supply/demand imbalances. Although the same 

approach was used in this updated analysis, additional 

factors were considered, including employment and 

population growth trends, the dependence of rapidly 

developing metropolitan areas on specific employers or 

industries, and the relationship between current economic trends and the potential demand for commercial 

real estate space. 

3 Construction activity generally refers to recent completions plus 

projects in process of being built. In the case of office and industrial 

properties, the source of data is CB Commercial/Torto Wheaton 

Research, and construction activity refers to completions for the last 

four quarters plus projects under construction. For all other property 

types, the source is F.W. Dodge and ERE Yarmouth, and construction 

activity refers to completions, projects in process of being built, 

starts, and pending projects. 

Most Active Construction Markets 

Charts 1 through 5 show the level of construction activity, for each property type, relative to the total stock of 

space as of June 30, 1998, for the top 15 major metropolitan markets. Although slowing somewhat, development in the Las Vegas market continues to lead all other 

markets in relative terms for office, industrial, and hotel 

construction. Las Vegas is also among the most active 

markets in apartment and retail construction. Other 

markets experiencing rapid development across multiple property types include Salt Lake City, Charlotte, 

Atlanta, Portland, Phoenix, Orlando, Dallas, Austin, 

Nashville, Jacksonville, and Seattle. As the charts show, 

office, industrial, apartment, and hotel construction 

activity rose from year-end 1997 levels among a majority of the fastest-developing markets. Retail development, however, appears to have slowed in a majority of 

the most active development markets during the first 

half of 1998. 

Comparing Construction Activity 

with Vacancy Rates 

Newly completed speculative projects must compete 

with existing vacant space. Accordingly, it is worthwhile to compare measures of relative construction 

CHART 1 

Source: CB Commercial/Torto Wheaton 

Top 15 Office Construction Markets* 

0 5 10 15 20 

Las Vegas 

Charlotte 

Orlando 

Salt Lake City 

Jacksonville 

Columbus 

Atlanta 

Nashville 

Dallas 

Austin 

Seattle 

Phoenix 

Portland 

Ft. Lauderdale 

Tampa 

National Average

 June 1998

 December 1997 

% of Stock 

* Includes last four 

quarters’ completions 

and projects under 

construction for: 

San Francisco Regional Outlook 12 First Quarter 1999 
In Focus This Quarter
 

CHART 2 CHART 3 

Top 15 Industrial Construction Markets* 

% of Stock

0 2 4 6 8 10 12 14 16 

Las Vegas 

Atlanta 

Riverside 

San Diego 

Salt Lake City 

Phoenix 

Austin 

Oakland 

Sacramento 

Tucson 

Baltimore 

Orlando 

Jacksonville 

Orange County 

Seattle 

National Average 

 June 1998

 December 1997 

* Includes last four 

quarters’ completions 

and projects under 

construction for: 

Source: CB Commercial/Torto Wheaton Source: F. W. Dodge, Lend Lease Investment Research 

Top 15 Retail Construction Markets* 

0 2 4 6 8 10 12 

Norfolk 

Orlando 

Las Vegas 

Atlanta 

Charlotte 

Richmond 

Greenville 

Phoenix 

Minneapolis 

Jacksonville 

West Palm Beach 

Dallas 

Baltimore 

San Antonio 

Denver 

National Average

 June 1998

 December 1997 

% of Stock 

* Includes completions, 

starts, projects being 

built, and pending 

projects as of: 

CHART 4 CHART 5 

Source: F. W. Dodge, Lend Lease Investment Research 

Top 15 Apartment Construction Markets* 

0 2 4 6 8 10 

Austin 

Orlando 

Portland 

Las Vegas 

Charlotte 

Dallas 

Phoenix 

Columbus 

Nashville 

Atlanta 

Raleigh 

Denver 

Birmingham 

Greenville 

San Antonio 

National Average 

% of Stock 

* Includes completions, 

starts, projects being 

built, and pending 

projects as of:

 June 1998

 December 1997 

Top 15 Hotel Construction Markets* 

% of Stock

0 5 10 15 20 25 30 35 40 

Las Vegas 

Salt Lake City 

Portland 

Raleigh 

Baltimore 

Tampa 

St. Louis 

Dallas 

Phoenix 

Jacksonville 

Charlotte 

Cincinnati 

Greenville 

Seattle 

Denver 

National Average 

 June 1998

 December 1997 

* Includes completions, 

starts, projects being 

built, and pending 

projects as of: 

Source: F. W. Dodge, Lend Lease Investment Research 

San Francisco Regional Outlook 13 First Quarter 1999 
In Focus This Quarter
 

CHART 6	 CHART 7 

Office Development Versus Vacancy Rates Industrial Development Versus Vacancy Rates 

20 12

18 Las Vegas 

Construction Activity as % of Stock 

Construction Activity as % of Stock 

Charlotte Las Vegas 10 

16 Orlando Jacksonville 

Columbus 

Atlanta 

14 Salt Lake Atlanta 8 Riverside 

12 Dallas San Diego Salt Lake 

10 Phoenix 6 

Phoenix Sacramento 

8 Tampa 4 

2 

6 

4 

2 

– 

2 4 6	 8 10 12 14 16 18 

Vacancy Rate (%) 

Source: CB Commercial/Torto Wheaton 

activity with current vacancy rates (as shown in Charts 

6 and 7 for office and industrial space). The main idea 

behind these charts is that market segments with high 

existing vacancy rates raise the degree of competitive 

pressure for newly built space; markets with high 

vacancies may have less justification for continuing 

increases in new stock. 

In the office sector, Las Vegas stands out as having the 

highest level of new development combined with high 

existing vacancy rates. Although the pace of development is markedly slower, office markets in both Atlanta 

and Dallas appear to be expanding rapidly despite high 

existing vacancy rates. In the industrial sector, Las 

Vegas, Atlanta, Riverside, Salt Lake City, and Phoenix 

all appear to be experiencing rapid development despite 

relatively high existing vacancy rates. 

Analyst Outlooks for Commercial Real Estate 

Advocate Caution 

The first six months of 1998 saw continuing strong 

market fundamentals in most major markets and 

most property types: CB Commercial/Torto Wheaton 

Research (CBC) reported continuing nationwide 

declines in office and industrial vacancy rates accompanied by increasing rental growth rates,4 Wheat First 

Union (Wheat) reported improvements in occupancy 

and rental rates across the 30 major apartment markets 

it follows,5 and Smith Travel Research (Smith) reported continuing improvements in average daily room rates 

4 CB Commercial/Torto Wheaton Research, The Office Outlook, 

The Industrial Outlook, and The Retail Outlook, Fall 1998. 5 Wheat First Union, Industry Report: Quarterly Apartment Review, 

October 21, 1998. 

– 

2 4 6 8 10 12 

Vacancy Rate (%) 

Source: CB Commercial/Torto Wheaton 

despite a modest decline in occupancy rates for the 

lodging sector (through the first nine months of 1998).6 

The performance of the retail sector has been more 

mixed, as indicated by a significant decline in estimated 

rental growth rates from 1996 to 1997 (CBC) while 

retail vacancy rates have held steady over the past 12 

months (F.W. Dodge).

7 

Despite these generally positive trends, market 

observers are becoming more cautious about the outlook for commercial real estate markets. Much of their 

concern stems from significant increases in projected 

supply in the face of moderating absorption rates. 

CBC, for example, projects that nationwide office 

vacancy rates will rise from 9.3 percent as of June 1998 

to 12.1 percent by June 2000 as a result of a sharp 

increase in completions combined with moderating 

absorption. Markets with the highest and most significant increases in projected office vacancy rates are 

highlighted in a recent Lehman Brothers study, which 

identifies 17 office markets as “danger zones.” 8 

Analysts have also raised concerns over rapid development in other property types. F.W. Dodge, for instance, 

anticipates a sharp rise in the ratio of retail completions 

6 Smith Travel Research, Smith Travel Research Announces 1998 

September and Third Quarter U.S. Lodging Industry Reports, 

www.str-online.com/news/releasedir/pr981104_3rdgtr.html. 7 F. W. Dodge, Real Estate Analysis and Planning Service: 2nd Quarter 1998. 

8 These markets are Salt Lake City, Columbus, Austin, Nashville, 

Charlotte, Orlando, Las Vegas, Baltimore, Atlanta, Dallas, Phoenix, 

Philadelphia, Indianapolis, Chicago, Sacramento, Miami, and Houston (Lehman Brothers, Commercial REIT Research: Eye on Office 

Markets, October 1998). 

San Francisco Regional Outlook 14	 First Quarter 1999 
In Focus This Quarter
 

to absorptions over the coming two years. In addition, 

the pace of hotel development has picked up substantially over the past two years to levels not seen since 

the late 1980s (see Chart 8). According to Smith, hotel 

completions continue to outpace demand and are 

expected to result in lower occupancy levels in 1999. 

For the apartment sector, Wheat cautions against a continuing escalation in apartment permits despite some 

expected slowing in employment growth in various 

markets over the coming 12 months.9 

Economic Conditions May Temper 

Commercial Real Estate Demand 

The nation’s economy has shown unprecedented 

resiliency, even as some indicators suggest that growth 

may moderate in the near term. For instance, weakened 

global markets have placed increasing pressures on 

exporters, who have seen a falloff in demand in the 

wake of weaker foreign currencies relative to the dollar. 

Domestic firms, too, face rising competition from 

cheaper imports. These factors have created negative 

near-term expectations for corporate profitability, 

which in turn have resulted in rising layoffs and slowing 

employment growth. Although most economists feel 

that prospects for a recession are remote in the near 

term, even a modest slowdown in economic growth 

could result in higher vacancy rates in markets experiencing rapid development. 

Over the longer term, various economic and demographic trends imply a weaker outlook for commercial 

real estate demand relative to past real estate cycles. In 

a recent analysis of the commercial mortgage-backed 

securities (CMBS) market, Moody’s identifies the following trends, each of which implies secular declines in 

demand for one or more property types10: 

•	 more efficient office space utilization as measured 

by continuing declines in square feet per worker; 

•	 more efficient inventory management as measured 

by a proportional increase in the ratio of inventory 

growth to growth in warehouse space; 

•	 shifts in spending patterns by baby boomers, the 

largest age cohort, away from goods and toward 

services; 

9 Wheat specifically notes deteriorating supply/demand ratios in
 

Dallas, Houston, Orlando, Charlotte, Nashville, and the San Francisco
 

Bay area.
 

10 Moody’s Investor Service, CMBS and the Real Estate Cycle:
 

Less Margin for Error, October 9, 1998.
 

CHART 8 

Hotel Development Heating Up 

(000’s) 

140 

120 

100 

80 

60 

40 

20 

0 

New Rooms Constructed 

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

* September 1998 annualized 

Source: Smith Travel Research 

•	 declining scrappage rates of obsolescent buildings 

because of a decline in the average age of the current 

stock of space relative to the comparable stage of 

prior cycles; and 

•	 expected declines in labor force growth as the 

proportion of older workers increases. 

In addition to these factors, other analysts have pointed 

out that tight labor markets and overtaxed infrastructure 

(e.g., water, roads, sewer, and public transportation) 

constrain demand by limiting growth within a particular 

market. Suburban areas that have seen the bulk of new 

construction over the past few years may be particularly hard hit if there is a backlash against the congestion 

and infrastructure capacity issues that accompany rapid 

growth.11 

Markets Most Vulnerable 

to Overbuilding 

Based on a review of supply and demand trends coupled 

with analyst opinions and projections, the following 

markets appear to be most vulnerable to broad-based 

overbuilding in the coming one to two years (see also 

Table 1, next page, for prevailing trends in these markets). These markets are discussed in more detail in the 

Regional Perspectives section. 

11 See, for example, Price Waterhouse/Lend Lease Investment 

Research, Emerging Trends in Real Estate 1999. 

San Francisco Regional Outlook 15	 First Quarter 1999 
In Focus This Quarter
 

TABLE 1 

Markets Most Vulnerable to Overbuilding: Summary of Trends and Expectations 

Construction Employment Net- Projected 

1H97 to 1H98 Activity Growth Migration Vacancy Rate 

Vacancy Rates (’95 to 1H98) Trends Trends Trends 

LAS VEGAS H H C E H 

ATLANTA H H C C H 

NASHVILLE H H C C H 

SALT LAKE CITY H H C C H 

CHARLOTTE E H C E H 

PORTLAND H H C C H 

PHOENIX C H C C H 

DALLAS H H C H H 

ORLANDO E H E H H 

Note: Arrows for vacancy and construction are intended to capture prevailing trends across all property types;
 

experience with respect to a specific property type in a particular area may differ. H = half.
 

Sources: CB Commercial, F.W. Dodge, Regional Financial Associates, and Smith Travel Association.
 

Las Vegas 

Las Vegas’s hotel, office, and industrial development 

far surpasses that of other major markets, with ratios of 

construction activity to current space of 37 percent, 19 

percent, and 12 percent, respectively. Rapid development is occurring despite high and increasing office 

and industrial vacancy rates, which place additional 

competitive burdens on newly completed space. The 

area’s retail and apartment sectors are also developing 

rapidly, ranking third and fourth, respectively, among 

major markets. Although Las Vegas continues to enjoy 

one of the fastest employment growth rates in the country, the rate of job growth has slowed considerably from 

1994 to 1996 levels. Its real estate markets are highly 

dependent on the gaming sector, which could be especially vulnerable to a nationwide slowdown in economic activity. The city would be particularly hard hit by a 

downturn in real estate prices, as fully 10 percent of its 

workforce is employed in the construction sector (twice 

the national rate). 

Atlanta 

Of the nation’s largest metropolitan markets, Atlanta 

ranks among the top ten in office, industrial, retail, and 

apartment construction, with ratios of construction 

activity to current space of 12 percent, 8 percent, 7 percent, and 5 percent, respectively. Development, much of 

which is widely reported to be speculative, is very 

active despite relatively high office and industrial 

vacancy rates. Atlanta’s expanding real estate markets 

have been driven largely by strong in-migration and 

employment growth rates. However, both these rates are 

slowing, and many market observers are concerned that 

the area’s development cycle has reached its peak.12 

Nashville 

Nashville ranks among the top ten metro markets in 

office and apartment development, with ratios of construction activity to existing space of 10 percent and 

6 percent, respectively. Although not among the top 15 

markets, Nashville’s hotel sector is expanding rapidly 

as well (construction activity stands at 12 percent of 

current space). Nashville’s economy is reported to be 

slowing because of recent losses in manufacturing-sector jobs and slowing net-migration rates. The rapid pace 

of development has recently placed downward pressure 

on office, industrial, and hotel occupancy rates. 

Salt Lake City 

Salt Lake City ranks among the top five markets in the 

nation in office, industrial, and hotel development, with 

ratios of construction activity to current space of 14 

percent, 6 percent, and 27 percent, respectively. The 

main drivers behind the area’s rapid development have 

been high-tech corporate expansions, population inmigration, and preparation for the 2002 Winter Olympic 

Games. However, both job growth and in-migration 

rates are slowing, which could result in lower absorption rates for commercial space in the near term. Over 

12 See the November 1998 issue of the Federal Reserve Board’s 

Beige Book. 

San Francisco Regional Outlook 16 First Quarter 1999 
In Focus This Quarter
 

the longer term, analysts have expressed concerns that 

development and job growth attributable to the 

Olympics will result in a significant glut of space following the Winter Games. 

Charlotte 

Charlotte ranks among the top five metro areas in 

office, retail, and apartment development, with ratios of 

construction activity to current space of 15 percent, 7 

percent, and 6 percent, respectively. The area’s hotel 

sector is also developing rapidly. Charlotte’s real estate 

markets are highly dependent on the health of the financial industry, which has been the primary driver of 

development activity. However, job growth in the financial services sector has recently slowed, and the manufacturing sector (which accounts for 19 percent of all 

jobs) is experiencing net job losses. 

Portland 

Portland has the third most active hotel and apartment 

development in the nation, with ratios of construction 

activity to current space of 25 percent and 7 percent, 

respectively. The area’s office market is also expanding 

rapidly. Portland’s development has been driven largely 

by in-migration and job growth in the technology sector. 

However, because of the significance of exports to the 

overall economy (exports to Asia account for approximately 7 percent of Oregon’s gross state product), the 

technology sector is particularly vulnerable to weak 

Asian markets. Accordingly, job growth has moderated, 

reaching its lowest level in five years. The area has also 

experienced a recent decline in construction-sector jobs. 

Although still strong, in-migration rates have fallen 

from 1996 levels. 

Phoenix 

Phoenix ranks among the top ten metro markets in 

industrial, retail, hotel, and apartment development, 

with ratios of construction activity to existing space of 

6 percent, 6 percent, 18 percent, and 6 percent, respectively. The area is also experiencing rapid development 

in the office sector. Phoenix has one of the fastestgrowing job markets in the country. Although still 

strong relative to the nation, employment growth has 

slowed somewhat since 1996, as has the rate of inmigration. The prominence of the semiconductor and 

high-tech businesses makes Phoenix especially vulnerable to the economic slowdown in Asia. 

Dallas 

Dallas ranks among the top ten metro markets in office, 

hotel, and apartment development, with ratios of construction activity to existing space 

of 10 percent, 19 percent, and 6 

percent, respectively. The area is 

also experiencing rapid development in the retail sector. Dallas’s 

economy remains one of the 

fastest growing in the country, and 

in-migration to the area continues 

to rise. However, economic growth 

has slowed somewhat recently because of weakening 

high-tech and energy sectors. Although its industrial 

base is more diversified today than in the mid-1980s, 

Dallas remains exposed to a large energy sector, whose 

profits are vulnerable to declining oil and energy prices. 

Concerns over the volume of planned office development have led to widely published reports of curtailments in credit availability to speculative office 

projects. Although tighter credit availability may ease 

pressures on vacancy rates over the long term, the market will still have to absorb the large volume of space 

presently under construction, much of which is speculative. 

Orlando 

Orlando ranks among the top three metro markets in 

office, retail, and apartment development, with ratios of 

construction activity to existing space of 15 percent, 9 

percent, and 7 percent, respectively. Of the nine markets 

discussed in this article, Orlando’s current pace of construction is perhaps easiest to support, thanks to rising 

employment and in-migration growth. However, despite 

strong employment growth, office vacancy rates have 

edged higher over the past 12 months because of the 

rapid pace of construction. Orlando may be more vulnerable than other metropolitan areas to a slowdown in 

the national economy owing to its dependence on the 

tourism sector. 

San Francisco Regional Outlook 17 First Quarter 1999 
In Focus This Quarter
 

Credit Availability Affects the Pace of 

Commercial Development 

CMBS and real estate investment trusts (REITs) have 

generated a significant share of funding for commercial 

real estate over the past several years.13 As a result, any 

disruption in CMBS and REIT markets strains credit 

availability for new commercial development. For 

instance, widening CMBS spreads in the wake of September’s market volatility have caused many issuers to 

either delay or cancel new CMBS issues. REITs, too, 

have reportedly curtailed purchases because of falling 

per-share values and a corresponding decline in equity 

issues to support acquisitions. 

Weaknesses in the CMBS and REIT markets also may 

be dampening many lenders’ enthusiasm for commercial real estate development. Construction lenders will 

be less willing to make speculative loans to the extent 

that permanent funding is not available, and CMBS and 

REITs served as major providers of such funding. 

REITs were particularly aggressive purchasers in such 

markets as Atlanta, Orlando, and Dallas.14 Tightened 

construction lending conditions appear to be borne out 

by the November 1998 issue of the Federal Reserve 

Board’s Beige Book, which indicates that new construction for speculative commercial projects has either been 

curtailed or come to a virtual halt throughout many Federal Reserve districts, including Atlanta and Dallas. 

Most districts also reported tightened credit conditions 

and higher loan pricing, which could further dampen 

construction activity. 

The turmoil faced by CMBS and REITs presents both 

opportunities and risks for banks. Many industry participants view tighter credit accessibility as a positive 

development in light of the rapid pace of construction, 

13 See “Strong Demand and Financial Innovation Fuel Rebounding
 

Commercial Real Estate Markets” in Regional Outlook, fourth quarter
 

1997.
 

14 See Lehman Brothers, Commercial REIT Data Book, December 9,
 

1997.
 

which, in some cases, has been accompanied by 

extremely tight loan pricing margins and a loosening of 

underwriting standards. However, some lenders may 

view the changing fortunes of CMBS and REITs as an 

opportunity to regain market share. In any case, it will 

take several months for recent market events to be fully 

reflected in hard numbers for construction activity. 

Whether tightening credit availability proves to be a 

temporary phenomenon given the recent, albeit gradual, recovery in CMBS spreads and the broad recovery 

in the equity markets, remains to be seen. 

Summary 

This article updates a previously published analysis that 

used year-end 1997 data to rank the potential vulnerability of major metropolitan areas to overbuilding. 

Using primarily midyear 1998 information, this update 

adds three markets to the six identified in the initial 

analysis as vulnerable to broad-based overbuilding. This 

assessment is based on a number of factors including 

construction activity trends, local area employment and 

population migration trends, as well as a collection of 

views and projections from credible industry analysts. 

For many of these markets, the prospects for near-term 

declines in commercial real estate demand may be 

increasing because of slower economic growth and 

weakened markets abroad. Certain secular demographic and economic trends also suggest the possibility of 

lower demand levels in the current cycle relative to prior 

cycles. Although data through June 1998 indicate ongoing rapid development, there is growing evidence that 

recent events in the capital markets have at least temporarily tempered the appetite for further development 

in some rapidly expanding metro areas. For these markets, most participants view the curtailment in credit 

availability in a positive light because it would serve to 

moderate the severe cyclical swings in real estate values 

experienced by several markets during the 1980s. 

Steven Burton, Senior Banking Analyst 

San Francisco Regional Outlook 18 First Quarter 1999 
In Focus This Quarter
 

Recent Trends in Syndicated Lending
 

•	 A strong U.S. economy, intensifying competition, 

and the increasing marketability of bank loans 

have driven record volumes of syndicated lending 

in the 1990s. 

•	 After several years of liberalized underwriting, 

evidence suggests that some banks have tightened 

standards and terms for loans to large commercial borrowers. 

•	 Market developments and underwriting trends 

over the past several years have implications for 

credit quality, earnings, and liquidity at institutions that hold or originate syndicated loans. 

Commercial and industrial lending is a major source of 

revenue for commercial banks, yet this business line has 

lagged other major lending categories in terms of liquidity, standardization, and commoditization. However, in recent years the transformation of commercial 

lending has accelerated and is altering the way lenders 

do business. This trend has been particularly apparent in 

syndicated commercial lending. This article briefly 

defines syndicated loans, reviews the 1990s boom in the 

market, and discusses the implications of competitive 

pressures and secondary market liquidity for underwriting trends and risk profiles of commercial banks active 

in this market. 

Syndicated Lending Overview 

A syndicated loan is a credit extended to one large or 

medium-sized corporate borrower that is originated by 

a group, or syndicate, of lenders. Syndicated lending 

differs slightly from participation lending, which is 

common in commercial banks. Although both types of 

lending allow for flexibility in reducing companyspecific risk and adhering to legal restrictions for loans 

to one borrower, only one lender originates a participation loan, which is then sold in undivided participation 

interests either concurrently or subsequently to third 

parties.1 A syndicate usually consists of a group of institutions that work closely on a number of deals that are 

sold to subscribers at origination. 

1 American Bankers Association, Banking Terminology, 3rd ed., 1989, 

p. 345. 

Syndicated loans can generally be categorized according to rating, terms, pricing, or target investors. The 

investment-grade loan market, often referred to as the 

pro-rata or retail market, is the lowest-risk segment of 

syndicated lending and comprises approximately 80 

percent of all volume originated from 1987 to 1997. 

These loans commonly take the form of liquidity backstops or lines of credit and are marketed to commercial 

bank investors. Loan Pricing Corporation (LPC) 

defines these credits as those rated BBB–/Baa3 or better, or nonrated deals with pricing equal to or less than 

rated deals in these bands. Near-investment-grade, 

leveraged, and highly leveraged markets, often referred 

to as B, C, and D tranche term loans or non-investmentgrade loans, include credits with longer maturities, 

greater risk, and higher pricing. Non-investment-grade 

loans are typically structured for institutional investors 

and compete more directly with the traditional highyield bond market. LPC defines non-investment-grade 

loans as those rated BB+/Ba1 or worse, or nonrated 

deals with pricing greater than deals graded BBB–.2 

Competitive Trends in the 

Syndicated Loan Market 

A handful of large U.S. commercial banking companies 

originate the vast majority of U.S. syndicated corporate 

credits across all quality types. According to LPC, 14 

U.S. banking companies were among the top 25 syndicated lenders (based on the number of agent or co-agent 

transactions) and accounted for half of 1998 syndicated 

loan transactions to U.S. corporations through midNovember.3 In 1997, nine U.S. banking companies were 

among the top 25 and executed 36 percent of the market’s transactions. Before 1997, the most active domestic commercial banks saw their market share erode from 

a peak of 45 percent of transactions in 1992 to 34 percent in 1996, primarily because of intensifying competition from nontraditional syndicated lenders such as 

investment banks and foreign banks. Although U.S. 

banks have recently recovered market share (as Japanese banks have significantly withdrawn from the market), a strong U.S. economy, expanding liquidity in the 

bank loan market, and a trend toward one-stop shopping 

2 Loan Pricing Corporation, Gold Sheets, Third Quarter 1998 Review,
 

p. 2.
 

3 Loan Pricing Corporation, Gold Sheets, November 16, 1998, p. 6.
 

San Francisco Regional Outlook 19	 First Quarter 1999 
In Focus This Quarter
 

in the financial services industry have attracted competitors to the syndicated market in the 1990s. 

Syndicated Loan Liquidity 

U.S. commercial banking companies retain or buy a 

large volume of syndicated loans, yet estimates show 

that most of the volume is sold to other institutional 

investors. Information from the shared national credit 

program4 indicates that at year-end 1997, FDIC-insured 

commercial banking companies had extended facilities 

and commitments totaling $1.8 trillion, of which an 

estimated $565 billion was funded. To put this figure in 

perspective, an official of the Office of the Comptroller 

of the Currency estimated that 57 percent of outstanding syndicated loans were held by foreign banks; 26 

percent by originating banks, mutual funds, and insurance companies; and 17 percent by subscribing banks.5 

Indeed, according to BankAmerica Corporation, the 

number of nonbank institutional investors in bank loans, 

including prime rate mutual funds, hedge funds, and 

insurance companies, increased from 14 in 1993 to 

more than 100 in 1998. These investors have played a 

pivotal role in enhancing the bank loan as a distinct 

asset class by increasing trading activity, demanding 

third-party loan ratings, and contributing to the development of loan derivative products. 

Perhaps the most important new development in syndicated lending has been the deepening secondary market 

for bank loans as many new investors seek to purchase 

them. As shown in Chart 1, the volume of secondary 

trading in bank loans has grown sharply, more than 

tripling between 1994 and 1997 to over $60 billion. 

Trading in 1998 through the third quarter was on pace 

to top the 1997 level. Traded loans are often noninvestment-grade issues, which have been the focus of 

most demand by the burgeoning institutional investor 

base. One important force behind the development of a 

bank loan secondary market has been rapid expansion 

in the number of bank loans rated by third-party rating 

services. 

Independent credit ratings of bank loans were initiated 

in 1995 when “several years of rapid development in the 

4 The shared national credit program is a cooperative examination 

program conducted by the three federal banking agencies and cooperating state agencies to review large, complex credits held at multiple institutions. Loans subject to review are syndicated loans or 

groups of loans and commitments of $20 million or more shared by 

three or more supervised institutions. 

5 “Concerns Mounting Over Risks in Booming Syndication Market,” 

American Banker, January 29, 1997, p. 20. 

CHART 1 

Secondary Market Trading in Syndicated 

Loans Has Tripled since 1994 

* annualized 

Source: Loan Pricing Corporation 

0 

10 

20 

30 

40 

50 

60 

70 

’91 ’92 ’93 ’94 ’95 ’96 ’97 3Q98* 

$ Billions of Syndicated Loans 

Traded in the Secondary Market 

syndicated bank loan market generated a critical mass 

of interest in the credit characteristics of these instruments.”6 Standard and Poor’s, Moody’s, Duff and 

Phelps, and Fitch/IBCA are now actively involved in 

rating bank loans. Through 1997, Standard and Poor’s 

and Moody’s combined rated $677 billion in loans. As 

rating activity increases access to and availability of 

standardized analysis and research for bank loans, 

including market analysis, ratings criteria, and historical 

loss recovery rates, investors are becoming more comfortable with loans as a distinct asset class. Moreover, 

independent loan ratings allow investors to value a company’s loans relative to its other rated loans or bonds. 

Bank loan secondary market activity and independent 

ratings have prompted the development of new ways to 

package and improve the market acceptance of these 

assets. As a result, the securitization of bank loans and 

the development of various types of derivative products 

have proliferated. As discussed in “CLOs Lure Another Major Bank Asset off the Balance Sheet,” in Regional Outlook, third quarter 1998, collateralized loan 

obligations (CLOs) are a major market development 

allowing for the securitization of corporate loans. A 

large investor appetite for varied types of asset-backed 

securities and a desire to move assets off the balance 

sheet to lower risk-based capital requirements have 

helped promote a sharp increase in this type of securitization. Loan derivatives also may allow lenders to 

better manage the trade-off between maintaining borrower relationships and avoiding excessive concentrations of risk. This trade-off has become increasingly 

6 “Bankrupt Bank Loan Recoveries,” Moody’s Investor Service, June 

1998, p. 5. 

San Francisco Regional Outlook 20 First Quarter 1999 
In Focus This Quarter
 

CHART 2 CHART 3 

0 

200 

400 

600 

800 

1,000 

1,200 

’88 ’90 ’92 ’94 ’96 3Q98* 

Nonleveraged Loans 

Leveraged Loans 

* annualized 

Source: Loan Pricing Corporation 

After Several Record Years, Syndicated 

Loan Originations Have Slowed 

$ Billions of Syndicated 

Loans Originated 

Note: LIBOR = London Interbank Offered Rate 

Source: Loan Pricing Corporation 

New Syndicated Loan Pricing Has Reversed 

after Several Years of Narrowing Spreads 

0 

10 

20 

30 

40 

50 

4Q90 4Q91 4Q92 4Q93 4Q94 4Q95 4Q96 4Q97 11/98 

0 

30 

60 

90 

120 

150 

A Basis Points above LIBOR BB Basis Points above LIBOR 

important with the trend toward one-stop shopping in 

financial services. 

One-Stop Financial Providers 

For several years, analysts have noted a trend toward 

financial services supermarkets—financial institutions 

positioning themselves as providers of a complete array 

of advisory services and financial products. One aspect 

of this trend has been the tendency of traditional 

lenders to improve their ability to offer a full array of 

equity and debt underwriting, as characterized by the 

expansion of Section 20 activities among major U.S. 

commercial banking companies. Traditional securities 

underwriters view entry into the syndicated loan market similarly. For example, no investment bank had a 

syndicated loan underwriting department in 1994, but 

several are now making inroads into the market, especially the leveraged market, and some increased their 

syndicated loan volume fivefold in 1997.7 In some 

cases, the desire of commercial banks to move toward 

one-stop financial services and the resulting approaches to relationship management have affected the underwriting of loans to large commercial borrowers that 

have multiple financing and advisory service needs. 

Historical Perspective on Syndicated 

Loan Underwriting Trends 

Increased interest by investors in bank loans and strong 

competition for business resulted in syndicated lending 

7 “The New Kids in the Syndicate: Investment Banks Are Moving in 

on the Leveraged Syndicated Loan Market,” Bloomberg, March 1998, 

p. 35. 

at historically narrow spreads and on more liberal 

terms. Accordingly, the syndicated loan market was a 

borrowers’ market for much of the 1990s. As shown in 

Chart 2, the volume of syndicated loan originations 

increased almost fivefold between 1991 and 1997, with 

record volume levels achieved in each of these years. 

Much of the volume was driven by growth in the origination of loans for the purpose of refinancing existing 

debt, especially from 1995 to 1997, as borrowers took 

advantage of increased lender competition and investor 

demand to reduce funding costs and extend maturities. 

In some cases, borrowers were able to refinance loans 

obtained just months earlier at significant savings and 

more favorable terms. 

Chart 3 shows that lending spreads compressed sharply 

from 1993 to 1997, particularly for lower-quality credits. LPC stated that “[e]xcessive competition has driven 

spreads and fees to all-time lows, with the investment 

grade market purely a relationship play.”8 Consistent 

with the financial supermarket concept discussed 

above, as relationship lending proliferated, many 

lenders were evaluating transactions on the basis of 

overall relationship returns rather than individual transaction returns. Consequently, borrowers willing to offer 

an institution ancillary business, such as cash management, securities underwriting, or securitization services, 

were likely to receive more favorable loan pricing than 

borrowers seeking to execute just one loan deal. 

During the same period, a clear trend toward weakened 

underwriting resulted in deteriorating risk/return rela8 Loan Pricing Corporation, Gold Sheets, First Quarter 1995 Review, 

p. 9. 

San Francisco Regional Outlook 21 First Quarter 1999 
In Focus This Quarter
 

CHART 4 CHART 5 

0 

20 

40 

60 

80 

100 

’90 ’92 ’94 ’96 3Q98 

364-day Five-Year Three/Four-Year 

After Several Years of Lengthening, the Average 

Maturity of New Investment-Grade Syndicated 

Loans Has Shortened in 1998 

Source: Loan Pricing Corporation 

Origination Volume (%) 

0.0 

1.0 

2.0 

3.0 

4.0 

1Q96 3Q96 1Q97 3Q97 1Q98 3Q98 

0 

5 

10 

15 

Sources: Moody’s Investor Services, Federal Reserve Board 

Trailing 12-Month IssuerBased Default Rate (%) 

Trailing Four-Quarter Average Growth 

in Nonfinancial Corporate Profits (%) 

Defaults on Speculative-Grade Corporate 

Bonds Have Risen and Growth in 

Corporate Profits Is Slowing 

tionships across syndicated lending categories. Financial indicators market analysts use to evaluate whether 

lenders are being adequately compensated for risk 

generally weakened. For example, the ratio of debt to 

earnings before interest, taxes, depreciation, and amortization rose to relatively high levels for an increasing 

number of leveraged and highly leveraged loans.9 Moreover, lengthening maturities reflected looser underwriting. A decline in the spreads between loans of one-year 

and five-year maturities made it cost-effective to borrow for longer periods. LPC indicated that the differential between fees on undrawn 364-day revolving loans 

and undrawn five-year loans had dropped by one-half 

during this period.10 As a result, many borrowers extended maturities on new credits, and, as shown in Chart 4, 

the average maturity of investment-grade loans originated in the mid-1990s lengthened significantly. 

Recent Underwriting Developments 

Beginning in late 1997, lenders and investors began to 

resist aggressively priced investment-grade and nearinvestment-grade loans. This resistance led to a leveling 

of pricing, fewer refinancing opportunities for borrowers, and increased focus on the higher-risk leveraged 

lending market, where nonbank institutional investor 

demand was strong and pricing was richer. In response, 

overall syndicated lending volume declined almost 16 

percent during the first three quarters of 1998 compared 

with the same period in 1997. However, within total 

new syndicated loan volume, leveraged loan origina9 Ibid., pp. 16-17. 

10 Ibid., p. 43. 

tions grew 77 percent to $200 billion during the same 

period, accounting for approximately one-third of all 

syndicated credits—the largest proportion of the market 

since 1989. Of particular note was that this growth in 

higher-risk lending came at a time when losses in speculative-grade bonds had been trending higher and 

growth in profits for nonfinancial U.S. corporations had 

been slowing (see Chart 5). 

Global economic turmoil and the flight to quality that 

disrupted the capital markets during the third quarter of 

1998 spilled over into the bank loan market and solidified a shift to a lenders’ market. LPC noted in its thirdquarter 1998 review of syndicated lending that “[r]ates 

and fees are on the upswing meaning opportunistic refinancings...continue to dwindle. Concessions suddenly 

are going to lenders rather than borrowers, and volume 

continues the drop [from levels] seen earlier in the 

year.”11 Growth in leveraged lending also declined 

sharply as the number of institutional investors in the 

market fell by one-half from the second quarter.12 

The shifting dynamics of the market in late 1998 were 

characterized by the aforementioned slowdown in originations, a sharp increase in pricing (see Chart 3, previous page), and evidence that underwriting had become 

more stringent. The volatility in credit markets resulted 

in deals being rescinded or incorporating “market flex” 

pricing language that enabled lenders to manage the 

yield requirements of investors due to changing yields 

on competing capital markets instruments. The influ11 Loan Pricing Corporation, Gold Sheets, Third Quarter 1998
 

Review, p. 3.
 

12 Ibid.
 

San Francisco Regional Outlook 22 First Quarter 1999 
In Focus This Quarter
 

CHART 6	 CHART 7 

(60) 

(40) 

(20) 

– 

20 

40 

60 

4Q90 4Q92 4Q94 4Q96 4Q98 

Some Banks Have Tightened Underwriting 

Standards and Terms to Large and 

Medium-Sized Corporate Borrowers 

Source: Federal Reserve Board 

Net Percentage 

Tightening Underwriting Standards 

Increasing Spreads on Loan Rates 

0 

3 

6 

9 

12 

12/14/94 12/20/95 12/18/96 12/17/97 12/23/98 

Source: Loan Pricing Corporation, Goldman Sachs, Bloomberg 

Total Returns* on Leveraged Loans Have Fallen 

Rolling 52-Week Total Returns Measured by the 

Goldman Sachs/Loan Pricing Corporation 

Liquid Leveraged Loan Index 

* Total Return = Accrued Interest + Bid Changes + Gains from Repayments Total Returns (%) 

ence of the secondary market on new loan pricing 

became apparent as investors required underwriters to 

factor in higher secondary market yields. In addition, as 

shown in Chart 6, the Federal Reserve Board’s November 1998 Senior Loan Officer Opinion Survey on Bank 

Lending Practices reported that a significant minority 

of surveyed lenders had tightened lending standards and 

terms for commercial loans to large and middle-market 

firms.13 On net, nearly 40 percent of domestic bank 

respondents had tightened lending standards for these 

borrowers for the three months ending November 30, 

and nearly half had increased pricing. These percentages are the highest reported since the last recession. 

Underwriting was also influenced by increased borrower demand for bank loans—a secondary effect of the 

market volatility in late 1998. The aforementioned Federal Reserve Board survey noted an increased demand 

for bank commercial loans primarily as a result of shifts 

from other sources of credit, namely the bond and commercial paper markets. For example, one industry participant estimated that the loan market represented 

roughly 60 percent of capital market financing in January 1998, 40 percent in July as the high-yield bond market boomed, and nearly 100 percent in September as the 

bond markets stalled.14 

13 Large or middle market firms are those with annual sales greater
 

than $50 million.
 

14 “Syndicated Lenders Swiftly Surmounted September Dip,” American Banker, December 10, 1998, p. 25.
 

Implications for Insured Institutions 

Although recent evidence suggests that some lenders 

have tightened standards and terms for loans to large 

commercial borrowers, market developments and 

underwriting trends over the past several years have 

implications for credit quality, earnings, and liquidity at 

institutions that hold or originate syndicated loans. 

•	 A slowing economy and stress in industries exposed 

to weakened international economic conditions 

could result in increased losses during an economic 

downturn, especially for banks that are holding 

higher-risk syndicated loans. Although nonbank 

institutional investors hold the bulk of the riskier 

tranches of syndicated deals, some banks ventured 

into riskier, longer-term issues in response to narrow 

pricing on traditional loan pieces held by banks.15 

Should liquidity become an issue in the secondary 

market, banks planning to sell these pieces may face 

losses. For example, as reflected in Chart 7, the 

rolling 52-week total return on the Goldman 

Sachs/LPC Liquid Leveraged Loan Index, which 

measures the performance of a diversified portfolio 

of the most actively traded performing leveraged 

loans, has fallen from over 8 percent in early 1998 to 

less than 4 percent in December 1998. Falling prices 

have caused reduced returns as required spreads on 

these credits have risen. 

15 “Banks Compete with Funds in Buying Long-Term Tranches of 

Syndications,” American Banker, March 19, 1997, p. 1. 

San Francisco Regional Outlook 23	 First Quarter 1999 
In Focus This Quarter
 

•	 Downstream subscribers that purchased thinly priced 

or loosely structured loans may not be adequately 

compensated for risk. This lack of compensation may 

be especially important for institutions that do not 

receive ancillary relationship income. Evidence suggests that downstream lenders became more willing 

to accept loans during the 1990s without receiving 

full documentation or making an independent credit 

analysis. The Office of the Comptroller of the Currency reportedly attributed this trend to a desire to 

add loan volume coupled with comfort about company prospects because of the strong economy and 

strong corporate profits.16 As a result, on a riskadjusted basis, the returns on these credits may hamper the performance of investing institutions. 

•	 Sustained reductions in syndicated loan liquidity 

may adversely affect revenues and increase percentages of loan amounts retained by active syndicating 

institutions. If institutional investors remain withdrawn from the loan market for an extended period, 

syndicates may have increasing difficulty marketing 

deals, especially in the non-investment-grade segment. As a result, institutions dependent on revenues 

generated by this activity may face declining income 

as fewer deals are executed, or they may have to hold 

larger percentages of undersubscribed transactions. 

This situation may be further exacerbated by consolidation in the U.S. banking industry, which has combined several major syndicate agents in the 1990s 

and has reduced the number of potential downstream 

investment-grade subscribers in the market. 

•	 Rising demand from borrowers exploiting relative 

pricing in the loan and capital markets may have 

credit and liquidity implications for underwriting 

institutions. Sustained volatility in the capital mar16 “Concerns Mounting over Risks in Booming Syndication Market,” 

American Banker, January 29, 1997, p. 20. 

kets may increase the demand for bank loans and 

will likely significantly increase funding costs for 

many borrowers. For example, LPC recently compared loans that were extended to seven companies 

in early 1998 with similarly structured loans extended to the same companies after the third-quarter disruption in the capital markets. The analysis revealed 

significant increases in required yields, ranging from 

112 to 388 basis points.17 Rising funding costs combined with a trend toward slower growth in corporate 

profits may reduce loan repayment capacity of borrowers in more troubled industries. In addition, 

banks that have extended liquidity backstops or 

backup lines of credit may be required to fund facilities that traditionally are not heavily used by borrowers. For example, without appropriate pricing 

adjustments, banks providing backup commercial 

paper loans may be called upon to fund these facilities as a result of volatility and relatively high 

spreads in the commercial paper market. 

Increases in credit spreads on securities and syndicated 

loans, the recent rise in speculative corporate bond 

defaults, and slowing corporate profits may portend an 

increase in commercial credit problems for commercial 

banks. Now more than ever, those involved in bank risk 

management should pay close attention to fundamentals, including careful credit analysis, diversification, 

and maintenance of prudent underwriting standards. 

Attention to these fundamentals may help alleviate the 

need to overreact to sudden changes in the market 

environment. 

Steven E. Cunningham, CFA, Senior Financial Analyst 

Ronald L. Spieker, Chief, Regional Programs and 

Bank Analysis Section 

17 Loan Pricing Corporation, Gold Sheets, November 16, 1998, p. 21. 

San Francisco Regional Outlook 24	 First Quarter 1999 
Regional Perspectives
 

Regional Perspectives
 

•	 Rapid commercial real estate (CRE) development in Las Vegas and Phoenix continues unabated, raising 

concerns about overbuilding. Slowing economies in Salt Lake City and Portland may be a sign that the 

recent strong growth in CRE development may be subsiding. 

•	 In contrast with 1990, community banks in the San Francisco Region with construction and development 

loan concentrations are now more common outside California. 

•	 In the aggregate, community banks in Salt Lake City, Las Vegas, and Portland have high construction and 

development loan exposure. 

Several of the Region’s Metropolitan Areas May Be Vulnerable to Overbuilding 

as a Result of Rapid Commercial Real Estate Development 

Growth in population, employment, and income, along 

with low interest rates and an ample credit supply, has 

helped real estate construction and development to 

flourish in recent years. Consistent with a regional 

economy that has outperformed that of the United 

States since 1995, several San Francisco Region real 

estate markets rank among the nation’s most active in 

terms of new construction. 

The In Focus article “Commercial Development Still 

Hot in Many Major Markets, but Slower Growth May 

Be Ahead,” Regional Outlook, first quarter 1999, identifies four markets in the Region as vulnerable to overbuilding. Two of these metropolitan statistical areas 

(MSAs), Las Vegas and Phoenix, continue to grow 

rapidly, especially in the construction sector. The other 

two formerly fast-growing MSAs, Portland and Salt 

Lake City, are slowing down, with employment growth 

below the average for the Region. The four markets present different types of risks. The risk of continued 

commercial real estate (CRE) overbuilding may be 

heightened in Las Vegas and Phoenix in light of expectations of weaker market conditions nationally. Softening in general economic conditions in Portland and Salt 

Lake City is likely to affect CRE by reducing demand in 

a period of increasing real estate supply. While real 

estate investment trusts have been active players in 

financing new development activity, community banks 

in several San Francisco Region metropolitan areas also 

have provided construction and development financing 

at a rapid pace. 

Although selected areas in the Region are experiencing 

considerable growth in construction and land development (C&D) lending, the aggregate exposure of community banks1 in the Region and the number of concentrated C&D banks2 have changed over the past decade. 

While Chart 1, next page, shows that, as a percentage of 

total assets, community banks’ aggregate C&D loan 

exposure in the Region remains below the Region’s 

peak at year-end 1990, the Salt Lake City, Las Vegas, 

Portland, and Phoenix MSAs now have higher aggregate exposure than in 1990. Likewise, the number of 

concentrated C&D banks in the Region is lower than the 

year-end 1990 peak, falling from 152 in 1990 to 52 in 

the third quarter of 1998, but the number has risen in 

several markets outside California. Map 1, next page, 

shows that at year-end 1990, 92 percent of the concentrated C&D banks were in California, primarily in 

Southern California. Conversely, Map 2, next page, 

shows that as of third-quarter 1998, more than 67 percent of these banks are located outside California—primarily in the Portland, Phoenix, Salt Lake City, and 

Seattle MSAs. 

The marked increase in exposure to C&D lending in 

some of the Region’s MSAs may warrant additional 

monitoring because in the aggregate, concentrated 

C&D banks’ earnings and asset quality in the San Francisco Region have historically been much more volatile 

during economic downturns than those of nonconcen1 Community banks are non-credit-card commercial banks with less 

than $1 billion in total assets. Community banks exclude industrial 

loan companies, which are special-purpose lenders that are prevalent 

in the Salt Lake City MSA. 

2 A concentrated C&D bank is a community bank with C&D loans 

greater than 15 percent of total assets. 

San Francisco Regional Outlook 25	 First Quarter 1999 
Regional Perspectives
 

CHART 1 C&D Loans as a Percentage of Total Assets 

Community Banks in Some San Francisco Region MSAs Have Increased Their C&D Loan Exposure 

0 

4 

8 

12 

16 

Note: MSAs = metropolitan statistical areas; C&D = construction and development 

Source: Bank Call Reports 

Year-End 1994 

Year-End 1990 

September 30, 1998 

U.S. Region Region without 

California 

California Phoenix Portland Las Vegas Salt Lake City 

trated C&D banks (see Charts 2 and 3). Furthermore, 42 

percent of the Region’s community bank failures during 

the past ten years had been concentrated C&D banks at 

one time during the five years prior to failure. Also, 

although national vacancy rates are falling and rental 

rates are climbing, market analysts are becoming 

MAP 1 

Most Concentrated C&D Banks Were Located 

in California as of Year-End 1990 

San Francisco 

San Jose 

San Luis ObispoAtascadero-Paso Robles 

Los AngelesLong Beach 

Orange County San Diego

Pierce 

San Juan 

Riverside-San 

Bernardino 

Sacramento 

MSA with 4 or More Concentrated C&D Banks
 

MSA with 1 to 3 Concentrated C&D Banks
 

Note: C&D = construction and development; MSA = metropolitan statistical area 

Source: Call Reports 

increasingly cautious about the CRE outlook. Overbuilding in the 1980s demonstrated that development 

decisions at the peak of an economic cycle are often 

based on expectations that positive conditions will continue. Also, individual development decisions may not 

consider the actions of other developers. Therefore, 

MAP 2 

Most Concentrated C&D Banks Are Located 

outside California as of the Third Quarter of 1998 

SeattleBellevueEverett, WA 

PortlandVancouver, 

OR-WA 

Salt Lake 

City-Ogden, 

UT 

PhoenixMesa, AZ 

Pierce 

Las Vegas, 

NV-AZ 

MSA with 4 or More Concentrated C&D Banks
 

MSA with 1 to 3 Concentrated C&D Banks
 

Note: C&D = construction and development; MSA = metropolitan statistical area 

Source: Call Reports 

San Francisco Regional Outlook 26 First Quarter 1999 
Regional Perspectives
 

CHART 2 

ROE Has Been More Volatile for Community 

Banks with High Concentrations in C&D Loans 

More than 15% Total Assets 

Note: ROE = return on equity; C&D = construction and development 

Source: Bank Call Reports 

Less than 15% Total Assets 

ROE Mean 

ROE Std. Dev. 

7.86% 

10.52% 

9.42% 

2.30% 

–15 

–10 

–5 

0 

5 

10 

15 

20 

1988 1991 1994

Community banks with less than 

15 percent of total assets in C&D 

Community banks with more than 

15 percent of total assets in C&D Loans 

1998 

ROE in Percent 

C&D Loans Comprise... 

active markets could become oversupplied rapidly 

because of a large volume of new development. 

The following sections summarize real estate market 

conditions and insured institution C&D lending exposure in four of the Region’s MSAs identified as vulnerable to potential overbuilding. 

Las Vegas 

Rapid Growth Remains Dependent 

on Gaming and Construction 

The In Focus article identifies the Las Vegas MSA as 

the most active construction market in hotel, office, and 

industrial space of the nation’s major metropolitan markets. Las Vegas’ retail space development also is among 

the strongest in the nation. Significant in-migration to 

Las Vegas spurred construction activity and boosted 

nonfarm employment to record levels during the 1990s. 

Although down from peak years, the area’s nonfarm 

employment growth rate remains one of the fastest in 

the nation (see Chart 4). 

Although Las Vegas remains one of the Region’s 

fastest-growing MSAs, its growth is heavily dependent 

on the hotel/gaming sector, which directly accounts for 

more than 25 percent of its employment. The rapid 

expansion of the MSA’s hotel/gaming industry in the 

1990s—Las Vegas had approximately 61,000 hotel 

rooms as of 1988 and more than 105,000 as of year-end 

1997—has both directly and indirectly stimulated its 

construction sector, which accounts for more than 10 

percent of its employment. Gaming and construction, 

which together directly employ more than a third of the 

CHART 3

Asset Quality Has Been More Volatile
 

for Community Banks with Concentrations
 

in Construction Loans
 

Problem Assets as a Percent

of Total Assets* 12 

Community banks with more than 10 

8 

6 

4 

2 

0 

15 percent of total assets in C&D Loans 

Community banks with less than 

15 percent of total assets in C&D loans 

1988 1991 1994 1998 

C&D Loans Comprise... 

More than 15% 

Total Assets 

Less than 15% 

Total Assets 

Problem Assets/Total Assets Mean 4.88% 3.09% 

Problem Assets/Total Assets Std. Dev. 3.16% 0.91% 

* Problem assets are the sum of past-due and restructured loans and leases
 

and other real estate owned.
 

Note: C&D = construction and development
 

Source: Bank Call Reports
 

workforce, are both highly cyclical sectors that vary 

with the strength of the national economy. 

The sustained building boom in Las Vegas has many 

industry experts concerned that several of its real estate 

market sectors may be oversupplied. For example, the 

National Real Estate Index estimates that in the 

hotel/casino sector, room supply will increase 20 percent to more than 125,000 rooms by year-end 2000. The 

increase in rooms is primarily due to the construction of 

five new theme casino/hotel/resorts, including the 

recently opened Bellagio. The National Real Estate 

Index estimates that in order to absorb the substantial 

CHART 4 

Job Growth Rates Have Fallen Sharply 

in Salt Lake City and Portland 

* Year-over-year percent changes in nonfarm payroll employment as of December. 

Not seasonally adjusted (NSA). 

Source: Bureau of Labor Statistics 

U.S. San 

Francisco 

Region 

Las Vegas Phoenix Salt Lake 

City 

Portland 

1997 

1998 7 

6 

5 

4 

3 

2 

1 

0 

Percent* 

San Francisco Regional Outlook 27 First Quarter 1999 
Regional Perspectives
 

additions to the hotel stock, visitor count must increase 

an additional 6 million per year by 2000. Increasing visitor count may prove difficult: Year-over-year visitor 

count through November 1998 has been flat despite the 

opening of Bellagio. While average occupancy rates in 

hotels have remained more than 86 percent through 

year-end 1997, several casino executives and analysts, 

most recently J. Terrence Lanni, chief executive officer 

of MGM Grand, Inc., have acknowledged the coming 

oversupply of hotel rooms in the Las Vegas market. 

Las Vegas’ office market also may be oversupplied, 

according to June 1998 information. The National Real 

Estate Index cites speculative construction activity for 

the recent increase in office development. The new supply has placed pressure on both rents and vacancy rates. 

As shown in Chart 5, vacancy rates, which at 14.3 percent are well above the national average, have risen for 

the fourth consecutive year. In addition, office completions increased more than 4 percent from second-quarter 1997 to second-quarter 1998. While the rate of 

increase in completed space appears to be falling, Coldwell Banker Commercial/Torto Wheaton Research 

(CBC) projects that office vacancy rates will reach 19 

percent by the year 2000. Further, office rental rates 

have been virtually flat since 1995 in Las Vegas despite 

an average 17.1 percent increase in rents over the same 

period for the 54 markets that CBC tracks nationwide. 

Las Vegas’ industrial property market may be experiencing some oversupply as of June 1998. The National 

Real Estate Index estimates that 85 percent of the 

industrial buildings completed during 1997 were speculative. Because industrial projects generally require less 

lead time and planning than office projects, developers 

CHART 5 

Metropolitan Office Vacancy Rates Have Been 

Rising in Las Vegas and Salt Lake City 

Source: Coldwell Banker Commercial/Torto Wheaton Research 

0 

2 

4 

6 

8 

10 

12 

14 

16 

18 

U.S. Las Vegas Portland Phoenix Salt Lake 

City 

Percent 

1998 Q3 

1997 Q3 

1996 Q3 

1995 Q3 

1994 Q3 

were able to cut back on new industrial supply during 

1998, thus stabilizing vacancy rates. The vacancy rates 

have declined 1.4 percent to 9 percent from year-end 

1997 through second-quarter 1998 because of a 65 percent decline in completed industrial square footage over 

the same period. CBC projects vacancy rates in this 

market segment will fall to 6 to 7 percent in future 

years. 

CRE Construction May Pose Risks 

for Las Vegas Community Banks 

The rapid hotel, office, and industrial market development may have heightened the risk exposure in the 29 

insured financial institutions with operations in the Las 

Vegas MSA. Ten institutions in 

the MSA, which hold more 

than 85 percent of the MSA’s 

deposits and each have total 

assets greater than $1 billion, 

are owned by large out-of-state 

bank holding companies that 

do not report geographic lending data. These institutions 

appear likely to have geographically diversified lending 

exposures and probably would not be materially affected by a downturn specific only to the Las Vegas MSA. 

However, the 11 smaller banks headquartered in the Las 

Vegas MSA, which have combined total assets of $1.2 

billion and hold about 7.6 percent of Las Vegas MSA 

deposits, may not be as geographically diversified as 

their larger counterparts and therefore may be most at 

risk to a downturn in the local real estate markets. These 

smaller community banks, eight of which have been 

chartered within the past five years, have a disproportionately high exposure to C&D loans. As of September 

30, 1998, the 11 community banks combined have 

C&D loans equal to 12.7 percent of total MSA community bank assets (see Chart 1). In addition, all three 

banks in the MSA with C&D loans in excess of 15 percent of total assets are community banks that were chartered within the past five years. 

Conclusion 

Las Vegas’ strong economic growth continues to promote real estate development despite the potential oversupply in the hotel and office real estate markets. The 

economic well-being of the MSA remains dependent on 

growth in the hotel/gaming sector, which has historically followed national economic trends. While several 

insured depository institutions operate in the Las Vegas 

MSA, the 11 community banks headquartered there 

appear most at risk to a slowdown in the area’s econoSan Francisco Regional Outlook 28 First Quarter 1999 
Regional Perspectives
 

my because of their lack of geographic diversification 

and their relatively high exposures to C&D lending. The 

concern about C&D lending exposure in these smaller, 

newer institutions is heightened because most of them 

have not been tested by an economic or real estate market downturn. 

Salt Lake City 

Slowdown May Adversely Affect Banks 

with High C&D Loan Exposure 

Preparation for the 2002 Winter Olympics, in conjunction with past growth in the high-technology industry, 

helped propel Salt Lake City to among the nation’s top 

three markets in office, industrial, and hotel development. However, some general economic indicators suggest that its growth may be slowing, as indicated by its 

job growth rate (see Chart 4). 

The pace of economic and construction activity 

declined markedly in 1998; job growth slipped to 2.5 

percent. As of November 1998, Regional Financial 

Associates, Inc. (RFA) forecasts that economic growth 

in 1999 will be only half that experienced during 1996 

and 1997. RFA projects that future growth prospects 

will be similar through the year 2000. Construction 

employment growth has declined from 7.4 percent to 

5.8 percent in the 12-month period ending December 

1998. Total construction starts were down 20 percent in 

the first half of 1998 compared with the same period in 

1997. The indicators in Salt Lake City all point to the 

same messages: (1) the economy is slowing and is 

expected to remain slow in the near future; (2) real 

estate market activity, whether measured in terms of 

construction employment or construction starts, has 

declined noticeably from 1997 to 1998. 

Despite the 19 percent falloff in new office construction 

starts between 1997 and 1998, CBC forecasts rising 

vacancy rates as a result of additional office completions. As shown in Chart 5, office vacancy rates have 

already risen slightly over the past two years. The reason for the projected increases is the large supply of 

office real estate in the pipeline. CBC projects that 

between 1998 and 2001, about 5.8 million of the 

planned 14.2 million square feet will be completed. 

While the supply of new office real estate is not slowing 

yet, the demand for office properties is. CBC notes that 

office employment rose 6.1 percent between 1996 and 

1997. However, CBC forecasts that new office employment growth will fall to a little more than half that rate 

between 1998 and 2000. As a result, net absorption is 

expected to be 3.2 million square feet between 1998 and 

2001, far less than the projected 5.8 million square feet 

of completions. Because the supply of office space will 

most likely exceed demand, vacancy rates are expected 

to reach 15.2 percent in 2001, far above the June 1998 

rate of 6.6 percent. 

Salt Lake City has the second highest level of hotel construction activity in the nation; about 29 percent of its 

hotel stock was either in the process of construction or 

in the planning stage in 1998. In 1997, about 1,660 

rooms were added, representing a 12-fold increase in 

annual construction over 1996. Average occupancy rates 

for Salt Lake City hotels declined to 80.9 percent in 

August 1998 from 82.7 percent a year earlier. Grubb & 

Ellis indicates that the Salt Lake City hotel market is 

nearing saturation. Many new hotel developments in 

1997 were smaller-budget or business-oriented projects 

that have lower development costs than the larger properties. Although the new hotel space will be needed for 

the 2002 Olympics, additional hotel expansion may not 

be economically feasible. 

Community Banks Have High 

C&D Loan Exposure 

The top four non-credit-card banks in Salt Lake City 

control nearly 54 percent of the MSA’s deposits; however, only 4.1 percent of their assets are in C&D loans. 

Conversely, the MSA’s community banks have the highest exposure to C&D loans of the 

four MSAs highlighted in this article. Although the C&D loan 

growth rate has slowed from 49 

percent in 1996 to less than 1 percent through third-quarter 1998, 

C&D loans for Salt Lake City 

community banks are 15.2 percent 

of total assets, almost triple the 5.7 

percent figure for the Region. 

More than half of the MSA’s 11 

community banks have C&D loan 

exposure of at least 15 percent of total assets. Historical 

evidence indicates that, in the aggregate, San Francisco 

Region community banks with greater than 15 percent 

C&D exposure could face substantial pressure during 

economic downturns. 

San Francisco Regional Outlook 29 First Quarter 1999 
Regional Perspectives
 

Conclusion 

Salt Lake City appears to be in the beginning stages of 

an adjustment period, one in which CRE activity may 

slow as a result of slower economic growth. This slowing may reduce the amount of new space coming on the 

market. However, it may also affect the city’s ability 

to absorb new and existing office space. The situation is 

complicated by the fact that Salt Lake City’s community banks have unusually high levels of C&D loan 

exposure. 

Portland 

Real Estate Markets Show Signs of 

Overheating despite a Slowing Economy 

In 1998, several of Portland’s CRE markets—office, 

hotels, and industrial—appeared to be at or near the top 

of the CRE business cycle. The supply of new space in 

these markets outpaced demand in 1998 and is expected to do so in the future. As a result, vacancy rates will 

be driven upward and rents and prices downward. 

Because these conditions exist in several property types, 

Portland was identified in the In Focus article as a market that may be vulnerable to potential overbuilding. 

Economy Has Been Hurt as the 

Asian Crisis Continues 

Portland’s economic boom in the mid-1990s can be 

traced largely to the rapid expansion of the high-tech 

sector, aptly named the “Silicon Forest.” The surge in 

semiconductor investment and plant construction triggered rapid growth in the local economy and played a 

key role in driving construction activity and the CRE 

market boom. In 1998, however, Portland lost 3,100 

manufacturing jobs. The losses were centered in the 

high-tech and electronics industries, which have been 

hit hard by the slowdown in exports to Asia. Nearly half 

of Portland’s exports (in dollar value) are high-tech or 

aerospace products.3 In 1997, the Portland MSA ranked 

13th in the nation in exports among metropolitan areas; 

it accounted for about 90 percent of Oregon’s $10 billion in exports. Agricultural and forest products also 

have been hurt by the decline in exports after mid-year 

1997. 

3 See Regional Outlook, second quarter 1998, for additional details on 

Oregon’s and the Region’s exposures to Asian exports. 

Portland’s economy has been slowing along with that of 

Oregon, and job growth slowed markedly in 1998, as 

shown in Chart 4. The decline was a sharp contrast with 

the growth rates of 3.7 percent or better that the MSA 

experienced from 1993 through 1997. In 1999, RFA 

projects that Oregon and the Portland MSA will add 

jobs at rates of 1.0 and 1.1 percent, respectively. Despite 

the slowdown, major players in the construction industry remain optimistic about current and future business; 

one builder noted, “It’s simply not turbo-charged like it 

was a few years ago.” 

An Abundant Supply of Commercial 

Real Estate in the Pipeline 

Despite the optimism, the weakness in the Portland 

economy in the past year is influencing conditions in the 

real estate markets. Before 1998, Portland’s office market had been robust, with a steady rise in new construction activity, very rapid absorption of new properties, 

and declining vacancy rates, as shown in Chart 5. CBC 

reported a vacancy rate of 5.6 percent as of June 1998, 

the lowest since 1980. However, as the economy has 

begun to slow, new office supply 

may begin to outstrip demand, 

according to CBC. In the first 

half of 1998, new office construction starts outpaced year-ago 

starts by 249,000 square feet. 

While construction activity accelerated, demand for office space 

may be softening; the growth rate 

of office jobs, which was close to 

6 percent per year from 1992 to 

1997, fell to just over 3 percent in 

1998. With increased supply and 

reduced absorption of office space, the vacancy rate in 

the year 2000 is expected to be 6.7 percent, which is still 

below the projected second quarter 1998 national 

vacancy rate of 9.4 percent. Because of the robust new 

office construction expected over the period from 1998 

to 2003, CBC predicts Portland will add an average of 1 

million square feet of office space per year, pushing the 

vacancy rate to more than 11 percent in 2003. This 

increase in new office space is expected to drive up 

vacancy rates and hold down rental rates. Finally, softening in the Portland economy in 1998 may add to the 

downside risks, if the addition of fewer office jobs 

reduces absorption of office space. 

Portland also has experienced a hotel construction 

boom. In the first half of 1998, seven new hotels, with 

San Francisco Regional Outlook 30 First Quarter 1999 
Regional Perspectives
 

a total of more than 1,000 rooms, opened in the Portland 

area. This increased supply of hotel rooms appears to be 

affecting market fundamentals and raising concerns 

about overbuilding. According to The Business World, 

Portland’s business journal, occupancy rates for hotel 

rooms in downtown Portland are falling more than room 

rates are rising. As of August 1998, the occupancy rate 

for downtown hotels stood at 82.2 percent, down 5.1 

percent from a year earlier. For the same period, room 

rates climbed only 4.1 percent. Moreover, the increase 

in hotel rooms has prompted Wolfgang Rood of 

Gordon/Rood Hospitality Consulting, Bellevue, Washington, to predict that downtown occupancy rates will 

trend downward over the next two or three years while 

room rates remain flat. Finally, slower economic growth 

forecast for Portland may reduce both business and 

pleasure travel. 

Portland’s industrial market also shows some signs of 

overheating. The vacancy rate, as reported by CBC, bottomed out at 3.9 percent in 1996. As of June 1998, the 

vacancy rate rose to 5.5 percent, and new construction 

starts for warehouses, which make up more than 70 percent of Portland’s industrial market, were on the rise. 

New industrial construction starts rose from a postrecession low of 325,000 square feet in 1992 to 3,780,000 

square feet in 1997. The pace of construction starts in 

this market declined somewhat in the first half of 1998 

compared with the first half of 1997, which may be a 

sign of developers pulling back projects in the face of 

changing market conditions. Still, the CBC forecast 

over the next six years shows new supply exceeding 

annual absorption; the vacancy rate is expected to rise 

gradually to 8.9 percent, while the growth of rental rates 

is predicted to slow. Conditions in this market could 

deteriorate further if the downturn in both exports and 

high technology continues to worsen and reduces the 

demand for industrial and warehouse space. In contrast, 

Portland’s retail real estate market has been in an expansion phase but does not appear to be overheating like the 

other markets. 

Community Bank Exposure to a 

CRE Downturn Is High 

Portland community banks’ relatively high levels of 

exposure to CRE lending have become more important 

as the real estate boom ages and the area’s economy 

slows. Because of their relative lack of geographic 

diversity compared with larger multistate banking companies and relatively high exposure to C&D loans, community banks in Portland could be materially affected 

by a downturn in the local real estate market. As shown 

in Chart 1, C&D loans account for 9.2 percent of their 

total assets as of September 30, 1998, much higher than 

the comparable figures of 5.7 and 

3.3 percent for the Region and 

nation, respectively. In addition, 5 

of the 14 community banks in the 

Portland MSA have C&D loans 

greater than 15 percent of total 

assets. Community banks in the 

Portland MSA have combined 

construction, commercial, and multifamily real estate 

loans totaling more than 30 percent of their total assets, 

which also is high relative to the Region and nation. 

Finally, 6 of the 14 community banks in the Portland 

MSA were chartered in the past five years. The high 

levels of exposure to the construction and CRE sectors, 

and the large number of new banks, clearly increase the 

vulnerability of Portland banks to a downturn in real 

estate activity. 

Conclusion 

Several areas of commercial real estate in Portland— 

office, hotel, and industrial—have been expanding very 

rapidly and appear vulnerable to overbuilding. The risk 

of overbuilding also has risen because of the softening 

in Portland’s economy, which will slow absorption of all 

types of new properties. Finally, community banks in 

the Portland MSA are much more highly exposed to 

construction and CRE lending than their peers in the 

Region or the nation. 

Phoenix 

Robust Growth Continues despite 

Vulnerable High-Tech Sector 

The Phoenix MSA is in the top ten nationally in the 

development of industrial, hotel, and retail space. 

Phoenix also has recently shown strong development of 

office space. The Phoenix MSA, like the Las Vegas 

MSA, is one of the fastest growing in the United States, 

with 4.6 percent payroll employment growth in the 12 

months ending December 1998 (see Chart 4). Strong 

employment growth in technology and services, as well 

as affordable housing prices, has spurred population inmigration, primarily from Southern California. However, the growth in technology over the past decade has 

made the MSA more susceptible to global developments affecting this industry, and the Asian financial 

San Francisco Regional Outlook 31 First Quarter 1999 
Regional Perspectives
 

crisis is beginning to affect technology employment. 

Two of Phoenix’s largest employers, Motorola and Intel, 

have cut a combined 4,000 jobs nationwide, according 

to RFA. These layoffs could slow Phoenix’s employment growth and lead to slower absorption of office, 

industrial, and retail space. Because of Phoenix’s 

strong, broad-based real estate development, significant 

technology-sector exposure, and history of real estate 

booms and busts, the area also is susceptible to potential overbuilding. 

The global turmoil affecting some technology companies will likely hurt Phoenix’s industrial property market. This market has been strong throughout the 1990s 

because of relocating companies and technology 

employment growth. The rapid 

construction that occurred during 

1996 and 1997 moderated through 

the second quarter of 1998 as the 

absorption of space slowed. Completed square footage declined 

more than 78 percent from the 

second quarter of 1997, and CBC 

projects that 1998 completions 

will decline about 33 percent from the year-end 1997 

level. The industrial vacancy rate, which has hovered 

between 6 and 8 percent since 1993, remains relatively 

low at 7.2 percent. Absorption of space, which has 

declined significantly since 1996, could continue to be 

affected by the Asian crisis and technology-sector overcapacity problems. 

Phoenix’s expansion as a tourist destination has spurred 

strong construction of new retail and hotel space. The 

Phoenix MSA was ranked sixth among the 54 CBC 

markets in growth of retail space from 1990 to 1997. 

According to F.W. Dodge, retail construction starts 

increased more than 12 percent from second-quarter 

1997 to second-quarter 1998. Retail vacancy rates, currently above the national level of 8.1 percent at 10.3 percent, are expected to remain close to this level through 

the year 2000, according to CBC. In addition, Phoenix 

added an estimated 6,064 hotel rooms in 1998, according to a Paine Webber research report, making it the 

third most rapidly expanding hotel market in the United 

States. 

After several years of stagnant construction activity, the 

Phoenix office market expanded rapidly during 1997 

and through second-quarter 1998. Until 1997, absorption of new space had outpaced completions in this 

market since 1991; however, completed square footage 

of office space has increased more than 11 percent since 

second-quarter 1997, and CBC estimated a 62 percent 

increase in completed square footage by year-end 1998. 

The office vacancy rate, currently below the national 

average at 8.8 percent, was expected to rise to more than 

10 percent by year-end 1998, which would be the first 

time it has exceeded 10 percent since year-end 1995. In 

addition, F.W. Dodge reports that more than 15 million 

square feet of office space is in the planning stages, 

indicating that construction of new space could remain 

strong through 1999. 

The current building boom in Phoenix has presented 

increased C&D lending opportunities to the 49 insured 

financial institutions with branches in the MSA. While 

the 29 community banks in the Phoenix MSA have 

grown their C&D portfolios significantly in the past 

several years, their exposure to C&D loans remains well 

below that of similar-sized institutions in Las Vegas, 

Salt Lake City, or Portland. Four community banks do 

have C&D loans totaling more than 15 percent of total 

assets, but aggregate C&D loan exposure to total assets 

is only 4.8 percent, well below the year-end 1988 high 

of 12.2 percent (see Chart 1). The exposure is slightly 

higher, at 5.6 percent of total assets, for the 13 institutions chartered within the past five years, 9 of which 

were chartered in 1997 or 1998. 

Conclusion 

While the Phoenix office market had not experienced 

significant construction activity until 1997, the hotel 

and retail markets appear to be moving toward a period of increasing supply, which could adversely affect 

vacancy and occupancy rates in 1999. In contrast, the 

industrial market has seen construction activity 

decline as absorption of space has slowed. This market, because of the Asian crisis and uncertainty in the 

technology sector, could be negatively affected in 

1999; however, supply appears to be much more flexible in the industrial sector than in other real estate 

market sectors, so overbuilding could be less of a concern in this market segment. In aggregate, community 

bank exposure is not near the level seen in the other 

three San Francisco Region markets discussed in this 

article, and it is well below the level noted in 1988, 

before the area’s last severe real estate recession. However, given the high percentage of banks chartered 

within the past two years in this market and the rising 

exposure levels in these newer institutions, the 

Phoenix market should be monitored closely for future 

real estate sector problems. 

San Francisco Regional Outlook 32 First Quarter 1999 
Regional Perspectives
 

Summary 

This article identifies four MSAs as vulnerable to overbuilding because of rapid CRE development in recent 

years. Even though the current pace of CRE activity is 

different in each of the four MSAs, construction projects coming on line and in the planning stages represent a substantive increase in supply. The two 

fast-growing MSAs, Las Vegas and Phoenix, may be at 

risk for sustained overbuilding, as CRE development 

continues to rise in economies that show no sign of 

slowing despite uncertainties surrounding national CRE 

market trends. The two slowing MSAs, Portland and 

Salt Lake City, are beginning to show signs of softening 

in CRE development, and the weakening economies 

may decrease absorption of new space at a time when 

ample supply is coming onto the market. 

Real estate disequilibrium, caused by overbuilding or a 

change in economic circumstances, could pose a risk to 

insured institutions actively supplying C&D financing. 

Community banks in the Salt Lake City, Las Vegas, and 

Portland MSAs have C&D loan exposure significantly 

above that of other major metropolitan areas in the 

nation. Managers of insured institutions, especially 

newly chartered ones where C&D activity is strong, 

should closely monitor local real estate market conditions and C&D lending exposures to avoid undue concentrations in this potentially volatile product. 

San Francisco Region Staff 

A special thanks for contributions by Thuan Le, Financial 

Economist, Division of Research; and the Division of Insurance Regional Offices in Atlanta, Kansas City, and New York. 

San Francisco Regional Outlook 33 First Quarter 1999 
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