Outlook
 

SPRING 2003 

In Focus This Quarter 

The banking industry has fared well overall in a slow-growth economic 

recovery. Higher fee income and wide interest margins have thus far more 

than compensated for rising loan loss provisions. But the road to recovery 

from the 2001 recession has proved to be long and uneven. The downturn 

was dominated by the problems of the corporate sector, and the recovery 

continues to be slowed by restructuring in a number of troubled industry 

sectors. A rebound in business investment and employment has been slow 

to develop, and credit quality problems persist in commercial loan portfolios. At the same time, expansionary monetary and fiscal policies have 

helped to keep consumer spending strong in the absence of significant job 

growth. Progress in resolving the uncertainties associated with terrorism, 

Iraq, and corporate governance reform appears to be the key to establishing 

a stronger and more balanced economic recovery in 2003. See page 4. 

By Staff of the Risk Analysis Branch 

Atlanta—The Region struggled in 2002 to emerge from 

the recession. However, exposure to certain stressed 

industries could weaken the recovery and contribute to 

further deterioration in insured institution asset quality. 

See page 12. 

Chicago—Amid improving economic and generally 

healthy banking conditions, the evolving nature of 

residential lending may be challenging some lenders’ 

risk management systems. See page 16. 

Dallas 

Midsouth—Job losses slowed in the manufacturing 

sector and overall. Credit quality deterioration abated 

and earnings improved among the area’s insured institutions. However, option risk appears to be increasing 

in the securities portfolio. See page 21. 

Southwest—Continued weak employment growth 

could contribute to deterioration in residential loan 

portfolios, particularly in markets in which home price 

appreciation outpaces household income. See page 24. 

Kansas City—The nation’s largest banks have benefited 

from inflows of deposits during the recent recession. 

However, growth of noncore funds continues to outpace 

increases in core deposits among the Region’s community 

banks. See page 28. 

New York 

Mid-Atlantic—Insured institutions headquartered 

in metropolitan areas that lagged national employment 

trends reported generally favorable conditions. However, 

if local economies remain sluggish, credit quality could 

weaken. Securities gains by large banks partially offset 

declines in market-sensitive revenues. See page 32. 

New England—Insured institutions continue to report 

sound conditions. Rates of home price appreciation 

may be unsustainable in some of the Region’s markets, 

but the potential that home prices will decline is 

modest. See page 37. 

San Francisco—Home price appreciation may slow 

in some areas because of weak employment and low 

affordability. Shifts in mortgage portfolio composition 

and changes in underwriting standards may challenge 

lenders in certain markets. See page 42. 

By Staff of the Regional Operations Branch 

Regional Perspectives 

San 

Francisco 

Kansas 

City 

Dallas Atlanta 

New 

York 

Chicago 

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

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

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

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

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

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

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

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

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

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

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

John Anderlik, Regional Manager, 816-234-8198 

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

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

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

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

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

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

to insured institutions nationally and in each FDIC region. 

Single copy subscriptions of the FDIC Outlook can be obtained by sending the subscription form found on 

the back cover to the FDIC Public Information Center. Contact the Public Information Center for current 

pricing on bulk orders. 

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

or to provide comments or suggestions about FDIC Outlook, please call Rae-Ann Miller at 202-898-8523 or 

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

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

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

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

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

Corporation. 

Chairman Donald E. Powell 

Director, Division of Insurance 

and Research 

Arthur J. Murton 

Executive Editor Maureen E. Sweeney 

Managing Editor Kim E. Lowry 

Editors Rae-Ann Miller 

Richard A. Brown 

Ronald L. Spieker 

Publications Manager Teresa J. Franks 
Letter from the Executive Editor 

To the Reader: 

The goal of the Regional Outlook is to provide useful, risk-focused information to bankers, examiners, 

financial regulators, policy makers, and the public. To strengthen these efforts, we are moving to a single 

issue format that tells the national economic and banking story and, at the same time, relates this story 

to regional economic and banking trends. The new format continues to give us flexibility to include 

feature articles about issues that may affect all insured institutions as well as provide analysis of trends 

affecting banks and thrifts in specific geographic areas. 

In addition, in response to feedback from our readers, we are pleased to offer FDIC State Profiles, a 

new, Internet-based publication. In an executive summary format, this publication provides an analysis 

of state-level economic and banking trends and financial performance data on institutions domiciled 

within each state. FDIC State Profiles have been provided to bankers at outreach events during the 

past year and have been well received. State Profiles can be found at www.fdic.gov. 

And finally, in light of the change in format and in line with our goal of providing forward-looking 

information about the national and regional economies and banking sectors, we are changing the name 

of our publication to FDIC Outlook. After you have read this edition, we would like to hear from you. 

Your feedback is essential as we strive to improve how we present risk-related information. E-mail your 

comments to rmiller@fdic.gov. 

Sincerely, 

Maureen E. Sweeney 

Executive Editor 
In Focus This Quarter 

Resolving Uncertainties in the U.S. Economic 

Outlook 

Introduction 

Most economic analysts would agree that the recession 

that began in March 2001 probably ended in early 

2002. Based on current data, it appears that the U.S. 

economy has expanded for five consecutive quarters, 

beginning in the fourth quarter of 2001, following three 

quarters of contraction. U.S. gross domestic product 

(GDP) grew at an inflation-adjusted rate of 2.4 percent 

during 2002, far outpacing the 0.3 percent rate of 

growth in 2001. 

Why the delay in declaring an end to the recession? 

Business cycle turning points are officially designated 

by the Business Cycle Dating Committee of the 

National Bureau of Economic Research (NBER). 

The official designation of the beginning or end of a 

recession is typically made some months after the fact, 

once revisions have been made to the relevant data. 

The NBER bases its calls on four main indicators: 

industrial production, real income, wholesale-retail 

sales, and employment. While the first three indicators 

were generally positive in 2002, the fourth—and 

arguably most important—indicator has not yet turned 

decisively upward. Accordingly, the NBER released a 

statement on February 12 saying that “additional time 

is needed to be confident” as to the direction of the 

economy.1 The lack of net job growth in 2002 has 

prompted comparisons with the recovery of 1991–92, 

the so-called jobless recovery. 

Why the sluggish recovery? In spite of a strong 

performance by consumers and homebuyers, as well as 

considerable monetary and fiscal stimulus, two factors 

account for the lackluster recovery. One factor is the 

ongoing problems of the corporate sector. Earnings 

growth overall has been slow in a difficult operating 

environment, and certain troubled industry sectors are 

undergoing painful restructuring. At the same time, 

significant progress is being made toward leaner cost 

structures, lower levels of indebtedness, and improved 

profit margins—factors that should lead to greater 

hiring and investment spending and an improvement 

1 The NBER statement can be found at http://www.nber.org/cycles/ 

recessions.html. 

in corporate credit quality once the U.S. economic 

recovery gathers momentum. 

A greater impediment to the current economic recovery appears to be the uncertainties associated with 

terrorism, Iraq, and corporate governance reform. 

These uncertainties make it difficult for investors and 

business executives to price transactions and make 

investment plans, thereby slowing economic activity. 

Although the banking industry on the whole has fared 

well in the recent slow-growth environment, bankers 

also must contend with these uncertainties. In a broad 

sense, the outlook for the economy and the banking 

industry in 2003 will be shaped by the progress that is 

made in restructuring troubled industry sectors and 

resolving uncertainties. 

Cleaning Up from the Corporate-Sector Recession 

While each recession is different, most downturns of 

the past 50 years have been associated with supply 

constraints or price shocks that raised inflation and 

interest rates and depressed business investment and 

consumer spending. For the most part, these traditional 

factors appear to be absent in the current downturn, 

with inflation and interest rates remaining at historically low levels. The recession that began in March 

2001 might better be characterized as a corporate-sector 

recession, as most of the bad economic news has been 

corporate news. Corporate profits declined by 2.2 

percent in 2000 and 7.2 percent in 2001 before stabilizing in the first three quarters of 2002. Business investment spending experienced the sharpest decline in a 

quarter century, with nonresidential business investment falling by 5.2 percent and 5.8 percent in 2001 

and 2002, respectively. 

In a sense, this latest downturn may be viewed as a 

product of forces driving the so-called New Economy 

of the late 1990s—as well as its excesses. During the 

expansion, some people used the term New Economy 

to claim that changes in market dynamics and the 

increasing importance of knowledge as a corporate 

asset were rendering traditional accounting methods 

obsolete as a guide to the true economic value of hightech firms. These ambitious claims appear to have 

FDIC OUTLOOK 4 SPRING 2003 
In Focus This Quarter 

largely collapsed with the subsequent large-scale 

decline of equity prices among high-tech firms. 

However, others were using the term New Economy 

to refer to long-term structural changes that were 

taking place in the economy, including increased 

global competition, productivity-enhancing technological innovations, and a greater reliance on marketbased financing.2 These changes appear to have had 

longer-lasting effects, bringing lower inflationary 

expectations, higher productivity, and greater market 

efficiency. The downside of these changes is a very 

difficult operating environment for the U.S. corporate 

sector and a drawn-out period of restructuring for 

troubled industry sectors. 

Global Competition and Slow Revenue Growth 

Corporate revenues and earnings have been hit hard by 

the recession, and, as a result, job growth and business 

investment in this recovery have been significantly 

weaker than the historical norm (see Chart 1). Global 

competition was a driving force behind the investment 

in new technologies and growth in merger activity in 

the late 1990s that helped U.S. corporations cut costs. 

But as inflation rates declined, global competition has 

increasingly placed downward pressure on output 

prices—first in manufacturing but increasingly in other 

sectors. Import prices for capital goods and consumer 

goods other than automobiles have fallen consistently 

since the mid-1990s. 

As a result, revenue growth has slowed or even become 

negative. Output prices measured by the core producer 

price index (PPI) grew by a mere 0.1 percent in 2002, 

down from 1.4 percent in 2001. Net sales for S&P 500 

companies grew by only 0.7 percent in the first three 

quarters of 2002 from the same period in 2001. Net 

income for the S&P began to recover slowly in the 

second half of 2002, after declining for five consecutive 

quarters.3 However, this modest recovery in earnings 

growth appears to be largely attributable to cost cuts 

and layoffs, which have hurt job growth and business 

investment spending. 

Equity Market Bubble and Corporate Governance 

Scandals 

During the period of rising stock prices leading up to 

early 2000, new companies by the hundreds issued 

equity to the public, while mature companies stayed 

ahead of competitors by investing heavily in new 

equipment and merging with rivals. This activity 

sparked a boom for financial markets and institutions 

that facilitated these transactions. Between 1997 and 

2000, more than 1,500 new companies issued equity 

shares to the market. Corporate debt issuance totaled 

about $ 3.6 trillion during this period, and 36,175 

mergers were consummated, with a total deal value 

of $4.6 trillion.4 At the time, this dynamic appeared 

to be a relatively healthy response to the challenges 

of intense competition and changing technologies, 

Chart 1 Index of Equipment and Software Investment 

Recovery in Equipment and Software Investment Has Been More Subdued than in Past Recessions 

* Treats the 1980s double-dip recession as one. 

Source: Bureau of Economic Analysis 

100 

105 

70 

75 

80 

85 

90 

95 

–8 –7 –6 –5 –4 –3 –2 –1 0 1 2 3 4 5 6 7 8 

Quarters Before/After the Onset of Recession 

2001 Recession 

Average of Past Five Recessions (1960–1991)* 

2 See “Banking Risks in the New Economy,” Regional Outlook, second 

quarter 2000, 3–13, http://www.fdic.gov/bank/analytical/regional/ 

ro20022q/na/index.html. 

3 As of mid-February 2002, Thomson First Call was estimating that 

earnings for S&P 500 companies had increased by about 11 percent 

in the fourth quarter of 2002 from the same quarter a year earlier. 

4 Data from IPOHome (www.ipohome.com/marketwatch/review/ 

2002main.asp), Haver Analytics, and Mergerstat (www.mergerstat.com). 

FDIC OUTLOOK 5 SPRING 2003 
In Focus This Quarter 

allowing new companies to pursue opportunities and 

older companies to restructure operations. 

Despite the efficiency with which the financial markets 

facilitated these transactions, the collapse of the technology bubble and recent corporate governance scandals exposed serious flaws in the system. In retrospect, 

stock valuations based on so-called intangible assets 

were largely illusory. A series of corporate scandals 

revealed earnings overstatements and conflicts of interest involving senior management, boards of directors, 

auditors, investment bankers, and equity analysts. Just 

as the investing public was becoming comfortable with 

the idea of buying and holding equities for the long 

run, serious questions were raised about the quality of 

information upon which investment decisions are made 

and the trustworthiness of major players in the capital 

markets. Reflecting investor wariness, equity prices 

remain depressed. The tech-heavy National Association of Securities Dealers Automated Quotations 

(NASDAQ) index currently trades about 75 percent 

below its March 2000 peak. In sum, the market value 

of equity shares traded on U.S. exchanges has fallen by 

about $7.5 trillion since early 2000. 

Industrial Overcapacity 

Many companies in the fastest-growing industries of the 

late 1990s used low-cost debt and equity capital to 

invest in new technologies and expand productive 

capacity. Annual U.S. growth in real spending on 

equipment and software averaged over 10 percent 

between 1993 and 1999. But by the late 1990s, companies found themselves with excess capacity as demand 

fell short of expectations. The overall capacity utilization rate for U.S. industries fell sharply beginning in 

third quarter 2000, hitting bottom at 74.6 percent in 

December 2001 and improving only a little in 2002. 

High-tech industries—telecommunications in particular—have experienced a rapid and uninterrupted 

decline in capacity utilization since mid-2000.5 The 

capacity utilization rate for the communications equipment industry stood at only 49.2 percent as of December 2002. 

Wide Credit Spreads 

While low stock prices have significantly raised the 

cost of equity financing for publicly traded firms, a 

sharp rise in risk premiums in corporate bond markets 

5 High-tech industries include computer and office equipment, 

communications equipment, and semiconductors and related 

electronic components. 

has also increased the cost of debt financing. In particular, yield spreads between investment-grade and speculative-grade bonds widened significantly, signaling 

volatility in the capital markets. The yield spread 

between speculative-grade and investment-grade bonds, 

which was approximately 300 basis points in mid-1999, 

rose as high as 800 basis points following the September 2001 terrorist attacks and remained near 600 basis 

points as of early 2003.6 This adverse trend in the 

credit markets was especially bad news to low-rated 

firms that needed to roll over maturing debt, and many 

of them were forced to default on their loans. 

Lower investor confidence affected not only speculative-grade borrowers but also some investment-grade 

borrowers. For example, the commercial paper market, 

which many investment-grade borrowers have used as 

a cheap source of funding, also appeared to be characterized by a higher degree of risk aversion beginning 

in early 2000.7 After reaching a peak of $351 billion 

outstanding in November 2000, the volume of 

commercial paper outstanding issued by nonfinancial 

companies had shrunk dramatically to $153 billion 

by January 2003. Some companies, fearing that sources 

of liquidity would not be available, secured term-out 

options for revolving lines of credit or backup commercial paper lines as a secondary source of liquidity.8 

Impaired Credit Quality 

Among the most telling measures of corporate distress 

are default rates and ratings trends on corporate bonds. 

The total default rate for U.S. bond issuers, which 

peaked in the last recession (March 1991) at a recordhigh 5.1 percent, rose again in the recent recession to 

as high as 4.9 percent (January 2002).9 The increase in 

default rates over the past two years has been attributed 

primarily to the low-quality issuers that came to market 

in the late 1990s. From 1996 to 2000, some 33 percent 

6 Data from Merrill Lynch Global Bond Indices, Bloomberg.com. 7 For a discussion on liquidity concerns in the commercial paper 

market see “The Road to Recovery for Commercial Credit Quality: 

Not without a Few Hurdles Ahead,” FDIC Regional Outlook, third 

quarter 2002, 3–8. http://www.fdic.gov/bank/analytical/regional/ 

ro20023q/na/index.html. 

8 A term-out option allows the borrower to convert the revolving 

credit, which generally matures in one year or less, into a term loan 

and repay it over a longer period of time. A commercial paper backup 

line is a commitment to provide a liquidity support for a company’s 

commercial paper program. The rationale is that the borrower does 

not intend to use the backup line, which generally costs more than 

issuing commercial paper, unless the commercial paper cannot be 

rolled over or repaid. 

9 Issuer-based default rates used here are 12-month trailing default 

rates calculated by Moody’s Investors Service. 

FDIC OUTLOOK 6 SPRING 2003 
In Focus This Quarter 

of new issuers were rated B+ or below. Already, 31 

percent of those issues have defaulted. Of those that 

remain, 61 percent are rated B+ or below, and 20 

percent are rated B– or below.10 But investment-grade 

issuers have also experienced higher default rates. The 

investment-grade default rate rose to a record high of 

0.2 percent in 2001 and promptly set a new record with 

a default rate of 0.5 percent in 2002. Last year was also 

a record year for “fallen angels,” as some 70 investmentgrade companies with debt totaling over $200 billion 

were downgraded to junk status.11 On average, there 

were 18 new fallen angels per quarter in 2002—three 

times the quarterly average between 1995 and 2000. 

Following a record high of 257 Chapter 11 bankruptcy 

filings by public companies in 2001, another 191 public 

companies filed for bankruptcy in 2002. The most 

common factor that ultimately causes companies to file 

for bankruptcy is a liquidity crisis brought on by financial weakness or suspicion of fraud. Moody’s reports 

that 652 U.S. companies experienced ratings downgrades in 2002 (with a deterioration in liquidity being 

the most common cause), while ratings upgrades 

numbered just 132 (see Chart 2). Still, companies that 

have remained highly rated have managed to take 

advantage of the benefits of lower interest rates. Total 

issuance of corporate bonds was a record 1.25 trillion 

in 2001, a level that declined only modestly over the 

first three quarters of 2002. 

Chart 2 

Consumers Lead the Economic Recovery 

Despite the problems of the corporate sector, strong 

growth in consumer spending and residential real estate 

activity kept the recession relatively short and mild. 

Real consumer spending grew by 2.5 percent in 2001 

and 3.1 percent in 2002—a vastly better performance 

than during the last recession. Consumer spending 

accounted for nearly 90 percent of all economic growth 

in 2002, as the recovery began to take hold. Key factors 

supporting consumer purchasing power during this 

period have included low inflation, aggressive monetary 

and fiscal stimulus, and the continued productivity 

gains that are a byproduct of corporate restructuring. 

Monetary policy has played a central role. After holding the federal funds target rate at 6.5 percent during 

the last half of 2000, the Federal Reserve reduced the 

rate eleven times in 2001, totaling 475 basis points. 

The additional 50-basis point rate cut in November 

2002 brought the federal funds rate down to 1.25 

percent. This aggressive policy of rate easing (fortuitously initiated two months before the recession officially began) pushed short- and long-term rates down 

to levels not seen for 40 years, which helped boost 

consumer spending in durable goods and housing. 

In this favorable interest rate environment, many 

consumers have been able to reduce debt service and 

Percent 

Credit Quality Impairment in 2002 Nearly Matched Previous Recession Levels 

Source: Moody’s 

U.S. Corporate Bond Ratings, Downgrades to Upgrades (R) 

0 

2 

4 

6 

8 

10 

12 

14 

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 

0 

1 

2 

3 

4 

5 

6 

Ratio 

U.S. Speculative-Grade Bond Issuer Default Rate (L) 

10 “Corporate Defaults Peak in 2002 Amid Record Amounts of Defaults
 

and Declining Credit Quality—Hazards Remain,” Standard & Poor’s,
 

January 23, 2003.
 

11 Credit Trends Weekly Commentary, Moody’s Investors Service,
 

January 20, 2003.
 

FDIC OUTLOOK 7 SPRING 2003 
In Focus This Quarter 

maintain household spending by refinancing existing 

mortgages at a lower interest rate. Homeowners refinanced some $2.58 trillion single-family mortgages 

in 2001 and 2002, in many cases reducing monthly 

debt payments.12 Many refinancing borrowers also 

chose to liquefy some of the built-up equity in their 

homes by “cashing out” an estimated $145.3 billion. 

In addition, homeowners added roughly $150 billion 

to home equity lines of credit and $161.7 in nonresidential consumer debt during this two-year period.13 

A recent study by the Federal Reserve estimates that 

refinancing activities may have contributed some 

$23 billion to consumer spending between January 

2001 and March 2002.14 

Fiscal easing, in the form of the 2001 Economic Growth 

and Tax Relief Reconciliation Act, also turned out to be 

extremely well-timed. Tax rebate checks totaling $38 

billion were mailed in mid-2001; they appear to have 

arrived near the deepest part of the downturn but before 

the recession was generally recognized. In addition, 

personal income tax cuts that took effect in 2002 helped 

offset weaker gains in wages and salaries. Personal tax 

and non-tax payments fell by 13.5 percent in nominal 

terms in 2002—the largest annual decline since World 

War II.15 Unemployment insurance benefits provided 

additional financial support to the household sector. 

Government unemployment insurance payments rose 

from $20.5 billion in 2000 to $31.9 billion in 2001. 

With the extension of eligibility for federal unemployment benefits in March 2002, these transfer payments 

nearly doubled in 2002 to $62.9 billion. 

Even without the increase in federal unemployment 

benefits, personal income more or less held ground 

throughout the downturn. Although real total labor 

income declined in the second half of 2001 and the 

first quarter of 2002, it still managed to grow slightly 

on an annual basis during both years. By comparison, 

real total labor income fell on an annual basis during 

each of the past three recessions. The ability of real 

incomes to continue growing throughout the downturn 

12 Mortgage Finance Forecast, Mortgage Bankers Association of
 

America, January 7, 2003.
 

13 “The Economic Contribution of the Mortgage Refinancing Boom,”
 

Economy.com, December 2002, and the Board of Governors of the
 

Federal Reserve System Consumer Credit Report (G.19).
 14 Canner, Glenn, Karen Dynan, and Wayne Passmore, “Mortgage
 

Refinancing in 2001 and Early 2002,” Federal Reserve Bulletin,
 

December 2002, http://www.federalreserve.gov/pubs/bulletin/2002/
 

1202lead.pdf.
 

15 Non-tax payments to the federal government include a variety of
 

fees, penalties, donations, and unclaimed bank deposits. 


in part reflects a combination of two key factors: low 

inflation, which increased the consumer’s purchasing 

power, and large increases in productivity, which 

supported wage gains. The productivity of the business 

sector, as measured by output per hour, rose by 4.7 

percent in 2002, the highest annual increase in over 

50 years (see Chart 3). These gains in labor productivity help to explain why the total compensation of 

salaried workers rose 3.4 percent last year, or more 

than twice as fast as the rate of inflation. 

A long-term increase in rates of productivity growth 

may be one of the lasting contributions of the New 

Economy. Although it is often accomplished through 

job cuts, as firms find ways to produce more with fewer 

workers, rising productivity growth over the long term 

makes the pie bigger in terms of corporate profits, 

labor compensation, lower consumer prices, or some 

combination of the three. In recent years, households 

appear to have captured much of the gains of higher 

productivity through lower prices and high rates of 

wage growth. The flip side of these gains, however, 

has been the near absence of net job growth—a fact 

that places the financial burden of corporate restructuring disproportionately on a relatively small number 

of U.S. households. 

Banks Fare Well in the Slow-Growth Recovery 

Thus far, the 2001 recession has had a limited net 

effect on the profitability of the U.S. banking industry. 

Despite significantly higher credit losses associated 

primarily with commercial loans to large corporate 

borrowers, U.S. commercial banks earned a record 

$23.4 billion in the second quarter of 2002, a mark 

that was nearly equaled in the third quarter. Insured 

thrift institutions managed to set earnings records in 

both the second and third quarters, at $3.9 billion 

and $4.0 billion, respectively. 

Three key factors have helped to insulate the banking 

industry from the full effects of the corporate sector 

recession. One relates to how banks have managed 

risks. With generally strong capital positions and earnings, banks have had an incentive to recognize losses 

promptly and move impaired loans off the balance 

sheet. Chart 4 shows that provisions for loss by the 

industry have slightly exceeded net charge-offs, even 

as loan losses have risen sharply in recent years. In 

addition to reducing problems through charge-off, the 

ability to sell problem loans has been enhanced by the 

FDIC OUTLOOK 8 SPRING 2003 
In Focus This Quarter 

Chart 3 

Labor Productivity Gains Surged in 2002, Extending Strong Gains That Began in the Mid-1990s 

6.0 

Year-over-Year Percentage Change

in Nonfarm Labor Productivity*

5.0 

4.0 

3.0 

2.0 

1.0 

0.0 

–1.0 

1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 

*Output per hour, all persons.
 

Source: Bureau of Labor Statistics
 

development of an active secondary market for loans. 

The 2002 Shared National Credit (SNC) report shows 

that nonbanks hold a disproportionate share of classified syndicated loans, suggesting that banks have been 

successful in selling riskier loans and participating out 

bigger shares to nonbanks. Banks have also managed 

risks in commercial loan portfolios by increasing the 

use of credit derivatives. The total notional value of 

credit derivative positions held by U.S. commercial 

banks has risen from virtually nothing in 1996 to $573 

billion as of September 2002. These instruments have 

proved useful in reducing the net losses imposed on 

banks in large corporate defaults. 

The second key factor mitigating the effect of problem 

loans on net income has been the changing structure of 

the income statement itself. Chart 5 shows that noninterest income rose from 32 percent of net operating 

revenue in 1990 to 43 percent in 2000.16 The increasing influence of noninterest income tends to offset the 

effects that loan loss provisions would otherwise have 

on bottom-line net income. For example, loss provisions totaled 19 percent of net operating revenue in 

both 1990 and 1991, but this ratio was held to just 12 

percent in 2001 and in the first three quarters of 2002. 

Moreover, the benefits of strong fee income have not 

been restricted to large institutions. While revenues 

from capital-market-related activities declined in the 

first three quarters of 2002, fee income related to 

deposit services rose strongly, boosting noninterest 

revenues for the industry as a whole. 

Chart 4 

Loss Provisions Have Outpaced Rise in Net Charge-Offs All FDIC-Insured Institutions ($ Billions) 

Source: FDIC 

Annualized Provision Expenses 

Net Loan and Lease Charge-Offs Annualized 

0 

10 

20 

30 

40 

50 

60 

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 Sept 

2002 

Chart 5 

Portion of Operating Income from Noninterest Sources 

Has Risen Significantly over the Past Decade 

Noninterest Income as Percentage of Total

Operating Income, FDIC-Insured

Commercial Banks 

Source: FDIC 

30 

32 

34 

36 

38 

40 

42 

44 

1989 1991 1993 1995 1997 1999 2001 16 Net operating revenue is defined as the sum of noninterest income 

and net interest income. 

FDIC OUTLOOK 9 SPRING 2003 
In Focus This Quarter 

The third, and perhaps most important, factor in boost- The Importance of Resolving Uncertainties ing bank earnings has been the effect that a steep yield 

curve has had on net interest income. The average 

yield spread between ten-year and six-month Treasury 

instruments in 2002 was 2.94 percent—a full 125 basis 

points higher than the average for 2001 and a level 

that has been exceeded in only two years since 1960. 

The steep yield curve helped raise bank net interest 

income by $19.3 billion during the first three quarters 

of 2002 compared with year-ago levels, significantly 

exceeding the $7.2 billion increase in loan loss provisions and helping boost net income to $68.5 billion 

for the first three quarters of the year. 

The ability of the banking industry to continue to earn 

record profits in the face of commercial loan losses of 

this magnitude is uncertain. However, there are signs 

that the credit quality picture may improve over the 

course of 2003. As noted above, significant progress 

has been made in restructuring troubled industry 

sectors and improving corporate profit margins. A 

pick-up in the pace of economic activity in 2003 

would help this process and could lead to a reduction 

in the number of problem commercial loans on bank 

balance sheets by the end of 2003. One factor that 

should come into play this year is the fact that bank 

lending standards to corporate borrowers have been 

progressively tightened since credit problems began 

to emerge in 2000.17 

Moreover, the factors that have helped to offset rising 

loan loss provisions—namely higher levels of noninterest income and net interest income—should remain 

largely intact over the course of the year. A factor 

that would threaten to impair net interest income is a 

substantial rise in short-term interest rates. Because the 

interest-rate sensitivity of bank portfolios appears to 

have risen in recent quarters, rising interest rates could 

significantly reduce net interest margins, particularly at 

smaller institutions. However, such an outcome would 

be unlikely to take place in the absence of a resurgence 

in economic activity that would bring offsetting positive effects on bank credit quality. So while the course 

of the economy in 2003 remains uncertain, it is reasonable to expect that the offsetting relationship between 

loan loss provisions and the other major components 

of the bank income statement will remain in place for 

the foreseeable future. 

17 See Federal Reserve Board, “Senior Loan Officer Opinion Survey on 

Bank Lending Practices,” http://www.federalreserve.gov/boarddocs/ 

SnLoanSurvey/. 

Before September 11, the greatest uncertainties facing 

the country were economic. When stock prices began 

to decline in early 2000, investors wondered how large 

the market correction would be and how business 

would be affected. Rising unemployment in early 2001 

added job security to the list of concerns on the minds 

of consumers. After September 11, however, a number 

of noneconomic uncertainties emerged. The attack 

itself depressed consumer and business expectations 

for months, and the possibility of additional terrorist 

attacks has heightened the general level of uncertainty 

since that time. If this were not enough, the Enron 

bankruptcy in late 2001 marked the onset of public 

concern about corporate accounting practices that 

would intensify with the emergence of similar episodes; 

in particular, the $100 billion collapse of WorldCom in 

July 2002. During the past six months, the possibility of 

war with Iraq has become a growing source of concern, 

with unclear implications for the price of oil and the 

economy in general. The combined effects of these 

uncertainties is shown in Chart 6, which tracks steady 

declines in both stock prices and consumer confidence 

that began in early 2000 and as yet have shown few 

signs of reversing themselves. 

For consumers and business executives, uncertainty 

complicates spending and investment plans. With 

greater uncertainty, it is harder to accurately predict 

future outcomes, including commodity prices and 

investment returns. If consumers and investors do not 

believe that they have enough experience and information to reasonably anticipate the future, they may 

choose to postpone transactions until the situation 

improves. Uncertainty, then, can impose real costs on 

an economy by delaying consumption and investment 

that would otherwise occur. Although it is not possible 

to quantify the costs of delayed spending and investment, they are widely perceived to be the key impediments to the economic recovery. 

Experience suggests that the prospects for resolving 

these uncertainties during 2003 are reasonably good. 

In the case of governance reforms, the Securities and 

Exchange Commission adopted a set of new rules in 

January 2003 covering corporate disclosure, auditing, 

and conflicts of interest, as required under last year’s 

Sarbanes-Oxley reform legislation. These rules come 

on the heels of new rules filed in 2002 by the New York 

Stock Exchange and NASDAQ that deal with codes 

of conduct, independent directors, audit committees, 

FDIC OUTLOOK 10 SPRING 2003 
In Focus This Quarter 

Chart 6 

Falling Consumer Confidence and Stock Prices Are Signs of Continuing Economic Uncertainty 

1600 

1500 

1400 

1300 

1200 

1100 

1000 

900 

800 

Conference Board Index of Consumer Confidence (1985=100) 

S&P 500 Stock Index, Monthly Close (1941–43=10) 

150 

140 

130 

120 

110 

100 

90 

80 

70 

60 

J F M A M J J A S O N D J F M A M J J A S O N D J FMAM J J A S ON D J FM 

2000 2001 2002 2003 

Source: Conference Board, Wall Street Journal (Haver Analytics) 

and other issues. While observers continue to debate the 

relative merits of these rules and the need for additional 

reforms, these developments mark significant milestones 

in moving beyond the governance scandals of 2001 and 

2002 and restoring investor trust in U.S. corporations. 

With regard to a possible conflict with Iraq, from an 

economic perspective it would clearly be preferable to 

resolve the surrounding uncertainty sooner rather than 

later. A reduction in the general level of uncertainty 

could provide a significant boost to the U.S. economy. 

In this regard, the best historical precedent would be 

the 1991 Gulf War, when a range of economic indicators moved sharply in the positive direction after 

the successful conclusion of the war. For example, 

the Conference Board reported that the expectations 

component of the consumer confidence index rose 

from a cyclical low of 55 in January 1991, as the air 

war in Iraq was beginning, to 101 in March 1991, 

after the successful conclusion of the war. While the 

precise outcome of the current crisis is difficult to 

predict, there are good reasons to believe that this 

particular source of economic uncertainty could be 

resolved in the first half of 2003. 

Staff of the Risk Analysis Branch 

FDIC OUTLOOK 11 SPRING 2003 
Regional Perspectives 

Atlanta Regional Perspectives 

Certain Key Industries Remain under Stress Chart 2 

Job Cuts across the Nation Increased Late in 2002 The Atlanta Region and the nation 

bypassed some local 

markets. The softening in economic 

conditions late in 2002 was reflected in 

the number of layoff announcements 

(see Chart 2), an indication that several industries remained under stress. This article looks at the 

Region’s stressed industries, examines their relative 

importance and geographic location, and assesses 

the implications for community banks headquartered in these areas. 

Following Declines in the Previous Four Quarters struggled to emerge from the recession 700 during 2002 as initial modest 

employment gains earlier in 600 

1Q01 2Q01 3Q01 4Q01 1Q02 2Q02 3Q02 Oct.–Nov. 

2002 

the year gave way to renewed 

Announced Job Cuts (000s)

500 

economic fragility (see 400 Chart 1). The comparative 

weakness of the Region’s 300 

economy was compounded 200 

by the fact that the recov­ 100 ery early in the year 

To provide a framework for our examination of 

the Region’s stressed industries, we grouped the ten 

industries that reported the greatest number of layoffs 

during October and November 2002 into four categories: manufacturing and high-tech, transportation, 

financial services, and government (see Table 1). 

0 

Source: Challenger, Gray, and Christmas, Inc./Haver Analytics 

Exposure to Stressed Industries Varies Widely 

in the Atlanta Region 

The exposure is greatest in the manufacturing and 

high-tech industries, which employed more than 2.3 

million workers in the Region in 2001. The government and transportation sectors each employed more 

than 800,000, while the financial services sector 

employed 645,000. However, the actual impact of 

continued industry weakness in these categories on 

the Atlanta Region economy likely would vary by 

location and an individual company’s financial health. 

To determine the potential exposure in a local economy, we calculated location quotients1 by county for 

each of the weak industries. We can then see where 

industries are concentrated in the Region. 

1 A location quotient measures an industry’s share of local employment 

Chart 1 

Employment in the Atlanta Region 

Has Struggled to Recover 

Employment Index

(March 2001 = 100, Seasonally Adjusted Data)

Atlanta Region 

United States 

Source: Bureau of Labor Statistics/Haver Analytics 

95 

96 

97 

98 

99 

100 

101 

Jan ’99 Jul ’99 Jan ’00 Jul ’00 Jan ’01 Jul ’01 Jan ’02 Jul ’02 

relative to the corresponding national share. Algebraically, the calculation is shown as:
 

Industry Location Quotient (LQ) = 


[Local Industry Employment/Total Local Employment]/ 

[National Industry Employment/Total National Employment]. 

If the calculated ratio is greater than one, an industry is more 

concentrated locally than nationally. As an example, we can 

calculate the telecommunications industry location quotient for 

Gwinnett County, Georgia, as follows: 

Telecom LQGwinnett = 

[Telecom EmploymentGwinnett/Total EmploymentGwinnett]/ 

[Telecom EmploymentUS/Total EmploymentUS] 

Or 

[6,892/315,252]/[2,044,034/146,361,949] 

Telecom LQGwinnett = 152 or the telecom industry is 52 percent more 

highly concentrated in Gwinnett County than at the national level. 

Employment data source: Global Insight, Inc. 

FDIC OUTLOOK 12 SPRING 2003 
Regional Perspectives 

Table 1 

Job Cuts Occurred in Several Key Industries in the Atlanta Region Late in 2002 

October–November Share of Total Cuts 

2002 Announced Job Cuts (%) Share Rank 

Total Announced Job Cuts 333,518 

Manufacturing and High-Tech 

Telecommunications 50,710 15 1 

Computers 42,734 13 2 

Aerospace 23,884 7 6 

Electronics 19,974 6 7 

Industrial goods 17,719 5 8 

Automotive 15,591 5 9 

Consumer goods 13,566 4 10 

Financial 30,419 9 3 

Transportation 29,536 9 4 

Government 28,131 8 5 

Source: Challenger, Christmas, and Gray, Inc./Haver Analytics 

High-Tech and Manufacturing Sectors Displayed 

Renewed Weakness Late in 2002 

The Atlanta Region’s manufacturing sector began to 

show signs of recovery early in 2002; however, by 

summer’s end, industrial payrolls had begun to fall again. 

Weakness in the manufacturing industry was evidenced 

by the fact that the Institute for Supply Management 

manufacturing index has fallen below 50, although it 

only rebounded to slightly above 50 in December 2002.2 

Affected industries ranged from high-tech manufacturing 

sectors, such as telecommunications and computers, to 

traditional industries, such as apparel. 

High-Tech: Telecommunications, Aerospace, 

Electronics, and Computers 

High-tech industries generally have not recovered 

from the significant decline in the NASDAQ and the 

effects of the recent recession, as evidenced by their 

comparatively poor stock performance. During the 

first two months of fourth quarter 2002, the Region’s 

high-tech sector lost more than 135,000 jobs, more 

than 40 percent of job cuts announced nationwide. 

Industry location quotients for several counties in 

large metropolitan areas in the Atlanta Region exceed 

one, an indication of an industry concentration above 

the national average. During the past year, continuing 

layoffs in high-tech industries throughout the Region 

have adversely affected the South Florida, Melbourne, 

Raleigh, and Atlanta metropolitan statistical areas 

2 An index of 50 or above indicates that the manufacturing sector is 

expanding; an index below 50 indicates that the sector is contracting. 

(MSAs). Further layoffs in these industries could 

constrain the economic recovery in these areas, especially as the effects of these layoffs are felt throughout 

the local economies.3 

Manufacturing: Consumer Goods, Industrial, 

Automotive 

Employment in the consumer goods, industrial, and 

automotive sectors is more highly concentrated in rural 

and smaller metropolitan areas of the Atlanta Region 

than employment in high-tech industries. Consumer 

goods include the production of furniture, a sector that 

has traditionally been a mainstay of the western North 

Carolina economy. This industry experienced sharp 

losses during the recent recession. Textiles, a component of industrial goods production, historically have 

dominated many of the Region’s rural economies. 

Automotive production, however, is a comparatively 

recent addition to the Atlanta Region industrial mix. 

Job cuts continue to occur at relatively high levels in 

these industries. It is important to note that layoffs in 

these sectors did not increase during late 2002, as they 

did in the high-tech sector. However, consumer debt 

levels remain high and job income growth is weak, 

increasing the potential for consumer spending to 

falter, further weakening these industries. Evidence of 

weakness may have appeared in the automotive sector 

3 The banking industry has experienced the effects of exposure to 

weakening in the high-tech industry. During 2002, the quality of large 

syndicated credits in the telecommunications and cable industries 

declined sharply; 27 percent of these loans were classified, up from 

just under 4 percent a year earlier. 

FDIC OUTLOOK 13 SPRING 2003 
Regional Perspectives 

as sales of light-weight vehicles fell substantially in 

November 2002, despite continued low interest rates 

and dealer incentives. Also, in October 2002 retail 

sales fell on a year-over-year basis for the first time 

since the 1990–91 recession. 

Transportation Services Continue to Be Hurt 

by the Effects of September 11 

The transportation industry, especially air services, 

continues to suffer from the aftermath of September 11 

and the recent recession. For example, the transportation industry announced nearly 30,000 job cuts during 

October and November 2002. The Atlanta Region, 

home to several airline hubs, is highly exposed to the 

industry’s financial difficulties, as reflected by relatively 

high location quotients in several counties. The US 

Airways Chapter 11 bankruptcy filing in August 2002 

contributed to layoffs at the Charlotte hub and reservations centers in Orlando and Winston-Salem. Delta 

Airlines has trimmed payrolls substantially in the 

Atlanta metro area, where it is the largest employer, 

and recently announced plans to cut at least 7,000 

more jobs by mid-2003. Northwest Airlines also plans 

to scale back its presence in Atlanta. Further transportation industry layoffs in the Region likely will 

continue to constrain the recovery. 

The Recent Recession Has Affected Government 

Budgets Adversely 

The recent recession has hurt state tax revenues. During 

2002, state tax revenues declined from year-ago levels 

in all Atlanta Region states except Florida and West 

Virginia. Nationwide, combined state budget gaps are 

expected to reach $60 billion in 2003. Should the recovery take hold, budget problems could persist, perhaps 

resulting in reduced expenditures, increased taxes, or 

both. Downsizing state governments would be expected 

to affect employment more significantly in capital 

cities, where location quotients are well above one. 

Many Developments Have Contributed to Layoffs 

in the Financial Services Sector 

Accounting scandals, weak equity market performance, 

high costs to the insurance industry because of losses 

on September 11, and cost-cutting following merger 

and acquisition activity in the banking industry 

Large Banks Have Performed Well 

in the Atlanta Region 

Commercial banks headquartered in the Atlanta 

Region with assets over $10 billion (excluding credit 

card banks) reported solid performance in third quarter 

2001. Year-over-year, the median return on assets ratio 

improved to 1.28 percent by September 30, 2002, up 

from 1.07 percent two years earlier. Gains in net interest income were primarily responsible, as the median 

net interest margin rose to 3.96 percent as of third quarter 2002, 28 basis points higher than a year earlier. In 

addition, lower provision expenses and increased efficiencies at these banks helped to bolster profitability. 

After slowing in 2001, loan growth rebounded as of 

September 30, 2002. The loan-to-asset ratio improved 

to just over 66 percent, a 140 basis point increase from a 

year before. Spurred by low interest rates and consumer 

spending, significant growth occurred in the 1- to 4­

family and consumer loan categories. Credit quality 

among large insured institutions has remained sound; 

the median noncurrent loan level for all loan types 

was stable at 0.86 percent as of September 30, 2002. 

However, the commercial and industrial (C&I) loan 

portfolio continued to show signs of weakness. The 

median past-due and nonaccrual C&I loan ratio rose 50 

basis points to 3.5 percent at year-end September 30, 

2002, but remained below the national median of 4.2 

percent. Although the Region’s median past-due and 

nonaccrual C&I loan ratio has more than tripled during 

the past five years, the bulk of these past-due loans were 

less than 90 days old at the end of third quarter 2002. 

Large banks headquartered in the Region have 

reported significant increases in core deposits during 

the recent period of stock market volatility. Should 

interest rates rise and funds begin to return to the 

equity markets, concern about liquidity and interest 

rate risk could increase. 

contributed to job cuts in the financial services sector 

early in 2002. Although layoffs were at relatively high 

levels, they have moderated during the year. Industry 

exposures in the Atlanta Region, reflected by comparatively high location quotients, tend to be concentrated 

in regional banking centers, such as Winston-Salem, 

Charlotte, Atlanta, Birmingham, and South Florida. 

Additional cost-cutting and layoffs related to consolidation in the banking industry could weaken the 

recovery. 

FDIC OUTLOOK 14 SPRING 2003 
Regional Perspectives 

Table 2 

Atlanta Region Metro Areas with High Exposures* to Multiple Stressed Industries 


Could Face the Greatest Challenges
 

(MSAs ranked by year-over-year percentage point change in noncurrents)
 

Exposure to Stressed Industries 

x Aerospace

AutomotiveComputersConsumer GoodsElectronics

x Financial

GovernmentIndustrial Goods

x 

TelecomTransportation

3 Count of Industries 

x x x x x x 6 

x x x x x x x x 8 

x x x x x x x x 8 

x x x x x x 6 

x x x x x 5 

1- to 4-Family 

Name Noncurrents (%) 

West Palm Beach, FL 2.15 

Raleigh, NC 1.12 

Charlotte, NC 0.55 

Washington, DC 0.61 

Greensboro, NC 0.73 

Tampa, FL 0.68 

Macon, GA 0.83 

Savannah, GA 0.49 

Atlanta, GA 0.70 

Norfolk, VA 0.31 

Year-over-Year 


Percentage Point
 

Change in 


Noncurrents
 

1.72 

0.64 

0.41 

0.36 

0.33 

0.30 

0.29 

0.09 

0.08 

0.06 

Job Growth (%)
 

October 2002
 

Year-over-Year
 

0.74 

0.87 

1.55 

–0.69 

–0.35 

0.07 

–0.27 

–0.36 

–2.82 

0.20 

x x x x x x x 7 

x x x x x x 6 

x x x x x x x x x x 10 

x x x x x 5 

* If an MSA has a location quotient above one in at least one of its component’s counties, this exposure is designated by an “x” in the corresponding industry under “Exposure to Stressed Industries.” 

Sources: Bank and Thrift Call Reports, September 30, 2002; Global Insight, Inc.; Bureau of Labor Statistics/Haver Analytics 

Implications for Insured Institutions 

Although the Atlanta Region economy has experienced modest improvement in employment growth, 

continued weakness in stressed industries could 

constrain the pace of the recovery. Consumer loan 

delinquencies typically have increased during times 

of rising unemployment rates and weak job growth.4 

Community banks5 headquartered in several of the 

Region’s metro areas have reported some weakening in 

asset quality over the year ending third quarter 2002, 

which likely is related to industry layoffs. Such deterioration could be further exacerbated in markets such 

as the Atlanta MSA, where job losses have been severe 

in several key industries (see Table 2). Any additional 

slowing in local economies stemming from continued 

industry layoffs could further pressure asset quality and 

contribute to a decline in loan growth. Consequently, 

management of insured institutions that hold relatively 

high exposures to these stressed industries should 

continue to monitor economic developments as the 

nation moves toward recovery. 

4 Russ Wiles, “Growing Consumer Debt Brings Out the Collectors,”
 

The Arizona Republic, October 25, 2002.
 5 “Community banks” are defined in this article as insured institutions
 

that hold assets less than $1 billion. This definition does not include
 

de novo or specialty institutions.
 

Conclusion 

If the recovery remains weak, local economies in the 

Atlanta Region with exposures to industries that have 

been slow to emerge from the downturn could be most 

vulnerable. Insured institutions could experience some 

weakening in consumer credit quality, as personal 

bankruptcy filings and mortgage foreclosure rates have 

continued to climb across the Region. Increased job cuts 

would further pressure consumer credit quality. Downturns in specific industries also could affect commercial 

real estate and construction adversely, resulting in 

continued weak absorption rates. Key sectors of the 

economy to watch going forward are nondefense-related 

manufacturing, transportation, state and local government, and, to a lesser extent, financial services. Local 

economies with relatively high exposure to more than 

one of these sectors may be most vulnerable. 

Jack M. W. Phelps, CFA 

Scott C. Hughes 

Pamela R. Stallings 

Ronald W. Sims, II, CFA 

FDIC OUTLOOK 15 SPRING 2003 
Regional Perspectives 

Chicago Regional Perspectives
 

The Region Experiences Improving Economic 

Conditions and Generally Healthy Banking Conditions 

The Region’s economic conditions improved in the 

year ending third quarter 2002, but progress was modest 

and uneven. Growth remains tepid following the 2001 

recession and as restructuring 

continues in some troubled 

industries. 

Employment during third quarter 2002 in the Region and the 

nation was about 0.8 percent 

below year-earlier levels (see 

Table 1). The recent pace of job 

loss in the Region was less severe 

than during the year ending third 

quarter 2001. In contrast, the nation shifted from 

marginal job growth to a mild decline. The Region’s relatively better performance partly reflects its low exposure 

to high-tech firms, airplane production, and some other 

sectors undergoing sharp contractions. Even so, exposure 

to telecommunications, airline services, steel, and other 

troubled industries dampens growth in the Region. 

Table 1 

Employment Trends Reflect Varying Rates 

of Improvement among States in the Region 

Percent Change from 

Four Quarters Earlier 

3Q01 3Q02 

Total Payroll Employment: 

Nation 0.1 –0.8 

Chicago Region –1.3 –0.7 

Illinois –0.9 –1.3 

Indiana –2.1 –1.2 

Kentucky –0.2 1.0 

Michigan –2.2 –0.8 

Ohio –1.3 –0.9 

Wisconsin –0.5 0.4 

Manufacturing Employment: 

Nation –5.2 –4.8 

Chicago Region –5.9 –2.0 

Illinois –4.8 –2.1 

Indiana –7.2 –2.7 

Kentucky –5.6 –1.7 

Michigan –6.2 –1.6 

Ohio –6.0 –1.8 

Wisconsin –5.5 –2.2 

Source: Bureau of Labor Statistics 

The contrast between the Region and the nation is 

more noticeable in the manufacturing sector, where 

the Region’s rate of job loss slowed noticeably in 2002, 

but the nation’s did not. This disparity partly reflects 

the fact that employment among the types of manufacturers found in the Region declined sooner than in 

other manufacturing sectors (before the cyclical peak) 

and improved sooner when the recovery took hold. 

Similarly, the varying industrial composition of the 

Region’s states is contributing to uneven degrees of 

improvement. States with high exposure to the motor 

vehicle-and-parts industry,1 for example, fared relatively well, as strong vehicle sales spurred third-quarter 

production of vehicles and parts to a level 11 percent 

higher than a year earlier. Although motor vehicle 

production may advance only modestly in coming 

quarters, the strengthening in manufacturers’ new 

orders during 2002, following six quarters of decline, 

bodes well for continued improvement in other parts 

of the Region’s manufacturing sector. 

Activity in residential housing markets was surprisingly 

robust in the past year. Nationwide, measures reflecting the affordability of homeownership for first-time 

buyers and repeat buyers were higher in 2002 than 

in 2000, despite the recession and job losses in the 

interim. As was the case with vehicle sales, unusually 

low interest rates contributed to strong home sales in 

the Region during 2002. 

In this economic environment, the Region’s banks 

and thrifts report healthy profitability and generally 

sound conditions. Their profitability as a group rose 

sharply, with third quarter, year-to-date annualized 

return on assets of 1.33 percent, which compares 

favorably with 1.02 percent a year earlier. This 

improvement is largely attributable to higher net 

interest margins. 

Aggregate data show 2.69 percent of total loans as 

past due2 in the third quarter (see Table 2). This 

percentage is below the 2.86 percent a year earlier, 

yet above the 2.12 percent two years earlier, before 

the recession began. Among the Region’s community 

1 The share of employment in the motor vehicles-and-parts sector 

is at least 65 percent higher in Michigan, Indiana, Kentucky, and 

Ohio than in the nation. 

2 The term “past due” includes loans delinquent by 30 days or more 

plus loans on nonaccrual status. 

FDIC OUTLOOK 16 SPRING 2003 
Regional Perspectives 

Table 2 

The Region’s Insured Institutions Report Varying Past-Due Rates 

Percentage of Loans Past Due 

3Q99 3Q00 3Q01 3Q02 

All Loans 2.02 2.12 2.86 2.69 

Commercial and Industrial 2.22 2.37 3.74 3.69 

Commercial Real Estate 

Nonresidential Real Estate 1.73 1.64 2.31 2.24 

Multifamily Residential 1.13 1.05 1.24 1.21 

Construction and Development 2.43 2.38 2.76 2.95 

Residential Real Estate* 1.82 1.99 2.67 2.77 

Loans to Individuals (excluding real estate loans) 2.78 2.98 3.13 2.54 

Addendum: 

Residential Real Estate* 

Large Banks (assets of $1 billion or more) 1.86 2.08 2.82 2.94 

Community Banks (assets under $1 billion) 1.76 1.80 2.24 2.22 

* Includes first and subordinate liens on 1- to 4-family residential properties. 

Source: Call Report Data, aggregated across all institutions in the Region 

institutions,3 the percentage of loans 30 to 89 days 

delinquent declined 21 basis points in the year ending 

September 30, 2002, suggesting that an improvement 

in nonperforming loans (those delinquent by 90 days 

or more plus those on nonaccrual status) may follow. 

Growth in aggregate nonperforming loans caused 

community institutions’ reserve coverage of these 

loans to fall to 105 percent in third quarter 2002 from 

147 percent at year-end 2000. This decline suggests 

that some institutions may need to reevaluate reserve 

levels; however, increases in capital and the ratio of 

reserves to total loans during the past two years 

provide some cushion. In addition, profitability of 

the Region’s insured institutions appears sufficient 

to support somewhat higher provision expenses, 

should they become necessary. 

Banking and Economic Indicators Suggest 

Changing Dynamics for Residential Lenders 

Bankers and regulators often consider residential real 

estate loans4 to be a low-risk lending activity because 

such loans historically experience relatively low 

3 “Community institutions” are defined in this article as insured 

banks and thrifts that hold assets of $1 billion or less and are not 

de novo or specialized (e.g., credit card) entities. 

4 Residential real estate loans include first and subordinate liens 

on 1- to 4-family properties. 

delinquency and loss rates. In fact, recent loss rates 

on residential loans held by community institutions 

headquartered in the Region are the lowest among 

major loan types, and net charge-offs remain very 

low, at only 8 basis points per annum. 

However, the gap between past-due rates on residential 

and all other loans held by the Region’s community 

institutions narrowed in the mid-1990s and did not 

expand during the 2001 recession, as occurred around 

the 1990–91 recession (see Chart 1). Indeed, while the 

past-due rate on residential loans remains below that 

of other loans, it consistently moved in line with the 

past-due rate for all other loans in recent years. 

To provide perspective for this discussion, residential 

real estate loans are the largest asset class held by the 

Region’s community institutions. Even so, their 40 

percent share of total loans in third quarter 2002 was 

down from 44 percent a decade earlier. Over the same 

period, the share of revolving, open-end loans within 

residential loan portfolios rose to 11 percent from 

7 percent. Ohio is home to four of the Region’s five 

metropolitan statistical areas (MSAs) in which community institutions hold median exposure to residential 

loans exceeding 55 percent of total loans.5 This high 

share reflects the fact that 39 percent of Ohio’s 

community institutions have thrift charters, and thus 

5 Only MSAs that are headquarters to at least ten community institutions are considered. 

FDIC OUTLOOK 17 SPRING 2003 
Regional Perspectives 

Chart 1 Chart 2 

The Gap between Past-Due Rates 

on Residential and Other Loans Remains Narrow 

for the Region’s Community Institutions 

Source: Bank and Thrift Call Reports for Chicago Region Community Institutions 

All other loans 

Residential real estate loans 

0.0 

0.5 

1.0 

1.5 

2.0 

2.5 

3.0 

3.5 

4.0 

4.5 

Percentage of Loans Past Due 

Sept ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00 ’01 ’02 

Source: Federal Housing Finance Board, national data 

Loan-to-Value Ratio Remains Elevated for More than 

20 Percent of Mortgages Closed 

Percentage of Mortgages Closed with

Loan-to-Value Ratio over 90 Percent

5 

10 

15 

20 

25 

30 

35 

’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00 ’01 ’02

a focus on residential lending, in contrast with 15 

percent elsewhere in the Region. 

Banking Considerations 

As the Region’s economic recovery unfolded through 

third quarter 2002, the performance of residential and 

nonresidential loan portfolios was better than immediately after the prior recession (see 1991 and 1992 in 

Chart 1). Even so, the shift to higher loan-to-value 

ratios on mortgages since 1994 (see Chart 2) and 

households’ rising debt service burdens (see Chart 3) 

leave lenders exposed to borrowers’ financial setbacks, 

such as layoffs, stock market losses, or high leverage. 

The high level of subprime mortgages in foreclosure 

and delinquent by at least 90 days6 suggests that at 

least one subset of borrowers has encountered significant debt-servicing problems. 

The share of past-due residential loans held by insured 

institutions in the Chicago Region as of September 30, 

2002, surpassed past-due rates for nonresidential loans 

to individuals and several components of commercial 

real estate portfolios (Table 2). Only residential loans 

and construction and development loans posted higher 

past-due rates than a year earlier, while other loan types 

showed modest improvement. The most pronounced 

deterioration in residential credit quality since late 

2000 occurred among large institutions with assets of 

$1 billion or more, as indicated in the addendum to 

Table 2. 

6 Based on September 2002 data reported by www.loanperformance 

.com in The Market Pulse, 2002, Vol. VIII, Issue 5. 

Chart 3 

Source: Federal Reserve Board of Governors, national data 

Debt Service Payments Absorb 

a High Share of Households’ Income

Percentage of Disposable Personal Income

11.5 

12.0 

12.5 

13.0 

13.5 

14.0 

14.5 

’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00 ’01 ’02 

Economic Considerations 

The 2001 recession and moderate recovery to date 

undoubtedly contributed to the rise in past-due rates 

on residential loans. In addition, pockets of local 

economic weakness likely heightened strains on 

residential loan quality in particular areas. For example, employment in Decatur, Illinois, has declined 

significantly since late 2000, and local lenders there 

report one of the highest median past-due rates on 

residential loans among MSAs in the Region.7 

Declines in mortgage interest rates since mid-2000 and 

a rise in refinancing activity probably helped temper 

the recent increase in mortgage delinquencies. In the 

7 In Decatur and elsewhere, the past-due rate reflects not only 

the impact of economic conditions but also individual institutions’ 

business plans and risk tolerances. 

FDIC OUTLOOK 18 SPRING 2003 
leveland-Lorain-Elyria

hicago

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 La Crosse

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Regional Perspectives 

aggregate, however, declining employment and slower Moreover, a rising share of recent mortgage originaincome growth overwhelmed the benefits to borrowers tions involves fixed-rate loans, which reduce borrowof lower mortgage rates and restructured balance sheets. ers’ vulnerability to future increases in interest rates. 

Indeed, fixed-rate mortgages represented about 85 

Shifts in the nature of recent refinancings likely reflect percent of conventional mortgages closed nationwide 

household caution and reduced net worth as well as in fourth quarter 2002, according to the Federal 

tighter underwriting criteria. Twenty percent of Housing Finance Board. 

refinanced mortgages in third quarter 2002 were for 

less than the unpaid principal balance (UPB) of the At the MSA level, housing markets in the Region are 

original loan (see Chart 4). Such refinancings, often not characterized as “overheated” or facing housing 

termed “cash flow” refinancings, typically lower price bubbles. Behind the aggregate data, however, 

borrowers’ debt burdens. At the same time, a declining are some submarkets where demand is weak relative 

share of refinancings—but still high, at 45 percent— to supply, triggering longer periods before a sale is 

were “cash-out” actions, in which new mortgages add made, falling home prices, or both. In any market 

5 percent or more to the UPB of the original loan. characterized by sustained declines in home prices 

and weak economic conditions, the probability of 

To the extent that refinancings allow households to payment default increases and the ability of homerestructure their balance sheets, they enhance borrow- owners to sell properties at prices sufficient to pay 

ers’ ability to handle current and future debt loads. off mortgages diminishes. In such situations, the 

accuracy of appraisals, underwriting standards, and 

Chart 4 oversight by lenders assume heightened importance. 

National Refinancing Trends Show 

Less Cash-Out Activity 

Percentage of Refinancings 

Note: UPB = unpaid principal balance of the original loan. 

Source: Freddie Mac 

1997 1998 1999 2000 2001 2002 

5 percent or more over UPB 

Less than UPB 

100 

0 

10 

20 

30 

40 

50 

60 

70 

80 

90 

Chart 5 

Successful Residential Lending Depends 

on Many Factors 

It is not possible to specify that weak economic conditions account for a certain percentage of the recent 

(or any future) rise in residential past-due rates, while 

changes in mortgage underwriting standards, marketing strategies and lending practices account for the 

remainder. As important as employment and income 

are to households’ ability to service debt obligations, 

a market’s aggregate job losses or gains are not the 

only factor influencing the performance of residential 

portfolios, as illustrated in Chart 5. Other important 

Percentage of Residential Loans (for Past-Due

Rate), or Percent Change (for Employment)

Relation of Past-Due Residential Loans and Employment Change Varies across MSAs 

Median past-due rate for residential loans as of September 30, 2002 

Cumulative employment change from fourth quarter 2000 to third quarter 2002 

–8 

–6 

–4 

–2 

0 

2 

4

Note: The past-due rates are for metropolitan statistical areas that are headquarters to ten or more community institutions.
 

Sources: Bank and Thrift Call Reports for Community Institutions; Bureau of Labor Statistics
 

FDIC OUTLOOK 19 SPRING 2003 
Regional Perspectives 

factors include variations in loan-to-value ratios, 

lenders’ pricing power, competition for prime (and 

perhaps subprime) credits, underwriting standards, the 

pace of economic growth, households’ debt-service 

burdens, the extent of refinancing activity, and home 

price appreciation (or stagnation). 

Currently, strong profitability and healthy conditions 

enable mortgage lenders to address problem credits 

and adjust risk management systems where necessary. 

Nonetheless, management should evaluate the changing nature and relative risks of this business line to 

determine how to operate profitably and safely in the 

current environment. For example, waves of refinancing, which were unheard of a decade ago, can quickly 

change the duration of lenders’ residential loan portfolios. Meanwhile, insured institutions facing competition 

from not only other local lenders but also nationwide 

institutions may respond to reduced pricing power by 

relaxing standards for loan-to-value ratios or borrower 

leverage limits. Others have focused on originating and 

selling mortgages in the secondary market, which 

involves a different set of potential risks and rewards 

than traditional make-and-hold lending.8 All told, residential mortgage lending is no longer a homogeneous 

business line, with one strategy and one set of risks 

facing most participants. As the environment for residential lending continues to evolve, lenders may need 

to reevaluate their traditional view about the relative 

risks of residential lending. 

Chicago Staff 

8 For further discussion of evolving lending practices and associated 

risks for mortgage lenders, see “Housing Market Has Held Up Well 

in This Recession, but Some Issues Raise Concern,” in Regional 

Outlook, National Edition, first quarter 2002. 

FDIC OUTLOOK 20 SPRING 2003 
Regional Perspectives 

Dallas Regional Perspectives 

Midsouth Economic and Banking Conditions 

Job Losses Continued in Many Areas of Chart 1 

the Midsouth during 2002; Some Signs Job Growth in the Midsouth Services Sector of Improvement Have Emerged Somewhat Offset Weakness in Employment Growth (Period-to-Period Four-
 Quarter Moving Average Percent Change)
 

Manufacturing and Other Sectors 

1.0 

0.5 

The Midsouth1 economy continued to lose jobs during 

the first nine months of 2002. However, the pace of 

losses abated in the third quarter, and employment 

levels varied across individual states. The Midsouth 

economy was on track to lose almost 13,000 jobs 

during 2002, but this estimate represents less than half 

the number of jobs lost in 2001 and suggests that the 

area’s economic malaise may be ending.2 The Mississippi economy already may have emerged from decline, 

0.0 

–0.5 Total Payroll 

Employment (bars) –1.0 

Manufacturing Sector 

–1.5 Service Sector 

Other Sectors* 

–2.0 

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

99 99 99 99 00 00 00 00 01 01 01 01 02 02 02 with modest job gains reported during the first three 

quarters of 2002. Employment levels were flat in 

Arkansas during this period, and minimal job losses 

were reported in Louisiana and Tennessee. 

*Other sectors include construction; finance, insurance, and real estate; government; 

mining; trade; transportation and public utilities. 

Source: Bureau of Labor Statistics 

Midsouth employment trends varied 

among the area’s 

major industries during 

third quarter 2002. Employment 

declined in the retail trade; 

construction; transportation and 

public utilities; manufacturing; 

and the finance, insurance, and 

real estate sectors (see Chart 1). Job 

losses in the manufacturing sector 

continued, but at a slower pace during the first nine 

months of 2002 compared with the previous year, 

providing some evidence that contraction in this 

sector may be ending.3 Job gains in the services 

(concentrated in health care) and local government 

1 The Midsouth area includes the states of Arkansas, Louisiana, 

Mississippi and Tennessee. 

2 According to the Bureau of Labor Statistics, the Midsouth economy 

lost 9,500 jobs during the first three quarters of 2002, 3,500 of which 

were lost in the third quarter. The annualized 2002 employment 

decline is 12,700, compared with 27,100 for 2001. 

3 Midsouth manufacturing employment declined by 15,400 jobs during 

the first nine months of 2002, compared with a decline of 66,900 in 

2001. Job gains in the services and government sectors partially offset 

losses in manufacturing, resulting in the net job loss figure mentioned 

in footnote 2. Manufacturing jobs represent 16 percent of total employment in the Midsouth, compared with 13 percent for the nation. 

sectors somewhat mitigated employment declines 

in other sectors. However, revenue collections for 

Midsouth state and local governments were down 

during 2002, suggesting that the favorable employment trends in this sector may not continue into 

2003. The sustainability of the Midsouth’s nascent 

economic recovery is tied to employment trends in 

the manufacturing and government sectors, which 

represent one-third of area jobs. 

Manufacturing Job Losses Slow, but the Potential 

for Continued Improvement Is Uncertain 

The manufacturing sector is still a key economic driver 

in the Midsouth economy. Although the share of total 

employment in this industry steadily declined during 

the past two decades, almost one out of every six jobs 

in the Midsouth economy remained in the manufacturing sector as of third quarter 2002. It is important to 

note that average wages in the manufacturing sector 

exceed those in certain areas of the service sector with 

skill and education requirements similar to those in 

manufacturing, such as food service.4 In addition, 

4 In 2001, the average hourly rate for Midsouth manufacturing jobs 

was $13.45, or 188 percent of the average wage for food service jobs. 

FDIC OUTLOOK 21 SPRING 2003 
Regional Perspectives 

almost 20 percent of the Midsouth’s gross state product Chart 2 

was attributable to manufacturing in 2000.5 

The Institute for Supply Management Index and Hours 

Worked Indicate Possible Improvement in Midsouth Manufacturing employment declined during the first Manufacturing Employment Conditions during 2003 nine months of 2002 and has done so every year since 70 Average Weekly Manufacturing Hours 45 

ISM Manufacturing Index 

(line, left scale) 

Worked (right scale) 

Oct ‘95 ‘96 ‘97 ‘98 ‘99 ‘00 ‘01 ‘02 

Three-Month Moving Average Weekly


1995, except during 1998, when employment increased 

Manufacturing Hours Worked
 

44 65 

modestly.6 All nondurable manufacturing segments 

(comprising apparel, chemicals, food products, paper, and 

textiles) recorded job losses during the period, except 

for food products.7 These declines primarily result from 

migration of low-skilled jobs to countries with cheaper 

labor costs. In contrast, jobs were added overall in the 

ISM manufacturing Index

43 60 42 

55 41 

50 40 

39 45 

38 40 37 

35 36 durable manufacturing segments (electronics, furniture 30 35 and fixtures, industrial machinery, lumber and wood, 

and transportation equipment) until 2000.8 Employment declines since 2000 in the durable manufacturing 

sector primarily result from the cyclical slowing of the 

U.S. economy and reduced demand, particularly for 

items businesses use to produce other goods.9 

Job losses in the manufacturing sector appear to have 

peaked at almost 67,000 in 2001 (see Chart 1). 

However, erosion has continued, and prospects for 

employment in this sector in 2003 remain unclear (see 

Chart 2). Average hours worked in the manufacturing 

industry in the Midsouth now exceed the low point 

reached during spring and summer 2001. However, this 

figure remains well below levels during the latter half 

of the 1990s.10 The Institute for Supply Management 

manufacturing index finished 2002 above 50, indicating 

that purchasing managers expect businesses to expand 

in terms of resource utilization. However, December is 

the first month in which the index topped 50 since 

August 2002, an indication that this recent improvement may be somewhat tenuous.11 

5 Data as of year-end 2000 represent the most recent gross state 

product figures available. 

6 Midsouth manufacturing lost 166,100 jobs between year-end 1995 

and third quarter 2002. Job losses occurred in each of the intervening 

years except 1998, when employment grew only 1,100. 

7 Midsouth food product manufacturers employed 148,900 in third 

quarter 2002, almost 32 percent of all nondurable manufacturing jobs. 

Employment in food products increased an average of .4 percent per 

year between 1995 and third quarter 2002. 

8 Jobs were not added in the electronics and lumber and wood 

segments of the durable goods industries. 

9 Overcapacity in the trucking and commercial passenger air service 

industries as well as steel mills has contributed to a significant reduction in demand for durable goods. 

10 Generally, manufacturers’ initial response to increased orders is 

to increase overtime hours for existing staff. New hiring usually is 

deferred until an increase in demand appears permanent. 

11 An index of 50 or above indicates that the manufacturing sector is 

expanding; an index below 50 indicates that the sector is contracting. 

Note: ISM = Institute for Supply Management.
 

Source: Bureau of Labor Statistics
 

Credit Quality Deterioration Appears to Have Abated, 

and Earnings Improved in Third Quarter 2002 

Although economic weakness persisted during third 

quarter 2002, insured institutions headquartered in 

the Midsouth reported sound credit quality and earnings. Furthermore, credit quality has improved among 

banks and thrifts operating in each of the Midsouth 

states since reaching cyclical lows during fourth quarter 2001.12 However, trends in past-due loan levels 

varied by state as of third quarter 2002. Insured institutions headquartered in Arkansas and Louisiana 

reported a slight increase from a year ago in the 

median past-due ratio, while institutions in Mississippi 

and Tennessee reported declines of 29 and 20 basis 

points, respectively. Median past-due loan ratios 

increased for Midsouth agricultural institutions but 

declined for most other institution types compared 

with year-ago levels.13 

Overall, earnings have improved for insured institutions in the Midsouth during the past year. Rising net 

interest margins, resulting from favorable trends in 

market interest rates and declines in funding costs, 

boosted the median return on assets (ROA) from just 

12 Median reported past-due loans were 2.68 percent of total loans 

in third quarter 2002, comparable with the previous quarter and down 

from 2.71 percent a year ago. The median past-due ratio peaked at 

3.04 percent at year-end 2001, the highest level since June 30, 1992 

(3.28 percent). 13 Agricultural institutions are defined as insured institutions holding 

at least 25 percent of total loans in agricultural production and farm 

real estate. The median past-due loan ratio for these institutions was 

3.28 percent as of third quarter 2002, an increase of 37 basis points 

from a year earlier. 

FDIC OUTLOOK 22 SPRING 2003 
Regional Perspectives 

Option Risk in Securities Portfolios Appears to Have Increased 

among Insured Institutions Headquartered in the Midsouth 

During the recession, loan growth slowed among insured Chart 3 institutions headquartered in the Midsouth.14 In an 

effort to maintain or boost earnings, some Midsouth 

institutions have begun to increase holdings of securities 

that carry option risk.15 Although overall no significant 

shift from loans to securities has occurred, migration 

Note: MBS = mortgage-backed securities. 

Source: Call reports for community commercial banks 

Mortgage-Backed Securities Represent 

a Growing Share of Securities Portfolios among 

the Midsouth Region’s Insured Institutions 

Total Securities (%)

Total Pass-Throughs (%) 

Pass-Throughs with Earliest Repricing or

5 

10 

15 

20 

25 

30 

35 

20 

30 

40 

50 

60 

70 

80 

Sep ‘99

Dec ‘99

Mar ‘00

Jun ‘00

Sep ‘00

Dec ‘00

Mar ‘01

Jun ‘01

Sep ‘01

Dec ‘01

Mar ‘02

Jun ‘02

Sep ‘02 

toward higher-yielding instruments in the securities 

portfolio has been reported.16 

Maturity over Five Years (right axis) 

MBS to Total Securities (left axis) 

Pass-Through Securities to Total Securities (right axis) 

The widening spread between the current yield on 

fixed-rate mortgages and comparable maturity U.S. 

Treasury securities has increased the attractiveness of 

mortgage-related investments. For example, the spread 

between the yield on 30-year fixed-rate mortgages and 

7-year constant maturity Treasury notes was 2.58 

percentage points as of September 30, 2002, compared 

with an average of 1.85 and 2.09 percentage points 

during 2000 and 2001, respectively. As a result, holdings 

of mortgage-backed securities have increased steadily 

and reached a historical high among insured institutions 

in the Midsouth during third quarter 2002 (see Chart 

3).17 Moreover, an increasing percentage of passthrough securities are repricing or maturing after five 

years. These trends likely will continue should interest 

rate spreads remain near late 2002 levels. 

High and increasing concentrations of pass-through 

securities and other mortgage-backed securities are 

14 Merger-adjusted loans grew 5.7 percent in third quarter 2002, 

compared with double-digit growth in 2000. The median loan-toasset ratio reported by insured institutions headquartered in the 

Midsouth peaked at 64.7 percent in third quarter 2000 and 

declined to 63.4 percent by September 30, 2002. 

15 Option risk refers in this article to the prepayment option mortgage holders typically grant borrowers. 

16 Aggregated securities for Midsouth community commercial 

banks represented 24 percent of total assets in third quarter 2002, 

1 percentage point higher than a year earlier. 

17 Mortgage-related securities (mortgage-backed securities and 

mortgage derivative securities) represented 32.2 percent (aggregated) of total securities held by Midsouth commercial banks in 

third quarter 2002, up from 19.2 percent in third quarter 2000 and 

27.5 percent in third quarter 2001. Thrifts are not included because 

of a lack of comparable information on securities maturities and 

repricing. 

likely to contribute to increased option risk in securities 

portfolios. Option risk generally is categorized as 

follows: 

•	 Extension risk: the possible deceleration of principal 

payments that occurs in a rising or high interest rate 

environment, which causes many mortgage-backed 

securities to lengthen in duration and decline in 

value. 

•	 Reinvestment risk: the possible acceleration of principal prepayments in a declining or low interest rate 

environment that likely will cause mortgage-backed 

securities to shorten in duration and decline in value. 

Reinvestment risk likely will remain a concern at 

least into early 2003, as the historically low interest 

rate environment is expected to encourage further 

mortgage refinancing activity.18 

18 According to the Mortgage Bankers Association (MBA), 

total mortgage originations are projected at $2.46 trillion for 

2002, declining to $1.77 trillion for 2003 (the third highest volume 

since 1970). Mortgage refinancings represented 58 percent of 

all mortgage originations, according to the MBA. 

FDIC OUTLOOK 23	 SPRING 2003 
Regional Perspectives 

below 1 percent in third quarter 2001 to 1.14 percent 

in third quarter 2002 (see Table 1).19 Median ROAs 

did not increase noticeably between the second and 

third quarters of 2002, an indication that narrowing 

interest rate spreads have begun to affect earnings. 

Table 1 

Insured Institutions Headquartered in the 

Midsouth Reported an Increase in the Median 

Return on Assets as of Third Quarter 2002 

Median % 

3Q02 3Q01 2Q02 

Arkansas 

Louisiana 

Mississippi 

Tennessee 

Midsouth 

Nation as a whole 

1.15 

1.11 

1.17 

1.08 

1.14 

1.10 

1.02 

0.99 

1.08 

0.94 

0.99 

1.00 

1.13 

1.11 

1.13 

1.11 

1.12 

1.08 

Source: Bank and Thrift Call Reports 

19 The median cost of funds as a share of earning assets dropped from 

4.08 percent in third quarter 2001 to 2.51 percent in third quarter 2002. 

Funding costs also may have reached a functional floor. 

In addition, less attractive reinvestment options are 

now available for funds coming from repayment 

(including prepayments on mortgages) of loans and 

securities extended or purchased during periods of 

higher interest rates. Midsouth insured institutions 

reported an increase in the median ratios for loan loss 

reserve coverage to total loans and noncurrent loans 

in third quarter 2002 compared with year-earlier levels. 

In contrast, insured institutions located outside the 

Midsouth reported virtually no change in median loan 

loss reserves to total loans and coverage of noncurrent 

loans during this period.20 

Midsouth Staff 

20 The median allowance for loan and lease losses to total loans ratio 

in third quarter 2002 was 1.32 percent for insured institutions in the 

Midsouth and 1.23 percent for insured institutions elsewhere in the 

nation. Median coverage ratios were 157 percent of noncurrent loans 

for Midsouth institutions and 166 percent for institutions elsewhere in 

the nation. 

Southwest Economic and Banking Conditions
 

Are Certain Housing Markets Vulnerable 

to Home Price Depreciation? 

Although a majority of economists polled 

by the National Association of Business 

Economics1 do not expect U.S. home 

prices to decline nationwide in the near 

term, some believe prices in certain 

metropolitan areas could fall because of 

deteriorating market conditions. This article 

identifies metropolitan statistical areas (MSAs) in 

the Southwest Region that could be vulnerable to 

the effects of declining home prices and discusses the 

factors that are contributing to this vulnerability. 

Generally, a housing price bubble exists when the 

expected rate of increase in home prices exceeds what 

market fundamentals will support. The potential for the 

1 See “NABE Outlook Panel: Recovery on Solid Footing without 

Further Stimulus,” September 2002, http://www.nabe.com/mem/ 

mac02/mac0209.pdf. 

development of “bubbles” can be determined in several ways; however, two 

commonly used approaches rely on either 

an econometric model or a price-toincome ratio.2 Our analysis uses the ratio 

of median home price to per capita personal 

income,

3 an approach based on the premise that, although home prices can rise 

rapidly relative to income growth in 

the short run, housing price appreciation 

cannot significantly exceed personal 

income growth over time. 

2 For a discussion of modeling house price bubbles using an econometric model, refer to Jesse M. Abraham and Patric H. Hendershott, 

“Bubbles in Metropolitan Housing Markets,” Journal of Housing 

Research, Vol. 7, Issue 2, 1996 (Fannie Mae Foundation). A discussion 

of the price-to-income ratio method appears in Shelly Dreiman, 

“Using the Price to Income Ratio to Determine the Presence of 

Housing Price Bubbles,” House Price Index Fourth Quarter 2000, 

March 1, 2001 (Office of Federal Housing Enterprise Oversight). 

3 For more detailed information on this methodology, refer to Michael 

D. Youngblood, “Is There a Bubble in Housing? New Evidence from 

123 Housing Markets,” The Market Pulse, Vol. VIII, Issue 4, 2002. 

FDIC OUTLOOK 24 SPRING 2003 
Regional Perspectives 

Our analysis identified three MSAs in the Southwest 

Region as vulnerable to the development of housing 

price bubbles: Colorado Springs, Denver, and Greeley, 

Colorado (see Map 1).4 Home price appreciation has 

begun to slow (see Chart 1, next page) and is expected 

to weaken further in these markets during 2003 because 

of continuing weakness in the local economies and 

relatively low affordability. 

4 Forty-two metropolitan areas were studied using median home price 

data from the National Association of Realtors and per capita 

personal income figures from the U.S. Bureau of Economic Analysis 

and Bureau of the Census. Economy.com provided both data series. 

Map 1 

Employment continues to slump in the high-tech 

manufacturing and telecommunications sectors in 

the Denver and Colorado Springs MSAs. Layoffs are 

occurring in these metro areas, and in 2002 both 

MSAs are expected to record the first annual job 

declines since the mid-1980s. Moreover, the recovery in the information technology sector in these 

MSAs likely will lag the U.S. recovery; as a result, 

Economy.com is forecasting a second consecutive 

year of job declines for these two MSAs in 2003.5 

5 Economy.com Précis Metro report, December 2002. 

The Southwest Housing Markets 

Are Generally Well Balanced 

Residential Exposure by 

Metropolitan Statistical Area 

High 

Moderate 

Low 

FDIC OUTLOOK 25 SPRING 2003 
Regional Perspectives 

Job losses have contributed to declines in personal 

income growth in these two metro areas, trends that 

are constraining the demand for housing in the near 

term. Despite the lowest mortgage rates in more than 

30 years, demand for housing in these MSAs has waned 

during the past year as the number of unsold homes 

has surged.6 Moreover, an oversupply of homes7 has 

occurred despite a slight decline in single-family housing 

permits during the first 11 months of 2002. Any further 

softening in demand could contribute to additional slowing of home price appreciation. Economy.com has identified the housing markets in these two MSAs as “highly 

overpriced” and vulnerable to a decline in home values.8 

Chart 1 

Home Price Growth Is Decelerating 

in Previously High-Flying Metropolitan Areas 

Percentage Change from a Year Ago

Denver 

Greeley 

Colorado Springs 

0 

2 

4 

6 

8 

10 

12 

14 

16 

18 

The Greeley, Colorado, economy continues to contract 

because of weakness in the manufacturing, construction, 

and trade sectors. The Greeley MSA housing market is 

slowing due to declining employment growth, weaker 

income growth, and a tapering off in housing demand. 

Consequently, home price appreciation has decelerated 

and, according to Economy.com, an oversupply of singlefamily housing has developed since the late 1990s.9 The 

combination of weak employment and income growth 

and relatively low affordability is expected to constrain 

home price appreciation in the Greeley MSA to levels 

at or below the general rate of inflation in 2003. 

While our analysis did not flag the Austin and Dallas 

MSAs’ housing markets as being vulnerable to the 

development of home price bubbles, they deserve 

mention. Employment losses in these MSAs equaled 

or exceeded the national average during 2001 and 

2002. Slumping employment already has placed 

downward pressure on home prices, particularly in 

the Austin metro area, that may carry over into 2003. 

The fact that appreciation in home prices already has 

begun to slow, allowing the gap between home prices 

and income to narrow,10 helps to explain why our 

approach did not identify these two MSAs. 

6 Listings of homes for sale in December 2002 were up 25.5 percent
 

in Colorado Springs (Pikes Peak Association of Realtors) from a year
 

ago, and 23 percent in the Denver area (Denver Metro Chamber of
 

Commerce) for the 12-month period ending October 2002.
 7 Colorado Office of State Planning and Budgeting, Colorado
 

Economic Perspective, December 20, 2002, p. 38.
 8 Celia Chen, “House Price Bubbles,” Regional Financial Review,
 

Vol. XIII, No. 8 August 2002.
 

9 Economy.com Précis Metro report, Greeley, Colorado, December 2002.
 10 Home price growth in the Austin MSA declined from 15 percent in
 

third quarter 2000 to slightly below 4 percent in third quarter 2002.
 

Home price appreciation in the Dallas MSA, which averaged 6 to 7
 

percent in recent years, slowed to around 2 percent by mid-2002
 

(Sources: National Association of Realtors and Economy.com report).
 

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

00 00 00 00 01 01 01 01 02 02 02 

Source: Office of Federal Housing Enterprise Oversight 

The deterioration in employment growth in the Austin 

MSA is the result of weakening demand and a buildup 

of excess capacity in the personal computer and semiconductor industries. This situation was aggravated 

by the stock market decline, problems in the technology 

industry, and drying up of venture capital and initial 

public offerings. The Dallas MSA was adversely affected 

by the recent recession and the fallout from September 

11, which resulted in significant layoffs in the high-tech 

(particularly telecommunications) and travel industries, 

pushing the metro area’s unemployment rate to 7 percent 

in third quarter 2002. 

Employment growth is expected to remain subdued in 

Austin and Dallas during much of 2003,11 as relatively 

high exposure to the ailing computer, telecom, semiconductor, airline, and energy industries is expected 

to slow economic recovery. Slower job growth and 

continued high levels of single-family housing construction likely will constrain home price appreciation in 

these markets. According to a study conducted by 

PMI Mortgage Insurance Co. in September 2002,12 

the Austin and Dallas MSAs were considered to be 

at high and medium risk, respectively, of slowing in 

home price appreciation because of continuing 

employment weakness. 

In addition to vulnerability to slowing in home price 

appreciation, sustained economic weakness like that 

in the Denver, Colorado Springs, and Greeley MSAs 

11 Economy.com forecasts annual employment growth of 1.4 percent
 

and 0.6 percent for Austin and Dallas, respectively, in 2003, well
 

below the long-term growth rates of the 1990s.
 

12 PMI Mortgage Insurance Co., Economic and Real Estate Trends,
 

Walnut Creek, California, September 2002.
 

FDIC OUTLOOK 26 SPRING 2003 
Regional Perspectives 

could exacerbate any deterioration in residential credit 

quality. The next section provides an overview of banking industry fundamentals in the Southwest Region. 

Weakness in Residential Credit Quality Has 

Not Yet Emerged among Mortgage Lenders 

in the Southwest Region 

Low mortgage rates have contributed to a robust housing sector and have helped to fuel home price appreciation in many metropolitan markets across the nation. 

The lowest mortgage interest rates in more than 30 

years also have spurred record purchase and refinancing 

activity. The Mortgage Bankers Association estimates 

that more than $2.4 trillion in mortgage volume will 

be originated in 2002, the highest amount on record. 

However, at the same time, past-due and foreclosure 

rates for certain types of mortgage loans continue to 

climb. FHA (Federal Housing Administration) and VA 

(Veterans Administration) loans reported near-record 

past-due levels of 11.6 percent and 7.8 percent, respectively, as of September 30, 2002.13 At 3.0 percent, 

conventional mortgage past-due rates are among the 

highest since the 1990–91 recession. Foreclosure rates 

for FHA and conventional mortgages also are at relatively high levels. These trends are problematic given 

the record number of new homebuyers who have 

purchased homes at higher prices. Should home 

values decline or price appreciation slow dramatically, 

past-due and foreclosure rates could climb higher. 

In light of these trends, we may expect deterioration 

to emerge in insured institution mortgage portfolios, 

particularly among banks and thrifts lending in markets 

discussed in this article. However, insured institutions 

in the Southwest Region reported a past-due ratio of 

2.13 percent for direct residential mortgages14 held as 

of September 30, 2002, slightly lower than a year ago.15 

Nationally, insured institutions reported similar levels 

of past-due mortgage loans.16 Banks and thrifts in the 

Southwest Region and nationwide also reported significantly lower residential charge-off rates than conventional, FHA, or VA mortgages. 

13 Data provided by the Mortgage Bankers Association.
 14 Direct mortgages refer to mortgages originated and held in an
 

insured institution’s mortgage portfolio, which may or may not be
 

underwritten under conventional mortgage guidelines.
 

15 FDIC Bank and Thrift Call Report data.
 

16 The average past-due rate for insured institutions in the nation
 

was 2.14 percent as of September 30, 2002.
 

It is important to note that mortgage lenders operating 

in the MSAs discussed in this article17 have not reported 

higher past-due or charge-off rates than insured institutions in other metro areas in the Southwest Region. 

This can be explained, in part, by the fact that banking 

performance generally lags economic performance, 

suggesting that should the current economic weakness 

continue, particularly in markets in which home price 

appreciation continues to outpace household income, 

deterioration in residential portfolios may yet emerge. 

Second, most insured institutions have greater proportions of conventional mortgage loans, rather than FHA 

and VA loan pools, which feature higher loss and delinquency rates. Third, equity as a percentage of total home 

value was 56 percent for third quarter 2002, according 

to data provided by the Federal Reserve Board Flow 

of Funds. Although this ratio has declined from 70 

percent 20 years ago, the equity position continues to 

provide an opportunity for borrowers to work out problems by selling the property or refinancing to lower 

cash flow requirements. Finally, low interest rates and 

competition for mortgage originations have allowed 

many homeowners to refinance and tap home equity. 

However, should interest rates rise, refinancing activity 

would be expected to slow. 

Trends to Watch 

Overall, insured financial institutions headquartered in 

the Southwest Region continue to report strong profitability and equity levels. During the nine months 

ending September 30, 2002, institutions reported an 

aggregate return on assets of 1.45 percent, the highest 

level since 1993. Similarly, equity plus the reserve for 

loan and lease losses reached a peak of 10.14 percent of 

total assets as of the end of third quarter 2002. Although 

weakness in insured institution residential credit quality 

has not emerged, some banks and thrifts may be susceptible to earnings pressure if mortgage originations fall. The 

Mortgage Bankers Association forecasts mortgage originations in the amount of $1.7 trillion for 2003, the third 

highest level on record. However, this projection represents a 28 percent decline from 2002 estimates and could 

adversely affect the profitability of insured institutions 

that rely on mortgage lending to generate fee income. 

Southwest Staff 

17 Insured institutions considered in this analysis hold more than 

25 percent of loans in direct mortgages and report total assets less 

than $5 billion. As of September 30, 2002, there were 451 such insured 

institutions in the Southwest Region, or one-third of the Region’s 

banks and thrifts. 

FDIC OUTLOOK 27 SPRING 2003 
Regional Perspectives 

Kansas City Regional Perspectives
 

The Kansas City Region economy was affected 

adversely during 2002 by the national recession and severe drought conditions. Employment growth1 was negative in 2002 for the 

second consecutive year as manufacturing 

layoffs continued (see Table 1). Heavy 

layoffs in Missouri’s manufacturing and 

retail sectors, two industries that employ 

a disproportionately high share of the 

state’s workers, were announced in 2002. 

The North Dakota and Minnesota economies 

also were affected significantly by contraction 

in the manufacturing sector, as well as in the 

mining industry. Despite substantial layoffs among 

Wichita’s aircraft manufacturers and Overland Park’s 

telecommunications sector, the Kansas economy 

posted a relatively high level of employment growth 

compared with other states in the Region. Continued 

strength in transportation and government employment 

helped to offset losses in other industries. 

Table 1 

The Region’s Employment Growth 

Was Negative Again in 2002 

Year-over-Year Employment Growth (%) 

2002 2001 2000 1999 1998 

Nebraska 0.5 0.1 1.8 1.9 2.5 

Kansas 0.4 1.0 1.3 1.1 3.4 

South Dakota 0.4 0.4 1.1 2.7 2.4 

Iowa –0.2 –0.6 0.7 1.8 2.6 

North Dakota –0.4 0.8 1.3 1.3 1.6 

Minnesota –0.6 0.0 2.4 2.3 2.6 

Missouri –1.5 –0.6 0.8 1.5 1.7 

Kansas City 

Region –0.5 –0.1 1.4 1.8 2.4 

Nation –0.3 0.2 2.3 2.3 2.6 

Sources: Bureau of Labor Statistics; Haver Analytics 

The slowdown in employment also has affected the 

Region’s commercial real estate markets adversely. 

For example, office vacancy rates in the Minneapolis 

metropolitan statistical area (MSA) reached 18.6 

percent by September 30, 2002 (compared with 16.1 

1 National recessions typically are measured by total output; however, 

state-level performance typically is measured by employment growth. 

percent for the nation), up from 

12.2 percent at year-end 2001.2 

The Minneapolis MSA vacancy rate 

ranked 15th among the nation’s 53 

largest metropolitan areas. Vacancy rates 

in the Kansas City and St. Louis office 

markets also are above the national 

average. Industrial market vacancy 

rates in these MSAs have almost 

doubled since 1999. However, only
 

the St. Louis metropolitan area,
 

with an industrial vacancy rate of
 

11.4 percent, exceeds the national 

rate of 10.9 percent. 

Severe drought conditions continue to affect the 

Region’s western states. Normally, drought conditions 

abate somewhat with fall precipitation, but continued 

dry weather has left drought conditions unchanged 

since midsummer 2002. Nebraska continues to be 

affected most adversely, with approximately two-thirds 

of its land area in “severe” or “exceptional” drought.3 

The state’s corn, wheat, and soybean harvests declined 

about 20 percent compared with 2001 levels, and 

hard-hit pasturelands made it difficult for ranchers to 

feed their herds. Farmers’ strong equity positions and 

reliance on crop insurance appear to have mitigated 

much of the drought’s negative effect in 2002. 

However, if drought conditions continue into the 

summer of 2003, local economies dependent on the 

agricultural sector may weaken considerably. 

Despite the weak economy and the effects of the 

drought, the Region’s community banks4 continued to 

report sound conditions and performance during third 

quarter 2002 (see Table 2). Earnings remained healthy 

as measured by posttax and pretax measures. Net interest margins were bolstered early in 2002 by a steeply 

2 Vacancy rate data are provided by Torto-Wheaton Research. Vacancy 

rates for major markets in the Kansas City Region are calculated as 

the ratio of unleased space to total leased and unleased space. 

3 U.S. Drought Monitor, December 10, 2002. http://drought.unl.edu/dm. 

The U.S. Drought Monitor is a joint project of the National Oceanic 

and Atmospheric Administration and the United States Department 

of Agriculture. 

4 “Community banks” are defined in this article as insured institutions 

that hold $250 million or less in assets, excluding de novo and specialty 

institutions. Thrifts were excluded because of their dissimilarities to 

commercial banks. 

FDIC OUTLOOK 28 SPRING 2003 
Regional Perspectives 

Table 2 

The Region’s Community Banks Continue to Report Healthy Conditions 

3Q02 3Q01 3Q00 3Q99 3Q98 

Return on Assets (%) 1.31 1.17 1.26 1.22 1.28 

Pretax Return on Assets (%) 1.63 1.48 1.65 1.63 1.76 

Net Interest Margin (%) 4.24 4.10 4.28 4.20 4.34 

Past-Due and Nonaccrual Loan Ratio (%) 2.22 2.31 2.02 2.09 2.16 

Leverage Capital Ratio (%) 10.52 10.38 9.92 9.91 10.40 

Loan Loss Reserves/Loans (%) 1.39 1.40 1.41 1.46 1.46 

Source: Call Reports, commercial banks in the Region with less than $250 million in assets, excluding new banks and specialty banks 

sloped yield curve, which helped community banks 

recover some of the 2001 margin losses caused by 

rapidly declining interest rates. Levels of past-due loans 

remained moderate in the aggregate at September 30, 

2002. However, 11 percent of the Region’s community 

banks reported past-due ratios exceeding 5 percent, 

a relatively high industry benchmark. Capital levels 

remain high compared with historical levels, and 

loan loss reserves are keeping pace with the level of 

problem loans. 

Despite Recent Deposit Growth, Community Banks 

Continue to Face Funding Challenges 

Throughout most of the 1990s, funding among the 

Region’s insured institutions steadily shifted from core 

funds to noncore funds.5 This shift contributed to a 

rise in community banks’ cost of funds, driving net 

interest margins downward and pressuring banks to 

engage in strategies that may have heightened the 

level of credit risk. The weak economy and significant 

declines in the stock market have prompted the greatest shift of deposit funds into the banking system since 

the early 1990s. Although community banks have 

shared in this deposit boom, most of the benefit has 

accrued to the nation’s larger banks. Funding pressures 

have been alleviated, at least temporarily, but could 

resume if the economic recovery takes hold and equity 

markets strengthen. 

5 Core deposits include checking account deposits, savings account 

and money market account deposits, and time deposits in denominations under $100,000. Noncore funds include time deposits in denominations of $100,000 or more and other borrowings, such as federal 

funds purchased, securities sold under agreements to repurchase, 

and borrowings such as Federal Home Loan Bank advances. 

Noncore Funds Grew in Importance in the 1990s 

The national median core funding ratio6 declined from 

a peak 91.4 percent in December 1992 to 81.2 percent 

by September 2000 (see Chart 1, next page). Strong 

equity markets during the 1990s were a primary 

contributor, attracting a significant volume of funds 

from lower-yielding bank deposits. The Wilshire 5000 

index posted double-digit returns for six straight years 

beginning in 1995, with returns in excess of 20 percent 

from 1996 through 1998. This high-return environment made it difficult for banks to compete for funds 

when time deposits were paying single-digit rates. 

In addition, the proliferation of investment options 

during the 1980s and 1990s—for example, money 

market mutual funds, which compete directly with core 

bank deposits—blurred the distinction between bank 

and nonbank products. The share of household deposits 

invested in money market mutual funds grew from 0.3 

percent in 1974 to 23.1 percent by 2001.7 

The funding shift in the Kansas City Region tracked 

the national trend during the 1990s. The median core 

funding ratio declined from a peak 93.9 percent in 

December 1992 to 84.0 percent in September 2000. 

Although the Region’s decline tracks the nation’s, 

this decline holds greater significance for banks in 

the Region because of differences in bank size and 

geographic location. Community banks typically rely 

more on core deposits than do larger banks, and the 

Kansas City Region has a higher concentration of community banks than the rest of the nation (see Table 3, 

next page). Larger banks consistently operate with 

6 The core funding ratio is calculated by dividing core deposits by the 

sum of total funds. 

7 Board of Governors of the Federal Reserve System, “Flow of Funds 

Accounts of the United States—Flows and Outstandings,” reported 

via Haver Analytics. 

FDIC OUTLOOK 29 SPRING 2003 
Regional Perspectives 

substantially lower volumes of traditional core deposits Chart 1 

than smaller banks (see Chart 1). This is not surprising Core Funding Has Stabilized after Years of Decline given that larger institutions typically have access to 

a greater array of noncore funding sources, such as 100 Kansas City Region Banks

commercial paper and sales of asset securitizations. 

Core Funds to Total Funds (%) 

95 

90 

85 

80 

75 

70 

Nation’s Banks 

Over $1 Billion, Nation 

Median Values 

These noncore funding sources often are associated 

with revenue-producing activities other than traditional loan and investment interest income. Larger 

banks typically have been more successful at diversifying revenue streams. Nationally, net interest income 

represented 75 percent of total income for banks with 

assets over $1 billion in 2001, compared with 87 65 

percent for community banks headquartered in the Sep ’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00 ’01 ’02 

Kansas City Region. Moreover, core funding takes	 Note: Excludes credit card and specialty banks. Not merger adjusted. 

Source: Bank Call Reports on added importance for community banks with a 

significant presence in rural communities facing longterm negative growth. The Kansas City Region is expe- Chart 2 

riencing severe, widespread rural depopulation.8 Core 

funds, long the staple of rural banks, are becoming 

difficult to attract or retain. 

Greater Reliance on Noncore Funds Increases 

the Cost of Funds and May Heighten Credit Risk 

The shift toward greater use of noncore funds throughout the 1990s adversely affected community banks’ 

cost of funds. Generally, large time deposits and other 

noncore funds, such as advances from the Federal 

Home Loan Bank System, are more costly than core 

deposits, such as checking and money market accounts. 

Community banks that increased reliance on noncore 

funds during the past ten years experienced steadily 

increasing interest costs compared with banks that 

maintained relatively high levels of core funding 

(see Chart 2). 

Not surprisingly, the overall rising cost of funds among 

the Region’s community banks, coupled with intense 

pricing competition on the asset side of the balance 

sheet, led to steady erosion in community banks’ net 

interest margins (NIMs). The aggregate NIM declined 

from 4.55 percent at September 1992 to 4.24 percent 

ten years later. Net interest margin pressures, combined 

with strong loan demand, prompted many community 

bankers to heighten credit exposure. The aggregate 

loan-to-asset ratio of the Region’s community banks 

increased from 53.7 percent to 65.5 percent during the 

8 A detailed discussion of rural depopulation trends appears in 

Kansas City Regional Perspectives, first quarter 2000. 

Kansas City Region Banks That Maintained Core Funds 

Had Lower Funding Costs 

Cost of Funds (Percent)

Banks in Lowest Quartile 

Median Bank 

Banks in Uppermost Quartile 

Median Values of Annualized Quarterly Data 

Note: Banks are grouped into quartiles by the proportion of September 2002 core 

funding ratio to September 1992 core funding ratio. 

Source: Bank Call Reports, Kansas City Region banks in continual existence 

September 1991 through September 2002, excluding credit card banks and other 

small specialized banks 

2.5 

3.0 

3.5 

4.0 

4.5 

5.0 

Sep ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00 ’01 ’02

Table 3 

The Kansas City Region Has a Greater
 

Proportion of Community Banks and
 

Rural Banks than the Rest of the Nation
 

Kansas City Region Rest of Nation 

% of Total Banks % of Total Banks 

91.3 Banks with assets 76.5 

of $250 million 

or less 

1.5 Banks with assets 6.3 

exceeding $1 billion 

65.5 Banks headquartered 39.4 

in rural counties 

Note: “Community banks” are defined as insured institutions that hold $250 million or less 

in assets, excluding de novo and specialty institutions. Thrifts are excluded from this table. 

Rural counties are nonmetropolitan statistical area counties that have urban populations 

under 20,000. 

Source: September 2002 Bank Call Reports 

FDIC OUTLOOK 30	 SPRING 2003 
Regional Perspectives 

same period. As loans typically carry more credit risk 

than other assets, this trend suggests that community 

bankers are increasing their tolerance for risk. Even so, 

higher loan concentrations did not prevent margin 

erosion during the 1990s. 

Recent Deposit Inflows Do Not Signal a Reversal 

of Funding Pressures 

Historically, funds flow out of the banking industry 

and into the equity and bond markets during times 

of economic prosperity and flow back into insured 

deposits during economic downturns. This trend has 

held true recently as a dramatic outflow of funds from 

banks occurred during the 1990s economic expansion, 

and funds returned to insured deposits during the 

recent recession. Household assets deposited in checking, savings, and time deposit accounts increased 9.3 

percent in the five quarters ending September 30, 2002. 

Household assets deposited in money market mutual 

funds declined slightly during that period. 

Although funds are returning to the banking system, 

much of the inflow is concentrated in the nation’s 

largest banks. The annualized core deposit growth rate 

for the nation’s 100 largest banks in existence during 

the past six years was 9.0 percent in the two years 

ending September 30, 2002, up from 1.1 percent in the 

four years ending September 30, 2000 (see Table 4). 

The Region’s community banks in existence during the 

past six years reported a more moderate increase in 

growth rates, from 4.4 percent (October 1996 through 

September 2000) to 6.0 percent (October 2000 through 

September 2002). This core deposit flow allowed 

community banks to slow the growth of noncore funds 

significantly. Note, however, that despite the deposit 

inflows during a weak economy, growth in noncore funds 

continued to exceed growth in core deposits. If economic 

and market stability return, community banks may face 

long-term funding challenges again. 

The account mix of core deposit growth further 

emphasizes this point. Although consumers are moving 

funds into banks, they are placing these funds in readily accessible accounts. Much of community bank 

deposit growth has occurred in checking, savings, and 

money market accounts, while time deposit growth has 

declined significantly (see Table 4). Apparently, 

although depositors are seeking the safety of insured 

deposits, they are not willing to lock into long-term 

commitments. If the stock market rebounds and funds 

Table 4 

Community Bank Core Deposit Growth Rates 

Have Increased Recently 

Community Banks Top 100 

Kansas City Region Nation 

Annualized Growth Rates (%)—September to September 

Total deposits 

1996 through 2000 

2001 through 2002 

5.47 

6.02 

4.51 

4.35 

Core deposits 

1996 through 2000 4.42 1.13 

2001 through 2002 

Checking and savings 

6.07 8.95 

1996 through 2000 4.87 2.81 

2001 through 2002 

Small time deposits 

10.28 14.66 

1996 through 2001 4.00 –1.34 

2001 through 2002 1.48 –10.03 

Total noncore funds 

1996 through 2000 20.12 10.70 

2001 through 2002 

Large time deposits 

6.47 –0.60 

1996 through 2000 15.08 13.23 

2001 through 2002 

Other noncore funds 

5.65 –1.41 

1996 through 2000 32.87 9.19 

2001 through 2002 7.91 3.26 

Note: This table refers to community banks headquartered in the Kansas City Region for 

the past six years. The "Top 100" category refers to the largest banks in operation during 

the past six years, with asset sizes ranging from $7 billion to $605 billion. 

"Community banks" are defined as insured institutions that hold $250 million or less in 

assets, excluding denovo and specialty institutions. Thrifts are excluded from this table. 

Source: Bank Call Reports, merger adjusted 

begin to move from banks into the equity markets, 

community banks will find it increasingly difficult to 

attract and retain core deposits. 

Therefore, community bankers must continue to monitor the long-term funding situation to ensure that lending and investment strategies related to core deposit 

inflows are appropriate. Moreover, managers should 

revisit the accuracy of current funding measurement 

tools. Do these tools help management identify and 

segregate shifts in funds among deposit accounts (for 

example, from certificates of deposit to money market 

accounts) from new funds flowing into the bank? 

Richard Cofer, Senior Financial Analyst 

John M. Anderlik, CFA, Regional Manager 

FDIC OUTLOOK 31 SPRING 2003 
Regional Perspectives 

New York Regional Perspectives 

Mid-Atlantic Economic and Banking Conditions 

Employment Growth in Some Mid-Atlantic Cities 

Has Not Kept Pace with the Nation 

While employment trends in the nation and the MidAtlantic Region improved modestly between March 

and October 2002, several of the Region’s metropolitan 

statistical areas (MSAs) did not keep pace.1 This article 

identifies MSAs that experienced a significantly higher 

rate of job contraction than the nation through October 2002 or exhibited weaker employment growth 

despite improvement nationwide.2 Most of them are 

small cities (labor force less than 1 million) with high 

concentrations of manufacturing jobs. Negative 

employment trends in some MSAs also reflect job cuts 

in state and municipal governments that have been 

affected adversely by the national recession. If these 

MSAs continue to lag the nation, banking conditions 

there could be negatively affected. The effects of the 

economic weakness will vary with differences in insured 

institutions’ business lines and risk profiles.3 (Employment data for the Region’s MSAs are provided in the 

Appendix.) 

MSAs That Lagged National Employment Trends 

Are Generally Smaller and Dependent on the 

Manufacturing Sector 

The Rochester, New York, economy relies more on 

manufacturing jobs than does the nation; manufacturing represents 18 percent of employment in Rochester 

compared with 13 percent for the nation. The rate of 

job contraction in Rochester eased between August and 

October 2002, similar to the national trend. However, 

as of October, Rochester’s rate of job growth (minus 

1 Employment growth for the nation, excluding the Mid-Atlantic Region, 

reached a floor of approximately minus 1.37 percent in February 2002 

and improved to minus 0.37 percent by October 2002. Job growth for 

the Mid-Atlantic Region bottomed in December 2001 at minus 1.12 

percent and eased to minus 0.51 percent by October 2002. 

2 For comparative purposes, national employment data exclude the 

Mid-Atlantic Region. Employment growth is measured by the yearover-year change in the trailing three-month moving average of 

employment for each MSA and the nation. 

3 Banking data for the Region’s MSAs represent medians. 

1.46 percent) remained lower 

than the nation’s (minus 0.64 

percent). The Rochester 

economy has been weakened 

by problems in technologyintensive firms, such 

as Global Crossing, 

Kodak, Xerox, and 

Corning, all of which 

announced significant layoffs 

during the recent recession. 

Similarly, the Elmira and Binghamton, New York (minus 2.22 

percent) MSAs lost jobs more rapidly than the rest of 

the nation during this period.4 These two MSAs rely 

heavily on computer hardware and telecommunications 

equipment manufacturing, industries that have experienced overcapacity. While the overall rate of job loss 

improved slightly in Binghamton between March and 

October, it declined in Elmira. 

Consistent with employment contraction, credit quality 

among insured institutions headquartered in the 

Rochester and Binghamton/Elmira MSAs has weakened 

in recent years. In the case of Binghamton/Elmira, credit 

quality has weakened to a greater extent than the 

national trend (see Table 1). However, institutions headquartered in Binghamton/Elmira are less heavily concentrated in commercial real estate (CRE) and commercial 

and industrial (C&I) lending, typically higher-risk lending businesses. Nevertheless, the ratio of the allowance 

for loan and lease losses (ALLL) to noncurrent loans 

has declined to a greater extent than for insured institutions across the nation and may be pressured further 

if the local economy continues to lag the nation. 

Insured institutions headquartered in the Rochester 

MSA have increased their concentrations in CRE and 

C&I loans to levels that are higher than elsewhere in 

the nation, with the median CRE loan concentration 

to capital doubling during the past four years. The pastdue loan ratio for banks and thrifts headquartered in 

this MSA equaled the nation’s as of third quarter 2002, 

4 Employment data for the Binghamton and Elmira MSAs are 

combined. 

FDIC OUTLOOK 32 SPRING 2003 
Regional Perspectives 

Table 1 

Risk Profiles for Insured Institutions Vary among Metro Areas That Have Lagged the Recovery 

Tier 1 C&I and ALLL Coverage ALLL to 

Number of Capital CRE Loans Past-Due of Noncurrent Total Loans 

Metropolitan Area Institutions Ratio (%) to Capital (%) Ratio (%) Loans (%) (%) 

Allentown 14 8.90 119 1.22 151 1.05 

Binghamton/Elmira 15 8.11 256 2.65 ▲ 140 ▼ 1.17 

Johnstown 10 8.55 223 2.17 ▲ 153 0.90 ▼ 

New York City 76 8.68 310 1.12 170 1.12 

Rochester 13 8.15 318 ▲ 1.85 118 1.05 ▼ 

Washington, D.C. 58 8.80 342 ▲ 0.74 361 1.19 

Wilmington 21 9.87 255 1.80 166 1.43 

U.S. Excluding Mid-Atlantic 6,183 8.87 297 1.87 167 1.22 

Notes: Past-due loans are loans 30 days or more past due or in nonaccrual status. Noncurrent are loans 90 days or more past due or in nonaccrual status.
 

CRE = commercial real estate. C&I = commercial and industrial loans.
 

Includes metropolitan statistical areas (MSAs) with at least ten insured institutions; therefore excludes the Mayaguez, Puerto Rico, and Trenton, New Jersey, MSAs.
 

Analysis excludes credit card and agricultural banks, and banks in operation less than three years. Banks with total assets over $10 billion also are excluded, as operations likely extend
 

beyond the metropolitan area in which these institutions are headquartered.
 

Triangle denotes an indicator that increased to a greater extent than the U.S. average during the past two years and that was above the U.S. average as of September 30, 2002. However, a
 

triangle appearing in the ALLL coverage ratio columns indicates that a value has declined more than the U.S. average and had fallen below the U.S. average as of the end of third quarter 2002.
 

Binghamton/Elmira includes the Binghamton and Elmira MSAs plus the surrounding Chenango, Cortland, Steuben, and Schuyler counties.
 

Johnstown includes the Johnstown MSA plus Bedford County.
 

Rochester includes the Rochester MSA plus the surrounding Seneca, Wyoming, and Yates counties.
 

Source: Bank and Thrift Call Reports
 

but loan charge-offs have outpaced the national average 

during the past year. Insured institutions in Rochester, 

on average, have increased provision expenses to 

replenish loan loss reserves; however, ALLL coverage 

remains well below the national average. 

Employment in Johnstown and Allentown, Pennsylvania, has contracted since first quarter 2002, and 

the rate of job decline worsened through October. 

Although manufacturing sectors in these MSAs 

continued to shrink, job losses have been widespread 

across industries. In Johnstown, for example, losses 

in manufacturing have been compounded by layoffs 

in the retail trade and transportation and public 

utilities sectors. In Allentown, job declines have 

also occurred in the retail trade and services sectors. 

Insured institutions headquartered in the Johnstown 

MSA have reported increases in loan delinquencies, 

consistent with the decline in employment conditions. 

The comparatively high median past-due loan ratio 

among banks and thrifts in this MSA is mitigated 

somewhat by a lower concentration of CRE and C&I 

loans to capital. One-half of insured institutions in the 

Johnstown MSA focus on residential mortgage lending. 

Insured institutions headquartered in the Allentown 

MSA had not reported deterioration in credit quality, 

on average, through third quarter 2002. Nonetheless, 

banks and thrifts in this MSA reported a lower median 

ALLL coverage level, potentially increasing their 

vulnerability to continued weakening in the local 

economy. However, modest commercial loan concentrations among insured institutions in Allentown likely 

would mitigate any weakening in asset quality. 

Employment in many cities in Puerto Rico has weakened because of a confluence of factors. First, the 

manufacturing-led recession in the U.S. mainland has 

contributed to job cuts in the island’s manufacturing 

sector. Second, the phase-out of Section 936 tax incentives provided to U.S.-based companies operating in 

Puerto Rico5 has contributed to the departure of some 

manufacturers, primarily labor-intensive industries such 

as food and apparel, to neighboring countries with lower 

labor costs. Finally, softness in the tourism industry and 

competition from other destinations has filtered throughout the island’s economy. Manufacturing jobs in 

Mayaguez contracted significantly during much of 2002. 

Manufacturing represents approximately 18 percent of 

this MSA’s employment, second to the government 

sector. The rate of job loss in the Mayaguez MSA deteriorated more quickly than in any other MSA in the 

Mid-Atlantic Region from March 2002 to October 

5 The 936 tax credit, which provided tax incentives to U.S.-based 

companies operating in Puerto Rico, expires over a ten-year period 

ending in 2005. The Puerto Rican government has enacted several 

incentives to help replace Section 936. 

FDIC OUTLOOK 33 SPRING 2003 
Regional Perspectives 

2002. Consistent with employment declines, credit 

quality has weakened among insured institutions headquartered in Puerto Rico. The median past-due ratio 

has increased on par with the national trend and may 

increase further if employment weakness continues. 

Manufacturing is not the only sector responsible for job 

losses in lagging areas. Employment losses in the Wilmington, Delaware, MSA occurred in the financial services and state government sectors as well. This MSA’s 

financial services sector employs more people than the 

manufacturing sector, and many of those jobs are more 

highly compensated. Employment in financial services 

weakened steadily from September 2001 through October 2002. Although employment declines decelerated 

slightly nationwide between August and October 2002, 

jobs were lost at an increasing rate in the Wilmington 

MSA. Insured institutions headquartered there reported 

an increase in the past-due ratio through third quarter 

2002, similar to the national trend. 

The situation in Trenton, New Jersey’s capital shows 

the serious fiscal problems many states face as a result 

of the recent recession. During first quarter 2002, as the 

nation was losing jobs, Trenton reported slightly positive job growth. The state’s growing budget imbalance, 

however, resulted in the layoff of more than 3,500 

government employees in July 2002. Job losses also have 

occurred in the city’s financial services and broader services sectors. The rate of job loss in Trenton between 

March and October 2002 was second in the MidAtlantic Region only to that of Mayaguez. Most insured 

institutions headquartered in the Trenton MSA reported 

past-due loan ratios below the national average through 

third quarter 2002. However, employment conditions 

weakened later in Trenton than in the rest of the 

nation. As credit quality typically lags economic conditions, job declines could pressure loan delinquency 

rates for insured institutions in the Trenton MSA. 

Employment Rates in Most of the Mid-Atlantic 

Region’s Larger Cities Kept Pace with the Nation 

Employment growth in most of the Region’s larger 

cities (labor forces greater than 1 million)6 kept pace 

with the nation through October 2002. Excluding 

the MSAs that experienced the highest rate of job 

6 The Region’s metropolitan areas with a labor force greater than 

1 million people are New York City, Washington, D.C., Philadelphia, 

Nassau-Suffolk, New York, Baltimore, Pittsburgh, and Newark. 

growth (Nassau-Suffolk, New York, at 0.15 percent) 

and the lowest (New York City at minus 1.67 

percent), employment grew at very similar rates in 

all the Region’s large cities. Moreover, except for 

Washington, D.C., where the rate of job loss 

increased through October, the rate of employment 

growth in the Region’s large cities has paralleled 

that of the nation. 

While employment in the New York City MSA 

continued to contract more rapidly than that of the 

nation, the rate of job loss has improved.7 Employment 

declined 3.1 percent during first quarter 2002, 

compared with 1.7 percent during third quarter 2002. 

Employment trends in New York City’s retail sector 

and business services sector also improved during 2002. 

In October 2002, the retail sector posted the first net 

gain in hiring since September 2001. However, job 

losses in the business services, manufacturing, transportation, and financial services sectors have been 

significant. The MSA is particularly vulnerable to 

further cutbacks or reduced compensation in the 

securities industry. While this industry represented 

approximately 5 percent of the jobs in Manhattan, 

it accounted for almost 21 percent of total salaries 

and wages because of its high compensation levels.8 

Like other cities in the Region, New York City faces 

a large fiscal imbalance that has prompted cuts in 

government employment. To help balance the budget, 

the city government approved an 18.5 percent property tax increase in November 2002, which could 

have broad and perhaps negative implications for the 

local economy. 

Loan quality remained favorable among insured 

institutions headquartered in the New York City 

MSA, on average, through third quarter 2002. Loan 

delinquency rates have remained well below national 

averages across loan types, although the median 

residential loan delinquency rate increased during 

2002. Residential loan quality may be pressured 

because of the property tax increase and a potential 

contraction in city government employment. Tax 

increases also likely will pressure commercial property 

cash flows. Exposure to CRE and C&I loans, typically 

higher-risk loan types, has increased among insured 

institutions headquartered in the New York City 

7 The New York City MSA includes the five New York City boroughs
 

as well as Putnam, Rockland, and Westchester counties.
 

8 Office of the State Deputy Comptroller for the City of New York,
 

“Review of the Four-Year Financial Plan for the City of New York,”
 

December 2002.
 

FDIC OUTLOOK 34 SPRING 2003 
Regional Perspectives 

Large Bank Profitability Has Declined with 

Shrinking Market-Sensitive Revenues 

Large banks (those with total assets over $10 billion) Chart 1 

headquartered in the Mid-Atlantic Region reported a Decline in Investment Banking and decline in the median return on assets, from 1.41 Venture Capital Revenues Has Been Offset percent in second quarter 2002 to 1.30 percent in the by Securities Gains in Third Quarter 2002 third quarter. The median net interest margin was flat 

2,000 Securities Gains over the period as asset yields declined with funding 

costs. Provisions moderated for most of the Region’s 

large banks in third quarter 2002. However, money 

center banks reported increased provisions on average 

Investment Banking and Venture Capital Revenue 

1,500 

$ Millions 1,000 during the quarter in response to continued weakness in 

corporate credit quality. Noninterest income declined 

moderately in third quarter 2002, largely because of 

declines in revenue from investment banking business 

500 

0 

lines, such as underwriting fees and brokerage, and losses 3Q01 4Q01 1Q02 2Q02 3Q02 

in venture capital activities. Conversely, securities gains	 Note: Includes institutions with total assets greater than $10 billion, excluding credit 

card banks. increased during this period, aided by declining market Source: Bank and Thrift Call Reports

interest rates (see Chart 1).
 

The malaise on Wall Street has hurt many market-
 Chart 2 

sensitive business lines, including asset management 

Initial Public Offering (IPO) and Merger and 

Acquisition Activity Has Dropped Sharply 

from Late 1990s–2000 Levels 

Source: Thomson Financial Services, Securities Industry Association Completed Global Mergers and Acquisitions ($ Trillions)

Initial Public Offering Activity ($ Billions) 

1990 1992 1994 1996 1998 2000 2002 

0 

1 

2 

3 

4 

0 

20 

40 

60 

80 

Right

axis 

Left 

axis 

activities, underwritings, initial public offerings, and 

mergers and acquisitions (see Chart 2). According to 

the Securities Industry Association, asset management 

fees declined 3.5 percent through the first nine months 

of 2002 compared with a year ago. This decline, should 

it continue in the fourth quarter, would be the second 

consecutive annual decrease in management fees after a 

decade of double-digit increases. Total underwriting 

dollar volume (including debt and equity) in 2002 was 

up slightly (1.8 percent) from 2001, after increasing 

almost 37 percent the previous year.9 

9 www.sia.com, January 8, 2003. Data represent amounts for 

New York Stock Exchange members. 

MSA on par with the national trend, as have ALLL 

coverage levels. 

Employment trends in the Washington, D.C., MSA 

(which includes parts of suburban Maryland, Northern 

Virginia, and two counties in West Virginia) began 

on a strong note in 2002 but weakened between March 

and October. Job losses have occurred in the business 

services, transportation, communications, and manufacturing sectors in the broader metropolitan area, 

particularly in parts of Northern Virginia. Job cuts in 

the airline, telecommunications, and technology 

sectors have affected the Northern Virginia economy 

adversely, especially in the Dulles corridor. Like the 

Trenton MSA, the District of Columbia’s local government faces budgetary challenges that have led to job 

declines in the government sector. 

Credit quality among insured institutions headquartered in the Washington, D.C., MSA remained favorable at September 30, 2002, compared with national 

trends. The median past-due loan ratio was lower 

across loan categories; the past-due CRE loan ratio 

was only a fraction of the national average. However, 

CRE loan exposure among insured institutions headquartered in this MSA increased during the latter part 

FDIC OUTLOOK 35	 SPRING 2003 
 

Regional Perspectives 

Appendix Table 1 

Employment Trends in Some (Mostly Smaller) Cities Have Not Kept Pace 

with the National Trends 

Employment Growth Employment Trends 

Metropolitan Area 

March 

2002 (%) 

August 

2002 (%) 

October 

2002 (%) 

Difference 

Between 

March–October 

Growth Rates (%) 

Difference 

Between 

August–October 

Growth Rates (%) 

Long-Term 

Growth Rate 

(1992–2000) (%) 

Allentown –0.95 –1.44 –1.45 –0.50 –0.01 1.80 

Binghamton/Elmira –2.39 –2.08 –2.22 0.17 –0.14 0.83 

Johnstown –1.38 –1.78 –1.94 –0.56 –0.15 0.88 

Mayaguez 0.44 –1.93 –2.51 –2.95 –0.58 0.80 

New York –3.12 –2.04 –1.67 1.46 0.37 1.78 

Rochester –1.83 –1.83 –1.46 0.37 0.37 0.96 

Trenton 0.21 –1.51 –1.79 –2.00 –0.28 1.73 

Wilmington –0.94 –0.08 –0.70 0.24 –0.62 2.71 

Washington, D.C. 0.26 –0.41 –0.59 –0.85 –0.17 2.52 

Albany 0.36 0.37 0.40 0.04 0.03 1.25 

Altoona –1.29 –0.60 0.11 1.40 0.71 1.34 

Atlantic City 0.77 1.07 0.76 –0.01 –0.31 1.48 

Baltimore 0.15 –1.00 –0.54 –0.69 0.45 1.86 

Bergen-Passaic –1.15 –1.39 –1.14 0.01 0.25 1.51 

Buffalo –0.70 –0.34 –0.38 0.32 –0.03 0.65 

Caguas –0.79 –2.22 –1.03 –0.24 1.20 3.70 

Dover N/A 0.96 0.42 N/A –0.54 N/A 

Dutchess County –0.65 –0.54 0.11 0.77 0.65 1.21 

Erie –0.80 0.60 0.57 1.37 –0.03 1.11 

Glens Falls –1.43 –0.55 0.00 1.43 0.55 1.21 

Harrisburg –0.16 –0.26 –0.25 –0.09 0.02 1.63 

Jersey City 0.63 0.63 0.61 –0.02 –0.02 1.72 

Lancaster 0.88 0.91 0.86 –0.02 –0.05 1.98 

Middlesex 0.37 0.10 –0.02 –0.40 –0.12 2.76 

Monmouth-Ocean 1.17 0.60 0.88 –0.28 0.29 2.66 

Nassau-Suffolk 0.54 0.15 0.15 –0.40 –0.01 2.08 

Newark –1.26 –1.00 –0.83 0.43 0.17 1.61 

Newburgh –0.08 0.47 0.75 0.83 0.28 2.08 

Philadelphia –0.59 –1.15 –1.03 –0.44 0.12 1.55 

Pittsburgh –1.11 –0.94 –0.65 0.46 0.29 1.26 

Ponce 0.17 2.92 1.95 1.78 –0.97 1.96 

Reading 0.08 0.59 0.47 0.39 –0.12 1.45 

San Juan –0.60 –0.05 1.18 1.78 1.23 2.57 

Scranton –1.06 –1.12 –0.76 0.30 0.35 1.08 

Sharon –1.54 –1.38 –1.05 0.49 0.33 2.00 

State College 0.33 0.69 0.47 0.14 –0.22 1.69 

Syracuse –0.31 –0.74 –0.27 0.03 0.47 0.76 

Utica –0.35 –0.42 –0.17 0.18 0.25 1.22 

Vineland –0.06 –1.44 –0.56 –0.50 0.89 0.88 

Williamsport –0.43 –0.72 –0.30 0.13 0.42 1.05 

York –2.28 –1.08 –1.29 0.99 –0.21 1.59 

U.S. Excluding Mid-Atlantic –1.31 –1.00 –0.64 0.67 0.35 2.54 

Note: N/A = not available. 

Data are year-over-year change in trailing three-month moving average of employment growth. 

Long-term trend is compound annual growth rate between 1992 and 2000. 

Sources: Bureau of Labor Statistics; Haver Analytics 

FDIC OUTLOOK 36 SPRING 2003 
Regional Perspectives 

of the economic expansion, driven in part by strong 

real estate development. At 266 percent, the median 

percentage of CRE loans to capital significantly 

exceeded the national level of 186 percent as of 

September 30, 2002, and CRE market conditions in 

the area have softened. A higher ALLL-to-noncurrent 

loan ratio than the national average may mitigate 

some of the increased risk exposure. However, as credit 

quality indicators typically lag the business cycle, 

emerging weakness in several of the MSA’s key industries could affect insured institution asset quality in 

the near term. 

Mid-Atlantic Staff 

New England job and income growth lagged 

that of the nation in late 2002, although 

state unemployment rates remained at 

or below the national average. 

Massachusetts (which accounts for 

half of New England’s economic activity) remained the greatest drag on the 

area’s overall job growth; however, stagnant labor markets characterized most of 

the New England states last fall. Strong 

productivity growth modestly boosted 

real per capita income during the first 

half of 2002, despite lackluster labor markets. Still, 

a meaningful rebound in economic growth in New 

England depends on a national economic expansion 

and, in particular, a resumption of steady gains in 

business investment. Continued improvement in 

the U.S. equities market would also support income 

growth and consumer spending across New England. 

Insured Institutions Remain Healthy 

Insured institutions headquartered in New England 

reported healthy financial conditions during the first 

nine months of 2002 (see Table 1, next page). Net 

interest margins rebounded, particularly in smaller institutions (total assets less than $1 billion) and remained 

relatively steady in larger institutions (total assets more 

New England Economic and Banking Conditions 

The New England Economy Continued 

to Lag the Nation Late Last Year 

than $1 billion) during the past two years. Steady levels 

of noninterest income and low loan loss provisions, aided 

by few asset quality problems, helped profitability. 

Smaller insured institutions report strong growth 

in traditionally higher-risk loan types (commercial real estate, construction, and multifamily). 

Larger institutions report strong commercial real 

estate and construction loan growth as well. As a 

result, higher-risk loans made up just over 38 percent 

of total loans as of September 30, 2002, rising from 

the recent low point of 28 percent in 1994. This 

increase occurred as insured institutions shrank 

mortgage-backed loan portfolios that historically have 

experienced low loss rates. Despite the decline in 

mortgage-backed loans as a percentage of total loans, 

the volume of long-term assets has increased following 

heavy refinancing of adjustable rate loans into lowerrate, long-term, fixed-rate products. The median ratio 

of long-term assets as a percentage of earning assets 

increased to almost 33.5 percent as of September 30, 

2002, from its recent low point of approximately 13 

percent in 1990. 

As funding costs increase, insured institutions will hold 

large concentrations of long-term, fixed-rate products. 

These assets have no repricing option and likely will 

show low prepayment rates, increasing institutions’ 

exposure to interest rate risk. Earnings may suffer as a 

result. Also, if the recovery stalls or the economy suffers 

another downturn, defaults may rise in the higher-risk 

portfolios, adversely affecting earnings. 

FDIC OUTLOOK 37 SPRING 2003 
Regional Perspectives 

Table 1 

New England Insured Institutions, Particularly Large Banks, 

Continue to Report Healthy Conditions 

New England Region < $1 billion > $1 billion 

Sept. 02 Sept. 01 Sept. 00 Sept. 02 Sept. 01 Sept. 00 Sept. 02 Sept. 01 Sept. 00 

Return on Assets (ROA) (YTD) 1.11 1.11 1.09 0.98 0.94 1.05 1.19 1.20 1.11 

Median ROA 0.88 0.81 0.91 0.84 0.77 0.90 1.08 1.08 1.04 

Net Interest Margin (YTD) 3.80 3.75 3.82 3.94 3.77 3.90 3.71 3.73 3.78 

Past-Due Ratio 1.12 1.27 1.22 1.22 1.38 1.33 1.05 1.19 1.15 

Core Deposits/Assets 65.62 65.13 65.63 69.66 69.30 70.15 63.22 62.64 63.02 

Noncore Funding/Assets 23.07 23.13 23.38 18.78 18.88 18.10 25.61 25.67 26.43 

Loans/Assets 57.85 60.75 62.32 62.74 65.06 66.44 54.95 58.18 59.94 

C & I Loans/Loans 12.94 13.08 13.28 7.32 7.13 6.75 16.75 17.04 17.47 

Consumer Loans/Loans 10.26 10.07 9.92 4.20 4.63 5.03 14.37 13.71 13.06 

Single Family RE & MBS/Assets 45.81 46.50 46.38 46.24 47.60 48.31 45.54 45.83 45.26 

Total Loan Growth (Year-over-Year) 5.17 5.71 10.85 6.19 8.23 11.55 4.49 4.10 10.41 

Tier 1 Leverage Ratio 8.30 8.59 8.55 9.92 10.01 10.26 7.30 7.72 7.55 

YTD = year to date. C&I = commercial and industrial.
 

RE = real estate. MBS = mortgage backed securities.
 

All figures are percentages.
 

Note: All data exclude credit card institutions, Fleet, and State Street.
 

Source: Bank and Thrift Call Reports, reported on a merger-adjusted basis
 

The Risk of Declining Home Prices Is Modest 

Nationally, strong home price appreciation has continued despite a recession. The same is true in Massachusetts (particularly in greater Boston, including Cape 

Cod), as well as in other areas of New England, such as 

southeastern New Hampshire, Providence, Portland 

(Maine), and Stamford (Connecticut). Since home 

sales and price growth typically slow during a recession, 

some concern exists that housing price “bubbles” may 

have formed in certain markets across the nation and 

in New England.1 In response to this concern, this 

article looks at where New England home prices may 

be headed and presents evidence that a near-term 

collapse in home prices, such as occurred in the early 

1990s, appears unlikely. 

1 For a discussion of home price issues, see “In Focus This Quarter,” 

Regional Outlook, first quarter 2002. 

Certain New England Markets May Be Exhibiting 

Unsustainable Rates of Home Price Appreciation 

What Are Home Price Bubbles? 

There is no precise definition of a “bubble” in the 

economics and finance literature. Typically, the term 

refers to episodes when market prices rise well above 

market fundamentals, or the factors that support prices 

in the long run. Thus, the rapid rate of home price 

appreciation observed in many New England markets 

in recent years does not, in itself, indicate a bubble. 

Economists use statistical models to try to identify 

market bubbles before they burst. Typically, these 

models estimate the relationship over time between 

market fundamentals (such as population, incomes, 

interest rates) and changes in some measure of home 

prices. Once the model is estimated, the current value 

of home prices can be compared with the value 

predicted by the model to identify markets where 

prices may have risen beyond what the fundamentals 

can support. 

FDIC OUTLOOK 38 SPRING 2003 
Regional Perspectives 

Three New England Markets May Be Susceptible 

to Price Corrections 

Three recently published statistical analyses suggest 

that home price increases have gone beyond the levels 

that market fundamentals would suggest in Boston, 

Providence, and Portland.2 Note that, even though 

the results of these analyses appear to be a fairly reliable indicator of overheating in home prices, their 

ability to forecast future price trends is limited. This 

is due to the fact that underlying economic fundamentals and housing supply dynamics also are key 

determinants of future home prices.3 

Chart 1 shows the Office of Federal Housing Enterprise Oversight’s home price index for these markets 

Chart 1 

Of Those Markets Possibly Showing 

Unsustainable Price Trends, Only Boston 

Has Begun to See Slower Price Growth 

Note: YTD = year to date. 

Source: OFHEO 

Weighted Repeat Sales Index

Percent Change One Year Ago

Providence 

Portland 

Boston 

’86 ’88 ’90 ’92 ’94 ’96 ’98 ’00 ’02ytd 

–10 

–5 

0 

5 

10 

15 

20 

25 

30 

2 Three models have produced the following results: 

1.“The Single Family Housing Monitor, Second Quarter 2002,”
 

Economy.com, September 2002, identifies Providence as
 

“overpriced,” with Boston and Portland “highly overpriced.” 


2.These same markets were identified by Local Market Monitor
 

as (respectively) 30 percent, 36 percent, and 15 percent
 

“overvalued” in Chris Horymski, “Where Is Your Home’s Value
 

Headed?” SmartMoney Magazine, November 15, 2002.
 

3.Michael D. Youngblood, “Is There a Bubble in Housing? New 

Evidence From 123 Housing Markets,” RiskView, LoanPerformance, 

Vol. VIII, No. 4, suggests that Boston was exhibiting a price 

bubble in 2001 (this finding likely held true in 2002 as well, given 

subsequent fundamental trends). 3 The original specification of the model estimated by LoanPerformance (Stephen Malpezzi, “A Simple Error Correction Model of House 

Prices,” Journal of Housing Economics, No. 8, 1999) had an adjusted 

R2 (goodness of fit) of 61 percent, while that for the Economy.com 

model had an adjusted R2 of 95 percent. On the question of forecast 

accuracy, Malpezzi used multiple variations of his disequilibrium 

model in 1999 to predict subsequent price changes, but was able, at 

best, to account for only 35 percent of the variation in price change. 

through third quarter 2002.4 Although home prices 

continued to appreciate at an accelerating rate in 

Providence, the rate of growth has begun to decelerate 

in Boston. While current rates of price appreciation 

likely may be unsustainable, the critical question for 

home owners and lenders in these markets is whether 

housing prices will begin to decline. 

Despite the Weak Economy and Recent Significant 

Price Appreciation, New England Home Prices 

Are Not Likely to Decline Significantly 

Unlike the early 1990s, several conditions are present 

today that should help prevent a substantial drop in 

home prices. These conditions include a relatively 

healthier economy, limited new supply, favorable 

demographic trends, and greater pent-up demand for 

housing. 

Economic Conditions Are Stronger Today than 

in the Early 1990s 

Economic conditions today, despite the recent recession, are not as dire as during the early 1990s. Fewer 

potential excesses in housing markets developed 

during the most recent expansion, and this recession 

has been much milder than that experienced more 

than a decade ago. 

During the 1980s, twin booms in commercial and 

residential real estate led the economic cycle, especially in southern New England, allowing real estate 

imbalances to develop which spilled into the general 

economy. More recently, however, residential and 

commercial real estate markets followed the boost 

in personal incomes caused by a strong information 

technology sector and significant gains in the equity 

markets. As a result, there was less time for price and 

supply imbalances to form and for speculative behavior 

to become entrenched. In addition, the cyclical effects 

of the early 1990s recession were compounded by 

downsizing in the defense industry and a collapse in 

the area’s dominant minicomputer industry-structural 

drags on growth that are absent today. 

4

The index records the price trend, based on resale or refinance, of 

a set of properties where past transactions are available. It is limited 

to conventional single-family purchase and refinance transactions 

that fall within the current conforming loan limit ($322,700 in 2003). 

FDIC OUTLOOK 39 SPRING 2003 
Regional Perspectives 

New Construction and Supply Have Been 

Restrained Relative to the 1980s 

Housing supply has been fairly restrained during the past 

decade, a much different scenario from that of the 1980s 

(see Chart 2). In addition, it currently does not appear 

that existing rental units are being converted on a large 

scale to owner-occupied condominiums in the greater 

Boston market. These conversions helped to suppress 

home prices in the early 1990s, even as new building 

activity had waned. 

Population Trends Are Stronger Today than in 

the Early 1990s 

The severity of the early 1990s recession in New 

England prompted an outflow of residents from some 

areas while dampening population growth in others. 

This demographic drag increased the inventory of 

homes for sale and reduced the number of potential 

buyers. Chart 3 shows the relationship between population and home price trends in Boston and Providence. The chart also may help explain why home 

price growth in Providence continued to accelerate 

recently, despite the weak economy. Continued population growth, thanks to a relatively easy commute 

to Boston-area jobs and lower home prices compared 

with similar properties closer to Boston, may be 

supporting housing demand and home price appreciation in the Providence area. Portland has also 

maintained steady population growth in recent years, 

supporting housing demand and price appreciation 

in that market. 

Pent-Up Demand May Mitigate the Magnitude 

of Any Price Declines 

Housing affordability recently has declined in many 

New England markets. The rapid rise in home prices 

during the late 1990s may have priced some buyers 

out of the market. If prices eased somewhat, these 

buyers could reenter the market, helping to avert 

the sort of precipitous price decline seen in the early 

1990s. Chart 4 shows trends in housing affordability 

during the past five years for several New England 

markets. In markets where affordability has dropped 

dramatically, such as Boston, pent-up demand may be 

more pronounced than in markets such as Providence, 

where affordability has changed little despite the 

recent runup in prices. 

Chart 2 

Unlike the 1980s, Housing Supply Has Been 

Restrained, Which Should Help to Support Prices 

Source: Census Bureau Single-Family Residential Permits Per 1,000 Residents

Rest of New England 

MA 

CT 

0 

2 

4 

6 

8 

10 

12 

’80 ’82 ’84 ’86 ’88 ’90 ’92 ’94 ’96 ’98 ’00 ’02 

Chart 3 

Boston 

Annual Change, Thousands

Percent Change One Year 

Home Price 

Appreciation (R) 

Population (L) 

–25 

0 

25 

50 

75 

’81 ’83 ’85 ’87 ’89 ’91 ’93 ’95 ’97 ’99 ’01 

Providence 

Annual Change, Thousands

Percent Change One Year Ago 

Home Price 

Appreciation (R) 

Population (L) 

0 

5 

10 

15 

’81 ’83 ’85 ’87 ’89 ’91 ’93 ’95 ’97 ’99 ’01 

Source: OFHEO and Economy.com 

Population Outflows Aggravated Home Price Declines in the Early 1990s, 

while Recent Population Growth Is Supporting Price Gains in Providence 

–10 

0 

10 

20 

30 

–10 

0 

10 

20 

30 

FDIC OUTLOOK 40 SPRING 2003 
Regional Perspectives 

What Are the Implications for Insured Institutions? Chart 4 

Falling Affordability May Have Created As of September 30, 2002, insured institutions in Pent-Up Demand in Some New England Markets, New England continued to report low aggregate Which Could Limit Future Price Declines 

delinquency and loss rates on residential mortgages 

and home equity lines of credit (in line with national 

trends). However, if home prices begin to falter in 

combination with continued weakness in the economy and a persistent rise in unemployment rates, 

residential real estate credit quality could deteriorate. 

Housing Affordability Index


Percent Change 1997–2002


10 

0 

–10 

–20 

–30 

–40 

Mortgage lending also may be more challenging today 

because of innovations in this business line since the 

last bicoastal real estate crisis in the early 1990s. 

These new practices include widespread adoption of 

automated appraisal systems, subprime lending, and 

higher leverage on purchase mortgages.5 

Residential lenders should be aware of the altered 

risk environment today compared to a decade ago, 

especially since many of these innovations have not 

weathered a severe real estate downturn. However, 

5 See “In Focus This Quarter,” Regional Outlook, first quarter 2002. 

Hartford

New Haven

Springfield

Providence

Portland

Bangor

Lewiston

Cape Cod

New London

Burlington

Pittsfield

Boston 

Source: Economy.com 

despite these changes, it appears likely that mortgage 

lending will retain a lower relative credit risk than 

credit card, non-real estate secured personal, and 

commercial lending. 

Norman Williams, Regional Economist 

Cameron Tabor, Senior Financial Analyst 

FDIC OUTLOOK 41 SPRING 2003 
Regional Perspectives 

San Francisco Regional Perspectives
 

Continued Economic Sluggishness, Shifts in 

Residential Mortgage Exposures, and Changes 

in Underwriting Practices Could Challenge 

the Region’s Mortgage Lenders 

Repeated refinancing waves during 2001 and 2002 

eased the effects of the recession on consumers in 

many of the Region’s local economies. Low interest 

rates and escalating home values in the Region during 

the past several years enabled borrowers to refinance 

and, by some estimates, cash out over $80 billion in 

home equity.1 This money has been used to pay off 

loans, purchase consumer goods, and make home 

price appreciation may have negative effects 

improvements. Going forward, slowing home 

on the economy as refinancing and cashout opportunities dry up. This 

article identifies the residential markets that could be 

vulnerable to price pressures 

as a result of adverse trends 

in employment, migration, or 

affordability. It also examines 

changes in the residential lending 

market that might increase risks to 

insured institutions. 

Employment Downturns Could Prompt 

Out-Migration in Some Markets 

Sluggishness in the high-tech and civilian aerospace 

sectors continued to affect nonfarm employment 

adversely in several metropolitan statistical areas 

(MSAs) throughout the Region. The most notable 

year-over-year declines as of November 2002 occurred 

in the San Jose, Seattle, San Francisco, Provo, 

Salt Lake City, Spokane, Boise, and Portland MSAs. 

The Region’s employment trends could affect migration 

and housing prices adversely. A Census Bureau study 

suggests that 31 percent of households that relocated 

across county lines between 1999 and 2000 did so for 

1 “The Economic Contribution of the Mortgage Refinancing Boom,” 

a joint research project of Economy.com and the Homeownership 

Alliance, December 2002, p. 7 (http://www.economy.com/store/ 

samples/refinancing1202.pdf). 

job-related reasons.2 During the early 1990s recession, 

when job availability in California declined, people 

moved out of the state.3 Nevada, Oregon, Washington, Arizona, and Utah were destinations for net 

migration out of California between 1990 and 1994.4,5 

As a result, home prices fell in California (primarily 

in Southern California) and home values increased 

in the surrounding states, most notably in Utah (see 

Chart 1). 

Domestic out-migration is already evident from some 

areas of the Region that suffered significant job losses 

following the 2001–02 recession. During 2002, United 

Van Lines identified net outbound household relocations for Utah, Washington, and California.6 Net 

out-migration has also occurred in the Bay Area and 

Seattle as a result of the technology industry problems 

and, more recently, Boeing layoffs in Seattle.7,8 

The Confluence of Weak Employment and 

Affordability Could Pressure Home Prices 

In addition to job losses and out-migration, prolonged 

periods of low affordability (a situation in which home 

price appreciation outpaces personal income growth) 

can affect housing prices. Because personal income 

is a key driver of home prices, “prolonged and rapid 

increases in the price to income ratio may be a sign 

2 Jason Schachter, Why People Move: Exploring the March 2000 Current Population Survey, Census Bureau Special Study, May 2001, p. 3.
 3 Stuart Gabriel, Joe Mattey, and William Wascher, “The Demise of
 

California Reconsidered: Interstate Migration over the Economic
 

Cycle,” Federal Reserve Bank of San Francisco Economic Review,
 

Number 2, 1995, p. 30.
 

4 Hans P. Johnson and Richard Lovelady, Migration Between California
 

and Other States: 1985 to 1994, a joint research project of the California
 

State Library and the California Department of Finance, November
 

1995, p. 33.
 

5 Utah Data Guide, Utah State Data Center, Governor’s Office of Planning and Budget, Demographic and Economic Analysis, Autumn 2001,
 

p. 9, (http://www.governor.state.ut.us/dea/publications/dataguide/
 

01udg10.pdf).
 

6 “Southern States Gaining Appeal, North Sees More Leaving,
 

According to Latest United Van Lines Study,” United Van Lines Press
 

Release, January 7, 2003.
 

7 Amanda Bronstad, “Moving—Southward Migration: Bay Area
 

Troubles Sending Workers In L.A.’s Direction,” Los Angeles Business
 

Journal, July 23, 2001.
 8 Bradley Meacham and Dave Woodfill, “Seattle Sees More People
 

Moving Out of City Than In,” Seattle Times, January 7, 2003.
 

FDIC OUTLOOK 42 SPRING 2003 
Regional Perspectives 

Chart 1 House Price Index, Year/

Year Percentage Change 

Home Prices Have Appreciated Only Slightly in Utah since 2000; 

Appreciation Has Outpaced the Nation in California 

California 

Nation 

Utah 

–10 

–5 

0 

5 

10 

15 

20 

25 

Recessions (shaded periods) 

California and Utah Correlation = –0.7 

’85 ’86 ’87 ’88 ’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00 ’01 ’02

Sources: Office of Federal Housing Enterprise Oversight and National Bureau of Economic Analysis 

of an overshooting cycle or a bubble,”9 as they may 

signal that speculative rather than fundamental factors 

are driving house prices. Over the long term, market 

forces are expected to correct any imbalances. 

Several studies have compared personal income levels 

with home prices and identified various areas in the 

San Francisco Region that may be vulnerable to 

housing price declines. Research studies published 

by PMI and LoanPerformance suggest that the 

confluence of employment and affordability issues 

in the Oakland, Phoenix, Portland, Salt Lake City, 

San Diego, San Francisco, San Jose, Santa Barbara, 

and Seattle markets could increase their vulnerability 

to home price declines (see Table 1).10,11 Of these 

markets, SmartMoney also identified the San Diego 

and Oakland housing markets as being overvalued 

by at least 29 percent.12 In addition, data from 

Economy.com reveal that the affordability index in 

the Santa Barbara, San Francisco, San Diego, and 

San Jose MSAs was nearly half the national average 

as of third quarter 2002. In addition to concerns about 

affordability, rising interest rates could increase new 

homebuyers’ mortgage costs as well as the cost of variable rate mortgages and further pressure home prices. 

9 Office of Federal Housing Enterprise Oversight, House Price Index,
 

Fourth Quarter 2000, March 1, 2001, pp. 7-8.
 10 “Economic & Real Estate Trends,” PMI Mortgage Insurance Co.,
 

September 2002 (http://www.pmigroup.com/media/pmi_eret02v3s.pdf).
 11 Michael D. Youngblood, “Is There a Bubble in Housing? New
 

Evidence from 123 Housing Markets,” The Market Pulse, Vol. VIII,
 

Issue 4, 2002 (Loan Performance Corporation).
 

12 Chris Taylor, “Your Home’s Value: Will It Rise or Fall?”
 

Smartmoney.com, November 15, 2002 (http://www.smartmoney.com/
 

mag/index.cfm?story=dec02-homes).
 

Foreclosures Have Risen in Some Areas, 

but Insured Institutions Continue to Report 

Low Mortgage Delinquency Ratios 

Low interest rates and home price gains generally 

mitigated the effects of the recent recession. However, 

high and rising foreclosure rates and above-average 

personal bankruptcy rates in Utah, Nevada, and Idaho 

through third quarter 2002 suggest that some homeowners are having difficulty meeting mortgage debt 

payments (see Chart 2, next page). In addition, foreclosure rates in Oregon, Washington, and Montana 

exceed levels reported during the early 1990s. Foreclosure rates for California have declined during the 

past year; however, an increase in the number of 

Notice of Default filings in several Bay Area counties 

suggests that a growing number of households in the 

area are experiencing financial difficulties.13 

Despite the rise in foreclosures, insured institutions headquartered in 13 of the Region’s 19 major MSAs reported 

year-over-year flat or declining median single-family 

mortgage delinquency rates.14 Of the six major markets 

13 “California Foreclosures Decline,” DataQuick Real Estate News, 

October 30, 2002 (http://www.dqnews.com/RRFor1002.shtm). 14 Based on a comparison of MSAs in which more than five insured 

institutions with total assets of less than $5 billion were headquartered. Insured institutions chartered as industrial loan companies, 

those with consumer loan-to-Tier 1 capital ratios exceeding 200 

percent, and those with single-family mortgage-to-Tier 1 capital 

plus loan loss reserve ratios of less than 25 percent were excluded 

to minimize the effects of insured institutions with broad lending 

markets or very small mortgage portfolios. The analysis also 

excluded insured institutions less than three years old, as these 

institutions often do not hold seasoned loan portfolios. 

FDIC OUTLOOK 43 SPRING 2003 
Regional Perspectives 

Table 1 

Nine Housing Markets in the Region May Be Vulnerable 

to a Home Price Decline Because of Economic Issues 

PMI Loan- SmartMoney Economy.com House Price Nonfarm Unemployment Unemployment 

Study Performance Home Price Housing (compound Employment Rate Rate 

Metropolitan Nonparametric (percent Affordability annual (year/year (annual % 

Statistical Test overvalued) (index) growth rate) % change) change) 

Area (MSA) Sept. 02 2002 Nov. 02 3Q02 3Q97/3Q02 Nov. 02 Nov. 02 Nov. 02 

Oakland High risk Bubble 29% 83 12.5% –0.1% 5.9% 0.8% 

Phoenix High risk 10% 151 6.4% 0.4% 5.2% 0.1% 

Portland High risk Bubble 23% 110 4.1% –0.7% 7.0% –0.4% 

Salt Lake City High risk 12% 135 2.9% –1.8% 4.9% 0.3% 

San Diego Bubble 41% 60 12.4% 1.8% 4.1% 0.4% 

San Francisco High risk Bubble 17% 59 12.3% –2.2% 5.2% 0.1% 

San Jose High risk Bubble 0% 62 12.1% –2.9% 7.8% 0.9% 

Santa Barbara N/A Bubble 17% 55 12.8% –0.3% 4.6% 0.6% 

Seattle High risk 19% 78 7.5% –2.5% 6.2% –0.1% 

Nation 111 6.7% –0.1% 5.7% 0.4% 

Notes: The Economy.com Affordability Index gauges, for each MSA, what percentage of a mortgage a household earning a median income and buying a median-priced home can afford.
 

Some studies did not include all the MSAs in the Region. The unemployment rate was not seasonally adjusted.
 

Sources: PMI Mortgage Insurance Co.; LoanPerformance; SmartMoney.com; Economy.com; Office of Federal Housing Enterprise Oversight; and Bureau of Labor Statistics
 

Chart 2 Foreclosure Start Rate (Perccentage) 

Foreclosure Rates Are High in Utah, Nevada, and Idaho 

Note: Data reflect four-quarter moving averages through third quarter of each year. 

Source: Mortgage Bankers Association of America via Haver Analytics 

0.0 

0.1 

0.2 

0.3 

0.4 

0.5 

0.6 

0.7 

UT NV ID US OR WA AZ MT HI CA WY AK 

1992 20021997 

with rising mortgage delinquency rates, median past-due 

ratios exceeded 1 percent only in the Provo and San Jose 

MSAs. Furthermore, insured institutions headquartered 

in the San Francisco Region generally reported healthy 

earnings, relatively high capital, and manageable proportions of problem assets through third quarter 2002.15 

15 As of September 30, 2002, 89 percent of the Region’s insured 

institutions were profitable, up from 82 percent in third quarter 1992. 

Similarly, the median Tier 1 leverage capital ratio reported in the 

Region was 9.1 percent, up appreciably from 8.1 percent a decade 

earlier. The third quarter 2002 median past-due loan ratio declined 

year-over-year from 1.49 percent to 1.28 percent and was down 

substantially from a median ratio of 3.25 percent in 1992. 

Structural Changes in the Residential Lending 

Market Could Challenge Insured Institution 

Risk Management 

Shifts in mortgage portfolio composition, changes in 

underwriting processes and standards, and heightened 

exposures to construction lending could pose new 

challenges in some markets. 

FDIC OUTLOOK 44 SPRING 2003 
Regional Perspectives 

Changes in Mortgage Portfolio Composition Changes in Underwriting Standards and Processes 

Could Affect Future Delinquency Trends Could Introduce New Risks 

Residential property markets are of prime importance 

to lenders that specialize in single-family mortgages, 

specifically the Region’s 94 savings institutions. 

Commercial banks are generally less exposed to residential mortgages and hold smaller concentrations 

now than a decade ago. Nevertheless, changes in 

local residential real estate values remain important 

to banks, given the current composition of bank residential mortgage exposures. Home equity loans and 

lines of credit constitute a larger share of community 

bank16 exposures now than ten years ago, while standard residential mortgages comprise a smaller proportion of direct mortgage exposures. 

Home equity-based loans may challenge lenders because 

these loans are often secured by junior liens on homes 

or carry adjustable interest rates. A decline in home 

value can quickly erode the collateral protection of a 

junior lien, and increases in interest rates can strain 

the ability of certain households to remain current on 

their debts. Commercial banks headquartered in the 

Santa Barbara, Provo, Oakland, Santa Rosa, Stockton, 

and San Francisco MSAs reported relatively high 

home equity credit-to-Tier 1 capital and reserve ratios 

as of third quarter 2002 (see Chart 3). 

Mortgage loan underwriting has changed somewhat 

during the past decade. Subprime lending has gained in 

popularity, and the underwriting process in general has 

become more automated. According to Inside B&C 

Lending, subprime mortgages represent about 8 percent 

of all mortgage debt nationally, and the outstanding 

volume of subprime mortgages grew 8 percent during 

the first nine months of 2002.17 The introduction of 

credit scoring and automated valuation models (AVMs) 

also has changed the way many residential lenders 

evaluate a borrower’s creditworthiness. The benefits 

of automation include speed and cost of execution 

and the removal of potential human biases. However, 

on the downside, the property is often not inspected 

and the model may not select appropriate comparable 

transactions. In addition, scoring models and AVMs 

have not been tested through a full real estate cycle. 

Federal Housing Finance Board surveys suggest 

that lenders in certain markets have also eased collateral protection requirements. During 2001, the loanto-purchase price (LTPP) ratio of at least one-quarter 

of purchase-money mortgages18 that originated in 

the Honolulu, Phoenix, Tucson, Las Vegas, Fresno, 

and Salt Lake City MSAs exceeded 90 percent 

Chart 3 

Insured Institutions in Northern California Hold Relatively High Concentrations of Home Equity Loans 

100 

Home Equity Exposure to

Tier 1 Capital and Loan

Loss Reserves (Median %) 80 

60 

40 

20 

0 

Santa Barbara

Provo

Oakland

Santa Rosa

Stockton

San Francisco

Nation

Tacoma

San Diego

Orange County

Salt Lake City

Phoenix

Seattle

San Jose

Portland

Cheyenne

Las Vegas

Riverside

Sacramento

Los Angeles 

Note: Medians are based on insured commercial banks with less than $5 billion in total assets that are not industrial loan companies and that do not have consumer
 

loan-to-Tier 1 capital ratios exceeding 200 percent. Only metropolitan statistical areas (MSAs) with more than five qualifying insured banks are shown.
 

“Nation” includes similar types of insured banks headquartered in MSAs outside the San Francisco Region.
 

Source: Bank and Thrift Call Reports (September 30, 2002)
 

16 Community banks are defined in this article as insured commercial 

banks that hold less than $5 billion in total assets. Industrial loan 17 “Record Loan Volume Fuels Strong Servicing Growth Through 

companies and specialty consumer lenders often meet this definition Third Q,” Inside B&C Lending, Vol. 7, Issue 24, December 2, 2002. 

but hold large concentrations of out-of-area loans. Therefore, they 18 Purchase-money mortgages include conventional loans used 

are excluded from this analysis. to finance the purchase of a single-family residence. 

FDIC OUTLOOK 45 SPRING 2003 
Regional Perspectives 

(see Chart 4), up substantially from the early 1990s. Chart 4 

Nationally, roughly 21 percent of mortgages had Collateral Margins Are Often Narrow similarly high LTPP ratios, more than double the ratio in Hawaii, Arizona, and Nevada reported in the late 1980s and early 1990s. According 50 Share of Mortgages Used to Purchase Homes (Percent)

to the Federal Housing Finance Board, commercial 

banks, rather than thrifts or mortgage companies, 

originated a disproportionately high share of these 

mortgages during 2002. Private mortgage insurance 

may mitigate losses in the event of foreclosure. 

However, higher LTPP ratios suggest that default rates 

on single-family mortgages could increase should job 

declines, migration trends, or rising interest rates 

adversely affect borrower cash flows or property values. 

> 90% LTPP 

80–90% LTPP 40 

30 

20 

10 

0 

Residential Construction Loans Are Also 

Vulnerable to Declining Home Prices 

Construction expenditure data and anecdotal evidence 

suggest that construction and development (C&D) 

loan exposures are composed, in part, of single-family 

development loans.19 Community institutions headquartered in the Provo, Salt Lake City, Las Vegas, 

San Luis Obispo, and San Jose MSAs hold relatively 

high concentrations of C&D loans (see Chart 5). 

Median C&D loan delinquency ratios remained low 

among institutions headquartered in these areas as of 

third quarter 2002. However, high concentrations are a 

concern because institutions with elevated C&D loan 

Chart 5 

LTPP = loan-to-purchase-price ratio.
 

Note: “*” denotes consolidated metropolitan statistical area. Figures are based on
 

terms for purchase money mortgages originated during 2001.
 

Source: Federal Housing Financing Board
 

exposures were more likely to fail during the banking 

crisis of the late 1980s and early 1990s.20 Deterioration 

in the construction loan portfolio during that period 

was attributed to softening market conditions and 

weak underwriting, especially among insured institutions headquartered in California. Since that time, 

underwriting standards have reportedly tightened.21 

However, 29 percent of Federal Deposit Insurance 

Corporation examiners responding to a recently 

conducted underwriting survey stated that institutions 

Insured Institutions in Fast-Growing Utah and Nevada Report the Highest Construction Loan Concentrations 

Construction Loans to

Tier 1 Capital and Loan

Loss Reserves (Median %)

160 

140 

120 

100 

80 

60 

40 

20 

0 

Provo

Salt Lake City

Las Vegas

San Luis Obispo

San Jose

Seattle

Spokane

Stockton

Santa Rosa

Sacramento

Portland


Riverside


Tacoma


Phoenix


Santa Barbara

Oakland

Cheyenne

San Diego

Nation 

Note: Medians are based on insured institutions with less than $5 billion in total assets that are not industrial loan companies and that do not have consumer loan-to-Tier 1 capital ratios
 

exceeding 200 percent. “Nation” includes similar types of insured banks headquartered in MSAs outside the San Francisco Region.
 

Source: Bank and Thrift Call Reports (September 30, 2002)
 

19 The actual proportion of C&D credits used to finance residential 

construction is unknown because of Call Report limitations. Only 

Thrift Financial Report filers must distinguish between residential 

and commercial construction loans. Examiners do report that the 

size of most community banks precludes them from participating in 

larger-scale office, industrial, and retail projects. 

20 Federal Deposit Insurance Corporation, History of the Eighties—
 

Lessons for the Future, Vol. 1: An Examination of the Banking Crises
 

of the 1980s and Early 1990s, Chapter 3, Washington, DC: Federal
 

Deposit Insurance Corporation, 1997.
 

21 Steve Burton, “Recent Trends in Construction Loan Underwriting,”
 

Bank Trends, Federal Deposit Insurance Corporation, July 1999.
 

FDIC OUTLOOK 46 SPRING 2003 
Regional Perspectives 

“frequently” or “commonly” made residential C&D 

loans on a speculative basis.22 

Challenges to Mortgage Loan Quality May 

Be Greatest in a Few Key Markets 

Weak employment and low affordability increase 

the vulnerability of the San Francisco Bay Area 

and, to a lesser degree, the Seattle and Portland 

22 Federal Deposit Insurance Corporation, Report on Underwriting 

Practices, September 2002 (http://www.fdic.gov/bank/analytical/ 

report/2002sept/uw0209.pdf). 

MSAs to slowing home price appreciation. In 

addition, the Provo, Salt Lake City, Las Vegas, 

Phoenix, and Boise MSAs recently have experienced relatively high foreclosure rates and 

personal bankruptcy activity. Insured institutions 

in most of these five markets hold high levels 

of C&D loans and also appear to hold elevated 

exposures to high loan-to-purchase price mortgages. A confluence of these risks could pressure 

the quality of mortgage portfolios going forward, 

particularly if job markets remain weak and 

interest rates rise. 

San Francisco Staff 

FDIC OUTLOOK 47 SPRING 2003 
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