Regional Outlook
 

FEDERAL DEPOSIT INSURANCE CORPORATION FIRST QUARTER 2002 

FDIC
 

San Francisco
 

Region
 

Division of
 

Insurance
 

Catherine I.
 

Phillips-Olsen,
 

Regional Manager
 

Phillip E. Vincent,
 

Regional Economist
 

Judy H. Plock,
 

Senior Financial
 

Analyst
 

John A. Roberts,
 

Economic Analyst
 

Shayna M. Olesiuk,
 

Economic Analyst
 

Regional Perspectives 

◆ The Region’s real estate markets have softened, in part because of weakness in 

the high-tech and tourism sectors—The slowing in the dot-com, semiconductor manufacturing, and tourism sectors has dampened demand for real estate, and vacancy 

rates have increased in some markets. 

◆ Many insured institutions in the Region hold relatively high construction loan 

exposures at a time when demand for real estate is weakening—During the past 

several years, robust construction activity has contributed to higher construction loan 

concentrations among insured institutions in some areas. Recent deterioration in the 

real estate sector may affect construction loan quality adversely. 

◆ Community construction lenders active in areas dependent on construction 

employment face additional pressures—Construction loan concentrations among 

community institutions tend to be higher in areas that rely on cyclical construction 

employment. This reliance during a period of weakening construction activity may 

adversely affect the quality of other segments of the loan portfolio. See page 3. 

By the San Francisco Region Staff 

In Focus This Quarter 

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

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

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

was underwritten during 2001. Nonconstruction residential mortgages traditionally 

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

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

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

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

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

recession-tested. 

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

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

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

that experienced ongoing residential construction during 2001, despite slowing local 

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

See page 9. 

By Scott Hughes, Regional Economist 

Judy Plock, Senior Financial Analyst 

Joan Schneider, Regional Economist 

Norm Williams, Regional Economist 

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

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

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

geographic regions: 

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

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

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

Dallas Region (CO, NM, OK, TX)
 

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

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

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

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

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

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

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

trends and developments at the regional level. 

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

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

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

For more information or to provide comments or suggestions about the San Francisco Region’s 

Regional Outlook, please call Catherine I. Phillips-Olsen at (415) 808-8158 or send an e-mail to 

cphillips-olsen@fdic.gov. 

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

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

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

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

the Federal Deposit Insurance Corporation. 

Chairman Donald E. Powell 

Director, Division of Insurance Arthur J. Murton 

Executive Editor George E. French 

Writer/Editor Kim E. Lowry 

Editors Lynn A. Nejezchleb 

Maureen E. Sweeney 

Richard A. Brown 

Ronald L. Spieker 

Publications Manager Teresa J. Franks 
’95 

Regional Perspectives
 

Regional Perspectives
 

•	 The Region’s real estate markets have softened, in part because of weakness in the high-tech and tourism 

sectors. The slowing in the dot-com, semiconductor manufacturing, and tourism sectors has dampened 

demand for real estate, and vacancy rates have increased in some markets. 

• Many insured institutions in the Region hold relatively high construction loan exposures at a time when 

demand for real estate is weakening. During the past several years, robust construction activity has contributed to higher construction loan concentrations among insured institutions in some areas. Recent 

deterioration in the real estate sector may affect construction loan quality adversely. 

• Community construction lenders active in areas dependent on construction employment face additional 

pressures. Construction loan concentrations among community institutions tend to be higher in areas 

that rely on cyclical construction employment. This reliance during a period of weakening construction 

activity may adversely affect the quality of other segments of the loan portfolio. 

Declining Demand for Real Estate Could Signal 

the Potential for Credit Quality Weakening 

among the Region’s Construction Lenders 

Robust economic growth over the past several years 

fueled significant construction activity throughout many 

areas of the San Francisco Region. During this period, 

many insured financial institutions increased concentrations in traditionally higher-risk construction and development (C&D) loans. This elevated exposure is of 

concern because demand for office and industrial space 

in the Region began to dwindle in the first half of 2001, 

primarily as a result of slowing in the high-tech sector. At 

the same time, demand for hotel rooms, retail space, and 

housing was adversely affected by a downturn in the travel industry, declining consumer confidence, and rising 

unemployment; in some areas these factors have been 

exacerbated in the aftermath of the September 11, 2001, 

terrorist attacks. 

Many Insured Institutions Have Significant 

Construction Lending Exposure 

One of the more significant vulnerabilities associated 

with C&D lending is the period between financing and 

completion of a project, the time during which market 

conditions can change dramatically. One key measure 

of the future marketability of construction in the 

pipeline is the vacancy rate. This analysis looked at the 

increase in vacancies over the past 12 months to gauge 

the degree to which current real estate conditions 

in different markets have fallen short of year-ago 

assumptions. For example, the San Francisco office 

vacancy rate was 3 percent in September 2000; by 

September 2001, the rate had jumped to 15 percent. 

The level of current construction relative to existing 

stock is another indicator of future marketability and 

CHART 1 

The Region’s Construction Employment Is Volatile The building boom in several of the Region’s markets 

brought with it an increased dependence on highly 

cyclical construction employment (see Chart 1). Community construction lenders1 with greater exposures to 

C&D loans are often in areas with relatively high 

employment concentrations in this recession-sensitive 

sector. As a result, weakening in C&D loan quality 

could be accompanied by softening in other segments 

of the loan portfolio. 

Year-Over-Year Percentage Change20 

15 

10 

5 

0 

–5 

Nonfarm 

Employment Recessions 

(gray bars) Construction 

–10 Employment 

’84’ 85 ’86 ’87 ’88 ’89 ’90 ’91 ’92 ’93 ’94 ’96 ’97 ’98 ’99 ’00 ’01 

1 Defined as insured institutions that report C&D loan exposures and 

hold less than $1 billion in total assets. 

Note: Hawaii does not disaggregate construction and mining employment; therefore, 

Hawaiian mining is included. 

Sources: Bureau of Labor Statistics and National Bureau of Economic Research 

San Francisco Regional Outlook 3 First Quarter 2002 
Regional Perspectives
 

suggests the level of C&D lending exposure in each 

property type. 

Construction lending is a significant component of 

loan portfolios among many of the Region’s insured 

institutions. Therefore, this article analyzes thirdquarter 2001 vacancy trends and construction volume 

relative to stock for each of the Region’s major market 

sectors to ascertain where conditions may be falling 

short of prior assumptions. 

The Economic Downturn in High-Tech Areas 

Adversely Affected the Region’s Office and 

Industrial Markets 

Rapid increases in high-tech sector demand for office 

space in the late 1990s spurred real estate construction 

volumes. However, the pronounced slowdown in the 

high-tech sector during 2001 pushed up office vacancy 

rates in metropolitan statistical areas (MSAs) with high 

exposures to the dot-com and semiconductor manufacturing industries. Several of these high-tech-dependent 

markets, including San Francisco, San Jose, Seattle, 

Oakland, and Phoenix, have also experienced significant office space construction that has continued 

through much of 2001 (see Chart 2). These five MSAs 

have seen greater increases in office vacancies in suburban properties than in downtown areas, a reflection 

of the tendency of dot-com companies to rent cheaper 

upgraded warehouses near fiber optic lines on the outskirts of the central business district. Given that office 

space takes considerable time to develop, rapidly rising office vacancies and strong construction pipelines 

suggest the potential for oversupply in these markets. 

CHART 2 

Areas with Significant Dot-Com Exposure
 

Experienced Office Vacancy Increases and
 

Relatively High Levels of Construction
 

3Q01 Annual Percentage Point

Change in the Office Vacancy Rate 

14 

12 

10 

8 

6 

4 

2 

0 

–2 

–4 

Portland 

Orange 

County 

3Q01 Office Construction as a Percentage of Stock 

1 2 3 4 5 6 7 8 9 10 

Ventura 

Seattle 

San Jose 

Oakland 

San Francisco Salt Lake City 

Phoenix 

Las Vegas 

Sum of U.S. 

Markets 

Sacramento 

San Diego 

Source: Torto Wheaton Research 

Declining manufacturing output adversely affected 

demand for industrial space in several MSAs throughout the Region during the 12 months ending in September 2001. In particular, Sacramento not only 

experienced a significant increase in industrial vacancy rates during this period but also had a relatively 

high proportion of space under construction as of September 2001. In 2000, a number of companies relocated to Sacramento because it was seen as a more 

affordable alternative to the Bay Area. Subsequently, 

the drop in the stock market in 2001 depressed market 

values, and the loss of venture capital funding, particularly for dot-com firms, meant that fewer San Francisco companies were entering the Sacramento 

market.2 Declining manufacturing employment in 

Sacramento and reduced in-migration from the Bay 

Area contributed to increasing vacancy rates that 

adversely affected the outlook for current construction 

projects in this MSA. 

Although Sacramento is the only major market to 

experience a significant change in its industrial vacancy rate and have a large share of industrial space under 

construction relative to stock, vulnerabilities in the 

C&D sector could exist in several other markets. The 

economic slowdown has already produced significant 

increases in industrial vacancy rates in the San Jose, 

Honolulu, San Francisco, Portland, and Phoenix 

MSAs. Continued weakness in the high-tech sector 

and the slowing global economy could further pressure 

vacancy rates in these markets. Additionally, markets 

such as Riverside and Las Vegas are expecting significant increases in industrial space given the level of 

construction in the pipeline, which, if not offset with 

equally robust demand, could further heighten the 

amount of unused industrial space. 

Fortunately, industrial real estate has a relatively short 

construction cycle. Consequently, builders typically 

can respond quickly to changing market conditions 

and avert severe supply and demand imbalances. 

Nevertheless, demand has shifted downward quickly 

in some of the Region’s markets, and industrial property construction has been significant in others. 

2 Colliers International. July 2001. Industrial Market Report, 

Sacramento (http://www.colliersmn.com/prod/ccgrd.nsf/City/ 

4BAE7F02FA76D74F88256AA90066871C/$File/Midyear2001.pdf). 

San Francisco Regional Outlook 4 First Quarter 2002 
Regional Perspectives
 

Waning Tourism Has Adversely 

Affected Hotel Demand 

Hotel occupancy and revenue rates in the Region had 

been strong through 2000; however, the 2001 economic 

slowdown and aftermath of the terrorist attacks dampened business and leisure travel significantly. In reaction 

to these developments, some Las Vegas construction projects that were in the early stages have been stopped. 

Hotel properties require a lengthy time to develop; therefore, the adverse effects of lower occupancies and hotel 

revenue per available room (RevPAR) may depress the 

value of ongoing projects. 

Third-quarter 2001 hotel occupancy rates in the San Francisco MSA dropped 10 percent from a year ago, reflecting the high-tech slowdown and the effects of the 

September 11 attacks. Although their declines were less 

dramatic than those of the San Francisco MSA, the rest of 

the Bay Area,3 Las Vegas, and Seattle reported steeper 

occupancy declines than the national average.4 Hotel 

RevPAR for the nation fell 15 percent in third-quarter 

2001 compared with a year ago, and all of the Region’s 

major markets experienced declines during this period. 

Markets that reported declines in RevPAR exceeding the 

national average include the Bay Area, Las Vegas, and 

Phoenix, as lower occupancies in the final days of September 2001 prompted aggressive room rate cuts. 

The tourism market softened noticeably following the 

attacks; however, hotel construction pipelines remain 

relatively robust in Sacramento, San Diego, Orange 

County, and San Francisco. Overall, the San Francisco 

MSA may represent one of the more vulnerable areas 

given its depressed revenue, lower occupancy levels, and 

the volume of ongoing construction relative to rooms 

available. Luxury developments may be affected more 

adversely because these properties have reportedly experienced the greatest declines in occupancy and RevPAR. 

Consumer Sector Pressures Have Affected 

Demand for Retail Development 

Relatively high levels of consumer confidence and 

favorable employment trends prior to 2001 buoyed 

prospects for retail development. However, demand for 

3 Defined in this article as the Oakland, San Francisco, and San Jose
 

MSAs.
 

4 For real estate figures, the “average” or national number is based on
 

the sum of metropolitan markets for which data are collected.
 

retail space during the year declined in some markets as 

a result of the slowing economy and the aftermath of the 

attacks. Net absorption of retail space was negative in 

the second and third quarters of 2001 in all of the 

Region’s MSAs except Salt Lake City. A considerable 

increase in the retail space vacancy rate combined with 

a relatively significant volume of construction starts 

could challenge C&D lenders in certain high-growth 

retail markets, such as Las Vegas and Phoenix. Las 

Vegas has experienced a slowdown in visitor volumes 

as a result of decreased air travel,5 especially following 

the terrorist attacks. The Las Vegas economy relies 

heavily on the travel-sensitive hotel and lodging sector,6 

and, as a result, the MSA’s unemployment rate rose 1.7 

percentage points in October 2001. The Phoenix MSA 

experienced job losses during the first ten months of 

2001, in part because of the area’s exposure to the slowing semiconductor manufacturing sector. 

Employment and Affordability Issues Heighten 

Residential Construction Concerns 

Deteriorating job markets coupled with eroding housing affordability could adversely affect multifamily 

and single-family markets. The number of apartment 

vacancies has risen in some markets. For instance, 

demand softened in some Bay Area submarkets following a significant decline in high-tech-related 

employment. The Phoenix, San Diego, Sacramento, 

and Orange County apartment markets experienced 

rising vacancies in the 12 months ending September 

2001 and also are expected to face relatively significant additions to apartment stocks in the 12 months 

ending September 2002. As a result, C&D lenders in 

these markets should carefully scrutinize project 

assumptions. 

Softening employment trends and deteriorating housing 

affordability have adversely affected some single-family 

home markets. Specifically, the San Jose, San Francisco, 

Portland, Oakland, Las Vegas, Phoenix, Seattle, Santa 

Cruz, and Eugene MSAs experienced above-average 

increases in unemployment rates. Job losses in these markets could dampen housing demand.7 Additionally, in the 

5 According to the Las Vegas Convention and Visitors Authority,
 

46 percent of visitors in 2000 arrived by air.
 

6 Hotel, amusement, and recreation employment in Las Vegas
 

accounted for 24 percent of total nonagricultural employment as of
 

October 2001.
 

7 For more information on this subject, please refer to the In Focus
 

portion of this publication.
 

San Francisco Regional Outlook 5 First Quarter 2002 
Regional Perspectives
 

Bay Area, Orange County, and San Diego markets, 

home price increases have significantly outstripped personal income growth over the past five years, a trend 

that might not be sustainable in the long term.8 The confluence of job losses and low and deteriorating affordability in the Bay Area has already contributed to 

declining median home prices in several submarkets. 

Recent anecdotal evidence suggests that higher-end 

homes have experienced greater pricing pressure and 

longer marketing periods. Insured institutions with 

C&D loan exposures in areas with rapidly deteriorating 

employment or affordability pressures could face deteriorating single-family C&D credit quality, particularly if 

they are financing high-end residential development. 

Robust Construction Activity Contributed to 

High C&D Loan Concentrations in Some Areas 

As of September 30, 2001, C&D lending was particularly important to community C&D lenders headquartered in 15 of the Region’s larger MSAs (see Table 1). 

Rapid changes in commercial and residential real 

estate market conditions could adversely affect insured 

institution credit quality, particularly among lenders 

CHART 3 

that specialize in construction lending in the higherrisk markets. 

Median C&D loan-to-Tier 1 capital ratios were particularly high among community construction lenders based 

in the Provo, San Jose, Las Vegas, Oakland, Portland, 

Sacramento, Salt Lake City, Riverside, and Phoenix 

MSAs. As noted in Chart 3, at least half of the community construction lenders in some of these markets 

reported delinquencies in their C&D loan portfolios. 

Although at a relatively low level, median construction 

loan delinquency ratios were higher among community 

construction lenders headquartered in the San Jose, 

Santa Rosa, Provo, Portland, and Salt Lake City MSAs 

compared with the Region’s other large MSAs. Additionally, at least one-quarter of community C&D lenders 

in the Portland, San Jose, and San Francisco MSAs 

reported third-quarter 2001 past-due C&D loan ratios 

exceeding 5 percent. Delinquencies in C&D portfolios 

are of particular concern because lenders typically fund 

or defer interest payments that the borrower will make 

over the term of the construction loan (e.g., through 

“interest reserves”). Thus, if a C&D borrower is past 

due, it could be the result of unforeseen building delays 

or difficulties with project sale or leasing. 

Community Construction Lenders in Parts of Utah, Oregon, and
 

Northern California Are Experiencing Loan Delinquencies
 

Construction Loans/Tier 1

Capital (Median Percentage) 150 

100 

50 

0 

Oakland 

Riverside 

San Diego 

Las Vegas 

Sacramento 

Phoenix 

Seattle Salt Lake City Stockton 

San Francisco 

Los Angeles 

Provo 

Portland 

San Jose 

Santa Rosa 

–0.5 0.0 0.5 1.0 1.5 2.0 2.5 

Past-Due Construction Loans (Median Percentage) 

Note: Size of bubble represents the volume of construction (C&D) loans held by community banks headquartered in that market. Includes 

markets with more than five C&D lenders and aggregate C&D loans exceeding $100 million. 

Source: Bank and Thrift Call Reports, September 30, 2001 

8 For more information, see “Regional Perspectives,” San Francisco Region, Regional Outlook, Fourth Quarter 2001 (http://www.fdic.gov/bank/ 

analytical/regional/ro20013q/sf/s3q2001.pdf). 

San Francisco Regional Outlook 6 First Quarter 2002 
Regional Perspectives
 

TABLE 1 

Community Construction Lenders in Some Markets Reported 

High Concentrations in Traditionally Higher-Risk Construction Loans1 

PERCENTAGE PERCENTAGE COMMERCIAL2 

OF COMMUNITY MEDIAN C&D OF CCLS1 AND 

INSTITUTIONS LOANS/TIER 1 WITH SINGLE-FAMILY3 

METROPOLITAN ASSETS OF NUMBER WITH C&D CAPITAL RATIO PAST-DUE PROPERTY TYPES 

STATISTICAL CCLS1 OF LOAN AMONG C&D LOANS WITH SIGNS OF 

AREA (MSA) ($ BILLIONS) CCLS1 EXPOSURES CCLS1 (%) >5% DETERIORATION4 

LAS VEGAS 4.3 23 91 147 14 RETAIL & S.F. 

LOS ANGELES 18.3 80 81 40 15 

OAKLAND 3.4 14 86 146 0 OFFICE & S.F. 

PHOENIX 4.7 32 81 122 19 OFF., RET., 

APT., & S.F. 

PORTLAND 3.4 15 93 134 36 RETAIL & S.F. 

PROVO4 1.1 7 86 173 17 

RIVERSIDE 2.8 20 100 124 10 

SACRAMENTO 2.7 10 90 128 0 INDUSTRIAL 

& APT. 

SALT LAKE 5.3 30 47 126 14 

CITY 

SAN DIEGO 4.3 26 81 83 14 APARTMENT 

SAN 6.7 26 77 75 25 OFF., HOT., 

FRANCISCO & S.F. 

SAN JOSE 2.1 7 86 162 33 OFFICE & S.F. 

SANTA ROSA4 2.7 7 100 97 14 S.F. 

SEATTLE 6.8 31 100 99 3 OFFICE & S.F. 

STOCKTON4 1.8 8 100 84 13 

1 Community construction lenders (CCLs) are defined as insured institutions with less than $1 billion in total
 

assets and any construction and development (C&D) loan exposure. This table includes only MSAs in the Region with
 

five or more CCLs and aggregate C&D loans of $100 million or more.
 

2 Identifies commercial property types by market with an annual percentage point change greater than the sum-ofmarkets (U.S. average) for third-quarter 2001 and higher construction starts-to-stock when compared with the
 

sum-of-markets for third-quarter 2001. The industrial availability index was used as a proxy for the industrial
 

vacancy rate. The hotel vacancy rate was defined as 1-occupancy rate. Forecasted apartment completions for the
 

four quarters ending September 2002 were used as a proxy for construction starts. In addition, Orange County’s
 

apartment property type was identified, but this MSA did not meet the criteria in footnote 1. Commercial property
 

types included are office, industrial, hotel, retail, and apartment real estate.
 

3 Identifies single-family (S.F.) residential property for the MSAs selected in this table (based on footnote 1) that
 

for October 2001 had an unemployment rate annual increase larger than the 1.5 percentage points reported for
 

the nation.
 

4 No commercial real estate data are available for Provo, Santa Rosa, or Stockton.
 

Sources: Bank and Thrift Call Reports (9/30/2001), Torto Wheaton Research (office and industrial property data),
 

Property and Portfolio Research (hotel, retail, and apartment property data), and Bureau of Labor Statistics
 

San Francisco Regional Outlook 7 First Quarter 2002 
Regional Perspectives
 

Lenders Active in Areas Dependent on 

Construction Employment Face Additional 

Challenges 

The current real estate slowdown could adversely affect 

more than just C&D credit quality. Historically, construction sector employment has been highly cyclical. For 

example, during the 1990 to 1991 downturn, construction 

employment in the Region declined 7 percent. Although 

the construction employment expansion buoyed job 

growth in several markets through 2000, job growth in 

this sector has begun to slow and has turned negative in 

several markets (see Chart 4). As the economy continues to weaken, the construction sector could again be 

disproportionately vulnerable to further job cuts. 

CHART 4 

Median C&D loan concentration levels tend to be greatest in markets with relatively high levels of construction 

employment (see Chart 5). Thus, insured institutions 

active in the Las Vegas, Riverside, Phoenix, Salt Lake 

City, and Santa Rosa markets could be particularly 

vulnerable given the heavy construction lending activity and the reliance of these markets on construction 

employment. Softening real estate markets and slowing demand for construction sector employment are 

typically a function of broader economic weakness. As 

a result, some weakening in asset quality and earnings 

among insured institutions in these MSAs could appear 

in other loan portfolio segments. 

By the San Francisco Region Staff 

Year-Over-Year Percentage

Change in Construction

Employment, Oct. 2001 

Falling Construction Employment May Signal Broader Economic Slowing 

2 1.2 

0 

–0.6 –2 –1.0

–1.8 –2.3 –2.3 –2.7 –4 

–4.7 –6 –5.0

–6.0 

–8 –7.2 –7.8 –7.8 –8.2 

–10 

Salem

Honolulu*

Portland 

San Jose

Salt Lake

City

Medford 

Spokane*

Provo 

Tucson 

San

Francisco 

Phoenix

Seattle

Ventura 

United

States 

* Construction and mining equipment are not disaggregated in these MSAs; therefore mining is included.
 

Source: Bureau of Labor Statistics
 

CHART 5 

Community Construction Lenders Headquartered in Markets Dependent 

on Construction Sector Employment Tend to Hold Higher Construction Loan Exposures 

Construction Loans/Tier 1Capital (Median Percentage)

200 

150 

100 

50 

0 

San Francisco 

Provo 

San Jose 

Portland 

Sacramento 

Seattle 

Stockton 

Los Angeles 

Oakland 

Salt Lake City Las Vegas 

Riverside 

Phoenix 

Santa Rosa 

San Diego 

0 2.5 5.0 7.5 10.0 12.5 

Construction Employment/Total Employment (Percentage) 

Note: Community construction lenders hold total assets of less than $1 billion. Size of bubble represents aggregate assets held by community institutions in the market. 

Sources: Bank and Thrift Call Reports (September 30, 2001), WEFA (December 2000) 

San Francisco Regional Outlook 8 First Quarter 2002 
In Focus This Quarter
 

Housing Market Has Held Up Well in This 


Recession, but Some Issues Raise Concern
 

Trends in housing markets are important performance 

drivers for many FDIC-insured institutions. The health of 

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

finance residential construction and is linked indirectly to 

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

market, was underwritten during 2001, with 56 percent of 

this activity in refinancing transactions.1 This activity 

makes recent trends in underwriting of particular interest. 

An ancillary issue for many mortgage lenders, interest 

rate risk, is not addressed in this article.2 

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

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

practices will fare during this downturn. Developments 

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

standards, and the emergence of subprime mortgage 

lending as a significant line of business for some banks. 

Mitigating this risk has been the steady appreciation of 

home prices, which have shown signs of softening in 

some markets but not to the extent seen at a comparable 

stage in previous recessions. 

Home price weakness may be more pronounced in 2002 

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

authors’ judgment, systemic weakness in home prices is 

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

institutions. Nonconstruction residential mortgages, even 

during the most pronounced periods of stress in the 1980s 

and early 1990s, remained the best-performing loan 

class, especially for lenders specializing in residential 

real estate; and, historically, these mortgages have been 

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

January 2002.
 

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

and Chicago Regions, Regional Outlook, First Quarter 2002.
 

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

insured institutions.3 

That said, however, there are pockets of risk for 

insured institutions. There is evidence that borrowers 

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

mortgage lenders. Further, a slump in residential real 

estate markets could be especially detrimental to 

insured institutions with significant exposures to 

housing construction because projects might not sell at 

projected asking prices or as quickly as anticipated. 

Finally, in specific markets where housing prices may 

have achieved unsustainable levels, some increase in 

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

stands out as a place to watch. 

The Recession Thus Far Has Had 

a Minimal Impact on Mortgage 

Delinquencies at Insured Institutions 

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

trends seen in past recessions. For example, new and 

existing home sales both set records during the year, 

while new home construction failed to decline, an 

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

prices—as measured by either the Office of Federal 

Housing Enterprise Oversight (OFHEO) repeat sales 

price index or the National Association of Realtors 

(NAR) median single-family price statistic—showed 

deceleration but remained well above trends seen at 

similar points in past recessions. This behavior partly 

reflected the early robustness of household income in 

the face of recession and relatively low fixed mortgage 

rates during 2001, which helped to counter some of the 

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

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

Boston Region, Regional Outlook, First-Quarter 2000. 

San Francisco Regional Outlook 9 First Quarter 2002 
In Focus This Quarter
 

CHART 1 CHART 2 

Through September 2001, Mortgage-


Related Delinquencies Remained Modest
 

Although the Much Larger Market for 

Existing Homes Has Held Up, New Home 

Prices Are Under Pressure 

Percentage Change from

Prior Year 

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

Existing 

New 

–10 

–5 

0 

5 

10 

15 

20 

,

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

01 

Percentage 

30+ Days Past Due 

0 

2 

4 

6 

8 

10 

12 

,

91 ,93 ,95 ,97 ,99 Sep ,

01 

0 

1 

2 

3 

4 

5 

6 

Percentage 

30+ Days Past Due 

95th Percentiles (R) 

mortgages equity lines 

75th Percentiles (L) 

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

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

Source: Bank and Thrift Call Reports 

initial adverse effects of the recession on housing 

demand. 

One sign of potential weakness appeared late in 2001 

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

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

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

predictive of prices for the much larger existing home 

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

adverse pricing trends in the new home segment do 

raise concerns for residential developers and insured 

institutions that finance residential construction. 

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

As detailed later in this article, home price growth 

began to weaken in 2001 in a number of metropolitan 

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

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

contractions in employment last year. 

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

weakness thus far. Through the first nine months of 

2001, insured institutions showed negligible advances 

in median past-due ratios for mortgages and equity 

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

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

lines of credit, although continued strong mortgage 

origination activity in 2001 may have masked (in the 

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

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

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

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

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

insured institutions’ earnings and capital, since it has 

held up better in prior recessions than other loan types. 

What Are the Risks Facing Housing 

Lenders in 2002 and Beyond? 

In an environment of significantly slower economic 

growth than prevailed during the 1990s, can the 

strength of housing prices and the relatively benign 

credit quality environment for housing lenders be 

expected to continue? The answer will depend on the 

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

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

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

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

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

San Francisco Regional Outlook 10 First Quarter 2002 
, UT

Miami– 

y, NY

Phoenix, AZ

, NV–AZ 

, MO–IL 

Tucson, AZ

Oklahoma City

, NY

, OK 

Kansas City

Tulsa, OK

, MO–KS

, NC–SC 

mingham, AL

, TN-AR–MS

Honolulu, HI

, SC 

Entire Nation

, FL

e City

alo

ville

 Lauderdale

Alban

Buff

 Louis

Green

egas

lotte

Salt Lak

Memphis

Las V

Char

St.

Bir

Ft.

In Focus This Quarter
 

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

Evolving Lending Practices Have Increased 

the Risk Profile for Mortgage Lenders 

Although history suggests that residential mortgage 

defaults will be relatively low even in a recession, 

changes in the mortgage market since the 1990–1991 

recession could affect mortgage performance during the 

present downturn. Many underwriting changes over the 

past decade have been driven in part by the growing 

importance of the secondary market for mortgage debt, 

and of Fannie Mae and Freddie Mac in particular. In 

1980, federal and related agencies had direct or indirect 

interests in approximately 17 percent of all mortgage 

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

increased to roughly 41 percent. Insured bank and thrift 

mortgage exposures grew over the same period, but, as 

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

trends notwithstanding, insured institutions still provide 

substantial funding, directly or indirectly, to the housing 

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

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

Although an active secondary mortgage market has 

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

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

CHART 3 

1993 2000 

days, lenders largely had to retain originated mortgages 

in their own portfolios. Consequently, only lenders with 

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

mortgage markets. The advent of the secondary market 

enlarged the pool of available funding and permitted both 

insured institutions and other originators to transfer their 

mortgage business readily into entities such as mortgage 

pools and trusts. Consequently, many new players, 

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

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

led to considerable commodification of the mortgage 

market. Rather than competing on the basis of traditional 

relationships, lenders’ market shares are increasingly 

driven by price. For smaller savings institutions that focus 

heavily on residential mortgage underwriting, this issue 

has likely elevated business risk. Heightened competition 

has caused some loosening of mortgage underwriting 

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

valuation techniques currently in place have not been 

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

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

mortgages. The ability of insured institutions to mitigate 

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

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

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

60 

40 

20 

0 

Source: Federal Housing Finance Board 

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

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

San Francisco Regional Outlook 11 First Quarter 2002 
In Focus This Quarter
 

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

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

Board, LTPP ratios are high and have risen in several 

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

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

with LTPP ratios exceeding 90 percent. 

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

insurance (PMI), recently the mortgage industry has 

allowed borrowers to avoid purchasing PMI. In particular, 

“piggyback” financing has made homeownership 

increasingly possible for households that cannot afford 

the traditional 20 percent down payment or do not wish to 

pay for PMI. With piggyback financing, the borrower 

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

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

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

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

are not. Thus, piggyback financing is probably most 

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

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

on all low down payment loans to the lender that 

retains the junior position. These institutions are, of 

course, compensated for some of this risk with the 

higher interest rates charged on the piggyback portion 

of these mortgages. 

Competitive factors have prompted the industry to 

enhance underwriting automation. As part of the push, 

credit scoring has become a routine part of the credit 

analysis process, and, increasingly, lenders are using 

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

since the 1990–1991 recession; consequently, their 

predictive ability in a downturn is uncertain. Although 

some have touted AVMs as the answer to appraisal 

fraud, the ability of statistical models to simulate the 

qualitative judgments considered critical to traditional 

appraisals is unknown. Paper appraisals reportedly 

7 Purchase money mortgages are loans extended solely for the initial 

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

continue to dominate the industry; however, recently, 

the two largest government-sponsored enterprises have 

begun accepting AVMs in lieu of standard appraisals 

for loans under $275,000.8 For lenders that specialize 

in HLTV mortgages, there is less room for error with 

AVMs. 

Cyclical Weakness Is Already Apparent 

in Subprime Mortgage Lending 

Historically, certain insured institutions have made 

mortgage loans with narrow collateral margins or to 

borrowers with limited or blemished credit histories. 

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

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

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

extent of bank involvement in subprime lending at any 

point in time is difficult. However, the FDIC estimates 

that fewer than 1 percent of all insured institutions 

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

originations peaked at 13 percent in early 2000, before 

moderating somewhat during the first three quarters of 

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

probably have some limited involvement in subprime 

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

the Minneapolis District offered loans to low-credit 

quality consumer borrowers in 1999.10 

Subprime mortgage loan performance appears to have 

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

trends on Federal Housing Agency (FHA)-insured 

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

with low down payments. The Mortgage Bankers 

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

in the year ending third-quarter 2001, the delinquency 

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

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

8 “Automated Appraisals Require Caution by Lenders,” American 

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

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

Federal Reserve, July 1999. 

San Francisco Regional Outlook 12 First Quarter 2002 
In Focus This Quarter
 

CHART 4 

Recent Mortgage Delinquencies for HigherRisk Loans Reached All-Time Highs 

Percentage of Mortgages

30+ Days Past Due

FHA 

Conventional 

,

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

0 

2 

4 

6 

8 

10 

12 

Source: Mortgage Bankers Association 

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

difficulties. 

A database of more than 6.5 million subprime loans 

tracked by Loan Performance Corporation (formerly 

Mortgage Information Corporation) reported similar 

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

from 5.5 percent one year earlier.11 Moreover, subprime 

delinquencies significantly exceeded those found among 

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

of possible concern are vintage data trends, which show 

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

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

recession. Alternatively, Loan Performance Corporation 

analysts have suggested that the 2001 refinancing boom 

might have created some adverse selection in mortgage 

pools originated during the relatively higher interest rate 

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

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

ratios for their age compared with similarly seasoned subprime loans 

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

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

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

Winter 2001. 

er-coupon and variable-rate loans comprised a significant 

share of mortgage originations during that period, overall 

prepayment rates on the 2000 vintage might have been 

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

loans of lesser credit quality behind and elevating the 

residual delinquency experience in that pool. 

Given these trends, an important issue for subprime 

lenders is their ability to anticipate and plan for the 

impact of an economic slump on their operations. Some 

institutions clearly adopt subprime lending as part of an 

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

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

borrowers recently provided additional resources to its 

loan services and default management departments. This 

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

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

C&D Lending Risks May Be Elevated in MSAs 

with Potential Supply/Demand Imbalances 

Historically, lending to finance housing construction is 

riskier than mortgage lending on existing structures. 

Insured institutions report construction and development 

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

commercial and residential construction. While it is thus 

impossible to ascertain from quarterly call reports the 

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

smaller insured institutions engage to some degree in 

commercial property development, their C&D lending 

largely finances single-family construction. If markets 

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

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

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

Demand for housing can be affected by two distinct 

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

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

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

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

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

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

San Francisco Regional Outlook 13 First Quarter 2002 
In Focus This Quarter
 

conditions, including interest rates. New supply of homes 

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

of market and economic signals is critical to the success 

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

of overestimating future demand could be multiplied if 

several builders inaccurately gauge changes in 

demand. Consequently, a construction market with 

numerous smaller developers, such as Atlanta, may 

see amplified swings in construction activity and may 

experience excess supply during certain periods. 

Although conceptually straightforward, measuring the 

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

can limit the effectiveness of this type of analysis. As 

already mentioned, some insight about current housing 

market conditions in specific metropolitan areas may 

be gained by analyzing both secular and cyclical 

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

the role of cyclical factors is of prime concern at this 

time. 

To measure the cyclical aspect of the relationship 

between a market’s supply and demand, some analysts 

rely heavily on the concept of employment-driven 

demand.16 Such analysis involves tracking a demand/ 

supply ratio based on employment growth and permit 

issuance. Areas where permitting activity continues to 

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

market.17 

Using a simplified version of employment-driven 

demand, we identified a number of metropolitan areas 

as being at risk for a rising imbalance in their housing 

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

These markets are displaying signs that residential 

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

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

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

CHART 5 

–120 

–100 

–80 

–60 

–40 

–20 

20 

40 

60 

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

December 2001 Year-to-Date Permits 

(Year-Ago Change) 

December 2001 Employment

(Year-Ago Change, Thousands) 

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

Some Larger MSAs Continued to See 

Permit Growth during 2001, despite 

Declining Employment 

0 

Greensboro, 

Minneapolis, 

& St. Louis 

Chicago 

Atlanta 

Portland, OR–WA 

Phoenix 

construction activity may not be responding in kind to 

local economies that have started to contract during 

this recession. Further, Phoenix, Portland, and Atlanta 

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

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

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

apparent that some markets identified in Chart 5 as 

having significant banking exposure to C&D lending 

also may have a cyclical imbalance in home building. 

Atlanta, for example, demonstrates one of the highest 

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

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

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

words, while employment-driven demand has softened 

in the metropolitan area, single-family construction 

activity has continued, and community bank lenders 

may have increased their level of residential financing 

commitments. 

Cyclical Risks May Be Developing 

with Respect to Home Prices 

Popular comparisons have been made recently 

between the healthy run-up in housing prices during 

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

2001. 

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

then charted the top 25 MSAs ranked by September 2001 median 

C&D/assets. 

San Francisco Regional Outlook 14 First Quarter 2002 
In Focus This Quarter
 

CHART 6 

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

Exposure Coupled with Potentially Growing Supply/Demand Imbalances 

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

0 

5 

10 

15 

20 

25 

30 

Change in Median C&D Loans-to-Assets 

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

–2 0 2 4 6 8 10 

Salt Lake City 

Atlanta Provo-Orem, UT 

Stockton, CA 

Greensboro 

Portland, OR–WA 

Phoenix 

MSAs with declining employment

 but rising permitting during 2001 

the past several years and the technology stock-fed 

speculative “bubble” in equity prices that persisted 

through early 2000. The subsequent bursting of this 

bubble and the resulting economic distress have raised 

concerns of a sequel featuring housing prices. 

According to the OFHEO repeat sales price index, 

there has never been an instance of outright declines in 

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

prices do exhibit strong cyclical tendencies, with the 

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

CHART 7 

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

in population-adjusted personal income growth,21 and 

some have pointed to a growing imbalance between 

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

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

Given that home price bubbles have occurred in the 

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

MAP 1 

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

Sources: OFHEO, U.S. Census Bureau 

The Widening Gap between Home Price and 

Income Growth Has Raised Some Concern 

Per Capita Income 

Home Price Index 

’85 ’87 ’91 ’93 ’97 ’01E ’89 ’95 ’99 

0 

2 

4 

6 

8 

10 

Drops in Affordability since the Mid-1990s
 

Are Most Prevalent in California 


and the Northeast
 

Top 10 percent of
 

MSAs ranked by decline
 

in affordability index, 1996
 

to 2001 (through June)
 

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

Source: Economy.com 

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

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

San Francisco Regional Outlook 15 First Quarter 2002 
In Focus This Quarter
 

resulted in significant negative fallout for these areas’ 

economies and insured institutions, it is useful to look 

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

scenario (with very low probability) for residential 

real estate markets during the current recession. It is 

unlikely that significant, systemic risks from home 

price bubbles have arisen yet for residential lenders. 

Of course, this situation could change if the current 

recession deepens or is protracted, or if growth during 

the subsequent recovery is anemic. Further, national 

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

affordability. These markets, and the residential lenders 

targeting them, may be more at risk as local economic 

growth falters. 

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

during the past several years. Not surprisingly, many 

of them—namely larger cities in California and the 

Northeast—are those that historically have seen the 

biggest swings in prices and a penchant for speculative 

excess. 

In markets with rapidly declining affordability, credit 

risk arises from the increasing likelihood that new 

borrowers will commit a greater share of household 

financial resources to meet monthly payments. Credit 

problems could become more readily apparent given 

any subsequent disruptions to employment or income 

in these markets—especially among households with 

limited wealth or that require multiple job holders to 

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

Disruptions to aggregate household liquidity from lost 

employment or decreased income can result in rising 

mortgage delinquencies. With respect to foreclosures, 

however, some research has suggested that the decline 

in prices relative to the balance owed on the mortgage 

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

owners with positive equity are likely able to sell their 

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

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

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

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

between rising LTVs and foreclosure rates. 

CHART 8 

Rising Foreclosure Rates Followed Falling 

Home Prices in New England a Decade Ago 

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

Annual Home Price Change (%) 

’79 ’84 ’89 ’94 ’99 

Inverse 

Price (R) 

Foreclosure (L) 

–20 

–10 

0 

10 

20 

30 

Foreclosure Started

(% of Existing Loans) 

0.00 

0.10 

0.20 

0.30 

0.40 

0.50 

homes profitably, thus avoiding foreclosure. Chart 8 

shows the strong relationship between declining home 

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

change in order to emphasize the relationship).23 

The data available through late 2001 were mixed with 

respect to home resale price trends at the MSA level. 

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

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

show about a dozen markets with year-over-year 

declines, none exceeding four percent. A deceleration 

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

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

should be noted that the OFHEO data do not include 

sales of high-priced homes and are less influenced by 

changes in the mix of homes sold than are average and 

median prices;24 this issue is more meaningful in the 

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

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

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

the two-decade correlation between foreclosures started and price 

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

both California and the nation. 

24 Data are obtained from aggregating repeat sales or refinancings of 

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

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

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

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

San Francisco Regional Outlook 16 First Quarter 2002 
In Focus This Quarter
 

TABLE 1 

As Recession Evolved, Home Price Appreciation Waned through 2001 

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

ANNUAL PERCENT CHANGES 

MSAS RANKED 

BY DECELERATION 

IN HOME PRICE INDEX 

FROM 1Q01 TO 4Q01 

OFHEO HOME PRICE INDEX 

NONFARM 

EMPLOYMENT 

1998– 

2000 1Q01 2Q01 3Q01 4Q01 

1998– 

2000 2001 

UNITED STATES 6.3 9.6 9.1 8.8 6.9 2.4 0.3 

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

SANTA CRUZ-WATSONVILLE CA 

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

SAN FRANCISCO CA PMSA 16.5 19.4 13.9 9.1 3.5 3.3 1.3 

SALINAS CA MSA 13.7 24.3 22.4 19.0 9.4 3.3 0.9 

SANTA ROSA CA PMSA 14.8 22.7 19.6 13.6 8.6 4.1 1.6 

OAKLAND CA PMSA 14.7 22.3 18.0 14.1 8.2 3.4 2.0 

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

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

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

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

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

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

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

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

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

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

BARNSTABLE-YARMOUTH MA 

NECMA 12.8 17.6 14.5 14.6 12.5 3.9 1.3 

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

DUBUQUE IA MSA 3.9 8.8 6.0 6.9 2.5 1.1 –0.6 

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

DENVER CO PMSA 11.1 13.7 11.8 10.9 7.9 3.8 2.3 

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

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

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

SAN DIEGO CA MSA 11.8 15.6 13.8 12.9 10.4 4.3 2.7 

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

TUCSON AZ MSA 3.3 8.6 8.0 6.8 3.6 3.5 0.8 

JERSEY CITY NJ PMSA 8.0 11.1 17.6 13.7 6.2 2.1 2.7 

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

RAPID CITY SD MSA 6.2 8.9 9.3 7.7 4.1 3.1 0.1 

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

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

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

San Francisco Regional Outlook 17 First Quarter 2002 
 

In Focus This Quarter
 

San Francisco Bay Area25 and parts of the Northeast, 

since prices for high-end homes (typically financed by 

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

Table 1 lists markets whose 2001 deceleration in home 

price growth was in the top 10 percent of the more 

than 300 metro areas for which the OFHEO statistic is 

available. The table also provides (where available) 

each MSA’s recent employment trend as an indicator 

of overall economic conditions. These markets may yet 

see even more pronounced deceleration in home price 

growth or even declines in home prices this year (as 

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

The metro areas in the table are 

ordered by the magnitude of their 

deceleration in home price growth 

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

growth in the recently overheated 

San Francisco Bay Area puts many of its MSAs near the 

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

Oakland, Denver, and San Diego also previously were 

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

more volatile appreciation rates, such as Utica and 

Fargo, comparisons of recent price trends are more 

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

year-ago price growth during first-quarter 2001. 

It is hard to generalize about which markets will see the 

most pronounced home price weakness as the recession 

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

are more likely to see significant downward corrections 

in price when economic activity falls for a prolonged 

period or by a sufficient magnitude. One study from the 

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

groups tended to respond similarly to local and national 

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

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

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

2001.
 

economic forces (fundamental, or “equilibrium,” price 

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

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

tended to see the most significant price swings over the 

past 20 years. 

History also provides some insights into the nature and 

extent of any price declines in markets where economic 

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

1990s, concluded that declines differed by property type 

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

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

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

boom saw the largest deflation) and from the nature of 

each city’s economic decline, which differed according to 

concentrations of job losses by industry and wage type, 

underlying demographic factors, and housing supply 

trends. 

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

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

recent years, this area witnessed double-digit home price 

appreciation that exceeded growth in per capita income 

by a wide margin. A recent analysis from the University 

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

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

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

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

income growth during this cycle as during the 1980s. 

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

Northeast generally) has seen little speculative purchase 

or construction activity in recent years, which should 

help to mitigate any price weakness through the current 

recession in these markets.30 

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

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

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

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

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

Quarter 2002. 

San Francisco Regional Outlook 18 First Quarter 2002 
In Focus This Quarter
 

Conclusion 

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

well in prior recessions. However, history might 

understate credit risks for insured institutions during 

this cycle because the mortgage lending business has 

changed since the last recession. Chief among these 

changes are robust mortgage market competition, 

which has contributed to narrower collateral margins; 

increased reliance on underwriting automation; and 

expanded involvement in the subprime credit market. 

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

are experiencing continued construction despite a 

cyclical slowdown (as measured by employment 

trends). Permanent mortgage lenders in certain areas, 

such as the San Francisco Bay area, could also face 

higher loss rates and foreclosures going forward, as the 

current economic weakness places downward pressure 

on home prices and dampens the ability of households 

to meet mortgage payments. 

Scott Hughes, Regional Economist 

Judy Plock, Senior Financial Analyst 

Joan Schneider, Regional Economist 

Norm Williams, Regional Economist 

San Francisco Regional Outlook 19 First Quarter 2002 
✁
 

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