Each depositor insured to at least $250,000 per insured bank

In addition, through September 30, 2000, core deposit demand continued to lag loan growth, further heightening the Region's reliance on noncore sources to fund new loans. Increasing loan-to-asset ratios and rising reliance on noncore funding sources could restrict liquidity options at some institutions.

An Economic Slowdown Could Increase Consumer Loan Losses

Regardless of the relative strength of the Region's banking industry, any further softening in the economy could affect insured institutions' credit quality adversely, particularly among institutions with large unsecured consumer loan portfolios. As of September 30, 2000, nearly all insured institutions in the Region reported some exposure to consumer credit, primarily credit card receivables (see Chart 2). However, the Region's 56 subprime⁴ and specialty credit card lenders⁵ managed over 50 percent of the Region's $700 billion in consumer credit.

⁴ A subprime lender is generally defined as an institution with identified subprime loan commitments (funded and unfunded) or residual interests in securitized subprime loans equal to at least 25 percent of Tier 1 capital.

⁵ A specialty credit card lender is defined as an institution with credit card loans comprising at least 50 percent of total loans and total loans comprising at least 50 percent of total assets.

Chart 2

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Subprime lenders (insured institutions that specialize in lending to individuals with weakened or no credit histories) may be particularly vulnerable in the event of an economic downturn. As of September 30, 2000, the Region's 39 identified subprime lenders held approximately $11.9 billion in subprime assets, primarily automobile, credit card, and mortgage loans. Most of these institutions (two-thirds, or 26) each had total assets of under $1 billion, and one-third were industrial loan companies operating in California or Utah. Although the Region's 26 subprime community lenders typically report higher capital ratios than similar-sized subprime lenders nationwide, they also experience higher net charge-off rates. In fact, the median net charge-off ratio reported by the Region's subprime community lenders is nearly three times that reported by all community-based subprime lenders in the nation. An economic downturn could increase credit delinquencies, loan losses, and collection costs to even higher levels at subprime institutions.

An economic downturn also could have an adverse effect on the Region's specialty credit card lenders, which have high unsecured consumer loan concentrations, experience above-average delinquency and loss rates, and often rely on noninterest income for earnings. As of September 30, 2000, the Region's 17 specialty credit card lenders managed nearly $367 billion in credit card receivables.⁶ The dollar volume of accounts managed by these institutions represented over half of the Region's and 16 percent of the nation's managed credit card commitments. Even in a period of economic expansion, these niche lenders have reported higher consumer loan delinquency and net charge-off rates than other groups of lenders (see Charts 3 and 4). Nevertheless, credit card lenders reported strong earnings through third-quarter 2000, primarily because of high noninterest income levels. In fact, over half of these institutions' annualized gross revenues were derived from noninterest income sources, such as card fees, interchange income,⁷ loan sale gains, and servicing-related income. Earnings from some of these activities could be sensitive to a downturn in the economy. For instance, interchange fee income might decline if consumers reduce their volume of credit card transactions. Changes in prepayment, default, or interest rates could affect the value of servicing-related assets and the volume of serviced receivables.⁸ Rising credit defaults could diminish investor demand for securitized credit card instruments, thereby reducing loan sale gains. Although specialty credit card lenders currently report healthy conditions, a softening of consumer creditworthiness or a decline in credit card transaction volumes could weaken them.

⁶ "Managed" credit card receivables include $52 billion in credit cards that have been securitized but continue to be serviced by an insured institution. Amounts owned outright by the Region's credit card lenders also include $49 billion in funded credit cards and $266 billion in unfunded commitments.

⁷ On an ongoing basis, credit card issuers receive interchange fees from card associations such as Visa and MasterCard in exchange for offering a particular brand of credit card. Ultimately, the card associations recoup the cost of these interchange fees from the merchants involved in the transactions. The fees, calculated based on the dollar volume of credit card transactions generated by the issuing institution's cardholders, generally average from 1 percent to 3 percent of transaction volume.

⁸ For additional information on gain-on-sale accounting, see "Gain-on-Sale Accounting Can Result in Unstable Capital Ratios and Volatile Earnings," Regional Outlook, second quarter 1998 (http://www.fdic.gov/bank/analytical/regional/ro19982q/pdf/ros19982.pdf).

Certain economic indicators may signal the potential for consumer credit weakness, which in turn may cause problems for the Region's consumer lenders, particularly those specializing in subprime loans or credit cards. These indicators include rising bankruptcy filings, increasing household consumption patterns, and elevated debt burdens.

Bankruptcy Filing Rates Remain above the National Average in Parts of the Region

As of September 30, 2000, five of 11 states in the Region reported personal bankruptcy filing rates that exceeded the national average (see Table 1). In fact, Nevada and Utah reported two of the five highest personal filing rates in the nation during 1999 and 2000. Idaho, Washington, and Oregon also reported above-average personal filing rates through September 2000. Furthermore, Utah's and Oregon's annualized personal bankruptcy filing rates rose through September 2000, which is contrary to a reported decline in bankruptcy filings nationwide over the same period. In addition, although Hawaii's personal filing rate remained below the national average through September 2000, the state recorded the largest percentage filing increase during the second half of the 1990s, a period of economic softness in Hawaii.

Table 1

The current level and trend of bankruptcy filing rates among these states are of particular concern for two reasons. First, personal bankruptcy trends have historically correlated strongly with consumer credit losses.⁹ For instance, between 1995 and 1998, elevated personal bankruptcy rates contributed to an increase in the Region's consumer delinquency and net charge-off rates, particularly among specialty credit card and consumer lenders (see Charts 3 and 4).¹⁰ In addition, increases in state personal bankruptcy rates (with the exception of Hawaii) occurred during a time of strong economic expansion.¹¹

⁹ Bishop, Paul C. February 1998. "A Time Series Model of the U.S. Personal Bankruptcy Rate." Bank Trends.

¹⁰ Delinquent loans include credits past-due 30 days or more or loans that are not accruing interest because they are not well secured and in the process of collection. Delinquency ratios are calculated by dividing the dollar volume of past-due and nonaccrual consumer loans by the dollar volume of total consumer loans.

¹¹ Several studies have evaluated the influence of different variables on bankruptcy filing rates. For instance, differences in unemployment rates, divorce rates, medical and automobile insurance coverage rates, gambling laws, wage garnishment laws, and social acceptance of bankruptcy have been cited as contributing to disparate filing rates across the states. For details, see Nelson, Jon P. October 1999. "Consumer Bankruptcy and Chapter Choice: State Panel Evidence." Contemporary Economic Policy, Huntington Beach, CA, and Feldstein, Stuart A. November 1998. "Where the Filings Are." Credit Card Management, New York, NY.

Although personal bankruptcy filing rates have moderated in several other states in the Region since 1998, the decline in filings may be attributable to consumers' use of additional household leverage rather than an actual improvement in consumer financial positions. Some analysts believe that the 1998-1999 refinancing boom supplemented household cash flows to the point that bankruptcy and default rates declined.¹² Specifically, bankruptcies may have fallen because the decline in interest rates during late 1998 precipitated a mortgage refinancing wave that eased consumer cash flow constraints. Households took advantage of the lower rates by refinancing home loans and consolidating high-cost credit card debt into home equity lines of credit (HELOCs). As noted in a recent Federal Reserve Board study, 42 percent of all homeowners who have refinanced their home mortgages did so during 1998 or the first five months of 1999, with 35 percent extracting "cash out" during the refinancing.¹³ The survey found that 45 percent of those cashing out equity used the funds to repay other debts, with debt consolidation funds representing roughly one quarter of all funds extracted.

¹² SMR Research Corporation. June 2000. Credit Cards, 2000: The Vanishing Middle Class Revolver, 115.

¹³ Brady, Peter J., Glenn B. Canner, and Dean M. Maki. July 2000. "The Effects of Recent Mortgage Refinancing." Federal Reserve Bulletin (http://www.federalreserve.gov/pubs/bulletin/2000/0700lead.pdf).

Asset Value Appreciation Influences Consumer Spending

Over the past several years, rising stock prices, rapid home appreciation, and widespread availability of credit have allowed consumers to spend more than their disposable personal income. In third-quarter 2000, personal consumption expenditures exceeded disposable personal income nationwide, resulting in a negative national savings rate.¹⁴ According to the Bureau of Economic Analysis, consumers financed expenditures by liquidating or leveraging equity in investment portfolios and homes and using credit card lines.¹⁵

¹⁴ The national savings rate is calculated by subtracting personal consumption expenditures from personal disposable income; personal disposable income equals earned income, transfer payments, interest, and dividends less taxes. Realized capital gains are not included in the personal disposable income calculation; however, income taxes paid on associated capital gains are deducted. Consequently, the national savings rate likely overstates the extent to which consumers are using debt to finance expenditures and understates savings generated through realized and unrealized gains on household investments.

¹⁵ October 30, 2000. Personal Income and Outlays: September 2000. United States Department of Commerce, Bureau of Economic Analysis (http://www.bea.doc.gov/bea/newsrelarchive/2000/pi0900.htm).

Increased stock ownership and rising stock market values have likely accommodated increased consumer expenditures. According to the 1998 Survey of Consumer Finances, the share of families at all income levels nationwide with stock holdings increased to nearly 50 percent, up from 40 percent in 1995.¹⁶ As shown in Chart 5, the stock market has soared while the savings rate has declined, suggesting that some of the additional expenditures are being financed by the liquidation or leveraging of equity holdings.

¹⁶ Kennickell, Arthur B., Martha Starr-McCluer, and Brian J. Surette. January 2000. "Recent Changes in U.S. Family Finances: Results from the 1998 Survey of Consumer Finances." Federal Reserve Bulletin (http://www.federalreserve.gov/pubs/bulletin/2000/0100lead.pdf).

Chart 5

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In areas of the country where home prices have appreciated significantly, homeowners also likely have financed expenditures by borrowing against the equity in their homes. This appears to be true in the San Francisco Region, where home prices appreciated over the past few years in several states, particularly California and Washington. Anecdotal evidence suggests that consumers may be extracting at least part of their home equity through lines of credit. For example, funded HELOC balances at the Region's insured institutions grew 23 percent between September 1999 and September 2000.¹⁷ In addition, mortgage debt levels nationwide have increased relative to disposable income, further supporting the contention that home equity is being leveraged to finance consumption expenditures.

¹⁷ These aggregate growth rates were adjusted for mergers by adding institutions merging into the Region into all reporting periods preceding the related merger and removing institutions no longer headquartered in the Region from prior reporting periods.

Debt Payments Have Increased as a Proportion of Disposable Income

The widespread availability of credit and a prolonged period of excellent economic conditions have allowed consumers to assume increased levels of debt. Higher debt levels have contributed to higher household debt service burdens. Nationwide, consumer debt service payments (including mortgage payments) represented 13.7 percent of disposable personal income in the second quarter of 2000, a level not seen since late 1987 (see Chart 6).

Chart 6

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Increasing personal debt service requirements may have the most significant effect on consumers with annual incomes less than $10,000 because of the growing use of credit card debt within this group. Data compiled by the Federal Reserve Board in the Survey of Consumer Finances indicate that between 1989 and 1998, the percentage of families holding credit card debt increased most rapidly among consumers in the lowest two income brackets (income less than $10,000 and income between $10,000 and $24,999 annually).¹⁸ Moreover, growth in the median level of credit card debt held by consumers in the lowest income bracket has far outpaced growth in every other income group (see Chart 7). Surveyed consumers with less than $10,000 in annual income nearly tripled balances held on credit cards between 1989 and 1998. Furthermore, in 1998, median credit card balances of consumers in the lowest income bracket exceeded the median level held by consumers in the next income bracket (income between $10,000 and $24,999). Debt-to-income ratios for the lower income brackets also generally increased between 1989 and 1998, in line with these debt level trends; consequently, households in the lowest income bracket are considered more financially at risk now than they were previously.¹⁹

¹⁸ Survey of Consumer Finances. Federal Reserve Board. 1992, 1995, and 1998 editions (http://www.federalreserve.gov/pubs/oss/oss2/scfindex.html).

¹⁹Credit Cards, 2000: The Vanishing Middle Class Revolver.

Chart 7

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The Slowing Economy Could Challenge the Region's Insured Consumer Lenders

An economic downturn accompanied by increased job losses and reduced stock market and home values could adversely affect the Region's insured institutions, particularly specialty consumer lenders. Already, personal bankruptcy filing rates are at historic highs, and a softening economy could limit consumers' ability to liquidate or leverage household assets to ease cash flow constraints. Increasing consumer default rates and higher credit collection costs could place pressure on asset quality and earnings at the Region's insured institutions, particularly subprime and credit card lenders. Given the potential for weakening in the consumer sector, insured institutions may benefit from evaluating current credit risk management policies.