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

Atlanta Regional Perspectives

Slowing Economy Poses Challenge for Region's Insured Institutions

Insured institutions may be facing the most challenging economic environment in nearly a decade (see this quarter's In Focus article). Economic growth in the Atlanta Region has moderated, but not to the same degree as growth in the nation. By early 2001, the Region's employment growth had slowed to 2.3 percent, down from nearly 3 percent during the first half of 2000. In all states in the Region except Florida, job growth rates have declined in recent quarters. Despite the slowing, labor markets in the Region generally remain historically tight. However, the downward trend in unemployment rates may have reached its nadir and, particularly in the case of North Carolina, jobless rates saw a significant increase in late 2000. Layoffs, which until recently have been limited primarily to the manufacturing and high-tech sectors, could spill over into the rest of the economy. The cumulative effect of layoffs across several industries could derail certain areas' economic growth, particularly in rural portions of the Atlanta Region. The magnitude of the Region's slowdown, however, will depend heavily on the depth and duration of any slowing in the national economy.

The slowing economy could pose revenue challenges for many insured institutions in the Atlanta Region. Reduced demand for credit and tightening underwriting standards likely will lead to slower loan growth. Moreover, net interest income could decrease because of the downward shift in the yield curve over the past year. Adjustable-rate loan products, for the most part, reprice immediately, and lower mortgage rates are swelling the refinancing of fixed-rate mortgages. For many commercial banks, the benefit of lower liability costs may take some time to materialize because of the repricing lags of maturity deposits and minimal room to lower nonmaturity deposit pricing. Additional profit pressures could result from lower levels of fee income, particularly fee sources that are market sensitive. The slowing economy also could lead to higher credit costs resulting from loan loss provisioning and higher overhead charges to collect nonperforming assets.

Community Banks in Highly Competitive Urban Markets Are More Vulnerable to Slowdown

Although the slowing economy may affect the entire Atlanta Region adversely, community banks operating in areas where there is a confluence of several risk factors could be more vulnerable. These risk factors include high growth, strong competition, aggressive lending practices, and relatively high rates of bank formation. Although perhaps characteristic of several metropolitan areas in the Atlanta Region, these attributes may be most apparent in the Atlanta metropolitan area.

Market Growth and Bank Formation

The Atlanta metropolitan area experienced significant market growth in the 1990s. Between 1990 and 2000, its population increased nearly 40 percent, adding more than 1.1 million new residents. The 3.3 percent compound annual rate of increase was more than double the national average. A rapid population increase may encourage new bank formation (for greater detail, see "De Novo Banking in the Atlanta Region," Atlanta Regional Outlook, first quarter 2000). In fact, the Atlanta metropolitan area has led the Region in the number of new bank charters since the end of the 1990 to 1991 recession.

Real Estate Development and Lending

In response to the rapid population growth of the past several years, Atlanta has experienced high levels of both commercial and residential construction activity. According to F.W. Dodge, the pace of Atlanta's commercial construction starts during the first three quarters of 2000 was nearly equal to the sum of the next five largest markets in the Atlanta Region.¹ Similarly, residential permitting in Atlanta during 2000 was greater than the combined totals of the next two largest markets, Orlando and Charlotte. Unexpected declines in absorption rates associated with the recent weakening in economic growth may affect the future performance of current real estate development, however. The downsizing in the high-tech and dot-com industries may prompt existing leased commercial space to return to the market. Areas such as Atlanta, Raleigh, northern Virginia, Charlotte, and Huntsville may be especially vulnerable. Greater difficulty in marketing new space and rising building costs (associated with higher energy prices) may be prompting developers to tap existing lines of credit. Community banks, many of which are non-recession-tested, have been very active in supporting a metropolitan area's real estate development and could experience weakening asset quality in a slower growth market.

¹ In descending order: Charlotte, Orlando, Ft. Lauderdale, West Palm Beach, and Tampa.

At 15.5 percent, construction and development (C&D) lending as a share of assets among Atlanta's community banks was nearly three times the U.S. metro average during fourth quarter 2000. This exposure is the highest in the nation and could pose significant credit risk if growth slows. Nearly one-third of community banks (39 institutions) in the Atlanta metropolitan area report a C&D exposure exceeding 15 percent. In contrast, before the 1990 to 1991 recession, the number of community banks in Atlanta with this exposure peaked at 20 in 1988. Moreover, the aggregate C&D exposure at year-end 2000 was 25.9 percent, in contrast to the previous peak of 21.1 percent in 1990 (see Chart 1). Given the high and rising C&D exposure, Atlanta may be more vulnerable than several other metropolitan markets in the Region to the effects of a slowdown in the local real estate market.² Macon, Raleigh, Naples, and Savannah also have exposures that exceed the national metropolitan average.

² The fact that C&D exposure can have a significant impact on bank performance during an economic downturn is made apparent by tracking the performance of banks at year-end 1988 with a C&D exposure in excess of 15 percent through the mid-1990s. Each of these institutions experienced a downgrade in its Uniform Bank Performance rating to a 3, 4, or 5 during that time. The number of banks with ratings of 3, 4, or 5 peaked in 1991 during the recession.

Chart 1

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Competition

Internet banking, alternative forms of saving and financing, bank acquisition activity, and the surge in new bank openings in recent years have altered the banking landscape in many urban areas. Competition has become increasingly fierce on both sides of the balance sheet. One indicator of the increasing level of competition in recent years is the rise in banks' cost of funds in several urban areas, such as West Palm Beach, Macon, Miami, and Atlanta. Slowing economic growth may prompt some lending institutions to relax underwriting standards to meet growth goals and capture market share.

It May Not Be Only Atlanta

Other metropolitan areas in the Region are also exposed in varying degrees to each of these potential vulnerabilities. Among them, Charlotte, Greenville, Orlando, and Greensboro rank relatively high in terms of cost of funds growth, C&D exposure, non-recession-tested banks, and market growth. Other areas, such as Macon, Richmond, Norfolk, and Naples, also exhibit some of these higher-risk factors.

Rural Areas Exhibit Unique Concerns

Rural areas in the Atlanta Region continue to face challenges in key components of the local economy: agriculture and manufacturing. The recent slowing in economic growth may further strain these economies and, consequently, the local banking industry.

Farming

A prolonged drought, structural changes in the tobacco industry, and continued low commodity prices have affected farmers' cash flow adversely in the Atlanta Region. Higher energy and fertilizer costs add further pressures. Farmers' ability to meet financial obligations will depend on continued government support. Moreover, farm land values must remain near current price levels in order to provide collateral protection for lenders. Residential and commercial development spreading outward from urban areas has helped to support farm land values. However, this support could weaken if economic growth continues to slow in urban areas. Anecdotal evidence suggests that farm land values not near urban centers have been supported by the purchase of "recreational" farms financed by accumulated gains in stock market wealth. Given the recent equity market declines, demand for land may decline. Also, should economic growth continue to slow, farmers may be faced with declining levels of off-farm income.

Financial hardship among Atlanta Region farmers could affect rural banks' asset quality adversely. In fourth quarter 2000 the Region was home to 31 agricultural banks with assets totaling $2.2 billion. Low commodity prices, drought, and higher input costs are most evident in Georgia, home of two-thirds of the Region's farm banks. In fourth quarter 2000, the percentage of farm loans in the Region's farm banks that were noncurrent or charged off exceeded the national averages by 53 and 12 basis points, respectively. Farming remains a critical component of the economy in many rural areas. Therefore, other nonagricultural assets held by rural community banks also may be vulnerable if agricultural sector weakness filters through the rest of the local economy.

The Lumber Industry

Economic conditions in the Region's softwood lumber industry have deteriorated recently and may affect many rural area economies adversely (see Atlanta Regional Outlook, third quarter 1998, for greater detail about this industry). The building boom of the mid- to late 1990s fueled demand for wood products and resulted in increases in lumber prices. In response, the Atlanta Region's lumber industry expanded rapidly. After building peaked in many areas during 1999, loggers and sawmills continued producing at high levels to generate revenue to service debt incurred by the recent expansion. As a result of excess supply and declining demand, prices in the industry have declined significantly in recent months. In February 2001, the producer price index for softwood lumber was more than 15 percent below year-ago levels. As markets have weakened, some reports have emerged about credit-quality problems in the industry.

Foreign competition could stress the softwood lumber industry further. On March 31, 2001, the Softwood Lumber Agreement with Canada expired, prompting concern that imports to U.S. markets will increase significantly. The agreement set a quota on softwood imports from Canada, which currently account for one-third of the U.S. market. The increase in imports coupled with potential further slowing in the U.S. economy and higher energy costs could have a negative effect on the already troubled lumber industry (which employs nearly 150,000 in the Atlanta Region), surrounding communities, and, ultimately, credit quality in the local economies.

Other Manufacturing

Textiles and apparel are large manufacturing employers in rural areas of the Atlanta Region (for a more detailed discussion of the industry, see Atlanta Regional Outlook, second quarter 1998). Slowing economic growth could further weaken conditions in these industries; the most vulnerable is the carpet and rugs subsector, which has experienced substantial growth thanks to the nation's construction boom during the 1990s.

Atlanta Region Staff

The Region's Economic Expansion Continued through Early 2001...

In 2000, nonfarm payrolls in the Region rose at a somewhat faster pace than in the nation. This gap widened during the early months of 2001 because of a continued deceleration in annualized U.S. job growth. The Region's rate of decline in factory sector payrolls also eased through the 15 months ending March 2001. In contrast to the strength in employment, the Region's housing market showed some signs of cooling during 2000. Permit issuance in 2000 was down 7 percent from the prior year, versus a 4 percent drop nationwide, but it did rebound in the first quarter of 2001. Also, existing home sales in the Region slowed slightly in 2000 following peak volume in 1999. Despite the slight decline in sales, home prices throughout the Region continued to rise, suggesting that limited inventory (rather than weakened demand) was responsible for the reduction in home sales volume.

...but Its Economic Fate Remains Tied to the Nation's

The national economic slowdown likely poses the most significant risk to the Region's economy at this time. The current absence of widespread economic imbalances in the Region's economy suggests that the health of the national economy will be the most important determinant of the Region's near-term economic performance. Slower growth in the national economy has resulted from protracted weakness in the manufacturing sector and a more recent, abrupt deceleration in information technology investment and consumer spending growth. The Region is just beginning to see the effects of the slowing national economy. For instance, after an initial lag, the Region's unemployment claims are now rising, in line with the national trend.

Office Markets around Boston Evidenced Some Cooling

Office real estate conditions eased in the Boston Region during first quarter 2001. Office vacancy rates in Boston and Cambridge increased slightly from record lows as blocks of sublease space were returned to the market because of a slowdown in the information technology sector. In downtown Boston, about 1.1 million square feet (about 3 percent of multitenant inventory) were on the market to be sublet in first quarter 2001, more than three quarters of the total amount absorbed in 2000. Average rents have leveled off between $50 and $65 per square foot for Class A space, following steady increases through 2000. Asking rents on select Class A properties, which commanded upwards of $85 per square foot in fourth quarter 2000, dropped to roughly $65 to $70 per square foot during first quarter 2001. Boston-area industrial markets, particularly in the suburbs, continue to exhibit lower vacancy rates. Hotel space remains in short supply around greater Boston, but demand appears to be softening with the national economy.

Construction lending in the Region increased during the latter half of the current expansion along with commercial real estate market activity and demand for space. Aggregate construction and development (C&D) loan growth has averaged 20 percent over the past three years. However, while C&D lending has increased in the nation and the Region, as business conditions begin to slow, concentration levels of construction to Tier 1 capital remain low compared with the late 1980s (see Chart 1).

Chart 1

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The Region's Banks Are Well Positioned to Weather an Economic Slowdown...

The Region's insured institutions are facing an uncertain economic environment from a position of relative strength. A prolonged period of economic growth has contributed to their favorable condition. In addition, the positive effects of consolidation, deregulation, technological advances, and market forces should not be understated. The combined effect of these factors has resulted in the historically high capital and earnings levels of the Region's banks and thrifts.

Asset quality remains a major driving force behind earnings as net charge-off and delinquency ratios continue to reach new lows. In 2000, 44 percent of the Region's institutions had zero or negative net charge-offs. This was the highest percentage of institutions in the Boston Region without net loan losses in a calendar year since at least the early 1970s. Delinquencies also continued to decline. As a result, provision expense has been modest, while the low level of nonperforming assets has served to boost net interest income.

...but Trends in Certain Risk Areas Point to Potential Longer-Term Concerns

While most institutions continue to report strong asset quality, some signs of developing problems may portend a downturn in credit quality within the Region. Commercial loan losses, while modest, have been rising steadily in the Region's largest institutions, most likely as a result of exposures to large, nationally syndicated credits that have begun to deteriorate as the economy slows and credit availability tightens. The credit card portfolios of large-scale credit card lenders also are exhibiting signs of weakness. These situations reflect the effect of aggressive competition on underwriting standards in these specific markets. Many analysts have cited the loosening of underwriting standards, particularly in 1997 and 1998, as a major contributor to the deterioration noted today.

Most of the Region's insured institutions are not participants in the nationally oriented markets cited above, but many have expanded commercial loan portfolios aggressively over the past few years. Aggregate commercial loan growth in the Region has outpaced that of the nation on average for the past four years. In each of the past six years, 40 percent or more of the Region's institutions that make commercial loans had commercial loan growth in excess of 20 percent (see Chart 2). The growth has been particularly pronounced in the Region's savings institutions; more than 50 percent of those involved in commercial lending expanded their portfolios in excess of 20 percent in each of the past three years. For many of these institutions, commercial loan concentrations relative to capital remain modest, but they are growing rapidly and warrant close scrutiny. Competition for commercial loans in the Region clearly has been fierce. Traditional commercial lenders are now fighting for business from new entrants into the market, including the Region's savings banks, out-of-Region banks utilizing credit scoring techniques, and nonbank financial companies. To the extent that the strong growth has been achieved, in part, by easing underwriting standards, problems may begin to emerge locally as the economy softens. This situation underscores the importance of strong credit administration practices to monitor and manage borrowers effectively in an uncertain economic environment.

Chart 2

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Overall, earnings remain fairly strong, particularly for commercial banks; however, profits in the Region's savings institutions have been declining steadily over the past three years, primarily because of net interest margin compression. Commercial banks have not been immune to margin compression, but savings institutions have felt the compression more acutely as their declines have been steeper on a percentage basis, and they typically have a greater reliance on net interest income as a percentage of total operating income. Between 1997 and 2000, nearly half the Region's insured institutions experienced a net interest margin decline of more than 20 basis points; more than a quarter experienced a decline of more than 40 basis points. The bulk of the margin erosion occurred in 1998 and 1999 as a result of the heavy refinancing wave that occurred during that period, coupled with an unfavorably shaped yield curve that made it difficult to redeploy prepayments into new investments at favorable spreads. Additionally, because the yield curve was low and flat, customers preferred fixed-rate loans, and many institutions opted to hold onto these loans to prop up eroding margins. The asset extension has not been countered by a lengthening of liabilities, as the flat yield curve has offered little incentive for depositors to go long. As a result, the duration of assets expanded considerably and was not offset on the liability side of the balance sheet; the effect was to heighten exposure to rising interest rates for many institutions in the Region. The lengthening of assets was evident in both commercial and savings institutions (see Chart 3).

Chart 3

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The higher interest rates that prevailed throughout 2000 significantly dampened prepayments and increased the demand for variable-rate loans. However, the imbalances that developed between 1997 and 1999 will take several years to correct unless actively managed, and only a slight improvement was noted in 2000. Institutions are now facing a renewed wave of refinancing as interest rates have fallen considerably in the first quarter. The average Mortgage Bankers Association refinancing index during the first quarter of 2001 was the highest on record. Further rate declines, should the economy continue to soften, may result in another prolonged refinancing wave, leading to further extension of asset maturities and continued margin erosion.

Although active management of securities portfolios, extending liabilities via wholesale funding sources, and implementation of off-balance-sheet hedging strategies can help to mitigate the rising level of interest rate risk, banks in the Region have done little to counter asset extension. The failure to mitigate the growing imbalances that may result from the current downturn in interest rates may lead to undue exposure to a future rise in interest rates, particularly if it is accompanied by a steepening of the yield curve. The present low interest rate environment should provide sufficient opportunity to employ risk reduction strategies.

Boston Region Staff

Chicago Regional Perspectives

Banking and Economic Conditions Vary among Region's Larger MSAs

The Region's economy softened in 2000, in line with national economic developments. A slowing economy poses challenges for debt service capacity of businesses and consumers, thereby making credit quality of banks and thrifts an increasing concern. Intense competition in recent years has heightened the risk profile of many of the Region's financial institutions. Given their increased risk profiles, banks' ability to weather credit quality deterioration is a key issue to watch.

This article explores some characteristics of the Region's major banking markets using a combination of banking and economic data. Analyzed are the Region's ten metropolitan statistical areas (MSAs), listed in Table 1, that have the highest number of insured institutions with assets of $10 billion or less.¹ These institutions represent 29 percent of the Region's banks and thrifts.² Banking and economic data used for the analysis include, but are not limited to, the items in Table 1.

¹Institutions with assets greater than $10 billion were excluded because their operations likely span a larger area than the MSA in which they are headquartered. Nevertheless, the indicators in Table 1 undoubtedly affect their risk profiles. Specialty institutions also were excluded.
² Institutions located in the Cincinnati MSA but outside the Chicago Region were included in the ratio computation.

Table 1

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Economic data include employment volatility and industrial diversity statistics.³ These two gauges provide insight into how an MSA could be affected by national economic trends. For example, the employment volatility measure shows the degree to which an MSA's employment growth rate varies with the national rate. The measure ranges from 0 to 100, with a low value indicating that an MSA's employment swings are mainly independent of national developments and a high value indicating the opposite. The industrial diversity index measures the industrial diversification of the MSA relative to the United States. A high value indicates diversity nearly as broad as the nation's, while a low value suggests that a few industries account for most activity in an MSA. All other things being equal, the higher the level of industrial diversification, the better positioned is an MSA to weather a national economic slowdown.

³ Data for this analysis are from Economy.com, Inc.

A comparison of values for Indianapolis and Grand Rapids-Muskegon-Holland, which are shown in Table 1, provides an example of how the gauges can be used to assess an MSA's vulnerability to national economic trends. Although the two MSAs are equally affected by national employment volatility, a slump in an industry operating in both MSAs could have a more damaging effect on the Grand Rapids area than on the more diversified Indianapolis area.

Just as employment volatility and industrial diversity differ among MSAs, so does banking industry performance. Banks and thrifts in some MSAs exhibit risks that appear relatively stable and modest, while institutions in other MSAs maintain relatively higher risk profiles and face rapidly changing competitive environments.

Chicago and Milwaukee, two of the larger markets, benefit from broad economic diversity. Asset quality indicators at Chicago's institutions remain generally favorable, although recent increases in the volume of traditionally higher-risk commercial forms of lending are among the highest in the Region. Although the past-due and nonaccrual (PDNA) ratio for insured institutions in the Milwaukee MSA is the third highest among the Region's top MSAs, it is only slightly higher than the national level.

Banking industry performance appears generally favorable for each of the markets analyzed, but a national economic slowdown could have a pronounced impact on MSAs with limited industrial diversity. Profiles of the three MSAs with the lowest industrial diversity index values in Table 1 are discussed below.

Detroit's industrial diversity is broader than it was in the 1980s, although the area remains heavily dependent on the motor vehicle sector and associated industries. Union workers at assembly plants and elsewhere who lose their jobs because of production cutbacks often continue to receive some income and benefits, which allow them to continue spending and making debt payments. The availability of these income supports is not as widespread, however, among nonunionized automobile suppliers or engineering and computer service firms tied to the motor vehicle sector.

The impact of an economic slowdown could be more significant for insured institutions in Detroit than for institutions in the Region's other large MSAs because they already are experiencing high funding costs, loan-to-asset ratios, and past-due ratios, as well as low and declining net interest margins. Meanwhile, aggregate Tier 1 capital levels and the allowance for loan and lease losses (ALLL) to total loans ratio have trended downward. A significant percentage of banks in the Detroit market are new. Their tendency to have higher levels of commercial and industrial (C&I) and commercial real estate (CRE) loans, as well as higher funding costs can be mitigated by higher capital levels. Institutions with C&I and CRE loans associated with industrial properties may face some challenges ahead. The MSA's vacancy rate for industrial properties has climbed over the past two years to 8.5 percent in 2000, the highest in the 12 years for which data are available. Additionally, vacancy rates for suburban office space remain moderate at slightly more than 8 percent, and they have been rising since mid-1999.

The Grand Rapids-Muskegon-Holland area stands out as an economic success story of the past decade, having benefited from a "Renaissance" development zone, the in-migration of people and businesses, and strong activity in its dominant sectors. The area's relatively high degree of cyclical employment volatility and low industrial diversity (high exposure to several manufacturing industries) likely will play a significant role in its near-term health should recent signs of economic weakness intensify. The area's auto suppliers and equipment manufacturers are relatively efficient and have a diversified customer base, but they could be affected adversely by recent vehicle production cutbacks and intense cost-cutting in this sector. Demand for office furniture, another major employment source, remained healthy through late 2000. Profitability pressures may trigger layoffs at a major office-furniture manufacturer, however, and the repercussions of slower growth in commercial construction nationally in the past year likely will be felt with a lag.

Grand Rapids' robust economy in recent years has led to very strong asset growth which, coupled with regional bank consolidation activity, has helped foster the entrance of new institutions into the market. The high percentage of new institutions has increased the level of competition and has contributed to significant increases in CRE lending associated with the MSA's economic expansion. The degree of competition in this market is underscored by funding costs that are among the highest in the nation; however, net interest margins are relatively strong given a loan mix weighted toward commercial forms of lending.

Peoria-Pekin's economy and financial institutions have weathered various economic challenges in the past decade, and their experiences may leave them reasonably well positioned for the current slowdown. Peoria's low cyclical employment volatility could shield it somewhat from a national slowdown, although it remains vulnerable to the presence of one dominant manufacturer. The MSA's manufacturing payrolls slid by about 1 percent over the past year, in line with the national pattern. The area's unemployment rate in January and February 2001 averaged 5.4 percent, up from about 4.5 percent in the same periods in 2000 and 1999, and average weekly hours worked in manufacturing have been falling for two years. Consequently, aggregate weekly earnings of factory workers in the area are shrinking. These trends could affect consumer credit quality and pressure the PDNA ratio. Mitigating this concern are the relatively low PDNA rate, high coverage of nonperforming loans, and a capital cushion built up at area institutions during the past two years.

Although most banking risk indicators in Peoria remain at modest levels relative to the Region's other large MSAs, the loan-to-asset and PDNA ratios are rising. Increases in the PDNA ratio in the past two years have been fairly widespread across nonresidential real estate, 1 to 4 family residential real estate, C&I, and consumer loan portfolios. Although consumer lending levels have been declining relative to other loan categories, they remain higher than in most other large MSAs.

Chicago Region Staff and Craig Thornton, Acting Regional Manager

Dallas Regional Perspectives

Vulnerability to a Downturn in the Real Estate Market Increases as Insured Institutions Expand Concentrations in Traditionally Higher-Risk Loan Categories

Real estate overbuilding contributed greatly to the Region's last banking downturn in the mid- to late 1980s. Major metropolitan areas, in Texas especially, saw significant deterioration in commercial and residential real estate values in a relatively short period.¹ While few expect a downturn in the Region's real estate market as serious as that of the 1980s, the experiences of that downturn highlight the risks associated with growing concentrations in traditionally higher-risk assets, such as commercial real estate and construction and development loans.

¹ For more information, please refer to History of the Eighties, Federal Deposit Insurance Corporation, 1997.

At year-end 2000, real estate loans accounted for 56.5 percent of the Dallas Region's total bank and thrift loan portfolio, the highest level since 1988. The traditionally higher-risk categories of commercial real estate and construction and development loans have dominated loan growth in the Region since 1997 and, at year-end 2000, accounted for 28.2 percent of the Region's loans, compared with 17.6 percent for the rest of the nation (see Chart 1).

Chart 1

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During the last half of the 1990s, real estate conditions improved in many Dallas Region markets; however, effects of the 1980s downturn linger. According to F. W. Dodge (FWD), only the Austin and San Antonio metropolitan statistical areas (MSAs) currently report office vacancy rates lower than the national average. Most of the office vacancy rates for the Region's MSAs covered by FWD are projected to improve over the next several years, based on current construction and absorption estimates. However, there are signs that the effects of the current economic downturn soon could be felt in the real estate industry. Results of a March 2001 KPMG survey found that 48 percent of the real estate executives polled predicted that property values will decline over the next 12 months, and 74 percent expect rents to decline.² While current real estate supply and demand factors appear in balance in most Dallas Region MSAs, should economic growth resemble a U- or L-shape scenario (as discussed in the In Focus article Economic Conditions and Emerging Risks in Banking), employment growth could slow quickly, causing pressure on vacancy and rental rates for all types of real estate. This situation may hold true particularly for MSAs currently experiencing difficulties in high-tech industries such as telecommunications, semiconductors, and personal computers.

² Robert Julavits, "Realty Execs Say Property Values, Rents Will Drop," American Banker, March 21, 2001, p. 11.

Signs of a slowing economy and identified weaknesses in some of the Region's important industry sectors may be pointing to challenges for insured institutions with high volumes of commercial real estate. At year-end 1997, commercial real estate loans held by 21 percent of the Region's insured institutions exceeded 200 percent of risk-based capital. By year-end 2000, 28 percent of the Region's banks and thrifts were in this category. Growing balance sheet concentrations in this traditionally higher-risk category warrant close attention because they represent increasing vulnerability to a downturn in the real estate sector.

Rising Oil and Natural Gas Prices Present a Mixed Picture for the Region

Oil and gas is an important industry for the Dallas Region. The Region produced more than 715 million barrels of crude oil in 1997 and employed 185,100 workers in the oil and gas extraction industry in 2000. According to the U.S. Bureau of Economic Analysis, the Dallas Region accounted for more than half the nation's oil and gas output and the industry's employment in 1998. The Region's reliance on oil and gas as an economic driver, however, has declined dramatically over the past 20 years. Oil and gas output as a share of overall gross regional product declined from 17 percent in 1982 to 5 percent in 1998 (see Chart 2). The growing importance of other industries, such as high tech, construction, and financial services, has more than offset the decline of oil's importance to the Region.

Chart 2

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The fallout from higher oil prices on businesses has not been widespread. Rather, its effects are being felt by significant users of petroleum products. Corporate profitability has eroded in energy-intensive industries such as transportation, textiles, lumber, paper, chemicals, rubber and plastics, and steel. Higher gasoline and heating oil prices have reduced consumers' real income, displacing demand for other goods and services.

Oil and natural gas prices will likely remain high throughout 2001 because of lean inventories, particularly of crude oil, and strong demand for natural gas. The greatest risk to households and businesses in the Region is the growing price volatility. In the event of a disruption to supplies, no matter how minor, sharp price spikes are likely; this likelihood has resulted in a "risk premium" on the current price of oil and natural gas. Rising oil prices played a key role in the Region's booming economy during the 1970s, while declining oil prices contributed to its recessions in 1982 and 1986. As evidence of differences between the Dallas Region and the nation, however, energy prices were a contributing factor in three of the past four U.S. recessions.

During the 1980s, the relationship between the oil and gas industry, the Region's economy, and the fortunes of insured institutions was more direct. Today the Region's economies have diversified considerably away from oil and gas exploration and production toward other key industries. Consequently, most of the economic effect of rising oil prices on banks in the Dallas Region is channeled indirectly through insured institutions' local economies.

A Slowing U.S. Economy and New Farm Legislation Likely Will Affect the Region's Agricultural Sector

U.S. agriculture has struggled over the past three years because of depressed commodity prices, recurrent drought conditions in certain areas, a strong U.S. dollar, and lagging exports. Since 1997, the United States Department of Agriculture's all-farm index of prices paid by producers has increased while prices received by producers have dropped. Consequently, Congress has approved historic levels of government payments over the past three years, doubling the Region's receipt of government support.

By 1999, 39 percent of the Dallas Region's net farm income was derived from government payments, significantly less than the 50 percent average nationwide. The primary difference is the livestock sector, which does not receive government payments. Specifically, 69 percent of the Region's agricultural cash receipts are derived from livestock products, compared with 51 percent for the nation. Government payments and net farm income for 2001 are forecast to be considerably lower than in 2000. Fortunately, livestock prices have performed well during the past two years, and the importance of this sector somewhat insulates the Region from the effects of lower government payments. However, the health and viability of the U.S. livestock industry could be adversely affected if the current outbreak of foot-and-mouth disease in Europe spreads to the United States.

While income from farming operations has suffered, the historic economic expansion and tightening labor markets helped create increased opportunities for nonfarm employment. Off-farm income in the Southern Plains averaged almost $80,000 per farm household at year-end 1999-an increase of 116 percent since 1991 and 38 percent above the U.S. average (see Chart 3). Increased reliance on off-farm income helped mitigate problems that could have resulted from depressed commodity prices, weather-related losses, and sluggish exports. However, this new reliance highlights the potential weakness that producers and their lenders may face during an economic downturn.

Chart 3

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Record government payments and increasing off-farm income benefited the Region's agricultural bank earnings and credit quality. The Region's agricultural banks, on average, report strong performance. However, total loans have increased to the highest level in the past ten years, and bank managers are beginning to report credit quality deterioration, as evidenced by declining borrower equity, increasing carryover debt, and rising receivables amid slowing sales for input suppliers. Additionally, the ratio of loan loss reserve to total loans has not kept pace with loan growth and is at the lowest level in a decade. The combination of lower off-farm income as a result of slowing economic growth and decreased farm income as a result of declining government payments could weaken many agricultural producers' ability to repay existing debt and could erode credit quality at the Region's agricultural banks.

Dallas Region Staff

Kansas City Regional Perspectives

The Agricultural Sector Remains Depressed, with Low Commodity Prices

The Kansas City Region's farm sector continues to be plagued by low commodity prices. Strong domestic and foreign production of wheat, corn, and soybeans has resulted in large inventories, depressing prices every year since 1996, as shown in Table 1. Moreover, the U.S. Department of Agriculture's (USDA's) outlook for these commodities in the 2001 and 2002 marketing years shows little improvement over the low prices seen in 2000. On the positive side, cattle prices continue upward, and hog prices have rebounded somewhat from extremely low levels in 1998 and 1999.

Table 1

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The low prices contributed to declining farm net income. Net farm income for the Region dropped 28 percent, from $11.1 billion in 1997 to $8.0 billion in 1999 (the most recent data available on a state basis). Estimated 2000 net farm income, based on national price levels and regional production estimates, is not an improvement over 1999. Yet the Region has not experienced any major production problems in the past two years, which would have resulted in even lower net farm income numbers.

Farm Banks Continue to Report Healthy Conditions despite the Depressed Farm Sector

Despite tough times for farmers, the Region's 1,212 farm banks,¹ which represent 61 percent of the nation's farm banks, reported healthy conditions at year-end 2000, capping a decade of strong financial performance. For example, farm bank earnings, as measured by aggregate return on assets,² were reported at 1.10 percent in 2000, similar to 1998 and 1999 results. In addition, farm bank credit quality has been relatively high. As shown in Chart 1 , total delinquent and nonperforming loans³ continue to represent a low percentage of total loans when compared with historical levels. In addition, net loan charge-offs, which represented just 0.21 percent of total loans as of year-end 2000, have not increased significantly.

Chart 1

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¹ Farm banks are defined as banks having farm operating or farm real estate loans totaling at least 25 percent of total loans.

² Return-on-assets ratios were adjusted for banks that have elected Subchapter S tax status to make their earnings comparable to those of non-Subchapter S institutions.

³ Delinquent loans are loans past due between 30 and 89 days. Nonperforming loans are loans that are placed on nonaccrual (not accruing interest) status or past due 90 days or more.

Reported capital and loan loss reserves, which cushion losses in lending and operations, also remain at relatively high levels. The aggregate equity capital ratio was 10.3 percent and the aggregate ratio of loan loss reserve to gross loans was 1.5 percent as of year-end 2000. These ratios were much lower at the beginning of the 1980s agricultural crisis, at 8.7 percent and 1.0 percent, respectively.⁴

⁴ See Table 3 in "Agricultural Sector under Stress: The 1980s and Today," Kansas City Regional Outlook, third quarter 1999, at http://www.fdic.gov/bank/analytical/regional/ro19993q/kc/k3q1999.pdf.

Government Payments, Carryover Debt, and Off-Farm Income Have Insulated Farm Banks from Problems

Why have farm banks been able to withstand the poor agricultural environment? The answer lies in government payments, carryover debt, and off-farm income, which have been critical to farm banks' reported health during the past three years. An examination of these factors helps to explain why the Region's farm banks have not reported significant deterioration in conditions.

Most important, government payments to farmers in 1998, 1999, and 2000 have mitigated some-but not all-of the financial stress caused by low commodity prices. Nationally, government payments set records in each of those years, with payments in 2000 reaching $22.1 billion. As the agricultural economy has weakened in the Region, government payments also have grown dramatically in importance.

Chart 2 shows how the percentage of government payments to net farm income in the Region has grown from slightly over one-quarter of net farm income in 1997 to more than 100 percent of net farm income in 1999. As a result, farmers have become heavily reliant on government payments to meet debt obligations. Farm bank managers stressed this point during an outreach meeting in March 2000,⁵ stating that many of their weaker farm customers waited for government checks before repaying operating loans.

⁵ Agricultural Bankers Roundtable meeting hosted by the FDIC in Omaha, Nebraska, March 28, 2000.

Chart 2

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Given the USDA 2001 and 2002 price outlooks, it appears that the Region's farmers will continue to rely on government payments in the near term. Any reduction in government payments could have a negative effect on farm banks, as borrowers would find it even more difficult to meet loan obligations and living expenses. All eyes will be on congressional negotiations pertaining to the 2002 farm bill, which could dramatically affect the Region's farmers and lenders.

Carryover debt also helps farm banks to report strong aggregate conditions. Because of the variability in production and price of agricultural products, bankers frequently carry over unpaid seasonal operating loans into the next season. The expectation is that a good operating season will offset one or two poor operating seasons. This practice effectively delays recognition of credit stress as these loans do not show up in reported delinquency figures. For example, in the 1980s farm crisis, farm banks' delinquency ratios did not rise significantly until 1984, three years into the crisis.⁶

⁶ For a discussion of how the current agricultural situation differs from that of the 1980s, including a discussion of carryover debt, refer to the Kansas City Regional Outlook, third quarter 1999, at http://www.fdic.gov/bank/analytical/regional/ro19993q/kc/k3q1999.pdf.

FDIC examiners report⁷ that the share of examined banks experiencing a "moderate" to "significant" increase in carryover debt levels jumped from about 10 percent in March 1998 to more than 40 percent by September 1999. Although the percentage of banks experiencing increases has moderated somewhat, it remains relatively high. Further persistence of low farm revenue could result in higher delinquency numbers at farm banks, because carryover debt has limitations, particularly for farmers without substantial real-estate equity to secure carryover loan extensions. Farm borrowers' balance sheets can be stretched only so far before bankers are unable or unwilling to extend additional carryover debt. At that point, delinquency levels escalate rapidly, as in the early 1980s.

⁷ FDIC examiner loan underwriting survey results; examinations conducted between September 1996 and September 2000.

The third factor that has benefited farm banks is that the strong nonfarm economy has boosted farmers' off-farm income levels. Off-farm income represents a large share of funds used to meet living expenses or make farm-related debt payments, particularly for smaller farming operations. USDA data for 1999 show that off-farm income represents 69 percent of total household income for farm households with farm revenues of $50,000 to $249,000. These smaller operations are the primary borrowers at many of the Region's farm banks. Data released in 1992 by the USDA show that most off-farm jobs are not related to farming. In fact, services and manufacturing employ 51 percent and 17 percent of rural workers, respectively, and government employment accounts for another 17 percent. Therefore, even in Midwestern states in which farm production represents the largest source of production output, off-farm income represents a critical share of farming families' total income.

The record-setting national economic expansion has been a tremendous boost to off-farm income, helping rural areas provide a wide range of employment opportunities. However, recent economic data and news releases suggest that the economic growth has slowed substantially and might be at or near zero. Reports of layoffs, lost shifts, and idled plants are increasing. A prolonged or severe economic slowdown could be harmful to farm banks' financial well-being, as farm borrowers might lose a substantial portion of household income through lost wages.

Thus far, farm banks have continued to report healthy conditions despite a depressed farm economy. However, stress cracks in their condition are apparent. Government payments and off-farm income have played important roles in preventing the cracks from widening. Currently there is uncertainty about the health of the general economy as well as about the role of government in farming and the direction that will be taken in the 2002 farm bill. Significant changes in these areas or a significant and widespread crop failure could expand the stress cracks.

Richard D. Cofer, Jr.
Senior Financial Analyst

Memphis Regional Perspectives

The Region's Economy Has Stalled

The Memphis Region's economy slowed sharply during the second half of 2000 and is now considerably weaker than the national economy. Payroll employment was stagnant in the fourth quarter of 2000 and first quarter of 2001.¹ Personal income growth likewise slowed. The Region's economic performance was hampered by waning consumer confidence, lower corporate profits, disappointing retail sales, and declining construction activity related to the national slowdown. The Region also was disproportionately affected by weaknesses in manufacturing.

¹ Seasonally adjusted annualized employment growth during the first three months of 2001 (measuring only changes from December 31, 2000, to March 31, 2001) that was a meager 0.3 percent, compared with the 3.2 percent annualized growth reported for the same period in the prior year, provides an indication of the magnitude of the recent slowdown.

Nationally, the manufacturing sector is contracting. The National Association of Purchasing Managers' Index² has been below 50, a level typically associated with a downturn in manufacturing, since the third quarter of 2000 (see Chart 1). The effects of the current slowdown in this sector are more pronounced for the Memphis Region than for the nation because of a higher concentration of manufacturing employment and the poor performance of the Region's manufacturing industries compared with the sector as a whole. Many of the Region's manufacturing companies have closed plants or laid off employees to reduce costs. The downturn in manufacturing has led to slower growth in other important sectors such as services, retail, and construction.

² The index is based on a survey of more than 250 companies within 21 industries in all 50 states and covers areas such as production, orders, commodity prices, inventories, and vendor performance as well as employment.

Chart 1

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Mississippi's economy appears to be in a serious downturn. Mississippi shed almost 20,000 jobs during the nine months ended March 31, 2001, considerably more job losses than the state reported during the 1990 to 1991 national downturn. Although the losses were driven by weaknesses in manufacturing, almost all sectors have been affected. With the maturation of the gaming industry, job formation in the construction and service sectors, previous drivers of state employment growth, evaporated. Also, the agricultural sector continues to face low commodity prices and escalating costs, and the timber industry is struggling with lower demand following a severe winter. As a result of these negative trends, personal income growth in the fourth quarter of 2000 slowed to its lowest rate since 1983. While some positive developments are expected, primarily the initial construction work for a new automobile manufacturing facility, the state's economic recovery appears to be largely contingent on improvement in the national economy.

The current slowdown in Mississippi follows a decade of strong economic growth spurred in large part by gaming and hotel development. Many insured financial institutions in the state responded with rapid growth of their own in the 1990s to match the booming economy. This period of expansion, in the economy and among insured financial institutions, makes adapting to the current downturn all the more difficult for the management of banks and thrifts.

The economies of Arkansas and Tennessee also may be vulnerable. Arkansas is even more dependent on manufacturing employment than is Mississippi, and continued weaknesses in the sector could begin to affect the state's overall economic health.³ After slowing appreciably in the fourth quarter of 2000, employment growth in Tennessee during the first three months of 2001 was close to zero. The rate of deceleration in employment growth over the preceding six months suggests that the state's economy has been affected disproportionately by the current national slowdown.

³ Manufacturing employment represents 22 percent of Arkansas' total nonagricultural employment, compared with a national level of 14 percent. Job losses in the manufacturing sector contributed to negative job formation in the state in January and February 2001.

Bank Credit Quality Has Deteriorated with Economic Conditions

As the national and regional economies slowed during the second half of 2000, large banks (those with total assets of $1 billion or more) began reporting deterioration in credit quality. Past-due loan ratios increased and loan losses rose in the third and fourth quarters of 2000 among the Region's 25 largest insured financial institutions (see Chart 2). In response to changing economic conditions and credit quality concerns, these banks began to reduce loan exposure levels early in 2000 and more recently began to add to allowances for loan and lease losses.

Chart 2

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Community banks (those with total assets of less than $1 billion) also reported deterioration in asset quality. In fact, community banks in the Region reported the largest spike and the highest aggregate ratio of past-due loans among the FDIC's eight Regions as of December 31, 2000.⁴ Rising delinquencies were widespread, with almost two-thirds of the Region's banks and thrifts reporting increases in past-due loan levels from the prior year. Loan loss rates also increased for most institutions. Community banks and large banks have responded differently to changing economic conditions. Whereas many of the Region's largest banks have slowed loan growth and boosted reserves for loan losses, many community banks have not.

⁴ Memphis Region community banks reported an aggregate past-due loan ratio (loans reported as nonaccrual or past due 30 days or more) of 2.86 percent at year-end 2000. This represents a notable increase over the 2.47 percent reported as of December 31, 1999, and the 2.48 percent reported as of September 30, 2000, and is the highest year-end past-due loan level reported in the Region since 1992.

Higher delinquencies were reported for almost every loan category, with consumer loans showing the largest jump.⁵ Consumer loan portfolios likely were affected by the fourth quarter layoffs as well as by growing consumer debt burdens. Commercial and industrial loan delinquencies also increased as many area businesses experienced declining profitability associated with the slowing economy. Construction loan delinquencies were also notably higher, likely influenced by the growing inventories of unsold newly constructed homes in many areas.

⁵ The aggregate consumer loan past-due ratio for community banks and thrifts in the Region increased from 3.15 percent of total consumer loans at year-end 1999 to 3.68 percent at year-end 2000.

Higher Credit Exposure Could Increase the Vulnerability of the Region's Banks

If economic conditions deteriorate further, Memphis Region banks and thrifts could be affected by credit quality problems more severely than during the previous economic downturn because of higher credit exposure levels. The aggregate loan-to-asset ratio for the Region's community banks at year-end 2000 was well above levels reported prior to the 1990 to 1991 recession (see Chart 3).⁶ Furthermore, loan portfolios at year-end 2000 were much more heavily concentrated in traditionally higher-risk loan types, primarily in commercial real estate and construction and development lending, increasing the susceptibility of area banks to any downturn in local real estate market conditions.

⁶ The aggregate loan-to-asset ratio for Memphis Region community banks at year-end 2000 was 66 percent, compared with 56 percent reported at year-end 1989.

Chart 3

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Credit exposure levels are particularly high in many of the Region's metropolitan areas, such as Lexington, Memphis, and Nashville. In many metropolitan areas, growing competitive pressures have led to rapidly escalating funding costs. In response, many insured institutions, accommodated by previous economic strength, accepted higher credit exposure in order to improve asset yields and maintain net interest margins.

As a result, bank earnings may be more vulnerable to changes in economic conditions than in prior periods of slowing. Pressures on net interest margins, previously masked to some extent by increasing credit exposure and asset yields, may intensify as loan demand wanes and banks and thrifts tighten underwriting standards in response to worsening economic conditions.

Higher credit exposure also may necessitate additional provisions to the allowance for loan and lease losses. In recent years, most banks' provisions covered relatively low loan loss rates; however, allowance levels did not keep pace with burgeoning loan portfolios. While lower allowance levels may have been appropriate during a time of economic prosperity, provisions may need to increase in the near term given the weakness in area economic conditions and rising delinquencies and loss rates.

The effects of the slowing national economy are beginning to be felt by community banks. This seems particularly true for institutions in the Midwest and Midsouth, where economic conditions have weakened the most and credit quality concerns are emerging. The extent of credit quality deterioration and the resulting pressure on earnings and capital levels depend largely on the duration and severity of economic weakness in the nation and Region, as well as the response of financial institution management to changing conditions.

Memphis Region Staff

New York Regional Perspectives

Region's Economy, although Slowing, Performed Well; However, Pockets of Weakness Are Emerging

Some measures indicate that relative to that of the nation, the Region's economy, although slowing, performed well through first quarter 2001. The Region's labor markets were tight, commercial and residential real estate conditions were generally favorable, and consumer spending was stable.¹ Furthermore, except for manufacturing, the Region's industry sectors reported job growth in 2000, albeit at a lower rate than in 1999 (see Chart 1).

¹Federal Reserve Beige Book, New York and Philadelphia Districts, March 7, 2001.

Chart 1

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Pockets of weakness are emerging, however, particularly among communities that have a higher concentration of manufacturing jobs. Reduced demand nationwide for manufactured products, including automobiles, computers, electronic equipment, and industrial machinery, has resulted in job losses in areas such as Buffalo and Elmira, New York, and Reading and York, Pennsylvania. These metropolitan areas, as well as several others in Pennsylvania and northern and western New York, which also have a high concentration of manufacturing jobs, could be hurt by reduced demand for durable manufactured goods.

Furthermore, some of the Region's office markets may be more vulnerable to an economic downturn. Office construction has been at substantially lower levels during the 1990s business cycle than during the 1980s, and vacancy rates remain generally low.² However, office construction has increased in northeastern New Jersey³ and suburban Maryland.⁴ Moreover, layoffs, particularly among Internet and other high-technology firms, could result in leased space returning to these markets as new construction is completed.

² For additional information on commercial real estate conditions, see New York Regional Outlook, third quarter 2000.

³ Kathleen Lynn, "Space Tight, Outlook Bright for Commercial Real Estate," Bergen Record, February 4, 2001.

⁴ Grubb & Ellis, Real Estate Forecast for Washington, D.C., 2001.

⁶ Uncertainty on Wall Street has implications for the Region's economy, particularly in New York City and surrounding areas. Although the finance, insurance, and real estate (FIRE) sector does not account for the largest proportion of the Region's job base, it represents a significant share of the Region's economy, as it provides some of the highest-paying jobs. The FIRE sector accounts for more than one-quarter (25.7 percent) of the Region's combined gross state products.5 Moreover, the Region's FIRE sector has grown faster than its overall economy, increasing 5.4 percent between 1997 and 1998 compared with 4.2 percent for the Region's economy as a whole. Layoffs by the Region's large brokerage firms, however, have increased. Furthermore, a decline in initial public offerings and merger activity has contributed to a drop in earnings reported by the Region's large banks (assets greater than $10 billion), which derive a significant portion of operating income from market-sensitive revenues.

⁵ Bureau of Economic Analysis. Excludes Puerto Rico, which was not available. Data for 1998 are the most recent available.

The Region's and the nation's economies also are linked to Wall Street by the wealth effect created by the rising stock market in the 1990s. Rising equity values have contributed to increased household net worth and have fueled consumer spending on homes, autos, and other purchases. During 2000, however, the wealth effect turned negative, as the nation's household net worth declined for the first time since 1945, reflecting declining equity prices. Reduced household net worth could depress consumer spending across the Region and the nation.

⁶ Federal Reserve Board, The Senior Loan Officer Opinion Survey on Bank Lending Practices, March 2001.

Credit Quality among the Region's Insured Institutions Shows Signs of Weakening

While reported credit quality indicators at year-end 2000 were generally sound, some weakening was evident, particularly among commercial and industrial (C&I) loans at the Region's large banks. Large banks' C&I past-due and charge-off ratios increased; however, these ratios remain below levels reached a decade ago. During 2000, the median C&I loan past-due ratio for the Region's large banks increased to 2.17 percent from 1.46 percent in 1999, while the C&I net charge-off ratio increased slightly to 0.47 percent from 0.44 percent. In comparison, during 1991, the median C&I past-due and net charge-off ratios reported by the Region's large banks reached 6.77 percent and 2.40 percent, respectively. Much of the C&I credit deterioration has been attributed to large syndicated loans booked between 1996 and 1998, when underwriting standards eased. Recent surveys prepared by the Federal Reserve Board⁶ indicate that nationwide, banks have tightened underwriting standards over the past year. Nevertheless, some indicators suggest that C&I credit quality may weaken further as C&I loans underwritten three years ago season and as the economy slows.⁷ Furthermore, C&I credit-quality weakness may be extending beyond the Region's large banks, as regional banks (assets between $1 billion and $10 billion) also reported higher C&I past-due and charge-off rates.

⁷ Moody's Investors Service, U.S. Banking Sector: Commentary of 4th Quarter 2000 Earnings, February 2001.

The slowing economy also may be having a negative effect on credit quality at the Region's community banks (those with assets less than $1 billion⁸). While past-due ratios remain generally favorable, 57 percent of the Region's community banks reported an increase in the past-due ratio during the second half of 2000. The increase primarily reflected weakness in residential mortgages, consistent with national trends. According to the Mortgage Bankers Association of America, in fourth quarter 2000, the percentage of delinquent mortgages in the United States reached the highest level since 1992. Moreover, weakening credit quality reported by community banks headquartered in the Region's manufacturing-dependent counties suggests that these banks may be experiencing the effects of the national economic slowdown more than community banks headquartered in counties less reliant on manufacturing jobs.⁹ Throughout the late 1990s, community banks in manufacturing-dependent counties reported a lower ratio of past-due residential loans than the Region's other community banks; however, in 2000, this trend reversed, likely reflecting weakness in manufacturing employment.

⁸ Excluding insured institutions less than three years old and credit card specialists.

⁹ Manufacturing-dependent areas are defined as counties whose manufacturing employment concentration is greater than the national average of approximately 15 percent. Of the 178 counties in the New York Region, 80, or 45 percent, have a ratio of manufacturing jobs to total jobs of greater than 15 percent. As of December 31, 2000, 212 established community institutions were headquartered in the Region's manufacturing-dependent counties.

In addition, while community banks' C&I past-due ratios remained favorable in 2000, the amount of past-due C&I loans increased. Past-due ratios were largely diluted by strong commercial loan growth experienced over the past two years. The increase in past-due loans suggests that improvements in credit quality that occurred throughout the late 1990s are waning as economic conditions soften. Moreover, although commercial real estate (CRE) loan quality reported by the Region's community banks also was relatively favorable, a slowing economy could weaken office market conditions and adversely affect credit quality. Two-thirds of the Region's community banks have increased CRE loan exposure as a percentage of total assets since 1998. Furthermore, a high percentage of the Region's newer institutions have increased CRE loan exposure. CRE loans constitute the largest share of new banks' loans, more than the Region's established community banks and more than new banks a decade ago. For more information on the Region's new banks, see New York Regional Outlook, first quarter 2001.

Weakening credit quality could lead to higher loan loss provisions and lower profitability for the Region's banks, as allowance for loan and lease losses (ALLL) levels have not kept pace with loan growth (see Chart 2). The median ratio of ALLL to Gross Loans for the Region's banks declined throughout the current economic expansion, falling to the lowest level since 1990. Nevertheless, capital ratios of the Region's banks are higher than a decade ago, providing additional cushion against potential losses.

Asset Extension Could Pressure NIMs Following the Mortgage Refinancing Wave

Chart 2

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Relatively low long-term interest rates and a flat yield curve, which prevailed periodically during the late 1990s and 2000, fueled consumers' preference for long-term, fixed-rate loans and contributed to lower net interest margins (NIMs) for the Region's community banks. These banks are generally more affected by NIM compression because of their dependence on the NIM or "spread" income, while large institutions derive much of their revenue from noninterest income.

More than two-thirds of the Region's community banks have reported an increase in concentration of long-term assets since 1997. In fact, 30 percent of the nation's community banks that hold a large concentration of long-term assets are headquartered in the Region,¹⁰ reflecting its greater concentration of mortgage lenders.¹¹ Moreover, the proportion of long-term assets (those that reprice after five years) may increase further should the level of mortgage refinancing continue at a high level.¹²

10 Established community banks with a ratio of assets maturing after five years to earning assets above the 90th percentile. Of the 443 banks that meet this criterion nationally, 135 are in the Region.

¹¹ Banks that have greater than 50 percent of assets in 1 to 4 family real estate loans and mortgage-backed securities.

¹² According to the Mortgage Bankers Association of America's Mortgage Application Index for Refinancing, the level of mortgage refinancings increased sharply during first quarter 2001.

While concentrations in longer-term assets should help bolster bank margins in a declining interest rate environment, a subsequent rise in rates, as occurred following the 1998 refinancing wave, could exacerbate NIM compression, particularly among institutions with high concentrations of long-term assets. As interest rates climbed following the 1998 mortgage refinancing wave, margins of community banks with greater concentrations in long-term assets tightened more than margins of other community banks.¹³ Should the 1998 scenario repeat, banks with higher concentrations of long-term assets could again experience greater margin compression, highlighting the importance of interest rate risk management.

¹³ The median NIM decline from 1998 to 2000 for community banks with high concentrations in long-term assets was 10 basis points, compared with 3 basis points for other community banks.

Kathy R. Kalser, Regional Manager
Robert M. DiChiara, Financial Analyst
Norman Gertner, Regional Economist
Alexander J. G. Gilchrist, Economic Analyst

San Francisco Regional Perspectives

Economic and Banking Conditions Are Sound but Face Increasing Pressures

The Region's economy remained sound and expanded faster than the nation's through first quarter 2001, albeit at a slower pace than in previous periods. Because of this slowing, there is concern about the sustainability of the Region's growth. For instance, the Oregon economy has softened significantly since mid-2000, mainly because of contraction in the forestry and manufacturing sectors. In addition, continued slowing in the national economy or a confluence of key developments could dampen the Region's economy. In particular, energy price increases and power interruptions, technology sector and equity market volatility, and commercial real estate market softness could affect growth prospects adversely.

As of December 31, 2000, a majority of the Region's insured financial institutions reported sound financial conditions; however, the trend toward tighter liquidity and weaker asset quality continued. For example, two-thirds of institutions open three years or more reported year-over-year declines in core-deposit-to-asset ratios. In addition, delinquent commercial and industrial (C&I) loan ratios increased noticeably throughout the Region; institutions with more than $1 billion in total assets reported almost a 60 percent year-over-year increase in the median past-due C&I loan ratio.

The Energy Crisis in the West Poses Both Immediate and Long-Term Problems

The recent surge in natural gas prices in conjunction with electricity cost and availability problems could slow the Region's economy. The mining, lodging, and agriculture sectors appear particularly vulnerable. In addition, highly leveraged households or marginally profitable businesses could be affected disproportionately by higher energy bills.

Natural gas prices nearly quadrupled nationwide during the winter of 2000. In California, where inadequate pipeline capacity further constrained supplies, the spot price for natural gas surged even higher and continues to hover well above the national average (see Chart 1). Rising natural gas prices, coupled with an inadequate number of power plant facilities in California, drought conditions in the Pacific Northwest, and California's ill-structured electricity deregulation program, also led to significant increases in wholesale electricity costs. Overall, these factors have contributed to rising retail gas and electricity prices in many western states and electricity availability problems in California.

Chart 1

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Rising energy prices and decreased electricity reliability could affect the Region's energy-intensive industries adversely. For example, mining and lodging consume a significant amount of electricity and could be affected disproportionately by higher energy costs. Mining is particularly important to the economies of Alaska, Idaho, Montana, Nevada, Utah, and Wyoming, while lodging is a major industry in Nevada and Hawaii.

Escalating energy prices and rolling outages already have affected several agricultural subsectors. Dairy, greenhouse, and poultry producers not only use large amounts of natural gas but also depend on electricity as a critical element of production. In addition, agricultural operations that use fertilizer and irrigation could experience cash flow pressures. The combined effects on these areas of agriculture could be especially damaging to California, which has a significant percentage of irrigated crops and exposure to the dairy and greenhouse industries. The resulting pressure on farm cash flows could affect the 125 insured financial institutions in the Region that have agricultural loan exposures exceeding 100 percent of Tier 1 capital. California accounts for nearly 20 percent of these lenders.

Higher retail energy prices act very much like a tax that reduces consumers' discretionary spending. Data suggest that energy price increases have a relatively greater impact on lower-income households than on higher-income ones. Consequently, credit quality at the Region's subprime lenders could be most affected by rising household energy costs.

Energy will remain a longer-term issue in the West. The threat of rolling outages will not be eliminated until California's investor-owned utilities become solvent and adequate generation capacity is built or conservation efforts become more effective. Given the interconnectedness of the West's power distribution network, other states also will continue to be affected.

Equity Market Weakness May Disproportionately Affect the San Francisco Region

Venture capital funding, which had been the growth engine in several of the Region's metropolitan statistical areas (MSAs) over the past several years, contracted during the fourth quarter of 2000. Northern California,¹ Los Angeles/Orange County, and Washington reported noticeable declines in venture capital funding, which contributed to layoffs and closings of a significant number of high-tech firms during late 2000 and early 2001. California and Washington accounted for about 33 percent and 5 percent, respectively, of all dot-com closures through February 2001. Furthermore, the significant number of layoffs reported in the surviving e-commerce, dot-com, and computer sectors nationwide correlates strongly with the large decline in the tech-heavy NASDAQ Composite Index between March 2000 and March 2001.

¹ Aggregated by PricewaterhouseCoopers; includes Silicon Valley and the San Francisco Bay Area.

Weakness in the stock market also could affect household financial positions and consumer spending adversely. The net worth of U.S. households dropped 2 percent during 2000, the first annual decline in 55 years.² Although the percentage drop was not large, consumers may spend less on retail goods and tourist activities, both of which are important to several states in the Region, including Nevada and Hawaii. In addition, declining equity market values could dampen trust income at insured institutions because trust revenues are usually tied to asset market values. Trust income has become increasingly important for some insured institutions. For instance, for the 76 institutions in the Region that reported income from fiduciary activities as of December 31, 2000, the median ratio of trust income to total noninterest income was 14 percent, up steadily from 9 percent five years earlier.

² Federal Reserve Board, Flow of Funds Data (B.100 Balance Sheet of Households and Nonprofit Organizations), March 9, 2001.

Sustained Softening in the Commercial Real Estate Sector Could Affect a Majority of the Region's Insured Institutions

Softness in some commercial real estate (CRE) markets could adversely affect insured financial institutions in the Region with elevated CRE loan³ concentrations. As of December 31, 2000, more than half of the Region's metropolitan insured institutions reported CRE loan concentrations exceeding 300 percent of Tier 1 capital, compared with only 29 percent of metropolitan institutions based elsewhere in the nation. Institutions with significant exposures to office, industrial, retail, and hotel properties in the Region's high-tech MSAs⁴ and tourism areas could be most vulnerable to a downturn in this sector.

³ CRE loans include nonfarm-nonresidential, multifamily, and construction loans. Because of Call Report limitations, CRE loans may include credits used to finance residential construction projects.

⁴ There are 13 MSAs in Arizona, California, Idaho, Oregon, and Washington, where the growth and concentration of high-tech employment exceeds the national average. (See San Francisco Regional Perspectives, third quarter 2000, for details.)

Demand for office and industrial space in the Region has been affected primarily by softness in the technology sector. Technology firm failures and layoffs reportedly have increased available office sublease space and placed downward pressure on CRE rents in the San Francisco, San Jose, and Seattle MSAs as well as the West Los Angeles office market. Given waning absorption rates and new construction in the pipeline, Torto Wheaton Research forecasts significant office vacancy rate increases in several of the Region's high-tech MSAs over the next two years (see Table 1).

Table 1

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Demand for hotel and retail commercial space also could suffer as a result of diminished consumer confidence and falling retail sales. Hotel and retail space in Nevada and Hawaii could be most vulnerable if a slowing economy contributes to a decline in leisure and business travel. Already, Las Vegas Strip hotels have reported falling room rates, a result in part of the slowing economy and of rising energy prices in California.⁵ Demand for retail space also could wane throughout the Region, given reports of declining retail sales in the West.⁶

⁵ Hubbel Smith, "Air Service to Las Vegas Keeps Growing But a Drop in Strip Hotel Room Rates May Signal Sagging Tourism Demand, Analyst Suggests," Las Vegas Review-Journal, March 23, 2001. www.lvrj.com/lvrj_home/2001/Mar-23-Fri-2001/business/15700408.html

⁶ Bank of Tokyo Mitsubishi/Union Bank of Switzerland, Warburg Retail Sales Survey, February 2001.

Insured Institutions in High-Tech Areas Could Be Most Affected

Of particular concern are insured institutions operating in certain MSAs in the San Francisco Region that are affected by a combination of the economic developments discussed in this article. The confluence of problems in the energy sector, volatility in the equity markets, and a weakening CRE sector could adversely affect CRE lenders in high-tech MSAs in California, Washington, and Oregon. These urban areas could be disproportionately affected by constrained energy supplies, declining levels of venture capital investment, layoffs among high-tech companies, and rising CRE vacancy rates.

San Francisco Region Staff