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

The nation's economic landscape has altered dramatically over the past year, creating possibly the most challenging environment in a decade for insured institutions. Unlike the 1990/1991 recession, which was preceded by regional economic downturns in many areas of the country, the current recession is being felt both domestically and globally. This global economic weakness may affect the depth and duration of the current national recession and the timing and strength of a recovery. The uncertainty and subsequent disruptions caused by the events of September 11 intensified the economic downturn that began last spring.

Various sectors of the economy face many challenges. Business investment may be slow to revive because of reduced corporate profits and underutilized plants and equipment. Near-record consumer debt levels and service burdens, along with a lack of pent-up demand, may forestall a surge in consumer spending. Weak global growth coupled with continued strength in the trade-weighted value of the U.S. dollar could restrict export opportunities. Fiscal stimulus at the federal level may be offset by budget cuts or tax increases by states or municipalities facing budget shortfalls. Monetary policy may take some time to spur economic growth as real short-term interest rates (federal funds rate less inflation rate) remain positive. Consequently, a quick and robust recovery may prove elusive. A persistent disinflationary or outright deflationary environment could present insured institutions with significant challenges. Loan quality could be affected in two ways: collateral asset values could decline, and borrowers' ability to service debt could be reduced if incomes and cash flow fall.

The Region's insured institutions that hold large lending concentrations (at least 15 percent of assets) in traditionally higher-risk categories may be more vulnerable to the effects of the current economic downturn. Within the Region, 361 community banks (assets less than $1 billion) held large concentrations in construction and development loans or commercial and industrial loans at third-quarter 2001. During the last recession, community banks with a high lending concentration in these categories were twice as likely to receive a problem bank rating.

Although the capital cushion at Atlanta Region community banks with a high lending concentration has declined modestly, capital levels among other community banks have increased. Community banks in the Region with a high lending concentration report an average equity-to-asset ratio of 10.68 percent. In contrast, the average equity-to-asset ratio among other community banks has increased 88 basis points to 12.51 percent since the last recession.

The Region's new insured institutions also may be at greater risk during the current downturn. About 25 percent of the nation's "non-recession-tested" insured institutions are headquartered in the Atlanta Region. Historically, such institutions are more likely to receive a problem bank rating or fail when they first experience an economic downturn.

Historically strong financial conditions among many of the Region's insured institutions may erode if the economic downturn continues. A prolonged period of slow or negative economic growth combined with a softening in asset prices, particularly for commercial and residential real estate, could have significant repercussions for certain types of the Region's insured institutions. Such an environment would likely be more challenging for community banks with high lending concentrations and startups experiencing their first recession. Typically, these types of institutions perform best in a rapidly growing economy. For this reason, banks with concentrations in traditionally higher-risk assets or that have adopted a business model that relies on rapid economic growth should evaluate their ability to operate during a period of slow economic growth.

The current economic environment in the Region differs from the recession in the early 1990s, when cyclical weakness was compounded by downsizing in the defense industry and overbuilding in the commercial real estate sector. However, certain white-collar industries, such as software and telecommunications, have been more significantly affected than other sectors of the economy during the current recession. A recent study conducted by Northeastern University reported that layoff announcements in Massachusetts have been concentrated among information technology (IT) companies, and that unemployment claims in the third quarter were rising three to five times faster in areas with concentrations in IT employment.

The Region's housing market is cooling but remains a faint bright spot in the economy. Existing home sales growth in the Region was weak through third-quarter 2001 compared with the nation, but remained positive. New home construction, as measured by building permit issuance, slowed in the Region through 2001 following strong gains in the late 1990s. Despite the softening economy, home price appreciation continued in metropolitan areas throughout the Region in 2001, suggesting that the weakness in sales was not due to a softening in demand.

The fundamentals of the current housing market are stronger than during the previous recession. Residential real estate markets in the Boston Region boast little speculative building and a generally limited inventory of unsold homes. However, should the economic downturn continue for some time, softening in housing prices could become widespread.

For many of the Region's insured institutions, the growing concentration of investment in long-term assets may be heightening interest rate risk. The rising exposure is particularly pronounced among the Region's small savings institutions (total assets < $1 billion); however, many of the trends noted for these institutions are present in large savings banks and commercial banks as well, albeit to a lesser degree.

The persistent decline in net interest margins that has eroded earnings steadily over the past few years appears to be a major contributing factor to the growing concentration in long-term assets. As a result, many institutions are holding higher-yielding, long-term fixed-rate assets in an effort to keep margins from falling further. These efforts to protect the current earnings stream may place longer-term earnings at risk if interest rate risk management does not contain exposure to rising interest rates. In 1995, just 10 percent of savings institutions reported that long-term assets exceeded 40 percent of earning assets. As of September 30, 2001, more than half reported a similar concentration level. The record level of refinancing that occurred in the fourth quarter of 2001 will likely result in higher long-term asset concentrations in the short term.

While asset maturities continue to lengthen, liabilities remain short. Of all time deposits in the Region's savings institutions, 75 percent mature or reprice in one year or less. This percentage actually has risen over the past few years as customers have become less willing to invest in longer-term instruments.

Longer-dated borrowings are being reported by the Region's savings institutions; however, this lengthening of maturities may not be reducing exposure to higher interest rates. The Federal Home Loan Bank of Boston, the primary source of term borrowings for the Region's savings institutions, reported that as of year-end 2000, approximately 63 percent of longer-term advances (with remaining stated maturity of more than three years) could be redeemed early at the lender's option, with most callable within one year. This fact suggests that a high percentage of the longer-maturity borrowings reported on Call Reports are, in effect, short-maturity liabilities in the event of a rising rate environment.

Clearly, interest rate risk is rising among the Region's savings institutions. Asset maturities continue to lengthen while liabilities remain short. Optionality is becoming a key funding issue, and measuring and projecting the sensitivity of core deposits to rising rates will prove difficult. As a result, interest rate risk measurement and management are becoming increasingly complex. Steps can be taken to mitigate some of the risk; however, there will be a trade-off between short-term profits and long-term earnings stability. Now is a good time for institutions to take action. When the rate cycle begins to turn, risk reduction strategies may be much more difficult to implement.

The effects of the national recession are keenly felt. The Chicago Region's unemployment rate of 5.4 percent in December 2001 was noticeably higher than its 3.8 to 4.0 percent range during the past three years. However, unlike most prior recessions, recent deterioration in the Region's labor markets has not been more severe than in the national market. This dissimilarity reflects, in part, the fact that the current economic slump involves such sectors as computers, air transportation, and tourism, which are not heavily concentrated in the Region. Even so, output of durable goods manufacturers, which are concentrated locally, continues to decline sharply. Consequently, year-end 2001 employment in the Region was 1 percent lower than a year earlier, with manufacturing employment 5 percent lower.

Lower interest rates are helping sustain demand for interest-sensitive items and enhancing borrowers' repayment ability despite slower growth in personal income and corporate profits. Even so, corporate bankruptcies rose noticeably in the past year, and signs of repayment problems are emerging among households. Should government payments to farmers, a major income source in some agricultural communities, be reduced under the provisions of a new farm bill, signs of stress also could become evident among the Region's small farmers.

Rapid declines in interest rates are affecting net interest margins (NIMs) and asset and liability management. Insured-institution NIMs generally have been shrinking over the past decade. Recently, however, short-term rates have fallen, causing the yield curve to change from inverted in late 2000 to steep and upward sloping by the end of 2001. Consequently, margin compression has reversed in recent quarters amid changing customer preferences and a substantially altered asset and liability management environment.

Falling mortgage rates triggered a surge in refinancing activity and spurred borrower preference for longer-term, fixed-rate mortgages. Higher volumes of mortgage origination activity have been a boon for many lenders, generating more fee income. However, unanticipated principal prepayments can present challenges for banks and thrifts. As long as interest rates remain low, borrowers are expected to maintain a preference for fixed-rate mortgages.

Securities portfolio trends are helping boost asset yields; however, these trends also increase portfolio sensitivity to changes in interest rates. Securities continue to represent a declining percentage of insured institutions' assets, and there has been a shift toward mortgage-backed securities and U.S. Agencies away from U.S. Treasuries. Also, a general lengthening of maturities or earliest repricing dates among mortgage-backed and corporate debt securities has occurred. Generally speaking, although current NIMs should be helped by these moves, a higher share of longer-term and mortgage-backed securities is expected to increase the sensitivity of securities portfolios to interest-rate fluctuations.

Retail customers now appear to favor shorter-term time deposits as well as nonmaturity money market deposit accounts and savings accounts. Accompanying this change is a move toward longer-term funding in situations where management has the most control over funding maturities, such as brokered deposits and Federal Home Loan Bank borrowings. Depositor movement toward shorter-term instruments will generally help margins in the near term, but this type of funding may reprice quickly when short-term rates increase.

Balance sheet changes associated with falling short-term interest rates in 2001 may have increased the exposure of certain insured institutions to rising rates. Banks and thrifts seeking to maximize current NIMs by increasing long-term, fixed-rate assets and shifting toward earlier repricing and shorter-term liabilities may be vulnerable should short-term interest rates rise or the yield curve flatten. Prudent interest rate risk decisions can be made only by reviewing the totality of an individual institution's rate-sensitive assets and liabilities. To that end, bank management now can review how well interest rate risk management systems performed during the recent period of substantial interest rate changes. In addition, management has the opportunity to ensure that their institutions are well positioned should interest rates either rise or experience significant, nonparallel shifts, such as happened in 2001.

Potential exists for weakening housing price growth in key Dallas Region metropolitan markets. Denver and Austin were two of the nation's fastest-growing metropolitan economies during the past ten years. In addition to robust employment levels, housing activity in these markets has been strong, spurred more recently by declining mortgage interest rates. However, economic weakening, whether the result of the aftermath of the September 11, 2001, attacks or of the slowing national economy, or both, is undermining the strength of these housing markets. Both metropolitan statistical areas (MSAs) may be vulnerable to weakening housing price growth because of overbuilding and sharp declines in employment growth.

Denver's housing market appears more vulnerable to flagging housing price growth. Since mid-2001, the Denver economy has been adversely affected by the slowing U.S. economy and the effects of September 11. Year-to-year job growth rates have decelerated every month since April 2001, and employment declined 0.3 percent in fourth-quarter 2001 from a year ago. Employment losses have spread beyond the metro area's ailing telecommunications, manufacturing, and travel industries and now are occurring among industries that represent 55 percent of Denver's total nonfarm employment.

Rapidly rising home prices during a period of deteriorating employment growth are unsustainable and could portend significant slowing in housing price growth in the Denver market. The decline in housing affordability could be particularly problematic for the first-time buyer and could dampen trade-up markets. Denver's housing market is overbuilt, and a substantial slowing in residential construction through 2002 is expected. Poor economic fundamentals (deteriorating employment conditions), declining housing affordability, and residential overbuilding are expected to contribute to considerable softening in home price growth in 2002.

The Austin MSA also experienced a deceleration in employment and home price growth in 2001. The Austin economy has been adversely affected by weakness in the computer, telecommunications, and semiconductor sectors, as well as the serious decline in the dot-com industry. However, housing affordability in the Austin metropolitan area remains comparable to the national average. Still, a growing supply/demand imbalance in residential construction exists.

Housing price growth in the Austin metropolitan area is slowing, particularly for high-priced homes. This sector of the real estate market had been hit hard by weakening in the high-tech sector and the failure of many Internet startup companies. Although housing prices are not expected to depreciate this year, prolonged difficulties in the high-tech sector could change the outlook for home prices in this MSA.

The Dallas, Fort Worth, and Houston economies are characterized by relatively moderate employment growth rates and do not show any serious signs of overbuilding. As a result, home prices are not expected to decline in these housing markets. Employment growth and affordable housing are likely to support some housing price appreciation in these markets in 2002, albeit at a slower pace.

Recent developments affecting collateral values suggest that risk in mortgage lending may be growing. The loan-to-value ratio of many new mortgages is increasing. More than 20 percent of all mortgages originated nationwide in 2001, almost three times the level in 1990, were for more than 90 percent of the value of the house. In addition, the increasing volume of cash-out refinancings has reduced homeowners' equity. Although home prices in these MSAs have not shown widespread declines, anecdotal reports suggest that high-end home prices are coming under pressure, especially in markets that experienced substantial growth in the high-tech sector in the late 1990s but have slowed since.

Recent rapid growth in mortgage portfolios among insured institutions in the five MSAs examined in this article suggests that many of these mortgages are not seasoned and are based on relatively high real estate values. Should home prices decline, many of these mortgages would be left with leaner collateral positions.

Wichita could be the Region's metropolitan statistical area (MSA) most affected by the aftermath of the terrorist attacks. Demand for airline travel dropped precipitously following the September 11, 2001, attacks. The travel industry and related companies, such as aircraft manufacturers, were affected most adversely.

The health of the Wichita economy is strongly tied to the aircraft manufacturing sector, which includes the area's top four employers; these companies announced significant layoffs or other employment changes following the attacks. Layoffs and any ripple effects could contribute to as much as a 1.6 percent rise in the unemployment rate in 2002.¹

¹ Center For Economic Development and Business Research, W. Frank Barton School of Business, Wichita State University, Wichita's Economic Outlook 2001 Review and 2002 Forecast.

A weakened economy may make it more difficult for businesses and individuals to repay loans at a time when insured institutions headquartered in the Wichita area have heightened credit risk. In the aggregate, institutions in Wichita experienced significant growth during the past three years in construction and development, nonresidential commercial property, and business lending, all of which are traditionally higher-risk forms of lending.

Fortunately, Wichita's insured institutions currently report solid financial conditions. Asset quality indicators remain favorable compared with historical levels. The number of problem institutions and those with troubled asset portfolios is small.

The Region's commercial real estate markets have experienced the brunt of the recession. Data suggest that all commercial real estate (CRE) submarkets-office, industrial, retail, multifamily, and hotel-have weakened to some degree in the Kansas City Region's three major metropolitan areas: Minneapolis-St. Paul (Minneapolis), St. Louis, and Kansas City.

Office and industrial markets show high vacancy rates. Torto Wheaton Research data show that the office vacancy rate for Kansas City significantly exceeds the national rate (which increased 4 percentage points during the first three quarters of 2001). Vacancy rates for the Minneapolis and St. Louis markets are in line with the nation's.

Minneapolis, St. Louis, and Kansas City industrial markets are experiencing rising vacancy rates, but rates remain below the national level. Minneapolis appears to be the most vulnerable to the high-tech sector slowdown in large part because of higher concentration in research and development industrial space.

Retail space and multifamily housing vacancy rates have risen but are not alarming. Vacancy rates for retail space in Minneapolis, St. Louis, and Kansas City, although they reached historically low levels in first-quarter 2000, are expected to rise through much of 2002, but not to levels that may cause concern.

The Minneapolis apartment market remains extremely tight. By contrast, the multifamily housing markets in St. Louis and Kansas City are characterized by significant new supply and sagging demand, a situation most pronounced in Kansas City.

Insured institution exposure to CRE stands at the highest level in a decade. Insured institutions in the Region's three major MSAs are reporting rapid growth in CRE lending and relatively high exposures to this loan type. This growth is occurring as property markets have begun to weaken, suggesting that institutions hold the highest level of new, or "unseasoned," CRE loans in the past decade.

However, current insured institution CRE exposures remain at or below the national level. In addition, although the CRE markets in Kansas City, Minneapolis, and St. Louis have weakened somewhat, they are not among the weakest in the country. Therefore, although insured institutions in these three MSAs face greater challenges related to CRE lending, banks and thrifts in other metropolitan areas could experience greater deterioration in loan quality.

The mid-South entered a period of economic decline prior to the national recession and underperformed the national economy in 2001 because of a heavy reliance on a weak manufacturing sector. The Region's apparel, automotive parts producers, furniture and fixtures, and lumber industries were among the sectors most affected by the overall slump in manufacturing.

As a result of the disparate economic weakness, banks and thrifts in the Region faced greater credit quality deterioration than those in many other areas of the country. Not surprisingly, banks and thrifts operating in those parts of the mid-South with the highest exposure to the manufacturing sector reported the most significant drop in credit quality.

The Region's manufacturing sector may be slow to recover when the nation's economy begins to improve. By year-end 2001, national manufacturing activity had begun to improve. However, the Region's manufacturing problems stem from structural and cyclical changes, suggesting that improvement in the regional manufacturing sector may lag that of the nation. For example, job losses in the apparel sector, which are likely to continue, appear to be permanent. Also, a previously strong automobile production sector has begun to weaken. Production volume, distinct from industry profitability, remained stable largely because of strong incentives, such as rebates and zero percent financing. The possibility that these incentives pulled automobile sales in 2001 from future sales and an increasing global overcapacity appears likely to lead to reduced automobile production.

Interest rate risk appears to have increased as banks and thrifts faced incentives to increase exposure levels in 2001. Incentives include the need to mitigate margin erosion, rapid balance sheet turnover, and a progressive steepening of the yield curve. The current steepness of the yield curve indicates that most market participants expect interest rates, particularly short-term rates, to rise. Rising short-term rates are likely to have an adverse effect on already depressed margins. The extent of the drain on an institution's earnings performance will be influenced largely by current asset/liability management. Managers must carefully weigh the trade-off of extending assets in an effort to improve margins against the potential adverse effects such asset extension could have on future earnings during a period of rising interest rates.

Most banks reported limited asset extension as of September 30, 2001. The level of long-term assets (assets with more than five years until maturity or repricing) held by all community banks in the Region rose from 15.8 percent of total assets at year-end 2000 to 16.4 percent as of September 30, 2001. Some institutions, many of which were already facing earning pressures, accepted much greater asset extension.

The incentive to extend intensified as the yield curve steepened sharply in late 2001. The asset extension that occurred during the first nine months of 2001 could continue at some institutions because a potential rate "trap" developed in late 2001. Short-term rates (3-, 6-, and 12-month rates) dropped by 140 to 170 basis points from August 31 to December 30. By comparison, long-term rates (10- and 30-year rates) rose slightly during this period. By year-end 2001, managers faced the alternatives of investing short-term at less than 2 percent or gaining 250 to 300 basis points by investing in intermediate- or long-term loans or securities.

Even as assets extended during the first nine months of 2001, depositors migrated to shorter-term products, leading to a modest contraction in liability maturities and repricing intervals. This change in customer preferences included an increase in aggregate balances of money market demand accounts and savings accounts and a switch from longer-maturity certificates of deposits to those with maturities of one year or less.

Interest rate risk management will likely become more complex and important in 2002. The potential for continuing interest rate volatility, this time in a rising rate environment, suggests that sound asset/liability management will be particularly critical to future earnings performance. At a minimum, managers should ensure that measurement processes accurately assess the effects of changing interest rates on performance, and that institutions operate within sound risk tolerances established by policy or board direction.

The September 11 attacks contributed to weakening in the Region's economy. Before the attacks, the Region's economy, although slowing primarily because of deterioration in the manufacturing sector, was stronger than the nation's. However, the aftermath of September 11, 2001, contributed to weakening in the Region's key sectors, including the financial, airline, and tourism industries. Furthermore, slowing in the national economy following the attacks contributed to additional job losses in the Region's manufacturing sector.

Post-September 11 conditions may result in more layoffs in the Region than in the nation, particularly in areas that depend on industries adversely affected by the attacks. The Region's rate of job growth, while keeping pace with the nation's before September 11, also may lag the nation in the post-attack period because of the economic weight of New York City. Though the Region's economic recovery may not match the nation's in timing or strength, it is unlikely to be as prolonged or painful as the Region's recovery in the early 1990s. The pace and vitality of any recovery is likely to depend on several factors, including the industrial mix of local economies and the "pull" effect from the national economy.

The Region's office market conditions weakened moderately in 2001, primarily reflecting reduced demand rather than excess supply as was the case a decade ago. Office vacancy rates increased in most of the Region's major cities in 2001, consistent with national trends, but remained below or near the national average. Vacancy rates rose sharply in downtown Manhattan as tenants flooded the market with sublet space.¹ Despite migration of businesses from lower Manhattan, vacancy rates also increased in midtown Manhattan and in northern and central New Jersey because of the influx of sublet space. Unlike Manhattan, however, which has added minimal new space, northern New Jersey is facing reduced demand for office space while a moderate amount of construction is nearing completion.²

¹ According to C.B. Richard Ellis, lower Manhattan's office vacancy rate tripled, to 10.6 percent in fourth-quarter 2001 compared with 11.0 percent for the nation.

² Gordon, Sally, January 4, 2002. "CMBS: Red-Yellow-Green Update Fourth Quarter 2001 Quarterly Assessment of U.S. Property Markets," Moody's Investor Service.

Banks are better positioned now than during the last recession, but challenges lie ahead. Though credit quality ratios reported by the Region's insured institutions are more favorable than a decade ago, weakness is becoming more widespread. In third-quarter 2001, one-third of the Region's banks reported at least a 25-basis-point quarter-to-quarter increase in the past-due ratio, a slightly higher percentage than a year ago.

The Region's large banks (total assets over $10 billion) reported continued credit quality deterioration, primarily in commercial and industrial (C&I) loans. Community and regional banks³ reported slightly higher C&I delinquencies, which suggests that weakness, to some extent, has migrated to small- and middle-market businesses. Community and regional banks also reported moderately higher commercial real estate (CRE) loan delinquencies, although past-due ratios are much lower than a decade ago. However, the Region's banks holding the highest CRE loan concentrations are headquartered in large metropolitan areas that have experienced softening CRE markets, such as New York City and northern New Jersey. Moreover, banks with riskier business strategies may be more vulnerable during the downturn. Subprime lenders, in particular, are experiencing greater credit quality and earnings pressures, reflecting the weaker credit profile of subprime borrowers.

³ Community banks are defined as insured institutions with total assets less than $1 billion. Regional banks are insured institutions with total assets between $1 and $10 billion.

Changes in the level and shape of the yield curve have implications for bank margins and interest rate risk management. During most of 2001, community bank funding costs declined to a lesser degree than did asset yields, in part because of deposit maturity schedules. Funding costs are poised to decline further as a large percentage of time deposits are scheduled to mature in the first half of 2002. Margins will likely rise in 2002, benefiting from a steeper yield curve, but competition may constrain margin improvement. Record mortgage refinancings in 2001 may increase concentrations of long-term assets, underscoring the importance of interest rate risk management, particularly for banks that focus on residential mortgage lending.

Softening demand for real estate, coupled with increased construction and development (C&D) loan concentrations, could challenge the Region's construction lenders. In addition, community construction lenders headquartered in markets that are highly dependent on cyclical construction employment could see weakening in other segments of the loan portfolio.

The economic downturn in high-tech areas adversely affected the Region's office and industrial markets. The slowdown pushed up office vacancy rates in those metropolitan statistical areas (MSAs) with high exposures to the dot-com and semiconductor manufacturing industries. Several of these high-tech-dependent markets, including San Francisco, San Jose, Seattle, Oakland, and Phoenix, also have experienced significant office space construction that has continued through much of 2001. Many industrial property markets have also seen softening. Of particular note, Sacramento experienced a significant increase in industrial vacancy rates and also had a relatively high proportion of industrial space under construction. Slowed company relocation from the Bay Area and falling manufacturing employment adversely affected the outlook for industrial development in Sacramento.

A steep decline in tourism following the September 11 attacks further dampened hotel demand at several of the Region's tourist destinations. For instance, the Bay Area, Las Vegas, and Phoenix markets reported above-average annual declines in revenue per available room for third-quarter 2001, as lower occupancies in the final days of September 2001 prompted aggressive room-rate cuts. The San Francisco MSA may be one of the more vulnerable areas given its depressed revenue, lower occupancy levels, and high relative volume of ongoing construction. Relatively robust hotel construction pipelines also characterized several other California MSAs.

Consumer pressures have affected demand for retail space adversely. Net absorption of retail space was negative in the second and third quarters of 2001 in all of the Region's major MSAs except Salt Lake City, as declines in consumer confidence and employment adversely affected retail sales. A considerable increase in the retail vacancy rate combined with a relatively significant volume of construction starts could challenge C&D lenders in certain high-growth retail markets, such as Las Vegas and Phoenix. Las Vegas experienced lower visitor volumes and tourism employment, while the Phoenix MSA shed high-tech-related jobs.

Employment and affordability issues heighten residential construction concerns. Demand for real estate weakened in some Bay Area submarkets following a softening in the high-tech sector. Meanwhile, the Phoenix, San Diego, Sacramento, and Orange County apartment markets have experienced rising vacancies and are expected to face significant additions to stock. Many MSAs with significant exposure to the high-tech sector, as well as the Las Vegas market, have reported above-average annual increases in the unemployment rate, a development that could dampen demand for housing. Moreover, home price increases have outstripped personal income growth significantly over the past five years in several California markets. Consequently, insured institutions with C&D loan exposures that are lending in areas of rapidly deteriorating employment, or in markets with affordability pressures, could experience deteriorating C&D credit quality.

Insured institutions that specialize in construction lending could be challenged by the decline in real estate demand. Median C&D loan-to-Tier 1 capital ratios were particularly high among community construction lenders based in the Provo, San Jose, Las Vegas, Oakland, Portland, Sacramento, Salt Lake City, Riverside, and Phoenix MSAs. Insured institutions headquartered in several of these markets reported relatively high C&D loan delinquency ratios as of third-quarter 2001. Lenders typically fund or defer interest payments on C&D loans, thereby avoiding borrower arrearages. Thus, C&D delinquencies could signal serious, unforeseen building delays or other difficulties.

Lenders active in areas dependent on construction employment face additional challenges. Median C&D loan concentration levels tend to be greatest in markets with relatively high levels of construction employment. Consequently, if waning construction activity leads to employment declines, insured institutions active in markets such as Las Vegas, Riverside, Phoenix, Salt Lake City, and Santa Rosa could experience deterioration not only in C&D loans but in other segments of the loan portfolio as well.