Economic Letter

As the U.S. struggles with its first economic slowdown in a decade, so do most of the major industrialized countries. Japan is sliding again into recession, with third quarter GDP growth of -2.2%. Europe also seems to be slowing, with a third quarter growth rate of 0.4% for the euro area as a whole, and -0.6% for Germany in particular.

Financial institutions are in the business of risk management and reallocation, and they have developed sophisticated risk management systems to carry out these tasks. The basic components of a risk management system are identifying and defining the risks the firm is exposed to, assessing their magnitude, mitigating them using a variety of procedures, and setting aside capital for potential losses.

The events of September 11 have had some of their worst economic effects on the airline industry, leading to a dramatic fall-off in passenger demand and substantially higher costs. But even before that day, the industry was facing bad times, with few airlines anticipating profitable performances in 2001. Some have argued that deregulation has contributed to the industry’s problems, and, furthermore, to problems for passengers.

Subprime mortgage lending has grown tremendously since the early 1990s and now constitutes a significant fraction of the overall mortgage market. This Economic Letter defines subprime mortgage lending, describes its growth, and presents evidence on the link between this market and the capital markets. This link should help encourage the flow of funds into subprime lending, thereby encouraging competition in this important market segment.

Financial innovation has greatly changed the business of banking. Instead of just accepting deposits and making loans the old-fashioned way, banks nowadays are increasingly active in lending without putting loans on their balance sheets, through either securitization of their asset portfolio or outright loan sales.

“Runaway” expenditures on health in the United States and what to do about them have been a feature of congressional debate for years. In 1998, the United States spent 13.6% of its GDP on goods and services associated with health care.

This Economic Letter is adapted from remarks by Robert T. Parry, President and CEO of the Federal Reserve Bank of San Francisco, delivered on November 19, 2001, to the 24th Annual Real Estate and Economics Symposium sponsored by U.C. Berkeley’s Fisher Center for Real Estate and Urban Economics.

Financial derivatives have greatly enhanced the range of tools available for managing financial risks. Currently, derivatives are widely used to mitigate and reallocate the financial risk related to changes in interest rates, exchange rates, stock prices, and commodity prices.

Economists and other analysts look for signs of the economy’s current and future performance in many places, including the bond market. One recent signal from that market that may prove useful involves the spread in the yields between junk bonds and other long-term debt instruments.