Economic Review
Fourth Quarter 2007 

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Risks of Identity Theft: Can the Market Protect the Payment System?   -   (PDF 277K)
By Stacey L. Schreft

Identity theft has been a feature of financial markets for as long as alternatives have existed to cash transactions.  But identity theft has recently occurred on a much larger scale.  Data breaches often involve the apparent loss or acknowledged theft of the personal identifying information of thousands--or millions--of people.   

Identity theft poses risks, not only to individuals, but to the integrity and efficiency of the payment system--the policies, procedures, and technology that transfer information for authenticating and settling payments among participants.  Identity theft can cause a loss of confidence in the security of certain payment methods and an unwillingness to use them.  Markets can cease operating or switch to less efficient payment methods.  Either represents a loss of efficiency for the economy. 

Schreft looks at the nature of identity theft today and the factors underlying its mounting risks.  She also explores whether markets are able to limit the risks identity theft poses to the payment system.

 


Industrial Loan Companies: A Growing Industry Sparks a Public Policy Debate - (PDF 221K)
By Kenneth Spong and Eric Robbins

Industrial loan companies, or ILCs, are a small, but rapidly growing part of the financial industry. These state-chartered institutions operate in seven states and have nearly all of the same powers as commercial banks. However, ILCs differ greatly from banks in one characteristic--the type of companies that may own them. ILCs meeting certain conditions may be owned and operated by firms engaged in commercial activities, thus skirting the prohibitions on mixing banking and commerce that apply to virtually all other depository institutions.

From a public policy standpoint, the proponents of commercially owned ILCs claim that such ownership will bring a new source of capital, innovation, and competition into banking, thus providing the public with a broader range of financial services. Critics, though, contend that ILCs owned by commercial entities may face significant conflicts of interest. Such ILCs, it is argued, would have strong incentives to lend to customers of the parent company on a favorable basis and without due regard for standards of creditworthiness. Another common argument is that the parent companies might be able to exploit their size and existing customer relationships in a manner that would give them a dominant role in banking markets, thereby reducing financial competition.

Spong and Robbins examine the public policy issues that arise from mixing banking and commerce. First, they review the history of ILCs and the basic legal and supervisory frameworks under which they operate. Next, they look at the reemergence of ILCs under their new forms of ownership and take a close look at individual ILCs and the types of business they conduct. Finally, they explore the public policy issues.
 


How Useful is Okun's Law? - (PDF 364K)
By Edward S. Knotek, II

From the beginning of 2003 through the first quarter of 2006, real gross domestic product in the United States grew at an average annual rate of 3.4 percent. As expected, unemployment during the period fell. Over the course of the next year, average growth slowed to less than half its earlier rate--but unemployment continued to drift downward. This situation presented a puzzle for policymakers and economists, who expected the unemployment rate to increase as the economy slowed.

Typically, growth slowdowns coincide with rising unemployment. This negative correlation between GDP growth and unemployment has been named “Okun’s law.” Part of the enduring appeal of Okun’s law is its simplicity, since it involves two important macroeconomic variables. Additionally, the relationship appears to enjoy empirical support. In reality, though, Okun’s law is a statistical relationship rather than a structural feature of the economy. As with any statistical relationship, it may be subject to revisions in an ever-changing macro economy.

Knotek considers the usefulness of Okun’s law for policymakers and economists. The evidence suggests that Okun’s relationship between changes in the unemployment rate and output growth has varied considerably over time and over the business cycle. Nevertheless, Okun’s relationship can still be useful as a forecasting tool--provided that one takes its instability into account.

 

Booms and Busts: The Case of Subprime Mortgages   -   (PDF 51K)
By Edward M. Gramlich

Booms and busts have played a prominent role in American economic history. In the 19th century, the United States benefited from the canal boom, the railroad boom, the minerals boom, and a financial boom. The 20th century brought another financial boom, a postwar boom, and a dot-com boom.

The details differed, but each of these cases featured initial discoveries or breakthroughs, widespread adoption, widespread investment, and then a collapse where prices could not keep up and many investors lost a lot of money. When the dust cleared, there was financial carnage and many investors learning to be more careful the next time. But fruits of the boom were still around to benefit productivity.

The late Edward M. Gramlich prepared the luncheon address for the Federal Reserve Bank of Kansas City’s 2007 symposium last summer in Jackson Hole, Wyoming. This article, based on his speech, describes why he believed the subprime lending market, despite its problems, is a promising development that has permitted low-income and minority borrowers to participate in credit markets.
 

Rising Foreclosures in the United States: A Perfect Storm   -   (PDF 348K)
By Kelly D. Edmiston and Roger Zalneraitis

Residential foreclosures in the United States have been rising very rapidly since 2006. In the second quarter of 2007, the share of outstanding mortgages in some stage of foreclosure stood at 1.4 percent, near historic highs and up from less than 1 percent a year earlier. The number of mortgages entering the foreclosure process reached an all-time high in mid-2007, suggesting that the foreclosure surge is likely to get worse before it gets better.

The foreclosure surge was created by a perfect storm of events. First, in recent years the share of subprime mortgage originations increased substantially. Second, foreclosure rates for adjustable-rate mortgages (ARMs) have increased considerably, especially for subprime ARMs. This increase is largely due to rising short-term interest rates and to payment resets for many nontraditional mortgages. Finally, high loan-to-value originations in recent years, coupled with stagnant or falling home prices, have left many people with insufficient equity to sell or refinance their homes.

Edmiston and Zalneraitis provide a detailed dissection of the current foreclosure surge. They conclude with a discussion of why the foreclosure situation is likely to get worse over the next one to two years and why it is likely to improve afterward.
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