Global risks shifting to you -- Reduce high yield funds

March 28, 2007

In a speech to the Wharton School of Business, IMF Managing Director Rodrigo de Rato focused on the shift of global financial risks from banks to the individual. The most alarming trend was the securitization of mortgages and other debt instruments.

Before 2000, banks would make loans, and keep them on the books. If a borrower defaulted, the bank foreclosed. Today, most banks bundle their loans into mortgage-backed securities, and sell them to investors. Credit card debt, corporate loans and even corporate jet leases can be bundled into a security that is sold on the stock market to pension funds, hedge funds and individual investors. In the past six years, this market has grown globally from around $.5 trillion to $2.75 trillion.

Since the banks sell the risk, they are more willing to loosen credit standards. As a result, more people default. In the fourth quarter of 2006, .5% of all loans foreclosed. This seems like a small number, but it is the highest ever reported in 37 years by the Mortgage Bankers’ Association. Since much of these securitized loans have been bought by pension funds, cash management divisions of corporations, and hedge funds, the pain will be felt throughout the stock market...and the individual investors who own them.

What the shift in global risks means:
Those individuals who own mortgage-backed securities are the less able to understand and withstand the risk involved than were the banks that created the loans.

In addition to owning debt risk in their stock portfolios, households have taken on a lot of personal debt. Personal household debt in the U.S. has risen to a record high of 19% of disposable income as of the fourth quarter of 2006, despite record low interest rate levels. This means that individuals have (unknowingly) taken on more risk at a time when they can least afford to.

Furthermore, the decline in pensions and fixed payment annuities means that individuals also must bear the responsibility of planning for their retirement with 401(k)’s and variable annuities. This further shifts the risk from corporate America to the individual.

Action steps:
First and foremost, become as educated as you can about your personal finances and retirement planning. Second, reduce your own personal debt. Third, make sure you understand what is in your investment portfolio. Fourth, if your portfolio contains mortgage-backed securities, high yield bond funds or other credit securities, discuss with your financial planner the possibility of decreasing your exposure in these areas.

Source: IMF, “Responding to Shifts in Financial Risks: the Need for Leadership”, Rodrigo de Rato, Managing Director, March 23, 2007.

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