Online Extra: Should Americans Be Risking the Farm?

Increased real estate debt, more lottery and casino gambling, a 640% increase in penny-stock trading -- U.S. investors are living on the edge

Just as investment banks are taking more risks, so are millions of individuals. They've bid up prices and accepted thinner safety cushions in the past few years on commodities, international stocks, and shares of the riskiest U.S. companies. Penny-stock trading has soared, up 640% from three years ago. Gambling and casino stocks have risen sharply in recent years. And home buyers have leveraged up, buying more expensive houses with more complex mortgages.

"Investors seem to be displaying signs of pure fearlessness," James Montier, global equity strategist at Dresdner Kleinwort Wasserstein, summed up recently. Says James Grant, editor of Grant's Interest Rate Observer and a financial market historian: "The world is stretching for return."

Risk, of course, is in the eye of the beholder. Most purchasers of stocks, bonds, commodities, and real estate would have argued two months ago that strong economies in the U.S. and abroad would make their latest plays all-but-certain winners. They paid for their hubris during the global sell-off during the month of May, which served as a cruel reminder that foreign stocks can go down, and quickly.


  Asset classes once thought too risky are now making up big chunks of people's portfolios, for better or worse. Money has poured into commodities, for example, on speculative fever. Copper and zinc seem the most removed from reality. The two metals are up more than 75% this year. Analyst John C. Tumazos of Prudential Equity Group sees copper prices declining by up to 65% by 2007.

Perhaps the biggest backdrop for taking risks today is the housing market. Average house prices rose 58% nationally from 2000 through 2005, and more than twice that in some places in California, Florida, and Nevada. The gains have been funded largely by additional loans and by more inventive borrowing terms, such as 40-year or 50-year mortgages and special adjustable-rate mortgages called option ARMs, which initially give borrowers the option of paying just some of the interest accruing.

Since 2003, about 30% of new mortgages have been ARMs, twice as many as in the three years before, according to the Mortgage Bankers Assn. Now that interest-rate hikes by the Federal Reserve are pushing up ARM rates, some homeowners are refinancing with fixed-rate mortgages that require interest-only payments. Trouble is, by paying only interest, they're counting on rising housing prices to help them build equity, a risk most Americans wouldn't have taken in the past.


  Increased real estate debt is the biggest reason that families "markedly" increased their total debt relative to assets from 2001 to 2004, according to a recently released Federal Reserve Board triennial study of consumer finances. Debt as a percentage of total assets increased from 12.1% to 15% during that period. And even though interest rates were going down, debt payments as a percentage of income rose from 16.7% to 18%.

The Fed also found evidence that more people are at risk of not being able to make their payments: 8.9% of households in 2004 had been at least 60 days late with payments in the previous year, up from 7% in 2001. Now that rates are going up, those numbers are sure to follow.


  Perhaps it's no coincidence that the additional risk-taking in markets is consistent with a steady increase in casino and lottery gambling. In 2004 gamblers lost $78.9 billion, 21% more than in 2001, according to Christiansen Capital Advisors. Personal incomes increased only 11% in the same period, says the U.S. Commerce Dept.

Why are people less averse to risk? Richard Bernstein, chief U.S. equity strategist at Merrill Lynch, says it's because they have confidence the Federal Reserve will save the day if there's a big problem in the markets, just as it has done for the past 20 years. But given the rising might of other economies now diminishing the Fed's power, that might not be such a good risk to take.

By David Henry

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