With complex derivatives, beware of the risks


NEW YORK -- A lot of wily investment professionals found themselves nuked in the market last month by a complex class of securities known as derivatives.

The pros borrowed money to pyramid their derivatives bets. But when interest rates rose, their gambles collapsed and their investments were vaporized. The unlucky treasurer of Procter C Gamble lost his company $157 million after a failed derivatives play. Pension-fund manager David Askin, pursuing what he thought was a conservative strategy, lost a large portion of his clients' money.

After the collapse, panic selling swept the high rollers. And when elephants stampede, a lot of unlucky mice are going to get flattened.

You probably got tromped on if you owned mutual funds that were invested in bonds. In order to raise money to cover their derivatives loans, the pros dumped truckloads of quality bonds at fire-sale prices. Bond prices dove -- inexplicably, to investors who didn't know what was going on.

So derivatives represent a new risk, even to those who imagine that they're not involved. The level of danger, however, is hard to assess.

These securities have conservative uses as well as speculative ones -- and not even professionals know for sure where the disaster lies.

A derivative security "derives"

its value from price changes in other market instruments. Cattle futures are a simple derivative. A cattle-futures contract gains or loses value as prices change for beef on the hoof.

When Wall Streeters speak of derivatives, however, they're more likely to mean that tangle of financial instruments tied to currency and interest-rate transactions.

Consider collateralized mortgage obligations (CMOs), which are backed by packages of government-guaranteed mortgage loans. You own the mortgages as an investor; the money you earn comes from homeowners' monthly principal and interest payments.

A Wall Street computer jock can take a single package of 30-year mortgages and split it into 30 separate investments, one

supposedly maturing every year. As homeowners repay their loans, all the principal payments can first be channeled to investors in the one-year security, then to investors in the two-year security and so on. That way, you can own a two-year piece of a 30-year mortgage loan.

And that's just a kindergarten example of how derivatives are constructed. Income streams are being sliced and diced in virtually incomprehensible ways, to enhance the yields in many types of mutual funds.

If this deal sounds so good, how come so many have lost so much? Here are just three of your derivatives risks:

* 1. Say you buy a CMO that your stockbroker says is going to mature in seven years. But the life of this investment actually depends on how fast homeowners prepay their mortgages. When interest rates rise, homeowners don't prepay as fast. Suddenly, your seven-year CMO might not mature for 20 years. That's what's known as "extension risk." If you try to sell early, you'll get killed on the price. "There's a stated average life on CMOs but no real maturity," says fixed-income expert Robert Andres of Martindale Andres & Co. in West Conshohocken, Pa.

* 2. Say your broker proposes "interest-only (IO) strips" -- passed off as a conservative investment with an unusually high yield. Conservative? Don't make me laugh.

IOs are a form of CMO that receive only the interest portion of the homeowners' monthly payments (POs -- principal-only strips -- receive the principal portion). The yield on IOs rises when interest rates do. But when rates drop again, the yield will shrink -- and "you never can say with certainty when it will pay off," Andres says. A five-year IO might actually run for 15 years. If you need the money early, it's hard to sell at a decent price. Andres' opinion: "These are shark-infested waters." Individuals should stay out.

* 3. Say that you're holding bond mutual funds -- anything from municipals to option-income funds. Your manager may be up to his ears in derivatives. The managers say that they're using them conservatively, to limit risk. But when the market turns, these investments can yield huge and unexpected losses.

The Securities and Exchange Commission is seeking better disclosure. Last week, the New York Muni Fund settled state charges that it failed to mention that derivatives made up 40 percent of its assets.

What can you do, until prospectuses disclose more? Don't invest in CMOs or other derivatives directly. And beware of any mutual funds that claim to pay super-high yields with no extra risk.

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