Derivatives Give Funds a Black Eye Painewebber Losses Make Investors Aware of Risks

Article excerpt

Wall Street may have outsmarted itself again - and given mutual funds a credibility problem.

In their constant search for new products, investment firms have produced things like junk bonds, interest-rate swaps and mortgage-backed securities.

All have their place, but financial markets tend to excess.

Junk bonds were a useful financing tool for companies with poor credit ratings; it wasn't a good idea to use them to finance billion-dollar takeovers in the 1980s.

Interest-rate swaps help companies get the kind of rates they want in the currencies they want them in. But Procter & Gamble Co. lost $103 million recently because it couldn't resist the temptation to speculate in swaps.

Mortgage-backed securities began as pools of home mortgages that "passed through" interest and principal payments to investors. They're a pretty safe investment for people looking for income.

Then securities firms and created collateralized mortgage obligations in various shapes. Some pay interest only (IOs). Others pay principal only (POs).

But these mortgage-backed securities have far more risk attached to them than plain passthroughs.

The securities proved unprofitable enough to investors who knew what they were buying. And some investors are suing PaineWebber Group Inc., saying that the firm exposed them to the risks of mortgage securities without their knowledge.

These people bought shares in PaineWebber's Short-Term U.S. Government Income Fund, which, despite its safe-sounding name, was putting a lot of money into risky mortgage-related investments. …