Matter of Security: Risky Derivatives Are Huge Source of Funds For Federal Agencies --- Investors Learn the Hard Way That `U.S.-Backed' Is No Guarantee of Safety --- `A Hungry System to Feed'
Last February, just before the Federal Reserve began jacking up interest rates, a U.S. Army welfare and recreation fund invested $15 million in what looked like a sure thing: A two-year, triple-A-rated, U.S. government-agency note with a tempting initial yield of 4.75%, well above the then-prevailing rate.</br></br>But in just three months, the note's yield was reset to 0% under a complex formula, making it dead money to the investor. So far, the Army fund has taken a 7.9% paper loss on the notes, a hefty hit for a short-term note in a supposedly low-risk fund that manages cash balances for Army base golf courses and bowling alleys.</br></br>"This is not wonderful," frets fund manager Jeffrey Dalbey.</br></br>This security, known as a structured note, wasn't issued by a penny stockbroker or a widget manufacturer. It was the Federal Home Loan Bank System, a lightly supervised, Depression-era creation, which is at the center of the gathering storm about the government's role in issuing such gimmicky and risky securities.</br></br>The Army wasn't the only investor to be burned by such safe-looking securities. Structured notes issued by the Federal Home Loan Bank System and other federal agencies also played a prominent role in Orange County's bankruptcy filing last month. Similar investments blew up last year in supposedly low-risk funds run by BankAmerica Corp. and Mellon Bank Corp., among others.