Regulators Step Up Probes Of Trading in Oil Markets

U.S. regulators disclosed a broad nationwide probe into potential oil-market manipulation and said they are expanding surveillance of energy markets. The move Thursday by the Commodity Futures Trading Commission, including its unusual announcement of an investigation in progress, comes after crude-oil prices topped $130 a barrel last week and tested all-time highs. On Thursday, light, sweet crude for July delivery settled $4.41, or 3.4%, lower at $126.62 a barrel on the New York Mercantile Exchange. Lawmakers in Congress have been pressing regulators to crack down on manipulation, as politicians seek to demonstrate ahead of the fall elections that they are responding to soaring gasoline prices. "It's important that people who are paying high gas prices understand the CFTC is on the case and that we're closely monitoring and in this instance deeply investigating any potential abuse in this important energy market," said Bart Chilton, a CFTC commissioner. Many economists and oil-industry executives say possible shenanigans by market traders have little or nothing to do with the high price of oil. They maintain that the rise is mainly due to fundamental factors such as rising demand, constrained supplies and the weak dollar. Still, suspicions have lingered that speculators have helped drive oil prices higher. At a series of congressional hearings over the past month, energy consumer groups and some financial insiders have contended that large investments in commodity futures by hedge funds and pension funds are distorting prices. Congress is weighing proposals to increase collateral requirements for futures traders and otherwise restrain their activities. The implied hope is that such moves will help rein in prices that have almost doubled in a year. The CFTC's announcement about its oil investigation suggested a single, broad probe that began in December 2007. But people familiar with its enforcement priorities say the agency is pursuing multiple oil investigations, and that many of them relate to one another. CFTC enforcement chief Gregory Mocek said the agency has about 60 manipulation investigations open in various commodity markets. The CFTC has expanded an investigation, disclosed previously by The Wall Street Journal, into alleged short-term manipulation of crude-oil prices via a widely used price-reporting system run by Platts, a unit of McGraw-Hill Cos. One suspicion is that energy companies and traders have at times issued a flood of orders during a time window used by Platts to determine its reported prices for physical oil transactions, then used the potentially distorted prices to make profits in other markets. Platts has said its system has safeguards to protect against manipulation. Subpoenas on the matter have gone out in several stages, people familiar with the cases say. The agency has also been questioning traders about similar activity in the jet-fuel market, people familiar with the matter say. Another area of concern for CFTC regulators is whether the owners of crude-oil storage tanks use their knowledge to make bets on oil-futures markets. In theory, the owner of a tank could issue misleading information about the tanks being full or empty, leaving the wrong impression about whether oil is in plentiful supply. Then they could make trades to profit on the misunderstanding. Artificial Price Unlike most stock markets, insider trading isn't generally illegal in commodities trading. An oil company can take advantage of inside information about its production outlook when it makes trades. However, if traders intentionally create an artificial price and use it to make money, charges of manipulation may arise. The CFTC regulates one of the fastest-growing financial markets with a fraction of the budget of the Securities and Exchange Commission. In the past, critics have called it a weak enforcer, but its small enforcement staff has sought to bring more ambitious cases in recent years, particularly in the energy markets. The CFTC doesn't oversee all U.S. commodities trading. Large speculators such as hedge funds often use unregulated over-the-counter platforms, whose prices may affect prices on regulated markets. Mr. Chilton, the CFTC commissioner, said regulators are looking at cases where traders have made simultaneous bets on unregulated and regulated markets, in particular in West Texas Intermediate crude-oil contracts. He said he wants to know "whether there's any possibility for attempted manipulations as a result." Apart from its investigations into specific allegations, the CFTC said Thursday it will require more information in general from large traders. It wants to know about their bets in commodity-linked index investments as well as speculative trades that they are able to place via Wall Street dealers, often in large quantities. The CFTC's acting chairman, Walt Lukken, said investors flooded into commodities after a credit crisis hit the financial markets last summer and risky bond investments lost popularity. "There was this enormous flight to safety," he said. "This is something we have to really drill down on in terms of where the money is coming from, and what its impact is on the markets." He stressed that the CFTC's move to require more information from institutional investors is separate from any probes into illegal trading activity. "I don't think anybody is indicating that index-fund investors, as a class, are causing broad illegal manipulation of the markets. It's a different issue from the crude oil investigation," he said. The CFTC's chief economist testified to the Senate last week that CFTC data on large traders shows that price increases in commodities "are largely unrelated to fund trading." "There's incredibly heightened scrutiny on these markets, and anybody who does business in these markets faces a lot of regulatory risks," said Paul Pantano, a Washington lawyer who represents many energy traders. "Commercial parties and speculators are operating in a market where the rules about what is considered manipulative conduct versus legitimate trading activity are not very clear." Providing Trading Data The CFTC said it reached an agreement with IntercontintentalExchange Inc. and the Britain's Financial Services Authority to require more information about the oil trading that takes place on the exchange's ICE Futures Europe platform. While ICE oil futures are traded electronically on computer terminals across the U.S. and have prices tied to oil futures offered by rival New York Mercantile Exchange, owned by Nymex Holdings Inc., they haven't been subject to the same CFTC reporting requirements as Nymex trading. ICE will now provide daily information on large trader positions in its oil-futures markets, divulge more details on market participants and notify the CFTC when traders exceed position limits. "The next important step for us is to slice and dice and beat up the data to see what it means," said Mr. Chilton. "We're in extraordinary times," said ICE Chief Executive Jeffery Sprecher. "When credible people are saying oil could go to $200 [a barrel], it's important that people recognize it's not the venue, it's the market dynamics." He said regulators should look at more data so they are comfortable that speculators aren't "artificially supporting the market."

Lost Opportunities Haunt Final Days of Bear Stearns

Twelve hours after agreeing to sell Bear Stearns Cos. for $2 a share, Alan Schwartz wearily made his way to the company gym for a much-needed workout. Today: Missed Opportunities. As the firm's fortunes spiraled downward, executives squabbled over raising capital and cutting its inventory of mortgages. Part Two: Run on the Bank. Executives believed they were about to turn a corner, but rumors and fear sent clients, trading partners and lenders fleeing. Part Three: Deal or No Deal? The Fed pressured Bear Stearns to sell itself, but a misstep in the hastily drawn agreement nearly scuttled the deal. It was 6:45 a.m., March 17, and Bear Stearns's chief executive had slept little since hammering out the ugly details of his fire-sale deal with J.P. Morgan Chase & Co. When Mr. Schwartz, already dressed in his business suit, trudged into the locker room, Alan Mintz, still in his sweaty gym clothes, made a beeline for the boss. "How could this happen to 14,000 employees?" demanded the 46-year-old senior trader, thrusting his face uncomfortably close to Mr. Schwartz's. "Look in my eyes, and tell me how this happened!" Two and a half months later, Mr. Schwartz still isn't quite sure. To Mr. Mintz and others, he has blamed a market tsunami he didn't see coming. He told a Senate committee last month: "I just simply have not been able to come up with anything, even with the benefit of hindsight, that would have made a difference." But many who lived through the seven tense months before the deal say Bear Stearns imploded because it was at war with itself. Buffeted by the most treacherous market forces in a generation and hobbled by indecision, the firm's leaders missed opportunities that might have been able to save the 85-year-old brokerage. Those missteps are expected to have a lasting impact beyond the people who once worked at Bear Stearns or owned its stock. Unlike Wall Street meltdowns in decades past -- from Drexel Burnham Lambert Inc. to Long-Term Capital Management -- the Bear Stearns collapse spurred direct intervention from the Federal Reserve. That step is likely to increase the central bank's role in solving future financial catastrophes and bring securities firms further regulation in the bargain. As shareholders prepare to approve the deal on Thursday -- at a price that angry investors forced up to about $10 a share -- interviews with more than two dozen current and former Bear Stearns executives, directors, traders and others involved in the action paint the first detailed picture of the fractious last weeks before the Fed helped underwrite J.P. Morgan's purchase of the trading powerhouse. Months before regulators pressured the firm to sell itself, nervous traders futilely begged Mr. Schwartz and his predecessor, James Cayne, to raise more cash and slash Bear Stearns's huge inventory of mortgages and the bonds that backed them. At least six efforts to raise billions of dollars -- including selling a stake to leveraged-buyout titan Kohlberg Kravis Roberts & Co. -- fizzled as either Bear Stearns or the suitors turned skittish. And repeated warnings from experienced traders, including 59-year Bear Stearns veteran Alan "Ace" Greenberg, to unload mortgages went unheeded. Top executives resisted, in part, because they were concerned the moves would upset the delicate calculus of appearances and perceptions that is as important on Wall Street as dollars and cents. If Bear Stearns betrayed weakness, they worried, skittish customers would pull their money out of the firm, and other financial institutions would refuse to trade with it. Instead of managing these fickle forces, though, a brokerage whose culture and fortune were rooted in the trading floor's steely manipulation of risk was swamped by them. Early Warnings An August conference call fails to calm investors. An early harbinger of the debacle to come appeared the first Friday in August. Bear Stearns executives hosted a conference call that day meant to reassure investors. The brokerage's stock had fallen sharply after the late-July collapse of two internal hedge funds tied to subprime mortgages, home loans made to the riskiest borrowers. Mr. Cayne and his top financial lieutenants touted the firm's strong cash holdings -- $11.4 billion, according to company officials -- and new longer-term borrowing agreements. They also pointed out that Bear Stearns itself actually had few subprime holdings. But executives' comments about the bleak state of the market for interest-bearing securities stoked investors' fears, helping spur a broad rout in stocks and driving Bear Stearns's own shares to a 12-month low of $106.55. Later that day, word leaked out that Warren Spector, Bear Stearns's co-president and chief of the division that oversaw the two failed hedge funds, was being forced out by Mr. Cayne. Amid the mounting bad news, a lifeline appeared: Mr. Schwartz, then Bear Stearns's co-president, and Henry Kravis, KKR's fearsome founder, had a conversation about the buyout firm possibly purchasing 20% of Bear Stearns. By Sunday, Bear Stearns's sleek, black tower in midtown Manhattan bustled with activity. About 8:30 a.m., a team from KKR assembled in the investment-banking department on the 43rd floor to begin dissecting the firm's books. Buying a piece of Bear Stearns was attractive to KKR as an entree into the lucrative brokerage business at a time when prices were cheap. For Bear Stearns, it was a chance to raise $2 billion or more in capital and gain a crucial seal of approval by putting an éminence grise like Mr. Kravis on its board -- a move Mr. Schwartz hoped would silence Bear Stearns's critics. Within two weeks, though, the talks would fall apart because each side had concerns. Among other things, Messrs. Schwartz and Cayne feared a deal might turn off Bear Stearns clients that competed with KKR. While Bear Stearns's mortgage team fielded questions from KKR that Sunday, the firm's risk officers were meeting in the sixth-floor executive offices with staffers from the Securities and Exchange Commission. The regulators had traveled from Washington to make sure Bear Stearns had access to the day-to-day loans it needed to fund its trading operation. After scrutinizing the firm's $400 billion balance sheet well into the afternoon, the regulators agreed to reconvene with Bear Stearns managers for daily briefings until the market crisis passed. Elsewhere in the building that afternoon, Bear Stearns's board was deliberating over Mr. Spector's resignation. Not everyone was convinced it was the right move -- including Mr. Schwartz, who had expressed his objections privately to Mr. Cayne. But Mr. Cayne was adamant. The collapse of the hedge funds had exposed the then-73-year-old CEO to criticism inside and outside of the company for being disengaged and for brushing off warning signs. Early on, he seemed unconcerned. Mr. Cayne said the funds weren't Bear Stearns's money: It belonged to big institutions, wealthy individuals and lenders who all knew the risks going in. Soon, though, the lenders forced Bear Stearns to extend one of the portfolios $1.6 billion of its own money to keep it afloat. A glib and gruff former scrap-iron salesman from Chicago with a penchant for cigars, golf and cards, Mr. Cayne had often taken off Thursday afternoons and Fridays that summer to play golf near his New Jersey vacation home. In mid-July, when the funds were melting down, both he and Mr. Spector had spent more than a week in Nashville, Tenn., competing in a bridge tournament. Mr. Cayne, who declined to be interviewed for this article, was said by people close to him to be particularly angry that Mr. Spector, who with his partners won the event, had been away from the office at such a sensitive time. Bear Stearns's board -- 12 men largely handpicked by Mr. Cayne -- approved Mr. Spector's departure. Mr. Schwartz, a longtime investment banker more accustomed to rubbing shoulders with clients like Walt Disney Co.'s Robert Iger than to monitoring trades or capital levels, was named sole president. Messrs. Spector and Schwartz had been promoted to co-presidents and co-chief operating officers in 2001. Mr. Cayne, the CEO, had leaned on them to keep their divisions running smoothly. Now, Mr. Schwartz, a former star pitcher at Duke University, had to carry a heavier burden. At age 57, he had little experience in the bond and mortgage businesses that made up an outsized share of Bear Stearns's revenue. But he decided to manage the firm's capital-market division himself rather than hiring a replacement for Mr. Spector. Mr. Schwartz moved to tighten oversight of the company's trading. He also began keeping daily tabs on the bond markets. Several times a week, he sat down with traders who had bet a lot of the firm's money, questioning them about strategy and results. In the weeks after rejecting KKR's approach, Bear Stearns received other offers of capital. J. Christopher Flowers, a former Goldman Sachs Group Inc. partner, had met with some of Bear Stearns's senior managers about the possibility of taking a 20% stake. But the meeting left Bear Stearns's representatives concerned that Mr. Flowers simply was trying to gauge their desperation. The next day, they told the Flowers team they weren't interested. Instead, Bear Stearns executives began working on what Messrs. Schwartz and Cayne saw as a more compelling option: a joint venture with Citic Securities Co. They reasoned a deal with the Chinese investment bank would bring in money and help increase Bear Stearns's miniscule presence in Asia. Smarting from criticism of his hands-off style, Mr. Cayne spent the Labor Day weekend on a whirlwind trip to Beijing to discuss terms with Citic executives. Into early autumn, the mortgage market continued to slump. Housing prices had plunged, and most major financial firms were slashing the value they placed on holdings backed by home loans. Bear Stearns -- with its immense stockpile of mortgages and related securities -- was particularly vulnerable. Despite months of price declines, those holdings were valued at about $56 billion -- a large portfolio for a firm its size. Still, SEC staffers -- who now were phoning in for weekly Wednesday-evening conference calls with the firm -- appeared comfortable. By Thanksgiving, some senior regulators were calling in less frequently. 'We've Got to Cut!' 'Ace' Greenberg argues to dump mortgage inventory. Inside Bear Stearns, though, skirmishes about its mortgage holdings at times grew heated. Some veteran traders insisted that Tom Marano, the head of mortgages, needed to trim his portfolio. Among them were Wendy de Monchaux, who as head of proprietary trading invested Bear Stearns's own money, and Steve Meyer, co-head of stock sales and trading. "Cut the positions, and we'll live to play another day," Ms. de Monchaux said often, invoking one of the firm's venerable maxims. But Mr. Schwartz, still boning up on the details of the mortgage markets, urged caution. For some of the assets, the market was frozen, Mr. Schwartz reasoned, so selling was out of the question. On others, he had mixed feelings. He didn't want to unload tens of billions of dollars worth of valuable mortgages and related bonds at distressed prices, creating steeper losses. Mr. Schwartz believed the portfolio at least should be better protected from further price declines. Spearheaded by Mr. Marano, a bearded 46-year-old trader with a Grateful Dead tattoo on his right shoulder, the mortgage team unfurled a hedging strategy known as "the chaos trade." The trade was a deeply pessimistic bet -- essentially a method for making money if the mortgage and financial markets cratered. The traders bet that the ABX, a family of indexes made up of securities backed by subprime mortgages, would fall. They made similar moves on indexes tracking securities backed by commercial mortgages. Finally, they placed a series of bets that the stocks of major financial companies with exposure to mortgages, including Wells Fargo & Co., Countrywide Financial Corp. and Washington Mutual Inc., would decrease in value as well. Late in September, with Bear Stearns and other financial stocks rallying, members of the firm's executive and risk committees gathered in Mr. Cayne's smoky, dark and secluded sixth-floor offices to discuss the hedges. Negotiations for Allianz SE's Pacific Investment Management Co. to take a nonequity stake of as much as 10% in Bear Stearns had recently fallen apart. That cost the brokerage a chance for capital and a coveted endorsement of Bear Stearns's creditworthiness. Mr. Cayne had just returned from the hospital where he'd been treated for an infection, and he looked thin and drawn. Mr. Greenberg, the firm's storied trader and former CEO, took center stage. As head of the risk committee, he had been reviewing the Wells Fargo and other negative stock bets. He wasn't happy. The financial-stock hedges were too risky, he warned, and should be closed out immediately. Moreover, he wanted the mortgage inventory slashed. "We've got to cut!" Mr. Greenberg demanded. Ms. de Monchaux and Mr. Meyer concurred. Oklahoma-bred and Missouri-educated, Mr. Greenberg was the embodiment of the "PSDs" -- poor, smart employees with a deep desire to get rich, upon whom the firm had been built. Mr. Greenberg, who ran the firm for 15 years before Mr. Cayne nudged him aside, was known on Wall Street for his voluminous memos, in the voice of a fictional character, urging traders on issues large ("it doesn't pay to get too arrogant") and small (save paper clips to cut costs). But it was Mr. Greenberg's trading style that had most defined Bear Stearns: Sell losing trading positions -- quickly. Mr. Greenberg still recalled what his father, an Oklahoma City clothier, told him: "If something isn't moving, sell it today because tomorrow it will be worth less." The hedges had made close to half a billion dollars and stood to make more as the stocks continued to fall. But since they had first employed the chaos trade, Mr. Marano and his team had been hectored almost daily by complaining phone calls from colleagues. Some of Bear Stearns's more superstitious traders even objected to the strategy's name: They were tempting fate by invoking chaos. Faced with the fierce divide among his top executives, Mr. Schwartz, who was generally supportive of the chaos trade, decided to abandon it. He wanted specific pessimistic plays that would offset specific optimistic bets, rather than the broader hedges Mr. Marano had employed. Frustrated, Mr. Marano ordered the trades undone. As October dawned, Messrs. Cayne and Schwartz had high hopes that a deal with Citic would bolster Bear Stearns's fortunes. On Oct. 22, Bear Stearns announced a joint venture in Asia that included a $1 billion cross-investment between the two companies. If regulators approved, Bear Stearns could count on getting $1 billion in the first half of 2008. But it would spend the same amount over a longer period for a complementary stake in Citic. Investors weren't impressed. Bear Stearns shares rose meagerly but backtracked days later. Over the next few weeks, Bear Stearns's competitors disclosed losses from bad mortgage-related bets. Merrill Lynch & Co. announced a loss amid write-downs of $8 billion; Morgan Stanley revealed losses of nearly $4 billion. To outsiders, it was beginning to look as if Bear Stearns had navigated the crisis relatively deftly. Inside the firm, that view wasn't as prevalent. Its mortgage holdings were still hefty, and its bond business was reeling. The firm continued to explore ways to raise money, hiring investment banker Gary Parr of Lazard Ltd. to try to bolster the firm's prime-brokerage business, which handled trading and lending to hedge funds and other big clients. Mr. Schwartz had also discussed a merger with hedge fund Fortress Investment Group. Neither effort would bear fruit. Time to Move On Alan Schwartz tells James Cayne he needs to step down as CEO. In late November and early December, tension mounted as Bear Stearns executives contemplated a bonus pool down significantly from a year earlier. Executives in the stock division blamed their counterparts in bonds. "Why should we pay those guys anything?" Mr. Meyer, the stock sales and trading executive, at one point demanded in a compensation meeting. Things only got testier when Bear Stearns announced abysmal fourth-quarter results on Dec. 20. Dragged down by a drop in the value of its mortgage inventory, the company reported its first quarterly deficit since it opened for business in 1923. The bond division, always the firm's cash cow, had a loss of $1.5 billion for the quarter. At lunchtime the next day, as employees prepared for the holidays, Bear Stearns received bleak news. An email from Pimco, the influential bond fund, said it had become uneasy about the financial sector in general. And the fund wanted to immediately unwind several billion dollars of trades it had agreed to with Bear Stearns. "This doesn't make any sense," Jim Egan, Bear Stearns's co-head of global sales, said in a hastily arranged conference call with William De Leon, a Pimco risk manager, and William Powers, a Bear Stearns alumnus and Pimco managing director. How could a snap decision throw cold water on such a longstanding relationship with such little warning? If Pimco planned to take such drastic action, Mr. Egan and his colleagues added, the decision should be made "corner office to corner office." Messrs. De Leon and Powers ultimately agreed to hold off on dramatic moves until January, when they'd have a chance to sit down with senior Bear Stearns executives. But before hanging up, Mr. Powers issued a stern, if familiar, warning: "You need to raise equity," he said. Many Bear Stearns veterans began pushing hard for Mr. Cayne's ouster, arguing the firm needed a more engaged leader. The dissatisfaction had been building since the summer. It grew after a Nov. 1 story in The Wall Street Journal documenting Mr. Cayne's frequent absences from the office for golf and bridge during the worst of the summer's hedge-fund crisis. The article also mentioned that Mr. Cayne had used marijuana in the past. He told employees in an email the same day that he hadn't "engaged in inappropriate conduct." Mr. Schwartz was reluctant to push Mr. Cayne out. He had led the company through some great years, Mr. Schwartz believed, and could be trusted to step down on his own. "Stand calm," he told the protesters. "We've got it under control." Several top managers began joking that they should hold a sit-in in Mr. Schwartz's 42nd-floor office until he agreed to unseat Mr. Cayne as CEO. Investors were growing impatient, too. Bear Stearns's fourth-largest shareholder -- Bruce Sherman, chief executive of money manager Private Capital Management Inc. -- was agitating for a change at the top. Shortly after the New Year, Mr. Schwartz stopped by Mr. Cayne's office. The pressure inside and outside of the firm for his departure had become too great, he told his boss. It was time to move on. This is the first in a three-part series. Part Two: Run on the Bank. Executives believed they were about to turn a corner, but rumors and fear sent clients, trading partners and lenders fleeing. Part Three: Deal or No Deal? The Fed pressured Bear Stearns to sell itself, but a misstep in the hastily drawn agreement nearly scuttled the deal.

Commodity Prices Soar, But Are They in a Bubble?

After being buffeted by the dot-com, housing and credit bubbles -- not to mention the Chinese stock-market bubble -- there is a readiness by people on Wall Street and elsewhere to ascribe the term "bubble" to all sorts of things. But when it comes to commodities like crude oil and corn, that may be off the mark. A bubble, says "The New Palgrave Dictionary of Economics," "refers to asset prices that exceed an asset's fundamental value because current owners believe they can resell the asset at an even higher price." But figuring out whether a commodity exceeds its fundamental value is difficult: Because there is no income stream, there is no equivalent to the price-to-earnings ratios that people use to value stocks. Prices, to be sure, are soaring -- crude oil fetched $132.19 a barrel in New York on Friday, up 103% from $64.97 a year earlier. Yet crude has posted similarly massive increases a number of times in the past three decades. Most notably, in the spring of 1980, as gasoline lines lengthened, the price of crude oil was 150% above the year-before level. That price spike was caused mainly by a production cutback by the Organization of Petroleum Exporting Countries -- coupled with the fact that consumers had few alternatives. But over time, the high prices spurred conservation by consumers and increased exploration and production in non-OPEC countries. Oil prices collapsed. The episode is a textbook example of the huge price swings that can occur when supply and demand are relatively inelastic in the short run, but not in the long run, says Harvard economist Greg Mankiw, who cited it in an economics textbook he wrote. Mr. Mankiw, like many others, thinks that increasing demand from China and other developing countries is behind much of the rise in oil prices. High prices are sparking some conservation efforts -- on his blog, he has noted that some people are switching to mass transit, buying bicycles and, in the case of one Tennessee farmer, switching from tractor to mule. "But it takes years for people to fully adapt," Mr. Mankiw says. In the meantime, the response of oil producers to rising oil prices seems more sluggish than ever, leading worries that crude production has peaked. The Paris-based International Energy Agency, which is conducting a comprehensive study of the world's top oil fields, is preparing to revise its oil-supply forecast downward. For other commodities, supply and demand change more quickly in response to higher prices. Some of the biggest recent price drops have occurred in commodities like wheat and cotton, which are renewable and have potential substitutes, says Howard Simons, a strategist at Chicago-based Bianco Research. By contrast, oil and natural gas aren't renewable, aren't recyclable and don't have easy substitutes. Corn is renewable, but because much of the corn crop is getting diverted toward making ethanol, its prices are rising as well. So it is far from clear that the first part of the bubble definition -- prices in excess of their fundamental value -- is in place. But the second part -- that people are buying in anticipation of selling at a higher price -- certainly is. Speculation has long played a role in the commodities markets, but in recent years it has become much larger. The traditional role of the commodity-futures markets was to allow players such as farmers and oil refiners to hedge against unexpected price swings. Now, more institutional investors are wading into commodity markets to invest, rather than hedge. In February, the board of the California Public Employees' Retirement System, or Calpers, the largest pension fund in the U.S., authorized putting as much as 3% of its $240 billion portfolio in commodities. Hedge-fund manager Michael Masters told a U.S. Senate committee last week that institutional investors "are one of, if not the primary, factors affecting commodities prices today." But Bianco Research's Mr. Simons say that because the final buyers of commodities are consumers rather than investors, the role of speculation is limited. "Commodities, unlike financial assets, cannot take on hope values very much," he says. "At some point, the price gets to the point where the buyer walks away." In commodity markets, what is traded aren't physical commodities but contracts that are essentially bets on where prices will go, Harvard's Mr. Mankiw says. The final effect of the bets is limited unless they encourage speculation in the commodity itself -- encouraging, say, a coffee broker to warehouse coffee in hopes of getting a higher price later. And that is what is happening, according to Mr. Mankiw's Harvard colleague Jeffrey Frankel, who says such speculative behavior is due to the sharp reduction in interest rates by the U.S. Federal Reserve. Low rates encourage commodity stockpiling, he says, by making it less attractive to sell commodities and put the proceeds into bonds and other debt instruments. Critics of Mr. Frankel's theory say the expected rise in commodity inventories hasn't shown up. Mr. Frankel has acknowledged that, but also notes that perhaps oil producers are leaving those inventories in the ground. That could be one reason why the Saudi king rebuffed U.S. President George W. Bush's request for increased oil production earlier this month. That would be a reckless game to play, because it could lead to the types of shifts that caused energy prices to drop precipitously in the 1980s, inflicting heavy damage on the Saudi and other OPEC economies. Indeed, the combination of a change in consumer behavior and an economic slowdown that is showing signs of spreading beyond the U.S. may already augur just the kind of sharp drop in prices that occurred back then. But if that happens, it won't be because oil prices were in a bubble; it will just be because that is the way commodity markets work.

Home-Price Declines Accelerate

Home prices are falling faster as the economy slows and turmoil in the mortgage markets continues. Prices fell an average of 1.7% nationwide in the first quarter from the final three months of 2007, according to the Office of Federal Housing Enterprise Oversight. The decline was the largest in the index's 17-year history. The government index, which is seasonally adjusted and based on data for home purchases, had dropped 1.4% in the prior quarter. Compared with a year earlier, home prices dropped 3.1% in the first quarter. The price drops, which occurred in 43 states, "spell further erosion in home-equity levels and potentially more trouble for mortgage markets," said the agency's director, James Lockhart, who added that the declines may help potential home buyers. Areas that had the biggest price gains over the past decade now are experiencing the sharpest declines. Prices in California and Nevada declined more than 8% from the prior quarter. A separate monthly index showed that prices fell 0.4% in March compared with February, and 3.7% from April 2007, when the index hit its highest point. The Office of Federal Housing Enterprise Oversight index tracks sales of single-family houses purchased with mortgages guaranteed by home-loan giants Fannie Mae and Freddie Mac. (Executives of Fannie Mae and Freddie Mac told Congress they are finally bringing down interest rates on large mortgages. Please see article.)

Oil Jump Casts Shadow On Forecasts

Just when investors thought it was safe to go back in the water, they are staring at a menacing new threat. Its name is oil. For two months, Wall Street breathed a sigh of relief that the Federal Reserve had brought the markets back from the brink of a credit disaster. Stocks rallied, helped also by resilient corporate profits and expectations that the government's fiscal stimulus checks would help keep stretched consumers in a spending mood. Despite a small respite Thursday, the surge in oil prices over the past few weeks is a terribly timed shock to the system. With the economy under significant strain, the oil price jump raises new questions about the viability of forecasts for stronger corporate profits during the second half of the year and the prospects for gains in stocks. Witness the damage done to Ford Motor Co., which said Thursday that it won't turn a profit in 2009 as planned because of higher raw-materials costs and slowing sales. The problem isn't just that oil prices are rising. It is the pace of the increase. When input costs rise gradually, it is easier for companies to pass them on to customers. When oil costs rise nearly 40% in just three months, margins and profits are going to take a hit. "There's already evidence that corporate margins are getting squeezed," say Deutsche Bank strategist Binky Chadha. Thomas Lee, stock strategist at J.P. Morgan, says that oil priced at $133 a barrel would translate into an additional $300 billion in expenses to be borne by corporations and consumers in 2008. "It's a staggering number," he says. If companies were to bear the full impact of that, Mr. Lee figures it would shave about $3 a share off earnings in the Standard & Poor's 500-stock index, which are expected at $93 a share for 2008. Companies are adjusting, but they are taking steps that will have ripple effects on the economy, such as grounding flights. Meantime, the prospects for an economic boost from more than $100 billion in stimulus checks on their way to consumers looks shakier every day. The rebates amount to an extra 1% of annual disposable income for consumers, notes UBS economist James O'Sullivan. Because it's concentrated in about a three-month period, it's the equivalent of a 4% increase to disposable income during that time period -- a potentially powerful jolt to spending. However, Mr. O'Sullivan notes that the oil price increase thus far this year acts like 1.5% tax on income, Mr. Sullivan says. "It's going to pretty much neutralize" the stimulus, he says. Consumers spend less of their income on energy than they did during the 1970s crisis, but much more than just a few years ago. Time and again they've proved adept at spending through any trouble. But with home prices continuing to fall and the job market weakening, the latest surge in oil prices could be the third leg kicked out from the stool, and a big problem for stocks in the months ahead.

Bad Oil Bets Come Back To Haunt Speculators

Surging energy prices are wreaking havoc on producers and speculators who made bets on lower oil prices, forcing some to buy oil to exit their positions. That, in turn, is helping push up oil prices. Producers who long ago struck deals to sell oil in future years are finding they locked in prices at as little as half what oil fetches in today's red-hot market. Some companies are unwinding these deals by buying back their oil contracts. Other market players, particularly speculators who misjudged the top of the market, are being forced to buy oil futures to close out bad bets. Those who tough it out are often being hit with crushing margin calls, requiring them to pony up more cash because their trade has gone deeper into the red. Edward Morse, chief energy economist at Lehman Brothers Holdings Inc., said some traders put big money into complex trades in the fall that fell apart when price relationships flip-flopped the last few days. The market is beset by talk that large producers "wanted to unwind their hedges, putting upward pressure on prices." Many factors are fueling oil's rapid rise besides this financial squeeze. Although demand has eased in the developed world as growth slows, consumption is robust in developing markets. China's stockpiling of oil ahead of the Olympics and use of diesel for power generation during earthquake rescue efforts have played a part in recent spikes. Big oil consumers such as airlines have become so alarmed by rising costs Wall Street trading officials said some are rushing to buy oil to lock in future costs. All this comes on top of heightened concerns that oil production will be weaker than thought. Oil's 15% rise this month has surprised even experienced players in the energy market. After rising 3.3% on Wednesday, oil futures for July delivery on the New York Mercantile Exchange were down $2.36, or 1.8%, to $130.81 a barrel Thursday. Prices of oil for delivery in 2009 and beyond have staged even more dramatic moves, surging 30% or 40% for the month, before settling back a bit Thursday. Other commodity markets have been in the grips of a painful financial squeeze. Even large, well-capitalized commodity merchants were taken by surprise when a number of agriculture contracts soared nearly simultaneously this spring.

Time's Parting Gift: Debt

Pity the folks at Time Warner Cable Inc. They've been looking forward to being free of their lumbering parent Time Warner Inc. They just didn't realize they'd have to pay a king's ransom to win that freedom. As Time Warner unveiled details of how it will carve off its big cable arm, analysts and investors were shocked to see that Time Warner Cable will have to borrow $10.9 billion to fund a special one-time dividend of $10.27 a share. The dividend will be payable just before the cable company is cut loose from Time Warner Inc. While some investors will share in the loot, 84% of the money -- or $9.25 billion -- will go into the coffers of Time Warner, for it to spend as it pleases. Investors had expected some kind of dividend to be paid ahead of the spinoff. But by being so generous to itself, Time Warner will leave its cable business weighed down with $24 billion in debt. That's equivalent of leverage -- the ratio of its debt to the past 12 month's earnings before interest, taxes deprecation and amortization, or Ebitda -- of 3.75. Time Warner Cable's internal target is 3.25. It's also higher than most of Time Warner Cable's main peers and rivals. Comcast Corp., the No. 1 cable operator by subscribers, has a ratio of 2.3, while Verizon Communications Inc. has 0.8 and AT&T Inc. is at 1.3, says John Hodulik, an analyst at UBS. Satellite-TV operator DirecTV Group Inc. has even lower leverage of 0.65, although the company is levering up to buy back stock. At the other end of the spectrum is Cablevision Systems Corp., the Dolan family-controlled cable operator that has a leverage ratio of about six, estimates Mr. Hodulik. But few on Wall Street see Cablevision as a model for financial engineering. Few worry that the company can make the payments on its debt load, because cable companies have been cash-flow machines. Time Warner Cable believes it can get its leverage ratio down to 3.25 by the end of 2009. But the debt will limit its ability to do deals or roll out new services. And growing competition from Verizon and AT&T -- which are rolling out high-speed fiber-optic networks -- might cause an exodus of customers, hurting the company's cash flow. That's the reason Comcast is deliberately keeping leverage low, despite grumbling from shareholders who want a big stock buyback.

American Cuts Flights, Adds Fees As Airlines Face Crisis

American Airlines on Wednesday took the most dramatic steps yet to respond to a deepening financial crisis that -- because of skyrocketing fuel costs -- many view as a greater threat to U.S. airlines than the industry crisis triggered by the Sept. 11 terrorist attacks. With the price of a barrel of crude hitting a record of $133, the unit of AMR Corp. said it will slash the number of seats offered by as much as 12% in the fourth quarter, its biggest single service cutback since the 2001 terror attacks. American said it will remove at least 75 of the 954 aircraft in its fleet and that of its regional American Eagle operation. Those steps could lead to job losses in the thousands. American Airlines is adding a $15 fee for passengers' first checked bag. The Journal asks some New Yorkers for their opinions. American, the world's largest airline by traffic measures, also said it will start charging some domestic passengers $15 to check a suitcase. American and other carriers, following the lead of UAL Corp.'s United Airlines, already charge some people $25 to check a second bag. "The airline industry will not and cannot continue in its current state," said Gerard Arpey, AMR's chief executive, at the company's annual meeting in Fort Worth, Texas. The new measures are designed to "reduce unprofitable supply," he told shareholders. In plain language, that means weeding out money-losing flights and limiting the number of low-priced seats in coach. (See related article.) Other carriers -- many of which already have announced capacity reductions of their own -- are expected to continue shrinking in an effort to offset rapidly rising fuel bills. Fuel costs, which are up 64% from a year earlier, are threatening to drive a new round of airline bankruptcy-court filings this year, some analysts warn, and, perhaps, more outright failures. Ben Hirst, general counsel of Northwest Airlines Corp., said he thinks the industry generally agrees that a 20% capacity reduction is probably needed. "Cash is burning, in really, really large amounts," he said. If other carriers follow AMR's lead, travelers will quickly see not only fewer flights, but higher fares. That would also likely trigger heavy job losses for airline employees. The industry shed about 130,000 in the dark days after the 2001 attacks, and most of those jobs never came back. The passenger airlines currently employ about 415,000 people. 'Race Is On' "The race is on to see if airlines can raise fares high enough to cover the fuel bills before they run out of cash," Roger King, a CreditSights analyst, said in a research note on Monday. Airlines currently face fuel-expense increases "near or exceeding" their levels of cash on hand. If oil prices keep climbing, rising fares could start to push a significant percentage of travelers away from flying entirely. That could reverse one of the most dramatic effects of the industry's deregulation in 1978, which led to a huge increase in flights, and brought intense fare competition, opening the world of air travel to millions of people. Among airlines, AMR has perhaps the most motivation to move aggressively. It's the only major, traditional U.S. airline that hasn't been through a bankruptcy-court restructuring, meaning it faces higher labor, fleet and other costs than its rivals. American also hadn't reduced its capacity as much as its rivals in recent months, so it is also playing catch-up. In addition to tacking on the $15 checked-bag fee, American said it is also boosting fees for other services, such as phoning for reservations assistance, shipping pets and checking oversize bags. The fee increases range from $5 to $50. The goal, it said, is to generate "several hundred million dollars" in additional annual revenue. That would be a drop in the bucket. Despite more than a dozen industrywide fare increases in recent months, airlines are capturing only a sliver of the added cost of fuel. Some analysts believe the U.S. industry will lose more than $7 billion this year, on an operating basis. By comparison, in 2001, the industry posted a $10.3 billion operating loss. The chief culprit of the current woes is a fuel bill that could total $60 billion this year -- a remarkable $18 billion to $20 billion higher than it was last year. The industry earned just $3.8 billion in net profit last year. Economic Shock Jim May, chief of the Air Transport Association, said the current situation represents "the worst economic shock since 9/11, and possibly one that is worse." The association, the leading airline trade group, forecasts fuel expense rising 72% this year from last. It's hurting carriers' bottom lines. AMR's first-quarter revenue increased 5% over the previous year period, but its fuel bill soared 45%. Northwest, which consumed the same amount of fuel in the first quarter as it did in the year-earlier period, spent $445 million more on fuel. However, it took in only $150 million in additional revenue in the latest quarter. Northwest, which plans to merge with Delta Air Lines Inc. if antitrust regulators don't block the combination, already has announced more modest capacity reductions and plans to remove some aircraft from service. Delta has done much the same and is offering buyouts to reduce its ranks by 2,000 employees. United has also announced capacity reductions. Some of the smaller discounters have reined in their growth projections. Other small airlines have already succumbed and gone out of business. The big airlines, deep in red ink again after two years of profits aided by their intense, post-2001 cost-cutting, are trying to raise more cash through debt offerings and asset sales, along with boosting the fees imposed on travelers. Further cuts are possible later in the year. Most observers expect airlines to maintain as much capacity as they can through the busy summer season, then cut back sharply in the fall when traffic traditionally slows anyway. Michael Linenberg, a Merrill Lynch analyst, said that if oil prices rise well past $150 a barrel, as some economists say is possible, "I think the government is going to have to step in," he said. "We can't have all these airlines shutting down." Staying Afloat In the wake of Sept. 11, 2001, the federal government poured $5 billion into the industry to provide airlines with much-needed cash to stay afloat, and to reimburse them for the shutdown of airspace following the attacks. Still, industry revenue took four years to return to 2000 levels, and profits took six years to bounce back. The sector racked up $35 billion in losses in five years before turning profitable again in 2006. The record price of crude oil is exacerbated by a further problem. Refiners currently charge up to $36 a barrel to turn crude oil into jet fuel; by contrast, a few years ago, they charged just $3 to $5 a barrel. As a result, the cost of fuel as it's pumped into an aircraft today is more like $160 a barrel, including taxes and fees. In 2002 the figure was $30. Last year it was $88.

Australia to Issue up to 50% More Bonds

CANBERRA, Australia -- Australian Treasurer Wayne Swan said Canberra will increase its bond issuance by as much as 50% in an effort to boost liquidity. In the bond market's most significant change since 2003 -- when the previous government committed itself to a liquid bond market despite no longer needing to raise debt -- Mr. Swan said the federal government will issue about A$5 billion (US$4.75 billion) in extra Commonwealth Government Securities in the year starting July 1. It also will pass legislation authorizing total additional issuance of as much as A$25 billion, he said. The move, which will increase the total supply of sovereign bonds to as much as A$75 billion, follows weeks of consultation with market participants. Mr. Swan also said that bonds issued by state governments will be exempt from interest withholding tax. Analysts said that should boost the attractiveness of state or semigovernment bonds. Canberra also will make it easier for market participants to borrow federal bonds from the Australian Office of Financial Management by widening the types of collateral accepted. Bond-market participants welcomed the changes after earlier this year lobbying the government for extra bonds as the global credit crunch exacerbated an already tight supply. "This is what we asked for," said Paul Bide, head of debt markets at Macquarie Bank and chairman of the Australian Financial Markets Association's market-governance committee. Australia has run large budget surpluses since the mid-1990s, allowing it to reduce the value of its bonds from a peak of nearly A$96 billion in 1997. But a lack of liquidity has bedeviled the market for years, as the size of the market was static. The global credit crunch encouraged a rush for risk-free assets, such as government bonds, straining supply even further. Foreign investors hold about two-thirds of Australia's government bonds, leaving a relatively small amount for Australian funds and banks, which use the bonds for, among other things, collateral with the central bank. The government has no debt in net terms and maintains a pool of physical bonds to support liquidity in three- and 10-year futures and to provide a benchmark for other interest-rate markets.

Wholesale Prices Climbed in April

A mixed report on wholesale prices for April revived inflation fears amid an unexpected jump in raw material prices. The Labor Department reported the producer price index for finished goods rose 0.2% in April, less than the 0.4% gain expected on Wall Street. The report contained a surprise reading on core inflation, however. The report's core index, which excludes food and energy items, climbed by 0.4% last month, seasonally adjusted. That's double the 0.2% rate expected on Wall Street. The latest report suggests corporate profits will be under pressure going forward. A weak economy and sluggish consumer demand will make it difficult for companies to raise prices to consumers, said Joshua Shapiro, analyst for MFR Inc. At the same time, prices of materials will be rising. "Consequently, higher input prices will probably have an increasingly negative effect on profit margins in the months ahead," he said.

Iceland in From the Cold

Sweden, Denmark and Norway have tossed Iceland a lifeline. The three Scandinavian countries' central banks have agreed to a €1.5 billion ($2.34 billion) swap facility with their Icelandic counterpart, allowing it to exchange local kronur for euros. In doing so, the three seem to be honoring an informal agreement to backstop Iceland's beleaguered banking system. The krona, which had slumped about 25% against the euro this year, jumped nearly 5% on the news. The new swap facility boosts the central bank's credibility as a lender of last resort for Iceland's commercial banks, which have substantial foreign-currency liabilities. The banks' shares and debt had, until recently, come under sustained speculative attack amid fears they would face credit-crunch-induced liquidity problems. At the very least, the Nordic trio's help buys Iceland some time. Faced with a sliding currency and inflation at 11.8%, the central bank had little option but to push interest rates to a record high of 15.5%. That has been taking its toll on economic activity, raising fears of a nasty recession and adding to pressures on the banks. Although a further half-point hike is still expected this month, the bounce in the krona offers hope that rates will not have to rise much further. Even so, €1.5 billion wouldn't be enough to cover a full-scale run on Icelandic banks by foreign depositors. That would call for another €4 billion, according to Moody's Investors Service. To forestall this worst-case scenario, the banks must continue their painful deleveraging, and the central bank will have to continue administering its bitter monetary medicine to restore confidence in the krona. But at least the Scandinavian lifeline suggests Iceland is no longer being left to face its troubles alone.

Beijing Shows Strong Hand in Shepherding Grief

Monday afternoon, a country that seems to be in constant motion came to a standstill. For three minutes, traffic froze, construction workers halted their drilling and workers stood silently outside their offices in white shirts that read "Press On." Associated Press A rescue crew in Tashui, China, stops work to mark respect for the dead. The moment of silence, part of a three-day period of national mourning to mark the 34,073 confirmed dead from the magnitude 7.9 earthquake that shook Sichuan province exactly one week before, came on a day of more grim news: The official Xinhua news agency reported that a series of mudslides had killed 200 rescue workers. The mourning reflects both a tremendous sense of loss and the government's desire to ensure that emotions are channeled properly. Even as concerned citizens around the country cried in honor of the dead pictured on television, some survivors in Sichuan found their grief turning into anger. During the official mourning period, the government has taken the unusual step of effectively shutting down entertainment in China -- silencing karaoke parlors, forcing entertainment programming off Web sites and TV stations, shutting down online games and suspending TV and online ads. The last time China undertook such a long national period of grieving was when Mao Zedong died in 1976. Historians say it is the first time such an event has been held in honor of regular citizens, rather than government leaders, according to Xinhua. The mourning period helps the grief-stricken nation "have some sense of psychological closure," said Dali Yang, the director of the East Asian Institute at the National University of Singapore. "It's all the more important because there's no national religion and the Chinese Communist Party cannot bring in a priest to help the healing process." The government is using its control of old and new media to shape the conversation. Party-run coverage from broadcaster China Central Television, including repeated footage of flags being lowered to half-staff, replaced normal programming on many broadcasters. Foreign broadcasts of HBO and other entertainment channels were replaced with a message that said they had been cut off "in order to express our heartfelt condolences for the victims of the disastrous earthquake."1 Chinese newspapers, some of which provided their own aggressive coverage last week, relied more on stories from Xinhua. Newspapers across the country used only black ink on their front pages. And on the Internet, the largest portal and video-sharing sites shut down some of their entertainment offerings in accordance with a government order. An order sent to some Web sites, as reported by a blog known as the Shanghaist, required them to "immediately report and give priority to reports on the national mourning days." Chinese bloggers, sometimes critical of government efforts to regulate speech, largely expressed solidarity with the idea of a mourning period; technology commentator Hong Bo, known as Keso, posted on his blog an ancient Chinese poem about crying. "It's pretty amazing that the government can do this," said Bill Bishop, a Beijing-based Internet entrepreneur. "I think it just shows some people may have gotten a little complacent about how the media work in China; it shows where the power really does still lie." The quake relief effort has received 10.8 billion yuan ($1.5 billion) in monetary and in-kind donations. The government hasn't yet said how much of that came from Chinese nationals. Office buildings, shops and restaurants all over the country held their own fund-raising efforts Monday. A Sunday-night telethon on China Central Television raised 1.5 billion yuan. The quake has cost companies 67 billion yuan in direct losses so far, according to the government. A retired soldier who joined mourners in the moment of observance along Beijing's Wangfujing area said he had been trying unsuccessfully to get a team of volunteers together to go to Sichuan. "I want to say to the people of the affected areas, 'Don't be afraid. The party, the country and the whole nation's people are all helping you,'" he said, as his eyes filled with tears. "I hope they can rebuild their homeland as soon as possible. I feel very proud to be Chinese." In Beijing's Tiananmen Square, hundreds rallied after the moment, carrying Chinese flags and shouting "Go, China," a phrase usually used at sporting events.

Fifth Third Sues as Fund Run by Citi Fuels Losses

The downward spiral of a Citigroup Inc. hedge fund has caused steep losses for at least three large U.S. banks that hoped it would rev up returns on a controversial type of employee life insurance. Besides triggering a lawsuit against an insurer and brokerage firm that arranged the hedge-fund investment for Fifth Third Bancorp, the losses may pressure Citigroup to give the banks some of their money back, as it has agreed to do for individual investors. Such a bailout would be costly, because the clobbered banks sank more than $1.6 billion into the hedge fund, according to the lawsuit and people familiar with the matter. The problems stem from Citigroup's Falcon Strategies hedge fund, a fixed-income vehicle that has plunged more than 75% in value. Many of the fund's investors were retail clients at the New York financial conglomerate's Smith Barney unit, including some who were told Falcon was a haven. The collapse is another headache for Citigroup's new management, led by Chief Executive Vikram Pandit, as it tries to rebound from crippling losses that stemmed partly from inadequate risk controls. Falcon's descent has caused a handful of high-level brokers to quit in frustration. Citigroup is spending $250 million to allow retail investors to exit from their positions without absorbing the fund's full losses. Falcon also attracted major banks that invested in the hedge fund as part of their bank-owned life insurance programs. Wachovia Corp., the fifth-largest U.S. bank by stock-market value, was the most heavily exposed, with more than $1 billion invested, people familiar with the situation say. The stake represented at least 7% of the Charlotte, N.C., bank's $14.9 billion in BOLI-related assets as of March 31. Fifth Third, of Cincinnati, sank $612 million into Falcon, according to the lawsuit the regional bank filed last month in U.S. District Court for the Southern District of Ohio. That was about a third of the bank's BOLI assets as of Dec. 31. Another regional bank also invested a sizable amount, people familiar with Falcon's operations say. The name of that bank couldn't be determined. In such bank-owned life-insurance programs, banks buy policies on their employees. When employees die, the banks collect. Because the income is tax-free, some critics contend that BOLI is a tax shelter. Last year, nearly 700 banks reported holding a combined $117.5 billion in their BOLI accounts, according to Michael White Associates LLC, a bank-insurance consulting firm in Radnor, Pa., and executive-benefits firm MullinTBG, of Deerfield, Ill. In recent years, many banks have grown aggressive with their BOLI programs, putting premiums into investment vehicles that let the banks record quarterly profits -- or losses. Quarterly profits or losses are tax-free, and the policies still pay when employees die. Falcon began stumbling last fall and by March 31 was valued at 20% of the original value, according to Citigroup documents. Fifth Third, which reaped $238 million in gains on its BOLI portfolio in a three-year period, suffered a BOLI-related loss of $177 million in the fourth quarter and a $152 million loss in 2008's first quarter. At Wachovia, Falcon's woes caused the bank's first-quarter loss to widen to $708 million from its previously announced $393 million loss. Wachovia didn't identify the exact source when it disclosed May 6 that it had a $315 million loss on its BOLI investments, but spokeswoman Christy Phillips-Brown confirmed that it came from Falcon. She wouldn't comment on the size of Wachovia's investment in the hedge fund or whether the company plans to pursue legal action over the Falcon stake. The market's turbulence has hurt BOLI results at other banks, too, from tiny Evans Bancorp Inc. in Hamburg, N.Y., to regional bank BB&T Corp. The Winston-Salem, N.C., bank had a loss of $15 million on its BOLI portfolio in the first quarter. Spokesman Bob Denham declined to say whether BB&T was a Falcon investor, though any future losses "will be small." A Citigroup spokeswoman wouldn't comment on the fund's impact on banks. Citigroup previously has said that Falcon was marketed only to sophisticated investors. In its lawsuit, Fifth Third alleges that Transamerica Life Insurance Co. and Clark Consulting Inc., both units of Dutch insurer Aegon NV, "utterly failed to properly manage and monitor" premiums that were invested in Falcon. Citigroup isn't named as a defendant. A Fifth Third spokeswoman declined to comment. Cindy Nodorft, an Aegon spokeswoman, counters that Fifth Third "was free to choose from a number of investment alternatives that they were familiar with," adding that the "terms of the policy were adhered to." Ms. Nodorft wouldn't say whether the Aegon units placed other banks in Falcon. "We continue to work closely with Citigroup as well as other financial institutions to address the developments in market conditions," she said.

Rebounds by Hedge-Fund Stars Prove 'It's a Mulligan Industry'

Jeffrey Larson lost $1.5 billion for his hedge-fund investors in a few painful weeks last summer. He shuttered Sowood Capital Management LP in July, one of the more embarrassing meltdowns in recent memory. So what are the 50-year-old Mr. Larson's summer plans this year? He is trying to raise money for a new fund, arguing that he has learned valuable lessons. And he is attracting some interest. Wall Street likes to consider itself a strict meritocracy, but hedge-fund managers who fail in ugly ways often convince investors to hand them piles of cash so they can give it another go. Says Ken Phillips, who runs RCG Capital Partners, a Boulder, Colo.-based firm that invests in hedge funds: "It's a mulligan industry," referring to the golf term for a second chance after a poorly played shot. "That's what makes America great." Just over a week ago, Drake Asset Management announced that it was closing its $2.5 billion hedge fund after heavy losses. Executives say they already have more than $800 million committed to a new fund. Some investors in Daniel Zwirn's D.B. Zwirn & Co. fund recently received subpoenas from the Securities and Exchange Commission regarding an investigation into the fund, which is closing. But some already have told Mr. Zwirn that they would be interested in giving him money for a new firm he is considering. Meanwhile, trader Philippe Jabre, who received a record fine for market abuse from the United Kingdom's market regulator, launched his own fund last year after raising $3.5 billion. And John Meriwether, who oversaw the collapse of Long-Term Capital Management a decade ago, is dealing with fresh losses at his latest hedge fund. Traders sometimes even get third chances. Take Brian Hunter. After leaving Deutsche Bank amid a dispute, his trades led to $6.6 billion of losses for hedge fund Amaranth Advisors. He now is advising a new fund. Investors have a range of explanations for opening their wallets for failed managers. Sometimes, managers demonstrate that big losses made them smarter investors, or they offer to waive some of their hefty fees for those who got burned in previous funds. Some managers who had stumbled in the past, such as David Shaw of D.E. Shaw and William Ackman of Pershing Square, restarted their careers and generated big returns. It can be helpful to have lost loads of money, rather than a smidgen of cash. "It's crazy, but the guy who's down substantially often will have a lot more options versus someone smaller who hasn't lost much money," says Neal Berger, who runs Eagle's View Asset Management, LLC and invests with funds. "Some investors will say 'lightning doesn't strike twice in the same spot,' or, 'there must be something smart about him that someone gave him the opportunity to lose so much money in the first place."' Those like Mr. Larson, who were felled by volatile markets rather than because of any improprieties, usually receive more interest from potential investors. "He was a smart guy who got caught in a severe market dislocation," notes RCG's Mr. Phillips, who says he would be interested in meeting with Mr. Larson to learn about his new fund. Still, Mr. Phillips acknowledges that there may be more to the phenomenon than a hard-headed calculus about returns. "The hedge-fund industry tends to glamorize managers," he says, "and people get star-struck."

The Next to Notch an Upgrade?

Getting moved up -- or down -- in the sovereign-rating hierarchy can have a profound impact on stock and bond markets in developing countries. These days, there is a distinct divide within emerging markets. Some are winning kudos for their economic policies and seem ready to leap up the ladder of credit quality. Others appear increasingly vulnerable to the effects of the credit crunch and may be poised for a slide. Last month, Brazil vaulted into the ranks of countries whose external debt is considered "investment grade," a momentous occasion for a country that less than a decade ago was gripped by financial crisis. Although the move was anticipated, it sent Brazilian shares to an all time-high. The next country in line to receive an upgrade on its sovereign rating could be Peru. "That's the one that everybody is focused on," says Joyce Chang, global head of emerging-markets strategy at J.P. Morgan Chase. Fitch Ratings has already judged Peru's external debt to be investment grade, but its larger counterparts, Standard & Poor's and Moody's Investors Service, have yet to follow suit. An S&P analyst said in April it may upgrade Peru to investment-grade status later this year. Clinching that status carries a host of benefits, because some institutional investors have restrictions on how much they can allocate to places that aren't considered investment grade. Propelled by exports of raw materials, Peru's economy is expected to grow 7% this year, according to the International Monetary Fund, compared with a little over 4% for Latin America as a whole. In recent years Peru has greatly reduced its overall level of debt and now depends only modestly on financing from overseas. "It's a little country that's working like a clock," says Guillermo Mondino, head of emerging-markets research at Lehman Brothers. Russia is another country that could merit a positive change in status, say some investors. "Their fundamentals are so strong, and they've been so prudent with fiscal policy, that economically they should be upgraded," says Thomas Cooper, who helps manage $6 billion in emerging-market debt at GMO LLC. Russia's external debt is already investment grade, but ratings agencies are reviewing the possibility of moving it a notch higher, potentially to a coveted A rating. By contrast, as the credit crunch has intensified this year, ratings agencies have alerted a host of countries that their sovereign-credit quality is at risk of slipping. In the past two months, S&P has added Kazakhstan, Turkey, Hungary and Romania to the list. All four are affected in varying degrees by tighter borrowing conditions worldwide, because their governments or banks depend on overseas financing. "The global credit squeeze is more severe, and likely to prove more prolonged, than anticipated," S&P noted late last month in its warning on Kazakhstan's rating. Another country that risks a downgrade: Argentina. It is struggling with accelerating inflation and recently faced a series of protests by farmers. The resignation of the country's economy minister after just five months on the job is part of an ongoing struggle over economic policy. The minister's departure prompted S&P to change its outlook on the country's sovereign rating to negative from stable. "The instability there has picked up quite significantly," says Mr. Mondino of

AIG Leasing Unit Mulls Split-Up

American International Group Inc.'s troubles are prompting one of the insurer's most-profitable units -- an airplane-leasing giant run by one of AIG's largest shareholders -- to consider seeking a split from the company, according to people familiar with the matter. Officials at powerhouse International Lease Finance Corp. have grown increasingly concerned that the company will be weakened by its parent's financial woes, these people say. The world's largest buyer of commercial aircraft, ILFC leases large numbers of planes to air carriers, and AIG's problems could make it more difficult for ILFC to compete in the increasingly crowded airplane-leasing industry. Last Thursday, AIG reported a $7.8 billion first-quarter loss, largely the result of a sharp decline in the value of financial instruments tied to subprime mortgages. In response, two major rating agencies downgraded ILFC's credit rating along with that of the parent company, even though ILFC reported a winning first quarter with a 41% increase in operating income to $272 million. The decline in the credit ratings is crucial to ILFC, as poorer ratings raise the rate of interest ILFC must pay to borrow money to finance airplane purchases. A divorce could also have consequences for the aviation business. ILFC is such a force that its fate will affect most everyone in the industry, particularly Boeing Co. and Airbus, which each count ILFC as their single-largest customer. It is possible that AIG and ILFC will be able to sort out the situation and stay together. Divesting ILFC would be complicated. Not only does ILFC generate profits for its parent, but AIG also takes advantage of billions of dollars in accelerated depreciation on jetliners, which helps hold down its taxes on other profits. ILFC was acquired by AIG in 1990 for $1.3 billion in stock. For years, ILFC benefited from AIG's strong credit rating and support when it borrowed money to finance plane purchases. "With the tremendous appetite for capital that we have, this is a very appropriate merger," said Mr. Udvar-Hazy in 1990. But there are potential threats to those advantages. Affected by a sharp decline in the value of credit derivatives the company sold as protection for a range of investments, including subprime mortgages, AIG logged $13.1 billion of losses in the past two quarters. Those losses are a key reason why two major rating agencies cut AIG's -- and ILFC's -- credit ratings last week.

Multiple Deposit Creation and the Money Supply Process

http://www.ags.uci.edu/~pvanhorn/Deposit%20Creation.doc Recall that money supply = cash in circulation + bank deposits Bank deposits, not cash, account for the vast majority of the money supply. This is the case even though cash deposits, and cash reserves, are the foundation of the banking system. The reason why the volume of bank deposits is so much larger than the total amount of cash is that banks practice Fractional reserve banking is when cash is deposited into a bank, the bank keeps only a small fraction of that cash as reserves and loans the rest of it out, at interest. Fractional reserve banking is closely related to the phenomenon of multiple deposit creation: when cash is deposited into a bank, the bank loans out most of that money, and most of the money loaned gets redeposited into the banking system, and gets mostly loaned out again, and redeposited, and so on. The chain of deposit creation, or excess reserves (ER) being loaned out and redeposited in the banking system, continues until the banks have basically no more excess reserves. Multiple deposit creation can also be understood as follows: When the Fed creates an additional $1 in bank reserves, total bank deposits (and hence the money supply) increase by a multiple of that amount. The multiplication of an initial change in reserves into a much larger change in bank deposits occurs because of the chain of deposit creation, in which excess reserves are loaned out and redeposited ad infinitum. ...

AIG 01 08 CDS exposure

$469 bil notional exposure Approximately $335 billion of the $469 billion in notional exposure on AIGFP’s super senior credit default swap portfolio as of March 31, 2008 was written to facilitate regulatory capital relief for financial institutions primarily in Europe. AIG expects that the majority of these transactions will be terminated within the next 12 to 24 months by AIGFP’s counterparties as they implement models compliant with the new Basel II Accord. As of April 30, 2008, $55 billion in notional exposures have either been terminated or are in the process of being terminated at the request of counterparties. In its 2007 Annual Report on Form 10-K, AIG had previously reported that as of February 26, 2008, $54 billion in notional exposures have either been terminated or are in the process of being terminated. AIG has recently refined its approach to estimating its net notional exposures on certain of these transactions that have unique features. The notional exposures on transactions terminated or that were in the process of being terminated as of February 26, 2008 is $46 billion under the refined method. AIGFP was not required to make any payments as part of these terminations and in certain cases was paid a fee upon termination. In light of this experience to date and after other comprehensive analyses, AIG determined that there was no unrealized market valuation adjustment to be recognized for this regulatory capital relief portfolio for the three months ended March 31, 2008. AIG will continue to assess the valuation of this portfolio and monitor developments in the marketplace. Given the significant deterioration in the global credit markets and the risk that AIGFP’s expectations with respect to the termination of these transactions by its counterparties may not materialize, there can be no assurance that AIG will not recognize unrealized market valuation losses from this portfolio in future periods, and recognition of even a small percentage decline in the fair value of this portfolio could be material to an individual reporting period. These transactions contributed approximately $89 million to AIGFP’s revenues in the three-months ended March 31, 2008. If AIGFP is not successful in replacing the revenues generated by these transactions, AIGFP’s operating results could be materially adversely affected. $57 billion exposure to super senior CDS Approximately $57 billion of the $469 billion in notional exposure on AIGFP’s super senior credit default swaps as of March 31, 2008 was written on investment grade corporate debt and CLOs. There is no uniform methodology to estimate the fair value of corporate super senior credit default swaps. AIG estimates the fair value of its corporate credit default swap portfolio by reference to benchmark indices, including the CDX and iTraxx, and third-party prices and collateral calls. AIG believes that its methodology to value the corporate credit default swap portfolio is reasonable, but other market participants use other methodologies and these methodologies may generate materially different fair value estimates. No assurance can be given that the fair value of AIG’s corporate credit default swap portfolio would not change materially if other market indices or pricing sources were used to estimate the fair value of the portfolio.

Auction Rate Issuers Pay to End Swaps

May 9 (Bloomberg) -- Taxpayers from Massachusetts toCalifornia are paying Wall Street banks to end derivativecontracts gone bad as they exit the collapsing auction-rate bondmarket, with penalties in some cases topping $10 million andcompounding the pain of rising borrowing costs. Sacramento County, California, paid Morgan Stanley $5million to cancel an interest-rate swap agreement when itrefinanced $79.5 million in auction-rate securities last month.The fee added to the cost of the bonds after the rate on thesecurities more than doubled to 9.8 percent in March as dealersstopped supporting the market. The breakdown of the $166 billion market where municipalrates are typically set through bidding run by a dealer issqueezing borrowers already hurt by the first decline in statesales-tax revenue in six years, according to the Nelson A.Rockefeller Institute of Government in Albany, New York. Citigroup, based in New York, was the top underwriter ofauction-rate securities in the municipal market, arranging $55billion in sales between 2000 and the end of last year, accordingto data compiled by Thomson Reuters. Zurich-based UBS AG, which said May 6 it will close or sell its municipal bond department,underwrote $42 billion, followed by Morgan Stanley of New York at$22 billion and 19 others. ``Most swaps are negotiated with the investment bank thatdoes the underwriting,'' Fuller said. ``It's unusual that anissuer would use a counterparty other than the underwritinginvestment bank.'' Dealers Flee For almost two decades, auction-rate bonds allowed localgovernments, hospitals, and closed-end mutual funds to issue debtmaturing in as long as 40 years at short-term rates that resetevery 7, 28 or 35 days through bidding. Investors and dealers began to abandon the market inFebruary on concern that the creditworthiness of companiesinsuring the bonds was deteriorating because of their losses fromguaranteeing debt backed by subprime mortgages. More than two-thirds of auctions failed, data compiled byBloomberg show, and the average rate on seven-day securities roseto 6.89 percent on Feb. 20 from 3.63 percent a month earlier, according to the Securities Industry and Financial MarketsAssociation. When an auction fails because sellers' ordersoverwhelm demand from bidders, rates are set at a predetermined``penalty'' level. Municipal issuers have replaced or announced plans torefinance more than $63 billion of auction-rate debt, accordingto Bloomberg data. Redding, California, expects to pay Citigroup $6.7 millionto close out a swap on $67.3 million of auction-rate bonds itsold, said Tom Graves, financial manager of the city's electricsystem, the recipient of the proceeds. Most borrowers also entered into swaps where they agreed tomake a fixed payment in exchange for variable payments from thebanks arranging the transaction, according to Jeff Pearsall, amanaging director at Philadelphia-based Public FinancialManagement, the largest adviser to U.S. municipalities. A swap is a type of derivative, or financial instrumentderived from stocks, bonds, loans, currencies or commodities, orlinked to specific events like changes in interest rates or theweather. In a swap, parties exchange payments based on aspecified amount of debt. For issuers of auction-rate bonds, the variable rates they received, based on the London interbank offered rate, roughly matched the cost of auction-rate bonds for more than five years. The relationship broke down this year as rates on auction-ratebonds soared and Libor fell. Sacramento County did a swap with Morgan Stanley inconjunction with a sale of $79.5 million in auction-ratesecurities for its airport in May 2006. The contract was to lastuntil the bonds, which were insured by New York-based XL CapitalAssurance Inc., matured in 2024. The county agreed to pay the bank a fixed rate of 3.785percent in return for a variable payment that was supposed tocover the cost of the bonds. The rate it received from MorganStanley was capped at 65 percent of the one-month Libor, whichaveraged 5.08 percent that month.

Productivity Rises Amid U.S. Slowdown

U.S. productivity rose at a solid pace in the first quarter, suggesting companies are adjusting quickly to the economic slowdown by shedding workers and cutting back on the number of hours worked. Unit labor costs -- a key gauge of inflationary pressures -- rose a mild 2.2% in the first quarter, and were up just 0.2% from a year ago. That was the smallest annual rise since 2004, and underscored workers' difficulty in securing higher wages during a slowdown. Labor is the biggest single expense in producing goods and services. Gains in productivity are crucial to allowing the economy to expand without rising inflation or declining profits. But Wednesday's report suggests that companies are cutting back on workers and hours worked. The number of hours worked tumbled at a 1.8% pace, the biggest drop in five years, reflecting recent declines in nonfarm payrolls to start the year. Long-term issues like productivity and underlying growth potential have taken a back seat to crises, centered in the housing and credit markets, that have commanded the Fed's policy. Last week, the Fed lowered the federal-funds rate -- at which banks lend to each other overnight -- by a quarter-percentage-point to 2% but signaled in a statement that it is likely to hold rates steady for an extended period. If productivity growth stays healthy, easing inflation concerns, the Fed probably won't be in a hurry to raise rates. The weak dollar also may be contributing to the growth in productivity by channeling more of the economy's resources into business involved in exports. Export-intensive industries tend to have higher productivity than the economy-wide average, studies show. That offsets to some extent the lower productivity found in fast-growing service sectors. Manufacturing-sector productivity jumped 4.1%, almost double the average for the economy overall. Meanwhile, consumer borrowing in the U.S. rose in March at an annual rate of 7.2%, the fastest pace in four months and more than double the 3.1% increase of the previous month, the Fed reported. The gain was much larger than economists had expected.

ECB Keeps Benchmark Rate Intact to Fight Inflation

May 8 (Bloomberg) -- The European Central Bank kept interestrates at a six-year high today to fight inflation, even as theeuro's appreciation and fallout from the U.S. housing slump curbeconomic growth. The Frankfurt-based ECB left its benchmark refinancing rateat 4 percent, as predicted by all 53 economists surveyed byBloomberg News. The central bank won't lower borrowing costsbefore September, according to a separate survey. With soaring food and energy prices pushing inflation above 3percent in the 15-nation euro region, the ECB is reluctant tofollow the U.S. Federal Reserve in cutting interest rates to shoreup economic growth. The International Monetary Fund estimatesexpansion will weaken to 1.4 percent this year from 2.6 percent in2007 as the stronger euro hurts exports and the U.S. housing slumptriggers a global slowdown. Since then, economic data have suggested Europe's economy iscooling. Executive and consumer confidence declined to the lowestlevel in more than two years in April and European retail salesdropped 1.6 percent in March from a year earlier, the most since

Fed Wants to Pay Interest On Bank Reserves

-- Federal Reserve Chairman Ben S.Bernanke, seeking ways to stabilize money markets, will askCongress for authority to pay interest on commercial-bankreserves this year, a person familiar with the discussions said. The central bank isn't authorized by Congress to beginmaking such payments until 2011. Allowing interest on bankreserves may allow the Fed to pump more funds into the bankingsystem without pushing its main policy rate lower, in effectseparating action to boost liquidity from monetary policy. ``It would have the effect of putting a floor under thefederal funds rate,'' said Walker Todd, a research fellow at theAmerican Institute for Economic Research in Great Barrington,Massachusetts. If the Fed paid an interest rate equal to the federal fundsrate, commercial banks would avoid dumping any excess cash intomoney market, which in the past has driven rates below the Fed'starget. The desk has struggled to keep the federal funds rate stableas banks attempted to manage their reserve needs most effectivelyat a time when credit markets were seizing up. The federal funds rate on May 2 traded in a range of 0.1percent to 2.5 percent even though the target was 2 percent. OnApril 23, the rate traded as low as 1 percent and as high as 10percent, even though the target rate was 2.25 percent.

Wachovia' Big-Loan Executive is Leaving

One of the most zealous commercial real-estate lenders during the industry's boom is losing its most aggressive deal maker. Mr. Verrone helped vault the Charlotte, N.C., bank from an also-ran in lending to real-estate owners and developers to by far the biggest in the business, according to some measurements. Lately, though, Wachovia and other lenders have suffered steep losses on commercial real estate because they were stuck with billions of dollars of debt when the credit crunch hit last summer. Wachovia, the fifth-largest U.S. bank in stock-market value, has taken write-downs of about $1.6 billion related to commercial mortgages and sharply reduced its commercial real-estate exposure. Separately, Wachovia's woes deepened with its disclosure Tuesday that its previously announced first-quarter loss of $393 million will widen to $708 million as a result of write-downs related to life insurance for bank employees. Mr. Verrone, known for quoting lines from "The Godfather" while negotiating deals, also was a champion of the complex mortgage-backed securities that allowed banks to bundle loans, slice them into tranches and sell them to investors. He also helped popularize so-called mezzanine financing, which allowed borrowers to put less of their own money at risk and was a crucial component of many highly leveraged transactions that were a hallmark of the real-estate boom. Last year, Wachovia originated $23.6 billion of commercial mortgages that were packaged into securities, compared with $14.9 billion by its closest rival, Credit Suisse Group, according to Commercial Real Estate Direct. Wachovia's heft left it badly exposed when turmoil erupted in the credit markets last year. In the second half of 2007, the bank took roughly $1 billion in write-downs related to commercial mortgage-backed securities. Wachovia's glum first-quarter results included an additional CMBS write-down of $521 million. Those losses likely could have been much worse. Because of Wachovia's aggressive selling of commercial real-estate debt, overall commercial-loan exposure at the bank plunged to $3 billion as of March 31, after the effect of hedges, from $13 billion in last year's second quarter.

Rule Clouds American Capital

Private-equity concern American Capital Strategies Ltd. has been placing full value on various loans it has made even as other investors who hold the same debt already have slashed the values. Now, a new accounting rule governing the use of market values for financial assets could force American Capital to bring its valuations down, and that could lead to big write-downs. That could slam the publicly traded company's shares. The company holds nearly $6 billion of high-interest loans it has made to medium-size companies, typically as part of leveraged-buyout transactions. The new rule, Statement of Financial Accounting Standards No. 157, which took effect in January, changes the way companies think about placing market values on assets that don't have hard prices. In a note Friday, Stifel Nicolaus analyst Troy Ward said the introduction of the accounting rule would likely have more impact on American Capital's asset valuations than on those of its peers. Under the new rule, companies will have to place greater emphasis on what someone else would pay for that asset if it were sold today. By contrast, until the end of last year, American Capital based the value of many of its investments on internal models and original transaction costs. The company started to apply the new rule in its first quarter. Financial results for the period are scheduled to be released Wednesday. Any write-downs in the quarter may be larger than even bearish analysts have predicted. That is because the values American Capital attached to many of its loans before the first quarter were considerably higher than values ascribed by other investment companies, according to company filings. American Capital declined to comment on specifics of its valuations, pointing to disclosures in its 2007 annual report. Shares in American Capital are flat for the year, in line with indexes that track financial companies. In 4 p.m. Nasdaq Stock Market trading Friday, the shares were down 57 cents, or 1.8%, to $32.01. Because of the way it is structured, American Capital pays out most of its profit as dividends, giving it one of the most attractive dividend yields in the Standard & Poor's 500-stock index. The company forecasts it will pay out a $4.19 per-share dividend this year, giving the stock a 13.1% forward yield. But in recent months, the company's balance sheet has become the focus for analysts, many of whom believe the midsize companies American Capital has invested in will experience hard times in a slower-growing economy. "Investors aren't appreciating the credit risk in the company's balance sheet right now," says Daniel Furtado, analyst at Jefferies & Co. who rates the company a sell. The slower-growing economy, along with reduced investor demand for leveraged loans, has caused the prices of many of American Capital's loans, many of which are inactively traded, to drop. The new accounting rule, with its emphasis on sale prices, could force American Capital to write down the value of its loans so those values are more in line with values posted by its peers. These valuation gaps aren't small. At the end of last year, American Capital valued an $18.6 million loan to insurer AmWINS Group Inc. at 100 cents on the dollar. That loan was trading at 80 cents on the dollar on Dec. 31, 2007, according to price data from Reuters Loan Pricing. At the end of November, the Eaton Vance Floating-Rate Income Trust valued that AmWINS loan at slightly less than 86 cents on the dollar. By the end of December, the Morgan Stanley Prime Income Trust valued a loan to AmWINS that matures a year earlier at 85 cents on the dollar. In fact, 11 companies show up in the debt-holding lists of both the Morgan Stanley fund and American Capital. In each case, at the end of last year, Morgan Stanley valued its loans lower than did American Capital, even in cases where the Morgan Stanley loan matured first. The biggest difference was in a loan for a household-products company, KIK Custom Products. The Morgan Stanley fund valued its KIK debt at just less than 70 cents on the dollar at the end of last year. American Capital gave its debt full value. Friday, the market price for KIK's loan was 35 cents on the dollar, according to Reuters Loan Pricing.

Will Microsoft Corp. make a comeback bid?

Yahoo Inc. shareholders, likely reeling from the Internet company's decision to refuse a $33-a-share takeover offer, may want to take solace in a couple of deals where "no" really meant "maybe." In the past, Oracle Corp. and PepsiCo Inc. backed away from takeover attempts, only to return to the negotiating table after their prey twisted in the wind. Take the saga of Quaker Oats. In 2000, PepsiCo walked away from its $14 billion offer to buy Quaker Oats after Roger Enrico, PepsiCo's chairman and chief executive officer at the time, refused to sweeten the company's bid. Rival Coca-Cola Co. stepped in within weeks with a $15.75 billion stock-swap bid. But then at the 11th hour, Coke's board backed away from the deal, as Director Warren Buffett and others expressed skepticism. That was just the opening for Mr. Enrico. With no other suitors, Pepsi swept in and made a deal for Quaker at essentially the same terms initially offered. Then there's Oracle CEO Larry Ellison, who was so intent on winning PeopleSoft that over an 18-month period he raised his price to $26.50 a share from the initial $16 in June 2003, bidding against himself at some points. The impetus for the deal's completion came when PeopleSoft's shareholders finally supported Oracle's bid. The final offer valued PeopleSoft at $10.3 billion, around twice the original $5.1 billion offer. Mr. Ellison brought the same single-minded purpose to his pursuit of BEA Systems last year, but this time let shareholders do the dirty work. Oracle bid $17 for BEA, which held out for $21 and for months didn't budge. Oracle finally walked away, sniffing that BEA probably wouldn't be able to do better. Activist investor Carl Icahn, a BEA shareholder and incensed by BEA's refusal to deal, did all the tough talking, eventually bringing both sides together at $19.38 a share. In general, though, such gamesmanship takes its toll on both the bidder and its the object of its affections. Shareholders generally hate uncertainty, and press management for a definitive view of strategy.