2

June 23, 2008 9:14 p.m. EDT

DOW JONES REPRINTS This copy is for your personal, non-commercial use only. To order presentation-ready copies for distribution to your colleagues, clients or customers, use the Order Reprints tool at the bottom of any article or visit: www.djreprints.com. • See a sample reprint in PDF format. • Order a reprint of this article now. Heart Deaths Linked to Lack Of Vitamin D ASSOCIATED PRESS June 23, 2008 9:14 p.m.; Page D3 CHICAGO -- Research linking low vitamin D levels with deaths from heart disease and other causes bolsters mounting evidence about the "sunshine" vitamin's role in good health. Patients with the lowest blood levels of vitamin D were about two times more likely to die of any cause during the next eight years than those with the highest levels, the study found. The link with heart-related deaths was particularly strong in those with low vitamin D levels. Experts say the results shouldn't be seen as a reason to start popping vitamin D pills or to spend hours in the sun, which is the main source for vitamin D. Megadoses of vitamin D pills can be dangerous and skin-cancer risks from too much sunshine are well-known. But also, it can't be determined from this type of study whether lack of vitamin D caused the deaths, or whether increasing vitamin D intake would make any difference. Low vitamin D levels could reflect age, lack of physical activity and other lifestyle factors that also affect health, said American Heart Association spokeswoman Alice Lichtenstein, director of the Cardiovascular Nutrition Laboratory at Tufts University. Results appear in the Archives of Internal Medicine. The study's lead author, Harald Dobnig of the Medical University of Graz in Austria, said the results don't prove that low levels of vitamin D are harmful "but the evidence is just becoming overwhelming at this point."

 

June 24, 2008

DOW JONES REPRINTS This copy is for your personal, non-commercial use only. To order presentation-ready copies for distribution to your colleagues, clients or customers, use the Order Reprints tool at the bottom of any article or visit: www.djreprints.com. • See a sample reprint in PDF format. • Order a reprint of this article now. Housing Study Says Worst Isn't Over As Local Markets Deal With Steep Drops By AMY HOAK June 24, 2008; Page D2 The housing slump, already shaping up to be the worst in a generation, still hasn't run its full course, according to Harvard University's annual report on housing, released Monday. And if job losses accelerate in coming months, that could push any recovery even further out, said Nicolas P. Retsinas, director of Harvard's Joint Center for Housing Studies. Job losses, he said, could be "the last shoe to drop, but a pretty heavy shoe." The center releases its "State of the Nation's Housing" report each year and the 2008 edition gave a grim prognosis for housing markets throughout the country. Local markets are dealing with drops in housing starts, new-home sales and existing-home sales -- corrections that are rivaling the deepest slowdowns since the World War II era, the center reported. On top of that, the fall in home prices and the rise in mortgage defaults are the worst on record since the 1960s and 1970s. All this adds up to a downturn that is "the most severe that we have seen," said Mr. Retsinas. Mr. Retsinas said that historically, housing markets usually recover after an economic recession and a mix of falling mortgage rates and dropping home prices. This housing downturn will likely take longer to rebound, he said, because of the high volume of foreclosures and the constraints in the credit markets.

 

June 24, 2008

DOW JONES REPRINTS This copy is for your personal, non-commercial use only. To order presentation-ready copies for distribution to your colleagues, clients or customers, use the Order Reprints tool at the bottom of any article or visit: www.djreprints.com. • See a sample reprint in PDF format. • Order a reprint of this article now. Money Managers Turn Bearish New Survey Shows That Fewer Pros See U.S. Stock Bargains By ELEANOR LAISE June 24, 2008; Page D2 Money managers' market outlook is getting gloomier, but they're not positioning themselves for a prolonged recession, according to a survey set to be released Tuesday. Just 32% of money managers believe U.S. stocks are undervalued, down from 42% three months ago, according to the latest quarterly Investment Manager Outlook survey by Russell Investments. Managers believe a slowing economy, inflation, shaky credit markets and energy costs are the top factors that could drag down stock returns in the second half of this year, the survey found. The survey, conducted May 29 through June 6, collected 335 managers' views on various asset classes and sectors. Russell, a unit of Northwestern Mutual Life Insurance Co., researches and selects money managers for investors, and markets the Russell lineup of market indexes. Relative to last quarter, managers became substantially more bearish on many areas of the stock and bond market. The U.S. large-company growth asset class, for example, remained the most popular, but is now favored by 57% of managers, down from 64% three months ago. "Growth" stocks are those whose earnings are growing faster than the market average. Despite the gloom, managers signaled that they're not bracing for a long recession. U.S. small-company stocks, which tend to perform well coming out of economic downturns, earned higher marks than three months ago. Since investors tend to gravitate toward large-company stocks in times of uncertainty, small caps have been severely punished during the credit crisis, says Paulo Silva, portfolio manager at Penn Capital Management in Cherry Hill, N.J. Now, he says, "some small-cap names seem to be becoming more attractive." Managers backed away from some traditionally defensive stock-market sectors. Just 54% are bullish on health-care stocks, for example, down from 71% last quarter, while 37% favor consumer staples, down from 47%. Technology, backed by 68% of managers, replaced health care as the most-favored stock sector. "People are beginning to eliminate the worst-case scenarios," says Erik Ristuben, Russell's chief investment officer for multistrategy solutions. "A profound recession is being taken out of the mix." Some survey results suggest managers are looking for the dollar to end its long slide. Managers lost enthusiasm for integrated oils and other energy stocks. Since oil is commonly priced in dollars, the falling greenback has boosted its price of late. "If dollars aren't devaluing, that's one less pressure point on the price of oil," Mr. Ristuben says. And foreign developed-market stocks, which have posted solid returns over the past several years, thanks largely to a falling dollar, are favored by just 42% of managers. That's down from 54% last quarter and a record low in the four-year history of the survey. Expectations of slower growth in places like the U.K. and continental Europe also colored managers' views of foreign developed-market stocks, Mr. Ristuben says. Managers are more confident in emerging-market stocks, which are favored by 49%, up from 46% three months ago. Though many emerging-market stocks have tumbled this year, developing economies "are the ones showing the most growth going forward," Mr. Silva says. Managers also signaled an expectation that U.S. interest rates will rise. Just 14% of managers favor U.S. Treasurys, down from 23% three months ago, while 27% are bullish on corporate bonds, down from 37%. Bond prices generally drop as yields rise. As managers backed away from defensive investments, they also lost enthusiasm for cash, now favored by 24%, down from 31% in the first quarter.

 

June 24, 2008

CREDIT MARKETS

DOW JONES REPRINTS This copy is for your personal, non-commercial use only. To order presentation-ready copies for distribution to your colleagues, clients or customers, use the Order Reprints tool at the bottom of any article or visit: www.djreprints.com. • See a sample reprint in PDF format. • Order a reprint of this article now. Junk Investors, Look Out if Defaults Rise Moody's Suggests Loan Recoveries Will Be on Low Side By LIZ RAPPAPORT June 24, 2008; Page C5 Investors in loans made to junk-rated U.S. companies could be surprised by how little they get back if borrowers start defaulting. A report to be published Tuesday by Moody's Investors Service argues that the explosion of loans issued by junk-rated companies in the past few years means that if they default, the recoveries on these loans might be less than in the past. The highest-priority loans, called first-lien senior secured bank loans, will likely recover on average 68 cents on the dollar upon default in this downturn, compared with a historical average of 87 cents, Moody's said. Typically, loan holders are considered the senior creditors when a company defaults, so they are the first lenders in line for a company's assets. But because companies issued so much of this debt, the loan holders will likely get back less than they have in the past, according to the report. Companies issued so much of this debt because it was popular with investors after the tech bubble burst, and the loans held up well during the previous downturn. Now, Moody's expects loan investors to fare almost as badly as investors in riskier junk bonds have done in previous busts. "It doesn't matter what you call something," says Kenneth Emery, author of the report. "What matters is where you sit in the liability structure." Since 2004, the number of junk-rated companies that borrowed money only in the loan market has doubled, according to the report. Now, these loan-only issuers amount to a third of all U.S. junk companies. Wall Street packaged these loans into popular structured-investment vehicles called collateralized loan obligations, which were among the biggest buyers of leveraged loans. Since the credit markets faltered last summer, loans have already logged unprecedented declines in their value as the M&A boom left a hefty pile of unsold loans hanging over the market. About $173 billion of that has been sold off since July, leaving $64 billion, according to Standard & Poor's Leveraged Commentary & Data. Valuations have improved, putting the average loan price back to 93 cents on the dollar from a low point earlier this year of 86 cents. But corporate defaults are expected to rise amid the economic slowdown and tighter lending standards by banks and other creditors. Weak recoveries don't help prospects for investors or for managers of collateralized loan obligations, which bought about 60% of the loans issues in the past few years. The credit-ratings agencies expect corporate defaults to rise to at least 5% by year end. "It's going to be 18 to 24 months before we slog through these pending defaults and get back to a more normal market," says Michael Bacevich, co-head of leveraged credit at Hartford Investment Management, which manages loan funds and collateralized loan obligations. Moody's also says second-lien, or low priority, loan holders are expected to recover just 21 cents on the dollar in this cycle, compared with 61 cents historically. Senior unsecured junk bonds are likely to recover 32 cents on the dollar compared with a 40-cent historical average. According to Standard & Poor's, the market is already showing investors expectations for weak recoveries on recent bankruptcies. California real-estate development entity LandSource Communities Development filed for Chapter 11 bankruptcy protection earlier this month, and its loans are trading at about 75 cents on the dollar. Its second-lien debt was most recently priced in the high teens, says S&P. For the 19 loans that have defaulted this year, the average price immediately after the default was 70 cents on the dollar, much lower than the average 91 cents during pre-2007 boom times. Ten-Year Treasury Falls Treasurys lost ground Monday as the stock market held relatively stable. The benchmark 10-year note fell 8/32 point, or $2.50 for every $1,000 invested, to yield 4.168%. That's up from 4.136% Friday as bond yields rise when prices fall. The government sells $30 billion in two-year notes Tuesday.

June 24, 2008

DOW JONES REPRINTS This copy is for your personal, non-commercial use only. To order presentation-ready copies for distribution to your colleagues, clients or customers, use the Order Reprints tool at the bottom of any article or visit: www.djreprints.com. • See a sample reprint in PDF format. • Order a reprint of this article now. Hedge Funds Get a Lesson Bear Indictments Prompt Review of Operating Procedure By JENNY STRASBURG June 24, 2008; Page C3 The indictment last week of two former Bear Stearns hedge-fund managers has potential for a second act no matter how the case ends -- as a manual for handling sensitive hedge-fund issues, ranging from questions about redemptions to the proper use of email. Corbis Former Bear Stearns manager Ralph Cioffi (left) after his arrest. When the window for withdrawals opens during tough markets, like this one, the tug-of-war intensifies between hedge-fund investors hungry not only for information about fund performance but also about whether co-investors are jumping ship or staying the course. The Bear Stearns-funds indictment alleges that, last spring, as hedge-fund manager Ralph Cioffi addressed the issue of redemptions on an investor conference call, he misled listeners about investors' redemption plans and didn't reveal his decision to pull some of his own money from the fund. He and his co-defendant, Matthew Tannin, are fighting the charges and maintain their innocence. Bear, after its near-collapse, is now part of J.P. Morgan Chase & Co. "This case has hedge-fund managers talking about how they handle conversations about what the future could be for their funds," says Jahan Raissi, a former Securities and Exchange Commission enforcement attorney who's now a lawyer focused on securities law in San Francisco. Messrs. Cioffi and Tannin managed funds whose holdings in mortgage-backed securities plummeted in mid-2007, eventually costing investors in the Bear Stearns funds $1.6 billion. The June 18 federal indictment alleges that the men misled investors about the health of their portfolio and their financial interests in the funds and investor redemptions. •  The News: The hedge-fund industry has been buzzing about a criminal indictment against two former Bear Stearns hedge-fund managers. •  The Issues: What are "best practices" for sharing information with investors about redemptions, and for internal communications? •  What's Next: Lawyers say hedge funds are looking at the indictment for lessons and training applications. The indictment alleges that, as Mr. Cioffi referred to the redemptions as "the big -- obviously, the question that we've been getting from a number of investors," he failed to tell investors about more than $50 million in withdrawals about to hit the funds last spring but instead said "I believe we only have a couple million of redemptions for the June 30 date." Mr. Cioffi also allegedly kept silent about $2 million he personally had pulled from one of the funds, according to the indictment. He reinvested that money in another, new Bear Stearns hedge fund investing in structured debt so that he would be taking risks alongside investors in that fund also, according to people familiar with his actions. Also, these people say, the managers believed that some clients who had put in redemptions planned to change their minds and keep money in. Lawyers say that in general hedge-fund managers have few legal obligations regarding disclosure beyond telling the truth. Some managers have partnership agreements in place, especially with powerful pension funds and other big investors, promising more-detailed disclosure, such as saying when hedge-fund managers withdraw their own money. At the same time, managers tend to want to avoid being too specific about how much money is walking, for fear of causing a crisis of confidence that leads to more withdrawals. "Managers almost always play very close to the vest what their redemptions are looking like coming up to the deadline for redemption requests, and the worse things get, the more cagey they get," says Scott Baker, a principal at Cook Pine Capital, a Greenwich, Conn., firm that has about $200 million in client money invested with hedge funds. "I pretty much want to hear a hard number for redemptions, and the managers you trust most will give you that." Disclosure obligations generally boil down to the materiality of the information in question, lawyers say. "Would a reasonable investor find that information useful in making an investment decision -- to stay in or get out?" says attorney Jay Gould, head of the hedge-funds practice at Pillsbury Winthrop Shaw Pittman LLP in San Francisco. Absent a clearly agreed-upon obligation to disclose the amount of redemptions or requested withdrawals, the cardinal rule is to avoid misleading investors, says Mr. Raissi. "If the redemption number's $50 million you can't say it's $5 million." Some managers guarantee investors that partners will keep a certain minimum amount of their own money -- say, 10% of a fund -- invested at all times. The Bear funds case has prompted discussions about making such language less precise so that partner withdrawals are less likely to require disclosure to clients. One manager of a fund with more than $10 billion recently postponed a planned withdrawal, because investors are particularly sensitive to such moves in this market, according to a person familiar with the situation. The indictment spotlights the case for email restraint, some lawyers add. The document quotes emails in which the defendants articulate their fears of the market -- in one instance calling the outlook for subprime investments "toast." The case has reignited discussions among hedge-fund lawyers and executives about doing more-frequent cleanups of computer systems to wipe out emails. Two lawyers for two hedge-fund firms with combined assets of more than $25 billion said they've tried to ban the use of the popular Bloomberg messaging system for anything but the most innocuous statements, such as about meeting times or lunch plans. Bloomberg retains all messages sent through its terminals for at least five years, according to a spokeswoman for the New York company. The spokeswoman says that more than 52 million messages are sent daily over Bloomberg and that financial professionals like the system's speed and compliance features, among others.

 

	June 24, 2008

HEARD IN ASIA

DOW JONES REPRINTS This copy is for your personal, non-commercial use only. To order presentation-ready copies for distribution to your colleagues, clients or customers, use the Order Reprints tool at the bottom of any article or visit: www.djreprints.com. • See a sample reprint in PDF format. • Order a reprint of this article now. Whither Beijing's Golden Touch? With Government Keeping Hands Off, China Market Falls June 24, 2008; Page C2 BEIJING -- China's stock-market swoon has sent the benchmark Shanghai Composite Index down by more than half in eight months to below the 3000 level, where many investors had assumed the government would intervene to provide support. But the hoped-for support hasn't come, and some analysts argue that the government's ability to rejuvenate stocks is dwindling. Repeated government intervention over the history of China's 18-year-old stock market has conditioned investors to expect that the government will step in when things get ugly -- or to cool stocks when they threaten to overheat. An online survey conducted by state-run broadcaster China Central Television and several Web sites during a 24-hour period last week found that 75% of the nearly 765,000 respondents expected new government measures to rescue the market. Beijing is always on guard for the possibility that financial or economic shocks could trigger public discontent -- an anxiety heightened by the desire to avoid any problems ahead of the capital's hosting of the Olympics in August. "It's time for the government to take some concrete measures to show the investors that the government pays great attention...to the health of the capital market," says Yuan Dejun, a senior economist with Beijing-based China Galaxy Securities. Beijing already has taken several steps this year to try to bolster market sentiment. In an effort to calm fears that a flood of new shares would dilute already weak prices further, it announced on April 20 stricter limits on the sale of a large category of stock that was becoming newly tradable. Three days later, it cut a tax on stock trades to 0.1% from 0.3% -- after having raised the tax in May 2007 to try to calm a market that was then soaring. But the effect of both moves was limited and short-lived, and stocks have continued to plunge, as investors worry about the impact of a global economic slowdown as well as Beijing's own efforts to tamp down surging inflation. The Shanghai Composite had its worst single-week drop in 12 years this month, falling 13.8% in the week ending June 13. On Monday, it closed at 2760.42, down 2.5% on the day and down 55% from its record close in October. "The government's interventions in the last six months have not had any lasting impact and, by encouraging investors to second-guess official intentions, they may have increased volatility," Mark Williams, an analyst from Capital Economics, said in a June 8 report. The government is likely to continue looking for ways to turn the market around. The People's Bank of China said in a recent report on financial stability that the central bank will pay "close attention to the market's development so as to improve the operation system of the stock market," and that the government "needs to take some fiscal and financial policies" to "effectively adjust market demand, and avoid big fluctuations of the stock market." One option analysts suggest Beijing could try is to speed up the awarding of quotas under its qualified foreign institutional investors, or QFII, system for allowing overseas capital into its tightly regulated domestic Class A share market. The total quotas available were raised to $30 billion in December from $10 billion, but as of April, the China Securities Regulatory Commission had approved a total of only $10.57 billion in quotas for 54 QFII institutions. In May, it issued quotas to two more companies, for which the amounts weren't disclosed. Theoretically, the arrival of additional capital from foreign investors hungry for China exposure should fuel demand for stocks. But Ha Jiming, chief economist of China International Capital Corp., a Beijing-based investment bank, is doubtful that expansion of QFII can really pull up stocks. "Just like with domestic investors, foreign investors have to look at fundamental factors before they invest in China stocks," says Mr. Ha, who points to signs of slowing in China's economy as one reason for the gloom affecting stocks. He expects gross domestic product will expand 10.3% this year and slow to 9.5% growth next year. Qiu Yanying, a Shanghai-based analyst with TX Investment Consulting Co., said the government could try to better guide investors' expectations for the stock market through more public statements. That might relieve the current panic among some investors and slow the downward trend, he said. But many investors have already lost confidence in government. "This time, we don't expect the government will be able to do something to boost market," says Ma Qianli, a small investor in Beijing. He thinks the government might have been able to turn things around if it had acted sooner, but now "it's already too late." "The issues that are now plaguing Chinese stocks cannot simply be solved through some government measures, as the key reason behind it lies on the fundamental factors" like the ongoing tightening of monetary policy, says Cheng Weiqing, a Beijing-based strategic analyst with Citic Securities. He says he anticipates a gradual recovery of the market starting near the end of this year, regardless of what steps the government takes in the interim.

 

	June 24, 2008

AHEAD OF THE TAPE By MARK GONGLOFF

DOW JONES REPRINTS This copy is for your personal, non-commercial use only. To order presentation-ready copies for distribution to your colleagues, clients or customers, use the Order Reprints tool at the bottom of any article or visit: www.djreprints.com. • See a sample reprint in PDF format. • Order a reprint of this article now. Driving Away Oil Speculators May Not Help June 24, 2008; Page C1 Talk about a waste of energy: Rather than pursuing constructive responses to $140-a-barrel oil and gasoline at $4 a gallon, we're chasing scapegoats. In congressional hearings Monday, witnesses and lawmakers decried the role of speculators in energy markets. Various proposals are pending to hamstring or banish them. The theory is that if we could only drive these people out of the market, the gas station would be a welcoming place for Hummers again. It's a comforting thought but lacks clear evidence. There's no sign of the hoarding that often accompanies wanton speculation or market manipulation. And prices are rising just as quickly in commodities mostly shielded from speculation, such as cadmium and rice. Still, assume for a moment there's truth to it. Doing something about it would require identifying the speculators. That's slippery, too. The Commodity Futures Trading Commission calls anybody who "does not produce or use the commodity, but risks his or her own capital trading futures in that commodity in hopes of making a profit on price changes," a speculator. That's an awful lot of people, including not only momentum traders but long-term investors with arguably less interest in pumping and dumping. If speculators account for 70% of Nymex oil trading, as critics note, then their disappearance would make the market less liquid and potentially more volatile, creating headaches for oil producers and users, notes Stephen Schork, editor of an energy newsletter. Driving them out of the market seems highly unlikely to slash the price of oil in half, as some congressional witnesses suggested. Michael Bordo, a Rutgers University financial historian, points out speculators always find a way to speculate. If barred from U.S. commodities markets, they will trade elsewhere, keeping prices high while taking business from the Nymex. They always get blamed for bubbles and panics, and sometimes they deserve it. That's not clear in this case, and stopping them might do more harm than good. Great Depression Home-Price Declines This week's additions to the grim annals of the housing bust include data on home prices and profit results from Lennar and KB Home. The Standard & Poor's/Case-Shiller home-price index, which reflects prices in 20 U.S. cities, is expected Tuesday to be reported down 16% in April from a year earlier, worse than March's 14.4% decline. "Most of the severe price declines are appearing now," says Mark Zandi, of Moody's Economy.com, who says house prices are down nationwide about 15% from their 2006 peak. With heavy inventory still to plow through, "I expect prices, when all is said and done, will be down about 25% this time next year," he says. That skid off the peak would rank it on par with the Great Depression. Lennar is expected to post a loss of 85 cents a share, compared with a loss of $1.55 last year, when it reports on Thursday. KB Home is expected to report a loss of $1.28 a share on Friday, compared with last year's $1.93 loss. --Karen Richardson Email mark.gongloff@wsj.com1 or karen.richardson@wsj.com2

 

	June 24, 2008

BOOKS

DOW JONES REPRINTS This copy is for your personal, non-commercial use only. To order presentation-ready copies for distribution to your colleagues, clients or customers, use the Order Reprints tool at the bottom of any article or visit: www.djreprints.com. • See a sample reprint in PDF format. • Order a reprint of this article now. Bookshelf Free to Choose, But Often Wrong By DAVID A. SHAYWITZ June 24, 2008; Page A17 Sway By Ori Brafman and Rom Brafman (Doubleday, 206 pages, $21.95) Flirting With Disaster By Marc Gerstein, with Michael Ellsberg (Union Square, 340 pages, $24.95) Consider Linda, a 31-year-old woman, single and bright. As a student, she was deeply concerned with discrimination and social justice and also participated in antinuclear protests. Which is more probable? (a) Linda is today a bank teller; (b) Linda is a bank teller and active in the feminist movement. When psychologists Daniel Kahneman and the late Amos Tversky conducted an experimental survey in the early 1980s asking people to answer this simple question, they discovered, to their surprise, that most respondents picked "b," even though this was the narrower choice and hence the less likely one. It seems that saliency – in this case, Linda's passionate political profile – trumps logic. Over the past quarter-century, Mr. Kahneman and his colleagues have gone on to identify a range of flaws in our critical faculties, reshaping the study of economics by challenging the assumption that a person, when faced with a choice, can be counted on to make a rational decision. While Mr. Kahneman (who received the Nobel Prize in economics in 2002) has confined most of his writing to academic journals, his ideas have found their way into popular culture through books such as Barry Schwartz's "The Paradox of Choice" and Nassim Taleb's "The Black Swan." "Sway," by brothers Ori and Rom Brafman, is the latest addition to this literature. It offers a breezy introduction to the science of decision-making and shows the many ways in which logical thought can be subverted or "swayed." Loss aversion, for example, may explain why car rental companies persuade us to purchase gratuitous insurance or why flat-rate telephone plans are so popular even when they end up costing us more. Value attribution – transferring "value" signals from one thing to another – may explain why hot-dog sales at the Coney Island food stand of "Famous Nathan" Handwerker shot up when he recruited local doctors to shop there while wearing their white coats and stethoscopes. Procedural justice may be the reason why venture capitalists favor the entrepreneurs who communicate with them most; a willingness to observe the dictates of process is taken as a proxy for quality. Some examples in "Sway" are less forceful than others. It seems a bit much, for instance, to blame value attribution for the failure of morning commuters to applaud a virtuoso violinist performing in jeans and a baseball cap at the entrance to a subway station. A simpler explanation: People were in a hurry to get to work. But the pacing of "Sway" is so fast that even questionable examples are gone in seconds, and soon you're on to the next, perhaps more enlightening, vignette. While the Brafmans are amused by our irrationality, Marc Gerstein is troubled by it and wants to understand why we have such difficulty recognizing our mistaken thinking before it is too late. In "Flirting With Disaster," Mr. Gerstein (assisted by Michael Ellsberg) explores the psychology underlying a series of disasters, including the Challenger explosion, the flooding of New Orleans, the collapse of Arthur Andersen and the fall of Long-Term Capital Management, a hedge fund run by supposed "geniuses." Mr. Gerstein believes that each disaster resulted from a series of bad decisions that could have easily been avoided. Why weren't they? In some cases, such as the 1981 collapse of the skywalk of the Kansas City Hyatt Regency, the central problem was a design change that was not properly evaluated. In New Orleans, bureaucratic inertia stripped the intensity from a series of urgent warnings. Another source of danger is the conviction that sophisticated models will enable us to capture complexity and defeat uncertainty. Long Term Capital fell as a result of such hubris. Mr. Gerstein is passionately interested in people and is profoundly disappointed when they behave badly; he is especially critical of bystanders – workers who know enough to speak out but who decide not to do so or who stop short of preventing a bad thing from happening. For Mr. Gerstein the question isn't just why NASA pushed for a Challenger launch over the objections of its engineers; he also wants to understand why the engineers relented despite their obvious concerns. Similarly, he is frustrated by employees at Arthur Andersen who reported gross irregularities to their managers but simply gave up when their complaints were ignored. Mr. Gerstein concludes that there are too many disincentives to speaking up; he would like to see more whistleblowers. He would also like us to pay more attention to warnings from experts. An important question raised by "Flirting With Disaster," though, is whether unheeded expert warnings are either as significant or as potentially useful as he implies. It seems probable that there is an element of selection bias here: Such warnings may be extremely common, especially in high-risk activities such as space flight or options trading – we just notice them when they happen to be both ignored and right. Moreover, the distinction between good ideas and dangerous ones – or between good leaders and bad – is seldom as clear as Mr. Gerstein would have it. Decisions must often be made with imperfect information. Clearly, a balancing act must be performed each time a rocket is set to launch, each time a new drug or medical device is introduced, and, for that matter, each time a decision is made. There is always a trade-off between action and reflection. Even if we could address every conceivable concern, disasters would still occur (after all, we can't think of everything) – only they would be accompanied, in the long run, by considerably less innovation and progress. As Mr. Gerstein urges, though, we could all do more – in our personal and professional lives – to reduce error, learn from mistakes and resist the passive acceptance of a flawed status quo. The question is whether we're rational enough to respond to the challenge. Dr. Shaywitz is a management consultant in New Jersey. See all of today's editorials and op-eds, plus video commentary, on Opinion Journal1.

 

	June 24, 2008

OPINION

DOW JONES REPRINTS This copy is for your personal, non-commercial use only. To order presentation-ready copies for distribution to your colleagues, clients or customers, use the Order Reprints tool at the bottom of any article or visit: www.djreprints.com. • See a sample reprint in PDF format. • Order a reprint of this article now. Watch Out for Sovereign Debt Risk By CARMEN M. REINHART and KENNETH ROGOFF June 24, 2008; Page A17 Optimists say that emerging-market defaults are a thing of the past. Emerging markets today, the argument goes, are relying more on domestically issued local currency debt, both inflation-indexed and non-indexed. This means their debts are far more stable and reliable than in the recent past, when a much larger share of government debt was issued externally and denominated in hard currency. This argument is wrong. In the past, the combination of high levels of domestic debt and inflation surges has often proven deadly for both foreign and domestic investors. Just look at Argentina today, a country not nearly as prosperous as its abundant natural resources would warrant. Already, a good share of Argentina's debt is in default. What else do you call it when a government that owes over $30 billion in inflation-indexed debt manipulates its consumer-price statistics? Through a variety of crude measures (such as firing its top statisticians), the government is publishing an understated inflation rate that is used for calculating indexation payments. The official inflation rate in Argentina for the past 12 months is under 10%. But the true inflation rate appears to be at least 30%, according to virtually every neutral source. Fudging indexation clauses to effectively default on debt is an old game. During the second half of the 1980s, Brazil abrogated inflation-indexation clauses embedded in its debt contracts. In the Great Depression, the U.S. government revalued gold to $35 per ounce from $20, effectively rewriting the contracts of foreign holders of U.S. debt. If external debt holders think that abuse of domestic debt holders is no cause for alarm, they should think again. Governments do not usually cheat holders of only one type of debt. In April, we published a National Bureau of Economic Research paper based on centuries of debt data from many countries. We found that most countries default on external debt only a bit less freely than on domestic debt. That is, contrary to popular belief, domestic debt holders are not necessarily a cushion for "senior claimants" holding externally issued debt. Over the course of history, emerging-market economies have had a hard time shaking off serial default. Each period of quiescence has been invariably followed by more turmoil, with the share of total countries in the world in default sometimes exceeding 40%, as it did during the mid-19th and 20th centuries. Considering the duress of domestic bond holders across the world as global inflation rises, it is surprising that both private investors and multilateral international financial institutions seem so complacent about the rising risks of defaults on external debts. The "this time is different" mentality is based on two mistakes. The first is the idea that domestic debt is something new. The other is the faulty economic logic that payments to domestic debt holders come out of a different pot than payments to external debt holders. There have been many episodes in the past where rising levels of domestic debt have sharply raised risks to external debt holders. There is nothing new about the rise of domestic debt markets. They are simply growing again after a bout of suppression during the high-inflation 1980s and 1990s. Earlier eras offer scant evidence that external creditors have been much safer than domestic debt holders. When India effectively defaulted on its domestic debt through massive inflation and financial repression in the early 1970s, external debt holdings suffered payment reschedulings even though they constituted only a tiny fraction of overall debt. Emerging markets could be in much greater trouble than the optimistic consensus suggests. If today's tepid growth in the U.S., Japan and Europe begins to take hold in emerging markets, Argentina's miserable indexed bond holders may soon have company. Ms. Reinhart is an economics professor at the University of Maryland, and Mr. Rogoff is an economics professor at Harvard. See all of today's editorials and op-eds, plus video commentary, on Opinion Journal1. And add your comments to the Opinion Journal forum2.

 

	June 24, 2008

PAGE ONE

DOW JONES REPRINTS This copy is for your personal, non-commercial use only. To order presentation-ready copies for distribution to your colleagues, clients or customers, use the Order Reprints tool at the bottom of any article or visit: www.djreprints.com. • See a sample reprint in PDF format. • Order a reprint of this article now. U.S.-Backed Mortgage Program Fuels Risks FHA Struggles To Eliminate Loans For Zero Down By NICK TIMIRAOS June 24, 2008; Page A1 Mortgages that allow consumers to put little if any money down when buying a home have largely disappeared as a financing option available from private lenders. But they are still available -- and growing more popular -- through a government-backed program. That's raising concerns among critics who blame no-money-down mortgages for many of today's housing market woes. And while federal housing officials are moving to end the practice, for now home builders are promoting the programs to move unsold inventory. "I just smell a massive taxpayer burden coming," says Sen. Christopher Bond (R., Mo.), who calls the programs "too good to be true." The offers -- including "100% financing" -- are made possible due to down-payment assistance programs run by nonprofit organizations. These programs are funded largely by home builders and also by private homeowners desperate to sell. The seller-funded groups provide enough down-payment money to buyers that they can qualify for a mortgage backed by the Federal Housing Administration, which requires at least a 3% down payment. Supporters of the down-payment programs say they help the FHA fulfill its goal of assisting first-time home buyers. But critics say the programs will burden the government agency, and taxpayers, with bad loans. The FHA, which essentially is filling the void left by the collapse of the subprime market, renewed a push to eliminate the programs this month, after warning that above-average default rates for seller-assisted down-payment programs will force the agency to request a government subsidy for the first time in its 74-year history. The agency says it will need $1.4 billion next year. The FHA estimates that down payments provided by nonprofit groups account for 34% of all 200,000 loans backed by the FHA so far this year, up from 18% in all of 2003 and less than 2% in 2000. And the agency says that borrowers are two to three times as likely to default on their payments when they receive a down payment from a nonprofit. D.R. Horton Inc., the nation's largest home builder by volume, is touting "100% financing" for its two- and three-bedroom condominiums near the beach in Maui, Hawaii, which start at $498,000. In the Seattle area, local builder Quadrant Corp. is advertising townhouses that can be purchased with as little as $500 down. "Use your coffee budget to move into a new home," says an online promotion. In the St. Louis area, Vantage Homes recently promoted its suburban developments with ads suggesting a new home should be on the list of things to buy for those "looking for something to spend your economic stimulus check on." Vantage Homes tells prospective homebuyers that they can afford a new house with down payment assistance by cashing in their economic stimulus check. A flier promoting D.R. Horton's Maui development, for example, says that funds for the down payment would be provided by Nehemiah Corp. of America, the largest private down-payment assistance provider. D.R. Horton, based in Fort Worth, Texas, didn't return calls seeking comment. Scott Syphax, president and chief executive of Nehemiah, a nonprofit organization, said D.R. Horton is one of 95,000 companies and individual home sellers that have participated in the assistance program. To critics, mortgages with down-payment assistance are similar to no-money-down subprime loans, which have triggered a wave of foreclosures. Most bankers believe defaults are so high because borrowers who encounter financial difficulties are more willing to walk away from a home when they didn't put much of their own money into the purchase. "The inescapable fact is that seller-funded down-payment assistance is particularly susceptible to losses," says Howard Glaser, a mortgage-industry consultant and former official at the Department of Housing and Urban Development. "Too often today's seller-funded loan is tomorrow's foreclosure." Stalled Home Sales Several years ago, during the height of the housing boom, some of the nation's biggest builders curtailed use of seller-funded assistance programs because lenders offered 100% financing, often via their subprime divisions. But home builders are again embracing the programs because home sales have stalled, the subprime market is largely shut and traditional lenders are requiring large down payments. Under the down-payment assistance programs, a third-party nonprofit provides the money to the buyer and is then reimbursed by the seller. The seller's contribution to the program isn't tax deductible as a charitable contribution. FHA regulations prohibit sellers from providing direct cash gifts to buyers, due to concerns that the value will be added to the price of the home, inflating its value. Home builders say touting no- or low-money-down financing helps bring in new customers, even if they ultimately choose more conventional financing. "The bottom line...is these promotions work," John F. Eilermann Jr., chief executive of McBride & Son Enterprises Inc., the parent company of Vantage Homes, said in an email. He said the current marketplace demands flexibility, and he credits "creative marketing," such as promotion of its $500-moves-you-in program, with increasing new home sales in 2007 from the previous year. Advocates of down-payment assistance say the programs are also good for the broader economy. Nehemiah's Mr. Syphax calls the FHA program an "economic stimulus." Home builders fear that eliminating the programs will cripple sales. "It would chill the market here," says Jeff Johnson, sales manager for Maracay Homes in Phoenix. Dick Whitmore, a 47-year-old construction superintendent in Phoenix, put up just $250 to move into a three-bedroom home that he purchased in March for $189,000. He says the down payment and closing costs, which came to about $12,000, were paid by the family selling the home via AmeriDream Inc., a down-payment-assistance program based in Gaithersburg, Md. "My wife and I are hardworking people, but to come up with five or six grand, that's next to impossible," he said. To sell Maui condos, home builder D.R. Horton touts its relationship with Nehemiah Corp., a seller-funded down payment assistance provider. Gloria Harris, a 57-year-old human-resources consultant, says she couldn't have bought her $216,000 two-bedroom condo in McLean, Va., in January without the $16,000 contributed by the seller to cover the down payment and closing costs. "I was having a hard time just trying to save because I was spending from week to week trying to live," she says. Avoiding ARMs To be sure, the overwhelming majority of subprime loans in default are adjustable-rate mortgages. FHA-backed loans, including those with down-payment assistance, are fixed-rate loans with income verification requirements, which have better track records. In Washington state, Quadrant Homes' Web address, www.500movein.com1, spells out its promotion for little money down on new homes. Assistance providers say their products helped keep low-income families away from subprime loans that reset to higher rates. The FHA had as recently as 2005 warned that eliminating seller-funded down payments would leave borrowers with "options that are more costly and riskier than FHA." They also reject criticism that they are responsible for the FHA's recent shortfall. "We are a convenient scapegoat," says Mr. Syphax. Seller-funded groups and supporters in Congress say that such programs should be regulated but not shut down, a proposal that HUD hasn't shown much interest in in recent years. "If there's a problem, let's fix it," says Rep. Gary Miller (R., Calif.), a vocal defender of the program and a former home builder and developer. In the past, nonprofit groups have consistently outmaneuvered Congress and the regulatory agencies that have tried repeatedly to shut them down, thanks in part to a well-coordinated lobbying effort by a coalition of the nonprofit companies, low-income housing and minority groups and home builders. "I have holes on my shoes from walking around Washington," says Mr. Syphax. The two sides have a long history of doing battle. Housing officials backed down from a fight in 1999, and earlier this year courts rejected a similar attempt to shut down the program. The nonprofit groups have the backing of several influential members of Congress, including Reps. Maxine Waters (D., Calif.) and Barney Frank (D., Mass.). The Congressional Black Caucus and the Congressional Hispanic Caucus sent letters this month to House and Senate leaders urging that the programs stay intact, citing their role in improving minority home-ownership rates. In current versions of the FHA modernization bill, the Senate would eliminate the down-payment programs and a vote on the bill is expected this week; the House version keeps the program in place. Rep. Frank said in an interview that he believed a compromise could be reached with the Senate that would preserve the program but with tougher lending requirements. "No one is talking about leaving it untouched," he says. Write to Nick Timiraos at nick.timiraos@wsj.com2

 

	June 24, 2008

DOW JONES REPRINTS This copy is for your personal, non-commercial use only. To order presentation-ready copies for distribution to your colleagues, clients or customers, use the Order Reprints tool at the bottom of any article or visit: www.djreprints.com. • See a sample reprint in PDF format. • Order a reprint of this article now. SEC Aims to Rein In The Role of Ratings By AARON LUCCHETTI, KARA SCANNELL and CRAIG KARMIN June 24, 2008; Page C1 The Securities and Exchange Commission plans to propose rules that may diminish the longstanding importance of credit ratings across various markets, including the $3.4 trillion money-market industry, in the latest blow to the rating business stemming from the credit crunch. The most significant portion of the rules, to be proposed Wednesday, would make it possible for U.S. money-market funds to invest in short-term debt without regard to ratings put on those securities by firms such as Moody's Investors Service and Standard & Poor's, people familiar with the matter said. Currently, SEC rules generally require that money-market funds purchase only short-term debt with high investment-grade ratings. The new rule would put more discretion in the hands of money managers to determine whether the debt is investment grade. The SEC also will propose rules that may diminish the importance of credit ratings in determining the amount of capital that investment banks are required to hold. In all, the proposal will put about a dozen changes on the table that could touch on the role of credit ratings for investors and banks. An SEC spokesman couldn't be reached for comment. The renewed effort is part of a wide-ranging regulatory push in the U.S. and Europe amid the credit crunch that has devastated many banks and investors. Major rating services -- Moody's Corp.'s Moody's Investors Service, McGraw-Hill Cos.' Standard & Poor's and Fimalac SA's Fitch Ratings -- have been blamed by some for underestimating the risk of default on hundreds of billions of dollars of mortgage debt. The dirty secret of some bond investors is that they simply bought securities with the highest yield for a given rating, which is why they snapped up complicated securities tied to subprime mortgages. Those securities often got high ratings but yielded more than other, more standard securities with the same rating. In 2003, the SEC asked the industry and investors for comment on similar changes to money-market funds and capital rules, but the ideas never went anywhere and were shelved amid mixed reviews. As the current credit crisis has unfolded, regulators have grown concerned that the reliance on ratings in various market rules gives investors a sense of false comfort, discouraging them from doing their own research when assessing the riskiness of bonds in their portfolios. By diminishing the role of ratings, they hope to reverse that. S&P, Moody's and Fitch declined to comment on the pending proposal. The proposals are expected to generate divided comments from investors and also may affect a range of other SEC provisions. "My initial reaction is, what's the alternative?" to using rating firms for the rules, said Hal Scott, a Harvard University law professor specializing in capital-markets regulation. "What we need to do is have more assurance that these ratings will be accurate." SEC Chairman Christopher Cox said at a recent hearing on rating firms that their role in the regulatory apparatus "may have played a role in encouraging investors' over-reliance on ratings." Despite the backlash against rating firms, their assessments of bonds still play a central role in decisions made by banks and investors. Last week offered the latest example, when Moody's downgraded the debt of bond insurers MBIA Inc. and Ambac Financial Group, triggering a selloff in the companies' stocks and fears of forced sales of bonds insured by the two companies. Regulators also depend on them. The Federal Reserve, after it arranged a sale of Bear Stearns Cos. to J.P. Morgan Chase & Co., said the Federal Reserve Bank of New York would take as collateral some illiquid, beaten-down assets from investment banks, but only if the assets were rated highly by rating firms. Other international codes such as Basel II also use ratings to determine how global banks manage their balance sheets. Investors have had similar rules on their books for decades that require they only buy bonds the major rating firms grade at a certain level or above. Some may now expand the list of rating firms they can use for such rules to include new firms. In an effort to create more competition in the rating industry, on Monday the SEC recognized a 10th bond-rating firm, Realpoint LLC, a former unit of GMAC. Institutional investors such as pension funds are looking to make changes in their ratings-based rules. The Illinois State Board of Investment, for example, recently requested more information from its money managers about their approach to buying bonds such as mortgage-backed securities. William Atwood, executive director of the $12 billion fund, said he would be reluctant to give new money to those managers who rely heavily on the ratings firms. "We've got to pay closer attention," said Richard Metcalf, director of corporate affairs at the Laborers' International Union of North America, which advises pension funds. "If that means creating additional levels of scrutiny of the process, we will do that." If regulatory changes succeed, ratings would become more of a guide, but not a quasi-regulation from the government on what investors can or cannot hold. Rating firms haven't protested this line of thinking, saying that they don't want their ratings to be misinterpreted as a catch-all recommendation to buy a security. While many investors and large institutions say they don't rely on ratings, recent lawsuits from holders of battered mortgage-related debt show that at least some used them extensively. In a lawsuit filed this month against Deutsche Bank AG, Buffalo, N.Y.-based M&T Bank Corp. said it had written down the value of two collateralized debt obligations by more than 90%. "The AAA and AA ratings were major considerations in M&T's determination to invest," the bank argued in its suit, "because they indicated that the notes were safe, stable, and nearly risk-free investments." M&T didn't sue the rating firms, saying they were misled. Deutsche Bank declined to comment. Write to Craig Karmin at craig.karmin@wsj.com1