It’s Just a Matter of Equity

By GRETCHEN MORGENSON

Published: September 16, 2007

The moribund private equity market stirred a bit last week as Kohlberg Kravis Roberts dredged up some buyers for loans to finance its $22 billion purchase of Alliance Boots, a British drugstore chain. But lingering investor wariness toward private equity maestros and their deals is far from the only problem facing the buyout business. There are graver threats that are, no surprise, the industry’s own making.

This is not just your humble research assistant talking. It is the view of Michael C. Jensen, professor emeritus at the Harvard Business School, leading scholar in finance and management, and the man whom many consider to be the intellectual father of private equity. In other words, a person uniquely qualified to opine on the matter.

“We are going to see bad deals that have been done that are not publicly known as bad deals yet, we will have scandals, reputations will decline and people are going to be left with a bad taste in their mouths,” Mr. Jensen said in an interview last week. “The whole sector will decline.”

Mr. Jensen was elaborating on the trenchant comments he made last month in a forum on private equity convened by the Academy of Management. There, he excoriated private equity titans who sell stock in their companies to the public — a non sequitur in both language and economics, he said — and warned that industry “innovations,” like deal fees that encourage private equity managers to overpay for companies, will destroy value at these firms, not create it.

He also said that private equity managers who sell overvalued company shares to the public, whether in their own entities or in businesses they have bought and are repeddling, are breaching their duties to those buying the stocks.

“The owners who are selling the equity are in effect giving their word to the market that the equity is really worth what it is being priced at,” he said. “But the attitude on Wall Street is that there is no responsibility to the buyers of the equity on the part of the managers who are doing the selling. And that’s a recipe for nonworkability and value destruction.”

Mr. Jensen’s interest in private equity goes back to 1989, when he wrote a seminal article titled “Eclipse of the Public Corporation.” In it he argued that new and more effective organizations were emerging that unified the interests of managers and owners, eliminating value-destroying practices so common at public companies.

These practices, examples of the so-called agency problem, are a product of corporate structures that allow managers — i.e., agents — to feather their own nests at the expense of owners — i.e., investors — whose interests they are supposed to serve.

For years, private equity firms seemed superior to the public company model, Mr. Jensen said. But recent developments, he said, have wiped out many of the advantages in private equity’s original design. Agency problems, precisely what private equity was supposed to eliminate, are cropping up as a result of the disastrous changes made by these firms, Mr. Jensen argues.

Raising permanent capital by issuing stock in a private equity firm is a prime example, because it destroys powerful incentives that kept these firms working hard for their investors, Mr. Jensen said. In traditional form, private equity firms raise capital from investors for a finite period of time, agreeing to pay them back, typically after 3 to 13 years. This not only provides a reasonable time horizon for gauging how well the firms perform, it also contains an implicit threat that if they don’t produce for their partners then they won’t be able to raise additional funds.

“This gives the capital markets a chance to say no,” Mr. Jensen said. “When you liquidate a fund if you don’t have very good returns, you’re going to have a tough time on the next fund. That’s a very, very important constraint that has played a significant role in the success of the private equity model.”

Mr. Jensen also deplores the newfangled fees that private equity firms are levying on their clients. Among the worst? Deal fees that rise in tandem with the size of the buyout, and special dividends that go only to the private equity firm, not its investors.

“Deal fees that are going to pay them to do deals whether they are good or not — now that’s nuts,” Mr. Jensen said. “And this notion of taking special dividends out only for the private equity firm — you can see the conflicts of interest that creates.”

Under the original model, private equity managers got annual management fees, but their biggest payout was supposed to be on the back end, based on the performance of the companies they had operated. But waiting for a back-end payday is not enough for today’s titans. They want their money up front.

“I can predict without a shred of doubt that these fees are going to end up reducing the productivity of the model,” Mr. Jensen said. “And it creates another wedge between the outsiders and insiders, which is very, very serious. People are doing this out of some short-run focus on increasing revenues, and not paying attention to what the strengths of the model are.”

Who cares about the model when there’s a mountain of money to be made?

Short-term thinking like that can do genuine damage, and Mr. Jensen fears such a result. “The sector is going to take a reputational hit of nontrivial proportions,” he said. “Private equity is not going to go away, but it’s going to take a hit.”

A sunny side to this dark view is that public company managers may begin applying parts of the private equity model to their own operations, according to Mr. Jensen.

“In principle, one ought to be able to duplicate virtually every aspect of the private equity model in a public company, except the actual going-private part,” he said. “It’s very difficult, but I think public corporations may begin to think about running themselves in this way.”

Now that’s something to hope for.

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Hedge Funds and the Little People

By GRETCHEN MORGENSON

Published: September 2, 2007

BURTON R. LIFLAND, a United States bankruptcy judge in Lower Manhattan, said last week that he needed more time to decide whether the liquidation of two failed Bear Stearns mortgage securities funds could proceed in the Cayman Islands, where they are incorporated, or in this country, where most of their assets and many of their investors reside.

Although there is little left in the funds to divvy up among investors and creditors, how Judge Lifland rules will be closely watched. That’s because most hedge funds are domiciled in faraway places where the courts may be, ahem, less friendly to investors than they are to the managers who park billions there. If the Bear Stearns funds are liquidated in the Cayman Islands, they will be shielded from investors’ suits, and all distributions to creditors will be handled by the courts there.

Bear Stearns wants the Cayman courts to oversee the liquidations. The firm’s spokesman, Russell Sherman, said: “Because the two funds are incorporated in the Cayman Islands, the funds’ boards filed for liquidation there. The return to creditors and investors will be based on the underlying assets and liabilities of the funds not on the location of the filing.”

Judge Lifland said in court last week that he would decide the matter shortly.

Ronald L. Greene, 79, a retiree in Northern California, is one investor watching the Bear Stearns case closely. Mr. Greene lost $280,000 in the Bear Stearns High Grade Structured Credit Strategies Fund and says he will join a suit that has been filed against the firm. He contends that Bear Stearns duped him with assurances that the fund’s high-quality investments would protect holders against market and credit risks.

Hedge funds are theoretically open only to institutional investors and extremely wealthy individuals, who are deemed savvy and well heeled enough to assess and weather complex risks. But documents from Mr. Greene’s files show that Bear Stearns Asset Management allowed investments of $250,000 in its fund, considerably smaller than the typical $1 million minimum for many hedge funds.

ON July 20, 2005, he received an e-mail message from his broker at a small regional firm, with the following header: “Bear Stearns High-Grade Structured Credit Strategies Fund will accept smaller investments this month on a limited basis.” Noting that the fund was temporarily reopening on Aug. 1, 2005, the message said that for investors who “do not have $1,000,000 to invest, the fund will accept a limited number of clients this month for 500k and perhaps 250k.”

The message went on to note the fund’s stellar performance: up a cumulative 29.4 percent since its October 2003 inception, and no down months.

Mr. Greene, a former engineer, said he invested in several hedge funds in recent years, aiming to preserve his principal. Most of the funds have worked out well, he said, producing slightly better-than-market returns with little volatility. He estimated that he has $600,000 to $800,000 invested in hedge funds.

He invested in the Bear Stearns fund in October 2005, and he said the fund appealed to him because its returns of about 1 percent a month did not seem to fall into the too-good-to-be-true category.

Mr. Sherman, the Bear Stearns spokesman, said the fund’s general partner was allowed to waive the $1 million investment minimum and that any investor in the fund had to have at least $5 million in liquid, investable assets.

“Everything went fine until last June,” Mr. Greene said; that was when he learned from his broker that the funds were having difficulties. “I asked him how they could be in trouble if they were high-grade securities. He said they were bundled high grade but not really high grade. If you’re going to be dealing with a high-grade securities dealer, I didn’t understand how that was an excuse of any kind.”

Mr. Greene said officials at Bear Stearns Asset Management conducted monthly conference calls with investors, discussing the funds’ performance.

For example, according to notes taken by another investor during some of these calls, Ralph R. Cioffi, senior portfolio manager for the fund and an executive at Bear Stearns Asset Management, predicted on Jan. 18, 2007, that fund investors would benefit from a negative bet that he had recently placed on subprime mortgages. Mr. Cioffi also said the fund had plenty of cash to take advantage of market dislocations, according to the investor, and that the team of people monitoring the securities in the fund had increased to 11.

The next month, according to the investor, Mr. Cioffi told conference-call participants that the fund had little exposure to subprime mortgages. And in April, Mr. Cioffi told investors that even though returns were down, the fund had not been forced to sell securities. Acknowledging that investors had been frightened by unusually high delinquencies on loans made in 2006, Mr. Cioffi said fund investors would be safer at Bear Stearns because it did its own due diligence and did not rely solely on ratings agencies, the investor said.

In June, the wheels came off the Bear Stearns hedge funds. Mr. Greene said that as soon as he learned that his fund was in trouble, he submitted a redemption request to Bear Stearns, through his broker. “We had all kinds of trouble getting them to admit they had received it,” he said. He never got any of his money out.

In mid-July, Bear Stearns told investors that the funds, once worth $1.5 billion, had lost almost all their value. By the end of June, the firm said, the fund Mr. Greene had held was down 91 percent.

“In light of these returns, we will seek an orderly wind-down of the funds over time,” Bear Stearns told its clients in a letter. Obviously, the lawsuits over this debacle are only just beginning for Bear Stearns. One of Mr. Greene’s lawyers, Jacob H. Zamansky, said he and his co-counsel have been contacted by fund investors from around the world. All tell the same story, Mr. Zamansky said.

“We believe that Bear Stearns misrepresented the risk to investors in the hedge fund, misrepresented the extent of risk controls that were in place to cut losses and misrepresented performance on conference calls to avoid a run on the bank,” he said.

Mr. Sherman, the spokesman, said that “the allegations are unjustified and without merit.”

“The accredited, high-net-worth investors in the fund,” he added, “were made very aware that this was a high-risk speculative investment vehicle.”

Of course, it will be up to the securities arbitrators to judge whether investors in the funds were misled about their risks. But these cases may also help regulators understand the degree to which retail investors have bought into hedge funds.

Back in 2003, the Securities and Exchange Commission conducted a study on hedge funds and determined that their investors were mostly institutions. But the study also warned that the types of hedge fund investors appeared to be changing. “Although we did not observe an existing retail market for hedge funds,” the study said, “the potential for that market is clearly at hand.”

The study was right. Four years later, that potential may have become a reality.

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TimesSelect Why the Roller Coaster Seems Wilder

By GRETCHEN MORGENSON

Published: August 26, 2007

STOCKS regained some composure last week, and not a moment too soon for investors worn out by the market’s turbulence. Credit markets remain easily spooked, however, and justifiably so. There is still so much that investors do not know about what lurks in portfolios around the world and exactly when it might jump out and say “boo!”

Periods of volatility come and go, of course. The question is, are the recent wild swings temporary, or are they a result of fundamental changes in the makeup of the markets?

Certainly, the huge pools of capital overseen by hedge fund managers play a big role in the volatility. And their propensity to congregate in the same trades means this: When the bets go awry, everybody runs for the exits.

The trouble is, their choice of refuge is often the United States Treasury market, which, at $4.4 trillion or so, is easily swamped by them. The mortgage securities market, for example, is $9 trillion, and when investors want to shift out of those securities and into the haven of Treasuries, volatility happens.

But other factors may be making the stock market’s downstrokes more pronounced. That is the view of Muriel Siebert, the Wall Street veteran and financial sage, former state banking superintendent of New York and founder of the Siebert Financial Corporation, a discount brokerage firm. Ms. Siebert, who has seen her share of markets, both bull and bear, said she believes that several recent changes to stock trading practices may be exacerbating the downdrafts when they come along.

“We’ve never seen volatility like this. We’re watching history being made,” she said. “When I look at it, I see changes in the marketplace that are influencing this.”

Naturally, as with everything market-oriented, the factors that concern her are related. Item 1: the Securities and Exchange Commission’s elimination last month of the uptick rule on short sales. This regulation was put in place in 1938 to defang so-called bear raids on stocks, when sellers ganged up on companies’ shares and profited by driving them down.

THE uptick rule required that anyone shorting a stock — selling shares he or she does not own in hope of making a profit — can do so only on an uptick in its price. But the S.E.C. got rid of the rule on July 6, after it concluded that such restrictions “modestly reduce liquidity and do not appear necessary to prevent manipulation.”

The commission drew its conclusions after years of study, analysis and discussion, of course. But Ms. Siebert said that with the rule no longer in place, it is easier for sellers to overwhelm stocks on down days. Their short sales may not be placed in the same bear-raid manner — they may be trying to hedge other positions, for example — but the downward push on a stock is the same.

“I don’t think we know the effect of it,” Ms. Siebert said. “The S.E.C. took away the short-sale rule and when the markets were falling, institutional investors just pounded stocks because they didn’t need an uptick. We have to look at that and say, ‘Did that influence and add to the volatility?’ ”

Her second concern relates to the influence of electronic trading in big-name stocks. The specialist system — in which a human being with capital at stake is obligated to use it to maintain orderly markets — has been in decline for years. But Ms. Siebert said that the recent down days in the stock market might have a lot to do with the fact that the New York Stock Exchange is now dominated by computerized trading. Unlike specialists, machines that match orders don’t have to put up capital to stabilize disorderly markets.

“Yes, the specialist system was like a candy store,” Ms. Siebert said. “But they also had an obligation to deploy capital and to the extent that institutions and hedge funds are placing orders electronically, it’s a plain and simple bid-and-ask procedure.”

Fans of electronic trading and the I-hate-specialists crowd will laugh this view off as antiquated. But recall that in the 1987 market crash, Nasdaq market makers — the equivalent of today’s electronic trading — abandoned their markets altogether. It was ugly.

Ms. Siebert is all in favor of trading online — two-thirds of her firm’s business is done on the Internet. But she said that the New York Stock Exchange should examine the spreads in its electronic trades — the difference between the bid and ask prices when transactions occur.

Wider spreads are often found in stocks where market makers put little or no capital at risk. “The spreads in New York Stock Exchange stocks were significant” during the recent wild swings in the market, she said.

Professional traders like volatility because it gives them profit opportunities. But individual investors, in Ms. Siebert’s view, are scared away by it. “Should we be looking at this, or are we just going to accept that markets will be this volatile?” she asked. “If so, will individuals continue investing in them?”

INDIVIDUAL investors are a concern to Ms. Siebert because her brokerage firm caters to them. But her point is well taken. Individuals should have confidence that they will not be whipsawed when they try to buy stocks.

Of course, the fact that hedge funds use such enormous leverage is another element at work here. Ms. Siebert said it would be instructive for regulators to get a handle on the degree to which leverage contributes to violent moves in stocks.

“These things represent a change in the way markets are moving,” she said. “Did they add to the pressures in the markets? Is anybody asking these questions? Or am I expecting too much?”

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Funds Stopped Playing Before the Game Got Ugly

By GRETCHEN MORGENSON

Published: August 19, 2007

TAKE-TWO INTERACTIVE SOFTWARE, the maker of Grand Theft Auto, the shoot-’em-up video game, disclosed last week that it had received a Wells notice on Aug. 9 from the Securities and Exchange Commission, alerting the company to a possible enforcement action.

Take-Two said the notice relates to long-ago option grants that have been under scrutiny for months by the S.E.C. and Robert M. Morgenthau, the district attorney in Manhattan. Three former Take-Two executives pleaded guilty this year to falsifying records related to the options, a result of the investigation by Mr. Morgenthau’s office, which continues.

Well-timed option grants to executives have been a focus of investigators and journalists for the last year or so. But other, more recent developments at Take-Two are noteworthy: the recent selling by some big hedge funds that only last March got together to install new management at the company, and the suspicious trading just ahead of the company’s early August announcement that it could not deliver the newest version of Grand Theft Auto to stores this October.

The delay of the wildly awaited game has certainly hurt Take-Two. Throughout the year, its management repeatedly promised investors that the game would be delivered on time. It did so in April, in June and again on July 9.

But on Aug. 2, the story suddenly changed. Grand Theft Auto IV would be delayed until the second quarter of 2008 because extra development time was required, the company said after the close of trading. Take-Two’s stock fell 16 percent the next day and has declined further. It closed on Friday at $12.25, down 31 percent on the year.

Trading patterns, however, indicate that somebody may have known about the bad news ahead of time. Heavy sellers on Aug. 1 took Take-Two’s shares down almost 5 percent on more than double this year’s average daily trading volume. It was the heaviest trading in the company’s shares since the second-quarter earnings report.

ON an Aug. 2 conference call with investors to discuss the game’s delay, Strauss Zelnick, Take-Two’s chairman, said when asked about the suspicious trading that because the company is so closely watched and its game so anticipated, some leaks are normal. “Leaks aren’t wonderful,” he added. “Having said that, it’s not really the focus of our attention.”

Mr. Zelnick is right. It really is more of a regulator’s issue.

Perhaps more intriguing is the recent dumping of Take-Two shares by SAC Capital Advisors, run by Steven A. Cohen, and the Tudor Investment Corporation, overseen by Paul Tudor Jones. Documents filed by the two funds last week with the S.E.C. report sales they made in the second quarter of 2007. Both funds were involved in a boardroom coup that ousted Take-Two management and directors last spring, but they seem to be abandoning the very management and board they put in place.

Let’s go back to March 20, when Take-Two shares hit a high of $23.79. That was just three days before the annual shareholder meeting at which the company’s management and board were booted.

The removal was the work of three big hedge funds and one mutual fund that got together March 4 with the goal of bringing in a new broom to clean up the troubled Take-Two.

In the effort, SAC Capital and affiliates, which had amassed a 15.6 percent stake in Take-Two, much of it in January and February, and Tudor Investment and affiliates, with 18.7 percent, were joined by D. E. Shaw, a hedge fund, with 9 percent, and OppenheimerFunds, a longtime Take-Two investor, with 23.7 percent.

The foursome reported their collaboration to the S.E.C., as required, and on March 7, they said Mr. Zelnick, chief executive of ZelnickMedia, would lead the cleanup crew. Mr. Zelnick had run BMG Entertainment, the global music label, and 20th Century Fox, the movie studio. Since the funds controlled so many Take-Two shares, Mr. Zelnick was a shoo-in at the annual shareholder meeting on March 23.

Oddly, on April 2, shortly after the group put its new executive and directors in place, it disbanded. Usually, investors who install executives and board members stick around to watch them increase the values of their stakes.

Not SAC and Tudor. By June 30, SAC had dumped almost all its shares; only 10,300 shares remained, worth $123,000. In the same period, Tudor sold almost half its stake, leaving it with 1.9 million shares, valued at around $23 million. D. E. Shaw has not filed for the quarter; Oppenheimer still has a very large stake.

Had the funds gotten wind of problems with Grand Theft Auto IV when they dumped the huge stakes they had only recently amassed? Interestingly, while these professionals were selling their shares, takeover rumors regularly buoyed the stock.

Edward Nebb, a spokesman for Take-Two and Mr. Zelnick, said the funds could not have known because top management discovered only on Aug. 1 that the game was not ready. It told the public the next day. “The process of developing a game such as Grand Theft Auto IV is extremely complex,” Mr. Nebb said. “At some point, management had to make a decision to either ship a game that was not up to the Grand Theft Auto standards or to delay the launch until it was. And that point occurred immediately prior to the public disclosure on Aug. 2.”

So why did SAC and Tudor get out so quickly after they drafted Mr. Zelnick? Representatives for the funds and for D. E. Shaw declined to comment.

Then there is the timing of a recent grant to Mr. Zelnick. Under the terms of a management agreement made in March, he was to receive a large stock option grant at an unspecified date between June and late August. The grant was to be made at the prevailing market price.

The significant drop in Take-Two’s shares since the agreement was struck makes its grant date interesting. Had Take-Two given Mr. Zelnick his options in July, for example, they would have carried a strike price of around $20 a share, well above recent levels. But under an amended agreement made July 26, the stock option grant owed to Mr. Zelnick will now be struck on Aug. 27, reflecting the depressed prices related to the Grand Theft Auto IV delay.

The date is certainly within the time frame of the original agreement. But given that the amendment came on July 26, less than a week before Take-Two disclosed the game’s production delay, one wonders about the timing.

MR. NEBB said the board considered the date to be prudent.

“ZelnickMedia employees did not participate in the board of directors’ decision regarding the date of the option. Independent members of the board made the decision to set the date and announce it well in advance, and they chose Aug. 27, 2007,” he said.

Now Mr. Zelnick must deal with the disappointment of a delayed game and the missed revenue it would have produced in the latter part of the year.

Still, he is doing what he can to calm investors.

On Aug. 9, the day Take-Two received the Wells notice, Mr. Zelnick and other company officials were meeting with investors at an invitation-only event in Beaver Creek, Colo. The event, sponsored by Janco Partners, a brokerage firm in Greenwood Village, Colo., that has been a big bull on Take-Two’s shares, included a reception and dinner and, the next morning, a 45-mile bicycle trip to the Vail pass with Andy Hampsten, a former professional cyclist.

At least that pesky Wells notice didn’t ruin the fun.

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A Week When Risk Came Home to Roost

By GRETCHEN MORGENSON

Published: August 12, 2007

FOR something that everybody assured us was “contained,” the subprime mortgage mess certainly has spread.

Last week, the hemorrhaging credit markets bled right into the stock market. The major indexes are still up for the year, thankfully, but the Dow Jones industrial average, which hit 14,000 just three weeks ago, has lost 5.4 percent of its value since then. And the Standard & Poor’s 500-stock index is down 6.4 percent from its July peak.

Why are the bond market’s troubles something for stock investors to worry about?

The easy answer is that all markets, both here and around the globe, are intertwined. And despite Wall Street’s insistence that diversification — and therefore safety — could be found in different types of assets, investors are again learning that diverse holdings often behave similarly. This is especially true in periods of uncertainty like the one we are enduring now.

But there are other reasons that the stock market is getting dinged by bond woes. One involves private equity firms, which provided perhaps the biggest push to stock prices when they paid significant premiums to acquire public companies. If these firms cannot borrow money in the bond market to finance their buyouts, or if they must pay more for those borrowings, their business models do not work as well. And that means the private equity bid for stocks fades away.

Even more surprising, to young hedge fund managers at least, is the way the credit crisis has begun to hammer seemingly conservative equity investment funds. This is another explanation for the stock market’s upheaval last week.

Using what are known as market-neutral strategies designed by computer models, hedge fund traders have been blindsided by a correlation between bonds and stocks that they never expected would occur.

Portfolios of this stripe are often known as quantitative funds; some of their most common trades are called statistical arbitrage. These bets are suggested by brilliant mathematicians and academics, using computer models to scour the markets for interesting trading patterns that continue for long periods.

For example, a computer might trace the relationship and trading characteristics of two similar assets, like shares of General Motors and Ford. The fund manager then makes trades, going both long and short, based on the way these shares generally trade. If Ford typically trades cheaper than General Motors, the manager would short Ford and buy G.M., capturing what might be small profits, but on a large volume.

Another type of trade might involve stocks’ performance immediately after an analyst downgrade or upgrade. Trades are placed on thousands of stocks to try to capitalize on the “typical” behavior that the computer coughs up.

Seeing that such bets typically generated profits over long periods left traders believing that their stakes were conservative.

The only trouble is, financial markets do not always trade in a way that is typical or predictable. And when they deviate from the norm, all the wonderful and smart trades stop behaving according to plan.

ANALYSTS call it model misbehavior.

In a research report from Lehman Brothers last week, Matthew S. Rothman described the phenomenon. Fund managers experiencing losses in their fixed-income portfolios who were unable to sell their positions then tried to unwind the trades they could sell — that is, stocks. They cashed in the shares they had purchased and bought back the ones they had sold short.

The result was that stocks that had historically been weaker became stronger, and vice versa.

“It is not simply that model returns are flat (or not working),” Mr. Rothman wrote, “but specifically that the models (ours included) are behaving in the opposite way we would predict and have seen and tested for over very long time periods (45-plus years).”

As a result, “risk models are miscalibrated for the current market environment,” he wrote.

Compounding the problem, of course, is the borrowed money these funds use to enhance their performance. When things start to unravel, leverage aggravates an already painful fall.

Mr. Rothman also pointed out that so many fund managers had the same trades on their books that when they went to cash out of them, the ill effects were exaggerated.

The losses that investors are suffering this month, he wrote, are comparable only to those in the 1960s and during the bursting of the Internet bubble. “This appears to be an event with little precedent,” he wrote.

None of this would be a problem, of course, if fund managers were not relying so heavily on just that — precedent — to make their decisions. Computer models seem so perfect, so scientific, so flawless, and they are advertised to investors in precisely that fashion. Ingenious models lull investors into a dangerous complacency about the risks they are taking. It is almost as if the models eliminate risk entirely from the markets.

But risk is never gone, as investors are recognizing with a jolt. And that is so even if Wall Street assigns conservative-sounding labels to portfolio strategies that are, in fact, aggressive.

“They have their standard deviations, correlations, ‘stable value’ and ‘real return’ funds and nothing for what the normal human being would call risk at all,” said Frederick E. Rowe Jr., a money manager at Greenbrier Partners in Dallas. “They’ve taken the word ‘risk’ and hijacked it. The concept of risk — the permanent loss of capital — vanished in the minds of the people who speak the new language.”

Risk, and all that it should connote to investors, is back in the language now. Unfortunately, it has brought an awful lot of losses with it.

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Mortgage Mania Didn’t Grip Everyone

By GRETCHEN MORGENSON

Published: August 5, 2007

THE seized-up United States mortgage market claimed more victims both here and abroad last week. The American Home Mortgage Investment Corporation, once a big lender, closed its doors, laying off more than 6,000 workers. In Germany, IKB Deutsche Industriebank received a $4.8 billion bailout from a government-owned group that said it would cover potential subprime losses at the bank.

In a report last week, Charles Peabody, an analyst at Portales Partners, an independent research firm in New York, characterized the state of the mortgage market this way: “Investors finally realized that there is such a thing as a bad mortgage loan. As a matter of fact, there is such a thing as a whole bunch of bad mortgage loans.”

As a result, Mr. Peabody noted, investors are no longer interested in most of the risky loans that mortgage bankers have been creating lately. Bankers can sell only the highest-grade pieces of those wonderful securities pools that were so popular among investors until about five minutes ago.

That gives two choices — neither one felicitous — to the bankers who originated the low-grade loans. They can either sell them at a loss, reflecting the market’s view of such debt, or hold them on their own balance sheets and watch them decline in value.

It is never pretty, watching a mania come undone. Unless you are one of the folks who never bought into the madness in the first place.

Michael A. J. Farrell, chief executive of Annaly Capital Management, a high-grade mortgage real estate investment trust, is one such man. And with a perspective on the residential mortgage and credit markets extending back to the 1970s, he is an excellent person to consult on what is likely to happen next.

Annaly is an investment management company that oversees a portfolio of strictly high-grade assets. The company invests solely in mortgages backed by government-sponsored entities like Fannie Mae, Freddie Mac and Ginnie Mae. Investors understand that it has little exposure to the current credit crunch and have bid up its shares almost 8 percent this year. The shares also pay a generous dividend of 6.4 percent at current prices.

For his conservative approach, Mr. Farrell confirms that for about two years beginning in 2003, he took plenty of abuse from more aggressive counterparts in the industry and from potential investors who urged him to buy lower-quality assets for their greater returns. Some of those ridiculing Mr. Farrell were the same people who jeered at investors who did not get the new paradigm, espoused in 1999, that any-Internet-company-is-a-good-Internet-company.

“I definitely took heat not only in my professional life but in my personal life,” Mr. Farrell said. “I had people stop me on the street while I was walking my dog saying, ‘Where is your dividend going?’ ”

During the crazy years, Mr. Farrell and his team decided against increasing the size of Annaly’s balance sheet. Investors willing to throw money into anything mortgage scoffed when the company turned them down. “We decided to withdraw from the market until the end of 2005, when we thought investment risk was being recognized by the market,” he said.

Mortgage real estate investment trusts came public like weeds during the boom, of course. But the strategies they use can vary widely. Some originate mortgages — New Century did, for example — and others buy mortgage loans in the secondary market, whether risky or not.

Most mortgage REITs do a bit of everything, explained Jeremy Diamond, a managing director at Annaly. As a result, investors in these companies must rely on their managers to put the right emphasis on credit risk and interest rate risk at different periods in a business cycle.

But because Annaly shuns credit risk, its investors are trusting its managers to bet appropriately on interest rate risk only. In this they are also conservative, holding assets with a duration of six months to two years. They also have one-third of their portfolio in fixed-rate assets, with the rest in adjustable- and floating-rate assets; this allows the portfolio to work well whether rates decline or rise.

“There is no official Annaly interest rate forecast,” Mr. Diamond said. “We manage the portfolio with no significant directional bias because we could be wrong.”

Annaly’s biggest challenge comes when rates plunge, as they did in 2004, pushing mortgage holders to refinance. But it has reduced its exposure to refinancing risk in recent months by raising about $2.5 billion in capital and reducing the premium-priced mortgages in its portfolio. While the company paid an average of $102.50 per $100 worth of bonds in its portfolio in 2003, its average is now $100.50.

When the mortgage market started to regain some of its sense in 2006, Annaly began raising money from investors. It made two stock offerings in 2006 and two more this year. Each time, the deals carried a higher price tag, reflecting investors’ appreciation of Annaly’s conservative business model. Even those who bought into the company’s most recent offering last month — at $14 a share — are ahead. Annaly’s shares closed Friday at $14.98.

Mr. Farrell and other Annaly executives also align themselves with their investors by not taking performance fees as most REITs do. Instead, the executives’ compensation, just 0.12 percent of assets under management, comes out of the company’s revenues.

So what does Mr. Farrell, who has been through at least three mortgage market seizures in his career, see on the horizon for the credit markets? More of the same turmoil, alas.

“I look at this sort of like 1990 and 1991,” he said, referring to the savings-and-loan crisis. “Against that background you had a $7 trillion economy that gave birth to the $300 billion Resolution Trust Corp. Now we have an $11 trillion economy and we’ve already seen $2 trillion of market capitalization going away” before many loans in the pools have actually defaulted, he said.

WHAT about the people who argue that the impact of the mortgage mess will be muted because risks have been spread well beyond the banks and into many parts of the financial world? Mr. Farrell takes the opposite view. Spreading the risk beyond the banking system will make the task of fixing the mess much harder.

“Even if the Fed eases, it is probably not going to help the housing market,” he said. “This repair cycle is going to take a lot longer because it is not concentrated in the banking system like it was in the 1990s. Back then, they could repair the banking system by dropping interest rates. Now they can’t bail out rich hedge fund guys in Greenwich.”

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Summer School for Investors Is in Session

By GRETCHEN MORGENSON

Published: July 29, 2007

It’s still summer but as the financial markets declared last week, back-to-school season for United States investors has arrived.

With the equity markets off sharply for the week and the credit markets seizing, investors are being forced to relearn some of the basics forgotten during the private-equity, easy-credit, corporate-buyout boom of recent years.

Our lessons for today:

HIGH GRADE DOES NOT NECESSARILY MEAN HIGH QUALITY Wall Street’s ability to spin straw into gold rivals that of Rumpelstiltskin, to be sure. But that doesn’t mean investors should buy it. They did with gusto, however, as the subprime mortgage mess starkly shows.

WHAT LOOKS LIKE A DUCK MAY NOT QUACK LIKE A DUCK In the burgeoning world of financial derivatives, where mortgage traders and investors play, a security’s structure — especially its use of collateral to cushion buyers from losses — can earn it a blessing from rating agencies. But that structure may not be enough to withstand a credit shock like the one now gathering momentum, which threatens even the higher-grade market for mortgages. These structures look even shakier when the collateral cushion is, as is often the case, risky bonds — not cash.

DON’T SWIM IN THE DEEP END OF THE POOL Investment pools known as collateralized debt obligations have been all the rage, and many of them contain oodles of mortgage-backed securities. (Derivatives of derivatives, in other words.) As Josh Rosner, an expert on mortgage securities at Graham Fisher in New York noted in a research piece last week, the leverage used to put such securities pools together can amplify losses. For example, a 4 percent loss in a mortgage-backed security held by collateralized debt obligations can turn into almost a 40 percent loss to the holder of the C.D.O. itself.

LOSSES CAN BECOME VIRAL Lang Gibson, a Merrill Lynch analyst, characterized the potential for losses in C.D.O. pools in a recent report. After Standard & Poor’s notified investors that it had raised its loss forecast to 11 percent to 14 percent for subprime mortgages made in 2006 (the previous estimates had been 6 percent to 8 percent), Mr. Gibson said that such a rate would put most classes of asset-backed C.D.O.’s at risk of principal loss. The only class not at risk in such a scenario is the highest-ranked securities. But the junior AAA-rated classes, as well as those rated AA, A or BBB, are all at risk as well, he said.

Investors bought into the myth of highly rated securities even though their generous yields should have alerted them to risks. We have not yet seen the downgrades of collateralized debt obligations, because they typically don’t occur until loans in the underlying securities are close to default. But we will.

EARNINGS ACTUALLY HAVE TO BE EARNED Corporate profits are healthy, but that doesn’t mean stock prices can’t drop. As stocks raced to new highs this year, many investors felt their prices were justified by robust corporate earnings. They were only partly right. Other powerful forces were at work as well: corporate buybacks and mergers, both of which require access to E-Z credit. For instance, the Standard & Poor’s Index Services Group estimated that almost $118 billion was spent on stock buybacks during the first quarter of 2007, up 17.5 percent from the $100 billion registered during the first quarter of 2006.

In the first quarter, S.& P. said, 101 companies reduced their actual share count by at least 4 percent, while 72 cut their average diluted shares, used to determine earnings per share, by at least 4 percent. That means that at least 4 percent of the growth at those companies came from share count reductions, not operating earnings.

The S.& P. data also show that information technology companies were the biggest buyers of their own shares, accounting for almost 23 percent of the total buybacks and 15 percent of the market value of that stock during the first quarter. Consumer goods companies were another major player in the repurchase arena last quarter, accounting for almost 15 percent of stock buybacks and 10 percent of the market value.

Merger frenzy has also contributed mightily to the bull market. According to Thomson Financial, $3.1 trillion in deals have been announced so far this year, almost as much as the $3.6 trillion conducted during all of 2006. Many investment banks, including Lehman Brothers and Deutsche Bank, have already advised on more deals, on a dollar basis, than they did during all of last year.

Private equity investors played a major role in this mania. During July, United States private equity investors did $90 billion worth of deals, Thomson reported, the second-highest monthly number on record.

DIVERSIFICATION IS NOT A PANACEA Many investors who bought securities backed by prime mortgage loans made to creditworthy borrowers thought that they would be fine no matter how disastrous subprime loans turned out to be. But as officials at Countrywide Financial confirmed in their quarterly results last week, mortage problems are now firmly in “prime” territory.

“There is no diversification,” declared Steven Eisman, a portfolio manager at FrontPoint Partners, during a July 19 conference call the investment firm sponsored on the subprime mortgage debacle. “If there is a problem with underwriting, there will be problems everywhere. The entire capital structure from equity all the way to AAA can go to nothing.”

Not one to mince words, Mr. Eisman added: “It is going to be many months before this market clears. The freakathon is yet to come.”

EVERY CLOUD HAS A SILVER LINING There are still bright spots in what looks like a very dark market scenario. Shutting off the credit spigot means profit opportunities for investors who were awaiting a return to sanity in the debt markets, especially those looking to pick up damaged goods. And with fewer acquisitions being made, the insider trading that seems to occur ahead of almost every deal will no longer produce easy profits for chiselers.

Finally, the slowdown in the credit market may mean that we will be spared some of the gushing accounts of merger deals and the brilliant stars who make them. Financial engineering is fun and all, and so delightfully lucrative. But reporting on the people who actually run companies is surely of greater value to the world at large.

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Mr. Vranos Has a Deal for You

By GRETCHEN MORGENSON

Published: July 22, 2007
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HEDGE fund managers are not short on chutzpah, as a rule. But it takes a special kind of cheek to ask investors at this very tender moment in the housing market for $750 million to fund a new company specializing in subprime residential mortgage loans.

Michael W. Vranos, celebrity bond trader and founder of Ellington Management, has that audacity. And then some.

Mr. Vranos oversees $5.4 billion in hedge funds and private accounts, and an additional $1.2 billion in a managed account, while also managing almost $23 billion in collateralized debt obligations (pools of loans backed by assets like home loans or credit card debt).

That might be enough to keep others busy. But Mr. Vranos is also peddling shares in a new entity called Ellington Financial LLC. An offering statement, dated July 12, began circulating on Wall Street last week; it is a private placement aimed solely at institutional investors, like pension funds and insurance companies. Friedman Billings Ramsey is the underwriter.

On its face, it may sound like a promising deal for speculators. Subprime loans are in the tank, as everyone knows. Surely there is money to be made picking up distressed properties for pennies on the dollar.

And isn’t Mr. Vranos one of the world’s leading experts on mortgage securities? The Ellington prospectus certainly confirms this. “He was praised during the difficult bear market of 1994 by Jack Welch, chairman of Kidder Peabody’s parent company, General Electric,” it noted, “who said that Mr. Vranos ‘has done a better job than 99 percent of the managers at G.E. at managing a cycle.’ ”

When Mr. Vranos was head of the mortgage securities trading desk at Kidder Peabody back in the early 1990s, Fortune magazine called him “one of the best bond traders on Wall Street,” the filing boasts.

The filing is silent, however, on a near calamity Mr. Vranos had with his fund during the financial crisis of 1998. When Long Term Capital Management imploded that fall, credit markets seized. Three hedge funds run by Mr. Vranos lost about 25 percent of their value but stabilized after he auctioned $2 billion in securities to meet margin calls.

ELLINGTON MANAGEMENT has obviously thrived since then. The filing shows that since 2000, Mr. Vranos has handily beaten the fixed-income average, producing double-digit gains in all those years but two.

His performance so far this year is not as stellar. At the end of May, his mortgage-backed credit funds were up 1.8 percent; his “composite” hedge fund return for the period is 3.81 percent.

But is now the time to raise $750 million in permanent capital on a subprime spending spree?

Subprime mortgage loans are certainly far cheaper now than they were just a few months ago. Still, the shakeout in the industry may have only just begun. Last week, major lenders like Washington Mutual and Countrywide Financial said they would no longer offer the most popular subprime loans, those carrying low two- or three-year fixed rates that then reset to much higher levels. As access to those loans is cut off, subprime borrowers will have greater difficulty refinancing billions in mortgages whose rates are shooting up right now. Defaults are likely to rise, even from today’s high levels.

Granted, timing is everything in market matters — and Mr. Vranos certainly has been through his share of up and down cycles.

Yet the timing of Ellington Financial’s hoped-for debut is intriguing because it appears to be a way for Mr. Vranos to unload subprime assets he bought a few months ago at higher prices than they would likely fetch today on investors.

Some $70 million of the offering’s proceeds is expected to go toward buying equity in something called Spyridon Holdings, which owns a real estate investment trust that Mr. Vranos’s management company formed in May 2007. It bought $345 million of the riskiest portions of mortgage pools, known as equity residuals, issued by the New Century Financial Corporation, a subprime lender that declared bankruptcy in April. New Century made the loans from 2003 to 2006, the filing said.

The $70 million earmarked from Ellington Financial’s investors to buy those assets will cover about 40 percent of the roughly $170 million Spyridon put up to buy them — it borrowed the rest. In return, Ellington Financial investors will receive 40 percent of Spyridon.

But what inquiring Ellington investors should want to know is exactly how those New Century residuals are being valued and whether that amount reflects reality or fantasy.

The Ellington prospectus says that the amount to be paid, estimated at $70 million, will be based “on fair market valuations of the New Century residuals provided at the time of purchase by one or more independent third parties.” But Ellington goes on to say that it expects any difference between those valuations and the $345 million purchase price to reflect only whatever cash the assets have distributed to Spyridon since they were bought and “any changes in interest rates over the course of such period.” Some $50 million in cash has been distributed by the New Century residuals, the filing said.

No mention is made about the decline since May in the values of subprime loans over all and in New Century loans in particular. Even the lender’s high-grade paper is taking a hit — last week, Standard & Poor’s downgraded by one notch several AAA-rated New Century securities consisting of second lien assets.

The problem, traders say, is that residual interests in New Century mortgage securities are not trading, so any valuation of the $345 million stake will likely be based on a model, not a true market. Besides, if the assets were such a good trade for Mr. Vranos, investors might be wondering, why is he sharing that largess?

Asked Friday whether the offering is a way to dump poorly performing securities onto investors for a higher-than-market price, Mr. Vranos first said that I should not have obtained a copy of the prospectus because it is a private placement. All he would say about the New Century residuals is: “I don’t know if they’ve declined. I’m not responsible for pricing them — we use third-party pricing. That’s obviously a question that potential limiteds ask all the time. Obviously we have an answer.”

Josh Rosner, an authority on mortgage-backed securities at Graham-Fisher, an independent research firm in New York, looked at the Ellington Financial filing details that I forwarded to him. He said: “If you are exposed to significant losses on a mark-to-market basis, your goal is, within the legal framework, to avoid having to take that mark. One of the ways that people are starting to avoid that is to resecuritize assets and put them into other vehicles at par. I think there is a strong chance that may be what’s happening here.”

So in addition to jettisoning some of the New Century residuals, the transaction with Ellington Financial may allow Mr. Vranos to value those that he owns elsewhere in his financial empire at a higher price than he otherwise could.

Hedge funds are unregulated entities and they want to remain that way. That is fine with me. But transactions like this one seem almost certain to draw scrutiny. And hedge fund managers as smart as Mr. Vranos should know that.

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Subprime, Subpar: For Sale?

By GRETCHEN MORGENSON

Published: July 15, 2007
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NOVASTAR FINANCIAL, a subprime mortgage originator based in Kansas City, Mo., has had its share of setbacks. That’s not surprising, given the carnage in its industry.

What is surprising? NovaStar’s stock has been on a tear lately, rising from $3.80 in February to $7.63, at Friday’s close. Even though the mortgage lending business continues to sink and shrink, NovaStar’s market valuation has risen.

Perhaps that is because, last April, NovaStar said it was seeking “strategic alternatives” — otherwise known as a “lifeline.” The stock is up about 50 percent since then. Some investors may believe a buyout lies ahead. Last week, there were whispers that the MassMutual Corporation, a financial services firm that trades as a closed-end investment company, might put money into NovaStar.

The two companies are already connected. Babson Capital, a money management unit owned by MassMutual, is a big NovaStar shareholder; it owns about 770,000 shares, or 2 percent of the company. Most of those shares were bought in 2006; the average cost to Babson is $27.85 a share.

Another interesting tie: Howard B. Hill, a managing director at Babson since 2005, was a vocal bull on NovaStar for years, posting messages on Yahoo and other stock boards until about the time he joined Babson. Like John P. Mackey, the chief executive of Whole Foods Market, who used Internet chat rooms to promote his point of view, Mr. Hill has been an avid poster on stock message boards.

Unlike Mr. Mackey, Mr. Hill used his last name while posting. He urged investors to buy NovaStar shares, with the stock symbol of NFI, for its dividend. One post that Mr. Hill made on Yahoo was headed “NFI gets positive returns every year.”

Mr. Hill pretty much quit posting messages about NovaStar after he joined Babson. But on June 6, 2006, he wrote on the Yahoo board: “I’m more bullish than I’ve been for more than a year on the group and NFI, but that’s all I can or will say on that.” NovaStar’s shares were at $31.29 that day.

Officials at MassMutual Financial Group and Babson, including Mr. Hill, declined to comment. NovaStar declined to comment as well.

While NovaStar might appear to be a unlikely takeover target, we all know that anything can happen in mergerland. Still, NovaStar’s business is plummeting, and it faces a number of legal challenges. Its monthly loan figures for June, disclosed last Thursday, show total originations of $254 million, down from $1.06 billion for the same period last year. The company generated an average of $12.1 million in loans each day last month; in June 2006, that daily figure was $48.2 million, albeit with one more day in the month.

Delinquencies among the company’s loans, meanwhile, are rocketing. In June, some 12.4 percent of loans in pools less than one year old were more than 30 days delinquent. That’s up from 5.2 percent at the end of 2006.

Furthermore, NovaStar has problems that other lenders don’t. On June 27, for example, the company lost a lawsuit in California that will require it and two other lenders to pay $46 million. A jury ruled in favor of American Interbanc and its contention that NovaStar Home Mortgage Inc., a subsidiary, used bait-and-switch practices in its mortgage-quote Web site. (NovaStar shut down its subsidiary in mid-2006.) Lanny J. Davis, a lawyer at Orrick, Herrington & Sutcliffe who represents NovaStar, said the company believes the verdict is incorrect and has sought to have it reversed.

On other legal fronts, the company settled a class-action suit in Washington State on June 27, paying $5 million to some 1,600 borrowers who contended that NovaStar hid loan fees, according to Ari Brown, the lawyer at Bergman & Frockt in Seattle that represented them. A $5 million settlement certainly doesn’t cripple NovaStar, but it may just be the beginning of such suits. While NovaStar had only a small presence in Washington, it generated more loans in California than in any other state. And Mr. Brown has also sued NovaStar on behalf of two California borrowers who contend that its loan carried hidden commissions — meaning that the suit may become a class action there.

THE Washington case was settled to avoid unnecessary legal expenses, Mr. Davis said, “but there was no admission whatsoever that any of the claims made in that case were meritorious.” The company maintains that loan fees were fully disclosed to borrowers and that they did not suffer actual damages because they would have had to pay those fees or more in any event.

“Regarding the California case, we are confident it is utterly baseless, its allegations misstate facts and have no merits, and that the transactions referenced in that case were entirely consistent with California law,” Mr. Davis said.

If MassMutual does indeed invest more in NovaStar, it would be a vote of confidence in the company and in subprime lending. Mr. Hill, the Babson managing director, is, as his online postings show, a fan of NovaStar and its industry. On Jan. 24, he published a report on Babson’s own Web site about subprime mortgage securities. Calling the press coverage of the sector “unrelentingly depressing,” Mr. Hill argued for a more upbeat view.

“We look at the glass as being 90 percent full now, with the potential to drop to only 80 percent,” he wrote. “What we find is that people do not generally lose their homes to foreclosure, even if the mortgage balance is higher than the market price of the house. Basically, if they have jobs, they pay their mortgages.”

That rule of thumb worked in previous periods but seems not to be working now. In the more than six months since Mr. Hill wrote his report, foreclosures have risen significantly, notwithstanding strong employment figures.

Mr. Hill declined to talk with me last week about NovaStar, his postings on the company and Babson’s investment. But in an interview with Bloomberg News on Friday he called coverage of the subprime mortgage meltdown “a bit overblown.”

Certainly NovaStar’s shareholders would love to see MassMutual, or anyone whose money is green, throw them a line. But would it be good for MassMutual’s investors?

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A Board That Knows Two Words: No Sale

By GRETCHEN MORGENSON

Published: July 8, 2007
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IT is the kind of takeover bid that shareholders dream of, with a suitor offering a healthy premium and the potential for postmerger success. So why is the target’s board dead set against it?

The bid in question is a nearly $400 million offer that AirTran Holdings, the discount airline with headquarters in Orlando, Fla., is making for the Midwest Air Group, based near Milwaukee. While Midwest’s stockholders are jumping up and down for the deal, its directors have staunchly rejected it. As a result, some Midwest shareholders wonder whether the board is performing its duty to the company’s owners or acting instead to benefit a management with whom it has long been associated.

Timothy E. Hoeksema has been chief executive of Midwest since 1983 and is also chairman of its board.

Some shareholders say their concerns begin with the fact that the Midwest directors refused for six months even to meet with officials of AirTran to hear their proposal. The board has not appointed a special committee to look at the bid. The company also has a poison pill in place to thwart a takeover.

“I don’t think management wants to sell the company at any price to anyone and I think the board has been supporting management,” said Joe Leonard, chief executive and chairman of AirTran. “It has been extremely unusual for the board not to hear what we have to say. We have said we were willing to pay for additional value if they could show that the value is there.”

Last month, at Midwest’s annual meeting, its shareholders rose up, booting out the three Midwest directors up for re-election and replacing them with AirTran’s nominees. Only then did Midwest’s directors agree to sit down with AirTran officials. That meeting will be on July 16.

AirTran said it first approached Midwest with a merger proposal more than four years ago. Rebuffed, it returned in 2005, and again last fall. Confronted with opposition from Midwest’s board, AirTran has raised the price on its most recent bid three times. The offer now stands at $9 in cash and 0.5842 shares of AirTran stock, equal to $15.43 at Friday’s close.

Midwest’s shares closed last week at $14.93. The AirTran deal reflects a 65 percent premium to Midwest’s stock price the day before last fall’s offer was publicized; it is set to expire on Aug. 10.

Before the AirTran offer came along, Midwest’s stock languished in the single digits, reflecting a string of losses at the company. Midwest was not alone in its difficulties — most airlines have shown losses in recent years. The company turned a $5.4 million profit in 2006.

AirTran says the merger would result in increased departures for the combined airline, an expansion of Midwest’s hubs and new markets. It would also bring 1,100 new jobs to Milwaukee, Midwest’s main hub.

But Midwest says the merger is not in the best interests of the company’s shareholders or the employees because it does not reflect the value of a strategic plan recently put in place by Midwest’s management.

“The board spent a lot of time and resources evaluating the AirTran offer and consistently concluded that it underrepresents the long-term value of the company,” said Carol N. Skornicka, Midwest’s general counsel and secretary. “The offer was so substantially inadequate the board did not engage in negotiations.” Ms. Skornicka declined to make Midwest directors available for interviews.

But Mr. Leonard said he is not persuaded that the Midwest board has responded properly to the offer. “In a normal merger-and-acquisition transaction, the board would appoint a special committee of independent directors,” he said. “They referred it to the governance committee. It has nothing to do with M. & A., but it does have as chairman Dave Treitel, who has been advising the company for a number of years.”

Mr. Treitel, a Midwest director since 1984, is chief executive of Simat Helliesen & Eicher, an aviation consulting firm that has worked for Midwest in recent years.

Midwest shareholders certainly seem fed up with the nine-member board. More than two-thirds of the votes at the annual meeting were cast against the Midwest directors who were up for re-election. With the exception of a new board member in 2006, there had not been a board change at Midwest since 1997. The new directors nominated by AirTran are not affiliated with it.

More Midwest directors might have lost their seats in the recent election if not for the fact that membership on the company’s board is staggered, meaning that only a few directors stand for election each year. In general, shareholders do not like the staggered terms for directors because that makes it difficult to oust an entire board that is seen as not performing.

Midwest’s outside shareholders have also resoundingly supported a tender offer for the company’s stock that AirTran started earlier this year. Almost two-thirds of the shares held by outside investors have been tendered.

Still, regardless of the shareholders’ support for the offer, a merger cannot happen without the board’s approval, Ms. Skornicka said. “Under Wisconsin law a board can consider other stakeholders, it can consider the interests of customers as well as employees,” she said. “While those things are difficult to quantify, they can impact the decision of the board.”

By agreeing to hear the AirTran proposal later this month, Midwest’s directors are by no means expressing an interest in negotiating, she said.

Mr. Hoeksema is undoubtedly less than eager to sell the company because he might lose his job as chief executive, a post that earned him $1.25 million in 2006. Mr. Hoeksema would also not receive an enormous windfall if Midwest changed hands — possibly giving him more of an incentive to hang on to his job so he can keep drawing a paycheck.

Documents show that if a change in control had occurred last December, Mr. Hoeksema would have received $2.6 million from a key executive employment agreement. Based on current prices, he would also get roughly $3.6 million when options and restricted stock vested as a result of a deal done around $15 a share. Not bad, but it is a far cry from the tens of millions and more that many other chief executives have received when their companies were sold.

Ms. Skornicka said Mr. Hoeksema’s relatively small payout in a merger reflected the modest compensation paid by the company in line with its industry and size. She said the payout played no role in the board’s response to the deal.

It will be interesting to see how Midwest’s newly configured board responds to AirTran’s offer.

“The shareholders who tendered their shares are saying, ‘I want you, the Midwest board, to remove the obstacles so I can get my money,’ ” Mr. Leonard said. “The shareholders didn’t vote out of ignorance. They’ve seen our plan, they’ve seen the Midwest plan and they knew what they were voting for when they tendered their shares.”

Certainly Midwest’s shareholders have spoken, and plainly. Now it becomes a matter of whether the Midwest board is listening.

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New Scheme Preys on Desperate Homeowners

Aleem Morris signed over his home in a complex arrangement.

By GRETCHEN MORGENSON and VIKAS BAJAJ

Published: July 3, 2007

With the housing market in decline, financial predators are finding yet another way to take advantage of people who fall behind on their payments.

The schemes take various forms and often involve promises to distressed homeowners of cash upfront, free monthly rent and a chance to retain their houses in the long run. But in the process, someone else takes over the deed, borrows as much as possible against the value of the house and pockets the cash. And, almost always, the homeowners still end up losing their homes.

There are no nationwide numbers on this common fraud, known as equity stripping, but it has turned up in almost every state. Seven states have passed laws to try to stop it. Still, with foreclosure rates rising rapidly, it will be a growing problem, consumer advocates say.

“Conditions now are perfect for these scams,” said Lauren K. Saunders, managing attorney at the National Consumer Law Center in Washington. “We are at the end of a period of rising real estate prices, so a lot of people have equity in their homes. But we also have a foreclosure crisis.”

Gloria and Fred Johnson fell for a sales pitch that they now regret. They had secured their version of the American dream — a home of their own — in the Bushwick section of Brooklyn in 2001.

For three years, they scrimped to save the $8,000 down payment for a two-family house. They took out a $226,000 mortgage backed by the Federal Housing Administration.

But in 2004, an injury forced Ms. Johnson, 38, to take a leave from her counseling job at Fountain House, an advocacy group that works with the mentally ill. They struggled financially on her disability payments and her husband’s income as a construction worker. By the summer of 2004, they had fallen two months’ behind on their mortgage.

So Ms. Johnson called the Home Savers Consulting Corporation, a Brooklyn company that advertised help for people facing foreclosure. “I saw the advertisement in a local paper,” she recalled. “I was in a tight situation and was scared to death I was going to lose my house.”

Because the Johnsons’ home had risen in value, they could have sold it and paid off about $275,000 in debt. But they wanted to remain in the house.

Ms. Johnson met with Home Savers officials and agreed to what she thought was a refinancing of her loan at a lower interest rate with more affordable monthly payments. But the Johnsons unknowingly transferred their deed to a straw buyer working with Home Savers, court documents contend.

That stand-in buyer qualified for a type of mortgage that would let him take cash out as part of the financing. He borrowed $425,000 against the house and pocketed $134,000, which included the Johnsons’ equity built up over the years.

Now the Johnsons are fighting to stay in their house and to recover their equity.

Jessica Attie, co-director of the foreclosure prevention project at South Brooklyn Legal Services and the lawyer for the Johnsons, said her office was overwhelmed with homeowners who had handed over their deeds to people pretending to help “save” their homes.

Officials at Home Savers could not be reached; the company’s telephone has been disconnected.

Such foreclosure-related offers have attracted the attention of legislators, and at least seven states have created laws against them. Last February, New York instituted the Home Equity Theft Prevention Act, which provides legal recourse to victims. And last month, the Massachusetts attorney general, Martha Coakley, banned for-profit mortgage rescue operations from the state after numerous complaints.

Victims are becoming more plentiful as homeowners fall behind on payments and find that they cannot refinance, with mortgage rates rising. The Mortgage Bankers Association recently disclosed that nearly 19 percent of all loans to less-creditworthy consumers, or 1.1 million mortgages, were either delinquent by more than 30 days or in foreclosure. At the end of 2006, the figure among these loans was 17.9 percent.

When a property enters foreclosure, it appears on a list at the county clerk’s office. Individuals and companies in equity-stripping schemes monitor the lists closely, contacting troubled homeowners either by phone, by mail or by knocking on their doors.

These companies advertise heavily in target areas. “Are you losing sleep because of mounting debt and harassing bill collectors?” asked one flier from a “foreclosure specialist,” Equitable Real Estate Solutions.

Aleem Morris, 30, who lost his job as a forklift operator three years ago, answered that flier. Behind in his mortgage payments on a two-story home in the Vailsburg neighborhood of Newark where he lived with his ailing 82-year-old grandfather, Mr. Morris was desperate. He had borrowed money from family and friends, but the house went into foreclosure in February 2005. He owed $118,000.

Mr. Morris said he met with Kenneth McKinnon, an official at Equitable Real Estate, and told him that he had bad credit, no job and was losing his house.

According to Mr. Morris, Mr. McKinnon said those troubles could vanish. Equitable would arrange for someone else to buy the house — temporarily, as it was explained to him. In return, Mr. Morris would receive $20,000 in cash and someone else would make monthly payments while he and his grandfather lived there for a year.

Along the way, the monthly payments would be made in Mr. Morris’ name, repairing his credit, so that he could qualify for a new mortgage. After a year, the Morrises could buy the house back for $315,000.

The house was sold for $315,000. Records show that in May 2006, Mr. Morris received his cash, and that his debts, including a tax lien and outstanding mortgage payments were paid. But the remaining $127,199, which probably represented his equity in the house, went to a mysterious “construction note,” that Mr. Morris said he knew nothing about. Mr. McKinnon told Mr. Morris that to make the deal work, a lot of people had to be paid.

Last October, Mr. Morris was informed that his house was again in foreclosure. He started looking for a lawyer. Essex-Newark Legal Services is handling his case.

“I had no idea what I was doing,” Mr. Morris admitted, saying that his grandfather will suffer the most. With the promise of quick money, repaired credit and a place to live without paying rent for a year, he was easily tempted. “Who wouldn’t take a deal like that?”

Mr. McKinnon answered his phone, but declined to discuss the case. He did not return subsequent messages.

Foreclosure rescue deals vary in execution but as Mr. Morris’s case shows, they capitalize on two things: borrower desperation and mind-bogglingly complex mortgage loan documents. A study published last month by the Federal Trade Commission found that the documents were so confusing that 9 of 10 borrowers could not identify upfront fees on mortgage loans and half could not specify the amount they were borrowing. Sam Finkelstein, an advocate for affordable housing, has encountered several variations of foreclosure rescue schemes. One program offered by RYM Technology Holdings, which is based in Birmingham, Mich., lured at least 20 struggling local homeowners and as many as 40 other people in Chicago, said Mr. Finkelstein, who is a housing organizer at the National Training and Information Center, a nonprofit group based in Chicago that supports housing groups around the country.

According to participants in the RYM Tech program, company officials promised that if the troubled homeowners signed over their property deeds to RYM Tech and made monthly loan payments as usual, in five years they would get their homes back, free of any mortgage.

RYM Tech said it would use the equity in their homes to invest in apartment conversions in New York and China, earning fees for itself and enough to pay back the mortgages. Best of all, the homeowners could stay in their homes.

Shakeela Muhammad, 55, a former account manager at Bank of America in Chicago, heard about the program from a friend. She had owned her home on the South Side since 1988, but when she was laid off in 1998 after an illness, she struggled financially. By 2005, she was significantly behind on her mortgage.

Ms. Muhammad said she checked out RYM Tech with the Better Business Bureau; no complaints. She also called Felix Daniel, the head of the company, to ask if her home would be at risk. Not at all, she said that Mr. Daniel told her, adding: “I give you my word on my life.”

In August 2005, Ms. Muhammad signed up. Four months later, she received a notice that she was in danger of losing her home; RYM Tech had stopped making her mortgage payments. It had also refinanced her house and taken out $44,157 in cash that represented her equity. Her home went into foreclosure in May 2006.

“It’s amazing to me how these people sit at a computer and just rob you,” she said. “I want everyone who did it in jail with the bubbas and the brothers.”

Securities regulators in Utah have issued a cease-and-desist order against RYM Tech, and Arizona officials said a hearing was scheduled for this month in its civil suit against the company for offering securities inappropriately. Phone messages left at Mr. Daniel’s home were not returned.

Lea Weems, a lawyer at the Home Ownership Preservation Project at the Legal Assistance Foundation of Metropolitan Chicago, represents Ms. Muhammad and has helped keep her client in her home. A hearing in her case is scheduled for mid-July.

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Only One Word for Subprime Mess

By GRETCHEN MORGENSON

Published: July 1, 2007

It has been several months since the subprime mortgage market started hitting the skids. Whenever the mortgage drama takes a new turn — like a hedge fund blowing up at Bear Stearns, as occurred in late June — some high-level official is rolled out to calm investors.

The trouble is, they all seem to have the same scriptwriter. In March, for example, Henry M. Paulson Jr., the Treasury secretary, said the subprime mess was “largely contained.” In April, Richard W. Fisher, president of the Federal Reserve Bank of Dallas, called the situation “mostly contained.” Ben S. Bernanke, the chairman of the Federal Reserve Board, has also used the word to describe the subprime problem.

Now the private sector is weighing in. At a conference in London last week, Timothy Bitsberger, treasurer of Freddie Mac, the home loan financier, called subprime woes “severe, but contained.” Not to be outdone, E. Stanley O’Neal, C.E.O. of Merrill Lynch, said at the same conference that the slump was “reasonably well contained.”

Containment certainly seems to be the consensus. Only question is, how big a container? GRETCHEN MORGENSON

THIRD TIME ISN’T THE CHARM Three strikes and Dr. Bruce D. Given was out as chief executive of Encysive Pharmaceuticals, a biotechnology company based in Houston that is developing a drug for pulmonary arterial hypertension, a life-threatening disease.

Dr. Given, who had run the company since 2002, was replaced as president and chief executive on Monday, 10 days after the Food and Drug Administration decided not to approve Encysive’s drug. It was the third time in 15 months that the F.D.A. had decided that Encysive had not sufficiently demonstrated that the drug, called Thelin, was ready for market.

The new president and chief executive is George W. Cole, who had been the chief operating officer since joining the company in November 2005. Encysive also announced that to conserve cash it was reducing its work force by about 70 percent, to 65 people.

Dr. Given had been criticized by investors for not disclosing the F.D.A.’s concerns about the drug after the first two regulatory setbacks. The F.D.A. does not discuss drugs under review, which means shareholders are dependent on the company for information.

Dr. Given had said he wanted the company and the F.D.A. to discuss things out of the spotlight. But after the latest setback, he accused the F.D.A. of reneging on an agreement as to how the data from the company’s main clinical trial was to be analyzed. The F.D.A. would not comment on the accusation.

In a conference call on June 18, Dr. Given noted that the drug had been approved in Europe, Canada and Australia and said Encysive would appeal the F.D.A. decision. ANDREW POLLACK

BEYOND SOLAR Howard Berke, 52, the serial entrepreneur who helped found Konarka Technologies in 2001 to develop low-cost flexible plastic solar panels, is getting ready to move on.

Konarka, based in Lowell, Mass., is still privately held and a couple of months away from starting up its pilot production line, but Mr. Berke stepped aside from daily management last week. Rick Hess, whom he recruited last year as his eventual successor, took over as C.E.O. while Mr. Berke became executive chairman, focusing on strategy.

Mr. Berke is also taking on a new job searching for prospective renewable energy investments for Good Energies, a subsidiary of a Swiss investment company, and one of the venture capital firms backing Konarka. One of them might become Mr. Berke’s 14th start-up venture. “There’s no such thing as a conflict of interest as long as you are transparent in your relationships,” Mr. Berke said.

One bonus of the arrangement is that it offers more chances to go to Switzerland, the homeland of Mr. Berke’s wife, Sabine, and the country where he hopes to serve as United States ambassador “somewhere down the road.” BARNABY J. FEDER

THE GENEROUS BLACKBERRY The BlackBerry has made James. L. Balsillie, the co-chief executive of Research in Motion, very wealthy. But Mr. Balsillie and Michael Lazaridis, the other C.E.O., still live with their families in modest homes near the company’s headquarters in Waterloo, Ontario.

Their apparent frugality has not extended to their charitable giving, though. The two men have become the leading benefactors of higher education in that area.

Last week, Mr. Balsillie gave 33 million Canadian dollars ($31 million) to establish the Balsillie School of International Affairs, a joint venture of the University of Waterloo and Wilfrid Laurier University that will be located in Waterloo. Mr. Balsillie gave an additional 17 million Canadian dollars to the Center for International Governance Innovation, another affiliate of the new school. Three years ago, Mr. Lazaridis gave 33.3 million Canadian dollars to establish a school for research in quantum-related physics in Waterloo.

“Global governance issues are complex and require an interdisciplinary approach,” Mr. Balsillie said in an e-mail message. “This new school of international affairs will produce the next generation of students and ideas to help shape solutions to the most pressing global issues of our time.”

Mr. Balsillie was raised in another part of Ontario and attended the University of Toronto’s Trinity College and Harvard. IAN AUSTEN

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Risk-Aversion Therapy on Wall St.

By GRETCHEN MORGENSON

Published: July 1, 2007

THE bloom came off the Blackstone Group’s rose last week as the share price of this celebrated private equity firm fell below its June 21 offering price of $31. Investors have some nerve to dump Blackstone’s shares — don’t they know who Steve Schwarzman is?

The mighty deal maker atop Blackstone, Mr. Schwarzman is. The man of the moment in le tout New York, whose already sizable fortune was augmented by his $7.7 billion stake in newly public Blackstone shares.

Blackstone declined to comment about its faltering stock — it closed on Friday at $29.27 — and it may still rally, of course. But its downward drift seems part of a shift in investor sentiment — away from risk — that looks anything but temporary.

This mood change was visible across Wall Street last week. In the corporate bond market, investors’ risk aversion was evident when at least eight companies decided to postpone or pull their planned sales of securities.

One example was Kia Motors, the South Korean carmaker, which canceled a $500 million bond sale. Another was U.S. Foodservice, a unit of Royal Ahold, the Dutch supermarket company. It postponed a planned sale of $650 million of senior notes on Wednesday; the securities were intended to finance a proposed buyout of the company by two other private equity titans, Kohlberg Kravis Roberts and Clayton Dubilier & Rice.

Risk aversion is also showing up in the derivatives market, where the issuance of collateralized debt obligations is slowing. Last year, issuance of collateralized debt obligations — which include commercial and residential mortgages, corporate loans and small-business loans — approached $500 billion, up from $235 billion in 2005, according to Thomson Financial. But that flood is subsiding: global issuance of these pools of debt securities came in at around $46 billion in June, well down from the $62 billion issued in March.

The mortgage market, meanwhile, continues to reel. Last week, the Carlyle Group, a big private equity firm, reduced by 25 percent the size of a fund backed by mortgage securities that it plans to offer to investors. The firm also cut the offering’s projected price.

A retrenchment on risk is not surprising, given that the anything-goes mentality among investors has lasted for the past three years. The mortgage market’s woes were the first to tip the balance, but corporate bonds, stocks and private equity will also feel the effects of a pullback in risk-taking.

“Until now we were in a period where risk was underpriced,” said Nouriel Roubini, a professor of economics at New York University’s Stern School of Business and chairman of Roubini Global Economics. “Debt was so cheap that anybody could take a semiprofitable company private and leverage it. Now the price of this is going to be more expensive.

“There are some $200 billion of L.B.O.’s in the pipeline,” he added. “I think some of them might not be done or they will be done at a higher cost.”

There is — as there always is — a historical parallel here. Go back to the late 1980s and you will see another easy-money era when a real estate bubble and takeover mania was fueled by the issuance of risky securities, in that case junk bonds. Back then, the firm at the center of the profits — and later, the plunge — was Drexel Burnham Lambert. Michael R. Milken, its brilliant bond impresario, figured out how to raise money for companies that investors had previously shunned (the corporate version of subprime mortgages).

Savings and loan institutions, using insured deposits, were the manic lenders 20 years ago. Commercial real estate development and multifamily housing projects were the favored investments. When that party ended, the United States taxpayer had to foot the bailout bill. It cost $140 billion.

Back then, as now, the public watched with dismay as big players in the takeover game pocketed enormous sums. (Remember Mr. Milken’s $500 million payday? It was in 1987.) The takeover titans’ gains were especially distasteful when viewed against mass firings at companies that had been taken over in leveraged buyouts financed by junk bonds.

TODAY we have subprime mortgages being financed by hedge funds, pension funds, insurance companies and other institutional investors. But these same investors have also been lax in their lending to corporations issuing debt, often at the behest of private equity managers who hope to take those companies private.

“In both the L.B.O. market and collateralized loan markets there are practices that are the equivalent of the reckless lending in subprime mortgages,” Mr. Roubini said. “Subprime people will say it was a niche problem. That’s nonsense.” And the correction of those freewheeling ways has only just begun.

Mr. Milken’s successors on the big money front are hedge fund managers and private equity guys, and their ostentatious displays of wealth have started to attract unwanted attention from lawmakers in Washington — concerned about such mundane things as taxes.

But what may be most unseemly about all this is that many of the lucrative fees being generated by these managers — the money that finances their lavish lifestyles — are coming out of the pockets of pensioners. Police officers, firefighters, teachers, sanitation workers — hard-working people who just want to be able to retire comfortably someday — are the pension fund investors paying enormous fees to get into hedge funds and private equity deals.

There will always be haves and have-nots. But that doesn’t make the ever starker contrast between the two any more desirable.

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