A credit default swap (CDS) is a credit derivative contract between two counterparties, whereby the "buyer" makes periodic payments to the "seller" in exchange for the right to a payoff if there is a default^[2] or credit event in respect of a third party or "reference entity".

In the event of default in the reference entity:

• the buyer typically delivers the defaulted asset to the seller for a payment of the par value. This is known as "physical settlement".
• Or the seller pays the buyer the difference between the par value and the market price of a specified debt obligation. This is known as "cash settlement".

While little known to most individual investors, credit default swaps are commonly used contracts to insure against the default of financial instruments such as bonds and corporate debt. But they also are bought and sold as bets against bond defaults -- a buyer doesn't necessarily have to own a bond to buy the credit default swap that insures it. When traders buy swap protection, they're speculating a loan or bond will fail; when they sell swaps, they're betting that a borrower's ability to pay will improve.

Banks and other institutions have used credit default swaps to cover the risk of default in mortgage and other debt securities they hold.

CDSs are financial devices that allow banks to spread the risk of default and enable hedge funds to efficiently speculate on the creditworthiness of countries(governments), companies or consumers. In a typical CDS deal, a hedge fund will sell protection to a bank, which will then resell the same protection to another bank, and such dealing will continue, sometimes in a circle. This practice has the potential to put investors into webs of relationships which are not transparent.

Credit-default swaps pay the buyer face value in exchange for the underlying securities or the cash equivalent should a company fail to adhere to its debt agreements.

[edit] Market

Proportion of CDSs nominals (lower left) held by United States banks compared to all derivatives, in 2008Q2. The black disc represents the 2008 public debt.

Credit default swaps are the most widely traded credit derivative product.^[3] The Bank for International Settlements reported the notional amount on outstanding OTC credit default swaps to be $42.6 trillion^[4] in June 2007, up from $28.9 trillion in December 2006 ($13.9 trillion in December 2005). By the end of 2007 there were an estimated $45 trillion ^[5] to $62.2 trillion ^[6] worth of credit default swap contracts outstanding worldwide. On September 23, 2008, Christopher Cox, Chairman of the U.S. Securities and Exchange Commission, placed the worldwide CDS market at $58 trillion, and stated it was "completely lacking in transparency and completely unregulated."^[7] The U.S. Office of the Comptroller of the Currency reported the notional amount on outstanding credit derivatives from reporting banks to be $16.4 trillion at the end of March 2008. (For reference and perspective, the U.S. GDP for 2007 was $13.8 trillion^[8], while the world's GDP for 2007 was estimated at $54.3 trillion ^[9])

In 2007 the Chicago Mercantile Exchange set up a federally regulated, exchange-based market to trade CDSs. So far, it hasn't worked because It's been boycotted by banks, which prefer to continue their trading privately.

[edit] Auctions

Auctions, termed credit event fixings, periodically occur where batches of Credit Default Swaps are traded. These are the auctions since 2005. ^[10]

Date	Name	Final price as cents in the dollar
2005-06-14	Collins & Aikman - Senior	43.625
2005-06-23	Collins & Aikman - Subordinated	6.375
2005-10-11	Northwest Airlines	28
2005-10-11	Delta Airlines	18
2005-11-04	Delphi Corporation	63.375
2006-01-17	Calpine Corporation	19.125
2006-03-31	Dana Corporation	75
2006-11-28	Dura - Senior	24.125
2006-11-28	Dura - Subordinated	3.5
2007-10-23	Movie Gallery	91.5
2008-02-19	Quebecor	41.25
2008-10-02	Tembec Inc	83
2008-10-06	Fannie Mae - Senior	91.51
2008-10-06	Fannie Mae - Subordinated	99.9
2008-10-06	Freddie Mac - Senior	94
2008-10-06	Freddie Mac - Subordinated	98
2008-10-10	Lehman Brothers	8.625
2008-10-23	Washington Mutual

[edit] Structure and features

[edit] Terms of a typical CDS contract

A CDS contract is typically documented under a confirmation referencing the credit derivatives definitions as published by the International Swaps and Derivatives Association.^[11] The confirmation typically specifies a reference entity, a corporation or sovereign that generally, although not always, has debt outstanding, and a reference obligation, usually an unsubordinated corporate bond or government bond. The period over which default protection extends is defined by the contract effective date and scheduled termination date.

The confirmation also specifies a calculation agent who is responsible for making determinations as to successors and substitute reference obligations, and for performing various calculation and administrative functions in connection with the transaction. By market convention, in contracts between CDS dealers and end-users, the dealer is generally the calculation agent, and in contracts between CDS dealers, the protection seller is generally the calculation agent. It is not the responsibility of the calculation agent to determine whether or not a credit event has occurred but rather a matter of fact that, pursuant to the terms of typical contracts, must be supported by publicly available information delivered along with a credit event notice. Typical CDS contracts do not provide an internal mechanism for challenging the occurrence or non-occurrence of a credit event and rather leave the matter to the courts if necessary, though actual instances of specific events being disputed are relatively rare.

CDS confirmations also specify the credit events that will give rise to payment obligations by the protection seller and delivery obligations by the protection buyer. Typical credit events include bankruptcy with respect to the reference entity and failure to pay with respect to its direct or guaranteed bond or loan debt. CDS written on North American investment grade corporate reference entities, European corporate reference entities and sovereigns generally also include restructuring as a credit event, whereas trades referencing North American high yield corporate reference entities typically do not. The definition of restructuring is quite technical but is essentially intended to respond to circumstances where a reference entity, as a result of the deterioration of its credit, negotiates changes in the terms in its debt with its creditors as an alternative to formal insolvency proceedings (i.e., the debt is restructured). This practice is far more typical in jurisdictions that do not provide protective status to insolvent debtors similar to that provided by Chapter 11 of the United States Bankruptcy Code. In particular, concerns arising out of Conseco's restructuring in 2000 led to the credit event's removal from North American high yield trades.^[12]

Finally, standard CDS contracts specify deliverable obligation characteristics that limit the range of obligations that a protection buyer may deliver upon a credit event. Trading conventions for deliverable obligation characteristics vary for different markets and CDS contract types. Typical limitations include that deliverable debt be a bond or loan, that it have a maximum maturity of 30 years, that it not be subordinated, that it not be subject to transfer restrictions (other than Rule 144A), that it be of a standard currency and that it not be subject to some contingency before becoming due.

[edit] Quotes of a CDS contract

Sellers of CDS contracts will give a par quote (see par value) for a given reference entity, seniority, maturity and restructuring; e.g., a seller of CDS contracts may quote the premium on a 5 year CDS contract on Ford Motor Company senior debt with modified restructuring as 100 basis points. The par premium is calculated so that the contract has zero present value on the effective date. This is because the expected value of protection payments is exactly equal and opposite to the expected value of the fee payments. The most important factor affecting the cost of protection provided by a CDS is the credit quality (often proxied by the credit rating) of the reference obligation. Lower credit ratings imply a greater risk that the reference entity will default on its payments and therefore the cost of protection will be higher.

The swap adjusted spread of a CDS should trade closely with that of the underlying cash bond issued by the reference entity. Misalignments in spreads may occur due to technical minutiae such as specific settlement differences, shortages in a particular underlying instrument, and the existence of buyers constrained from buying exotic derivatives. The difference between CDS spreads and Z-spreads or asset swap spreads is called the basis.

To give an example, ABC Corporation may have its credit default swaps currently trading at 265 basis points. In other words, the cost to insure 10 million euros of its debt would be 265,000 euros per annum. If the same CDS had been trading at 170 basis points a year before, it would indicate that markets now view ABC as facing a greater risk of default on its obligations.

[edit] Pricing and valuation

There are two competing theories usually advanced for the pricing of credit default swaps. The first, which for convenience we will refer to as the 'probability model', takes the present value of a series of cashflows weighted by their probability of non-default. This method suggests that credit default swaps should trade at a considerably lower spread than corporate bonds.

The second model, proposed by Darrell Duffie, but also by Hull and White, uses a no-arbitrage approach.

[edit] Probability model

Under the probability model, a credit default swap is priced using a model that takes four inputs:

• the issue premium,
• the recovery rate (survival rate),
• the credit curve for the reference entity and
• the LIBOR curve.

If default events never occurred the price of a CDS would simply be the sum of the discounted premium payments. So CDS pricing models have to take into account the possibility of a default occurring some time between the effective date and maturity date of the CDS contract. For the purpose of explanation we can imagine the case of a one year CDS with effective date t₀ with four quarterly premium payments occurring at times t₁, t₂, t₃, and t₄. If the nominal for the CDS is N and the issue premium is c then the size of the quarterly premium payments is Nc / 4. If we assume for simplicity that defaults can only occur on one of the payment dates then there are five ways the contract could end: either it does not have any default at all, so the four premium payments are made and the contract survives until the maturity date, or a default occurs on the first, second, third or fourth payment date. To price the CDS we now need to assign probabilities to the five possible outcomes, then calculate the present value of the payoff for each outcome. The present value of the CDS is then simply the present value of the five payoffs multiplied by their probability of occurring.

This is illustrated in the following tree diagram where at each payment date either the contract has a default event, in which case it ends with a payment of N(1 − R) shown in red, where R is the recovery rate, or it survives without a default being triggered, in which case a premium payment of Nc / 4 is made, shown in blue. At either side of the diagram are the cashflows up to that point in time with premium payments in blue and default payments in red. If the contract is terminated the square is shown with solid shading.

The probability of surviving over the interval t_{i − 1} to t_i without a default payment is p_i and the probability of a default being triggered is 1 − p_i. The calculation of present value, given discount factors of δ₁ to δ₄ is then

Description	Premium Payment PV	Default Payment PV	Probability
Default at time t1
Default at time t2
Default at time t3
Default at time t4
No defaults

The probabilities p₁, p₂, p₃, p₄ can be calculated using the credit spread curve. The probability of no default occurring over a time period from t to t + Δt decays exponentially with a time-constant determined by the credit spread, or mathematically p = exp( − s(t)Δt) where s(t) is the credit spread zero curve at time t. The riskier the reference entity the greater the spread and the more rapidly the survival probability decays with time.

To get the total present value of the credit default swap we multiply the probability of each outcome by its present value to give

[edit] No-arbitrage model

In the 'no-arbitrage' model proposed by both Duffie, and Hull and White, it is assumed that there is no risk free arbitrage. Duffie uses the LIBOR as the risk free rate, whereas Hull and White use US Treasuries as the risk free rate. Both analyses make simplifying assumptions (such as the assumption that there is zero cost of unwinding the fixed leg of the swap on default), which may invalidate the no-arbitrage assumption. However the Duffie approach is frequently used by the market to determine theoretical prices. Under the Duffie construct, the price of a credit default swap can also be derived by calculating the asset swap spread of a bond. If a bond has a spread of 100, and the swap spread is 70 basis points, then a CDS contract should trade at 30. However owing to inefficiencies in markets, this is not always the case. The difference between the theoretical model and the actual price of a credit default swap is known as the basis.^{[citation needed]}

[edit] Uses

Like most financial derivatives, credit default swaps can be used to hedge existing exposures to credit risk, or to speculate on changes in credit spreads.

[edit] Hedging

Credit default swaps can be used to manage credit risk without necessitating the sale of the underlying cash bond. Owners of a corporate bond can protect themselves from default risk by purchasing a credit default swap on that reference entity.

For example, a pension fund owns $10 million worth of a five-year bond issued by Risky Corporation. In order to manage the risk of losing money if Risky Corporation defaults on its debt, the pension fund buys a CDS from Derivative Bank in a notional amount of $10 million that trades at 200 basis points. In return for this credit protection, the pension fund pays 2% of 10 million ($200,000) in quarterly installments of $50,000 to Derivative Bank. If Risky Corporation does not default on its bond payments, the pension fund makes quarterly payments to Derivative Bank for 5 years and receives its $10 million loan back after 5 years from the Risky Corporation. Though the protection payments reduce investment returns for the pension fund, its risk of loss due to Risky Corporation defaulting on the bond is eliminated. (However, the fund still faces counterparty risk if Derivative Bank becomes insolvent and cannot honor the CDS contract). If Risky Corporation defaults on its debt 3 years into the CDS contract, the pension fund would stop paying the quarterly premium, and Derivative Bank would ensure that the pension fund is refunded for its loss of $10 million (either by taking physical delivery of the defaulted bond for $10 million or by cash settling the difference between par and recovery value of the bond). Another scenario would be if Risky Corporation's credit profile improved dramatically or it is acquired by a stronger company after 3 years, the pension fund could effectively cancel or reduce its original CDS position by selling the remaining two years of credit protection in the market.

[edit] Speculation

Credit default swaps give a speculator a way to profit from changes in a company's credit quality. A protection seller in a credit default swap effectively has an unfunded exposure to the underlying cash bond or reference entity, with a value equal to the notional amount of the CDS contract.

For example, if a company has been having problems, it may be possible to buy the company's outstanding debt (usually bonds) at a discounted price. If the company has $1 million worth of bonds outstanding, it might be possible to buy the debt for $900,000 from another party if that party is concerned that the company will not repay its debt. If the company does in fact repay the debt, you would receive the entire $1 million and make a profit of $100,000. Alternatively, one could enter into a credit default swap with the other investor, by selling credit protection and receiving a premium of $100,000. If the company does not default, one would make a profit of $100,000 without having invested anything.

It is also possible to buy and sell credit default swaps that are outstanding. Like the bonds themselves, the cost to purchase the swap from another party may fluctuate as the perceived credit quality of the underlying company changes. Swap prices typically decline when creditworthiness improves, and rise when it worsens. But these pricing differences are amplified compared to bonds. Therefore someone who believes that a company's credit quality would change could potentially profit much more from investing in swaps than in the underlying bonds, although encountering a greater loss potential.

[edit] Taxation

The U.S. federal income tax treatment of credit default swaps is uncertain.^[13] Commentators generally believe that, depending on how they are drafted, they are either notional principal contracts or options for tax purposes,^[14] but this is not certain. There is a risk of having credit default swaps recharacterized as different types of financial instruments because they resemble put options and credit guarantees. In particular, the degree of risk depends on the type of settlement (physical/cash and binary/FMV) and trigger (default only/any credit event).^[15] If a credit default swap is a notional principal contract, periodic and nonperiodic payments on the swap are deductible and included in ordinary income.^[16] If a payment is a termination payment, its tax treatment is even more uncertain.^[17] In 2004, the Internal Revenue Service announced that it was studying the characterization of credit default swaps in response to taxpayer confusion,^[18] but it has not yet issued any guidance on their characterization. A taxpayer must include income from credit default swaps in ordinary income if the swaps are connected with trade or business in the United States.^[19]

[edit] Criticisms

Warren Buffett famously described derivatives bought speculatively as "financial weapons of mass destruction." In Berkshire Hathaway's annual report to shareholders in 2002, he said, "Unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends on the creditworthiness of the counterparties to them. In the meantime, though, before a contract is settled, the counterparties record profits and losses--often huge in amount--in their current earnings statements without so much as a penny changing hands. The range of derivatives contracts is limited only by the imagination of man (or sometimes, so it seems, madmen)." The same report, however, also states that he uses derivatives to hedge, and that some of Berkshire Hathaway's subsidiaries have sold and currently sell derivatives with notional amounts in the tens of billions of dollars.^[20] Berkshire Hathaway, with a market capitalization of $196 billion^[21], certainly does have enough equity to collateralize or guarantee these contracts.

The market for credit derivatives is now so large, in many instances the amount of credit derivatives outstanding for an individual name is vastly greater than the bonds outstanding. For instance, company X may have $1 billion of outstanding debt and there may be $10 billion of CDS contracts outstanding. If such a company were to default, and recovery is 40 cents on the dollar, then the loss to investors holding the bonds would be $600 million. However the loss to credit default swap sellers would be $6 billion. When the CDS have been made for purely speculative purposes, in addition to spreading risk, credit derivatives can also amplify those risks. If the CDS were being used to hedge, the notional value of such contracts would be expected to be less than the size of the outstanding debt as the majority of such debt will be owned by investors who are happy to absorb the credit risk in return for the additional spread or risk premium. A bond hedged with CDS will, at least theoretically, generate returns close to LIBOR but with additional volatility. Long term investors would consider such returns to be of limited value. However speculators may profit from these differences and therefore improve market efficiency by driving the price of bonds and CDS closer together.

However CDS premiums can act as a good barometer of company's health. If investors are not sure about a firm's credit quality they will demand protection thus pushing up CDS spreads on that name in the market. Equity markets will then draw a cue from the credit markets and push down the stock price based on fear of corporate default. For example the credit spread of Bear Stearns widened significantly in the period immediately prior to being bailed out by the Fed and JP Morgan, providing equity investors with advance warning of impending problems at the company.^{[citation needed]}

It acts like 'insurance' but isn't. "It is an insurance contract, but they've been very careful not to call it that because if it were insurance, it would be regulated. So they use a magic substitute word called a 'swap,' which by virtue of federal law is deregulated," according to Michael Greenberger, a law professor at the University of Maryland and a former director of trading and markets for the Commodity Futures Trading Commission. ^[22] The deregulation of the swaps market is thanks to provisions in The Commodity Futures Modernization Act of 2000.

Swap prices are hard to find^{[citation needed]}. Traders looking up prices on the Internet or on private trading systems see information that is hours or days old^{[citation needed]}.

[edit] Operational issues in settlement

In the US, the settlement and processing of a CDS contract is currently the subject of concern by the US Federal Reserve. In 2005, the Federal Reserve obtained a commitment by 14 major dealers to upgrade their systems and reduce the backlog of "unprocessed" CDS contracts. As of January 31, 2006, the dealers had met their commitment and achieved a 54% reduction.^[23]

In addition, growing concern over the volume of CDS contracts potentially requiring physical settlement after credit events for names actively traded in the single-name (only one reference entity^[24]) and index-trade market (where the notional value of CDS contracts significantly exceeds the notional value of deliverable bonds) has led to the increasing application of cash settlement auction protocols coordinated by ISDA^{[citation needed]}. Successful auction protocols have been applied following credit events in respect of Collins & Aikman, Delphi Corporation, Delta Air Lines and Northwest Airlines, Calpine Corporation, Dana Corporation, Dura Operating Corporation and Quebecor. ISDA is also using a protocol for the settlement of contracts on Fannie Mae and Freddie Mac debt, after these entities were placed in conservatorship.^[25]

One large difference between credit default swaps and insurance, is you do not need to own the bond or instrument being insured in order to obtain insurance on it. If the bond fails, then, theoretically, you get paid, possibly along with many others. Yet the "insurer" of the bond is not regulated and the transaction is beyond federal or state regulation. This allow speculators to make money by purchasing insurance on a company's bonds and then shorting the stock of the company in great quantity and getting a payoff that exceeds their risk of shorting if the price of the company's stock increases. The fact that you need not be a party to owning the bond also explains why the total value of credit default swaps is so high, indeed higher than the total value of the bonds issued.

[edit] LCDS

A new type of default swap is the "loan only" credit default swap (LCDS). This is conceptually very similar to a standard CDS, but unlike "vanilla" CDS, the underlying protection is sold on syndicated secured loans of the Reference Entity rather than the broader category of "Bond or Loan". Also, as of May 22, 2007, for the most widely traded LCDS form, which governs North American single name and index trades, the default settlement method for LCDS shifted to auction settlement rather than physical settlement. The auction method is essentially the same that has been used in the various ISDA cash settlement auction protocols, but does not require parties to take any additional steps following a credit event (i.e., adherence to a protocol) to elect cash settlement. On October 23, 2007, the first ever LCDS auction was held for Movie Gallery.[7]

Because LCDS trades are linked to secured obligations with much higher recovery values than the unsecured bond obligations that are typically assumed to be cheapest to deliver in respect of vanilla CDS, LCDS spreads are generally much tighter than CDS trades on the same name.

Many candidates simply ask supporters for money and a vote. Obama uses social media tools to ask for even more

Technology and an appreciation of how to use it have always been important to political campaigns. Franklin Delano Roosevelt used radio to get his message across effectively to voters. Lyndon Johnson rode a helicopter to get him around Texas in his famous race for the Senate. John F. Kennedy understood the power of television better than Richard Nixon during the race for the Presidency in 1960. And Republican operatives in the 1970s built direct mail into a fund-raising behemoth that powered party gains for 20 years.

The current generation of Presidential candidates—and their advisers, such as James Carville, Karl Rove, and David Axelrod—will likely go down in history as even more innovative in their ability to use technology to an advantage.

The 1992 Clinton campaign understood advertising via cable television. Clinton's advisers realized that instead of expensive commercials on the networks, they could target a cable ad buy right down to a Zip Code. They built an extremely sophisticated procurement system to buy ads with the greatest impact. This was consequential: Clinton is the only two-term U.S. President who never received a majority of the vote, and one could argue that instrumental to his victory was his campaign's understanding of technology.

Today, all candidates for high political office follow the Clinton cable TV playbook.

Bush Microtargeting

In 2004, tech use by George W. Bush's campaign defined his reelection. Bush's advisers, including Rove, invested in better ways to reach voters in heavily Democratic areas. Precincts in inner cities and certain suburbs have traditionally been 70% to 80% pro-Democrat; Republican candidates wouldn't even campaign there. But the Bush campaign honed microtargeting to reach people who voted infrequently and who might be open to their message.

The Bush campaign assembled information on millions of voters in swing states and bombarded those people with messages they wanted to hear. The campaign targeted people who vote often and are registered Democrats, but whom the Bush team thought it had a chance of persuading.

According to Adrian Gray, the National Voter Contact Chairman for Bush/Cheney 2004, the campaign was especially effective in targeting African American voters in Ohio. Nationally, 8% of African Americans voted for Bush, but in Ohio he received 16% of the African American vote. The Bush campaign also focused on New Mexico, a state Bush lost in 2000 by 366 votes, and microtargeted Hispanics. Result: The white vote for Bush fell 2% in 2004, but his Hispanic vote increased 12%—enough to put him over the top in the state.

Tipping the Balance

This microtargeting strategy was the difference in the election. Bush certainly would have lost without such successful targeting. Essentially, Karl Rove took a page from the Oakland A's highly successful general manager, Billy Beane (the key subject of the best seller Moneyball), and followed the data rather than simply gut instinct.

Now, just one election cycle later, most major candidates from both parties have used sophisticated microtargeting. As it happens, we at Rapleaf help many candidates, organizations, and unions—including some involved in the 2008 election—analyze voters better to engage and activate supporters.

This Presidential cycle has already seen a highly improbable upset for the Democratic nomination. Barack Obama beat his (initially) better financed and more entrenched opponent, Hilary Clinton, at least in part by deploying better technology. Obama's campaign strategist, Axelrod, has built a system from the ground up that does something quite simple: It asks people for their help.

The Third "Ask"

In politics, supporters traditionally get two "asks" from candidates: one for money, and one for a vote. That's it. That means most of the campaign work is done by a few paid staffers. Not a very participatory democracy.

The Obama campaign has turned this notion on its head and built a community involvement strategy. Axelrod and his team realized that supporters of a political candidate are passionate and want to help. And while most have full-time jobs and families, and can't spend weekends knocking on doors, they all have five minutes to spare to help out. The Obama campaign has brilliantly taken advantage of this by actually asking people for help. They're letting a large number of people do a small amount of work each.

So if you go to an Obama rally (or just sign up on his Web site), you might be asked to call three voters in a swing state. Or if they know you are a member of Digg (the popular site that lets users vote on articles of interest), Obama's people may ask you to Digg an article that is favorable to Obama or critical of his opponent. Or they might ask you to put a bumper sticker on your MySpace (NWS) page.

In 2012, all major candidates will be leveraging their supporters more effectively. But for now, Obama's campaign has the technology advantage.

See BusinessWeek.com's slide show for more on tech-savvy Presidential candidates.

Hoffman is chief executive of Rapleaf

Auren Hoffman is CEO of Rapleaf, a company that collects and analyzes publicly available people data from the Internet.

Book publishing could keep itself vital by taking a page from Web 2.0 technologies, but it has a long way to go. Here are some lessons
Amazon.com's Kindle electronic reader has come a long way since its late 2007 debut was met with mixed reviews, some derisive. Who could forget the moment at last year's Le Web Conference in Paris, when legendary designer Philippe Starck sniffed (BusinessWeek.com, 12/20/07), "It's a pity. It's almost modern." The audience erupted into laughter.

Amazon (AMZN) is laughing now. The Kindle, a device that lets people download, store, and of course read books in a digital format, could become a $1.1 billion business for the company next year, accounting for 4% of sales, according to a widely read Aug. 11 note by Citigroup (C) analyst Mark Mahaney.

Trailblazer that it is, Amazon knows well the benefit of applying a little technology to the stodgy business of publishing. Its flagship e-commerce business is one of the big success stories of the Internet, having revolutionized how people browse, shop for, and review books. Through Kindle, Amazon could do the same for how people read books.

Publishing is a subject near and dear to me—and not only because for the past two years I have been writing my first book. One of my parents was a philosophy professor and the other taught high school literature. Books were everywhere in my upbringing.

I want to keep it that way. A way to do that is to ensure that publishing learns how to exploit the full benefits of the social media tools now taking hold of the Web. Newspapers dragged their heels and look what's happening to them. As great as the Kindle is, publishing has a long way to go.

Herewith, five lessons that book publishers should take from the new Web.

Make it social.
Reading a book is an incredibly solitary experience. That's both a blessing and a curse. Like most busy professionals, I don't have a lot of downtime. What little free time I have could easily be filled by other pursuits—chiefly, time with a husband I rarely see. When I do commit to a book I love, I want to talk about it. This impulse explains why book clubs were all the rage in the 1990s.

There has to be a way for Web 2.0—a movement whose raison d'etre is to connect people—to meet the ongoing need for building community around books. Every publisher should at a minimum build a Facebook app. around its titles. The limitation with book clubs is time- and space-related. Not everyone can get their schedules (and geography) to mesh, and not everyone can read a book in the same time frame. But social networking could do for book clubs what Scrabulous did for fans of Scrabble—it let them play games together online, whenever they want

Yelp has mastered the art of making the most of online excitement in an offline world. The business review site became a force in San Francisco because of the real-world scene that grew up around it. Yelp events became raucous parties. It made the site stickier because it became an integral part of many people's social life. Suddenly, sitting alone at a computer penning a 1,000-word essay on why you love your dry cleaner became a social experience.

Take book tours out of the stores.
The conventional wisdom in publishing is that book tours no longer work. I agree, insofar as tours are confined to bookstores. The sad truth is that bookstores are declining in relevance. There are exceptions, of course, but even stores that draw big crowds for an author will struggle to reach the wide community of people interested in a particular author.

I'm learning this firsthand through what I'm calling my User Generated Book Tour, announced on my blog on a whim. My only rule: I'd go to 10 cities (not including San Francisco, Los Angeles, and New York) based on response and enthusiasm. With few exceptions, I've held no bookstore events.

And while I give huge props to my publisher Gotham for funding a very unconventional book promo, this approach hardly breaks the bank. Blogs and other social media tools including Twitter, Facebook, MySpace (NWS), and LinkedIn almost surgically pinpoint a writer's fan base in any city, rendering marketing easy and cost-effective. Any writer who's been savvy about social networking has at the same time been mapping a fan base and contacts throughout the country.

Digg founder Kevin Rose is a master of promotional tours. Once he established his Diggnation as a popular weekly podcast, he took it on the road. He'd hold a Live Diggnation anywhere and lines would form around the block.

There's a strong payback for intimately connecting with local audiences. Promoting anything—be it a Web site or book—is like running for office; nothing takes the place of face-to-face interaction. And by giving up on book tours because they happen in the wrong venue, publishers are throwing away a powerful tool.

Create stars—don't just exploit existing ones.
When an author is established, publishers have to do less to make a book sell. So bidding wars start. As a result, even some best-sellers aren't very profitable.

Instead, publishers should take a page from the handbook of Gawker founder Nick Denton and create stars. Find micro-celebs with a voice, talent, a niche base of readers, and most important—enthusiasm. Then leverage the publisher's brand (and the techniques I advocate, of course) to blow them out.

Require as part of the contract that the author blog, speak on panels, attend events. Give them incentives for delivering—say, though Web traffic of the number of followers they amass on Twitter.

Sure, publishers would have to spend more on promotion. But because they're spending less on an advance—say, $50,000 for a lesser-known writer than the hundreds of thousands of dollars (or more) they'd spend on a star—they can afford the bigger promotional budget. "It's taken some time for publishers to recognize that a successful site is as strong a 'platform' as a magazine, newspaper, or TV gig," says Patrick Mulligan, my editor at Gotham.

Even better: Tie that rising star to a multi-book deal from the beginning. Then any promotion is an investment in those next two books. It's basically the record-label model, made cheaper and easier via the branding-power of the social Web.

Go electronic from the get-go.
You might be stunned to learn that in book publishing, once you get to the final manuscript stages, there is no electronic version. The manuscript is FedEx'ed back and forth with Post-it Notes. If FedEx were to lose it, publishers lose months' worth of copy edits, legal edits, and other elements of the painstaking publishing process. There's not even a photocopy. No joke.

That makes publishing the book in other digital formats a challenge at the outset. Publishers would do well to keep the book electronic— even if it's PDFs of typeset pages. That would help them blast teaser chapters around the world (engaging bloggers and the long tail of the press). Presumably it would help get the book on Kindle and other e-books from day one.

This is as big a mindset change as it is a technology one. Many publishing houses just don't think about digital versions, relegating them to a few poor guys who work in a dungeon somewhere. Some publishers may want to force hardcover sales, but the music industry has learned the hard way: You can't control how people want to consume content in a digital age. Apple (AAPL) enshrined digital religion early on in its iTunes Music Store.

Make e-commerce even easier.
Yes, Amazon transformed how we shop for books. But the industry can go much further. Take the titles far beyond Amazon.com—through one-click widgets appended to blogs, Facebook pages, and other sites across the Web. Link these tools directly to PayPal and Google Checkout (GOOG). Think: one-click purchase, not one click takes you to Amazon.

Take these steps, book publishers, and stay vital.

How can book publishing better tap Web 2.0 tools? Share your ideas in the Reader Comments section below.

Lacy has been a business reporter for 10 years, most recently covering technology for BusinessWeek. Her book, Once You're Lucky, Twice You're Good: The Rebirth of Silicon Valley and the Rise of Web 2.0, was published by Gotham Books in May 2008. She is also Silicon Valley host of Yahoo Finance's Tech Ticker.

A major shift in the way companies obtain software and computing capacity is under way as more companies tap into Web-based applications

At first, just a handful of employees at Sanmina-SCI (SANM) began using Google Apps (GOOG) for tasks like e-mail, document creation, and appointment scheduling. Now, just six months later, almost 1,000 employees of the electronics manufacturing company go online to use Google Apps in place of the comparable Microsoft (MSFT) tools. "We have project teams working on a global basis and to help them collaborate effectively, we use Google Apps," says Manesh Patel, chief information officer of Sanmina-SCI, a company with $10.7 billion in annual revenue. In the next three years, the number of Google Apps users may rise to 10,000, or about 25% of the total, Patel estimates.

San Jose (Calif.)-based Sanmina and Google are at the forefront of a fundamental shift in the way companies obtain software and computing capacity. A host of providers including Amazon (AMZN), Salesforce.com (CRM), IBM (IBM), Oracle (ORCL), and Microsoft are helping corporate clients use the Internet to tap into everything from extra server space to software that helps manage customer relationships. Assigning these computing tasks to some remote location—rather than, say, a desktop computer, handheld machine, or a company's own servers—is referred to collectively as cloud computing (BusinessWeek, 4/24/08), and it's catching on across Corporate America.

The term "cloud computing" encompasses many areas of tech, including software as a service, a software distribution method pioneered by Salesforce.com about a decade ago. It also includes newer avenues such as hardware as a service, a way to order storage and server capacity on demand from Amazon and others. What all these cloud computing services have in common, though, is that they're all delivered over the Internet, on demand, from massive data centers.

A Sea Change in Computing

Some analysts say cloud computing represents a sea change in the way computing is done in corporations. Merrill Lynch (MER) estimates that within the next five years, the annual global market for cloud computing will surge to $95 billion. In a May 2008 report, Merrill Lynch estimated that 12% of the worldwide software market would go to the cloud in that period.

Those vendors that can adjust their product lines to meet the needs of large cloud computing providers stand to profit. Companies like IBM, Dell (DELL), and Hewlett-Packard (HPQ), for instance, are moving aggressively in this direction. On Aug. 1, IBM said it would spend $360 million to build a cloud computing data center in Research Triangle Park, N.C., bringing to nine its total of cloud computing centers worldwide. Dell is also targeting this market. The computer marker supplies products to some of the largest cloud computing providers and Web 2.0 companies, including Facebook, Microsoft, Amazon, and Yahoo (YHOO). "We created a whole new business just to build custom products for those customers," Dell CEO Michael Dell says.

"Now it's a several-hundred-million-dollar business, and it will be a billion-dollar business in a couple of years—it's on a tear."

One of those customers, Microsoft, has made cloud computing one of five priorities for fiscal 2009, according to a recent memo from CEO Steve Ballmer. Microsoft's version of cloud computing, Software-plus-Services, is designed to let customers choose whether they want traditional software, software services, or a combination of the two. In the memo, Ballmer promised that employees would hear more about the company's cloud computing platform initiatives in the next version of its Live and Online technologies, scheduled to be unveiled in October. About 9% of IT managers who responded in a Goldman Sachs (GS) survey said they planned to use Microsoft for software services this year in addition to those they already use.

Reliability Is a Concern

Many chief information officers remain concerned about the reliability and security of cloud-based services. Events like the six-hour outage on July 20 of Amazon's S3 service, designed for developers who want easy access to storage over the Internet, give CIOs reason for pause. "It's hard to turn a big ship very quickly," says Daryl Plummer, managing vice-president of consulting firm Gartner (IT). "You have technologies that are like cement in these businesses—they're hard to change and get rid of." Plummer says that about $8 out of every $10 spent on technology in corporations is for maintaining systems, rather than innovating.

At Sanmina, spurring innovation is one of the main motivations for investment in Google Apps, Patel says. "One of our strategies to be competitive on a global basis is to be innovative in terms of how we work with our different teams, with our customers, and our suppliers," he says, adding that his company operates in an extremely competitive industry. The price doesn't hurt, either. The enterprise version of Google Apps costs $50 per user per year, while a license of Microsoft Office Professional retails for $499.99. True, Google Apps lacks some of Office's features. But Google Apps compensates in that it's more adept at fostering collaboration among employees scattered across the globe, Patel says. "We see [cloud computing] as a very compelling proposition in the long term," he says.

As appealing as the prospect of cloud computing may be, many CIOs, analysts, and even vendors themselves, see it emerging only gradually in the enterprise. "It will be a draining of the pond," says Dave Girouard, president of enterprise for Google. While more than 500,000 organizations of varying sizes use Google Apps, more than half use the free version, according to Girouard.

Moving HR Functions to Google Apps

Now that he has let employees dabble in Google Apps, Patel is considering moving applications related to human resources, such as absence reporting and expense reporting, to cloud computing. He is also eyeing Amazon's Web services, which include both storage and server capacity. "Clearly from an enterprise standpoint we're going to take some baby steps first, try out some lower-priority applications to be sure it's a strong platform," Patel says.

In general, CIOs say cloud computing, whether it's software services or additional server or storage capacity, needs to improve a bit before enterprises will adopt on a larger scale. Security and reliability are big challenges. When Amazon's S3 storage service went down, many companies had trouble doing business. For smaller companies, the trade-off between the cost savings of using Amazon's service and the occasional hiccup in reliability is worth it.

"With Amazon, the benefits of easy scalability and low price far outweigh the occasional downtime," says Peter Yared, CEO of iWidgets a small company, who estimates he spends four times less by using Amazon Web services vs. conventional server hosting. Although Yared's Web site worked on July 20, he had trouble for about six hours with some user-generated code that was stored on Amazon's S3 service. Still, larger companies typically require a higher degree of reliability.

Another issue that worries CIOs is the ability to comply with regulations, including Sarbanes-Oxley rules that govern corporate financial reporting, and the Health Insurance Portability & Accountability Act (HIPPA), which sets rules for security and privacy of health records. ITricity, a European provider of cloud computing capacity, couldn't previously offer services to companies that required compliance with financial and health-care regulations. Currently, though, the company is installing what's known as a private cloud using IBM's Blue Cloud software and services, which turns a corporate data center into its own cloud. Since a private corporate cloud is blocked off from the Internet with firewalls, it provides a level of security that will make it possible for iTricity to offer services to the accounting, financial, and health-care markets.

Finding a Middle Way

In the past six and a half months, iTricity has spent more than $779,000 upgrading to IBM's new technology. That technology promises to give iTricity much more agility in offering services to customers. Now, customers who want additional computing capacity must wait a week. IBM's approach will cut that lag time roughly to an hour or less, iTricity says. "Our new slogan with iTricity capacity in the market is power by the hour and power within the hour," says Robert Rosier, founder and CEO of iTricity.

Because companies have such a large investment in existing technology infrastructure, many people think there will be a hybrid approach where companies will do some of their computing internally, possibly in a private cloud, while other tasks will be offloaded to the public cloud. "One of the key challenges for corporate IT departments, in fact, lies in making the right decisions about what to hold onto and what to let go," writes Nicholas Carr in his book, The Big Switch.

Girouard at Google says he is confident more and more companies will get comfortable with letting go. "Over time as larger and larger businesses decide to use Google Apps, there will be an upswing in the revenue," he says. Right now, Google's strategy is to get as many people and companies as possible comfortable using Google Apps. To that end, the company is doing things like providing Google Apps for free to universities. "We're generating millions of users for life," he says.

Patel and a growing number of employees at Sanmina may well be among them.

King is a writer for BusinessWeek.com in San Francisco.

Beyond computers, Wi-Fi-enabled televisions, set-top boxes, and cars are entering the market

Many people are familiar with the coffee shop's Wi-Fi, while others even know how to set up a simple home network. Pretty much everyone, however, knows that Wi-Fi is what makes it all possible. That ubiquity is what many venture firms are counting on as they invest in a group of startups putting Wi-Fi into cameras, televisions, and even keyboards and mice.

The number of Wi-Fi chips sold is expected to top 1 billion this year, up from more than 200 million sold in 2006, according to data from ABI Research. Beyond computers, Wi-Fi-enabled televisions, set-top boxes, and cars are entering the market. That's good news for those backing the standard, but it could pose a problem for the multiple startups betting on different wireless standards for connecting computers to peripherals, transmitting wireless video, and managing home-automation networks.

Carl Showalter, founding general partner with Opus Capital, says the current and next-generation versions of Wi-Fi have the bandwidth to offer video and can do a variety of things at lower power; energy use and wireless bandwidth have been the most common stumbling blocks to using the technology in more applications. For Opus, Wi-Fi's primacy in the market has translated into investments in Eye-Fi, which announced an $11 million Series B round this month for a card that Wi-Fi-enables a digital camera, and in GainSpan, which raised $20 million at the end of 2007 for its ultra-low-powered Wi-Fi chipset, which could be used in sensor networks and home automation.

So where in the home might Wi-Fi work? First, it's good to recall that Wi-Fi currently allows us to transmit a lot of data, really quickly, over distances of about 120 feet. In each generation of the technology standard, the amount of data that can be transmitted has expanded, essentially enabling the networks to carry more information, faster. Some companies are now working on ways to use the proposed 802.11n next-generation Wi-Fi standard, set by the IEEE, to transfer high-definition video to televisions.

Home Office to Living Room

Wi-Fi started out in the home office, linking computers to broadband connections, then to each other without cables. It could soon replace technologies such as Bluetooth or proprietary lasers in wireless keyboards and mice, thanks to a new project at Intel (INTC) called Cliffside. Researchers on the project are developing technology to add short-range transmission to Wi-Fi's capabilities. In June, Ozmo Devices came out of stealth mode with $12.5 million in funding from Intel Capital, Tallwood Venture Capital, and Granite Ventures with plans to use Cliffside technology in developing a line of Wi-Fi-enabled keyboards and mice. Products should be available later this year.

The office conquered, Wi-Fi is now making a beeline for the living room with attempts to deliver high-definition video to the television from set-top boxes, PCs, or DVD players. Samsung and Philips already offer Wi-Fi chips in televisions for standard-definition content. In late July, Cisco (CSCO), which has a pretty hefty stake in Wi-Fi with its Linksys-brand routers, led a $16 million round for Celeno Communications, a startup trying to make Wi-Fi-based home entertainment networks a reality. It's worth noting that several other technical standards are trying to win out when it comes to replacing the wires associated with televisions and their accoutrements. Those include ultra-wideband, wireless HD, and the newly formed WHDI Special Interest Group.

More Potential

Eric Zimits, a managing director with Granite Ventures, says the market for cable replacement between the TV and DVD player might end up using a specialized standard developed by the consumer electronics device makers, but he also says Wi-Fi provides more value by allowing content to move between more devices around the home. Standards such as ultra-wideband and wireless HD only travel distances of a few feet, making it impossible to use them to send a movie playing on the DVD player to a TV elsewhere in the home. In contrast, standards such as Wi-Fi or WHDI would make it possible to have just one set-top box that could wirelessly transmit content to all home screens.

The final potential home networking coup for Wi-Fi would be in the home-automation market, where emerging standards such as Zigbee and Z-wave are trying to succeed. As Wi-Fi sheds its power-sucking problems, it could also wirelessly control battery-powered thermostats, surveillance cameras, and other sensors. As your home fills up with gadgets running on the Wi-Fi network, venture firms will need to look for startups that can set bandwidth priorities among devices so that your television signal doesn't break up when your thermostat kicks on.

Provided by GigaOm—

Apple's Ambitious iPhone 3G Plans

It intends to make at least 40 million iPhones in the next year; selling so many will hinge on global success and fixing connection glitches

by Peter Burrows
Forecasting iPhone sales is one of tech's toughest guessing games. Since Apple's iPhone 3G came storming out of the gate with 1 million units sold in the three days after it went on sale July 11, analysts have scrambled to come up with a reliable forecast for how many of the devices the consumer electronics maker will sell in the coming years.

Many analysts expect Apple (AAPL) to sell around 11 million iPhone 3Gs in 2008 and another 25 million in 2009. But perhaps the most optimistic forecast is from Piper Jaffray (PJC) analyst Gene Munster, who expects the company to sell 13 million this year and 45 million next year.

While final sales can't be known until after the fact, clues are emerging as to Apple's production plans. As of mid-August, they were ambitious, BusinessWeek has learned. Apple plans to build 40 million to 45 million iPhone 3Gs in the 12 months through August 2009, according to a person familiar with the company's plans. The low end of that range is 52% more than the 26 million Munster expects the company to sell in that time. Apple boosted its production plans when initial sales proved stronger than the company expected, says the person, who requested anonymity. On launch day, the company expected to build 30 million iPhone 3Gs in 12 months. Apple declined to comment beyond reiterating that it expects to reach a stated goal of selling 10 million iPhone 3Gs in 2008.

The company's ability to reach that 40 million-plus goal will likely hinge on a successful introduction in several countries by the end of next year. Apple will also need to avoid component supply constraints and, maybe most important, address complaints over the performance of the updated version of its popular music-playing mobile phone.

Speeding Things Up

Apple's intention to sell the iPhone 3G in an ever broader circle of countries gives analysts cause for optimism. Analyst Michael Cote of Cote Collaborative recently told Fortune magazine he estimates Apple sold 3 million iPhone 3Gs in the first month, when the product was only available in 22 countries. Even if the sales growth clip slows after the initial burst of sales to gadget lovers, overall iPhone unit sales growth could accelerate given Apple's big international expansion plans. The company expects to begin selling in 20 more countries on Aug. 22. By next year, Apple may also be selling in the vast, swiftly growing Russian and Chinese markets. Also, Apple recently expanded distribution to include 986 Best Buy (BBY) stores.

Until recently, the major problem facing Apple and its partners was how to get enough iPhone 3Gs to market. Daily production has been running at around 150,000, says the person familiar with Apple's plans. If maintained five days a week for 52 weeks, that pace implies an annual production of 39 million devices. Suppliers of iPhone parts are used to handling far greater volumes; cell-phone makers such as Nokia (NOK) sell hundreds of millions of phones a year.

Apple will also need to reduce the time it takes to activate a phone once it's purchased at retail stores, says Needham & Co. analyst Charlie Wolf. "The physical process of activating the phone is the bottleneck," Wolf says. The process can take as long as 30 minutes, though Wolf says he's been told that Apple is working on improvements aimed at reducing the procedure to about 15 minutes.

Addressing Usability Glitches

Another challenge for Apple is a growing chorus of complaints over the phone's performance. Reports of problems began to fill the blogosphere in the second week of August, as owners reported an inability to obtain the fast "3G" wireless access even in places where these advanced networks were in place. Users have also lamented dropped phone calls and frequent switching from 3G to slower 2G networks.

While Apple has never publicly confirmed the problems, BusinessWeek first reported on Aug. 14 that the glitches relate to a communications chip in the device from Germany-based Infineon (BusinessWeek.com, 8/14/08), and that Apple plans to resolve issues with a software upgrade, rather than a product recall. An update came on Aug. 19, but many users and analysts quickly complained that the patch didn't solve the problems. According to reports, some customers say the update created new problems, in some cases rendering their iPhone useless. To now, the glitches haven't dragged down demand, Wolf says. "If the problems linger and the percentage of people being impacted grows, they'll have a problem," he adds.

An Apple spokeswoman won't confirm that there were any problems with the phone, or whether there would be follow-on updates. "We're always working to improve our products for our customers," Apple spokeswoman Jennifer Bowcock says. Apple hasn't made immediate changes to its production timetable in light of the glitches either, says the person familiar with Apple's production plans.

Adapting to Change

Even if Apple's existing production plans prove overly ambitious, Apple is still likely to meet the average estimates for actual iPhone sales. Also, Apple is known for having a supply chain that's efficient enough to adapt quickly to changes in demand. That would help the company avoid a major buildup of unsold products that would need to be sold at a discount or, worse, written off.

Munster says he's optimistic even in the face of the reported glitches. While he says he has not had access to Apple's actual production plans, he based his bullish forecasts for iPhone 3G sales in part on the success of Motorola's (MOT) hit Razr phone, which sold more than 100 million units even though it lacked some of the breakthrough features and brand popularity of the iPhone. Munster also expects Apple to release cheaper models at its annual Macworld show in January. Taken together, the moves could help Apple meet his aggressive targets even sooner than Munster expects it to.

See BusinessWeek.com's slide show on the next generation of iPhone apps.

Burrows is a senior writer for BusinessWeek, based in Silicon Valley .

Bankrupt Retailers: Pushed to the Brink

Changes in the law have sharply reduced retailers' ability to reorganize, driving many to liquidate quickly

People walk by a Sharper Image store Feb. 20 in San Francisco. Justin Sullivan/Getty Images

by Pallavi Gogoi

On Feb. 19 the electronic gizmo retailer Sharper Image filed for Chapter 11 bankruptcy protection. As part of its court filing, Sharper Image management committed to its lenders to close 90 of its 184 stores. But within weeks, newly appointed Chief Executive Robert Conway decided to liquidate the rest of the stores. Conway, who is a principal at turnaround specialist Conway, Del Genio, Greiss & Co., reached the conclusion that it would be nearly impossible to secure adequate financing to restock the remaining 94 stores. "We didn't want to delay the process to a point where there would be no value left, and we decided liquidation was the best option. The last few stores closed at the end of July," says Conway.

But the final nail in the coffin for Sharper Image came three years earlier, when U.S. bankruptcy law was revised to add cash payments to utilities and other suppliers, and place a 210-day cap on the amount of time bankrupt companies have to decide whether to keep a lease.

No Time to Reorganize

The rapid dissolution of Sharper Image took many in the bankruptcy industry by surprise. But that chain isn't alone. Several retailers that have filed for Chapter 11 protection (BusinessWeek.com, 7/21/08) since the economy started swooning have unraveled just as quickly: Wickes Furniture closed down its 36 stores. Friedman's is in the process of selling off jewelry and is closing its 377 stores, while Whitehall Jewelers is liquidating its 300 stores. All these companies filed for bankruptcy reorganization in 2008. And in December 2007, Bombay Co. and Levitz closed all their stores.

The new provisions in the bankruptcy law—pushed primarily by mall owners, suppliers, and utility companies, and signed by President George W. Bush in 2005—were intended to shorten the time that a company stays under court supervision. The point was to protect creditors, who sometimes had to wait years for payments while lawyers racked up hefty fees and managers collected big pay packages. "There was a pattern in some bankruptcy courts of granting extensions for as long as the debtor wanted, and that had to be stopped," says Lynn LoPucki, a professor at the University of California at Los Angeles School of Law and author of Courting Failure: How Competition for Big Cases Is Corrupting the Bankruptcy Courts.

Not everyone thinks sick companies should be given a second, or sometimes third, lease on life. Already many retail experts believe that chains overexpanded during the flush consumer spending of the past decade, and that parts of America now have more stores than people to shop at them. Given the track record of some big retailers, even if the latest bunch of troubled companies were to emerge from bankruptcy, they might wind up right back in court a few years later. Bradlees, Tower Records, and FAO Schwarz are among those that have filed multiple bankruptcies in recent years.

Strong Headwinds

All filers are covered by the new bankruptcy law, but the changes were particularly harsh on retailers. For companies that already are short of cash—and, in the current environment, unlikely to find new financing—these new provisions in the law can amount to a death sentence. "Liquidity is sucked out of the debtor in a way that it becomes hard to survive," says Lawrence Gottlieb, chair of the bankruptcy and restructuring practice at New York law firm Cooley Godward Kronish, who has represented creditors' committees in the bankruptcies of Sharper Image and Linens 'n Things.

Retailers already face strong headwinds. Consumers' appetite for discretionary purchases has dwindled sharply, and credit conditions are tight. That has led to shrinking sales month after month at most retailers and a string of store closings. Foot Locker (FL) is closing 140 stores; Wilson's Leather is closing 160; Ann Taylor (ANN), 117; and jeweler Zales (ZLC) has closed 105.

For some chains, times are even more desperate, and the drumbeat of retail bankruptcies grows louder by the day. So far this year, 15 retailers with assets of $100 million or more have filed for Chapter 11 bankruptcy, up from seven for all of 2007, according to Bankruptcydata.com, which tracks such filings. On Aug. 4, Boscov's, a department-store chain with 49 stores in the Northeast, filed for Chapter 11, just a week after the 177-store Mervyn's chain in California filed for protection from creditors.

Retail experts wonder what fate awaits these and other retailers such as Goody's Family Clothing and Linens 'n Things, which are already in Chapter 11. According to research tracked by LoPucki, in the 20 years prior to 2005, 41% of the 94 retailers that filed for bankruptcy went out of business. Those that emerged included such well-known outfits as Kmart (SHLD), Winn-Dixie Stores, and Macy's (M).

This time around, almost all of the retailers that filed in the first three months of 2008 dissolved quickly. The others face tough choices. Executives from Goody's and Boscov's didn't return calls to discuss their options.

Credit conditions are so tight that lenders are not willing to provide any wiggle room to distressed retailers. Talbots (TLB), for instance, isn't among the litany of bankrupt retailers. But earlier this year the upscale clothing chain had to extend its payment terms with its vendors to 45 days from 22 days, after Bank of America (BAC) and HSBC (HBC) refused to renew lines of credit worth $130 million and $135 million, respectively.

Pressure from Landlords, Vendors

File for bankruptcy, and the pressure now intensifies enormously. Prior to 2005, debtors had 60 days from filing for Chapter 11 to assume or reject a lease. Most of the time, bankruptcy courts would grant repeated extensions that lasted two years or more. Bankruptcy experts argue that gift of time was crucial: They say it takes a minimum of two Christmas cycles before a retailer is ready to put its finances in order and see if its reorganization plan is working.

But mall owners don't like to house bankrupt retailers. An extended, court-run reorganization can hurt the landlord's chance of securing positive financing terms. The real estate industry lobbied successfully for the 210-day cap on how long companies have to assume or reject leases. "Macy's got at least two Christmas seasons, but today if a company files in January, they don't even have until Christmas to decide what they will do," says lawyer Gottlieb.

Even as the lease decision looms, companies have to pay a cash deposit within 30 days to the utility companies that provide gas, electricity, and water to their stores. The purpose of that change was to provide assurance of the filer's ability to pay bills in the months going forward. Previously, just an assurance had been enough.

At the same time, vendors who ship goods to a company in the 20 days preceding a filing can get a priority claim that requires they be paid in full. The 2005 law also put an 18-month limit on how long the bankrupt company has to submit a restructuring plan; previously there was no limit. After the 18 months, creditors or other interested parties can offer their own plans.

Retailers may have stores in multiple locations and hundreds of vendors supplying a variety of items. "Stores immediately lose working capital," says Harvey Miller, a partner and bankruptcy specialist at New York law firm Weil Gotschal. He worked with Macy's in the past and has recently worked with several retailers including Goody's Family Clothing, a 355-store chain that operates in 20 states and filed for bankruptcy on June 9. Miller says Macy's reorganization, which took four years, wouldn't have been possible under the new setup. "In stress situations, you have to analyze by circumstances and not make deals under a formula," he says.

Landlords Say Retailers Overstate Law's Burden

Usually under Chapter 11, stores can sublet the leases to bring in much-required cash. However, most of these lease terms are expensive, because they were drawn up in the past decade when retailers were expanding and consumers' appetite for shopping seemed limitless. Today, not too many retailers are opening up or expanding. It's not surprising that Goody's Family Clothing canceled a lease auction that was to be held in the second week of August for 66 of its stores, after it was able to secure bids on just three of them in a previous auction.

"The rule that was meant to protect landlords is now coming back to bite them, because they will be left with neither stores nor payments," says Weil's Miller.

Landlords say that retailers and their lawyers are making the law look much worse than it is. That's because even though the law set a 210-day cap, it did leave some wiggle room and allowed a bankruptcy judge to grant an extension if the landlord consented.

"Now why wouldn't landlords consent to extend leases, when they know it's difficult to find another tenant?" asks Norman Kranzdorf, chairman of the Bankruptcy Task Force of the International Council of Shopping Centers, a trade group that represents mall owners. Besides, he says, landlords are entitled to a smaller claim—so if a retailer decides to close a store and still has a multiple-year lease outstanding, the landlord can claim payments only for a two-year period rather than for the remainder of the lease as they could previously.

"Sure, retailers don't have the luxury of time as they did before, but it's not that much of a detriment because landlords also lose at the bargaining table," argues J. David Forsyth, a partner at law firm Sessions, Fishman & Nathan in New Orleans, who represents landlords.

Ultimately, though, it's all a question of control, says Elizabeth Warren, law professor at Harvard University. She says that the impact of store closings is bound to be felt across the broader U.S. economy in coming months. "This will have a ripple effect through communities with hundreds of job losses, loss of taxes, and suppliers going out of business," says Warren, who in 2005 testified to Congress against changes to the bankruptcy law. "Bankruptcy is countercyclical—it is a tool designed to be a cushion during a downturn so that everybody takes a small hit for the short term and emerges stronger for the long term."