Lacking a Grand Plan, Europe Limps Ahead

In 2011, European leaders have been unswerving in their commitment to muddling through.

Not for them grand or decisive moves to resolve the euro zone's twin government and bank financial crises. Instead, they have settled on a series of smaller gestures, over which they have haggled publicly beforehand and often afterward. Some actions may have helped their currency union hobble through the year; others will at best reduce the chances of a future crisis.

France's Nicolas Sarkozy and Germany's Angela Merkel in Berlin in July.

"It's not pretty," says Daniel Gros of the Brussels-based Centre for European Policy Studies.

Can the policy makers win ugly? Given it's the season of goodwill, let us examine what could go right in the next few months.

The first reason policy makers might be more optimistic is that the European Central Bank has adopted a more active stance, even though its rhetorical position hasn't changed much.

New President Mario Draghi continues to hold the position that financing governments isn't the job of the ECB. But analysts say it's more important to look at what he's doing, rather than at what he's saying. Under his watch, and in spite of the protests that government finance isn't the job of the ECB, the securities-market program that buys government bonds has continued to expand—to €211 billion ($275 billion)—following significant purchases of Spanish and Italian bonds.

The ECB has also shown itself willing to take more aggressive action, as demonstrated by its decision to offer banks three-year funds for the first time ever this week. The ECB can argue that a more aggressive stance is warranted by banks' deteriorating cash positions and the risk that a credit crunch in the euro zone could develop as a result. But this, to be followed by at least one more such offer in 2012, should help banks overcome a liquidity crunch next year—and what's the harm if they use these funds to buy a few sovereign bonds?

Euro-zone governments are also hoping their current bailout fund, the European Financial Stability Facility, will be able to limp through until they get the permanent fund established in mid-2012.

Their hopes that it could be "leveraged" up to €1 trillion—as agreed at the leaders' October summit—have been comprehensively dashed, and it isn't clear what the plan is when France is downgraded from its triple-A status, which could happen any day. (Ideally, say some European officials, Germany would be downgraded by a similar amount, meaning that euro investors no longer have any triple-A assets to choose from.)

There should be enough usable guarantees to cope with Ireland and Portugal, the fund's two current clients, with Greece's expected initial demands from the fund, and with financing for some bank recapitalizations. But the fund is in no shape to act decisively should Spain or Italy get dragged into deeper difficulties.

So euro-zone governments are also hoping something else will happen: that Italian investors will start to become attracted to Italian government bonds.

Marc Chandler, global head of currency strategy at Brown Brothers Harriman in New York, says European officials "may have to resort to what economists are sure to consider 'financial repression,' which strongly encourages, if not forces, domestic entities to buy more government bonds."

Mr. Gros says Italian private investors—as well as the country's banks and investment institutions—may also begin to see Italian bonds as attractive. With Italy's 10-year bonds yielding 4.5 percentage points more than Germany's, the extra returns over a decade could even start to look attractive for Italian savers.

But if there is a case that muddling through might, just, work with the help of an activist central bank and Italian savers, the path ahead is strewn with pitfalls.

One issue is the sheer size of euro-zone governments' refinancing requirements next year. According to the International Monetary Fund, the Italian state's fund-raising needs in 2012 are equivalent to 23.5% of gross domestic product; Spain's are 20.6% of GDP. Even if Italian savers play ball, what about Spain's?

Greece, the longstanding stone in the shoe of the euro zone, also remains a challenge. It is currently renegotiating private debts to secure a 50% write-down from private creditors. The talks, which Finance Minister Evangelos Venizelos said earlier this week were going well, will have to be concluded in March when €14.5 billion of government bonds comes due. Even if negotiations conclude in time, Mr. Gros says a Greek collapse in the Argentine style—it's 10 years this week since the last Argentine debt default—can't be ruled out.

Last, but not least, are the banks. The plan adopted to boost bank capital agreed by European leaders in October has, say many analysts, made prospects for 2012 even worse. Banks were told to raise their minimum capital level to 9% of assets—based on the market value of sovereign debt in their portfolios. Nicolas Véron, of Brussels think tank Bruegel, argues that the decision to value government bonds according to market value risks amplifying the crisis. (As the value of their bonds fall, banks need more capital. But, in troubled economies, the only option for guaranteeing that capital is the already-struggling government.)

"This is a recipe for massive credit rationing and misallocation, for which there is more and more anecdotal evidence," he argues in a paper published Thursday. Mr. Véron says that euro-zone mechanisms for raising capital should replace at least some of the national guarantees, and that the link between regulatory capital and market prices should be broken. In the meantime, the feedback loop between sovereign credit and bank funding conditions has been reinforced, despite the ECB's efforts.

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AIG's Benmosche Extends His Stay

American International Group Inc. Chief Executive Robert Benmosche has told the company's directors that he would like to remain in his job longer than previously planned, signaling he is in for the long haul after weak markets slowed the government's exit from the bailed-out insurer.

Mr. Benmosche said in an interview that he plans to run New York-based AIG beyond next year, his health permitting. The 67-year-old, who was diagnosed with cancer in late 2010, previously indicated he planned to return to retirement sometime in 2012.

"I've talked to the board and said that if I stay healthy—and I'm still hopeful—I would like to stay on for another year," he said. "I want to stay active and energized, and having too much time on my hands is not healthy, I think."

AIG's board doesn't have to approve Mr. Benmosche's decision to stay, according to people familiar with the matter. The CEO previously threatened to quit two years ago due to frustrations over government-imposed pay curbs. The issues were worked out, and now the U.S.-AIG partnership is likely to last longer than both sides wanted, even though the government currently is a passive shareholder.

Robert Benmosche, in his family's theater, says that getting the government out of AIG is 'not a priority.'

Mr. Benmosche's latest comments come as AIG shares have declined 50% this year. The share price needs to improve before the government will consider reducing its stake.

But getting the government out is "no longer important; it's just not a priority" for the company because it is up to the Treasury Department to decide when to sell, Mr. Benmosche said.

A year ago, AIG was an improbable market darling, its stock soaring and generating hope that the U.S. could completely exit its investment in AIG by 2012. The Treasury still owns 77% of AIG following its 2008 rescue of the company and a sale in the spring of some AIG stock. Since then, "with the market situation and confusion in Europe, all that has changed the climate," Mr. Benmosche said.

Company and government officials still want to earn a profit for U.S. taxpayers on the Treasury's $40 billion-plus AIG investment, so the government has put off plans to divest its remaining stake until market conditions improve, say people familiar with the matter.

Mr. Benmosche said AIG's share price last December "was abnormally high," partly a result of the relatively small percentage of stock in the public's hands at the time. But the shares currently trade at about half their book value, or reported net worth, reflecting investor doubts about AIG's balance sheet and profitability.

Mr. Benmosche, who joined AIG in August 2009, has been widely credited with turning the company around and selling assets to help repay its record bailout, which at its peak used over $130 billion in taxpayer funds. He previously was CEO of MetLife Inc. from 1998 to 2006, the year he retired.

AIG recently started buying back shares in the open market as part of a $1 billion program unveiled in November. Mr. Benmosche wouldn't disclose how much stock AIG has repurchased but said the buybacks will continue. He said the share repurchases are meant to signal to investors that "we have a high degree of confidence…that we have excess cash" even amid weak markets and a year in which insurers had to foot large bills for damage from major earthquakes, storms and other disasters.

Since November, AIG's shares have traded between $20 and $25, below the $28.73 level that Treasury needs to break even on its investment in the company. The shares closed Thursday at $24.16, up 8 cents.

The shares have dropped 17% since AIG's stock offering in May, underperforming other large property-and-casualty insurance companies but doing better than the stocks of large banks and some life insurers.

Over the past few weeks, senior executives met with investors from Denver to Boston, including some who say they can't find any compelling reason to buy the shares when there are other, better-performing insurers to invest in.

Mr. Benmosche said he has told investors that AIG expects to rebound as markets start to improve, and the company is focusing on profitability by being selective about the insurance policies it writes.

He also has said AIG has the option to allocate capital to overseas growth markets if the U.S. commercial-insurance industry proves too competitive. But he acknowledges that investors' doubts about AIG's reserves are a "headwind" that will take a long time to overcome.

AIG sees a planned initial public offering of its aircraft-leasing unit, International Lease Finance Corp. as a priority next year, Mr. Benmosche said. The timing of ILFC's stock offering hasn't been decided, but the goal is for the first sale of a minority stake in the world's second-largest aircraft lessor to fetch as much as $2 billion to $3 billion, according to people familiar with the matter.

Proceeds from the IPO will go to the U.S. Treasury, which is positioned to recoup another $6.8 billion in bailout funds from AIG asset sales. Another slug of cash, roughly $1.5 billion, is sitting in escrow until it can be released to help pay down the balance.

Mr. Benmosche said getting the ILFC IPO done will give AIG flexibility on what to do with its one-third stake in pan-Asian life insurer AIA Group Ltd., which currently is worth $12 billion. AIG can sell some of its AIA stake now, but company officials would prefer to wait for a more-opportune time.

AIG also is working on being "Fed-ready" in 2012, by preparing its internal controls, finances and risk management systems to meet standards of the Federal Reserve, which could become the company's primary regulator due to AIG's size and its ownership of a thrift.

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Pyongyang Myth-Builders Step It Up

Kim Ki Nam has one of the toughest jobs in North Korea.

The 82-year-old former professor heads the department in North Korea's ruling party responsible for filling North Koreans' minds with awe, devotion and unswerving respect for the dictatorial Kim dynasty.

His task now: rapidly elevate the country's youthful new leader, Kim Jong Eun, to the status of quasi-deity in the minds of the North Koreans, including the elite, to legitimize the succession and solidify Mr. Kim's rule.

The Propaganda and Agitation department led by Mr. Kim, who is no relation to the ruling patriarchy, has been working on the project since 2009, when Kim Jong Il selected his third son as his successor.

Some of the department's early handiwork includes the outrageous claims of ability often associated with Kim Jong Il and widely ridiculed outside the country.

North Korea's new leader is described in one report from May 2009 as "an excellent general who displays the extraordinary talent of hitting the center of the target no matter how many times he fires."

The current leader's grandfather and founder of North Korea, Kim Il Sung, was said to have made a hand grenade from a pine cone to blow up an American tank.

Then, when Kim Jong Il was born, propagandists reported that the sky was filled with lightning and thunder, as well as a rainbow.

As recently as Wednesday, Korea Central News Agency reported many natural wonders observed around the country, such as the sky turning red and a huge snowstorm suddenly stopping, as the people mourned their dead leader.

Myth-building in North Korea is a serious business. Analysts say it is critical for the regime to ensure that the personality cult of the Kim family remains intact and its rule unchallenged.

Mr. Kim, who has been head of the propaganda department since 1992, had worked at various state media as an editor from 1964 until he joined the ruling party in 1977, according to a South Korean government website. He wasn't interviewed for this article.

North Korean students are taught Revolutionary History from elementary school to university, a subject full of tales that mystify and beatify the Kim dynasty, said Jun Myung-ho, a defector based in Seoul, who worked in North Korea's ruling Workers' Party for nine years before escaping to the South in 2004.

"The regime has to keep doing it, regardless of whether people believe it or not, because they need to establish the legitimacy of the family," said Mr. Jun. He recalls that teachers harshly scolded students with low grades in the subject.

According to Cheong Seong-chang, a senior fellow at think tank Sejong Institute near Seoul, the myth-building process for Kim Jong Eun has been progressing smoothly. But the sudden death of Kim Jong Il has accelerated the need for accounts of the younger Mr. Kim as the rightful heir.

That effort got rolling almost immediately after Pyongyang revealed the demise of the elder Mr. Kim, and has been going strong since then in the state-controlled media.

"No force on earth can check the revolutionary advance of our party, army and people under the wise leadership of Kim Jong Eun," said North Korea's state news agency in one of its first reports following Kim Jong Il's death.

In an editorial Thursday, North Korea's main newspaper Rodong Sinmun referred to Kim Jong Eun as "the outstanding leader of our party, military and people and a great successor.''

Already, songs sing his praise, such as this one: "Cheok, cheok, cheok [marching sound]./ Our general Kim's step is sending the spirits of February high and moving forward./ Cheok, cheok, cheok./ When [he] steps vigorously, all the people follow./ Cheok, cheok, cheok."

It is by no means certain that Kim Ki Nam and his staff can pull off the promotion of Kim Jong Eun as the rightful leader of the North Korean people, at least to the degree required to maintain power. Making the task harder is Kim Jong Eun's youth. He is thought to be 28 years old, in a culture that recognizes seniority based on age.

Kim Man-soo, another North Korean defector, says the impact of state propaganda has weakened significantly since Kim Jong Il took the reins of power in 1994 after his father, Kim Il Sung, died.

"It worked only until Kim Il Sung died. Kim Jong Il failed to win the hearts and minds of people as economic conditions got worse and worse. People don't believe it anymore," said Mr. Kim, who worked at a hospital before he left North Korea in 2006.

For Kim Ki Nam, that is the challenge. Any significant erosion of the mythology increases the risk that key senior figures, particularly in the military, might challenge the "great successor."

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BMW, Mercedes Duel in U.S.

BMW AG and Mercedes-Benz are locked in an expensive race for bragging rights as this year's top-selling luxury car in the U.S. market, and customers are benefiting.

The two German luxury-car brands this year have zoomed past Toyota Motor Corp.'s Lexus division, which has reigned as America's top-selling luxury auto maker since 2000, and are running neck and neck to grab the U.S. crown.

Heading into December, BMW had sold 221,073 cars and sport-utility vehicles in the U.S. market, a rise of 12.3%, and just 1,582 more than Daimler AG's Mercedes, whose sales are up 11.8% from a year ago.

BMW and Mercedes are providing dealers with sales incentives. Above, a worker unwrapped the one millionth 1 series in Germany, this month.

The battle is being fought by lease incentives and purchase discounts, helping customers such as Mike Goodstein, who lives in a Columbus, Ohio suburb, nab a great lease deal on a BMW 535xi.

"I bought it now because, quite frankly, around the holidays is the best time of the year to buy one. They have all kinds of rebates and holiday cash," said the 47-year-old.

Luxury car maker always have year-end sales, of course, counting on well-heeled customers to spend annual bonuses. But this year's campaign is especially hot because Toyota's troubles have given rivals their first fighting chance in years to grab the U.S. sales crown. Mercedes also is fighting off Volkswagen AG's Audi globally for second place after BMW, making its U.S. showing all the more important.

Sensing an opportunity to grab market share, BMW and Mercedes have quietly offered dealers discounts they could apply selectively when they have chances to steal customers away from competitors. Now, with the title of top-selling brand on the line, both BMW and Mercedes have hit the gas on incentives in hopes of nosing the other out.

Both are offering discounts for around $4,800 a vehicle, according to research firm TrueCar.com. Most of the discounts are more subtle than the straight cash rebates typically offered by mass-market brands like Ford and Chevrolet.

BMW and Mercedes, for example, are waiving the first two month's payments on leases and loans for many models, which can give buyers a price break of up to $2,000. They also are offering subsidized interest rates of as low as 0.9%, and discounts for returning customers, according to summaries distributed to dealers. On lease deals, they often assume a high residual value after the vehicles are returned, which helps lower monthly payments.

For instance, buyers can get a 30-month lease on a Mercedes C250 sedan for $349 a month.

Mike Jackson, chief executive of AutoNation Inc., the largest dealer by sales in the U.S., said its sales of premium vehicles rose 35% in November, powered mostly by Mercedes and BMW. The German car makers have launched updated models with new technology that few others can match.

"The new vehicles haven't just been home runs, they have been grand slams," Mr. Jackson said.

Moreover, upscale brands that trail BMW and Mercedes in technology are struggling. Sales for Honda Motor Co.'s Acura division and Infiniti, owned by Nissan Motor Co., are both down, and Ford Motor Co.'s Lincoln sales are flat. General Motors Co.'s Cadillac sales are up, but only by 4.5%.

In Fort Lauderdale, Fla., Melissa Foster drove her late model Mercedes C-Class to her dealer and found a bargain she couldn't pass up on a new C250. "My husband just loves his new car," said Ms. Foster, 39, of Fort Lauderdale, Fla. "I went in for a service and ended up coming home with a new car."

Peter Miles, sales chief for BMW's North American arm, played down the duel, saying the auto maker is getting a lift from a redesigned X3 compact SUV and a new all-wheel-drive version of its 5 series sedan.

While the No. 1 spot in U.S. sales would be "a nice recognition from the industry, I'm not sure our customers pay attention to that," Mr. Miles said, adding: "I am sure there is a little friendly competition going on" between BMW and Mercedes.

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Hedge Fund Chief Falcone Rejects an Offer to Settle by SEC

Prominent hedge-fund manager Philip Falcone has rejected a Securities and Exchange Commission settlement offer that would have banned him from the securities industry and essentially ended his career, people familiar with the matter said.

The move by SEC officials to reach a settlement came before an affiliate of Mr. Falcone's firm, Harbinger Capital Partners LLC, disclosed in a securities filing Dec. 9 that he and two senior executives have been warned by the SEC they could face civil-fraud charges.

An SEC spokesman declined to comment. A Harbinger spokesman said "any comment on settlement talks would be inappropriate."

The SEC's push for a multiyear ban on the 49-year-old billionaire from the hedge-fund industry is a sign of how seriously agency officials view alleged misconduct by Mr. Falcone that is now being investigated, people familiar with the matter said.

Mr. Falcone rose to prominence in 2007 with lucrative bets against subprime mortgages, and he is known for both big gains and big losses. The SEC is scrutinizing his hedge-fund business on three fronts, according to regulatory filings.

In March, Harbinger said it was under investigation by the SEC for possible market manipulation. The agency also said it was probing a loan Mr. Falcone took out from the fund in October 2009.

In the firm's regulatory filing earlier this month, Harbinger disclosed an unspecified third issue related to agreements with certain investors.

The Wall Street Journal has reported that the third matter is tied to whether Harbinger improperly agreed to allow some investors, including Goldman Sachs Group Inc., to cash out of their holdings, while barring other clients from withdrawing their money, according to people familiar with the matter.

An SEC multiyear ban likely would make it impossible for Mr. Falcone to continue running his hedge fund as a hands-on operation. Such a ban likely would include barring him from managing assets of the investors in his funds, people familiar with the matter said.

If Mr. Falcone agreed to an exile, it also would threaten his bet on LightSquared Inc., a new wireless-communications firm.

Mr. Falcone is trying to win crucial regulatory approvals for LightSquared but faces resistance from some lawmakers, including Sen. Charles Grassley (R., Iowa).

In a letter to Mr. Grassley in July, the chairman of the Federal Communications Commission, which will decide on granting crucial broadcasting spectrum allocations to LightSquared, said it had a "character policy" that is part of licensing decisions.

The regulator "will consider certain forms of non-FCC related misconduct," the letter said. The letter noted that the FCC usually doesn't consider allegations that haven't resulted in a conviction.

An FCC spokesman couldn't be reached for comment Thursday. Mr. Falcone and Harbinger haven't been charged.

The SEC's determination to push Mr. Falcone at least temporarily out of the business where he made his name and fortune comes amid pressure on the agency from lawmakers to show it takes a tough enforcement stance.

"The SEC has a varied but limited number of sanctions, and it's certainly under pressure to be drawing on its entire arsenal, and that includes industry bans as well as monetary penalties," said Daniel Richman, a law professor at Columbia University.

Bans have been part of some civil-fraud settlements reached by the SEC recently. In September, Barr Rosenberg, the co-founder of investment-management firm AXA Rosenberg Group LLC, agreed to a lifetime bar from working in the securities industry.

The SEC accused Mr. Rosenberg of concealing an error in the computer code of the investment model his firm used to manage client assets. Mr. Rosenberg didn't admit or deny wrongdoing.

Harbinger's assets hit $26 billion in 2008 as investors flocked to the fund, but setbacks since then include investment losses and client withdrawals. In the third quarter, Harbinger's assets fell to less than $5 billion, according to investor documents.

LightSquared has been beset by technical challenges and accusations of trying to improperly influence regulators. The company has denied any wrongdoing.

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Risks Cloud Outlook for Economy in 2012

The U.S. economy is poised for another year of muddling through.

Most private economists forecast a modest 2% growth rate for the U.S. in 2012, with a pace subdued by housing woes, a lackluster job market, and cuts by government. Economists also warn of potential spillover from weakness abroad, including a mild recession apparently under way in Europe.

The forecasts call for slightly more growth than this year's overall rate—which economists surveyed by The Wall Street Journal estimate will come in at about 1.7%.

To be sure, the recovery has shown surprising muscle in the final months of 2011—prompting many economists to raise their fourth-quarter growth estimates to 3.5% or more. Upside surprises aren't out of the question.

But for the most part, the outlook for 2012 is being shaped by four themes:

Global weakness—which threatens to undermine U.S. exports and could snowball if the European crisis deepens or another problem erupts.

Global growth will slow to around 2.7% in 2012 from about 3.0% this year, but there will be wide variation from continent to continent, according to forecasting firm IHS Global Insight. Europe is likely in recession, economists say, while developing economies such as China will ease back on growth as they manage inflation.

That will limit, but not torpedo, the market for U.S. exports, which have been a relative bright spot throughout much of 2011.

"We know the global economy is going to slow. The question is by how much," said Nariman Behravesh, IHS Global Insight's chief economist.

The foreclosure problem—which will keep the housing market flat on its back.

Housing will continue to languish, with foreclosures holding down prices, sales and new construction. The past year saw a reduction in the overhang of empty or financially stressed homes. But there's still a lot of overhang left.

The supply of "shadow" inventory—homes that are being foreclosed on or where their owners are three or more months delinquent—stood at 3.4 million in October, down from a peak of 4.2 million, according to Barclays Capital. The bank projects a steady fall to 2.7 million by the end of 2012. That remains well above a shadow inventory of 1.5 million at the beginning of the recession.

A lackluster job market—which means U.S. businesses will keep adding jobs, but at a rate too slow to put much of a dent in unemployment.

Forecasters at Wells Fargo predict the economy will add an average of 123,000 jobs a month—or about the number needed to keep pace with population growth.

This means the politically salient unemployment rate should stay above 8% through the November elections.

Economists see the job market hobbled by the slow growth in demand as well as structural challenges, including a mismatch between the skills of many unemployed workers and skills demanded by companies.

Weak job gains will result in only "marginal improvement" in personal income, according to Wells Fargo.

That means a problem for consumers in 2012. They stepped up spending in 2011, but can't continue to do so, say economists, if income growth remains subdued.

Consumer spending is projected to rise at a relatively sluggish pace of around 2.0% in 2012, down from the 2.6% annual rate economists expect for the fourth quarter of this year.

Government belt tightening—which will keep subtracting from growth.

The state and local government sector, where layoffs and budget cuts have weighed on growth in the past year, will subtract 0.3 percentage points from 2012 growth, IHS Global Insight says. Cuts by the federal government will subtract .23 percentage points from growth.

More than just budget cuts, though, Congress's acrimony and propensity for last-minute deals will weigh on business and consumer confidence. Economists' 2% growth projection assumes the 2011 payroll tax cut will be extended into next year, even though that hasn't happened.

Next year, the U.S. economy will continue to recover from the 2007-2009 recession, but it remains a long road back.

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Santander Unpopular at Home

As Banco Santander SA scrambles to raise funds by shedding assets abroad, it faces a backlash at home from angry customers saddled with some €4 billion ($5.2 billion) of paper losses on risky bonds the bank sold four years ago to fund a landmark takeover.

Hundreds of customers who purchased the bonds, which will automatically convert to common shares in October 2012, say Santander's bankers failed to spell out the investment's risks, according to consumer groups, plaintiffs' lawyers and regulatory complaints.

Spain's securities regulator said in an October report that it detected irregularities, including sales of the bonds before legal documents were filed, but it can't force the bank, Europe's second-largest lender by market value, to repay its clients.

Santander says it complied with all relevant rules for the €7 billion placement, which ranks as the world's largest-ever sale of convertible bonds.

Two individuals already have filed separate lawsuits against Santander seeking full refunds based on alleged disclosure missteps. In addition. Spanish local consumer association Adicae says it is helping 600 bondholders to negotiate a deal with Santander, as part of a broader effort to curtail banks' marketing of "toxic savings products." If those talks fail, the group says it will sue, seeking refunds for investors who were told the complex securities were savings products.

Benita Pedrosa, a 64-year-old widow on an €800-a-month pension, said she invested her life savings in the bonds because her local branch manager assured her the money was safe.

The investment's value declined by more than €30,000, or more than half its value. The bank recently dismissed her request to void the contract, and she said she now plans to complain to regulators.

The complaints by Santander customers echo the reactions of U.S. retail investors who invested in higher-yielding and supposedly safe auction-rate securities.

As the market for these investments froze in early 2008, regulators forced dozens of banks to repurchase tens of billions of dollars' worth of these investments. Now analysts are questioning whether Santander will have to compensate investors.

"The perception is that a significant number of pensioners have no clue what they bought," said Daragh Quinn, a banking analyst with Nomura. "If enough people complain, Santander is in trouble."

The standoff comes as Santander and other European banks face pressure to raise capital amid market tumult. European banking regulators recently instructed Santander to come up with more than €15 billion in new funds. The bank is counting on the issuance of shares tied to the convertible bonds to fill roughly half of the shortfall, while also selling assets in fast-growing Latin American markets.

Santander Chief Executive Alfredo Sáenz recently ruled out any compensation for convertible bondholders. "In essence, they're in the same situation as shareholders," he said on a conference call.

In late 2007, Santander sold the convertible bonds to 129,000 Spanish retail customers to fund its portion of the €72 billion purchase of ABN Amro NV, the Dutch lender that Santander bought along with two other European banks.

Called Valores Santander, the bonds offered a 7.5% interest rate in the first year, and then were set to pay 2.75 percentage points above the European interbank lending rate during the remaining four years. If the bid for ABN failed, Santander would return the cash to clients after a year, giving Valores a deposit-like feature.

But the bid succeeded, and the bonds will automatically convert into shares in October 2012 at a 16% premium to Santander's share price at the beginning of October 2007.

Under those terms, Valores holders stood to profit on the security if Santander's stock rose by at least that much over the next five years. But Santander's shares, which closed at €5.78 Thursday, would need to more than double to €14.13 by October for that to happen.

Spain's securities regulator, CNMV, examined the deal last year after complaints rolled in. It said in October it had "sufficient cause to qualify [Santander's] behavior as incorrect" in 26 cases related to the bond sale, which warranted voiding the sales contracts.

The CNMV can't require the bank to repay its clients, and it can't levy fines in individual cases. It can only refer those investors the courts. The regulator declined to comment on specific cases beyond its October report.

Santander color-coded Valores as a "yellow product," aimed chiefly at wealthy and sophisticated clients. In some cases regular retail-banking clients could buy it, "when the branch worker believes that the product fits their risk profile," according to Santander's internal guidelines.

Ms. Pedrosa, the widow who said she plans to pursue a case with the CNMV, said she didn't fit this profile. She paid €60,000 for bonds that are now worth €24,000.

In several cases, the CNMV found Santander began selling Valores before publishing the prospectus that laid out the bond's key terms and conditions. Sales contracts seen by The Wall Street Journal indicate Santander sold Valores to customers as early as Sept. 6, 2007, almost two weeks before the prospectus was published.

The bank views contracts signed before the prospectus's publication as expressions of interest, not sales orders, according to one person familiar with the sale.

Jorge Segura, a 48-year-old prison therapist, is suing Santander. He wants the bank to return his €45,000 Valores investment partly because he bought the bonds two days before the prospectus's publication.
His case is scheduled to go to trial in March.

Others followed Santander's lead. Spanish banks sold more than €20 billion in convertible bonds and preferred stock to retail customers between 2007 and 2010. Many of these securities also have accumulated steep losses.

"It's always a temptation for a bank to use its client base to place its own securities, but it's at the very limit of what's ethical," because retail clients often aren't savvy enough to carefully weigh the risks, said Carles Vergara, a finance professor at IESE Business School in Madrid.

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ECB Overnight Deposits Reach New 2011 High

Use of the European Central Bank's overnight deposit facility reached a new record high for the year Thursday, suggesting recent measures by central banks and policy makers still aren't enough to restore confidence in inter-bank lending markets.

Banks deposited €346.99 billion ($453.38 billion) in the overnight deposit facility, up from €264.97 billion a day earlier and a previous high for the year of €346.36 billion, reached earlier this month.

The high level reflects ongoing distrust in inter-bank lending markets, where banks prefer using the ECB facility as a safe haven for excess funds rather than lending them to other banks.

The high deposit level also suggests markets aren't fully convinced that the ECB's massive long-term loan allotment is enough to fortify the currency bloc's banking sector. The central bank extended nearly half a trillion euros in long-term loans to euro-zone banks Wednesday, hoping to ease fears of a new credit crunch as banks struggle to borrow from markets.

Separate actions in recent weeks by central banks and policy makers have also sought to make dollar loans cheaper for euro-zone banks and to boost fiscal integration in the bloc.

Bank of England Governor Mervin King on Thursday said that warning signs for the debt and banking crisis remain "sufficiently red," although funding stress for euro-zone banks should be relieved in the months ahead.

The ECB further said banks borrowed €6.34 billion from the ECB's overnight lending facility, compared with €7.55 billion borrowed a day earlier. When markets are functioning properly, banks only use the facility to the tune of a few hundred million euros overnight.

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Hungary keeps wary markets guessing after S&P cut

Hungary's second credit downgrade to 'junk' in a month heightened risks of a full-blown market crisis, with investors anxious for clarity on whether it will push the country closer to or further away from an international aid deal.

Late on Wednesday Standard and Poor's cut Hungary's long-term rating by a notch to BB+, sending the forint currency lower and lifting bond yields.

The agency cited the centre-right government's unpredictable policies, adding to pressure on Prime Minister Viktor Orban to start official talks with the International Monetary Fund and EU about a funding backstop.

The government said the downgrade was unjustified and still expected the negotiations with lenders to go ahead in January.

Bond prices fell on Thursday, though the deputy head of the country's debt agency said he did not expect the news to spark panic selling.

"Yields are 30-35 basis points higher, but this jump came on small amount of selling...there is no dumping of assets," a fixed income trader added.

The Fidesz party led by Orban, who broke ties with the IMF in 2010 to regain "economic sovereignty, is expected to push through legislation this year which the EU has said it should withdraw, notably a central bank bill seen undermining the bank's independence.

"At the moment (Orban) is sitting in the car in head-on collision mode and is not willing to move," a diplomatic source told Reuters on Wednesday, before the S&P downgrade.

Orban is seeking a new "insurance" type financing deal, which could help Hungary retain access to market funding next year, but at the same time does not want lenders interfering with his unconventional policies to boost the economy.

"(The downgrade) could, alongside market weakness, push Hungary towards engaging more constructively with the IMF and EU. It may also serve to fast-track the negotiations," Barclays said in a note.

"But there is also a risk that Hungary's government will try to soldier on without outside financial support, instead turning to more unorthodox policy measures."

The government has stabilised its budget with a series of ad hoc taxes and nationalised pension assets since it swept to power with a two-thirds majority in April 2010. Several of its measures have shocked investors and earned the ire of the European Union.

European Commission President Jose Manuel Barroso asked Orban in a weekend letter to withdraw the central bank bill.

Fidesz has since proposed several amendments to the bill, but has left some contentious parts about the expansion of the Monetary Council intact. Orban has said the government and the central bank must cooperate to provide funding for the economy.

SECOND RATINGS CUT TO JUNK

S&P was the second rating agency within a month, after Moody's, to cut Hungary's debt to below investment grade.

Hungary targets one of the EU's lowest budget deficits next year at 2.5 percent of GDP, but it faces possible recession which poses a risk to the sustainability of its deficit cuts and could jeopardise the government's pledge to reduce debt which at 80 percent of GDP is the highest in central Europe.

Hungary needs to roll over close to 5 billion euros in external debt alone, on top of forint denominated papers, next year.

The country's debt agency said on Thursday its net financing needs for 2012 totalled 674 billion forints and that it would raise 4 billion euros in hard currency debt, either from the market or other sources.

The forint traded at 306.75 to the euro on Thursday morning at 0833 GMT following the downgrade which pushed the currency lower in overseas trade late on Wednesday.

A dealer said investors would likely hold off selling until the new year or until Fitch, the last agency to keep Hungary in investment category, decides to downgrade it as well.

"Investors for now go for the high yield, there is no panic, no selloff," the dealer said.

Hungary's 5-year bonds traded at 9.10 percent on Thursday while the yield on the 10-year benchmark bond was at around 9.12 percent.

"Hungary's economic fundamentals do not justify a junk rating, but the damaging policies of the Hungarian government have undermined investor confidence and this is the key reason why both Moody's and S&P have decided to cut Hungary's rating," Danske Bank said.

"Furthermore, it is clearly worrying that the Hungarian government apparently continues to ignore how negative the consequences of its actions are."

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China Considers Letting Pensions Invest in Domestic Stocks

Some Chinese officials are pushing for a system that would allow local governments to take some of the nearly two trillion yuan ($317 billion) socked away in pension funds and invest in domestic stocks, according to people familiar with the matter.

The effort comes as the authorities continue to look for ways to boost returns on capital sloshing around the world's No. 2 economy.

China's securities watchdog and other government agencies have discussed a proposal that would involve setting up a new entity similar to the country's National Social Security Fund, these people said. That fund would invest a portion of the money in the domestic stock markets on behalf of local governments, which oversee pension funds that are expected to total about two trillion yuan by year-end, the people said.

Currently, local pension funds can park their money only in low-yielding instruments such as bank deposits and government bonds.

Such a plan would mark another significant step by China toward developing its still-nascent capital markets as it moves toward facilitating more capital flows across the border—a key condition for its ambition of turning the yuan into a global currency. It could also help underpin Chinese stocks: Shanghai's main benchmark is down by about one-fifth so far this year over concerns that domestic economic growth is slowing.

It's unclear how such a fund would be structured or whether it would gain the approval of China's top leaders. Proponents will likely face skepticism because China's stock markets have been plagued by irregularities among listed companies, which could put pensioners' interests at risk, and because returns in the stock market aren't guaranteed and pensions could lose money.

The plan would need approval from the State Council, China's cabinet, the people said.

China started to overhaul its national pension system in the late 1990s amid concerns over a rapidly aging population, and put in place a system under which pensions are largely managed at the local level. Funding and terms depend on the location, but they are funded by a mix of public money and contributions from employers and employees. Such funds are separate from the National Social Security Fund, which was set up in 2000 with funding mainly coming the central government.

Now, a lack of asset-management expertise among local governments has added to worries about potential funding shortfalls down the road, leading to calls for an asset-management fund that could invest the assets on their behalf, the people with knowledge of the matter said.

Also of concern is the potential for local pensions to be misused by corrupt officials, the people said. A widely publicized corruption case in 2006 involved the dismissal of the then-Shanghai party secretary, Chen Liangyu, for alleged misuse of money in the city's social security fund. He was convicted of taking bribes and embezzling public funds.

Some Chinese regulators have endorsed the idea of forming an entity like the National Social Security Fund to manage local pensions.

"We need to consider how to aggregate all the local pensions currently scattered around different provinces and set up or entrust a specific entity" to invest the funds, said Guo Shuqing, chairman of the China Securities Regulatory Commission, China's securities watchdog, at an economic forum last week.

Mr. Guo pointed to the National Social Security Fund as an example, noting that the fund, whose investments range from Chinese stocks and bonds to foreign equities, has generated annualized returns of 9.17% since its launch a decade ago.

Dai Xianglong, a former central-bank governor who now heads the National Social Security Fund, said in a speech posted on the fund's website Tuesday that certain government agencies are considering aggregating some basic pension funds currently managed by provincial and municipal governments and then investing some of the funds in financial assets like stocks.

"It's the right move, and we're supportive of that," Mr. Dai said.

Allowing local pensions to buy stocks could help add liquidity and credibility to China's stock market, which has been populated with individual investors and rife with insider trading, analysts say. It could also help boost the sagging fortunes of the mainland market, which has taken a beating this year on worries about China's economic growth.

Still, some analysts questioned how fast the plan would be put together. Merging China's local pension funds into a coherent investment vehicle is "a major problem," analysts at North Square Blue Oak, a London-based institutional broker, wrote in a research note.

"While there are many suggestions on how to invest pensions into the stock market, a major increase outside of the [National Social Security Fund] cannot be achieved until this issue is resolved," the analysts said.

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Funds Sue Deutsche Over Deal on Claims

Two hedge funds filed a lawsuit accusing a Deutsche Bank AG unit of reneging on a $1 billion deal to buy their claims for losses in Bernard L. Madoff's Ponzi scheme.

The suit, filed in a New York federal court by Kingate Global Fund Ltd. and Kingate Euro Fund Ltd., is a sign of the negative consequences of recent court decisions against the trustee overseeing the bankruptcy of Mr. Madoff's firm.

Courts have handed down recently a series of unfavorable decisions to Irving Picard that limit his ability to further recover money. Those decisions have pushed down the value of Madoff-related claims to 60 cents or less on the dollar, according to the lawsuit. Such claims traded near 75 cents about six months ago.

The lawsuit filed by Kingate alleges that Deutsche Bank Securities Inc. has been dragging its feet since August 24, when both parties signed a letter confirming terms of its deal to purchase Madoff claims from Kingate.

Deutsche Bank "is going back on its written binding commitment to purchase the Kingate Funds' claims because it does not want to pay what it now views, with the benefit of hindsight, as too high a price," according to the complaint filed by Richard I. Werder Jr., a lawyer for the Kingate funds. The value of the claims is down by more than $90 million since late August, the hedge funds alleged.

The lawsuit seeks a judgment stating that the confirmation letter is binding and that Deutsche Bank hasn't negotiated in good faith. Deutsche Bank has said it will finalize the purchase at the original price but only if it gets written assurances that it will be eligible for payouts from a pot of nearly $3 billion in forfeitures of money and property related to the case recovered by federal prosecutors in Manhattan, according to people familiar with the matter.

That is in addition to an $8.7 billion pot recovered by Mr. Picard from people who took profits from phony investments.

In a statement, Deutsche Bank said it "will purchase Kingate's claim if both parties can finalize mutually acceptable documentation." William Tacon, a liquidator of the Kingate funds, declined to comment.

Mr. Picard has been appointed special master to distribute the money collected by prosecutors, but the Justice Department hasn't determined exactly how or to whom the funds will be given out. A spokeswoman for Mr. Picard said he couldn't comment on pending litigation.

The Kingate funds fed billions of dollars to Mr. Madoff before his Ponzi scheme collapsed three years ago. Under the deal with Deutsche Bank, it would purchase the funds' combined claim of about $1.6 billion for a cost of about $1.1 billion, or about 66 cents on the dollar, according to the confirmation letter. The letter said the deal was "firm, irrevocable and binding," but also that it was subject to negotiation and execution of a purchase and sale agreement, which is where the transaction has stalled.

One ruling in September struck down most of Mr. Picard's $1 billion lawsuit against the owners of the New York Mets and their associates. That ruling could have implications for Mr. Picard's ability to collect billions of dollars from others he has sued, the trustee's aides have said.

The Kingate funds have also been sued by Mr. Picard for allegedly ignoring signs of the Ponzi scheme. The Deutsche Bank deal would allow the funds to complete a legal settlement with Mr. Picard and distribute some money to its own investors, the Kingate lawsuit says.

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Banker Will Lead Spanish Crisis Fight

Mariano Rajoy, Spain's newly elected prime minister, selected a well-known former deputy finance minister and investment banker to spearhead his government's efforts to pull the euro zone's fourth-largest economy out of its worst crisis in decades.

Spain's new finance minister will be the 51-year-old Luis de Guindos, an economist who held various positions, including deputy finance minister, in the governments of conservative Prime Minister José María Aznar during the 1996-2004 period. Later, he headed investment bank Lehman Brothers in Spain, a financial-sector think tank and has been a frequent commentator in the local press.

A good communicator and English speaker, Mr. de Guindos will assume the dual challenge of pushing through tough overhauls at home while shoring up international confidence in Spain, a key task at a time of soaring borrowing costs. As he isn't a member of Mr. Rajoy's Popular Party, he is viewed as independent in Spanish political circles.

Mr. Rajoy's cabinet formation comes just over a month after his conservative Popular Party won a landslide victory in general elections, making Spain the third ailing euro-zone economy to see a change of government in recent months after administrations in Italy and Greece collapsed over their inability to push through economic overhauls demanded by the European Union and financial markets.

Mr. Rajoy has promised to make reducing the country's unemployment rate—now above 21%—and meeting its deficit-reduction commitments with the EU his top priorities.

In a break with usual practice, the veteran politician waited until taking his oath of office earlier Wednesday before announcing the ministries that will make up his government and the people that will head them.

Overall, Mr. Rajoy has cut the number of ministries to 13 from 15, though he created a new budget ministry that will assume responsibility for budget and tax issues. It will be headed up by Cristóbal Montoro, 61, previously the Popular Party's chief economic spokesman. Mr. de Guindos's finance ministry will have responsibility for overall economic policy.

Mr. Montoro also held various positions in the Aznar governments of 1996-2004, including that of budget minister. The economic overhauls made during those years are largely credited with helping to ensure that Spain entered the euro in 1999 and to transform the country into one of the currency area's chief growth engines until the global financial crisis struck in 2007. Some critics, however, have charged that those same policies encouraged the formation of Spain's massive housing bubble, the fallout of which continues to weigh heavily.

"The combination of de Guindos and Montoro is great news," said Angel de la Fuente, head of Kepler Capital Markets in North America. "They both have experience from the Aznar government and de Guindos knows financial markets well."

Although Mr. Rajoy had pledged the foreign-affairs ministry would be the most important in his new government, helping to raise Spain's profile in international economic forums, he chose the relatively unknown José Manuel García-Margallo to head this ministry. Mr. García-Margallo, 67, who was a member of the first democratic parliament after the death of Gen. Francisco Franco, has been a member of the European Parliament for the past 17 years.

Mr. Rajoy appointed Madrid's popular mayor, Alberto Ruíz-Gallardón, a moderate with broad appeal across party lines, as justice minister.

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European Banks Rush to Grasp Lifeline (Video)

Hundreds of euro-zone lenders took out €489.19 billion ($640 billion) in low-interest loans from the European Central Bank on Wednesday, as the currency area extended a massive financial lifeline to its struggling banking industry.

The unexpectedly heavy demand from 523 banks for the three-year loans highlighted the severity of Europe's financial crisis, while also stirring some hopes that the action could help defuse it, or at least prevent it from getting worse.

Investors didn't seem convinced that the loans would drastically improve banks' prospects. After rallying when the ECB announced plans for the program earlier this month, the Euro Stoxx Bank Index fell 1.5% on Wednesday. In a mildly bearish sign about prospects for the euro debt crisis, yields on Italian and Spanish bonds inched higher.

The ECB's loan program—the first in which it has offered three-year loans—appears to be the central bank's main weapon, at least for now, in combating Europe's crisis. The ECB has resisted pressure from politicians and market participants to aggressively buy euro-zone government bonds, arguing such a move is outside its purview. But if the central bank eases fears about the Continent's banks, that would go a long way toward relieving anxiety about many countries' overall financial health.

Through the loans, the ECB is trying to address a crucial weakness in the euro zone's financial system. Nervous institutional investors have essentially stopped lending to banks, fearful of their heavy holdings of government bonds and other assets that appear at growing risk of default.

If the dry spell persists into 2012, it could become a major problem. European banks have more than €700 billion of their own debt maturing next year, including more than €200 billion in the first three months, regulators and analysts say.

ECB officials feared that without intervention, many banks would cut lending to small businesses and households, strangling Europe's weak economy.

"It's much better to have this funding locked in rather than praying the market reopens," said John Raymond, an analyst with CreditSights in London. "I don't think you can say it's a game-changer…but it sort of slows down the vicious circle."

Under the three-year loan offer on Wednesday, banks could borrow as much as they wanted at the low rate as long as they had the necessary collateral. Another batch of three-year loans will be available Feb. 29.

Politicians including French President Nicolas Sarkozy have floated the idea that banks will use the new ECB cash to buy government bonds in financially shaky countries, where lackluster demand has pushed their borrowing costs to unsustainable levels. But bankers and analysts doubt that will happen on a large scale, given the perceived riskiness of such bonds. Banks are free to use the loans for whatever they choose.

U.S. officials have urged European leaders to move more aggressively to prevent the crisis from hurting the U.S. economy. The U.S. officials view the ECB loans and other steps by euro-zone leaders as constructive but are pushing for further action to reduce Italy and Spain's borrowing costs.

The 523 banks that borrowed Wednesday range from giants like Italy's Intesa Sanpaolo SpA, one of the few banks to confirm its participation, to tiny lenders. The ECB didn't disclose which banks borrowed under the new program. It's possible that banks from outside the euro zone also pounced on the opportunity to secure cheap ECB financing. Any bank with a legal subsidiary in the euro zone is eligible to borrow from the ECB facility.

"It appears that a very large majority of the large financial institutions" in Europe participated, said Laurence Mutkin, head of European interest-rate strategy at Morgan Stanley.

The ECB's loan program isn't without risks. Some experts and regulators worry banks are becoming more addicted to central bank aid, making it harder for them to eventually stand on their own. At the same time, the program could push banks in countries like Spain and Italy to grow more entangled with their governments—a phenomenon that fueled today's crisis.

While the banks on Wednesday borrowed €489.19 billion, much of that was simply replacing other outstanding ECB loans coming due. Analysts estimated Wednesday's loans injected about €190 billion of new liquidity into the banking system.

Nick Matthews, an economist at the Royal Bank of Scotland, said European banks face about €230 billion of debt maturing in the first quarter of 2012 alone. "This operation is not going to cover all the maturities," he said.

Traditionally, banks satisfied much of their day-to-day financing needs by issuing unsecured bonds to institutional investors around the world. But the market for such debt largely evaporated in July, when Europe's crisis intensified. Regulators and bankers increasingly worry that funding markets could remain shut well into the new year.

The ECB's loans are attractive largely because of their price. The central bank will charge an interest rate that is the average of its benchmark rate over the three-year life of the loans. That rate is currently 1%. It's likely to remain well below what most banks would have to pay to borrow from market sources.

Indeed, the cheap financing is leading some European banks to take steps that further entwine them with their governments.

In Spain Tuesday, the government sold €5.6 billion of bonds in an auction that saw interest rates dive to 1.7% from 5.1% a month earlier. Analysts say the surging demand most likely stemmed from small and midsize Spanish banks buying the bonds in order to use them as collateral for this week's ECB loans.

Such a trade could prove lucrative for the banks, given the gap between the interest rates the Spanish bonds generate and the amount the banks are paying to borrow from the ECB.

But it also means Spanish banks are more vulnerable to their government's financial woes.

In Italy, 14 banks this week issued €38.4 billion of government-guaranteed bonds eligible to serve as collateral with the ECB, according to a document released on Wednesday by Italy's stock exchange. Those banks have been battered amid worries about their excessive holdings of Italian government debt.

"The bank-sovereign nexus still has not been successfully broken and if anything is being reinforced," said Mr. Matthews, the RBS economist.



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U.K. GDP Grows, But Deficit Expands

The U.K. economy expanded by more than initially estimated in the third quarter, according to the latest official figures published Thursday, but the nation's current account deficit widened to the largest ever recorded.

The Office for National Statistics said gross domestic product expanded 0.6% in the third quarter compared with the second, against a previous estimate of 0.5%. When compared with the year earlier, growth was unrevised at 0.5%.

The ONS said fresh data showed agriculture and construction contributed more than initially thought to the nation's third-quarter output.

However, latest estimates show second-quarter output was flat compared with the previous three months, compared with a previous estimate of expansion of 0.1%. Second-quarter construction output was lower than first thought, the ONS said.

Also Thursday, the ONS said the U.K.'s current account deficit widened to £15.2 billion ($23.83 billion) in the third quarter, from a revised £7.4 billion in the second. That is the biggest current account deficit since records began in 1955, the ONS said, adding that the record deficit was caused by a wider goods trade deficit and a fall in U.K. companies' earnings overseas.

Business investment in the third quarter rose 0.3% on the three previous months, to £30.1 billion, driven by investment by manufacturers.

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IAG Beats Virgin in BMI Takeover Batttle

International Consolidated Airlines Group S.A. Thursday beat rival Virgin Atlantic in the takeover battle for Deutsche Lufthansa AG's loss-making airline British Midland International, or bmi, helping to secure the group's future growth at London's congested Heathrow airport.

IAG, which owns British Airways and Iberia, said it had agreed to buy bmi for £172.5 million ($271 million) in cash, although it may end up paying less as Lufthansa has agreed to pay compensation if it can't sell bmi's small regional and bmibaby subsidiaries before completion.

Bmi, which reported an operating loss of €154 million for the first nine months of the year, has about 10% of the take-off and landing slots at Heathrow, the world's busiest international passenger airport, making it an attractive asset. If the deal goes through, the proportion of slots IAG owns at the airport will rise to about 53%.

"Buying bmi's mainline business gives IAG a unique opportunity to grow at Heathrow, one of our key hub airports," said IAG Chief Executive Willie Walsh.

He said that the ability to use the slots more efficiently "provides the option to launch new long-haul routes to key trading nations while supporting our broad domestic and short-haul network."

IAG said it will also maintain a comprehensive domestic schedule, including the Belfast, Northern Ireland route.

The deal will come as a blow to Virgin Atlantic. According to a report in the Times newspaper earlier this month, Virgin had made a non-binding offer of about £50 million for bmi, seen as vital for Virgin as a feed airline for its transatlantic routes.

Through a code-sharing agreement, bmi provides around 20% to 30% of Virgin traffic. There is no guarantee that BA, the dominant player on transatlantic routes from Heathrow, will honor that pact if IAG's deal for bmi goes through.

Virgin couldn't immediately be reached for comment.

The deal, subject to approval by the European Commission, is expected to be completed by the first quarter of 2012. IAG will pay £60 million to Lufthansa in four installments pre-completion, with an agreement that if the deal breaks down, the sum will be repaid in the form of slots. There is also a £10 million termination fee, payable if either side walks away or if IAG fails to get initial regulatory approval by March 31.

The sale will also come as some relief to Lufthansa, which has been looking to rid itself of the loss-making airline for a number of years. It was forced to buy bmi for £223 million when the U.K. airline's founder, Michael Bishop, exercised an option to sell his majority stake to the German airline in 2009. Lufthansa has made efforts to restructure bmi by focusing on routes serving the oil industry in the Middle East and Russia.

However, political turmoil in the Middle East this year foiled the airline's plans to return bmi to profit.

Lufthansa Chief Executive and Chairman Christoph Franz said shareholders will benefit from a "sharpened corporate profile and a stronger financial position of the group."

IAG, meanwhile, said it will be forced to cut jobs due to bmi's losses, but didn't say how many. Lufthansa has agreed to take on bmi's defined benefit pension scheme.

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Facebook's Goal: To Be a Blue Chip (Video)

Mark Zuckerberg spent Facebook Inc.'s early years trying to keep it cool. But the founder and CEO of the social-networking giant has spent the last 18 months methodically preparing Facebook to look and act more like a blue-chip business.

"There was a period in Microsoft's evolution where they said, we want to put a computer on everyone's desk," said Mr. Zuckerberg in a recent interview. "That's the way that I want to run Facebook...We want to be operating in a way that we're working towards this longer vision of where we think the world should be."

Facebook plans to file early next year with the Securities and Exchange Commission to take the stock public in the second quarter of 2012, according to a person familiar with the matter. The IPO could raise as much as $10 billion at a valuation of more than $100 billion.

The poor IPO debuts this year of Internet companies Groupon Inc. and Zynga Inc. has put new scrutiny on Facebook. Groupon shares are down 12% from their first-day's close, while Zynga fell below its IPO price within minutes.

As hard as it is to reach a public offering, it is even more difficult for young businesses to play head-to-head against tech stalwarts such as Apple Inc. and Microsoft Corp. But interviews with Mr. Zuckerberg and others inside Facebook reveal the eight-year-old company is trying to emulate the influence, staying power, and meticulousness of the biggest technology companies.

Since last year, Facebook executives have been crafting dummy scripts for quarterly earnings calls, addressing imaginary questions from analysts about the company's revenue and profit, people familiar with the matter say. They have even written a top-secret draft of an IPO prospectus, a role traditionally left to bankers.

The company's chief financial officer, David Ebersman, has been professionally auditing Facebook's financial statements each quarter, say people familiar with the matter, and avoiding the accounting approaches that raised questions for Groupon and Zynga.

Although Mr. Ebersman has played tough with Wall Street bankers, telling them he's skeptical about what they can contribute to an IPO, he's also communicated his interest in moving forward with a standard public offering, people familiar with the matter said. Facebook has little interest in taking a page from Google Inc.'s book, which did an electronic auction-style offering.

Even the CEO's trademark Adidas flip-flops are growing up. Mr. Zuckerberg, 27, has upgraded to Brooks running shoes and went so far as to wear a dark blue tie and sports coat when President Obama visited in April—a sartorial move he was once loathe to take for the many bankers, lawyers and CEOs he meets.

The company has both scale and a strong brand, says Lise Buyer, a Silicon Valley-based IPO consultant.

But the big question, says Ms. Buyer, will be Facebook's ability to operate profitability through ups and downs.

One remarkable thing is just how few employees are needed to create the company's $4 billion in revenues.

Facebook employs 3,000, a number dwarfed by Microsoft's 90,000 and Google's 31,000.

"The missing piece that we haven't seen yet is reliability," she says. "The blue chip stocks are the ones that people talk about belonging in widows and orphans funds. Historically, technology IPOs don't make that list.
Because of its scale, Facebook could be different."

Questions Linger on Madison Avenue

The company still has a ways to go to convince Madison Avenue advertisers. Even today, most of Facebook's ads are for small advertisers, according to data firm comScore Inc. Facebook has yet to prove that it can increase its advertising on such a scale to snag the big brand names who drive billions of dollars to TV, radio and print campaigns.

Facebook is also still plagued by doubts about its commitment to users' privacy, an issue that had dogged it since its earliest days. Despite a landmark settlement with the Federal Trade Commission in which the company agreed to privacy audits for 20 years, questions remain over how it manages the trove of private data it owns.

Facebook's rapid growth—it now has 800 million members—had Wall Street anticipating an IPO more than two years ago. But Mr. Zuckerberg, known for his product vision but impatience with finance, has been reluctant to go public.

People familiar with Mr. Zuckerberg's thinking say he worried about the damage an IPO could do to the company's culture and wants employees focused on making great products, not the stock price, they say.

And if it were up to Mr. Zuckerberg, Facebook would remain private. But a federal rule which forces financial disclosure once a company has more than 500 shareholders ultimately convinced him it was the right step.

Mr. Zuckerberg says he can head off the ill effects of an IPO by assembling a management team tough enough to resist shareholders' short-term desires. "People always talk about the downsides of these things," Mr. Zuckerberg said, referring to IPOs, "and I do think they're real, but the management of the company fundamentally has control over the decisions it makes."

Building a Broader Management Team

Structuring a strong executive team has been Mr. Zuckerberg's most complex challenge, he said. "It was not something I had any experience doing when we were scaling up from a company of 50 people to 100 people to where we are now," he said.

Mr. Zuckerberg has been drawn to tech's blue-chip CEOs from his earliest days in Silicon Valley, when he asked for introductions to CEOs like Intel Corp.'s Paul Otellini and Microsoft's Bill Gates.

Facebook's strategy now reflects more than just Mr. Zuckerberg's thinking. Few early executives remain.

Facebook's founding president, Sean Parker, left the company in 2005. In 2008, co-founder Dustin Moskovitz and Chief Technology Officer Adam D'Angelo left to start companies.

After Mr. Parker's departure, Mr. Zuckerberg took sole responsibility and realized he needed help.

"What Mark was doing was cycling through people until he found the ones who could make it happen," says Facebook board member Marc Andreessen, a partner at the venture capital firm Andreessen Horowitz. "It had to be done. The alternative would have been a much lower quality company."

His top lieutenant is Sheryl Sandberg, who left Google in 2008 to become Facebook's chief operating officer. The 42-year-old created a business model for the company and brought a team of Google ad veterans.

"I think of P&G, these companies that are iconic, that change what they do in the industry and then are around for a really, really long time," said Ms. Sandberg. "We need to be around and thriving when Mark is old."

Mr. Ebersman, 41, has been Facebook's finance chief since 2009, and has taken the lead dealing with Facebook's potential IPO bankers.

The company has also bulked up its legal department, starting with the hiring of chief counsel Ted Ullyot in 2008. Mr. Ullyot, 44, a former associate counsel at AOL Time Warner, also worked as chief of staff to then-attorney-general Alberto Gonzales.

Mr. Ullyot has built the legal department to 45 lawyers from 12, allowing the company to quickly respond to legal challenges ranging from intellectual property to privacy

For his part, Mr. Zuckerberg suggests that "blue chip" doesn't go far enough in defining the role he sees for Facebook.

After being read one definition—that a blue chip is a corporation with a national reputation for quality, reliability and the ability to operate profitably in good times and bad—he said: "I hope our reputation isn't just national."



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ECB Sees Record Refinancing Demand

The European Central Bank allotted €489.19 billion ($639.96 billion) in the first of two keenly-awaited three-year refinancing operations Wednesday, beating market expectations in a sign that banks expect other sources of funding to remain tight through 2012.

The result will fuel hopes that banks might use the funds to prop up euro-zone sovereign bond markets.
The ECB said it allotted the three-year loans—the longest maturity ever offered by the central bank—to 523 banks. The amount allotted was the most ever for a longer-term refinancing operation, exceeding the previous record of €442 billion set at the June 2009 one-year auction.

At a separate three-month refinancing operation Wednesday, the ECB allotted €29.74 billion to 72 banks.

The news had a positive impact on the markets, with the CAC-40 in Paris recently up 1.3% at 3094.29, having climbed initially to 3121.29. Frankfurt's DAX 30 had added 1.2% to 5917.95, just off the day's 5965.35 high, while in London the FTSE 100 had gained 0.6% to 5451.18.

The euro made a new high for the day, and the week, of $1.3199 in the aftermath of the announcement, but has slipped back a few ticks since, recently trading at $1.3138.

The record refinancing allotment comes as the ECB aims to head off a potential credit crunch and economic slowdown or even recession next year by providing unlimited liquidity to euro-zone banks.

Many analysts had expected demand for the three-year loans to exceed €300 billion as banks sought to secure long-term funding amid deepening strains on interbank markets.

Some market participants believe that the new funding facility might encourage private banks to buy their government's debt or hold on to existing sovereign bonds, reducing pressure on the ECB itself to support sovereign bond markets.

"Due to the interlinkage between banks and their governments, banks could potentially save themselves by saving their sovereigns," said Christian Schulz, an economist at Berenberg Bank in London.

Strong demand at Tuesday's successful Spanish treasury bill auction signalled that the enhanced liquidity may already be helping some peripheral debt markets, as the government raised more funds than planned and at a lower cost than at its previous outing.

ECB President Mario Draghi reiterated Monday that he hopes the new liquidity measures will restore credit to households and firms. But he said banks can also use the cash to buy back their own bonds or buy government bonds.

Still, analysts warned that banks' appetite for the risk of additional government bonds on their balance sheets may be limited given the pressure they are under to reduce the size and riskiness of their balance sheets and build up their reserves.

Banks may instead park the excess liquidity in the ECB's overnight deposit facility or use it to help refinance debt, analysts said. Use of the ECB's deposit facility surged to €251.35 billion Tuesday from €225.55 billion Monday, as banks favored parking money with the ECB over lending it to one another because of fears around their counter-parties' exposure to weak euro-zone sovereign debt.

Analysts had expected strong demand at the three-year operation due to the possibility of early repayment after one year, as well as banks' efforts to restructure their balance sheets and the expiry of a three-month refinancing operation this week.

A sharp decline in demand for Tuesday's one-week ECB tender and a strong take-up of €141.93 billion for a one-day bridging facility, aimed at tiding banks over from the one-week to the three-year facility, further fuelled expectations of strong demand.

Demand was expected to come largely from banks in peripheral euro-zone countries, where the long-term funding market is currently very difficult. The ECB doesn't provide a break-down of the banks bidding for the funds.

The ECB's second three-year refinancing operation is due to be allotted on Feb. 29, 2012.

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Euro rallies, ECB tender seen boosting confidence

The euro rose on Wednesday on speculation many euro zone banks would apply for cheap loans offered by the European Central Bank, which may improve risk demand if it is seen to help lenders boost their finances and ease pressure on indebted European states.

The ECB launches its first ever offer of unlimited, ultra-cheap three-year funding to banks later in the day to help them lower their funding costs. Investors hope the tender will tempt banks to buy Italian and Spanish debt and pull yields lower.

A Reuters poll shows euro zone banks will tap around 310 billion euros at the tender, while some analysts expect the central bank may allot even more funding.

Further signs that Europe's funding crisis is easing would be positive for the euro, but some analysts said that making more loans available to struggling banks would ultimately do little to solve the euro zone debt crisis.
Some argued that overall market sentiment for the single currency would remain negative.

The euro rose 0.6 percent on the day to a session high of $1.3155, and some analysts expected a big take up at the tender could push the euro higher to target levels around $1.3170 or even $1.3225, particularly if stock markets rally.

"It's possible we might see these levels today, as the ECB auction may give back more confidence to the market," said Antje Praefcke, currency strategist at Commerzbank in Frankfurt.

But she added: "The euro's problems are not going to fade just because of the year-end, and I wouldn't go into the new year and buy the euro strongly."

Sources reported more than 10 Italian banks, including major lenders, were looking to apply for the loans by using state-guaranteed bonds as collateral, with talk they could tap as much as 70 billion euros, or around 15 percent of the total.

EURO UPSIDE LIMITED

Gains in the euro pushed the dollar 0.5 percent lower versus a currency basket to 79.504, pulling further away from an 11-month high hit last week. Against the yen, the dollar slipped 0.2 percent to 77.72 yen.

Market participants were focussed on how the euro would react after the tender, and some analysts expected that big gains in the euro would be limited as many investors were interested in selling the single currency if it rises.

"Traders are cautious on the upside and favor a sell-on-rallies approach," Citi analysts said in a CitiFX Wire note.

"Only a daily close above $1.3132 would prompt them to reassess."

Despite its gains versus the dollar, the euro hit an all-time low against the Australian dollar as improving risk appetite increased the appeal of commodity-linked currencies.

The Australian and New Zealand dollars each rose around 1 percent versus the U.S. currency
The euro was flat at 1.2188 Swiss francs, but remained on the back foot as the Swissie has been gaining strength since last week when the Swiss National Bank kept the euro/swiss floor unchanged.

This disappointed some speculators who had bet on a rise to 1.2500 francs.

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N.Korea military, uncle to share power with Kim heir

North Korea will shift to collective rule from a strongman dictatorship after last week's death of Kim Jong-il, although his untested young son will be at the head of the ruling coterie, a source with close ties to Pyongyang and Beijing said.

The source added that the military, which is trying to develop a nuclear arsenal, has pledged allegiance to the untested Kim Jong-un, who takes over the family dynasty that has ruled North Korea since it was founded after World War Two.

The source declined to be identified but has correctly predicted events in the past, telling Reuters about the North's first nuclear test in 2006 before it took place.

The comments are the first signal that North Korea is following a course that many analysts have anticipated -- it will be governed by a group of people for the first time since it was founded in 1948. Both Kim Jong-il and his father Kim Il-sung were all-powerful, authoritarian rulers of the isolated state.

The situation in North Korea appeared stable after the military gave its backing to Kim Jong-un, the source said.

"It's very unlikely," the source said when asked about the possibility of a military coup. "The military has pledged allegiance to Kim Jong-un."

North Korea's collective leadership will include Kim Jong-un, his uncle and the military, the source said.

Jang Song-thaek, 65, brother-in-law of Kim Jong-il and the younger Kim's uncle, is seen as the power behind the throne along with his wife Kim Kyong-hui, Kim Jong-il's sister. So too is Ri Yong-ho, the rising star of the North's military and currently its seniormost general.

The younger Kim, who is in his late 20s, has his own supporters, but is not strong enough to consolidate power, analysts said.

"I know that he's been able to build a group of supporters around himself who are of his generation," said Koh Yu-hwan, president of the Korean Association of North Korean Studies in Seoul.

"So it is not entirely elders in their 70s, plus some like Jang in their 60s, who are backing him. These young backers will be emerging fairly soon."

Koh said the coterie was put in place by Kim Jong-il before he died. "The relative calm seen these few days shows it's been effective. If things were not running smoothly, then we'd have seen a longer period of 'rule by mummy,' with Kim Jong-il being faked as still being alive."

He said the younger Kim would accept the set-up, for now. "Considering the tradition of strongarm rule by his father and grandfather, things can't be easy for him," he said.

MAKES SENSE

Ralph Cossa, an authority on North Korea and president of the U.S. thinktank Pacific Forum CSIS, said it made sense that the ruling group would stick together.

"All have a vested interest in regime survival," he said. "Their own personal safety and survival is inextricably tied to regime survival and Kim Jong-un is the manifestation of this. I think the regime will remain stable, at least in the near-term."

He added in a commentary that the new group may be inclined to reform, but stressed this was far from confirmed.

"Over the long term, there appears to be some hope, primarily emanating from Beijing, that Kim Jong-un will take North Korea down the path of Chinese-style reform, apparently based on the belief that Jang is or will be a "reformer."

"Who knows, this may be true. While this could relieve the suffering of the North Korean people over time, it will do little to promote the cause of denuclearization, however."

The high-level source also said the North Korea test-fired a missile on Monday to warn the United States not to make any moves against it. Pyongyang however had no immediate plans for further tests barring an escalation of tensions.

"With the missile test, (North) Korea wanted to deliver the message that they have the ability to protect themselves," the source said.

"But (North) Korea is unlikely to conduct a nuclear test in the near future unless provoked" by the United States and South Korea, the source said.

The unpredictable North's nuclear program has been a nagging source of tension for the international community. Pyongyang carried out nuclear tests in 2006 and 2009, and has quit six-party talks with South Korea, the United States, China, Japan and Russia on abandoning its nuclear program and returning to the Non-Proliferation Treaty.

The high-level source also said Beijing was only notified of Kim's death earlier on Monday, the same day that North Korean state television broadcast the news. Kim died on Saturday.

A leading South Korean newspaper reported on Wednesday that China learned of Kim's death soon after it occurred.

China has given no official comment or even hints suggesting it was told of Kim's death before the public announcement.

Beijing, the North's closest ally and biggest provider of aid, has pulled out the stops to support the younger Kim. The government has invited him to visit, and in an unusual gesture, President Hu Jintao and Vice-President Xi Jinping also visited the hermit state's embassy in Beijing to express their condolences. Roads leading to the embassy were blocked.

Mainly, the prospect of instability on its northeastern border worries China and it sees the younger Kim and his coterie as the best prospect for keeping North Korea on an even keel.

North Korea has been pressed by China to denuclearize and is willing to do so on condition that North and South Korea, the United States and China sign an armistice replacing a 1953 ceasefire agreement, the source said.

The two Koreas have been divided for decades and remain technically at war since their 1950-53 conflict ended with an armistice but no peace agreement. The United States backed the South, while China supported the North in that conflict.

Pyongyang also is convinced there are U.S. nuclear weapons in South Korea and demands Washington pull them out, the source said.

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