The Wall Street Journal-20080212-breakingviews-com - Financial Insight- Why Microsoft Should Fret- More May Be on the Line Than Just Online Business In the Pursuit for Yahoo

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breakingviews.com / Financial Insight: Why Microsoft Should Fret; More May Be on the Line Than Just Online Business In the Pursuit for Yahoo

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Microsoft justifies its $44.6 billion bid for Yahoo as a way to build sufficient scale in the search and advertising businesses to counter the Google juggernaut. That hasn't stopped the software giant's shareholders from fretting. They have more reason to worry now that Yahoo's rejection of the $31-a-share bid increases the likelihood Microsoft will need to pay more to clinch its quarry.

But what if at stake in the battle isn't just Microsoft's position in selling ads, but the very survival of its core software business? Microsoft would never admit that so much is on the line. Still, there is a case to be made that acquiring Yahoo would go beyond rectifying Microsoft's online business to strengthening the moat protecting its franchise on desktop computers around the world.

It all goes back to Yahoo boss Jerry Yang's notion of making Yahoo the "start page" for every Internet user around the world. At the moment, Microsoft actually is the start page for most computer users -- even before they log onto the Web, most open the company's desktop or Outlook products and services to get rolling.

Google is trying to change that. It sees a future in which customers bypass Microsoft to use the applications, such as spreadsheets and word processors, on offer through Google Docs. So far, Google Docs hasn't dented Microsoft's desktop dominance. But its growth is impressive. In November, unique users of Google Docs surged to 1.6 million from 600,000 in June.

Why does this matter? Microsoft is expected to book $36 billion, or 61% of its revenue, from selling such software in fiscal 2008, according to Credit Suisse Group. Yet it derives all of its operating profit from these sales. Just a 20% nibble out of this business by Google would translate into at least $5 a share to Microsoft's investors.

Google is a long way from posing such a threat. But as the search engine increases its stranglehold as the starting page of choice, it gets a little easier to see how Microsoft might rationalize digging deeper into its pockets.

AIG's CDO Burp

Shareholders are rightly unnerved when a company clashes with its auditor. So when it was announced yesterday that American International Group's accountants had said the valuation process for the insurer's $500 billion-plus credit-derivatives portfolio wasn't up to snuff, investors chopped 12% off its share price. AIG now expects losses for October and November on exposure to subprime mortgage- related collateralized debt obligations to be more than four times what it forecast just two months ago.

While an inability to value those instruments casts doubt on whether AIG should be in the business at all, its actual loss doesn't threaten the insurance giant. Unless more credit skeletons emerge from its closet, the news may turn out to be worse for CDO investors and underwriters than for AIG shareholders.

That is because AIG looks to be taking a loss on CDOs that haven't, so far, misbehaved. The banks and investors licking their wounds have been burned mostly by CDOs stuffed with subprime mortgages originated in 2006. That was when lending standards really plummeted, leading to high levels of defaults.

AIG stopped writing credit derivatives on subprime-related CDOs in December 2005. If the roughly 8% loss it now forecasts on its subprime credit portfolio is the canary in the coal mine for pre-2006 CDOs, there may be a lot more pain to come for investors in those securities.

Moreover, that wouldn't even require subprime mortgages from the first half of this decade to sour. Investment managers who oversee CDOs are, in some cases, allowed to substitute assets for the maturing debt in their collateral pools. If these managers had swapped in a lot of toxic 2006-vintage mortgage bonds for debt that came due in CDOs issued prior to that year, it could explain why securities that started out benignly have started to cause trouble.

-- Rob Cox and Dwight Cass

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This column is by breakingviews.com, an online financial commentary site.