Zuckerman’s book depicts the evolution of hedge fund megastar John Paulson’s massive payday resulting from his timely bet against sub-prime mortgages when housing prices appeared to have a one-way ticket to the moon . Zuckerman’s portrait of the colorful gallery of individuals who won and lost as a result of the housing meltdown makes the book a compelling read even for financial novices.

“The Greatest Trade Ever” has recently received renewed attention amidst the SEC’s allegations regarding Goldman Sachs role in Paulson’s trades. Who thought a book about the hedge fund industry could be a page- turner?

Space is limited, so reservations requested. Call 781-431-1160; events@wellesleybooksmith.com. The event will be downstairs at Wellesley Booksmith, 82 Central St.

John Paulson hasn’t been accused of any wrongdoing. But the hedge-fund billionaire has gone on the offensive to reassure investors that his huge firm will emerge unscathed from a case that has drawn him into a political and legal vortex.

The steps, including a conference call with about 100 investors late Monday, come amid indications from some clients that they might withdraw money from his firm after a lawsuit brought by the government against Goldman Sachs Group Inc. related to an investment created at his firm’s request.

Investors have indicated they are concerned that scrutiny over the firm’s deals may spread, including to overseas regulators. They said they wanted to protect themselves in case new information emerges that could damage the hedge fund, they say. Another issue, they say: The legal case could simply prove a distraction for Mr. Paulson.

“Some of the callers asked pointed questions, almost like a court inquisition, but most people were supportive,” said Brad Alford, who runs Alpha Capital Management. “I felt reassured that he did nothing wrong.”

“It’s not a rush for the doors,” said another investor in Paulson & Co. who has communicated with larger Paulson investors since Friday, when the government unveiled its Goldman case.

Mr. Paulson sent a letter to investors Tuesday night saying that in 2007 his firm wasn’t seen as an experienced mortgage investor, and that “many of the most sophisticated investors in the world” were “more than willing to bet against us.”

Mr. Paulson’s firm focuses on largely liquid investments, those relatively easy to sell without pushing prices much lower. Even if a number of investors ask out, the firm likely will be able to sell investments without crippling their holdings, investors say.

Some traders have been examining Mr. Paulson’s top holdings and positions in which filings indicate he has been a substantial holder since the news, they say. When the news of the lawsuit broke on Friday, some of these stocks, including Conseco Inc., Cheniere Energy Inc. and AngloGold Ashanti Ltd., fell sharply.

The case has delayed the initial public offering of a Canadian investment fund, Propel Multi-Strategy Fund, formed to give investors exposure to two funds advised by Paulson, according to people familiar with the offering. Propel didn’t respond to requests for comment.

On the Monday night conference call, some investors asked if Mr. Paulson or anyone at the firm had received a government notice of potential civil charges, called a Wells notice, according to people familiar with the call.

Mr. Paulson said no. Mr. Paulson said the case wasn’t a distraction that was affecting the firm’s investments, and that he was confident the public glare would abate.

On the conference call, Mr. Paulson calmly explained the trade with Goldman, which involved a “short” bet on mortgage bonds. He said that the very nature of the transaction required both a “long” and “short” investor, suggesting that investors knew that a bearish investor had bet against the deal.

Mr. Paulson suggested to clients that the large investors who purchased the Goldman deal and others relied on rating firms, and didn’t do enough of their homework, investors say.

The hedge-fund firm has a deadline next Friday for investors who want to withdraw money on June 30. Paulson allows most investors to pull out four times a year, but they need to give at least 60 days notice. Investors can cancel redemptions before the end of June.

Magnetar Capital LLC, another hedge-fund firm that, like Paulson, was heavily invested in collateralized debt obligations in 2007 also has been working to reassure investors that it believes its mortgage-linked investment strategy was sound and can withstand regulatory scrutiny.

Investors in Magnetar, which oversees some $7 billion in assets, also have a deadline next week to request June withdrawals of money. The Evanston, Ill.-based firm sent an 11-page letter to investors Monday saying that it didn’t control which individual assets went into CDO deals in which it invested.

It isn’t clear whether scrutiny of Magnetar will rattle its investors, who have known some details of the firm’s strategy for several years. An article this month in news outlet ProPublica was the latest to assert that Magnetar designed deals built to fail that caused cascading losses for investors on the other side of the trades. The hedge fund’s strategy was the subject of a Jan. 2008 Wall Street Journal article. Magnetar told investors this week that it based its mortgage-CDO strategy on statistical models, not a fundamental belief that the housing market would slide.

A Magnetar spokesman said, “Our communications with investors have been very positive and supportive.”

—

Stephen Grocer and Ben Dummett contributed to this article.

Paolo Pellegrini, a former top executive at hedge-fund Paulson & Co., told investigators at the Securities and Exchange Commission that he had informed ACA Management LLC that his firm was betting against the transaction at the center of a lawsuit the SEC brought against Goldman Sachs Group Inc. (GS), according to a person familiar with the matter.

The testimony, in late 2008, could undermine the government’s case against Goldman, which is accused of misleading ACA, the deal manager, about Paulson’s bearish position on the deal.

Pellegrini and the Paulson team worked with both Goldman Sachs and ACA to structure the deal.

(This story and related background material will be available on The Wall Street Journal Web site, WSJ.com.)

SEC spokesman John Nester said, “Our case is built on a thorough evidentiary record that includes testimony, documents, handwritten notes and emails that will be presented in court at the appropriate time.”

Details of Pellegrini’s testimony were reported earlier by CNBC.

The SEC in its complaint alleges that Goldman “misled ACA into believing” the Paulson firm “shared a long interest with CDO investors.” Goldman has denied wrongdoing and is fighting the charges.

ACA Management, an asset-management company set up under the umbrella of bond insurer ACA Financial Guaranty Corp., earned fees for overseeing investment portfolios of mortgage securities, corporate loans and other credit assets. Goldman engaged the firm when Paulson approached it looking for a way to extend its bearish bet on the housing market, the SEC complaint alleges. The CDO management business at ACA was headed by Laura Schwartz, a former Merrill Lynch investment banker who previously worked in divisions of the bank that originated securities backed by U.S. subprime loans and commercial mortgage debt.

Ms. Schwartz was a main point person in the discussions between ACA and Goldman and was at an early 2007 meeting with representatives of Paulson and Goldman, according to Goldman’s responses to the SEC’s “Wells” notice of possible civil charges, regarding the issue. After that meeting, Ms. Schwartz emailed a Goldman employee to ask for feedback on the meeting and said she wasn’t clear about how Paulson wanted “to participate in the space,” the Goldman papers said.

Ms. Schwartz, when reached on her cellphone, did not stay on the line. She no longer works for ACA. A representative for ACA Financial didn’t comment.

Last fall, when Goldman responded to the SEC’s Wells notice, the securities firm argued that whether ACA perceived Paulson to be the so-called “equity” investor in the CDO–and therefore having a “long” position–was “of no moment.” ACA, Goldman has argued, was supposed to be an independent expert on selecting mortgage assets.

Goldman argued in documents it submitted to the SEC that Ms. Schwartz, who was deeply involved in selecting the assets for the Abacus deal, should have known from previous ACA-managed deals that hedge funds could have both long and short positions in a CDO. Goldman cited an ACA-managed CDO that closed in late 2006 whose equity investor was a hedge fund called Magnetar Capital that also took short positions in the same deal. “Certainly, ACA could have questioned Paulson about its interests if the information was significant to it,” Goldman’s Wells response to the SEC said.

At ACA, Ms. Schwartz’s roles included reviewing and approving securities that would be part of investment pools the firm oversaw. In presentations to investors, she often talked about her extensive experience analyzing residential mortgage-backed securities and ACA’s expertise and ability to select mortgage securities, according to people familiar with the matter.

ACA Management managed CDOs put together by several Wall Street firms including Bear Stearns Co. and UBS AG (UBS), according to records reviewed by The Wall Street Journal. At the end of 2007, ACA Management was overseeing around $19 billion in CDOs, the bulk of them bundles of mortgage-backed or asset-backed securities. Of about 30 CDOs managed by ACA, more than half were issued during 2006 and 2007, according to the company’s financial statements.

NEW YORK — Gregory Zuckerman is a senior writer at The Wall Street Journal and author of The Greatest Trade Ever: The Behind-the-scenes Story of How John Paulson Defied Wall Street and Made Financial History.

Thanks to a huge and successful bet that the U.S. housing market would crumble, John Paulson’s firm, Paulson & Co., made $15-billion (U.S.) in 2007. He personally took home $4-billion (U.S.).

Here, Mr. Zuckerman speaks about the controversial 2007 deal that made Paulson & Co. $1-billion and prompted the Securities and Exchange Commission to file civil fraud charges against Goldman Sachs Group Inc. on Friday.

In your book, you describe some of the exact transactions that have now landed Goldman in hot water. How did you hear about them?

Covering the story at the Journal I heard rumblings and complaints for over a year. All kinds of competitors levelled accusations. There were investment bankers, at some of the top firms on the street, who criticized [Paulson] behind the scenes. So there was a lot of smoke – so I figured there must be some fire as well.

Many of the accusations were blatantly wrong. I got to the point where I was comfortable reporting what had happened. Then there’s the question: Was there something improper or not? I’m of the belief that it’s a really fascinating grey area. Especially for Paulson, one can level criticism and there may be some ethical issues, but it’s much harder to say it’s illegal.

You wrote that not every bank was willing to do these kind of deals. So why some and not others?

The ironic thing is that at Bear Stearns, of all places, a senior banker there turned Paulson & Co. down. They may have had some notion of how it might look on the front pages, which is what Goldman Sachs is seeing right now. Clearly, selling these deals to investors is a whole other level than what Paulson did, which was going to the banks and asking them to create this … paper.

You also have to remember what the period was like back then. This was late 2006, early 2007, when people still thought that John Paulson was tilting at windmills, that he was a merger-arb [specialist] who didn’t know that much about real estate. Now we look back and say, “How do you not warn investors that Paulson had a role in creating these things?” At the time, even if he told investors, I’m not sure how many of them would have run the other way.

Some reviewers have said you’re too nice to Mr. Paulson in the book.

I don’t see him as either as a hero or a villain. He’s a great character to me and I love great characters. I’ve been accused of lionizing John Paulson, but he has condemned the book and won’t speak with me … If some people think he was unethical I can understand that view. Other people think he did nothing wrong whatsoever. I’m open to that argument as well. I don’t think it’s my job to shove an opinion down the throat of my reader.

You can argue that he should have been satisfied in betting against billions of dollars of potentially dangerous mortgages and he shouldn’t have taken the step of going to various investment banks and asking that they create more products so he could short them. By the same token, he didn’t sell any of the stuff to investors.

Yes, more toxic mortgage assets were created because of John Paulson and his team, but someone had to be on the other side. These were big boys and sophisticated investors, and [Paulson] had no obligation whatsoever to tell them not to take the other side of this trade. Paulson was very, very focused on making a lot of money from what he saw as a coming collapse of the mortgage market. I don’t believe they saw [these deals] as improper.

Do you think more investigations connected to similar deals will be forthcoming?

You would think so, because this was one of many that John Paulson and his team entered into and that other hedge funds also worked on. I know there are lists of CDOs that [regulators] have been examining since late 2008, if not earlier, so they clearly have been digging into all this stuff. It could be this one was the worst.

In the book, you profile others who also bet against the housing market, including some little-known investors who made huge profits. What did these people, John Paulson included, have in common?

It’s just startling to me, and remarkable, that the experts who should have known better got it wrong and it’s these outsiders who made the most money: John Paulson, who was a merger-arb [specialist]; Paolo Pellegrini, who just a couple of years before doing this trade was living in a one-bedroom apartment with no money in the bank and no job; Michael Burry, a doctor-turned-investor, who knew stocks, but didn’t know anything about mortgages.

It took some outsiders to figure out that a historic collapse was coming. In some ways it gives all of us encouragement that maybe we know a little bit more, and have a little bit more of a perspective than perhaps those on Wall Street, the so-called experts.

It took John Paulson months to convince investors that housing would crumble.

Now it’s taking him awhile to get them excited about gold, his latest passion.

When Mr. Paulson’s Paulson & Co. late last year announced it was starting a hedge fund to make a big gold bet, many on Wall Street expected investors to line up. Paulson & Co. scored about $20 billion in profits in 2007 and 2008 wagering against subprime mortgages and financial companies. It then bought financial shares last year to add more gains.

Some gold traders expected Mr. Paulson’s new fund, launched Jan. 1, to raise billions of dollars and even help push gold higher when it started buying this year.

That hasn’t happened. Despite months of investor meetings, Mr. Paulson has raised $90 million or so for his new gold fund, according to people close to the matter. Even the $250 million that Mr. Paulson himself placed in the fund hasn’t persuaded many investors to get on board.

The fund, despite gains this month that bucked a selloff for gold, has lost about 10% since it was launched, investors say. That’s making it that much harder for Mr. Paulson to convince clients.

“I am a long-term believer in inflation, but I feel the weakness in the economy in the short run will trump the longer-term story” for gold, says Christopher Zook, who at CAZ Investments LP invests about $150 million in hedge funds.

Mr. Zook considered but decided not to invest in the gold fund for now. “It’s purely my negative view on gold in the short run,” he said. “I just am waiting for hopefully a better entry point.”

The disappointing response may be a sign that investors are becoming more cautious about the yellow metal, which has declined about 1.7% this year, though it has risen this week.

Shares of AngloGold Ashanti Ltd., one of Paulson & Co.’s biggest gold-mining bets, have fallen to about $37 from nearly $47 in early December.

Mr. Paulson has told his investors he expects his new fund to outperform gold prices as they rise. That suggests it also could do worse than the market if the dollar continues to rally, pushing gold down further.

Some gold traders expected John Paulson’s new fund to raise billions of dollars and even help push gold higher when it started buying this year. That hasn’t happened. Despite months of investor meetings, Mr. Paulson has raised $90 million or so for his new gold fund, according to people close to the matter

Some investors have noted that exchange-traded funds that use leverage, or borrowed money, to bet on gold might be able to match Mr. Paulson’s fund. By contrast, it was almost impossible for many investors to replicate the complicated derivative moves that Paulson & Co. undertook with its credit funds in 2007 to bet against subprime mortgages.

Also, some Paulson & Co. investors may have had their fill of gold. The firm already has about 10% of its holdings in gold-related investments apart from the new fund.

It’s too early to count Mr. Paulson out.

Paulson & Co. raised just $147 million for its first credit fund in the spring of 2006, a time when housing was raging. Money soon was rolling into the fund, however, and his gains turned enormous in 2007.

Some investors are asking why they should pay Mr. Paulson to invest in gold, as he doesn’t have years of commodity experience. But some said the same thing about his housing investments before they turned into winners.

Mr. Paulson has told investors that his gold strategy is a long-term one that will reap rewards over the next few years as the value of leading currencies drop. Recent weakness in gold prices could enable Mr. Paulson to buy up gold miners and derivatives at lower prices. That would make it easier for him to rack up gains later on.

Write to Gregory Zuckerman at gregory.zuckerman@wsj.com

Mr. Paulson has told his investors he expects his new fund to outperform gold prices as they rise. That suggests it also could do worse than the market if the dollar continues to rally, pushing gold down further.

Some gold traders expected John Paulson’s new fund to raise billions of dollars and even help push gold higher when it started buying this year. That hasn’t happened. Despite months of investor meetings, Mr. Paulson has raised $90 million or so for his new gold fund, according to people close to the matter

Some investors have noted that exchange-traded funds that use leverage, or borrowed money, to bet on gold might be able to match Mr. Paulson’s fund. By contrast, it was almost impossible for many investors to replicate the complicated derivative moves that Paulson & Co. undertook with its credit funds in 2007 to bet against subprime mortgages.

Also, some Paulson & Co. investors may have had their fill of gold. The firm already has about 10% of its holdings in gold-related investments apart from the new fund.

It’s too early to count Mr. Paulson out.

Paulson & Co. raised just $147 million for its first credit fund in the spring of 2006, a time when housing was raging. Money soon was rolling into the fund, however, and his gains turned enormous in 2007.

Some investors are asking why they should pay Mr. Paulson to invest in gold, as he doesn’t have years of commodity experience. But some said the same thing about his housing investments before they turned into winners.

Mr. Paulson has told investors that his gold strategy is a long-term one that will reap rewards over the next few years as the value of leading currencies drop. Recent weakness in gold prices could enable Mr. Paulson to buy up gold miners and derivatives at lower prices. That would make it easier for him to rack up gains later on.

Write to Gregory Zuckerman at gregory.zuckerman@wsj.com

Some hedge funds have started to adjust their investment strategies as European officials voice harsher criticism of investors who have used exotic investments to bet against the debt of countries like Greece, traders said.

Elected leaders in France and Germany have highlighted what they view as a potentially destabilizing but largely hidden influence of banks, hedge funds and other investors in the markets for Greek sovereign bonds.

The officials have taken the strongest aim at the use of credit-default swaps, insurance-like contracts that pay out when an issuer defaults, and rise in value as credit conditions deteriorate. One recent report in Spain’s El Pais newspaper said the country’s intelligence service is investigating “speculation” in Europe’s markets.

Some players whose strategy was to purchase credit-default swaps that would pay out in the event of a Greek default got spooked last week by talk that European officials might try to make such swap trades illegal in the future. Though investment strategies are constantly in flux, given the potential precariousness of that market, some hedge funds began shifting toward a more currency-driven strategy, say people familiar with the matter.

On Wednesday, the euro dropped sharply against the dollar, indicating that bearishness toward the European currency might be mounting.

The scrutiny is such that some investors wagering against Greece are becoming tight-lipped, sharing few details about how their trades are faring. Other investors have avoided making any of these trades, citing worry about a potential backlash from politicians and others.

“You can add to the pressure by making these trades, and that made us uncomfortable. We’ve worried about public and government criticism,” says Avi Tiomkin, chief investment officer of Tigris Financial Group, a $2 billion New York investment firm that has been concerned about the health of the euro for more than two years. Instead of buying credit-default swaps to bet against specific countries such as Greece, Tigris has been betting against the euro and buying gold, he says, trades that could do well if debt problems grow for Greece and others.

One sign of strength emerged Wednesday, after the Spanish treasury completed the sale of €5 billion ($6.9 billion) of 15-year bonds. The treasury offered a hefty premium on the deal, but received offers to buy more than €13 billion worth of the new bonds.

Spanish officials are quick to reject comparisons with Greece, where deep fiscal problems are compounded by a history of dubious budget accounting. “As markets see that our diagnosis of the situation is correct and that the measures we are taking are adequate, this offers reassurance,” said Deputy Finance Minister Jose Manuel Campa.

Some of the longtime bears say they have trimmed some CDS holdings to cash in profits as they moved on to buy CDS protection on the debt of the United Kingdom, Japan and other nations that haven’t been the focus of recent concerns.

They have also concentrated their focus on the euro. A wide swath of fund managers and Wall Street traders agree that the euro is likely to fall against the dollar this year. If Greece and other Southern European countries default on their debts, they argue, the perceived weakness in the euro-zone economy will cause the currency to fall. Similarly, moves by European Union officials to bail out a teetering economy like Greece’s could also weaken the common currency.

Operating under the theory that the U.S. is likely to recover from its financial woes faster than Europe will, the large asset-management firm BlackRock Inc. began shorting the euro late last year, according to someone familiar with the matter. At that time, the euro was trading at close to $1.50, which seemed too high to last, this person says.

Other funds that have made recent bets against the euro include the large New York hedge-fund managers Paulson & Co. and Moore Capital Management LP, say other people familiar with the matter. The two firms declined to comment Wednesday.

Write to Gregory Zuckerman at gregory.zuckerman@wsj.com and Kate Kelly at kate.kelly@wsj.com

A year ago, investors were dealing with heavy losses from the most brutal stock-market selloffs in years. The last thing they expected was a ferocious bull market. And yet, shares soon began to soar — climbing more than 50%.

Last year’s unexpected stock rebound — and the sudden selloff last week — should remind investors to be on the lookout for the next surprise. That’s because big profits come in being early to the next trend, and in preparing for the next downturn.

“If you don’t leave yourself open to surprises, when they occur you probably won’t respond correctly,” says Mike O’Rourke, chief market strategist at institutional trader BTIG LLC.

It’s a simple rule of thumb: Buy before the good news; sell before the bad. The tricky part comes, of course, from guessing where the news might break to begin with.

Here are some places to watch:

Energy Boost: Many analysts expect energy prices to keep climbing, as demand from China pushes oil prices higher.

But Mr. O’Rourke says crude prices could actually drop below $50 a barrel this year, helping to fuel an economic recovery. He argues that as China applies the brakes on its growth, and is no longer focused on filling its strategic petroleum reserve, prices could fall.

“Despite this record Chinese demand in 2009, crude has been unable to sustainably move above the levels achieved in the spring” of 2009, Mr. O’Rourke says. “If this demand wanes, it could have a real problem” for energy prices.

Meanwhile, more energy supply is on the way, which also could pressure prices. There have been major oil discoveries in recent years, including in the Gulf of Mexico and off the coast of Brazil. And the U.S. Geological Service said last month that Venezuela’s Orinoco Belt held far greater oil reserves than had been believed.

Heady Growth: Most economists predict subpar growth in the U.S. and around the globe in 2010. Consumers are dealing with too much debt, help from government spending will peter out, and businesses aren’t spending much.

But if the recovery conforms to historic patterns after major downturns, it could be surprisingly strong.

Some recent data have been encouraging, with manufacturing activity at its highest point since the summer of 2004. An index compiled by the Institute for Supply Management rose to 58.4 in January from less than 55 in December. A reading above 50 indicates expansion. A recent survey showed banks have stopped making it tougher for consumers and businesses to borrow, another hopeful sign.

“The more I look at the data, the more this looks like a typical recovery,” says Norbert J. Ore, chairman of the ISM survey committee.

Robust growth may have to await a rebound in employment. But the improving data are a reminder that the economy just might surprise with its strength.

Japanese Jitters: Investors are concerned about the debt piled up by countries including Spain and Portugal. Some worry that the European Union or others might have to step in to help Greece deal with its debt.

Not as many investors are focused on Japan, though perhaps they should be. Japanese government debt as a percentage of gross domestic product is around 220%, up from 120% in 1998, according to the International Monetary Fund. (In contrast, federal debt is around 85% of the U.S.’s GDP.) Demand has long been strong for Japanese debt, and 10-year bonds yield well below 2%, partly because most of it is held by loyal Japanese citizens. Some observers have been warning about Japan for a decade. The country’s debt markets have been steady, but there are indications that domestic buying is slowing.

Any troubles for that market would be more worrisome than woes in some other countries, given the size of Japan’s bond market — about $7.5 trillion — and the role Japan plays globally.

Another potential worry: the U.K., which has its own debt issues, as well as an economy dominated by the still-troubled financial sector.

Municipal Mess: Municipal bonds have long attracted conservative investors. That might change as the poor health of various states and municipalities comes under scrutiny.

Short-term bonds issued by the state of California yield less than 2%, for example, due to strong demand. But the state is facing a budget deficit of almost $21 billion. As interest expenses rise, they represent a larger chunk of the state’s revenue, a worrisome shift. If investors begin to worry about the health of various municipalities, they could push prices lower for various bonds.

Growing Greenback: There are reasons to expect a dollar rebound. Worries about the debt of European nations took hold last week, pulling down the euro and sending skittish investors back to the U.S. dollar. Gold and commodities fell, too.

If U.S. growth proves stronger than expected, the Federal Reserve could signal an interest-rate increase, which also would help the dollar and weigh on shares of gold miners and other commodity producers.

Health-Care Recovers: Health-care stocks were haunted by the specter of President Obama’s overhaul plans, though the shares have generally held up. In recent days, they’ve been hit by downbeat earnings — such as last week’s quarterly results from Pfizer, which helped send the drug maker’s share price down 5% over two days.

But some of these shares could see healthy gains. Merck, for example, trades at price/earnings multiples that are below the overall market, yet sports a hefty dividend yield of nearly 4%. If the stock market turns rocky (and it certainly did last week), those dividends will look more attractive.

Health-care companies may have an easier time raising prices if the government can’t settle on an overhaul plan, some analysts say.

Write to Gregory Zuckerman at gregory.zuckerman@wsj.com
 

Countries have dealt with debt woes before.

But the latest fears about government debt now riling some European markets are being fueled by a relatively new trading tool that lets investors bet against nations’ bonds.

Credit-default swaps, or CDS, enable investors to protect themselves from a default of the debt of a range of nations or wager on the likelihood of such a scenario.

In recent weeks, prices for CDS contracts have soared as investors snapped them up on worries about the bulging debt of nations including Spain, Portugal, Greece and Latvia. The CDS moves—highly visible and widely watched—have compounded the angst of stock and bond investors, analysts say, helping to pressure global markets.

On Thursday, the cost of CDS contracts that insure the debt of a number of euro-zone members with large budget deficits rose again. The annual cost of insuring €10 million ($13.9 million) of Greek government debt against default for five years rose €26,000 to €423,000 Thursday. Stocks fell sharply in Europe and the U.S.

CDS are contracts that serve as insurance on all kinds of debt. With sovereign debt, if a nation defaults the CDS buyer would get paid by the seller of the CDS insurance. Though government defaults are rare, the value of CDS contracts rise and fall to reflect investors’ outlook on the bonds they are designed to insure.

The market for CDS has boomed in recent years. Seven years ago, there was less than $3 trillion of CDS contracts outstanding; today there are more than $25 trillion of these contracts, according to the International Swaps and Derivatives Association. When prices for CDS on the debt of firms like American International Group Inc. and Lehman Brothers Holdings Inc. soared in 2008, investors interpreted the moves as signals of troubles ahead.

Now the same is happening with CDS prices rise for a variety of nations, marking one of the first potential government-debt crises in which CDS contracts are helping to spread unease. That is creating another real-time measure of investor worries—a barometer that itself can generate more anxiety.

“It’s easier to buy protection and transact a ’short’ position, that’s half the reason CDS were developed, so people can hedge risk,” says Tim Backshall, chief strategist at Credit Derivatives Research, an independent research firm in New York. “You can move [other markets] with those trades.”

It has always been possible to sell short—or bet against—government bonds directly. But investors say buying CDS can be an easier way for them to quickly enter a wager.

For one thing, CDS can be purchased by investors who don’t own the underlying debt but want to wager that it is likely to weaken, meaning they can be bought not only by people hedging other bets but also by investors making straight wagers.

And a CDS buyer usually doesn’t have to produce as much collateral to make a bearish trade as the investor would to make a similar wager in the government-bond market. For example, some dealers allow an investor to bet against $10 million of Greece’s debt by putting up as little as $2 million and then make quarterly payments of about $105,000. If the same investor wanted to short Greece’s government debt, or borrow and sell it hoping for a drop in price, the investor might have to place as much as $10 million into an account with a brokerage firm.

Some have criticized CDS as a sentiment indicator, noting the swaps sometimes suggest that countries are headed for a default though yields on bonds issued by those countries don’t indicate such a dire outcome. They also don’t always see heavy trading, opening the door to potentially sharp price moves.

“The CDS market is reflecting where dealers are willing to make a market,” says Matt Luckett, a partner at Balestra Capital, a hedge fund that has purchased CDS contracts that protect a range of government debt. “When dealers run out of sellers” of CDS, prices can move sharply simply for lack of supply.

Some analysts say the CDS market shouldn’t shoulder blame for the market turbulence. Just as some financial companies attracted short sellers in 2008 as they faced serious problems, nations such as Greece, Spain and Portugal have piled on debt and have yet to convince investors that they will put their fiscal houses in order. That is the underlying reason for the troubles, not the trading in CDS, some say.
And for some nations, such as Greece, government bonds actually moved more than CDS prices in recent months, suggesting that CDS trading provided reassurance to the market, rather than concern. In recent days, though, the trend has reversed.

“Blaming the problems on the CDS market appeals to the populist in everyone, but in this case it’s hard to argue with the deteriorating fundamentals,” says Mr. Backshall.

Write to Gregory Zuckerman at gregory.zuckerman@wsj.com

On the heels of one of the worst years in stock-market history, some experts say investors should shift more money into a surprising area: emerging markets.

For years, shares and bonds from emerging markets made investors wary. Sure, their growth often could be much stronger than that of developed economies, partly because of robust population growth and steadily improving standards of living. But countries such as Brazil, Mexico, China, South Korea and many in Africa often were handicapped by heavy debt, weak currencies, poor corporate governance and high volatility.

That view is changing. Last year’s financial meltdown raised questions about the attractiveness of developed nations, which have been dealing with their own serious debt, currency and governance issues.

And with few analysts predicting robust growth in developed markets for some time, there’s a new appreciation for the promise of robust expansion in some emerging markets.

“Most developed countries have similar economic problems,” including over-indebtedness and aging demographics, says James Paulsen, chief investment officer at Wells Capital Management, who predicts that many developing nations will see their currencies rise in value, helping investments in those nations. “Emerging countries possess stronger inherent growth possibilities.”

Daniel Arbess, manager of the Xerion Fund, a hedge fund, at Perella Weinberg Partners, says that “emerging markets are arguably the single most important avatar of investment opportunity for our generation. The demand for commodities to support the modernization and urbanization of developing economies, and the demand for food and products by growing consumer classes, should continue to fuel opportunities for years to come.”

Faster Growth

Some stock markets in developing nations, including Brazil, already have soared from their lows reached earlier this year. The widely followed MSCI Emerging Market index, which tracks emerging-markets shares, is up 60% this year, compared with a gain of 10% for the Dow Jones Industrial Average. (The Dow fell 1.6% last week.)

On a price-to-earnings basis, however, shares of many emerging-markets companies are comparable to those in developed regions, says Marko Dimitrijevic, a hedge-fund manager who focuses on emerging markets. On a price-to-sales basis, they’re still a bit pricey, however, according to some investors and analysts.

Profits of companies in emerging markets “are growing faster than developed markets, yet often still trade at a discount” based on their strong growth and reasonable P/E ratios, says Mr. Dimitrijevic, who runs Everest Capital, a top-performing fund based in Miami.

He’s a fan of India, Korea, Nigeria and the Middle East region; he’s less keen on Mexico and China, which are more expensive.

Nations outside of the U.S. and developed Europe now account for almost half of global gross domestic product, Mr. Dimitrijevic says. It was less than 40% in 1990. It helps that many of these nations are transitioning from dependence on demand from developed nations to a more balanced exposure to both local and foreign demand.

And while nations with emerging markets once were criticized for excessive government involvement, the rush by the U.S. and other nations to rescue companies and rack up debt to spur economic growth has taken the air out of that argument.

Dangers still loom for investors focused on emerging markets, though. Accounting standards in some countries aren’t up to par, disclosure can be less robust, and the size of some markets in Africa and elsewhere can be small.

Some doubt the ability of emerging markets to buck the likely slow growth of the developed world.

Beware a ‘Double Dip’

“If your world view is that the recession is over and we are about to start a great bull market, then emerging markets should outperform,” says Matthew Tuttle, who runs investment advisory firm Tuttle Wealth Management. “If you believe, as we do, that we are in for a double dip [another downturn for the economy] and things will get worse before they get better, then emerging markets will not be a good place to be.”

Mr. Tuttle agrees that nations like Brazil, Russia, India and China should do well over the long haul. But he worries that these stock markets have gained between 50% and 100% this year, saying that “those types of numbers aren’t sustainable…. I would wait for some sort of pullback.”

Analysts say bonds from many emerging-markets nations are less attractive than stock because so many of these countries now are rated investment grade. So investors are no longer being compensated for the risks of going abroad.

Individual investors can find it difficult to buy debt from companies in emerging markets — and some small companies can be harder to track.

As a result, Mr. Tuttle recommends mutual funds such as the Lazard Emerging Markets Portfolio fund, which is up 58% so far this year and has an expense ratio of 1.5%, and debt-and-currency-focused PIMCO Developing Local Markets fund, which has climbed 19% and has an expense ratio of 1.1%. Among so-called tactical funds — which usually can go into all kinds of markets — Ivy Asset Strategy fund is up 19% this year, and Blackrock Global Allocation fund is up 17%.

Exchange-traded funds like the iShares MSCI Emerging Markets Index Fund track the MSCI index, providing exposure to Brazil, China and other markets, though not to smaller markets. It’s up more than 50% so far this year.

The numbers hardly tell the story.

Today, the Dow Jones Industrial Average stands roughly 2000 points below where it was on this end-of-summer weekend one year ago. No one knew then, of course, but the U.S. stock market and the world economy were just days from historic calamity, unprecedented in the lives of anyone born in the last 80 years.

And today? We are nearly six months into one of the most impressive bull markets in memory; the Dow has risen 46% since early March. The Nasdaq Composite Index is up 60%.

Go figure. It’s been a year of horrors and opportunities for investors.

The troubles began in 2007 with rising defaults among “subprime” mortgage borrowers and a market slowly drifting downward from an all-time high set that October.

But then critical mass was reached over a stunning two-week period last September. The U.S. government rapidly took over mortgage-lending giants Fannie Mae and Freddie Mac, along with huge insurer American International Group.

Onetime Wall Street power Lehman Brothers filed for bankruptcy, wounded brokerage giant Merrill Lynch rushed into the arms of Bank of America, and federal regulators seized Washington Mutual in the largest bank failure in U.S. history.

At one point, panicked investors offered to buy U.S. Treasury bills without asking for any return on their investment, hoping to simply find somewhere safe to put their money.

By early 2009, when the stock market hit what looks like its post-crisis bottom, the collapse had vaporized more than $30 trillion, a decade’s worth of investment gains.

Yet, almost as stunning as the fall, has been the stock market’s recovery. Although still well below 2007 levels, the market has defied horrible levels of unemployment, a housing market that is still barely breathing and an economy bound in recession.

There are ample signs that the worst is over, of course, and a recovery may already be under way. (Yes, but tell that to the millions who have lost jobs, business owners who have shut down their companies or the legions whose retirement nest eggs may not recover in time. Their personal recessions may never be over.)

So what have investors learned from all this? With a full year of hindsight, here are some lessons of the crisis:

Diversification doesn’t always work. Financial advisers have drilled into investors the need for diversification. But the past year has taught that spreading money around the globe and into different asset classes sometimes results in less safety than one would expect. The lesson isn’t to put more eggs in a single basket, but to acknowledge the limits of diversification.

Markets are more interlocked than ever before. When the U.S. markets began to fall, investors pulled money from foreign stocks, almost every kind of bond and even investments that sometimes are sold as a way to protect a portfolio, such as commodities and hedge funds. Even gold, a traditional haven, experienced some rough periods as investors raised cash by selling almost anything they could get rid of.

Understand every investment. Even the most sophisticated investors can be fooled by complicated investments.

In October of last year, Chuck Prince, Citigroup’s CEO, said “we expect to return to a more normal earnings environment as the year progresses,” while UBS CEO Marcel Rohner said “we expect positive investment bank performance.” But Citigroup and UBS turned into two of the biggest losers from the crisis, as the seemingly safe collateralized debt obligations on their books led to billions of dollars in losses.

Just as banks need to make sure they understand the risks and downsides of their holdings, so do individual investors.

Make sure your portfolio is as liquid as you need it to be. Some of the biggest mistakes were made by investors who thought their holdings were more “liquid,” or easy to exit without incurring big cost, than they actually were.

Even university endowments run by some of the most sophisticated investors were surprised to find that their hedge funds, private equity and other holdings were difficult to exit in the heat of the crisis. They’ve vowed to do a better job of matching their needs and their investments.

Government works. The aggressive steps by the government seem to have helped avert an even deeper recession, or even a depression, suggesting that big government can sometimes be a friend of business.

And today? We are nearly six months into one of the most impressive bull markets in memory; the Dow has risen 46% since early March. The Nasdaq Composite Index is up 60%.

Go figure. It’s been a year of horrors and opportunities for investors.

The troubles began in 2007 with rising defaults among “subprime” mortgage borrowers and a market slowly drifting downward from an all-time high set that October.

But then critical mass was reached over a stunning two-week period last September. The U.S. government rapidly took over mortgage-lending giants Fannie Mae and Freddie Mac, along with huge insurer American International Group.

Onetime Wall Street power Lehman Brothers filed for bankruptcy, wounded brokerage giant Merrill Lynch rushed into the arms of Bank of America, and federal regulators seized Washington Mutual in the largest bank failure in U.S. history.

At one point, panicked investors offered to buy U.S. Treasury bills without asking for any return on their investment, hoping to simply find somewhere safe to put their money.

By early 2009, when the stock market hit what looks like its post-crisis bottom, the collapse had vaporized more than $30 trillion, a decade’s worth of investment gains.

Yet, almost as stunning as the fall, has been the stock market’s recovery. Although still well below 2007 levels, the market has defied horrible levels of unemployment, a housing market that is still barely breathing and an economy bound in recession.

There are ample signs that the worst is over, of course, and a recovery may already be under way. (Yes, but tell that to the millions who have lost jobs, business owners who have shut down their companies or the legions whose retirement nest eggs may not recover in time. Their personal recessions may never be over.)

So what have investors learned from all this? With a full year of hindsight, here are some lessons of the crisis:

Diversification doesn’t always work. Financial advisers have drilled into investors the need for diversification. But the past year has taught that spreading money around the globe and into different asset classes sometimes results in less safety than one would expect. The lesson isn’t to put more eggs in a single basket, but to acknowledge the limits of diversification.

Markets are more interlocked than ever before. When the U.S. markets began to fall, investors pulled money from foreign stocks, almost every kind of bond and even investments that sometimes are sold as a way to protect a portfolio, such as commodities and hedge funds. Even gold, a traditional haven, experienced some rough periods as investors raised cash by selling almost anything they could get rid of.

Understand every investment. Even the most sophisticated investors can be fooled by complicated investments.

In October of last year, Chuck Prince, Citigroup’s CEO, said “we expect to return to a more normal earnings environment as the year progresses,” while UBS CEO Marcel Rohner said “we expect positive investment bank performance.” But Citigroup and UBS turned into two of the biggest losers from the crisis, as the seemingly safe collateralized debt obligations on their books led to billions of dollars in losses.

Just as banks need to make sure they understand the risks and downsides of their holdings, so do individual investors.

Make sure your portfolio is as liquid as you need it to be. Some of the biggest mistakes were made by investors who thought their holdings were more “liquid,” or easy to exit without incurring big cost, than they actually were.

Even university endowments run by some of the most sophisticated investors were surprised to find that their hedge funds, private equity and other holdings were difficult to exit in the heat of the crisis. They’ve vowed to do a better job of matching their needs and their investments.

Government works. The aggressive steps by the government seem to have helped avert an even deeper recession, or even a depression, suggesting that big government can sometimes be a friend of business.

But questions remain about whether all the spending will eventually lead to inflation or other problems, making this a qualified lesson of the period.

Don’t let financial companies become too big to fail. It’s not clear if regulators fully understand this lesson of the fiasco. For years, critics said companies like Fannie Mae and Freddie Mac had grown too large, and that firms like Lehman Brothers carried too much debt. Today, firms like Goldman Sachs and J.P. Morgan Chase are growing and might end up too big to be allowed to crumble, some analysts say.

Factor into any investment equation a worst-case scenario. Too many investors piled into housing-related investments, confident that real estate never had dropped on a national basis or that investment-grade mortgage investments never defaulted. They would have been better served to examine potential holes in their bullish stance.

Don’t get too gloomy. Like the old saying goes, in every crisis is an opportunity. As nations around the globe confronted the crisis and pumped huge sums into their economies, the economy stabilized. And even as the recession looked its worst, the stock market began to sense that a recovery was coming.