The risk arbitrage business has suffered the same magnitude of shakeup as the larger financial services industry. How could it be otherwise, given the deep entanglement of hedge funds with brokerage firms and the fact that arb portfolios are exposed to the whipsawing of global corporate liquidity and to intensely volatile equity markets.

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The past month has proven a lesson in adversity for even the most seasoned risk arbitrageurs. And the crisis is not over -- not by a long shot. Deal spreads began to gain a semblance of normalization last week with the ring-fencing of the world's largest financial institutions, but the repercussions are still being felt. Arb funds themselves are absorbing redemptions and liquidations and waiting to re-enter the market.

How spreads on M&A deals will look when the worst is over is not an easy call. There will be different assessments of what constitutes normal deal risk. Leverage will be rethought. And the deal pool will change. And what is the outlook for M&A in coming quarters? One hint: Look at pending deals in the current risk arbitrage world.

To get an idea why arb spreads have widened so dramatically over the past month, you have to grasp how the market has grappled with assessing deal risk. Risk arb is essentially an M&A insurance business. When arbs buy into an announced merger, they accept the risk of losing an M&A premium if the deal does not close. To accept that risk, arbs charge a premium -- the deal spread. Typically, that spread is a function of the cost of capital and knowable issues, such as antitrust and the time value of money. However, market turmoil, teeth-rattling volatility and government interventions in banking threw those risk assessments into disarray.

It's obvious that deal spreads widened after the bankruptcy filing of Lehman Brothers Holdings Inc. and the near collapse of American International Group Inc. As bank lending froze, concerns arose that pending deals could collapse if debt commitments were not honored. Also, the plunging Dow Jones Industrial Average raised anxieties that cash buyers might conclude they were overpaying and seek to reprice deals. This is exacerbated by the high number of cash, as opposed to stock-swap, deals in the current pool of arb situations. Cash deals are harder to hedge and more susceptible to steep drops in the stock market.

But there have been structural issues in the business of risk arb that contributed to the wider spreads and subsequent losses at the end of the third quarter just as much -- or more so -- as actual deal risk. Redemptions have taken their toll, as funds have been forced to raise cash or have been caught on margin with failing or troubled brokerage companies. (In the case of Lehman, some funds may have seen their positions sucked into the bankruptcy.) Seeking a source of funds, arbs were forced to sell out their positions, particularly for the most liquid, easily unloaded stocks, such as those in the $50 billion buyout of Anheuser-Busch Cos. by InBev SA. That, in turn, contributed to wider spreads and a temptation to unwind positions. Indeed, when capital needs to be raised, arb portfolios are typically the most liquid and the most quickly tapped.

Adding to the mix, index funds have also been selling. When indexers are not willing to take risk, the selling becomes indiscriminate and the arb market is not big enough to absorb the volume.

In the recent crisis, hedge funds have also been viewed as credit risks, an arb notes. Merger arb spreads are a function of cost of capital, which has become difficult to control as investment bank credit spreads have widened and banks have pushed funding costs through to hedge funds, the arb says.

The proliferation of hedge funds has also altered the underlying structure of the business and changed the market response to upheaval, one veteran arb says. During the much shorter crash of 1987, there were fewer limited partnerships, and risk arb was more concentrated inside investment banks. Arb spreads were not hit in the same way because the market did not have to absorb redemptions and margin calls, he says.

To put it in perspective, the Anheuser deal traded in early August at a spread of $12.84, or 2.7%. Before last week's bank equity infusion, the spread hit $11.50, or 19.6%. The BCE Inc. telecommunications buyout by Ontario Teachers' Pension Plan, Providence Equity Partners Inc. and Madison Dearborn Partners LLC traded out from C$2.85 to C$8.90 ($2.52 to $7.88), or 26%. Dow Chemical Co.'s acquisition of Rohm and Haas Co. went from $3.05 to $17, or 27.7%.

Certainly, some of that increased potential gain derives from a higher risk premium, not technical market problems in the arb world. As one arb says, the crisis might be over for financial firms, but it's not over for merging companies that still face recession, must report earnings and execute credit pacts.

Remarkably, for all the Sturm und Drang, the current deal pool has largely held up and seems relatively safe. Since Sept. 15, in the U.S. alone, 12 mergers have closed for an aggregate value of roughly $46 billion, including the $22 billion acquisition of Wm. Wrigley Jr. Co. by Mars Inc., which included a $2.1 billion equity investment from Berkshire Hathaway Inc. and a $17 billion debt package led by Goldman, Sachs & Co.

During the same several weeks, no announced deals have failed, although some unsolicited offers have fallen by the wayside. The first of these was Electronics Arts Inc.'s offer for Take-Two Interactive Software Inc., which was pulled on the eve of the Lehman bankruptcy. Since then, Sumitomo Heavy Industries Ltd. of Japan dropped its bid for Axcelis Technologies Inc. and a string of hostile bidders folded their tents: Bristol-Myers Squibb Co. chose not to outbid Eli Lilly and Co. for ImClone Systems Inc., Service Corp. International backed off its unsolicited approach to Stewart Enterprises Inc., Walgreen Co. retreated from its offer for Longs Drug Stores Corp., Waste Management Inc. backed away from Republic Services Inc., Vishay Intertechnology Inc. from International Rectifier Corp., United Technologies Corp. from Diebold Inc. and LS Power Equity PartnersTransAlta Corp. from

But ImClone still has its pending deal with Lilly, the Republic merger with Allied Waste Industries Inc. appears on track, and CVS Caremark Corp.'s tender offer for Longs closed.

It's not particularly surprising, given the lending environment, that deals without defined debt commitments would fade. But arbs think a hostile deal environment could easily heat up again as bank funding becomes available.

The extent of a recession remains uncertain and there might not be the level of hostile bidding that occurred in 1988, but it will not just be Warren Buffett looking to buy distressed companies, an arb says, alluding to the possibility that Electricité de France SA and Kohlberg Kravis Roberts & Co. might persist in attempts to woo Constellation Energy Group Inc. from its deal with Berkshire's MidAmerican Energy Holdings Co. But EdF is constrained in making a bid by a standstill agreement tied to its joint venture with Constellation.

In a recession, targets with beaten-down stocks will take a defensive stance, and bidders usually make low-ball offers, the arb says. This leads to competitive bidding situations, he says.

Arbs expect that even if M&A dealflow is constricted for a time in many sectors, there will be distressed financial services deals much as there was in the wake of the savings and loan crisis, which brought a surge of transactions that lasted into the late '90s.

And pending bank deals, such as Bank of America Corp.'s $34 billion merger with Merrill Lynch & Co. and Wells Fargo & Co.'s $14 billion merger with Wachovia Corp., are likely to close. The strategic value of both deals, coupled with the will of regulators for them to proceed, make them pretty safe bets. The Merrill Lynch deal currently trades at a spread of $1.98, or 8.6%, and the Wachovia merger at 41 cents, or 6.3%. The Banco Santander SA acquisition of the 75.6% of Sovereign Bancorp Inc. it does not own traded at a spread of 52 cents, or 15.9%.

There have also been several financial services deals that closed while the current crisis unfolded or, at least, look likely to get done, including Safeco Corp. by Liberty Mutual Group and UnionBanCal Corp. by Mitsubishi UFJ Financial Group Inc. (which also recently bought a stake in Morgan Stanley). Nationwide Financial Services Inc. by parent Nationwide Mutual Insurance Co. and Philadelphia Consolidated Holding Corp. by Tokio Marine Holdings Inc. also appear as if they will close. (Nationwide Mutual is buying NFS shares in the open market at a discount to its deal price while arb spreads are out of whack.)

There is no doubt that there have been large strategic deals in the works that have not been announced because of the changed credit environment, an arb says. If the current mess is more a financial services event than an overall economic rupture, some of these deals will surface in coming months, he says.

And for the most part, signed deals in healthcare, pharmaceuticals and technology have traded in a relatively stable manner in recent weeks.

A recession and tight liquidity would put small-cap companies on the ropes, another arb says. This could translate to a wave of small-cap deals, he says.

But the crisis, and its attendant deals, is still at hand. The Wrigley close gave little succor to arbs playing the remaining leveraged mergers. Of this pool, five probably deserve particular mention: the InBev acquisition of Anheuser-Busch, the UST Inc. deal for Altria Group Inc., BCE; Huntsman Corp.'s buyout and merger with Hexion Specialty Chemicals Inc. and Dow Chemical's acquisition of Rohm and Haas.

The key to each of these deals is lending. The Bud deal has a consortium of 39 lenders, but nevertheless InBev last week still postponed its rights offering, an equity bridge, because of market conditions. InBev insists its lenders stand behind their commitment. UST and Altria agreed to defer funding until 2009 at the request of lenders. Altria exposed itself to a 50% raise in the reverse termination fee to gain the extension. Both deals involve companies that are cash generators in recession-averse businesses and strategic alignments. Both deals are likely to close, but it will be some time before another deal with a $47 billion debt package comes to market, an arb says.

Rohm and Haas, aside from uncertainty over antitrust approval, seems more a victim of indiscriminate spread fluctuations than anything. But arbs are currently wary of deals in cyclical and commodity industries, given the possibility of a prolonged downturn.

Huntsman, the last of the deals from the buyout bust that was the "petite crise" of 2007, is its own unique animal -- perhaps the deal that draws the line against buyers and banks trying to wriggle out of debt commitments. Huntsman is in the midst of both credit agreement talks with Credit Suisse Group and Deutsche Bank AG for a $15 billion debt package and several court battles. The debt commitment terminates Nov. 1. Hexion parent Apollo Management LP, which risks a tortious interference damage claim in Texas for seeking termination of the deal, has offered to put up equity to get it financed. And the Huntsman family and several hedge funds have provided Huntsman with cash. In all likelihood, the deal will end up in a New York court with Hexion facing the banks over the credit agreement. A host of similar situations this past year have, in varied degrees, worked in favor of private equity and bank lenders. Huntsman could break that trend.

Unlike Bud, BCE might be victimized by a smaller loan syndication. The BCE lenders re-signed their debt contracts in July under an agreement to close by Dec. 11. This reiterated commitment, coupled with bailouts intended to free up lending, should mean a done deal. But as a $50 billion leveraged club deal, BCE now looks like a dinosaur.