iTunes cannot convert Apple Lossless tracks to 128 kbps AAC files when sync'ing with iPhone
I had a similar problem with few of my tracks. The conversion is done live, while syncing. Basicly the problem is with the particular sound track, not the lossless codec (ALAC) itself. I used a third party utility to re-encode the original (keeping it to ALAC) and then iTunes managed to re-encode the track back to 128kBit AAC. Hope this helps.


  Does iTunes maintain a parallel, down-sampled, library on disk when I check this option? 


No - re-encoding is done live, that's why it's so slow.