...Carlyle Capital invested in triple-A rated mortgage debt issued by Fannie Mae and Freddie Mac, and like other investment vehicles it had leveraged its capital aggressively, borrowing $31 for every dollar of equity. As of February, it had $21.7 billion worth of assets in its investment portfolio. But as those investments lost value, creditors demanded that it put up more and more money in margin calls. A $150 million line of credit from its parent, the Carlyle Group, was not enough to keep it out of trouble as lenders demanded more collateral to back up their loans.
By Wednesday, it had already defaulted on about $16.6 billion of debt and some lenders started to liquidate assets. Talks to halt liquidations and revive the fund’s finances failed Wednesday night after the value of collateral declined further, prompting additional margin calls worth $97.5 million.
The announcement sent shudders through Asian and European markets as investors fear more funds, even those investing in highly-rated assets, could run into trouble. Banks are calling in loans or ask for more collateral as the value of assets backed by mortgage-securities continue to decline.
The collapse of talks between Carlyle Capital and some of its lenders, which include Bear Stearns, Bank of America, Citigroup and Merrill Lynch, shows that a plan earlier this week by the Federal Reserve to back some assets like private mortgage bonds has not stopped banks from demanding more collateral....
Global stocks tumbled and the dollar fell further Thursday as the effects of Federal Reserve efforts to restore liquidity to financial markets faded and the investment fund Carlyle Capital succumbed to the credit crisis.
Carlyle Capital said it expected its lenders to "promptly" take over all its assets after talks with banks to refinance the fund failed. Its shares plunged more than 70 percent in Amsterdam, taking their loss for the past two weeks to more than 90 percent.
The Nikkei 225-stock average fell 3.3 percent, the Hang Seng index plunged 4.8 percent, and the S&P/ASX 200 declined 2.3 percent.
The dollar fell to as low as ¥99.78, a level it had not reached since 1995, while the euro rose to a new record of $1.5623.
Reuters reports that Carlyle Capital -- an affiliate of Carlyle Group that counts former President George H. W. Bush among its advisers -- can't pay back the $16.6 billion it owes banks. So its lenders are taking possession of its assets to try to recoup some of the money they lent. Interestingly, it said that the only assets held in its portfolio as of Wednesday were U.S. government agency AAA-rated residential mortgage-backed securities (MBSs). If these securities are indeed worth their AAA rating, I wonder how much of a "haircut" those lenders will take.
This latest collapse is evidence of two viciously destructive cycles in the global credit markets which government policy decisions are making even worse. The first cycle is driving down the stock market, setting inflation on fire, and hammering the dollar -- which is down 68% since 1/19/01 -- as the economy slows. The second cycle is reinforcing a chest-clutching decline in the value of the $6.1 trillion MBS market:
* The Bernanke call. As I've posted, this means that Federal Reserve Chairman Ben Bernanke's moves mark a ceiling below which the market keeps falling. The basic idea is that when the stock market falls, the Fed responds by flooding the market with money -- interest rates have fallen from 5.25% to 3% and are likely to hit 1% and then there's the "Term Auction Facilities" like this week's $200 billion month long swap of government securities for MBSs. The lower rates and added money spur inflation -- oil (+357% since 1/19/01), food prices rise (e.g., milk prices +12% in 2007) and gold futures hit $1,000 -- but do nothing to solve the basic problem -- which is to recapitalize banks. The market falls on the announcement of a new credit market problem, such as Carlyle's default, and the cycle begins anew.
* The MBS liquidation tumble. This vicious cycle ls driving down MBS prices with stunning speed. Sentiment is broadly negative and news of missed margin calls at large highly leveraged funds only elevates fear of a vicious cycle of more forced selling at deep loss, collateral shortfalls, and more missed margin calls. Today's announcement by Carlyle Capital is an example of this cycle in action.
Unfortunately, these two vicious cycles reinforce each other. The MBS liquidation tumble drives down the value of the very collateral that the Bernanke call is using in its latest effort to stop the credit crunch. The market will fall as a result and banks' MBS portfolios will have an even lower value than they did before. This will create a need for even more capital which they may try to raise by selling other, more liquid, assets.
[In other words, the value of the Fannie Mae and Freddie Mac mortgages is going to fall as well, making them less secure, and since they're basic parts of every mutual fund, it will hit a whole lot of small investors in the pocketbook. Mortgages are usually a conservative choice for investors because theoretically they *know* that X amount of money will be paid in on a schedule, so they're reliable. Not so much these days with the problems with refinancing and the "market fluctuations" that are driving up the interest on some loans, so much that people are defaulting on payment.]
Meanwhile, with the labor market heading south, people will find themselves squeezed between the rising prices of gasoline and food, their inability to borrow money, and their employers' unwillingness to pay them enough to keep up with their rising costs. This is reflected in an NBC/WSJ poll in which respondents said that they are worse off than they were four years ago.
It seems to me that the solution is for banks to write off all the bad assets and raise capital. (After writing this I read in today's Wall Street Journal that Nobel laureate Myron Scholes has made a proposal along these lines). I don't know why this is not happening, though several possibilities come to mind: there is not enough capital out there to refill their coffers, nobody knows how much those bad assets are worth, and/or the government does not want to be seen as bailing out the banks.
Sometimes society is faced with a choice between bad and worse. This is such a time.
Why am I interested in this? Well, it looks like a remarkable mistake being made by some very important people, and unlike Eliot Spitzer's zipper difficulty it will negatively affect many people's lives. The Carlyle Group has connections. Interestingly, their webpage is not loading today at http://www.thecarlylegroup.com. However, I have some links from articles I wrote a few years ago about them. This one from 2003 looks at the Carlyle Group's war profiteering. This 2002 article from The Nation looks at it as 'crony capitalism.' Who are the cronies?
...Under the leadership of [Frank] Carlucci, a former CIA deputy director who was Defense Secretary in the Reagan Administration, Carlyle has become the nation's eleventh-largest defense contractor, a major arms exporter to Saudi Arabia and Turkey, one of the biggest foreign investors in South Korea and Taiwan, and a key player in global telecommunications, wireless, real estate and healthcare markets. Since 1987 it has invested $6.4 billion in 233 transactions, with a rate of return of 36 percent on its completed investments. Carlyle currently has $12.5 billion invested....
...That's where Carlyle's global network of statesmen and former officials comes in. [Former President George H.W.] Bush is Carlyle's senior adviser on Asia and makes his money by giving speeches at Carlyle's investment conferences. [James} Baker, who was Bush's Secretary of State, is Carlyle's senior counselor and a member of the firm's Asia, Europe and Japan advisory boards. John Major, the former British prime minister, was named chairman of Carlyle Europe last year. Carlyle's advisory boards are peppered with corporate executives from Boeing, BMW, Toshiba and other big multinationals, and men of influence like former Bundesbank president Karl Otto Pohl, former Thai prime minister Anand Panyarachun and former US ambassador to Japan (and former Speaker of the House) Thomas Foley. Carlyle's new asset management group is run by Afsaneh Beschloss, the former treasurer and chief investment officer of the World Bank.
By hiring enough former officials to fill a permanent shadow cabinet, Carlyle has brought political influence to a new level and created a twenty-first-century version of capitalism that blurs any line between politics and business. In a sense, Carlyle may be the ultimate in privatization: the use of a private company to nurture public policy--and then reap its benefits in the form of profit. Although the fund claims to operate like any other investment bank, it's undeniable that its stable of statesmen-entrepreneurs have the ability to tap into networks in government and commerce, both at home and abroad, for advance intelligence about companies about to be sold and spun off, or government budgets and policies about to be implemented, and then transform that knowledge into investment strategies that dovetail nicely with US military foreign and domestic policy....
Now, I'm not a financier or economist; I can't give you chapter and verse on all of this. But I'd be very interested to learn more about what's going on and how it's going to affect all of us.
...By early evening, Carlyle Capital, a publicly traded affiliate of Carlyle that is incorporated on Guernsey, an island in the English Channel, was preparing an announcement that it could not meet the banks' demands. Carlyle Capital would collapse, and its investors would lose $900 million -- including Carlyle Group executives who owned 15 percent of the company.
The demise of the fund is a shock to the private-equity giant, long proud of its record of returning an average of 26 percent, net of fees, to investors of nearly 60 funds. Carlyle Group manages $81 billion in assets for unions, pensions, endowments, individuals and foreign governments. In the past two years, it returned $18 billion in profits and equity to its clients.
Carlyle Capital is now a blot on that record. The company's business was to borrow money to buy mortgage-backed securities, and to make money on the difference between the firm's borrowing costs and what it earned on the interest paid on the bonds.
Its stock closed at 35 cents a share yesterday after the fund defaulted on more than $16 billion in assets. The shares have dropped 93 percent since Tuesday....
Many investors think Carlyle Capital is only the tip of the iceberg. Drake Management's three hedge funds, with nearly $5 billion under management, recently suspended investor redemptions as it considers liquidating its assets. Nuveen Investments, purchased last year by Chicago private-equity firm Madison Dearborn Partners, faces lower profits and slower growth because of higher borrowing costs brought on by the credit crunch.
Peloton Partners, a hedge fund based in London, was forced to liquidate its funds recently, and Thornburg Mortgage, a big U.S. lender, failed to meet margin calls by lenders last week. Citigroup is committing $1 billion to shore up its hedge funds.
Analysts said the fear is that the banks will move more aggressively to seize assets from troubled funds, triggering a cycle that will make it difficult for funds to meet margin calls....
This is what a reordering of the world economy looks like in real time.
Don't think of yesterday's economic news as discrete events. They are small pieces of a much bigger reversal in a series of imbalances that made Americans feel richer than they were and created unsustainable distortions in the world economy that are now righting themselves.
Americans are consuming less, and their houses and other assets are becoming less valuable. Painful as they may be, in the long run, both trends must happen to restore sustainable growth. But in the short run, they are wrenching changes that are probably causing a recession.
The weaker U.S. economy, combined with low interest rates due to Federal Reserve rate cuts, has made traders around the world less inclined to buy dollars. Thus, the value of a dollar fell below 100 yen yesterday for the first time since 1995, and slumped to a new low against the euro. Unpleasant as that is for people planning European vacations, it should help cushion the blow to the economy by making U.S. exporters more competitive.
On the way up, a worldwide boom of cheap credit fueled consumer spending, kept the U.S. economy strong and artificially boosted the prices of real estate and other assets. Now the reverse is happening. Lenders made too much money available, taking on too much risk for too-low interest rates. The pullback is reflected in yesterday's other big business news, the default of Carlyle Capital, a fund operated by District-based private-equity giant Carlyle Group.
The Carlyle fund had increased its returns by borrowing money from banks to buy securities backed by mortgages. When the value of those securities fell and lenders demanded more collateral, lenders took control of the fund and began dumping its assets into a market that was already swimming in such securities.
Simultaneously, the lessening availability of credit is causing consumers to spend less. That causes lenders to be more cautious, making the credit problems more severe. It is what leaders of the Federal Reserve call an "adverse feedback loop."
There was clear evidence yesterday that Americans are spending less. The Commerce Department reported that retail sales fell 0.6 percent in February, a sign that consumers are bringing their spending more in line with what they can afford after a decade of spending beyond their means. Auto dealers and restaurants took the biggest hits, as people delayed purchases of new cars and saved money by eating in.
This pullback by consumers and reduction in credit availability are behind the increase in home foreclosures that RealtyTrac announced yesterday. The 60 percent jump reflects the fact that U.S. assets are becoming less valuable, making consumers poorer. With home prices down 8.9 percent in the past year (according to the Case-Schiller index), the dollar lower and stock prices down, we aren't as rich as we thought we were.
"The distress we are seeing in the credit markets, the pullback in consumer spending, the retreat in the dollar -- these are really all part of the same story," said David A. Rosenberg, chief economist at Merrill Lynch. "We had a dramatic overextension of credit and consumption growth for a long time."
In economics textbooks, such a rejiggering of economic forces happens in a nice straight line. In practice, it happens haltingly, with world markets on edge, day after day. Days like yesterday, full of jangled nerves and creeping panic.
Washington policymakers are trying to keep this adjustment of the world economy as orderly as possible, trying to prevent the economic undertow from hurting too many Americans.
In a survey released yesterday by the Wall Street Journal, 71 percent of economists said they thought the economy was in recession.
The Bush administration and the Federal Reserve stress that they're not trying to prevent fundamental adjustments. Home prices need to come in line with fundamentals, as do spending and savings rates. Credit needs to become available at prices commensurate with risk.
"It's by no means all bad that the U.S. is slowing down," said Adam S. Posen, a senior fellow at the Peterson Institute for International Economics. "Because at some point we've got to repay all the debt we have accumulated."
So policymakers have adopted strategies that don't stand in the way of that repricing. For example, this week the Fed agreed to let Wall Street firms obtain up to $200 billion worth of ultra-safe Treasury bonds in exchange for spurned mortgage debt, an effort to bring stability to that market. But it has refused to buy those mortgage assets outright, which would prop up their price.
The Bush administration has supported various proposals to make it easier for people to refinance into government-insured mortgages and has enacted a stimulus program to bolster consumer spending in the second half of the year by sending tax-rebate checks to 130 million Americans. But it has vehemently resisted proposals through which the government would buy mortgage debt.
"I've never seen a government be able to circumvent the business cycle in a capitalist economy, but at the same time, the government is going to pull out all the stops to minimize the instability," Rosenberg said. "The grim reality is that recessions are a part of life. It's like surgery. You don't feel good as you get out of the operating room, but inevitably there's a healing process and things get better."
