Twilight of the hedge funds

Carlyle Capital can't meet its margin calls. "Deleveraging's" widening gyre continues to turn.


Andrew Leonard
March 6, 2008 9:50PM (UTC)

The word of the day on Wall Street is "deleveraging." The simplest way to explain the concept is with an old bromide: What goes up, must come down. If you borrow a lot of money to make big bets in the market when times are good -- a process known as "leveraging" -- then you are going to owe a lot of money when the bets go sour and you have to settle your accounts -- deleverage -- during the inevitable bad times.

But it's even worse than that, because the process of deleveraging in and of itself causes more deleveraging. If you are a hedge fund and your bank wants you to pay back a loan, and you don't have ready capital at hand, then you must sell off some of the assets you are invested in. But when a bunch of hedge funds all try to sell off their assets at the same time, the frenzy only puts more downward pressure on the price of those assets, which means that the overall investment position of the hedge funds gets even worse, encouraging more creditors to come knocking at the door, and requiring the fire sale of even more assets.

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As Warren Buffett told CNBC on Monday, "waves of deleveraging" are sweeping through financial markets. Perhaps all you need to know to explain why Wall Street is in a state of panic is the headline of a Wall Street Journal article published this morning: "Deleveraging's Vicious Spiral Picks Up Speed." That is an amusement park roller coaster no one wants to ride.

For the very freshest example of what's giving Wall Street the heebie-jeebies, one has only to turn to Carlyle Capital, a unit of the private equity group that all lefties love to hate. On Thursday, Carlyle Capital announced that seven of its creditors had asked for immediate repayment of loans, but Carlyle didn't have the cash to meet the margin calls. As Felix Salmon at Portfolio.com notes, this is what we used to call "default."

But Salmon notes something even more interesting, and disturbing. Carlyle Capital wasn't out there investing in crazy CDO squareds and other inscrutable complexities like some of your more daring hedge funds and investment banks -- it was placing its bets on mortgage bonds issued by the government-sponsored enterprises Fannie Mae and Freddie Mac. Back in the day, these would have been considered fairly prudent, safe investments -- triple A securities backed by the full power and authority of the U.S. government. The problem: Carlyle borrowed so much money to make its bets on those mortgage bonds that it put itself in a highly vulnerable position should its bets go awry, even slightly. Salmon points the finger: "The company leverages its $670 million equity 32 times to finance a $21.7 billion portfolio," reports the Journal. Thirty-two times!

James Picerno at the Capital Spectator points to an excellent summary of the current financial crisis delivered by Malcolm Knight, general manager of the Bank of International Settlements, in a speech given last month at the Ninth Annual Risk Management Convention and Exhibition of the Global Association of Risk Professionals.

No one knows how long the present deleveraging process will take or what its precise dynamics will be. We do know, however, that it will have to run its course, and that it is accompanied by deflation in asset prices until a new equilibrium is found. As history has shown, this process can be painful.


Andrew Leonard

Andrew Leonard is a staff writer at Salon. On Twitter, @koxinga21.

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