Wouldn't Trust those Titans with my Grocery Money

Tuesday, 3:59 pm

Mar

11

2008

I’m not an economist. However, over the years, I have figured out a couple of things: Don’t borrow what you can’t afford to pay back. If you’re going to invest money in speculative instruments (which come with a high risk factor), make sure you can afford to lose what you’ve invested. Make sure you don’t stick all your eggs in one basket. Plan for the unexpected. And understand that what goes up will eventually come down. It may go up again, but it will not go up and up and up and up, infinitely. These seem to be pretty good rules to live by.

With regard to all of these financial institutions and hedge fund managers who invested enormous chunks of borrowed money into speculative mortgage securities, they seem to have forgotten those basic rules in the heat of the moment.

Take Carlyle Capital Corp, for example. They’re an affiliate of the Washington based private equity firm called Carlyle Group. The latter has its fingers in lots of pies (including part ownership of Dunkin Donuts, to my everlasting dismay). They’ve been around the block a few times, so you’d think they might have some common sense where investing is concerned. The whole outfit is run by very wealthy (or at least they were) individuals with a lot of world experience.

Carlyle Capital Corp was created in mid-2006 with the stated objective:

...of achieving attractive risk-adjusted returns for shareholders through current income and capital appreciation. CCC invests in a range of fixed income assets including high-grade mortgages and credit products.

We’ll leave it to posterity to assess the risk-adjusted part of that objective. They appear to have been formed to specifically jump whole hog into the residential mortgage backed securities party.

Now here’s the great part.

In December of 2007, when everyone else was starting to get really sweaty nervous about the sub-prime mortgage fallout, Carlyle Capital had approximately $670 million in equity from which they wanted to build a mortgage backed securities portfolio. In other words, they wanted to purchase large blocks of mortgage debt, principally, Fannie Mae and Freddie Mac mortgage debt, which is, all other things being equal, a fairly safe investment. (Not that all other things were equal...) Fanny Mae and Freddie Mac securities are backed by the US government. But CC didn’t have enough money to establish a respectable fund.

So....they leveraged their $670 million in equity. In other words, they used that money as collateral to borrow from a number of lenders. Now here’s the sticky wicket...they leveraged that $670 million thirty-two (32) times until they’d raised 21.7 billion dollars. That’s right. They used that same $670 million as collateral, 32 times. And lenders didn’t appear to have a problem with that concept. Because the sky was the limit and the good times were rolling. Everybody was getting rich. Irrational exuberance, some sage once said.

Alas. The air started leaking out of the housing bubble. (Most of us with two brain cells to rub together realized it was a bubble, didn’t we??)

Investors started cashing in and fleeing. And the value of the securities started dropping like boulders. The funds shares dropped about 75% and finally, trading was suspended.

A couple of weeks ago, the lenders, also in a world of hurt, slapped margin calls on Carlyle Capital. CC’s equity was dropping and the lenders wanted CC to pony up extra dough to cover the shortages. CC missed several of the margin calls and went into default. They didn’t have the money to cover their debt or losses. Oops.

As of this week, the Carlyle Capital’s margin calls exceed $400 million and are still climbing. Their lenders are starting to sell off their securities, at greatly reduced values, to get the money owed them. Carlyle Capital’s equity has been almost entirely wipe out at this point. And they still owe several billion dollars to lenders. I’m sure that the foremost thought in the lenders’ panicky minds is..."Will we ever see it? Oh God, we need it. Now!” Much negotiation ensues.

The titans of finance who loaned enormous amounts of money based on a rather modest $670 million in former equity include: Bank of America, Bear Stearns, Citigroup, Credit Suisse, Deutsche Bank, JP Morgan Chase...among several others. They are, obviously, not happy about this turn of events, but they were perfectly happy to dig the chasm they’ve suddenly fallen into. And let’s be clear...Carlyle Capital Corp is a mere pinprick on the financial landscape. I don’t feel sorry for any of them, but their hurt is going to end up being everyone else’s hurt. Yours and mine, included.

Isn’t the world of economics and finance fun? If I ran my finances like they run theirs....

It reminds me of a certain 9 year old who used to tell me, “But all my friends are allowed to do that. Everybody’s doing it....” And, of course, the age old retort, “If all your friends wanted to jump off a bridge, would you do it, too?” It looks as if the titans of finance said, “um, yeah.” And did.