The Trouble with Carlyle

Story Highlights:

• Carlyle Capital Corp., a division of private equity firm the Carlyle Group, failed to meet four out of seven margin calls from its banks.
• Investors fear Carlyle's failures point to larger problems in perceived "safe" agency mortgage securities—securities backed by government-sponsored enterprises like Fannie Mae and Freddie Mac.
• Although recent price volatility in the mortgaged backed securities market plays a factor, Carlyle Capital's own leveraging tactics are the major cause of its predicament.
• Carlyle's failure to meet margin calls is too small a problem to affect the broader credit markets.

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Credit market fears continue to shift shapes, with the most recent incarnation in the forms of agency mortgage securities (think Fannie and Freddie) and Carlyle Capital Corp. Carlyle Capital made headlines announcing it was unable to meet requirements for four out of seven margin calls received this week. The margin calls, totaling $37 million, come on the heels of another set of margin calls and collateral demands received last week.

Carlyle Fund Gets Default Notice after Margin Calls
By Edward Evans, Bloomberg.com
https://www.bloomberg.com/apps/news?pid=20601087&sid=aqrhXPaeh7cE&refer=home

It seems Carlyle might not fulfill all its margin obligations and has already received one notice of default. This wouldn't be too troubling, except Carlyle Capital didn't engage what many view as "risky" subprime or structured debt. Carlyle invested in presumably "safe" agency mortgage securities—securities backed by government-sponsored enterprises like Fannie Mae and Freddie Mac—ratcheting fears concerning these securities, normally viewed as less risky than junk bonds. Could it be subprime has finally infected the entire debt market?

Probably not. Prices for agency mortgage securities have been falling recently—mostly tied to investor fear surrounding the subprime fallout—and mortgage bonds spreads have been widening. Investor concern about Fannie- and Freddie-backed securities has caused their market values to slip. As a result, banks are demanding additional collateral on loans issued against these securities. All this has led to the spate of margin calls.

Carlyle Capital is particularly impacted because its $21.7 billion portfolio is financed through leveraging $670 million in equity using short-term loans—a portfolio 32 times the size of its equity! Because Carlyle Capital is so highly leveraged, even a small price decline in its agency mortgage securities creates a large paper loss, contributing to its current margin woes. Look at it this way: If Carlyle wasn't massively leveraged and receiving margin calls, it could just hold the securities and they would likely redeem at par, as expected. In other words, the underlying securities themselves are fine—Carlyle Capital's current predicament is a result of its leveraging tactics, not a systemic problem in agency mortgage securities.

Firms who choose to leverage themselves this way intentionally take on additional risk for the chance of outsized return—and they know the inherent risks should their bets flop. In fact, we wouldn't be surprised if Carlyle Capital and a few other similar firms fail—it's merely the market's way of weeding out unsustainable levels of risk. Firms can and do fizzle out all the time—in good times and bad—and it isn't a sign of broader problems. Incidentally, Carlyle Capital Corp. is just one investment division run by the Carlyle Group, and though it's on the brink of flopping, it probably won't affect the Carlyle Group much (a firm managing 55 funds in 21 countries).

Although Carlyle Capital's failure to meet margin calls made big headlines, it's too small of a problem to affect the entire, otherwise healthy broader credit markets. For all the fear surrounding credit markets and its rippling effects, the trouble remains at the riskiest end of the spectrum. Overall, debt markets are functioning fine—borrowing continues to grow and default rates remain low—which wouldn't happen in a true credit crisis. Weeding out troubled areas merely allows for healthier, continued growth.