Opening Bell: The Great Hedge-Fund Unwind

Carlyle Capital leads the way; the Bushies get (regulatory) religion; rotten meat; unlucky pennies, etc.

The hedge fund Carlyle Capital all but collapsed last night, stunning investors with the speed of its fall from being one of the biggest-name investment vehicles spawned by the late credit bubble to its latest victim.

Bloomberg reports the public company said late Wednesday it has defaulted on $16.6 billion in debt after its banks withdrew their money from the fund. Carlyle’s pleas to its lenders failed to prevent them from issuing margin calls (requirements to put up more collateral for investment loans) because of the plunging value of Carlyle’s investments, which spiraled uncontrollably until it wiped out all of the company’s cash.

The Wall Street Journal drops the news on C2 and third from the bottom of its Business & Finance column A1—presumably based on the notion that everyone saw this coming? It seems like bigger news to us than that, though the WSJ does play it higher than The New York Times, which doesn’t have the story at all and doesn’t even list it on the business section of its Web site.

The Financial Times appears to have put the paper to bed before the news broke late last night, but does manage to splash a Reuters story across the top of its Web site.

Carlyle is a spinoff vehicle of famed private-equity investor David Rubenstein and his Carlyle Group, long beloved for the conspiracy theories it has inspired, in part because of the close connections it has had to the Bush and Bin Laden families, and in part because everyone loves a leveraged-buyout company.

The fund went public in July and was in trouble right from the start, the WSJ reports, despite what seemed like a solid business plan—to borrow big money to buy mortgage-backed bonds that paid somewhat more than the cost of borrowing. Carlyle simply borrowed way too much on investments it thought were safe but were in fact far from it. It took $670 million in equity and borrowed more than $21 billion to juice its returns. That’s a leverage rate of more than thirty-two times. Leverage can magnify small returns into huge ones, but it’s a two-way street: small losses can turn into routs just as easily.

The papers say the debacle is a major wound for the Carlyle Group, though we suspect it’ll be just fine somehow. The real implication of this story is if even the most sophisticated gods of finance are getting sucked in and spit out of the deleveraging machine, when will it stop? Bloomberg says not any time soon.

“Carlyle won’t be the end of it,” said Greg Bundy, executive chairman of Sydney-based merger advisory firm InterFinancial Ltd. and a former head of Merrill Lynch & Co.’s Australian unit. “There’s more to come. The problem is no one can give you an educated guess about how much.”

As if to prove Bundy right, three more hedge funds shut down or blocked investors from withdrawing their money in the last twenty-four hours or so, the FT reports. Drake Management, which has $12 billion in assets, said it would allow investors to vote on liquidating three of its hedge funds after more than half tried to withdraw their money. A $900 million Amsterdam hedge fund called Global Opportunities Capital shut down investor withdrawals for a year, and Blue River Asset Management of Colorado also shut down.

We like this Journal lede:

Many investors in a hedge fund run by Drake Capital Management LLC are trying to pull their money out. They are finding out hedge funds love to take investors’ money but can’t always give it back.

Bloomberg gives us the best context:

At least a dozen hedge funds have closed, sold assets or sought fresh capital in the past month as banks and securities firms tightened lending standards. The industry is reeling from its worst crisis because bankers—staggered by almost $190 billion of asset writedowns and credit losses caused by the collapse of the subprime-mortgage market—are raising borrowing rates and demanding extra collateral for loans.
What we’re seeing right now is the so-called Great Unwind of the massive debt of hedge funds and others, it’s accelerating at an alarming rate, and it’s going to get much, much nastier.

Here’s how the WSJ presciently described it last April:

No one is sure what will happen to this complex brew in the event of a serious market downturn. When markets turn bad, leverage can create a snowball effect. Lenders and derivatives dealers demand that investors provide them with more collateral—the stocks, cash, or other assets they pledge to cover potential losses. Sometimes investors dump stocks and bonds to raise cash. Prices drop more, losses accelerate, and more selling ensues. Some Wall Street analysts have taken to referring to a nightmare version of this scenario as “The Great Unwind”…

America has been a nation of debtors for years. Prior to the 1929 stock-market crash, brokers allowed customers to buy stocks with as much as 90 percent borrowed money—called margin debt. When the market began sliding, investors had to dump shares to keep their debt levels below 90 percent, igniting market panic. Nowadays, the SEC limits margin borrowing by most investors to 50 percent of a stock’s purchase price.

But those limits don’t apply to all of the derivatives and other financial instruments that now pack the portfolios of hedge funds and other big investors. Estimates by analysts of leverage at major securities firms, borrowing by hedge funds, and margin loans to individuals added up to $4.9 trillion in 2006, compared with $1.8 trillion in 2002.

Gotta love those 1929 references.

Laissez Farewell

The WSJ goes big on A1 with an exclusive interview with Treasury Secretary Henry Paulson and reports that the Bush administration is calling for more regulation of markets to try to prevent a repeat of the current financial crisis.

We’ll quote at length because it’s a lengthy list of regulations from the free-marketeers:

Mr. Paulson told The Wall Street Journal that the recommendations of the President’s Working Group on Financial Markets, which he leads, include strengthening state and federal oversight of mortgage lenders and brokers. The group will also recommend implementing what he termed “strong nationwide licensing standards” for mortgage brokers, a move that will probably require legislation.

The group also will propose directing credit-rating firms and regulators to differentiate between ratings on complex structured products and conventional bonds. In addition, it wants rating firms to disclose conflicts of interest and details of their reviews and to heighten scrutiny of outfits that originate loans that are enveloped by various securities.

Another recommendation from the panel is to push issuers of mortgage-backed securities to disclose more about “the level and scope of due diligence” and about the underlying assets of the securities. The panel is also seeking disclosure of whether “issuers have shopped for ratings”—that is, have had to go to more than one credit-rating firm before getting the triple-A stamp of approval.

And the panel will urge global bank regulators to revisit the latest version of bank capital requirements, known as Basel II for the Swiss city where they were negotiated, so that banks that take on risks hold sufficient capital. The panel also wants regulators to complete updated standards for how banks manage liquidity.

This doesn’t go far enough—it’s our opinion that the credit-rating model is hopelessly conflicted and needs to be dismantled, for instance—but it’s better than the laissez-faire fundamentalism we might expect to hear (though we understand that’s political poison these days and the Bush administration is in part playing catch-up to congressional Democrats). Still, we’re especially glad to see that Treasury agrees about the need to put a check on the scandalous mortgage-broker industry. We imagine markets will be comforted, too.

The WSJ also says Paulson will call for Fannie Mae and Freddie Mac to raise more capital and cut their dividends.


In an interesting Heard on the Street column, the WSJ reports on C1 that Wall Street is treating one of its own—Bear Stearns—as if it has a contagious disease.

Bear swears it doesn’t have any cash problems, but the Street ain’t so sure:

Traders handling certain long-term transactions, such as credit-default swaps, said they are being extra cautious when Bear is the counterparty. In some cases, traders are seeking higher-ups’ permission before acting

Credit-default swaps are bets investors make as insurance against a company’s going broke. Essentially, what the WSJ is saying here is that investors are skeptical about buying swaps from Bear Stearns because they wonder if the company itself might go broke.

Some hedge funds that use Bear as a prime broker also have been shifting portions of their business to other firms in recent weeks, according to hedge-fund managers and consultants who help pension funds and wealthy people choose where to place their money. A similar shift occurred last summer, but Bear soon recovered much of the lost business.

The WSJ says Bear Stearns has thirty-three times more debt than equity, a ratio that readers who’ve had their coffee will recognize as even higher than that of the soon-to-be-former Carlyle Capital mentioned above.

Screw the Shareholders

The Journal’s David Wessel, in his A2 Capital column, discusses the coming massive federal bailouts and what those might look like.

Wessel quotes Myron Scholes, a Nobel-winning hedge-fund manager, saying the government should pour capital into the banking system. That would bail out current debt and shareholders.

We agree with the Princeton finance professor quoted toward the end of the story who says these investors need to be wiped out before any taxpayer money is put into these companies. The government shouldn’t subsidize the risk-taking of these shareholders and bondholders.

Tofu, Anyone?

In non-financial (but even more stomach-turning) news, the Los Angeles Times reports on the California meatpacker who testified before Congress yesterday about what led to the massive recall last month of more than 140 million pounds of beef.

Steve Mendell, the president of Westland/Hallmark Meat Co., initially denied that so-called “downer” cows—sick ones that aren’t supposed to be slaughtered for food—were killed for meat. But Congress went to the videotape, the exec hung his head, admitted it was true and said “my life is up in smoke.” The WSJ reports the Humane Society worker who went undercover to report on the doings says he worked at the plant for six weeks without training.

Mendell’s firm is not the only one doing this, of course. It just got caught. These are problems that are going to come with the structure of our current factory-food system. (Cue promo for one of our all-time favorite pieces of journalism, “Fast Food Nation”). If you can stomach watching the video embedded in the LAT story, do so. We’re not veggie burger fans—yet. But keep trying us, meat industry.

Bad Moon Rising

In economic news, Reuters reports a measure of retail sales fell 1.1 percent in February, according to MasterCard. That’s the steepest drop since the credit-card company started keeping track in 2003. January registered an anemic, but still positive gain of 0.2 percent.

Most chief financial officers think the country is in recession and won’t emerge until next year at the earliest. Just 13 percent said they expect the economic downturn to end in 2008, nearly as much as think it will extend into 2010 and beyond.

That finding suggests that the U.S. is in for a more serious downturn than the last two recessions, each of which lasted eight months…

About one-third of the finance chiefs said their companies are feeling the effects of the problems in the lending markets directly, either through the reduced availability of credit or higher credit costs. Three-quarters said the U.S. Federal Reserve’s interest-rate cuts haven’t helped their firms.

Oil touched $110 a barrel, another record, before ending just below that figure. The dollar fell to a new low against the euro. One euro now buys $1.55 dollars.

The Perverse Penny

Finally, we like this Chicago Tribune look at the perverse economics of (literally) making money.

These days, your thoughts are worth 1.7 cents.

That’s what it costs the government to forge a penny, thanks to the rising price of metal. A nickel costs 10 cents. Congress, in its infinite wisdom, has concluded that’s a pretty bad deal.

The Trib says pennies may be made of steel by the end of the year. Here’s a better idea: Get rid of the stupid things.

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Ryan Chittum is a former Wall Street Journal reporter, and deputy editor of The Audit, CJR's business section. If you see notable business journalism, give him a heads-up at Follow him on Twitter at @ryanchittum.