March 7, 2008
Carlyle Capital and the failure of memory
Opinions vary on whether, when the financial system eventually recovers from the credit crisis, which it does not look like doing any time soon, things will work differently in future.
Some argue that the shock caused by over-complexity in the credit market is so great that investors will pull back permanently from putting money in collateralised debt obligations and the like.
Instead, there will be a long-term swing towards “re-intermediation” – banks providing credit directly from their balance sheets rather than acting as intermediaries that transfer that risk to investors by selling them sophisticated securities.
Personally, I do not believe it and Exhibit A for my scepticism is Carlyle Capital, which has got itself into trouble by leveraging its equity 28 times to buy supposedly impeccably safe AAA-rated mortgage-backed securities.
This is the same trap that befell Long-Term Capital Management only 10 years ago – it employed leverage of nearly 40 times its equity to arbitrage tiny differences in bond prices. When markets became volatile, small movements in the prices of those securities brought the fund down because they were heavily magnified by leverage.
After Long-Term Capital, there was a lot of talk about how hedge funds would avoid such high levels of leverage again. But Carlyle Capital has been caught out by doing the same thing again.
The broader point is that financial markets have a tendency to repeat the cycle of greed, during which competition reduces yields and forces banks and funds use more leverage and complexity to make profits, followed by fear.
During times of fear, everyone regrets what has happened and says it will not happen again. But Carlyle Capital shows that mistakes repeat themselves, after an time long enough for jobs to change hands and investors to forget.
Judging by the constant state of war that has plagued mankind as far back as recorded history can detect it is clear that we are not about to change to any tangable degree.It is best to appreciate us for what we are.The late great Hyman Minski had a handle on we humans and spelled it out pretty clearly in his Financial Instability Hypothesis.Minski is great reading for anyone trying to understand the repetitive nature of the bubble and bust cycles that have plagued capitalism.Minski posited that prolonged periods of econ/market stability will eventually breed instability in the same.As risk premiums contract investors increase credit risk and leverage percieving sure winnings.Also Minski’s work regarding increasingly speculative credit structures puts the current housing and mortgage market debacle into a state of crystal clarity.From hedge to speculative to ponzi structures Minski could just as easily been writing of traditional mortgages, IO’s and option adjusted ARMS.DNA being limited to the current pool of participants would indicate the bubble and bust cycle is here to stay. Minski provides a workable tool for investors to avoid following the heard over a cliff.Its a shame that the b-schools pay homage to the moneterists and libertarians and miss the brilliant work of the great Minski.
Posted by: gym-bob | March 7th, 2008 at 7:35 pm | Report this comment“institutional memory” is a capitalist rejoinder to Lysenko’s genetics.
For me, the quote of the day (admittedly not from the FT) was to the effect, in connection with the Thornburg situation, that ‘the banks are shooting their customers.’
But ‘this time it’s different.’
Ontology repeats philogeny.
Posted by: Dwight | March 7th, 2008 at 8:59 pm | Report this commentSir
I’m less interested in why the clowns in Carlyle re-visit the past. What I’m more interested in is why, in the middle of the worst credit crisis in living memory, Carlyle Capital were allowed to leverage up $22bn in debt on a 32 base multiple.
What don’t these morons and their “bankers” understand by the words “credit crisis”.
Is it oversimplifying to suggest that this kind of rank stupidity is precisely why there is a credit crisis; is it not because of this casino like mentality that conservative investors are bolting to the door with their savings clutched in their hands, causing the credit crisis; is it not for this reason that there is now serious doubt whther the clever products that have been concocted to spin credit faster and faster, preferably so that the risk pretends to land on someone else’s balance sheet, will survive.
It is about time that regulators got off their backsides to start having a close look at a financial system that seems more rotten at the core as each day passes.
Posted by: Jim | March 8th, 2008 at 5:59 am | Report this commentSorry, since I’m in full swing with my early morning rant, can someone explain to me why the Financial service industry and in particular banks, are seemingly exempt from being brought to book for reckless trading??
Is there some reason why the Carlyle Group Directors and their Bankers shouldn’t be in the dock explaining why they’re so clever??? Would this not perhaps help to focus the mind of these barrow-boys dressed in silk ties and PHD’s???
Posted by: Jim | March 8th, 2008 at 6:11 am | Report this commentWell, it seems to me many are not understanding what is really happening here.
Posted by: fxtrader | March 8th, 2008 at 12:07 pm | Report this commentFirst, it is a myth that leverage is necessarily good or bad - it simply multiply the effects of a good trade and similarly of a bad trade - the key to using it, is obviously to trade an appropriate level of equity. So it would be very useful to the debate if the media and posters understood that the fact that a fund (or a bank - because after all the bank’s primary function is to “create” liquidity, mostly out of thin air - remember that without confidence, banks are fundamentally insolvent, hence bankrupt) uses high leverage does not necessarily mean it is more risky.
Leverage, used correctly, makes sense in many cases, especially allowing to weather short term price dislocations. Though of course, with the dislocation is in credit itself, it causes trouble. But still I would argue that the issue is more to do with the banks in the first place than with CCC or other funds. The banks were all too happy to provide that level of leverage in the first place - don’t forget that those securities are backed by US gvt agencies, hence the implicit US Govt backing - this is the sort of assets that banks have considered is essentially risk free, and hence agreed to lend silly amounts of money. That said, the banks margin calls are exacerbating the problem - also, I suspect there’s something quite cynical going on here. Imagine, you know one fund has high leverage and fairly low margin, their assets are US govt guaranteed, now what about pushing them over the cliff, so the bank can pick up these assets at a very deep discount? Make a bundle of profit along the way.
Because if CCC can’t make the margin calls, the banks will take hold of the assets - in theory they should cash their value in to settle the initial credit lines given to CCC - but in the current depressed market for those, they are very likely to hold onto those assets until the market crunch recedes, say 12-18 months - and at that time they will essentially realise the profits from the trades CCC set up. Now, obviously, down the lines journalists will not care looking this up. Just like by early 99, the media had forgotten it all about LTCM, and was in awe by the webvan.com and the likes - to be clear, the banks that “rescued” LTCM made a bundle on those assets. Yes there was systemic risk, but within the banks portfolio most of LTCM assets did very well for their new owners.
Let us be clear - I am not defending those that leverage up to the hilt and then are forced sellers - they clearly haven’t managed risks/exposures adequately - but let us not be diverted of what is really going on.
Those who are obsessive maniacs cannot change their behaviour. They are in a mental state where they can neither remember the past nor see present reality. Believe me, why should they? They were the objects of veneration for a decade in Wall Street. Did not Carlyle go on a leverage spree raking billions of dollars (other people’s money) and collecting companies like children collecting stamps? Thereby lifting stock market quotations all the way? Mr. Scwartzman is unshaken in his faith that his model will never go wrong. The tragedy is that it has worked for such a long period! His victims - companies taken over- will suck out their existence and pay the debt or go bankrupt. Mr. Schwartzman can hold more of his birthday binges.
Posted by: K. Subramanian | March 9th, 2008 at 6:26 am | Report this commentIt is unfortunate that Carlyle Capital got into this trouble but it is interesting to note that Hedge Funds are not Carlyle’s,KKR’s and Blackstone’s specialty. Their speciality is private equity (Blackstone started originally as an M&A shop) and I think they have dabbled in something they do not know so much about and have the core competence to handle because of the mismatch,the mismatch being that Hedge funds are short-term in nature and investors can redeem their capital at any time but private equity is long term and investors are locked in for an appreciable number of years. The leverage used in Private equity is usually straight debt and is borne by the investee company that if it is showing good cashflows can keep the bankers at bay but Hedge funds are percieved to be risky and the debts are on the SIVs themselves which makes the bankers understandably nervous.They (Carlyle) may have made those trades thinking that the bankers and their investors are similar to the ones that finance their private equity deals but alas it is a different beast altogether. I think it all comes down to the diversification of risk and conglomerate-type argument. An investor can diversify his/her risk themselves and do not need a company to do that for them. It is good to have a conglomerate company but it is always wise to stick to what you know and understand best.
Posted by: Omo Ugowe | March 10th, 2008 at 7:54 am | Report this commentThe prevailing view on my side of the Pond is that the current overall financial crisis is due to too little controlling legislation and too much easy money.
Thus far [again, on this side of the Pond], there has been no new legislation and the cost of money has been further reduced.
Stay tuned, guys and gals.
Posted by: James Hannah | March 11th, 2008 at 12:09 pm | Report this commentExcess leverage is inherently bad, and unknown to Nature.
Posted by: SwissPablo | March 11th, 2008 at 4:22 pm | Report this commentIn small amounts, the collateral damage inflicted by deleveraging will not harm the system but as the scale of unraveling increases, so does the collateral damage.
Anecdotes abound to the effect that few major institutions couldn’t face the reality check of diminishing returns in a mature market. Lax regulation and total lack of common-sense (let alone morals) created the fantastic preconditions for the rest.
At this point we really must ask ourselves whether systemic damage should go unpunished. Just as any economic enterprise can be taken to court for damages of various nature (think Lipitor, think Exxon Valdez) so should be the actors whose damage reached far and beyond the boundaries of their immediate economic surroundings.
Of course some will be shouting and arguing about the Vienna School, schumpeterian rights of the fittest vs. the weakest, velocity of capital movements, etc.
But doesn’t stability and well-being have a Value as well? Whoever is destroying this value should be taken to task to repay.
Amen.