Leverage Collapsed Calyle Capital Fund

The fund's collapse shows how Wall Street's biggest players have begun playing hardball with some of their best clients. And they reveal how jittery banks have become about their own loan exposures. In the case of Carlyle, 12 banks had lent the fund about $21 billion, or $20 for every dollar of initial capital. It also illustrates how the credit crunch has moved far beyond subprime mortgages. Carlyle Capital's portfolio consisted exclusively of AAA-rated mortgage backed securities issued by Fannie Mae and Freddie Mac. They are considered to have the implied guarantee of the U.S. government and pay par at maturity. Carlyle Capital's investment strategy looked like easy money at first. The fund would exploit the difference between the interest earned on its investments in mortgage securities and the costs of financing those investments. Like so many other hedge-fund blowups, Carlyle's troubles came from borrowing too much money. The secret to making money was borrowing massive sums. Carlyle Capital managed only $670 million in client money, but used borrowings to boost its portfolio of bonds to $21.7 billion. Until last week, when the dealers started selling the fund's collateral, it was about 32 times leveraged, a level one mortgage-company analyst called "astronomical." The leverage, combined with severe dislocation in the credit markets, has proved to be Carlyle Capital's undoing. With their balance sheets under extreme pressure, banks have tightened their purse strings and are now requiring more collateral for loans. And in Carlyle Capital's case, the prices of the collateral -- the residential mortgage backed securities, or RMBSs -- have dropped to levels not seen in more than 20 years. The fund said in its statement late Wednesday that the value of the RMBS collateral continues to drop.