Bond Retreat

Ten years ago today, one of Carlyle Group’s mortgage funds, Carlyle Capital Corp (CCC), was seized by creditors. Precipitated by dwindling liquidity, the fund’s effective insolvency would amplify those global “dollar” pressures and lead to Bear Stearns’ untimely demise mere days later. The fund’s corporate parent issued a statement on March 6, 2008, that read:

The last few days have created a market environment where the repo counterparties’ margin prices for our AAA-rated U.S. government agency floating-rate capped securities issued by Fannie Mae and Freddie Mac are not representative of the underlying recoverable value of these securities.

Translation: CCC used AAA-rated super senior MBS in its mammoth $21.7 billion portfolio to fund those very same assets as collateral in the repo market. Haircuts were increased even on those MBS pieces having nothing whatsoever to do with subprime, nor were they unprotected (thickness) in each structure, which meant CCC would have to post additional collateral it did not have. Selling the assets was out of the question given the behavior of prices surrounding them.

One of the most mystifying parts of the story was that this particular investment vehicle was put together in July of 2007. Heavily leveraged from the very start, it’s short history reads almost as a paradox. In other words, it failed not even a year into its existence, raising significant questions about what Carlyle was thinking.

In truth, it’s managers had no illusions about the looming crisis. In July 2007, they were to some degree betting on it. That’s the thing about the 2007-09 monetary panic; even those who were expecting it to get bad were surprised at just how bad, and where those problems hit the hardest. They were thinking illiquidity, just not total illiquidity.

The investment thesis was simple enough; as subprime MBS became more untouchable by a broader subset of Wall Street (really Lombard Street), those firms would increasingly demand solid assets. Liquidity pressures particularly in the repo market would lead many to ditch the “toxic waste” in favor of the pristine GSE-guaranteed MBS CCC had bought in bulk. Spreads were always thin, so even as they were expected to fatten in CCC’s favor it still required enormous leverage and size to capture them in any worthwhile fashion.