Economics: Carlyle Group tries to stop rot at Capital

Carlyle Capital was did not aim to be a sub-prime lender. In fact, most of its investments were in packages rated as AAA. But, as senators asked Fed chief Bernanke several weeks ago, how could packages be rated AAA when the underlying securities were by definition far from that?

Carlyle raised the money to buy the packages from consortia of banks. But they were lenders to Carlyle not investors. As a result, all the risks of the US property market have fallen on Carlyle. Some of those lenders have demanded that assets be sold to cover margin calls. But worse, some are even calling for the fund to be liquidated entirely, and are forcing the issue by calling in their loans.

As the property market falls, the value of the security is falling - even though the underlying loans may still be performing. Banks are eyeing the equation between outstanding capital and asset value - and they don't like the widening gap.

The so called "margin calls" are simply where a bank is owed x on security of y but the value of the security falls below an agreed figure. The fund must either pay cash to cover the investment or to put up more security - known as collateral.

For the banks, there is a problem - if the value of the assets fall, then so does the value of their security. When that happens, their own balance sheet starts to suffer. And when that happens, regulators start to look at what is called "the capital adequacy ratio." That is determined by regulators on a case-by-case basis against standardised norms - but, as a result of a global standard called Basel II, each bank is examined on a "risk assessed basis." If a bank finds that its capital adequacy ratio falls, it must inform the regulator. In a number of cases, such falls have triggered forced takeovers.

So Carlyle's bankers are between the devil and the deep blue sea. Carlyle is, for many of the bankers, just another brick that is falling out of the wall that they thought was a secure loan.

Of course, history repeats itself and the current sub-prime crisis and subsequent rapid downturn in US property prices is a direct replication of what happened in the UK in the late 1980s and early 1990s. But it has been complicated by the policy of securitisation of loans - to form "asset backed securities."

What no one seems to have fully understood is that those assessing the risk were too remote from the underlying risk - once bundled, the individual loans were not again assessed. And although the ratings agencies have not said how they assessed the quality of ratings, there are indications that it was based upon the perceived competence and quality assurance of the original packager.

But even that was removed from the actual risk assessment. The system for creating the packages often involved a financial institution such as an investment bank raising funds and passing them to a mortgage lender. That lender assessed the loans and lent the money in return for a management fee. The package, when sold out, was often then traded out to a waiting market - a market that then Fed Governor Greenberg had said, in 2002, was a good thing: he liked asset backed securities.

And he would, because it recycled Wall Street cash into the high street and allowed the feel-good factor of easy home purchase and rising house prices, even though other inflation was higher than ideal and the general economy was not doing so well. Also, easy credit helped the USA's population, which was not getting any or any significant pay rises, to purchase property that higher interest rates would have precluded.

Carlyle Capital's lenders include banks that have already declared massive sub-prime related losses in their own divisions - Citgroup, Bank of America and Merrill Lynch are among them.

The difficulty now is that the margin calls, and forced sales, are producing a contagion that is travelling around the world. Carlyle Group is based in the UK. Other companies in Europe are also suffering.

Carlyle Group has asked Carlyle Capital's lenders for a moratorium on the enforcement process, and not to take steps that would force the fund into liquidation. But there is only so far that the banks are able to go to accommodate Carlyle or anyone else in a similar position.