Financial Times (Blogs)
John Gapper
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 ³re-intermediation²
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.
http://blogs.ft.com/gapperblog/
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