Friday, March 7, 2008

Death By Leverage

I'm still on a trip, so posts are brief.

Carlyle Capital Corp. (CCC), an offshoot of the vaunted Carlyle Group, is in the news today about failing to meet margin calls. It is a recently listed (Amsterdam) investment company that bought AAA-rated GSE paper (FannieMae's, etc.) on margin. The idea was quite simple: capture the yield spread between margin loans (via ABCP, repos, etc) and the GSE securities.

Just like all such "gather pennies in front of steamrollers" rate arbitrage operations, the size had to be huge to make it worthwhile. From the 2007 annual report:

Total Equity: $669.5 Million
Total Assets: $21.8 Billion (mostly GSE's)

Divide and ...(drumroll)... leverage: 32.5 times.

No further comments.

Update: The Fed, getting increasingly panicked of losing the credit crunch "game" in a very big way, announced an increase in its TAF facility from $30 billion per pop to $50 billion. It will also do more term repos. Both TAF and repos, the Fed said, could be increased in size as needed.

Translation: Ben keeps shouting "come seven" even as the dice keep coming snake eyes (see yesterday's post). Oh well... one of these days he will either (a) figure it out, (b) be replaced, (c) resign, or (d) be taken away by guys in white suits screaming and foaming at the mouth. All the while, Moe will be happily fishing in Bermuda - as in: "sometimes you go long, sometimes you go short and sometimes you go fishin'.."


  1. With regard to “margin calls” – am I correct in saying that because these instruments are “off-exchange”, there is no formal structure for margin flows? It appears to me that we have started to witness a process by which the Prime Broker to the hedge fund can demand (almost) however much money it wants as a margin call, force a fire sale of the fund’s assets, then buy those assets on the cheap.

    Does anyone know how true is the above description?

    Have the dogs now started turning on each other?


  2. H,
    If as the above anon postulates that the dogs have turned on each other and cannibalism becomes fashionable, is there a real danger to the system of good assets being lost? Even if Exxon may do well, can investors lose access to their shares if the brokerages gets dragged down? Do you see it getting that bad?

  3. I sincerely doubt that the Prime Brokers want these assets, at any price, any price at all.

    The problem with these assets is that they are illiquid. Everything is illiquid. The prime brokers make their money moving assets, not sitting on them.

    whoever takes these on is going to own them for the very long haul.


  4. No, brokers don't want to own their customers' securities any more than banks want to own their borrowers homes.

    As for dogs, finance/markets has always been a dog-eat-dog world.

  5. Flashback to Wednesday, March 5, 2008 - Two Notable Events

    I wonder if foreigners will keep filling it, or eventually throw in the towel and look for better things to do with their savings.

    China Investment Corp suspends investments in overseas financial cos - report
    March 06, 2008: 08:47 PM EST

    Mar. 6, 2008 (Thomson Financial delivered by Newstex) --

    BEIJING (XFN-ASIA) - Sovereign wealth fund China Investment Corp will suspend investments in overseas financial companies due to high investment risk, the Beijing Times reported, citing Wang Jianxi, a CIC executive vice-president.

    'As sovereign wealth funds have low risk tolerance, investment in overseas financial assets, such as Blackstone and Morgan Stanley (NYSE:MS) , will be suspended,' Wang said, referring to two companies CIC has invested in.

  6. Wow, the CIC stake in Blackstone is down 50% in half a year. They've got our money, I don't think they'll want to be sending it back just to lose it. I'm guessing overseas means east over the Pacific? They say they have a 5-7 year time horizon, but one of the first things I read on these sites was losing 50% means you have to gain 100% just to get back. I'm sure us on mainstreet irritating whinings are like knats to the halls of power here in the states, but is this the start of us being a global financial pariah?

    Brant, Atlanta, GA

  7. The problem with the financial markets is growing, not ceasing. And like Japan tried but failed miserably to salvage their banks, now we have US saving the failing banks.

    Pretty soon, governments across the world will try to save the crumbling US economy. By which time we will need some genius to theorise how fiscal policies work on a global basis.

  8. Re: With regard to “margin calls” – am I correct in saying that because these instruments are “off-exchange”, there is no formal structure for margin flows?

    Not so much a matter of "off-exchange" as much as manually intensive and very subjective. This stuff is getting hand calculated and nobody is clear about the formula or methodology. A lot of nervous clerks who know better then their bosses. Watch for a palace revolt. There's people thinking I'm not losing my job or worse for this BS.

  9. Re: margin calls

    No, not quite. Just because securities trade OTC doesn't mean there aren't public prices for them (not for all, of course). For example, GSE's are actively traded and appear on many broker screens, like Cantor.

    And when margin calls reach these kinds of numbers, I guarantee you it is not clerks making the judgment, but the big boys at the very top. A few big customers falling flat on their face and failing to meet their calls can result in massive losses for the firm, so...


  10. Margin calls..

    Somewhere, just today, I saw a headline positing that JPMorgan and Citadel might be "tag teaming" Thornburg. Recalling that Citadel seems to have made out OK on Sentinel assets, playing the role of "vulture", and given, that the bulk of Thornburg's portfolio is of good "quality"...merely non-conforming....hmmm...makes one wonder..


  11. When the Olympics are over
    late this year, we might see
    a change in China's policies.

    Less need to "make nice" then.

  12. I think you will find his March 10th commentary of interest:

  13. "No, brokers don't want to own their customers' securities any more than banks want to own their borrowers homes."

    Didn't BlackRock say they wanted in on the agencies now ? If the broker can get some interest from other big funds and asset managers, I would assume he'd be very tempted to ream his client and flip the assets onto willing buyers, if that client is not generating enough fee income.

  14. Free markets are those regulated
    for fairness, with risk of error to
    be made on the side of regulation.
    -------- Mao Say Me

    An unrelated regulatory issue ...

    The testing of the model for the
    Citigroup building was done with
    the wind loads perpendicular to
    the sides, not at oblique

    An architecture student studied the
    plans long after the building was
    finished, and asked about the wind

    The chief engineer then realized
    that the novel side pillar design
    actually demanded skewed wind
    tests. When these were done, the
    design failed the maximum rated
    wind loads.

    An emergency operation was quietly
    executed where scores of key
    structural features were
    reinforced from the inside.
    Huda thunk.

  15. Ok my dear commie(s), here is a refreshing outlook about regulation, or its lack thereof, regarding the current crisis.

    You may note that Mish's solution is different than your more government mumbo-jumbo, and I agree with him. Would you care to comment?

  16. Re: Mish call to abolish the Fed, the FDIC and fractional lending.

    What he recommends is equivalent to dynamiting the foundations of a 100 storey building, with all people still inside.

    Oh, and all survivors are expected to fend for themselves, no medical help is to be available.

    The man is a financial Luddite.

  17. What you are debating is known in game theory as The Tragedy of the Commons. It is simply a fractal of the prisoner's dilemma played as a multiplayer game. It has a non-zero sum solution and neither of you are even close.

    Greenie, Hell is right, you only have to open your history books to see that excess credit expansion DID occur when the world had little regulation and the operated on a gold standard. Whether you think the solution worked or not, or whether you think we traded one demon for another, credit expansion did occur.

    Hell, even if we ignor Mish's recommendations (which is likely for political reasons), please explain how the current system (with its regulations) will not eventually crash down with the building full of people? (Smarter regulations?) How will the US, Europe, Japan pay off their debt without ultimately defaulting on billions of investors? Assuming an economy grows by 4%/year (a very generous assumption), many developed countries in are now paying more in interest on their debt (public + private) than their economy can even grow by. The US has more debt than Argentina did when it defaulted, Japan's public debt is now 194% GDP). Most major economies in the world are headed for contraction.

    The building crashes either way.

    The governement/no government (regulation/no regulation) debate is most decidely the wrong place to look if we are going to solve this problem-- really try to prevent it from happening again (at least for a long time, as it will happen again no matter what we do).

  18. "What he recommends is equivalent to dynamiting the foundations of a 100 storey building, with all people still inside."

    Not so fast, darling :) The building is collapsing by itself, and threatening every evildoer as well as all others like you and Moe. All that Mish is suggesting is that the next building is not made in the same manner as the current one. Your position is different, because you are one of those trapped in the building for no fault of yours. So, you like 'good cockroaches' to be left out in the name of extinction of species, but the harmful cockroaches to be taken to prison.

  19. "The building crashes either way."

    Exactly my point. Hell's post is an early indication of who will be blamed for this collapse by the Wall Streeters - people like Mish, who have been pointing out what is wrong with the current status quo.

  20. Re: Leverage- All that media attention on "rogue trader" Jerome Kerviel was absurd. There are thousands of rogues far higher on the financial food chain making far more irresponsible decisions.

    Greenie- Your passive-aggressive use of affectionate terms like "dear" and "darling" is creepy. I think I know who you are on Mish's comment site and you are creepy there too.

    "Tragedy of the Commons"- Yep, that's pretty much the situation in a nutshell. I need a drink. Fine, I'll say it. The UN needs to issue child permits. The implications of doing this are horrendous. The implications of not doing this are worse.

  21. Dink, I never commented on Mish's site in my current reincarnation.

  22. Greenie, I hear and agree with you that 'free marketeers' will get blamed... thought to be fare, the free marketers will blame the pro regulators.

    The problem is that both camps see how the other is wrong.

    Are you a partisan (more insterested in necine conflict) or are you interested in solution?

    I realize you have to choose sides in life. My only point is I really think you both are picking the wrong war.

  23. Thai, you have indigestion with the fractals - been there, done that. I read all the early papers by Axtell and others 8-9 years back. My own research in Biology mirrors something similar, but in genetic interaction networks instead of human social interaction networks. I am an Electrical Engineer by background.

    Anyway, the only take home message I got from those papers is that the real world networks form power law distribution rather than Gaussians. The rest are just fictions.

    Rather than 'tragedy of the commons', what we have at present is the normalization of the dislocations created by three watershed events in human history - (a) discovery of America, a continent with unlimited resources, (ii) rise and fall of British empire, linked to industrial revolution and (iii) WW II. Every abnormality you see in the world today is somehow linked to one or more of the above. Hell lives in a world, where (i - iii) are reality rather than dislocations, and so he likes solutions to preserve them in core form. I can go into the details later.

  24. Nonsense, how could any geneticist ever make such a claim. There is no 'reversion to a mean', The year 1491 was not some 'natural state of man'. The passing of your 'big three' were certainly watrershed moments in human history, but there were, are and will be many others.

    Increasing complex systems are an unstopable fact. The sun deposits 4.4 x 10 16 watts of power on our planet every year-- the equivalent of 440 million large power plants.

    We only have a shortage of ideas and cooperation right now.

  25. I generally admire your metaphors, but your latest one is a bit problematic. Allow me to explain. Bach was a master of a particular brand of melodic and harmonic invention now taught in music schools and conservatories as the common practice method, a style of composition that was, as it happens, only identified as such after the fact.

    Bach's brand of counterpoint, a term which broadly defined denotes the process of juxtaposing one or more notes against another note or series of notes within a well defined tonal framework, does indeed feature several vertical strands of melody. However, the melodic strands stand alone successfully as pleasing independent musical statements. Rarely though, as you suggest, are they allowed to do so. Instead they are typically integrated into three or four part triadic harmony such that the vertical melodies are subsumed into a horizontal harmonic framework.

    To cut to the chase, there is nothing random in the design or the sound of a Bach melody, even though, as in the case of his many fugues, there is clearly a hierarchy inherent in his compositions such that Bach's opening statements are the drivers for his compositions and therefore have a clear prominence.

    Finally, a voice within a melodic strand is only dissonant or consonant depending on what precedes it and follows it. Put another way, without context, a lone voice has no definable character whatsoever.

    Are you familiar with Bach? Unlike most composers, if you play his piano music separately for each hand you will likely just hear random notes, frequently dissonant instead of harmonic.

  26. Pardon me, it's late and I mistakenly referred to that which is horizontal, melody, as vertical, and that which is clearly vertical, harmony, as horizontal.