Carlyle Mortgage Fund Receives Default Notice

The Carlyle Group’s publicly traded mortgage fund, Carlyle Capital Corp., missed four of seven margin calls on Wednesday and received one notice of default. It expects to receive another shortly. The company says this is the result of margin requests that weren’t “representative of the underlying recoverable value.” It is, however, representative of the global credit squeeze.

To understand what’s going on, one needs a quick lesson in just what the company does. According to its press release boilerplate, “Management employs leverage to finance the Company's investments and its income is generated primarily from the difference between the interest income earned on our assets and the costs of financing those assets.” Leverage means borrowing from Wall Street firms using repurchase agreements that require assets to be put up as collateral. When the value of the assets (mortgage-backed securities in this case) declines, the repo counterparty (the Wall Street jargon for the lender) can and does demand more cash or assets be put up to cover the gap, a “margin call.”

The margin calls the company had faced until Wednesday amounted to $60 million. Then, it got socked for another $37 million by seven of its 13 repo counterparties. In a statement issued yesterday, John Stomber, Chief Executive Officer, President and Chief Investment Officer of the Company, said, “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. Unfortunately, this disconnect has created instability and variability in our repo financing arrangements. Management is actively working with the Company’s repo counterparties to develop more stable financing terms.”

Carlyle Capital is working to put its house in order. Since August, it has sold off $1 billion in residential mortgage backed securities. It has eliminated its dividend. On February 28, it waived an incentive fee to enhance its liquidity. And its parent, the Carlyle Group, has put up $150 million in a subordinated revolving line of credit.

Bloomberg reported on this piece in some detail, and the news service quoted Hans Peter Lorenzen, a London-based credit strategist with Citigroup, who gave the best explanation of what’s going on, “The banks are tightening credit standards and trying to curtail the lending they do. One of the ways you do that it is increase haircuts you charge.” That is, make it more costly to borrow, and one won’t have to lend as much to meet demand. Of course, if the fund hadn't borrowed quite so much . . . .

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