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Lend long, borrow short: Still a bad idea

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For about two years, we told clients that we were concerned about the financial markets. There were a number of “imbalances” in the system. We didn’t know when or how these would start to correct but we were confident that they would eventually have to work themselves out. We told everyone to expect bumps and not get too excited by stellar investment returns. We recommended that our clients own a disproportionate amount of international and emerging market stocks. In retrospect, I think we struck the right balance – cautious but not panicked.

We were disturbed by what we were seeing. We had clients walk in the door with mortgages that seemed insanely high relative to their salaries and tell us they had showed the lenders their actual incomes. We were seeing short term bond funds up to their eyeballs in illiquid mysterious securities. We had clients whose landlords were trying to railroad them into buying their apartments as they could not afford to pay the mortgage after interest rates rose.

We thought we had our eyes wide open. But, really, we saw nothing. The breadth, depth and sheer volume of what it turns out was going on over the last 5-7 years is truly astounding.

While the common denominator among all of these would seem to be inscrutable acronyms, there are some common themes:

The combination of leverage with an emphasis on insecure borrowings is lethal in a credit crunch.

In a credit crunch, the value of long term securities gets hit which lowers the value of the collateral backing the short term loans which then forces the liquidation of the long term securities which then further lowers the market value of these securities.

Lower security prices can dramatically increase the amount of collateral that the borrower has to post against loans. First the value of the existing collateral will have dropped (the long term securities are used to secure the loan) while the loan amount remains the same. In addition, the lenders start to get worried about the daily drops in the value of the collateral and want more of it.

If the investor put up a lot of their own money originally, this is not a problem. They can easily make these margin calls. If they borrowed almost all the money, this is a serious problem for the investor and anyone who lent them money.

This downward spiral is an old and familiar story. Lending long, borrowing short. In more recent times, it played a key role in the Savings & Loan crisis in the 1980s and the Long Term Capital Market collapse in the 1990s. The higher the leverage the greater the damage.

So when I read the story of what Carlyle Capital did, my jaw dropped to the ground.

Carlyle Capital was a company set up to buy over $20 billion worth of high credit quality mortgage securities. These securities only paid a slightly higher interest rate than you could earn holding onto US treasuries.

These would be considered very run of the mill fixed income investments. Suitable for Grandma. Boring.

These securities because less boring if you borrow 97% of the money to buy them, which is what Carlyle did. This allowed them to leverage their capital an astounding 32x in order to juice up returns. Assuming the lenders required an extra 2% of collateral (standard practice), this left just 1% of the value of the securities as cushion in case something went wrong.

This was a stunningly stupid thing to do. This should have been apparent to anyone with ANY experience in the financial markets.

What has left our jaws hanging

Carlyle Capital is and who the lenders were.

Carlyle Capital is an offshoot of the Carlyle Group. They are the definition of establishment. They regularly put people like George Bush (Sr.), James Baker III and former UK Prime Minister John Major on the payroll. They own vast portions of America.

The panics the short term borrowers forcing the sale of even more securities. Etc etc.

Apparently Balance Sheet 101 is not taught in business school anymore.

The poster child for “Lend long/ borrow short” must be Carlyle Capital, an offshoot of the Carlyle Group. The Carlyle Group is a bu

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