Blaming the Fed for Carlyle's Collapse

Some pundits suggest that the Federal Reserve's move to prop up the banking system prompted creditors to play hardball with Carlyle Capital

by Peter Coy

Managing Director of the Carlyle Group David Rubenstein HECTOR MATA/AFP/Getty Images

Could the Federal Reserve's efforts to prop up the banking system have the unintended consequence of pushing some debt-burdened hedge funds out of business? The question arose this week after Carlyle Capital—a fund with $22 billion in assets at its peak—announced that creditors were seizing its collateral because it couldn't meet margin calls, or requests for additional collateral.

Carlyle Capital's announcement came just two days after the Federal Reserve's announcement that it would allow 20 big commercial and investment banks to borrow up to $200 billion in Treasury securities in exchange for high-quality collateral. A source close to Carlyle Capital endorsed the idea that the Fed's action might have contributed indirectly to its crash, saying in response to a question from BusinessWeek, "it's possible that the move by the Fed emboldened some lenders."

How could the Fed unintentionally have contributed to Carlyle's unraveling? The theory is that the Fed's action made Carlyle Capital's assets more lucrative to the firm's large creditors. Therefore, those creditors had an incentive to let Carlyle Capital fail and seize its assets. Robert Peston, business editor of the BBC, advanced the idea Mar. 13 on his blog, and the notion was quickly picked up and circulated by other bloggers.

Incentive for an Asset Grab

The Fed's Mar. 11 action allows the Fed's 20 primary dealers to borrow Treasuries against the kind of assets that Carlyle Capital owns. In other words, any primary dealer that could get its hands on Carlyle Capital's assets could turn around and use them to get highly desirable Treasuries from the Fed. Since Carlyle Capital isn't a primary dealer, it couldn't do such a deal with the Fed itself.

In short, because of the Fed's move, Carlyle Capital's assets were worth far more in the hands of its creditors than they were in the hands of Carlyle Capital itself. So those creditors had a financial interest in letting the fund go out of business and grabbing the assets.

That's the theory, anyway. If it's true, then many other hedge funds that hold desirable collateral—and have been hoping for forebearance from their creditors—may find it much harder to cut a deal.

The BBC's Peston wrote: "Hedge funds that have borrowed from banks against the security of mortgage-backed debt could be about to see their assets sucked into the banking system and their businesses vanish. It's a process known as deleveraging the global financial economy, yet another manifestation of the puncturing of the debt bubble."

No Comment from the Fed

Contacted on Mar. 13, Fed spokesman David Skidmore said he had not heard of the theory before. There was no comment from the Fed as of midafternoon on Mar. 14. Among Carlyle Capital's lenders who were contacted on Mar. 13 or early on Mar. 14, there was no comment by late in the day from Merrill Lynch (MER), Credit Suisse (CS), Citigroup (C), or Deutsche Bank (DB).

Coy is BusinessWeek's Economics editor.