Last Updated: March 7, 2008: 4:02 PM EST
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How mighty Carlyle fell

Despite its high-flying reputation and seemingly safe investments, a Carlyle Group subsidiary finds itself in deep trouble. Is there a buying opportunity?

By Colin Barr, senior writer

NEW YORK (Fortune) -- Throw a heavy user of short-term financing into an increasingly fearful market, and you have the makings of a disaster - as investors in Carlyle Capital learned this week to their dismay.

Shares of the Amsterdam-listed mortgage investment fund were suspended Friday after Carlyle Capital's lenders began selling off the firm's $21.7 billion portfolio to meet margin calls. The move came on the heels of the fund's failure to meet multiple demands for additional collateral after the value of its bond holdings dropped. Carlyle Capital - an affiliate of U.S. private equity giant Carlyle Group that twice tapped its parent for loans during an earlier liquidity squeeze back in August - said Friday it was considering "all available options."

It's a steep fall for a division of the once invincible-seeming Carlye, which has long populated its corridors with luminaries like former Secretary of State James Baker and longtime IBM chief Louis Gerstner. But like Thornburg Mortgage (TMA) - the Santa Fe, N.M.-based mortgage lender whose shares lost half their value Monday after the company missed margin calls - Carlyle Capital appears to have few options that will leave shareholders with more than a few pennies on each invested dollar. Thornburg and Carlyle Capital were tripped up by two forces: A sharp decline in the prices of assets from houses to mortgage-backed bonds, and the companies' own reliance on money borrowed cheaply from Wall Street in overnight or short-term markets.

David Merkel, chief economist for broker-dealer Finacorp Securities, says the firms' dependence on short-term loans called repurchase agreements, or repos, meant they had "no time to react" when the latest round of mortgage fears descended on the debt markets last month. Over the past month, the spreads between government-backed Treasury securities and even the safest nongovernment debt have widened as investors have demanded more compensation for perceived risk. That trend has sharply driven up costs for firms such as Carlyle Capital and Thornburg that borrowed using repo loans that mature in as little as a day or a week.

The huge sums the firms borrowed only compounded those woes. Carlyle Capital reportedly borrowed more than $30 for each dollar of equity held in the firm - meaning that when its holdings dropped 3%, the firm's margin was wiped out, prompting its lenders to demand more collateral.

The problems at Thornburg and Carlyle Capital surprised some investors because both firms have billed themselves as having invested in only high-quality assets: prime jumbo mortgages in Thornburg's case, and so-called agency securities - those issued by government-sponsored mortgage investors Fannie Mae (FNM) and Freddie Mac (FRE, Fortune 500) - in Carlyle Capital's.

But since the mortgage securities market collapsed last summer under the weight of rising defaults on recent subprime loans, investors have been determined to steer clear of any paper that carries even the slightest whiff of credit risk, or the prospect that the loan won't be repaid. That fear has only increased as house prices have steepened their yearlong decline.

As asset values have dropped, leveraged investors such as hedge funds have been forced to sell their holdings, resulting in further price declines for even the safest nongovernment securities. Wall Street banks such as Citi (C, Fortune 500) and JPMorgan (JPM, Fortune 500) - the lender that recently served Thornburg with a notice of default - have been reticent about stepping into the breach, because they have been busy conserving capital after the collapse of demand for leveraged corporate buyout loans and other recent setbacks.

Those trends were all too evident Thursday and Friday, with shares of big lenders ranging from Fannie Mae to Washington Mutual (WM, Fortune 500) testing new depths amid worries that the value of their portfolios is in decline amid mass selling of mortgage securities - even though high-quality assets have so far faced few defaults or late payments.

Indeed, the public statements from Carlyle Capital and Thornburg have focused very much on this point. "Unfortunately, this disconnect has created instability and variability in our repo financing arrangements," Carlyle Capital chief John Stomber said this week. "The turmoil in the mortgage financing market that began last summer continues to be exacerbated by the mark-to-market accounting rules, which are forcing companies to take unrealized write-downs on assets they have no intention of selling," Thornburg chief Larry Goldstone said Monday.

While Merkel agrees that fair-value accounting rules have created some "difficulty," he says the true Achilles heel of the likes of Thornburg and Carlyle Capital is their dependence on short-term financing. Short-term borrowing terms can change so quickly that a firm lacking substantial capital can find itself running out of money in short order. He compares this week's tumult with the 1994 cetes crisis, in which the Mexican government's use of short-term borrowing left it with rising costs and a plunging currency after the Federal Reserve raised interest rates.

Knowing that short-term borrowers have run into problems before won't make Thornburg and Carlyle Capital feel any better, but Merkel says there's an opportunity here as well. Firms with solid balance sheets and long time horizons, like big insurers, now have an opportunity to buy high-quality assets on the cheap. "These are abnormally high spreads," Merkel says, referring to the gap between yields on government-issued and other sorts of bonds.

But don't rush in, he adds: wait for a bit after the fund liquidation madness subsides and build a position over a matter of weeks. After all, he says of the fear that has been driving the market recently: "This isn't going to turn on a dime."  To top of page

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