Sunday, March 9, 2008

Sorry, I missed your call...

Some market players are becoming a bit “antisocial” these days. The latest one to breach the market etiquette was Carlyle Capital, a multi-billion-dollar investment fund and offshoot of the powerful private equity group, Carlyle Group. Apparently, Carlyle’s bankers had been calling for days and, after days of silence, the company came out last week to simply say “Sorry… I missed your calls!”

Now these are not any calls. They’re margin calls, and missing them is a pretty serious matter! Indeed, the news added fuel to the fire that has been burning in credit markets for months, sending risk premia to scary new heights as investors began to wonder who else might join Carlyle’s in its antisocial behavior! And sure enough, later on Friday, another company, Thornbug, a provider of “jumbo” (large) mortgages said it couldn’t meet its margin calls, putting its survival in doubt.

So what are margin calls? I mean, who’s calling? And are Carlyle & co. being plain rude?

Telling the tale: Let’s say we’re back in July 2007. You take a look at the latest economic data releases—rising mortgage delinquencies, falling house prices and all—and somehow decide that, nonetheless, it’s still a fabulous time to invest in mortgage-related securities. So you go to your broker and say:

“Hey, I see some high quality stuff out there.. but I only have one thousand dollars to invest. Why don’t you lend me another couple of thousand? I can make more money this way! And if it makes you feel better, I can give you collateral for the loan. Some good, low-risk bonds I own, maybe some cash…Deal?”

Now that’s smart! So now you have two thousand dollars to invest, which means that you can make much more money. How?

Working out the multiples: Say you only had your own $1,000 and the price of your chosen investments went 20% up. You gain—20% (or $200). But now you have $3,000 invested so a 20% price increase translates into a $600 profit. So you take your $3,600, pay back the $2,000 you owe to your broker (with some interest) and you are left with $1,600—a hefty 60% gain on your initial investment!

Of course that’s all great if the market goes up. If it goes down, yes, you guessed it… You’re SCR#($@D! And if you bother to do the calculation, you will note that, the more money you borrow to invest (or the more “levered” you are), the more multiply scr#($@d you are in a downturn!

The collateral you deposited with your broker is the “margin.” Brokers ask for margins because they know the downside can get pretty ugly in Dow-Land. And they want to be comforted that, even if your market acumen were misplaced, and your investments went downhill, they can still get their money back.

Reasonable deals: But let’s go back to last July. So you borrowed $2,000, added it to your own $1,000 and invested all of it in securities that are linked to the performance of residential mortgages. But you didn’t pick any mortgages. You knew that something was fishy in the subprime sector, so you said “I’ll only go for the safe stuff, triple-A-rated securities linked to mortgages issued by Fannie (Mae) and Freddie (Mac).” “These can’t possibly go bad,” you thought. “Not only are they good quality, but Fannie and Freddie are government-sponsored agencies. And the government can’t possibly let them join the fallen.”

“Sounds reasonable,” said your broker. So he lent you the money, but under the following conditions: That at any point in time, you maintain collateral in your account that is at least 15 percent of the market value of your assets. This is the maintenance margin. And that, if your “equity (or the value of your investments minus your debt) fell below the maintenance margin, you would need to find extra collateral and deposit it in your margin account. Otherwise, he reserved the right to start selling part of your existing collateral and use the cash to repay part of your debt, so that your equity goes back up again to acceptable levels.

Now I made up the 15% but, generally, the level of the maintenance margin depends on a number of factors. These include government regulations, brokers’ discretion, the level of competition among brokers to get your business, your overall creditworthiness and how risky the investments you want to make with the borrowed money are.

So, for example, you would expect that when many brokers compete for your business, they might be a bit more lax in the restrictions they place on you, and be happy with a 10% maintenance margin (provided it still lies within the government’s regulatory limits). Similarly, if a certain type of investment is very volatile, your broker will want a bigger cushion since the value can go down very rapidly.

When margins hit the fan: Come August 2007. Markets are getting nervous, as a series of land-mines explode in the credit world—mortgage delinquencies, bankrupt hedge funds, defaulting “SIVs”, major banks under threat. Your investments begin to shake. Your equity is still in positive territory but it’s getting dangerously close to the maintenance margin level. Indeed, as the crisis continues through November, ooops, the equity drops below the margin. And… you receive a call!

“Hello?” (It’s your broker!) You panic… and don’t pick it up! He leaves you a, message, a kind reminder that you need to replenish your margin account, else…

Shoot! Markets are cash-strapped and there is little hope you will find any investor willing to fund you. What to do? You call your mother!

“Hey mom, how are ya, not sure you’ve been following the news… but my investments are in a bit of a strain these days. And I’m short of cash. So when I heard Carlyle Capital managed to get a $150 million credit line from its own mother, Calryle Group, I got inspired and thought you might be able to lend me a few hundred bucks.”

Your mom is upset. “I can’t believe you refused your broker’s calls! What the hell will he think of me??” “I spent years teaching you manners, helping you build your reputation, and now this!” So she sends you the cash, together with a sweet, motherly note saying that this is your last chance.

But the credit-market carnage continues and is spilling over even to “safer” securities, the Fannies and Freddies of this world. This time it’s very serious. Not only are your investments going down. Not only is there more volatility in the market. Not only are you short of cash. But so is your broker, which makes him more nervous about his clients potentially going bust. So as soon as your equity falls below the margin, he calls again… and again and again. And as you “miss” his calls, he leaves you a message notifying you that he just took over your collateral, sold it for cash and used it to reduce your debt. And that, in light of the abysmal market conditions, you’re likely to get more calls soon.

That’s the Carlyle story.. kind of. One important difference being that Carlyle was not two, but thirty times leveraged, so start doing the math to see by which multiple it’s getting scr#^$%d.

But there is a bigger issue.. bigger than Carlyle, Thornbug & co. The more companies are facing margin calls, the more “fire sales” you would expect either by themselves (to reduce their exposure to risky assets with plummeting value) or by their brokers (as they want to recoup at least part of the cash they lent). This is driving prices down to obscenely low levels, even for securities that (in "normal" circumstances) would be safe.

So fasten your seatbelts, because the next few weeks will be bumpy. And, unlike most circumstances, calling your mother won’t help.

Glossary: Maintenance margins, equity, leverage, margin calls, etiquette

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