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I would like to waltz through today's news, but before I do... For those of you who haven't read my pieces on the I banks and brokers, I urge you to peruse (in the following order):

I know it is a lot of reading, but I feel it is well worth the time if you have any financial ties to this indutry, and the subject companies explored, in particular. The forced liquidation of asset backed securities and mortgages this weak definitely makes these researched opinion pieces appear awfully prescient. I, unfortunately, cannot take credit for being a genious since the writing was clearly on the wall. As for what is happening to the companies in question, well, readers of my blog not only saw this coming but know that the worst is yet to come. The financials are not even halfway through their downcycle, and some of the big name brands are at risk of insolvency. Let's turn to today's

Hedge Funds Squeezed As Lenders Get Tougher

The financial turmoil is taking on a new dimension: Banks that lent money to hedge funds and other big risk-takers are asking for some of it back.

Loans from banks and brokerages had allowed hedge funds, which manage some $1.9 trillion in clients' money, to amass many times that amount in investments. But as the value of mortgage-backed bonds and other investments has dropped in recent weeks, the lenders are demanding that borrowers put up more cash or assets. (Banks, Brokers, & Bullsh1+ part 2 - credit risk?)

This is producing a negative cycle that has policy makers deeply worried. When investors rush to dump assets, prices fall and lenders feel compelled to make further demands, or "margin calls," which cause even more selling.

So far, the turbulence touched off last summer hasn't resulted in many big hedge-fund blowups. If that changes, banks and other financial firms could end up holding even more hard-to-sell securities. Already, their troubled investments, especially in securities tied to mortgages, have cost them some $140 billion in write-downs. (Banks, Brokers, & Bullsh1+ part 1 - marking Level 2 and 3 to market may cause insolvency)

Stock investors took note yesterday. The Dow Jones Industrial Average fell 214.60 points, or 1.8%, to 12040.39. Financial stocks led the way, with Bank of America Corp., Citigroup Inc. and J.P. Morgan Chase & Co. all declining by more than 2.5%...

...The issue came to the forefront yesterday as Carlyle Capital Corp. said it failed to meet margin calls on loans backing part of its $21.7 billion portfolio of highly rated securities issued by Fannie and Freddie. Carlyle Capital, whose shares are listed in Europe, is managed by a unit of Washington, D.C., private-equity firm Carlyle Group.

Fannie and Freddie are perceived as having the backing of the U.S. government, so they're usually seen as a safe haven.

"The fact that this is happening in top-quality agency paper is really worrying," said Tim Bond, a strategist at Barclays Capital in London. "It's marking an extension of this stress into the group of players who only invest in the safest mortgage-backed stuff." (Banks, Brokers, & Bullsh1+ part 2 - the issue is the excessive leverage that was granted without the proper credit risk management and controls, not a mistake made regarding the liquidity of the securities in question. It was not impossble to see this coming. I saw it when I wrote the articles, and I was aware of it years before hand. This is why I am loathe to use even up to 2x leverage in my own operations)


The Carlyle news comes a week after margin calls triggered the implosion of London hedge fund Peloton Partners LLP, which analysts estimate could leave the funds' 14 lenders -- including Deutsche Bank AG, Goldman Sachs Group Inc., Lehman Brothers Holdings Inc., Merrill Lynch & Co., Morgan Stanley (Banks, Brokers, & Bullsh1+ part 2 and The Riskiest Bank on the Street  - readers of my blog not only saw this coming but know that the worst is yet to come) and UBS AG -- holding as much as $17 billion in problematic mortgage securities.

The impact has extended beyond hedge funds to other firms that borrowed to buy mortgage-backed securities. Thornburg Mortgage Inc. said this week it failed to meet a demand from its lenders for $28 million, triggering defaults across its other financing agreements. Thornburg had met over $300 million in margin calls by late February, but was asked at the end of the month to pony up $270 million more.

... Typically banks and brokers provide financing to hedge funds through so-called repo transactions, in which a fund turns over securities as temporary collateral for a loan. The fund later buys back the securities at a higher price that includes interest on the loan.

The top banks and brokers in the U.S. -- including Morgan Stanley, Goldman Sachs and Bear Stearns -- had some $4.4 trillion in repo loans outstanding as of Feb. 20, according to the Federal Reserve Bank of New York, though only a fraction of those are to hedge funds.

Now, banks and brokers are scaling back their exposure both by tightening standards on repo loans and reacting quickly when clients run into trouble.

A bank might lend 97 cents against the collateral of a high-quality mortgage security with a market value of $1 -- a difference known as a "haircut" that insures the lender against losses. If the value of the collateral drops to 95 cents, the borrower faces a margin call. (Banks, Brokers, & Bullsh1+ part 2 and The Riskiest Bank on the Street : this could have been read last year when I wrote it, hedge funds and their relationship with prime brokers will cause an implosion of credit and collateral pricing, which will be devastating to the I banks and funds alike) 

In Trouble Overnight

Because repo loans often last only one day, hedge funds can find themselves in trouble literally overnight.

"The mandate of any prime broker or repo trader requires that they hold sufficient collateral that can be liquidated with a high degree of certainty within a tight time frame, even next day," says Glen Mifsud, head of Credit Suisse Group's fixed-income prime services in London, which works with hedge-fund clients.

When hedge funds can't come up with cash to meet a margin call, they are at risk of losing all access to credit and shutting down immediately. In that case, banks and brokers are forced to seize the collateral, leaving them holding the troubled securities at the root of the hedge funds' problems. Analysts say banks may have to take billions of dollars in further write-downs. (Namely, The Riskiest Bank on the Street and Is This the Breaking of the Bear?, who are in the most vulnerable positions considering exposure as a percentage of their tangible equity)

The funds facing the greatest pressure are those that are highly leveraged, meaning they have large borrowings relative to the money entrusted to them. Carlyle Capital managed only $670 million in client money, but used borrowing to boost its portfolio of bonds to $21.7 billion, meaning it was about 32 times leveraged. (See Banks, Brokers, & Bullsh1+ part 2 for how this happened)

Peloton, the fund that imploded, used borrowings to boost its portfolio by four to five times and possibly more. Brad Alford, founder of Alpha Capital Management, an Atlanta investment-advisory firm, says such funds were exploiting "a lot of small mispricings in the debt markets and were levering up their returns significantly." (See Banks, Brokers, & Bullsh1+ part 2 for how this leverage i magnified several times over for the equity holders of Morgan Stanley, et. al.)

Now, says Mr. Alford, "they are facing that once-a-lifetime event that they thought would never happen." (The problem is that this "once in a lifetime event" is happening every few weeks now. Remember, just because you have never seen a black swan doesn't mean the don't exist!)

In a sign of the increasing tensions between banks and their borrowers, Carlyle Capital Chief Executive John Stomber issued a statement yesterday complaining that the margin calls demanded by lenders were excessive. "Unfortunately, this disconnect has created instability and variability in our repo financing arrangements," he said.