Vicious cycle
In the early stages of the financial turmoil, the riskiest securities such as those backed by subprime mortgages were hit by selling. Now, as margin calls intensify, hedge funds and others find they must unload even high-quality assets such as bonds backed by the government-sponsored mortgage Fannie Mae and Freddie Mac. They have no choice but to sell these high-quality assets in order to meet margin calls and live another day.
A margin call happens when banks call in their loans to hedge funds or other investors. It forces the investor to sell off assets to raise cash, driving prices for those assets lower, leading to more losses and more margin calls. This is what economists call a “margin spiral.”
An recent example is Carlyle Capital Corp.’s failure to meet margin calls on loans backing part of its $21.7 billion portfolio of highly rated securities issued by Fannie and Freddie. Funds like the Carlyle group 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. A famous example of a highly leveraged fund is Long-Term Capital Management (LTCM) which blew up in 1998.
Source: WSJ