Another swift and stunning reversal of fortune came at the hands of Carlyle Capital Corp., a listed hedge fund that also traded in the mortgage market. It also succumbed to liquidation in March 2008. Its parent company, Carlyle Group, is one of the most successful alternative asset franchises in the world, managing more than $81 billion in assets for the world's most sophisticated clients.
The fund's demise came just eight months after it listed its stock on the Euronext Amsterdam stock exchange in 2007. Similar to Peloton Partners, CCC's collapse was another casualty of a liquidity crisis. Carlyle Capital's strategy was not fraught with complex derivatives or secretive black-box trading schemes. Its strategy was simple: Borrow capital at low short-term interest rates and invest this borrowed capital in long-term AAA-rated mortgage bonds issued by the Federal Home Loan Mortgage Corp. and Federal National Mortgage Association. Carlyle Capital's investment strategy was to make money on the difference between its cost of short-term borrowing and the larger coupon payments received from Freddie Mac and Fannie Mae on their long-term bonds. It also used significant leverage to get more juice out of its interest-rate spread.
However, the dramatic decline of the mortgage-backed securities market and death spiral of Fannie Mae and Freddie Mac led to a steep erosion in the value of the mortgage-backed securities held by Carlyle Capital. The decline in the value of Fannie Mae and Freddie Mac securities came to a head in early March 2008 when margin calls from Deutsche Bank, J.P. Morgan Chase Bank and other lenders reached more than $900 million. At that point, the lenders then began to seize the Carlyle Capital hedge fund's collateral and its assets; primarily highly rated mortgage-backed securities. Carlyle Capital quickly went out of business.
One last data point should suffice: Bayou Management LLC started out as a legitimate hedge fund but quickly degenerated into outright fraud. The two principals, founder Samuel Israel III and CFO Daniel Marino, were sentenced to prison, Mr. Israel for 20 years and Mr. Marino for 21 months.
The story of Bayou begins in 1996 when, within a few months after the Bayou fund opened and started trading, Bayou sustained trading losses and began lying to its customers about the fund's profits and losses. To cover the difference between actual and projected profits, and to keep clients and attract new ones, Bayou transferred back into the fund a portion of the trading commissions that the fund had paid to Bayou Securities LLC during that year. Bayou Securities was a separate broker that Bayou had set up to process the trades from the fund — earning a commission on Bayou's losing trades.
Bayou did not disclose to its clients that the fund's performance was being bolstered by these rebates. Consequently, Bayou clients were left with a false impression that the Bayou fund had made a profit. By December 1998, the Bayou fund's mounting losses could not withstand an independent audit. So, Bayou dismissed its independent auditing firm and created a fictitious accounting firm — Richmond-Fairfield Associates — to pose as its independent auditor. But it was Mr. Marino who was the sole principal of Richmond-Fairfield, and the accounting firm had no other clients. Through this accounting firm, Messrs. Israel and Marino fabricated the annual audit of the Bayou fund as well as manufactured fictitious financial statements
All good frauds eventually come to an end. By 2004, Messrs. Israel and Marino had stopped trading and had transferred the rest of Bayou's assets to Israel and other non-Bayou entities but still sent periodic statements to investors describing profitable trades. But their scheme came to light when, in May 2005, $100 million was seized by legal authorities from the state of Arizona who became suspicious when they found huge sums of money being shifted around different accounts in rapid fashion.
As a final and sadly funny postscript to this whole mess, Mr. Israel went missing on June 9, 2008, one day before he was to go to prison. His car was found near the towering Bear Mountain Bridge over the upper Hudson River in New York. On the dust of his car's hood was written the message: “Suicide is painless” in a reference to the theme song from the movie and TV show “M*A*S*H”. Mr. Israel was later captured at a trailer park where he had been driven by his girlfriend after leaving his car. He is now serving his 20-year prison sentence.