£11bn Carlyle hedge fund goes bust after jittery banks pull plug

Carlyle Group, one of the world's largest private equity firms, was forced to admit yesterday that its £11bn Guernsey-based offshoot had gone bust after banks including Merrill Lynch refused to support a refinancing package.

Carlyle Capital, a hedge fund that invested primarily in two US mortgage lenders, was in effect shut down only two weeks after issuing its annual report for 2007 with a clean bill of health from the auditors PricewaterhouseCoopers.

Carlyle said from its New York offices that the Channel Islands fund had "not been able to reach a mutually beneficial agreement to stabilise its financing". Its shares were almost worthless after they fell more than 70% on top of the 90% drop since the company's problems became public last week.

A spokeswoman said the fund would be wound up and assets returned to its main lending banks. She said market volatility had wrecked any chances of survival and jeopardised other leveraged funds.

Fears that rivals would face the same hard line from banks gained ground as the credit crunch appeared to worsen.

Analysts argued that a jump in short-term interbank loan rates - making it more costly for banks to borrow from each other - put pressure on lenders to claw back cash from hedge funds and private equity groups. An offer by the Federal Reserve, the US central bank, to swap ailing mortgage-backed bonds for guaranteed treasury bills may also have encouraged banks to pull the plug on Carlyle.

Fed chiefs said on Monday they had put aside $200bn (£100bn) of treasury bills to underpin the mortgage-backed bond market. Analysts said banks keen to reduce the riskiness of their loans could withdraw from firms such as Carlyle and swap them for more secure government debt.

However, the continued decline of the US housing market appeared last night to be the crucial trigger. Carlyle Capital invested in AAA-rated mortgage debt issued by government-backed lenders known as Fannie Mae and Freddie Mac. Like other investment vehicles, it used high levels of borrowing to generate higher returns. According to the company's figures, it borrowed about £32 for every pound it raised from investors.

A decline in house prices in the US amid a wave of repossessions has cut the value of derivatives linked to Fannie Mae and Freddie Mac mortgages. The two lenders are considered the most secure in the US, but have suffered along with others since the global credit crunch hit last year.

The Carlyle fund borrowed money from at least a dozen banks, including Bank of America, Citigroup and Merrill Lynch. Carlyle's New York office kept a tight grip on the management of the fund and offered a line of credit during negotiations with the banks. Talks collapsed when a fire sale of £2.5bn in securities led to a fall in the value of the remaining £8bn worth of holdings, leaving the banks poised to force a liquidation and to seek to recover the assets.

Carlyle first came to prominence in the UK following a £140m investment in the government-owned defence contractor, QinetiQ. The private equity firm was accused of profiteering at the taxpayer's expense after it made more than £250m profit when the contractor was privatised in 2006, only three years after the initial investment.

Carlyle Capital was the first of the firm's 60 funds to be floated on the stockmarket. It was listed on the Amsterdam exchange at almost £10 a share and registered in Guernsey to benefit from its low-tax regime. The spokeswoman said: "It was designed to provide attractive, risk-adjusted returns for shareholders by investing in a diversified portfolio of fixed-income assets.

"Due to the low-risk, low-return nature of the US government agency-backed securities, a large position (and thus a correspondingly large amount of leverage) was required to realise gains substantial enough to warrant the investment. At the time, this approach was time-tested in the market for these types of assets.