The apparent overnight meltdown of a $22 billion (£10.9 billion) credit fund is a huge embarrassment for Carlyle Group, the US private equity firm with unrivalled links to big business and global politics.

Even a few weeks ago it would have been inconceivable that a fund operated by such a well-established and respected investment firm that specialised in AAA-bonds would suddenly melt down - especially when it invested in bonds underwritten by Freddie Mac and Fannie Mae, the US government-chartered mortgage groups.

When Carlyle, one of the biggest private equity firms in the world, with about $75 billion of assets under management, set up its ill-fated mortgage bond fund in 2006, it thought that it was on to a sure winner.

Happy in the knowledge that the fund was investing in bonds backed by high-quality mortgages and guaranteed by Freddie or Fannie in the event of a default, Carlyle leveraged the fund to a ratio of $30 of debt for every $1 of equity.

By leveraging the fund so much, Carlyle hoped to increase the return on the fund's equity investment to about 15 per cent annually, with minimal risk. In recent days, however, the fund's lenders became so rattled by the escalating credit crunch that they demanded far more additional collateral than they really needed and the fund melted down.

This is likely to go down as a watershed moment, both for the credit crunch and for Carlyle, the investment firm that was set up in 1987 and now makes buyout, start-up, property and hedged fund investments across the world.

The firm, which once boasted John Major, the former Prime Minister, as its European chairman, is chaired by Louis Gerstner Jr, the former IBM chairman, who joined Carlyle in 2003.

Mr Gerstner works closely with David Rubenstein, William Conway and Daniel D'Aniello, three of the founders who are still actively involved in the group, which manages 55 funds, employs 500 investment staff and has its headquarters in Washington.

Although the group has never before seen anything like the meltdown of its Carlyle Capital Corp (CCC) mortgage bond fund, it is no stranger to controversy.

Most of this stems from the roster of high-profile politicians on its books who, critics argue, have helped it to win more than its fair share of profits from the defence industry through companies such as United States Marine Repair, United Defence and Aerostructures Corp.

James Baker III, the former US Secretary of State, served as a senior adviser between 1993 and 2005. George Bush Sr, the former US President, and his son, the President, have served on its board.

Bruce Rosenblum, a Carlyle managing director, is chairman of the Private Equity Council, a group set up by the biggest buyout firms to represent the industry.

In the US, Carlyle has been accused of using its contacts to win business contracts in relation to the war against terrorism and the conflict in Iraq. In the UK, its most controversial investment has been in QinetiQ, formerly the Defence Evaluation and Research Agency of the Ministry of Defence.

Carlyle, which owns Dunkin' Donuts and recently took Hertz, the car rental company, public, tried unsuccessfully to buy the Virgin Media UK cable business last year.

It would be foolish to be too pessimistic about the outlook for Carlyle on the basis of its bond fund meltdown. The firm insisted yesterday that the fund's woes would “have no material impact” on any of its other funds and noted that it did not have any other exposure to mortgages. Moreover, its other funds are far less highly leveraged.

But this episode will still take a big chunk out of its reputation, and the next few years are unlikely to be as profitable for Carlyle as a whole as the past few.

Like most private equity firms, Carlyle typically finances about two thirds of its leveraged buyouts with debt. And debt is becoming more expensive and harder to come by. That will damage returns. At the same time, it is harder for the group to sell existing investments because some potential buyers will be unable to raise the debt needed to finance these kinds of purchases.

Carlyle, then, is down but not out.

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