In Michael Lewis’ bestseller The Big Short, when Greg Lippman, one of the top traders dealing with the kind of derivatives that helped implode the world’s economy, was asked who was selling insurance on all the lousy subprime loans, he answered concisely: Dusseldorf. “Stupid Germans,” Lippman purportedly told wary hedge-fund investors, despite the fact that he worked at a Deutsche Bank. “They take the ratings agencies seriously. They believe in the rules.”
But the Germans selling the credit default swaps to Goldman Sachs—the very swaps at the heart of the SEC’s case against Goldman Sachs—weren’t stupid. In fact, they were wily and wealthy financial players. Nor did they necessarily play by the rules: Their dealings with Goldman seemed designed to evade regulatory and auditor supervision—something the SEC conveniently shoved down the memory hole in order to paint the Germans as just another victim of Goldman fraud.
In short order, Rhineland became one of the biggest buyers of the complex investment products puked out by the likes of Lippman at Deutsche Bank, JP Morgan Chase—and Goldman.
Rather than suckers, a thorough study of the case indicates that Dusseldorf-based IKB Deutsche Industriebank—which seems to eerily resemble the “stupid Germans” Lippman was referring to when seeking buyers for his eventually toxic collateralized debt obligations—was playing the same game that Goldman was.
In a nutshell, the SEC is alleging that hedge-fund titan John Paulson approached Goldman with a list of mortgage-backed securities he wanted to bet against and, since it's generally not possible to bet directly against a mortgage-backed security, Goldman agreed to provide credit protection, before pawning off the mirror image of Paulson’s basket, named Abacus, to unsuspecting customers, while pocketing a profit on both sides of the transaction.
Enter Dusseldorf’s IKB. Beginning in 2001, CEO Stefan Ortseifen pursued a strategy to turn his modest operation that specialized in lending to small and midsize companies into an aggressive global player dealing in risky assets while, as detailed by financial reporter Nick Dunbar, getting around the prying eyes of his largest shareholder, a conservative, government-owned development bank. Specifically, he set up off-balance-sheet, offshore company called Rhineland Funding, The Wall Street Journal reported, that would buy risky securities, while escaping direct regulatory or auditor scrutiny. Since IKB controlled Rhineland, which was listed on the Irish stock exchange, and lent it money, it could siphon profits out via hefty management fees. Meanwhile, IKB remained at arm’s length, reducing its exposure by pawning off a portion of its dicey Rhineland loans to others.
It was a piece of regulatory arbitrage: In essence, IKB was investing in complex mortgage bonds without having to set aside regulatory capital or report the increase in risky assets to its regulators or auditors.
In short order, Rhineland became one of the biggest buyers of the complex investment products puked out by the likes of Lippman at Deutsche Bank, JP Morgan Chase—and Goldman. One banker told Euroweek that IKB—through Rhineland and similar tactics—had become one of the five or six largest investors in Europe. Thus, Goldman found them a willing buyer for the junk piled into Abacus.
The crucial question in the SEC’s case against Goldman is whether Rhineland should have been told that Paulson was ultimately the short-seller in this deal or that he had played an important role in selecting the securities that went into Abacus. While it’s not clear that in 2007 anyone would have been worried about a little-known hedge fund being short a deal if they weren’t already worried about Goldman being short, Rhineland certainly should have asked how the portfolio was constructed.
So why didn’t Rhineland—or the managers who controlled it from Dusseldorf—make these inquiries? Most likely, because IKB was playing the game even more aggressively.
Because Rhineland was an off-balance-sheet entity, IKB’s exposure to Rhineland was limited by the size of its guarantees and credit lines. If a particular transaction lost money, the conduit, Rhineland, was on the hook, but the bank, IKB, was not. If Rhineland made money, on the other hand, the bank took a big share of the gains. In short, the profits were the bank’s and the losses were someone else’s problem. Financial engineering at its best—and worst.
Simultaneous with the Abacus deal, IKB executives were busy with another piece of financial chicanery, insulating their bank from losses at Rhineland courtesy of a French bank, Calyon, which agreed that, if requested, it would pay $2.5 billion for assets held by Rhineland. In exchange, the value of those assets would be guaranteed by IKB and a bond insurer named FGIC. The deal was known as Havenrock II.
But Abacus and similar deals were already sucking money out of Rhineland, according to a person familiar with the matter. The ratings agencies were threatening to downgrade a host of subprime bonds, scaring off other lenders. Deutsche Bank, which had bought a piece of the liquidity facility IKB provided Rhineland, alerted German authorities, according to Dunbar.
A closing dinner for Havenrock II was held in Dusseldorf in July 2007, according to Bloomberg News. Just three days later, IKB announced that it was failing and had to be rescued by the German government. Calyon was out $2.5 billion. IKB paid $625 million to Calyon. But FGIC refused to pay the remaining $1.875 billion. Calyon sued FGIC, FGIC sued IKB. FGIC wound up paying Calyon just $200 million in a settlement, according to reports.
When Calyon asked IKB to pay for the shortfall, IKB said that Calyon “failed to conduct any, or any adequate, appraisal of the risks,” according to a report from Bloomberg. Calyon wasn’t cheated or duped, IKB said. Rather, the bank entered into the agreement to “fulfill its ambitions to develop and diversify significantly its activities in securitization and structured credit,” IKB said in court filings quoted by Bloomberg.
In other words, IKB’s defense against Calyon anticipated in an eerily precise way Goldman’s defense: Everyone involved were big boys who knew—or should have known—what they were getting into.
IKB has taken a deserved pounding in Germany. Four members of the board of managing directors were forced to step down. The CFO was ousted, along with Ortseifen, who was charged with stock-market manipulation and embezzlement. (The charges were later dropped when investigators concluded they couldn’t establish an intent to harm the bank.) The assets—and losses—from Rhineland were brought onto IKB’s balance sheet.
The SEC omitted these facts from its complaint. It’s hard to make a case, after all, when the victim acts even more capriciously that than alleged wrongdoer.