Author: Teri Buhl and John Carney

Goldman Sachs was not the only investment bank selling the complex securities that ultimately resulted in staggering losses for the German bank IKB Deutsche Industriebank. Traders at Deutsche Bank sold similar collateralized debt obligations (CDOs) — built from credit protection on a portfolio of mortgage-backed securities selected in consultation with hedge fund manager John Paulson — to the German bank. And like Goldman, Deutsche Bank didn’t reveal Paulson’s role in the construction of the CDOs. So far, the SEC has not charged Deutsche with fraud relating to these transactions.

The failure of Goldman to disclose the role of Paulson to buyers of a single synthetic CDO forms the heart of the fraud charges the Securities and Exchange Commission filed against Goldman earlier this month. Paulson’s hedge fund, Paulson & Co, made billions of dollars by betting against portfolios of mortgage-backed securities, often by purchasing the short position in CDOs structured by large investment banks.

Two Deutsche Bank traders who requested anonymity say that Paulson’s role, both in selecting a reference portfolio and in shorting it, was never disclosed to any customers taking the other side of the trade on CDO deals. In fact, they never told clients who was on the other side of a trade. The traders cited IKB as one of the customers who bought CDO trades for which Paulson & Co helped select the reference portfolios.

In a typical synthetic CDO deal, an investor will approach an investment bank with specific criteria for the long or short position it wishes to take — say, a certain vintage mortgage backed security, with a certain rating, and the type of underlying loans. A “reference portfolio” that lists securities matching those criteria is constructed and the bank takes the position opposite the investor’s. If an investor wants to be long the reference portfolio, for example, the bank will initially take the short side of the trade by purchasing credit protection from the investor on the portfolio. Often, the bank will then seek out another customer who wants to buy the opposite side of the trade, either simultaneously with the closing of the deal or sometime afterwards.

Both IKB and Paulson & Co made requests for new CDO deals. IKB was a long investor, which meant it wanted to sell credit protection on a reference portfolio. As we reported this weekend, IKB often sought deals offering the highest yields, which meant that they needed to sell protection on portfolios referencing subprime mortgage bonds. Paulson & Co was a short investor, which meant it wanted to buy credit protection on a reference portfolio.

Deutsche Bank’s U.S. CDO underwriting group that worked with IKB was co-headed by Michael Lamont, who left the firm in 2008 to work for Seer Capital. When Lamont was reached for comment he wouldn’t talk about his trades at Deutsche Bank. Traders who worked with Lamont at Deutsche confirmed he was the point man to sell CDOs to IKB.

Greg Lippmann, head of ABS trading at Deutsche Bank, was also involved in working with hedge fund clients like Paulson who wanted to short the housing market and bet against the CDOs his bank was selling to IKB. Traders we spoke to who worked on an IKB-Paulson deal think the transaction did not violate securities laws and instead were simply offering each client what they were asking for: two different directional bets on the housing market.

“Deutsche’s view was: you’re all big boys, you do your own research. Here is what’s in the security — you choose if you want it or not. IKB knew exactly what they were buying,” said a Deutsche Bank trader who sold CDOs.

Deutsche Bank’s head of communications Ted Meyer said he wouldn’t comment on specific client transactions. But he did say that the absence of a third party collateral manager distinguished the Deutsche Bank deals from Goldman’s Abacus 2007 deal.

“What distinguishes Deutsche Bank’s CDO transactions is that both long and short investors were given the opportunity to select the specific collateral to which they were seeking exposure and mutually agreed on the CDO portfolio. No third-party collateral manager was utilized for these deals, which eliminated the potential for deception with respect to the role of such a manager,” Meyer said.

This was a crucial difference between the Deutsche Bank transactions and the Goldman Sachs deal targeted by the SEC. The Deutsche Bank traders did not use third party collateral managers who would put an independent stamp of approval on the deal. Most Goldman deals did not use an independent collateral manager, either.

But the 2007 Abacus deal did use ACA as a collateral manager; the SEC complaint says IKB wouldn’t buy from Goldman without a third-party manager. According to the SEC, the thought was the third party would add another brand name to help add credibility to the risky product.

In late 2006 IKB had lost the senior portfolio manager who had founded its Rhineland conduit that purchased many of its CDOs. Perhaps it believed that an outside expert could fill the role of the portfolio manager — a sort of outsourcing of investment decision making with the hope that an independent manager would offer an ethics check on the deal. Still, as late as March 2007, our sources indicated that IKB was meeting with Deutsche Bank executives to inquire about the purchase of new CDOs — without a third party collateral manager.

Larry McDonald, author of the book on Lehman Brothers “A Colossal Failure of Common Sense,” experienced the cowboy style of derivative bond trading first hand during this time. McDonald says, “Look: things were moving so fast on the trading desks at all banks during this time — it was like the Wild West. We didn’t have laws on most of these derivates trades. But just because everyone was doing it doesn’t mean it passed an internal ethics check. I worked next to these guys. They knew what they were creating could be viewed as morally wrong, but there was no real law to stop it and the profits were so big.”

Note: Robert Khuzami, the head of SEC enforcement, was previously a lawyer at Deutsche who oversaw a legal team that helped build the bank’s CDOs.

The German bank on the losing end of the Goldman Sachs derivatives deals that have attracted the ire of the Securities and Exchange Commission was so absorbed in the pursuit of high-yield returns from financial instruments linked to the U.S. housing market that it preferred to lose one of its top executives rather than change course.

This single-minded pursuit of yield provides an important context for the SEC’s case against Goldman. In hindsight, it can appear that Goldman must have been committing some kind of fraud in order to sell subprime CDOs that performed so badly. But at the time, the buyers of these instruments were actively seeking exposure to subprime risk.

In 2002, IKB Deutsche Industriebank, the German bank, named as a victim in the SEC’s complaint against Goldman, launched an off-balance sheet, off-shore “conduit” called the Rhineland fund to buy up mortgage bonds and derivatives linked to the bonds. But by 2006, when Goldman and others began to see trouble ahead in the US mortgage market, and AIG had largely stopped writing credit insurance on subprime debt, the founder of the fund was attempting to chart a course away from the coming mortgage storm.

“I made several proposals for a more sophisticated portfolio management to address expected negative market developments,” Rhineland portfolio manager Dirk Rothig wrote in an e-mail to Fortune magazine in 2007. “These risk-management proposals were not accepted by IKB.”

Rothig left the Rhineland fund in 2006.

After the loss of its star portfolio manager, IKB continued to buy mortgage bonds and collateralized debt obligations through both the Rhineland fund and a similar fund called Rhinebridge. They were focused on the riskiest end of the market — subprime bonds.

“IKB was still buying strong in early 2007, but they were very specific about the collateral they wanted in the CDO’s. They had a big research team of 20 guys and would inspect the asset quality outside of what any rater was saying about the bond. They wanted subprime paper,” said a trader at Deutsche Bank who worked with IKB. Other Deutsche Bank employees who requested anonymity confirmed IKB’s hunger for subprime collateral.

IKB would approach banks with a request for a specially tailored CDO that matched their investment strategy of seeking out exposure to the riskiest bonds, because these came with the highest yields. And according to bank staffers involved in these transactions, which included not only Goldman but its German rival Deutsche Bank, they paid tens of millions of dollars in fees to get into these deals.

IKB may have been driven to this risky strategy because it was already somewhat distressed. Like many conduits, IKB’s Rhineland and Rhinebridge funds depended on the short term commercial paper market for funding. They would borrow short term debt on the commercial paper market in order to fund their purchases of mortgage bonds and CDOs. The difference between the costs of borrowing and the yield on the investment assets was the source of their profits. The assets of the conduits served as collateral for the short-term loans, which meant lenders to Rhineland and Rhinebridge would be entitled to their assets if they couldn’t make good on their debt.

The borrow short, invest long conduit strategy can be effective so long as the short term borrowing is cheap and easily available. But for IKB, borrowing on the short term commercial paper market was becoming more expensive, perhaps because lenders were concerned about the quality of its subprime heavy asset portfolio. In order to profit despite rising borrowing costs, IKB had to seek out ever riskier assets with higher yields.

Kostas Iordanidis, a portfolio manager for Olympia Capital and Julius Baer during the housing boom, says he saw Rhineland’s short term commercial paper for sale at higher yields than almost any similar funds. When he asked his broker about the situation, he found couldn’t get a good answer. Iordanidis figured something wasn’t right and told his broker to highlight in red any Rhineland paper so that “when you send over the days ‘buys’…my team knows never to buy it.”

“Banks like IKB were aggressively shopping just for yield. It was institutions’ hungry demand for B-rated paper that offered a high yield above government paper, which really caused a miss-match in the price of the paper and set them up for failure because the liquidity risk wasn’t priced in,” said Iordanidis.

This situation became critical when the commercial paper market began to freeze up in the second half of 2007. The IKB conduits found that they couldn’t raise the funds to roll their existing paper. At the same time, the market for their subprime assets nearly shut down, making it difficult for IKB to raise funds by liquidating their portfolio. For a time IKB attempted to sell some assets, but the discounts it had to offer were so steep it just gave up trying.

By late 2007, Rhineland Funding and Rhinebridge were collapsing, threatening to bring down IKB with them. The government owned German bank KfW rescued IKB with a series of capital injections that eventually totaled over 9.5 billion euros. The chase for yield turned out to be a very, very costly pursuit.