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.