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.