Goldman's 'Victim' in SEC Case Was a Yield Chaser

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' 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.