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Dr Frankenstein of Dusseldorf

Risky Finance 8 August 2007

While the mainstream financial press may have been shocked by the news from IKB last week, the credit derivatives cognoscenti at London-based investment banks were somewhat less surprised. But do not expect them to shout about the monster whose rampant growth lined their pockets so handsomely.

It all began in 2001. IKB’s CEO Stefan Ortseifen, who was fired last week, wanted to grow his business. But he wanted to do so without using the Mittelstand lender’s balance sheet, which would have required the approval of its biggest shareholder, the publicly-owned KfW.

So IKB began playing with the bubbling test tubes of the derivatives laboratory. The solution followed the nostrums of modern portfolio theory—namely diversification into unfamiliar foreign credit markets—while using the latest in financial engineering trickery to manage the risks and exploit a regulatory arbitrage loophole.

In early 2002, it set up a ‘conduit’ called Rhineland Funding, which was domiciled in the US but controlled from Dusseldorf. Rhineland’s job was to access foreign credit markets by buying investment grade CDOs or ABS.

Crucially, IKB would not buy the CDOs directly and hold them on its balance sheet. Rather, Rhineland would raise capital by issuing short-dated commercial paper (CP) and investing the proceeds. Once the CP holders had received their (modest) coupons and Rhineland’s administration costs had been taken care of, IKB could enjoy any excess returns in the form of a ‘management fee’.

All IKB had to do in return was provide a backstop loan facility to repay the CP holders if Rhineland couldn’t do so or if its portfolio was downgraded, as well as posting a ‘credit enhancement’ of about €500m (which was later syndicated out). This convinced the credit rating agencies Fitch and Moody’s that Rhineland could invest in assets with ratings below the triple A level that were usually required to back CP obligations.

At first sight, Rhineland resembled a bank. It took short-term deposits from CP investors and invested them in riskier, long-term assets, paying the difference to its shareholder, IKB. But it was no more a bank than Frankenstein’s monster was a human being.

Instead of being a conservative mittelstand lender like IKB, Rhineland was designed as an offshore entity lacking an independent regulator or auditor in order to reap regulatory arbitrage benefits. Governance was largely outsourced to the investment banks that provided funding and investment assets for Rhineland, and the rating agencies that watched over this process.

Moody’s may have dubbed it an ‘arbitrage conduit’ but the only way Rhineland could generate cash was by growing. The result was a CDO-devouring monster. As Moody’s puts in its latest note on the conduit, “Rhineland has, over the years, increased its investments in CDOs at a constant rate of approximately $3bn per year”. From 2002 onwards, London structured credit houses flocked to Dusseldorf with proposals for feeding Rhineland.

By the time I first learned about it, in late 2003, IKB had become everyone’s biggest client. Credit derivatives teams at firms such as Deutsche Bank, JP Morgan and BNP Paribas were boasting of bringing in annual trading revenues and fees from IKB of the order of $30-50m. IKB wasn’t upset to learn this, as its own annual fees from Rhineland were of the same magnitude.

When I published this information in Risk magazine early in 2004*, the IKB and the investment banks were irritated but the party continued. By July 2007, Rhineland had swollen into a monster with $19bn commercial paper outstanding and a heavy exposure to US sub-prime mortgage debt.

At this point, IKB had a total exposure of over €8bn to Rhineland, amounting to twice its Tier 1 and Tier 2 capital. But the idea that this posed a risk was blithely ignored in IKB’s 2006 annual report which contains the following gem: ‘the level of unexpected risk may only exceed our limit in 0.04% of cases’.

Yet all it took was the mere threat of sub-prime downgrades by Moody’s to put Rhineland into a tailspin. The reason all of this slipped out was apparently because half of the liquidity facility initially provided by IKB had been syndicated out to international banks that actually knew what was going on in sub-prime. One of them, Deutsche Bank, blew the whistle on IKB and alerted German regulators.

KfW has since taken over the tottering conduit, with the help of €3.5bn of credit support it has provided together with a consortium of German banks. In addition to protecting IKB from insolvency, this should prevent losses to CP investors if sub-prime defaults occur in the Rhineland portfolio. But given the recent turmoil, the CP market is likely to soon stop funding Rhineland, forcing KfW and the other backstop and credit enhancement syndicate members to take billions of CDOs and ABS onto their balance sheets.

What happens then? The publicly-owned KfW is already under fierce pressure from German politicians to get IKB and Rhineland off its hands. The big international banks in the syndicate will hardly be keen to sit on this hot potato as credit markets tank. How ironic it will be if the London-based credit derivatives desks that earned so much from their favourite client during the last five years get to make it all over again when the assets of Rhineland and IKB are sold off in a fire-sale.

*The great German structured credit experiment, Risk, February 2004, page 17

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