The idea for the offshore bank had been his. The German management at IKB had taken to it, as he put it, “like a baby takes to candy.” He’d created the bank when the market was paying higher returns to bondholders: Rhineland Funding was paid well for the risk it was taking. By the middle of 2005, with the financial markets refusing to see a cloud in the sky, the price of risk had collapsed: the returns on the bonds backed by American consumer loans had collapsed. Röthig says he went to his superiors and argued that, as they were being paid a lot less to take the risk of these bonds, IKB should look elsewhere for profits. “But they had a profit target and they wanted to meet it. To make the same profit with a lower risk spread they simply had to buy more,” he says. The management, he adds, did not want to hear his message. “I showed them the market was turning,” he says. “I was taking the candy away from the baby, instead of giving it. So I became the enemy.” When he left, others left with him, and the investment staff was reduced, but the investment activity boomed. “One-half the number of people with one-third the experience made twice the number of investments,” he says. “They were ordered to buy.”
He goes on to describe what appeared to be a scrupulous and complicated investment strategy but was actually a mindless, rule-based investment strategy. IKB could “value a CDO down to the last basis point,” as one admiring observer told Risk magazine in 2004. But in this expertise was a kind of madness. “They would be really anal about, say, which subprime originator went into these CDOs,” says Nicholas Dunbar. “They’d say we won’t take loans from First Franklin but we will take them from Countrywide. But it didn’t matter. They were arguing about bonds that would collapse from one hundred [par] down to two or three [percent of par]. In a sense they were right: they bought the bonds that went to three, rather than to two.” As long as the bonds offered up by the Wall Street firms abided by the rules specified by IKB’s experts, they got hoovered into the Rhineland Funding portfolio without further inspection. Yet the bonds were becoming radically more risky, because the loans that underpinned them were becoming crazier and crazier. After he left, Röthig explains, IKB had only five investment officers, each in his late twenties, with a couple of years’ experience: these were the people on the other end of the bets being handcrafted by Goldman Sachs for its own proprietary trading book, and by other big Wall Street firms for extremely clever hedge funds that wanted to bet against the market for subprime bonds. The IKB portfolio went from $10 billion in 2005 to $20 billion in 2007, Röthig says, “and it would have gotten bigger if they had had more time to buy. They were still buying when the market crashed. They were on their way to thirty billion dollars.”
By the middle of 2007 every Wall Street firm, not just Goldman Sachs, realized that the subprime market was collapsing, and tried frantically to get out of their positions. The last buyers in the entire world, several people on Wall Street have told me, were these willfully oblivious Germans. That is, the only thing that stopped IKB from losing even more than $15 billion on U.S. subprime loans was that the market ceased to function. Nothing that happened—no fact, no piece of data—was going to alter their approach to investing money.
On the surface the IKB’s German bond traders resembled the reckless traders who made similarly stupid bets for Citigroup and Merrill Lynch and Morgan Stanley. Beneath it they were playing an entirely different game. The American bond traders may have sunk their firms by turning a blind eye to the risks in the subprime bond market, but they made a fortune for themselves in the bargain, and have for the most part never been called to account. They were paid to put their firms in jeopardy, and so it is hard to know whether they did it intentionally or not. The German bond traders, on the other hand, had been paid roughly one hundred thousand dollars a year, with, at most, another fifty-thousand-dollar bonus. In general, German bankers were paid peanuts to run the risk that sank their banks, which strongly suggests that they really didn’t know what they were doing. But—and here is the strange thing—unlike their American counterparts, they are being treated by the German public as crooks. The former CEO of IKB, Stefan Ortseifen, was given a jail term (since suspended) and has been asked by the bank to return his salary: 805 thousand euros.
Dirk Röthig had enjoyed a ringside seat not only to IKB but to the behavior of its imitators, the German state-backed banks, the Landesbanks. And in his view, the border created by modern finance between Anglo-American and German bankers was treacherous. “The intercultural misunderstandings were quite intense,” he says, as he tucks into his lobster. “The people in these banks were never spoiled by any Wall Street salesmen. Now there is someone with a platinum American Express credit card who can take them to the Grand Prix in Monaco, takes you to all these places. He has no limit. The Landesbanks were the most boring bankers in Germany so they never got attention like this. And all of a sudden a very smart guy from Merrill Lynch shows up and starts to pay a lot of attention to you. They thought, ‘Oh, he just likes me!’” He completes the thought. “The American salespeople are much smarter than the European ones. They play a role much better.”
At bottom, he says, the Germans were blind to the possibility that the Americans were playing the game by something other than the official rules. The Germans took the rules at their face value: they looked into the history of triple-A-rated bonds and accepted the official story that triple-A-rated bonds were completely risk-free.
This preternatural love of rules almost for their own sake punctuates German finance as it does German life. As it happens, a story had just broken that a German reinsurance company called Munich Re, back in June 2007, or just before the crash, had sponsored a party for its best producers that offered not just chicken dinners and nearest-to-the-pin golf competitions but a blowout with prostitutes in a public bath. In finance, high or low, this sort of thing is of course not unusual. What was striking was how organized the German event was. The company tied white and yellow and red ribbons to the prostitutes to indicate which ones were available to which men. After each sexual encounter the prostitute received a stamp on her arm to indicate how often she had been used. The Germans didn’t just want hookers: they wanted hookers with rules.
Perhaps because they were so enamored of the official rules of finance, the Germans proved especially vulnerable to a false idea the rules encouraged: that there is such a thing as a riskless asset. After all, a triple-A rating was supposed to mean “riskless asset.” There is no such thing as a riskless asset. The reason an asset pays a return is that it carries risk. But the idea of the riskless asset, which peaked about late 2006, overran the investment world, and the Germans fell for it the hardest. I’d heard about this, too, from people on Wall Street who had dealt with German bond buyers. “You have to go back to the German mentality,” one of them had told me. “They say, ‘I’ve ticked all the boxes. There is no risk.’ It was form over substance. You work with Germans, and—I can’t emphasize this enough—they are not natural risk takers. They are genetically disposed to fucking it up.” So long as a bond looked clean on the outside, the Germans allowed it to become as dirty on the inside as Wall Street could make it.
The point Röthig wants to stress to me now is that it didn’t matter what was on the inside. IKB had to be rescued by a state-owned bank on July 28, 2007. Against capital of roughly $4 billion it had lost more than $15 billion. As it collapsed, the German media wanted to know how many U.S. subprime bonds these German bankers had gobbled up. IKB’s CEO, Stefan Ortseifen, said publicly that IKB owned almost no subprime bonds at all—which is why he’s now charged with misleading investors. “He was telling the truth,” says Röthig. “He didn’t think he owned any subprime. They weren’t able to give any correct numbers of the amount of subprime they had, because they didn’t know. The IKB monitoring systems did not make a distinction between subprime and prime mortgages. And that’s why it happened.” Back in 2005, Röthig says, he proposed to build a system to track more precisely what loans were behind the complex bonds they were buying from Wall Street firms, but IKB’s management didn’t want to spend the money. “I told them you have a portfolio of twenty billion dollars, you are making two hundred million dollars a year and you are denying me six point five million. But they didn’t want to do it.”