Tail risk in the Rhineland | FT Alphaville

Tail risk in the Rhineland

IKB, the bailed-out German bank, has been thrust ignominiously into headlines once again.

IKB was one of the investors in Goldman Sachs’ now-infamous Abacus CDO, which lies at the heart of an SEC law suit against the American bank. Rhineland Funding, the ABCP conduit which financed IKB’s acquisition of Abacus, in addition to many other subprime CDOs, has also resurfaced.

The creation of IKB’s conduits is still something of a mystery, however.

This Federal Reserve working paper is worth reading for an insight into just how and why these massive conduits popped up — and why they did so primarily in Europe, as opposed to say, the States.

Here’s the paper on how the conduits worked:

The hardest-hit ABCP vehicles followed a “credit arbitrage” investment strategy which amounted to going long the AAA credit spread. They borrowed at the short end of the credit spread term structure by issuing ABCP and lent at intermediate and long maturities, primarily by investing in AAA- and AA-rated asset-backed securities. Such strategies, which have some similarity to those of Long Term Capital Management (LTCM) and other fixed-income arbitrage strategies, have been likened to “picking up nickels in front of a steamroller” because they produce low per-unit returns with modest volatility in most states of the world but large negative returns in some bad-tail states of the world (Duarte, Longstaff, and Yu 2007). Credit arbitrage ABCP vehicles were almost immune to all but two events: Unprecedented declines in credit quality of asset-backed securities, or a loss of access to funding in the ABCP market. Either event was predictably likely to be associated with broad disruptions in financial markets. That is, in creating and operating such vehicles, the sponsors mainly took on systematic bad-tail risk.

Et voila — both these things came to pass in 2007.

In hindsight, what could possibly have led banks like IKB to take on such tail risk?

The paper says:

Our evidence implies that both government-induced distortions and owner-manager agency problems played a role. Among the varieties of government-induced distortions, we find little support for hypotheses that favorable regulatory or accounting treatment fostered sponsorship, but some evidence in favor of mechanisms that highlight leverage, such as Merton (1977) or John, John, and Senbet (1991). We find sponsorship to be more likely the lower a bank’s equity-to-assets ratio, and the economic size of the leverage effect is significant. The most material government distortion was associated with government ownership or control: A significant minority of vehicles was sponsored by German Landesbanks and their vehicles were more likely to be a relatively large fraction of the sponsor’s assets. However, it is not clear that government chose to take the risks associated with ABCP vehicles. It may be that governance of such banks was weak, in which case one might interpret the Landesbanks’ role as a particular instance of owner-manager agency problems.

Here IKB is an outlier since it wasn’t a Landesbank — one of Germany’s public sector financial institutions.

It was, however, majority-owned by KfW, the state-owned development bank. And there’s been some suggestion that IKB’s former CEO Stefan Ortseifen wanted to increase business without requiring the approval of KfW — hence the off-balance sheet, foreign-asset-gobbling conduit, Rhineland.

Ortseifen is currently on trial in Germany for manipulating IKB’s share price, by playing down the subprime threat in July 2007, and breach of trust. German prosecutors decided last summer not to charge him for breach of trust concerning those ABCP conduits.

(H/T Achim Duebel)

Related links:
Goldman’s dirty customers – John Carney, The Daily Beast
Ackermann to testify in German case – FT
Deutsche Bank also ‘victimized’ Goldman ‘victim’ – The Atlantic