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By Root 201 0

’t call it a bank. If they had called it a bank, people might have asked why it was not regulated. They called it a “conduit,” a word that had the advantage that no one understood what it meant. Rhineland borrowed money for short periods of time by issuing something called commercial paper. They invested it in longer-term “structured credit,” which turned out to be a euphemism for bonds backed by American consumer loans. Many of the same Wall Street investment banks that raised the money for Rhineland (by selling the commercial paper for them) sold Rhineland the bonds backed by the American consumer loans. Rhineland’s profits came from the difference between the rate of interest it paid on the money it borrowed and the higher rate of interest it earned on the money it lent through its bond purchases. As IKB guaranteed the entire enterprise, Moody’s rating service gave Rhineland its highest rating, enabling Rhineland to borrow money cheaply.

The Germans in Düsseldorf had one critical job: to advise this offshore vehicle they had created about which bonds it should buy. “We are one of the last to get our money out of Rhineland,” Röthig told Risk magazine, “but we’re so confident of our ability to advise it in the right way that we still make a profit.” Röthig further explained that IKB had invested in special tools to analyze the complicated bonds, called collateralized debt obligations (CDOs), that Wall Street was now peddling. “I would say it has proven a worthwhile investment because we have not faced a loss so far,” he said. In February 2004 all this seemed like a good idea—so good that lots of other German banks copied IKB, and either rented IKB’s conduit or set up their own offshore vehicles to buy subprime mortgage bonds. “It sounds like quite a profitable strategy,” the man from Moody’s who had awarded Rhineland’s commercial paper a triple-A rating told Risk magazine.

I met Dirk Röthig for lunch at a restaurant in Düsseldorf, on a canal lined with busy shops. From their profitable strategy IKB has announced losses of roughly $15 billion, though their actual losses are probably greater, as German banks are slow to declare anything. Röthig viewed himself, with some justice, more as victim than perpetrator. “I left the bank in December 2005,” he says quickly, as he squeezes himself into a small booth. Then he explains.

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