Pickup on North Street

In March 2002, a seemingly innocuous meeting took place in the offices of Landesbank Kiel (LB Kiel), in the German port city of Kiel. Sitting at the boardroom table were a pair of Americans, Wayne King and Ken Karl, whose business cards were emblazoned with the crossed-keys logo of UBS. Facing them were Franz Waas, an executive board member at LB Kiel, and his new head of portfolio management, Martin Halblaub. The two Germans were part of a sophisticated international new wave in finance that made regional German banking slightly less boring than it had been for hundreds of years — and slightly more profitable. For LB Kiel's owners, it offered a way to shake loose from state ownership and taxpayer guarantees.

The pitch document the Americans brought to Kiel was for North Street 4, and they explained how it would “leverage” UBS's “global asset management expertise.”

 In reality, it amounted to UBS's setting up a Cayman Islands special purpose vehicle — a financial robot — that would invest in some $3 billion of investment-grade bonds. By asset management, UBS meant that it would move bonds in and out of the android over time. LB Kiel would be exposed to the “second loss” layer of this portfolio, a slice of risk some $500 million thick, for fifteen years. The investment was like the filling of a gigantic sandwich, resting on an equity layer that was supposed to protect LB Kiel, while the German bank was supposed to protect UBS from losing money on the “super senior” layer above.

Like LB Kiel's similar deal with Barclays eighteen months earlier, there was a built-in flaw with such sandwich arrangements. “You've got an inherent conflict of interest,” a senior UBS official would later concede. “Whose interests are you actually protecting? Are you looking after UBS's interests, or the second loss provider [LB Kiel]?” Listening to the pitch, Halblaub felt uneasy about the inherent conflicts, and he hesitated to sign up to the deal. “What's the matter — don't you trust us?” joked Karl. There was nothing to suggest that Karl and UBS weren't sincere about wanting to help their client, and so Waas intervened — to abort the deal now would cast doubt on how serious LB Kiel was about entering new markets. LB Kiel agreed to buy North Street 4.

Initially, Karl filled up North Street 4 with corporate debt issued by familiar companies like Disney, the Burlington Northern and Santa Fe railroad, cable television company Viacom, and supermarket chain Safeway, among others. By October, with the approval of LB Kiel, many of these corporate stalwarts had been replaced by mysterious names such as INHEL 2002-A, OOMLT 2002-3, and NCHET 2001-NC2. In just seven months, some 70 percent of the North Street 4 portfolio had been replaced by securitizations, of which a quarter were funding U.S. subprime and home equity lending, as well as credit card loans and commercial mortgages. NCHET 2001 was a subordinated tranche — or the next-to-bottom layer — of a securitization deal backed by subprime mortgages from New Century Financial Corporation. INHEL 2002-A was a mezzanine certificate backed by mortgages sourced by IndyMac, a Californian bank.

Via a daisy chain that ran through the Cayman Islands, the UBS New York trading desk, and special-purpose companies in California, the burghers of Schleswig-Holstein, the ultimate owners of LB Kiel, were indirectly lending millions of dollars to aspiring middle-class American consumers eager to buy homes, cars, and those big-screen TVs. That was what LB Kiel wanted, an ultra-safe, diversified package stamped “triple-A” by century-old ratings agencies. The tool that joined cautious Germans and buoyantly optimistic Americans was the ABS CDO, the financial innovation that played a crucial role in stoking the housing bubble.

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