Great UBS Mea Culpa

UBS wrote down $37B over the past 12 months, quite a mistake, but they sure aren't shy about it. In a very informative report to shareholders, they outline the disaster. This should be essential reading for any senior risk manager (go here and download 'Shareholder Report on UBS's Write-Downs'; essential reading for junior risk managers includes Maxim, FHM, and Fark.com).

The report goes over the entire mess, and highlights several issues at work. 70% of the losses came from their fixed income group. 15% came from the Dillon Read Capital Management (acquired in only 2005), and the rest, other, all pretty much based on the subprime, and its affect on other structure product spreads.

Much of the growth in the Fixed Income group came from fat fees on repackaging residential mortgages from the US into mezzanine (ie, Ba rated) CDOs and reselling them. This generated fees of about 150 basis points, compared to fees of only 40 basis points on senior tranches. Now, in fixed income, 150 basis points is a lot of spread, so you have to wonder where they thought this edge was coming from. Its like, if someone told you they could repackage US Treasuries, take out 50 basis points, and make everyone happy. The spreads are just too thin, you can only get this kind of edge by taking huge risk, in Treasuries for example, it implies there must be some kind of yield curve bet, or selling some swaption, and in these markets, they just aren't that inefficient to think 50 basis points is there no matter how smart you are. If they thought there was 150 basis points in free alpha via repackaging pools of RMBS, they should have done the math. So the spreads alone should have been a warning signal, and suggest senior management was ignorant of the basic pricing and historical performance of credit returns. It was doomed based on this analysis alone.

The 150 basis points on the mezzanine piece necessitated keeping about 60% of the RMBS on their books, both the super senior pieces, and the first-loss pieces. But this looked good, because as a AAA rated bank, they funded everything at this ridiculously low rate, and so made positive carry on this stuff. So it seemed like arbitrage. They also bought AAA rated ABS of various collateral, and, because ABS AAA trades above bank AAA rates, had positive carry on this. When the mortgage market blew up, everything in structured finance cratered even though asset quality was pretty unchanged, and they exited with a loss in the third quarter of 2007 on things backed by credit cards and autos, merely because spreads widened.

At the end of the problem, their pipeline could not be sold, so they were stuck with the 40% they anticipated selling.

The bank had several groups evaluating risk, and so no own had real ownership of the issue. One group, internal audit, did 250 such reviews a year, so their rather perfunctory review is understandable--any group that does 250 risk reviews a year is worthless, because they don't have the clout to tell anyone with power no, they have too much to do to fight such a battle. Furthermore, only 5 years of data on RMBS pricing was used for stress tests and Value at Risk. Given the 2000-2005 period was benign, this understated the risk significantly. Any stress test or VAR needs to count observations in terms of cycles, not days: 1990 hotels, 1990 Commercial mortgage backed securities, 1997-8 emerging markets, 2001 CDOs and telecom, 1996 credit card, 1994 yield curve, and draw inferences from different products, because the historical losses of one type of derivative over 5 years is just not sufficient to get a real sense of a worst-case-scenario.

Further, they assumed normality, because they assumed these were tradeable assets, and over short horizons, even asymmetrically distributed credit instruments are well approximated by a normal distribution. But the secondary market for derivatives is much less liquid than the prices indicate, because these instruments are dominated by new issues, so you get lots of data that seems to be moving like a futures price, but in practice, you can't sell an outstanding issue at anything like these prices. When the market collapsed and many firms wanted to exit these positions, the losses were highly asymmetric, typical of credit cycles. One should apply annual worst-case-scenarios, applying the losses from the adverse cycles above, to anticipate correctly for such losses on these kinds of instruments. I'm only 42, but I've seen it many times, and every business line has managers who have a 10 year plus spotless record, but this is merely survivorship bias within the firm.

In sum, they appeared to make 3 key mistakes.

First, that warehousing AAA ABS paper added value to the bank. Warehousing prime paper funded at their AAA rate was merely abusing their internal funding. The profits from the portion they sold as mezzanine tranches was intoxicating, but left residual risk via the unpackaged debt (equity and super-senior) that only looked profitable because they were funded incorrectly. This massive residual was only tenable because it seemed to generate profits, not costs.

Secondly, their risk metrics were based on short, biased samples, and one should assume that any credit can be just like Telecom in 2001. Credit has to use long investment horizons, and highly asymmetric return characteristics, because that is the game. A bond is really like selling out-of-the-money puts on equity, because you make money 80% of the time, and lose 20%, and historically, the returns to High Yield bonds has basically been the same as Investment Grade. Don't expect to make money warehousing credits--its a cost of intermediating, not a benefit. Banks like UBS should recognize their value-add comes from intermediating, not warehousing. Warehousing is a residual effect as part of being a dealer, but there should be strict ex ante limits on this stuff precisely because any such assets on the balance sheet are, at best, treading water--any positive carry is from perverse funding rates, especially considering these are generally going to be first loss positions. Basically, the structured group was generating these fees, at seemingly positive carry, but it was implausible there was ever this much edge in the assets.

A final problem was the never re-underwrote the agency ratings. That is, they assumed AA rated paper would be ok, because it has, historically, a 0.05% annual default rate. But as mentioned, underwriting standards were changing, and the rating agencies dropped the ball. Now, with tens of billions of dollars at risk, one has an obligation and ability to re-underwrite this, and the changes in origination criteria should have made it clear these residential mortgages were different than those issued only 5 years ago.