April 6, 2008 – Today’s “Sunday Business” section of The New York Times is a “keeper.” It contains several fine and germane articles which will bear reading again and again as time passes and as events in the financial world continue to develop.

The lead story is about the subprime-mortgage travails of UBS, the giant of Swiss banking, which was formed as a merger of Union Bank of Switzerland and Swiss Bank Corporation in 1998. UBS found itself with a total exposure of $80 billion in less-than-stellar mortgages, some of which had been posted by its Dillon Read subsidiary. To date, it has written down $37 billion, which is more than Citi, or Merrill Lynch, or any other bank anywhere, has written down.

UBS had bought mortgage-backed securities through usual Wall Street providers, beginning about 2005, in an effort to catch up with Merrill Lynch and Bear Stearns, which were ahead of the pack in this end of the business and making money hand over fist in so doing. UBS had not made loans directly to homeowners.

Its Chairman, who will be resigning, said that he first learned of the exposure of $80 billion when he came back from vacation early in August, which was three months after its Dillon Read Capital Management hedge fund was shut down following large trading losses, and six weeks after two Bear Stearns hedge funds collapsed. He blamed UBS’ failure to comprehend the risk on a misreading of the market for mortgage securities and on a breakdown in its risk-management apparatus. The Times quoted the chairman as saying “The key issue is that the system operated within its limits, given the assumed quality and liquidity of the assets…Clearly, there was a problem when you build such a concentrated exposure and it doesn’t appear on any of the appropriate radar screens.”

And then there was the bureaucracy. Major investment decisions required the approval of the management committee; then a special risk-assessment group had to sign off; then the Group Executive Board – or sometimes the Chairman and two other senior executive officers would bestow a blessing, or not. That’s a lot of committees. A former senior trader at Dillon Read was quoted as saying “No one got out unscathed. But the committee process inhibited UBS from acting quickly.”

Several observations come to mind:

• While not specifically mentioned in the article, it would seem that UBS, together with many others, relied upon the rating agencies’ characterization of mortgage-backed securities as worthy of the “AAA” designation. One wonders, in retrospect, about the justification for placing so much reliance upon others’ judgment concerning the inherent value of a “security” whose father (or fathers) remained anonymous. “The system operated within its limits, given the assumed quality and liquidity of the assets.” Was an $80 billion exposure justified by “assuming” that the rating agencies were correct in their analysis? Was the reliance total, or was independent analysis performed? (But then, how could there be, since tens, or hundreds, or perhaps thousands of individual loans were bundled in one package – “take it or leave it. Parent unknown.)”

• One wonders about the extent of liability of the rating agencies themselves in all this.

• UBS may have thought that, since very numerous individual loans constituted a particular package, it was buying “diversification.” The problem was that it was not “diversification” at all; rather it was concentration within one particular asset class.

• Obviously, work needs to be done on UBS’ risk-management system. The “appropriate radar screens” need to be re-evaluated.

• And finally, perhaps this unfortunate loss demonstrates the inherent vice in a layered, bureaucratic, committee system which intends to promote operational efficiency but, instead, results in rigidity and management insulation at precisely the time when fast problem-recognition and action “on the ground” is imperative in order to forestall disaster. Management was asleep.

I have a foreboding that the last chapter hasn’t yet been written. There may be more bullets yet to be bitten at the major banks with respect to subprime mortgage loans. And then there is the whole question of derivatives, a trading game in which the banks are highly-leveraged enthusiastic participants. Mr. Buffett himself has warned us about that; and based on his past performance, perhaps we should pay attention. It’s not so much the potential loss of investment that can hurt; rather, it’s the leverage that could take down some very large players.

William Kurtz
http://www.candlewave.com