Tuesday, December 11, 2007

UBS's Subprime Hit Deepens Credit Worries


UBS AG became one of the biggest casualties of the U.S. subprime-mortgage meltdown yesterday, announcing that it would take a $10 billion write-down and sell a chunk of itself to the government investment arm of Singapore and an unnamed Middle Eastern investor.

The disclosures stoked anxiety about potential losses lurking on the books of other banks. That UBS, long known as a conservative lender, could take such a financial hit suggests that the wave of industry write-downs, which so far total about $50 billion, may be far from over.

In recent weeks, UBS began using a more conservative method for valuing complex debt securities tied to U.S. subprime mortgages. As a result, the bank said it might record a net loss for the year. The "ultimate value of our subprime holdings...remains unknowable," the bank said yesterday.

The news came as other financial institutions announced moves to shore up their balance sheets. Washington Mutual Inc. said it plans to cut its dividend, slash jobs and sell preferred stock to raise $3.7 billion in capital. Bond insurer MBIA Inc. said it will receive up to $1 billion from private-equity firm Warburg Pincus LLC.

Earlier this fall, as banks disclosed a first round of write-downs due to subprime problems, some investors expressed optimism that the worst was over -- that banks had used the third quarter as an opportunity to clean up their balance sheets. But the continuing erosion of the value of the mortgage securities now appears to be bringing another round of pain.

UBS, which had already taken a $4.4 billion third-quarter write-down, said that as mortgage data worsened, it changed the way it fed data into its model for valuing mortgage securities. Among other things, it began factoring in higher projections of homeowner defaults and comparing its loss projections with indexes that track the value of mortgage securities. It concluded that it needed to assign a lower value to its holdings.

UBS's decision to sell as much as 12.4% of the company to Singapore and the Middle Eastern investor for $11.5 billion is the latest in a string of deals in which state funds or banks in Asia and the Middle East have taken stakes in Western financial firms. Government "sovereign-wealth funds" have invested about $46.8 billion in European and U.S. financial firms since January 2006, according to Morgan Stanley estimates. The UBS deal comes just a few weeks after Citigroup Inc., also hobbled by subprime problems, received a $7.5 billion investment from the Abu Dhabi Investment Authority, which will ultimately own a 4.9% Citigroup stake.

"It is a further sign of how the balance of the world economy is changing," says Gerard Lyons, chief economist at Standard Chartered PLC in London. "Also it is a reflection of the current fragile state of the financial sector in the West."

At the heart of UBS's problems are collateralized debt obligations, or CDOs. These complex securities are created when pools of debt, some of it tied to subprime mortgages, are sliced into pieces carrying different levels of risk and return, then sold to investors. UBS's exposure is through a combination of internal, or proprietary, trading positions, as well as its underwriting business.

Like other banks, including Citigroup and Merrill Lynch & Co., UBS ended up with CDO slices considered the safest. But in recent weeks, banks have had to write down even those senior slices. Merrill Lynch and Morgan Stanley also took write-downs on such securities.

Using computer models to figure out how much such securities are worth is an inexact science. November mortgage data showed that mortgage delinquencies and defaults were increasing, which contributed to UBS's decision to take a large write-down.

Merrill, which has $15.2 billion in CDO exposure remaining, could also need to take a further write-down, as could Morgan Stanley, according to analysts. Merrill already disclosed a third-quarter write-down of $7.9 billion, and it has $20.9 billion in remaining exposures to CDO assets and subprime mortgages. Morgan Stanley has already taken a hit of $3.7 billion in the first two months of the fourth quarter, which could grow based on its $6 billion in remaining subprime and CDO exposure.

In a speech to Morgan Stanley employees last Monday, Chief Executive John J. Mack said the firm is still trying to clarify the extent of the subprime losses. The subprime losses, he said, aren't easy to quantify because the markets keep changing. He said the firm expects to have a better read in the next week and a half.
[From East to West]

Merrill Lynch and Morgan Stanley declined to comment.

As U.S. homeowner-default data worsened in recent weeks, it became clear that UBS might need to mark down its subprime assets further, which could in turn put pressure on its capital base. Starting about two weeks ago, it approached a handful of potential investors, says one person familiar with the situation. The Middle East was an obvious place to look, because many Gulf states and their ruling families have money at the Swiss bank. Asia also made sense because UBS's investment bank is active there.

UBS Chairman Marcel Ospel called Singapore government officials he knows, according to another person familiar with the matter. The Asian city-state is an increasingly important market for UBS's core business of private banking for wealthy individuals. It took only about a week to put together the deal. The Government of Singapore Investment Corp. agreed to invest 11 billion Swiss francs ($9.75 billion) for a stake that could range from 7.3% to 10.5%, depending on the terms of the convertible-stock purchase. The deal makes Singapore UBS's largest shareholder.

UBS didn't disclose the name of the second investor, which it said will invest two billion Swiss francs for a stake of between 1.3% and 1.9%. One person familiar with the deal identified the second investor as one based in Saudi Arabia.

The bank is continuing to talk with other investors around the globe in an effort to raise additional funds, Mr. Ospel said yesterday.

For sovereign-investment funds, investing in banks and financial institutions is attractive because of their depressed stock prices. UBS shares, for example, are down 24% this year. Such deals also are opportunities to link with firms offering expertise in financial services such as private banking.

UBS joins a growing list of Western banks, including Barclays PLC and HSBC Holdings PLC, that have received capital injections from Asia and the Middle East this year. The sovereign funds "are really smart and are getting to see a huge number of opportunities around the globe at the moment," says Guy Cornelius, a managing director in Lehman Brothers Holding Inc.'s fixed-income department. "They see so many opportunities because they have the best growth in capital right now, are highly sophisticated and know that they can be in the driving seat."

Such deals, however, could spark more governmental inquiries in the U.S. and Europe. Last month, the U.S. Senate Committee on Banking, Housing and Urban Affairs held a hearing on sovereign-wealth funds. In addition, the Group of Seven leading industrial nations is taking steps to address the increasing influence of sovereign-wealth funds. G7 officials are concerned the funds may become a source of volatility in financial markets or cause national-security problems if they seek stakes in companies that are sensitive from a national-security standpoint.

Zurich-based UBS, formed from the 1998 merger of SBC Corp. and Union Bank of Switzerland, has about 83,000 employees and is one of the largest wealth managers in the world. Last year, it reported a net profit of 12.26 billion Swiss francs. But it has struggled with its identity in recent years. It pushed aggressively into investment banking, but at times its investment bankers chafed at the Swiss bankers' historically conservative culture. It reached a boiling point earlier this year when several high-level investment bankers left.

Soon after, losses began to mount at UBS's internal hedge fund, Dillon Read Capital Management. Chief Executive Marcel Rohner is now pulling back in some areas of investment banking, cutting bankers in fixed income and toughening its lending requirements to hedge funds and leveraged-buyout houses.

UBS has never posted a full-year loss, mainly due to the strength of its wealth-management operations, which in 2006 accounted for about 40% of the company's profits.

UBS's holdings tied to subprime mortgages eroded its core "tier 1" capital to about 10.6% at the end of September and came close to falling below a UBS internal target of keeping capital in double-digit figures. Traditionally, the bank has tried to maintain a high level of capital relative to peers because some of its wealth-management clients tend to be sensitive about its financial health, the bank said. The capital-raising measures announced yesterday will raise the bank's tier 1 capital to 12%, the company said in a statement.

In recent weeks, as the mortgage data deteriorated, the bank made changes to the way it crunched the numbers, including lowering the time it assumed it would take for a loan to default.

Mr. Ospel said UBS decided to "calibrate our models to an extreme distressed scenario." That ultimately led to the write-down.

"This is a very bleak outlook" for the U.S. housing market, Mr. Rohner said.

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