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Another fine mess at UBS

When Meriwether invited Union Bank of Switzerland to eat a special dish with him at high table, it seemed too good to be true. It was. Why did a bunch of Swiss bankers rush in where the rest of Wall Street feared to tread? By David Shirreff.

The eve of destruction

Collateral damage

There is no better example of desire outliving performance than the trade that UBS did with Long-Term Capital Management (LTCM) in 1997. When LTCM was riding high and a 40% return each year seemed feasible, potential investors were clamouring for a privileged piece of the action.

Among them was Union Bank of Switzerland. During the course of 1997 it struck up a relationship with LTCM by taking a combination of equity and equity option positions in the fund. UBS, which on October 2 described the transaction as "exceedingly complex", has released only limited information on the deal.

In three tranches UBS sold LTCM the right to buy from UBS a fixed number of shares in LTCM's own fund. The [European-style] options with a premium value of $300 million could be exercised in seven years' time. To hedge its position, UBS bought shares in the fund to the value of $800 million.

This transaction was priced to approximate an $800 million floating rate loan. It earned UBS the much coveted opportunity to invest $266 million directly in the fund.

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