Editors letter: There’s only one lesson to learn from UBS
UBS has done a service to all investors in bank stocks and bonds by making public the report requested by the Swiss Federal Banking Commission into the root causes of its sub-prime losses.
It’s on UBS’s website; it’s 42 pages long and we recommend you read it and ask yourself how much of this applies to every other leading bank. If 42 pages sounds a bit daunting, we suggest you start on the last page, when the report finally cuts to the real heart of the matter.
If you do that, you’ll miss some intriguing, astonishing and at times toe-curling revelations. You’ll miss chapter and verse on the chaotic creation of DRCM, the internal hedge fund that plucked out its top fixed-income traders just when the investment bank was aiming to bulk up in fixed income, sabotaged senior management succession planning, robbed the investment bank of good risk managers and left the bank’s top executives utterly distracted by the misbegotten implementation of an unproven hedge fund business model reporting inside UBS’s asset management division but exposing its investment banking division to risks.
You’ll miss the many mistakes in risk management. You won’t read how the bank used a five-year history in which asset-backed securities enjoyed low volatility to conclude that, if it insured super-senior positions against just 2% in losses they could count as fully hedged and so could be dismissed from firm-wide value-at-risk stress tests on the basis they had been de-risked.
You’ll miss the hilarious episode when the bank’s own treasury has to stop investing its surplus liquidity in high-quality Japanese government bonds, following a lower country risk limit being taken on Japan, so starts to invest instead in US ABS on the grounds that they are triple-A rated and repo-able.
You’ll miss also the admission that in its risk assessment of CDOs of ABS, the bank didn’t look through to the underlying collateral and so failed to weigh factors such as, oh, underlying mortgage delinquency rates, Fico scores, vintage, whether debts were first or second lien, price developments in the housing market.
You can take as read the process whereby huge underwriting positions in CDOs – of a size which in any other division of the investment banks would have required approval from commitment committees of senior bank executives – were nodded through by more junior staff on the basis that, look, the collateral is already accumulated and the deal ramped up, what are we going to do, unwind it all?
You’ll simply have to assume the sheer wishful thinking that characterized the bank’s formulation of strategy. Senior management wanted a more profitable fixed-income division that could close the gap on the industry leaders and allowed itself to be convinced that this could be achieved, and the balance sheet expanded, without taking on more risk.
Skip past all this and you’ll get to the heart of the matter. The final page deals not with business strategy, trading, risk management and controls or financial reporting. It deals with compensation.
Employees were paid not on the basis of their skill in generating alpha but simply for taking UBS’s low-cost, short-term funding and ploughing it into high-yielding sub-prime-related assets. This provided incentives to several separate businesses to build up concentrations of carry trades in mezzanine CDOs. Bonuses were paid on the basis of P&L on these trades at day one. Such bonuses exceeded the long-term incentives in deferred equity that should have made traders and their bosses pause and think about the effect of their actions on UBS’s brand and franchise value.
Here we quote: "Essentially bonuses were measured against gross revenue after personnel costs, with no formal account taken of the quality or sustainability of those earnings."
Sadly, in banking, it was ever thus. Readers may be losing their appetite for the history of the sub-prime crisis. But the industry will be vulnerable to the next crisis, and the one after that, until the day its leaders grasp the one issue they don’t want to touch: they must take a more rational approach to how some of the best-paid professionals in the world are compensated.