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UBS Sets Things Right


By: Vidya Ram | July 15, 2008

LONDON - UBS stands by its "You and Us" motto by offering an olive branch to investors that it duped into buying auction-rate securities even after the market began to go down the tubes.

Late on Tuesday the bank announced that it was developing a vehicle that would repurchase up to $3.5 billion of auction rate preferred stock issued by closed-end tax-exempt funds, and would be eligible to all clients who held the stock in their UBS account on July 15. The clients will get all their money back as well as any dividends that are unpaid.

UBS closed up 10.4%, or 0.63 $1.87, at $19.83 in New York trading on Wednesday.

UBS's move is a response to the mounting pressure on brokerages which sold auction rate securities to their clients. Last month Massachusetts's top securities regulator, William Galvin, filed charges against UBS, alleging that UBS financial advisers sold auction rate securities to clients without making them aware of the risks, even when the market for the securities began to freeze. (See "Another Legal Headache For UBS")

Over the past two decades demand for auction rate securities, the long-terms issued by governments and corporations, which have their interest rates reset at periodic auctions, has soared. Corporate America, which has nearly $100 billion of these securities on their balance sheet, ignored the fundamental illiquidity of the assets, because of the regular auctions, treating them as a cash equivalent. (See "Auction-Rate Securities: From Bad To Worse")

However, when demand for the securities began to seize up, brokers like UBS began to write down not only their own assets, but those of their clients, and stopped buying back the bonds from their clients, as they had in the past.

Banks have tried to deal with the threat of litigation in different ways. HSBC, for example is buying back all the auction rate securities issued by municipalities and student loan companies, as well as some of those issued by closed-end mutual funds.

In comparison UBS's offering seems rather more paltry: the trust that it creates will buy back just some of the stock issued by closed-end mutual funds, which form less than a third of the $330 billion of the total market.

The auction rate stock of tax exempt mutual funds are also not those that have suffered the largest markdowns. As the auctions have frozen, a secondary market for these assets has developed, providing practically the only way of valuing the assets. In the secondary market the stock of tax exempt mutual funds are going at discounts of between and 10.0% and 12.0%, according to Espen Robak, the president of Pluris Valuation Advisors. That's against the 10.0% to 50.0% discount for securities issued by student loan companies, while there are some collateralized debt obligation linked assets commanding even larger discounts. "The reason why they have chosen auction rate preferred may be that they are not as seriously impaired. The student loan securities that they sold to their clients would have very significant potential write-downs," said Robak.

That's probably one reason why UBS says it's in discussions with the Securities and Exchange Commission, over the proposed structure, though a spokeswoman declined to comment. UBS says that it will begin to repurchase the stock about 30 days after it gets the necessary regulatory approval.

Though the stock will be brought onto UBS's balance sheet, the bank isn't proposing to buy it outright, but instead will be placed in the trust, and remodeled as a new kind of security, similar to variable rate demand notes, which will then be sold to money market funds. Like auction rate securities, variable rate demand notes have their interest rate set at periodic auctions. Unlike auction rate securities, clients who are sold the variable rate demand notes will receive a liquidity guarantee from a bank (either the bank that sold the assets or another backer) should the auctions fail.

By taking on these assets, that have continued to fall in value, UBS will add to its own risk position, but it clearly thinks it's a price worth paying. The bank says in the second quarter it will post either a minimal loss or just break even. Analysts estimate its write-downs for the three months ending June will come in at up to $8.0 billion. But its troubles don't end there: the reputational damage inflicted by its losses and a tax probe by the Department of Justice in the U.S. have hit the bank hard, particular in its staple, wealth management business.