UBS thought subprime was safer than Japanese Government Bonds

The Shareholder Report on UBS Write-Downs is very informative and interesting, but what I found most striking was the fact that UBS started buying US asset backed securities in 2002 because it thought that Japanese Government Bonds were too risky. This switch took place in the Relative Value Trading (RVT) portfolio used by central treasury to manage the liquidity buffer for the entire UBS Group. This portfolio was run by Foreign Exchange / Cash Collateral Trading (FX/CCT) within the investment banking business of UBS. The report states:

UBS created the ABS Trading Portfolio in late 2002 / early 2003 after Credit Risk Control (“CRC”) downgraded its country rating for Japan. This meant that FX/CCT had to reduce its then substantial holding of Japanese Government Bonds (“JGB”). Because FX/CCT retained the same level of funding liabilities and an unchanged revenue budget, it proposed to build up a portfolio of US ABS. In order for the assets to be a suitable replacement for the holdings of JGB that were to be liquidated, any replacement securities had to be:

• REPO-able;
• Highly rated - i.e. AA or AAA;
• Capable of being pledged to (one or more of) the primary Central Banks as collateral for UBS’s own borrowings; and
• Capable of being sold in the short term.

There were also a number of other advantages of ABS perceived at the time, including small spreads, USD denomination and no interest rate dependencies (floating rate instruments only in the portfolio). Because they had a higher yield (e.g. than government bonds), including ABS in the RVT Portfolio meant that there was no negative carry trade in the RVT Portfolio.

This reminds me of the famous statement by Mirabeau during the French Revolution: “I would rather have a mortgage on a garden than a mortgage on a kingdom”. The fate of UBS’ subprime assets has been only marginally better than that of Mirabeau’s assignats.

Posted at 9:44 pm IST on Tue, 22 Apr 2008         permanent link

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