Kids, we have some fascinating reading in store for you this weekend.
The "conservative" Swiss banking giant UBS — and I put that in quotes for obvious reasons — wrote down a previously unimaginable $37 Billion dollars. Their shareholders were (ahem/cough) quite perturbed. So the nice folks at UBS, with an assist from KPMG, put together a 50 page report detailing the hows and whys UBS took such a humungo hit.
For what you would expect to be a dry report, it is absolutely compelling reading. It explains much more than the subprime fiasco. The report implies that management didn’t really understand what the hell they were getting into with their purchases of Warburg/Dillon Read Capital Management. This unit eventually became UBS’ internal hedge fund (it has since been shut down).
I wonder if management ever truly understands the nuts and bolts of these large acquisitions. We will find out if JPM knew what they were getting into getting the Fed into with the Bear Stearns (BSC) acquisition.
The report includes an indictment of the firm’s compensation packages. The current structure — big salaries and bigger bonuses — encourages the riskiest and most short term of strategies. Prudence, risk management, and long term thinking were not money makers for employees. When the time came for the company to take its writedowns, many of these bad actors were long since gone. Go on, take the money and run.
You may not be surprised to learn that external consultants were involved and recommended "streamlining of risk processes." I don’t know if these unnamed consultants were McKinsey & Co., but the whole description has a faint Enron-like smell to it.
A few other questions arise from the report:
Why do very risky strategies seem to end up in Fixed Income ?
How did Risk Control fail so badly?
Why was there an "Absence of risk management" and "Incomplete risk control methodologies" ?
Who created these compensation system ?
Again, this is just the tip of the iceberg in terms of asking what went wrong.
I wonder if this the inevitable banking equivalent of the Minsky moment. Perhaps these megabanks are simply too big, too unwieldy to be appropriately managed as hedge funds, rather than sleepy conservative banking institutions. The perverse incentives encourage reckless behavior.
Fascinating stuff . . .
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Sources:
Shareholder Report on UBS’s Write-Downs
18 April 2008
http://www.ubs.com/1/e/investors/agm.html
UBS ShareholderReport.pdf (download)
Related:
A good name sliced, diced and traded
John Gapper
FT, April 24 2008 03:00 | Last updated: April 24 2008 03:00
http://www.ft.com/cms/s/0/51099762-1198-11dd-a93b-0000779fd2ac.html
How UBS came undone
Roderick Boyd
Fortune, APRIL 23, 2008: 4:38 PM
http://money.cnn.com/2008/04/23/news/companies/ubs_deflates.fortune/
Too many risks, too few controls, says UBS report on write-downs
David Gow in Brussels
The Guardian, Tuesday April 22 2008
http://www.guardian.co.uk/business/2008/apr/22/ubs.europeanbanks
I can’t believe I’m going to recommend this but CNBC had an incredible run of clips yesterday with Stiglitz and Hormats along with interviews with El-Arrian and Roubini. All are well worth listening to (take notes there’ll be a quiz) because it frames the problem. The one most germane here is one segment the guest was Bob Engle, also a Nobelist, and who’s work was used as the basis for much of the modeling. As both he and Stiglitz point out there were deep flaws in the way the models were applied because folks didn’t really understand them. A perfect complement to the UBS coverage.
I watched that yesterday — its already queued up to post later this weekend.
Here are two issues to be addressed…until they are, I will stay away from U.S. Stocks.
1) Overvalued stocks cause company management to make stupid decisions. I believe most U.S stocks are overvalued, as the S&P trades at 22 times trailing earnings. Not only is this at a level (outside recent bubbles) that has been major tops in the past, it is worsened by the fact that margins have been at record levels and the very basis of capitalism suggests that must mean revert with creative destruction. If anyone says the market is not expensive, they are basing it on forward looking guesses and only comparing it to recent bubbles when it was even more overvalued.
2) The structure of publicly traded companies is based on the tenet that management is responsible to the shareOWNERS…management actually reports to the shareowners. In a pizza place, the owner is the manager’s boss. In U.S. Companies, the executives (managers) act like they own the place and answer to nobody but themselves and with good reason…they own vast amounts of shares too. While employee ownership is based on the concept of aligning management and shareowners, I believe it has become distorted. Like Barry said, they are only interested in short term, risky strategies to cash in their options, which are awarded by themsleves basically. Also these COOs, CIO, CFOs and certainly CEOs and their direct reports are likely all multi-millionaires and have little concept of what is going on with Joe Sixpack.
The very basic tenets of equity ownership are being trampled on and many people buying stocks today don’t care to or don’t have enough shares to hold management’s feet to the fire. For example…does anybody buying IBM consider that IBM will have 25% of their employees in India by 2010? They are selling out their U.S. workers to beef up the bottom line and thus their own pay packages. Buy that stock and you are tacitly endorsing this. Yet many buy IBM simply because they beat by 2 cents or Cramer or some analyst said so.
«For example…does anybody buying IBM consider that IBM will have 25% of their employees in India by 2010? They are selling out their U.S. workers to beef up the bottom line and thus their own pay packages. Buy that stock and you are tacitly endorsing this. Yet many buy IBM simply because they beat by 2 cents or Cramer or some analyst said so.»
But that makes double winners — their shares go up, and their neighbours become poorer and this moderates inflation and enhances the buying power of their increasing wealth.
«The report is practically an indictment of the entire iBanking sector’s compensation packages. The current structure — big salaries and bigger bonuses — encourages the riskiest and most short term of strategies.»
But this report is a classic part of that game. Since compensation is tied to increases in value, it pays for new management to paint as black a picture as they can and take as many charges and losses as possible when they start, so they start from a low base and can get higher compensation.
This is the Minsky story said another way: executive compensation is a call option, and they more valuable the lower of the initial price is. Compensation is higher the more volatile a company;s fortunes are.
If you are paid 10% of the increase of stock price of a company, which sequences of stock price level are more profitable for you:
1) 100 110 120 130 => compensation is 3.
2) 100 40 70 100 => compensation is 6.
This is not even finance, it is basic arithmetic.
Goldman Sachs’ Hormats had to translate for us common folk (irony there), and of course spin it as much as possible. Imagine if Stiglitz could really speak his mind, but alas, being in the club and having friends in the financial sector, he has to pull punches and soften the real truth.
“Since compensation is tied to increases in value, it pays for new management to paint as black a picture as they can and take as many charges and losses as possible when they start, so they start from a low base and can get higher compensation.”
I don’t fully agree with this…maybe the new CEO wants to kitchen sink the losses, but I guarantee you those feeding him the info are trying to paint the brightest picture to cover their own blunders. I used to feed certain metrics to the CEO in a past life and I guarantee you my supervisors wanted the best possible spin at all times to go the the CEO.
What’s interesting to me is that this kind of news is every day yet we stll have some who feel it is no big deal.
Not only do you have the end of the debt machine, we have inflated energy which has some of the same smell as Enron too.
Here is some FYI from the trenches:
My business is seeing direct losses at the margins due to people’s inability to pay for “as much” or “at all”. Just do with out.
A large regional manager I know confided in me some of his franchises can’t cover their notes or make payroll. Layoffs are coming and this is a company you would never expect.
A local regional bank is now charging .50 cents for all ATM/debit card transactions.
And…the most important inside info…my wife can’t believe there are “no” sales in the super market. she couldn’t beleive it and she would know. She’s a hawk for these kinds of things.
We all need to stop debating the obvious and start talking about what are the best moves going foward.
It looks as if stock options should be made illegal.
Big Al…I think restricted shares are much better than options, but tie them to long term performance only…and they should not be enough to turn middle managers into multi-millionaires.
The other problem with options…as soon as they vest, they are exercised and dumped…increases the float.
It wasn’t a writedown; it was a slowdown in profits – George Bush
Stock buybacks are another game for the insiders that has long term consequences. They raise EPS, sop up the excess float from option grants, asnd does nothing to materially improve the corporation. Meanwhile, spending on R & D, new equipment, salaries, health care, etc wanes. I do not know how you quantify this but down the raod we will end up with weakened corporations and bloated, rich retired execs.
IBM has bought back $94 Billions in shares since 1995.
If Wipro and Infosys are experiencing a cratering of business, when does that blow IBM’s latest gimmick out of the water?
No conversation about the long-term risk management track record of UBS is complete with at least a footnote about its exposure to the Long Term Capital Management failure.
Larster is 100% correct. We’re going to be learning a very hard lesson very soon. Not only is the money long gone, but that money was also supposed to be used on capital expenditures and other productive investments, so we’re going to get hit with the same tab many times over.
As a charter member of the Former UBS Traders Club (left on my own accord a few years back to do something useful with my life), I can say that while, as our host points out,
“[t]he perverse incentives [of ibanking] encourage reckless behavior,”
UBS was the proverbial fool at the poker table. Our managers, nice guys all, truly nice, were idiots. Our quants had great analytical ability, some could have contributed in a real way to the field, but you wouldn’t trust them to balance your checking acct. As for Mr. Jenkins, who gets roasted in the report, well, let’s just say he had a remarkable, almost Clintonian, ability to, ahem, obfuscate.
UBS = nice guys playing way out of their league.
To borrow a comment from Mrs. Z.- since the financial sector ( fed. included) of our economy cannot participate in the process of creative destruction, it has a tendency to engage in ” destructive creation” of credit/ liquidity.
It is worse than Enron. It was State sponsered, international and systemic. This is the ‘modest’ S&L crisis on steroids.
Zell. ‘Destructive creation’. Very apt.
UBS $37B Write Down, Part II
Buried at the end of the report is the criticism of the financial compensation system in place at UBS for traders and the engineers of structured products. The bigger question is how little their system differs from any other large bank or brokerage fi…
Steve Barry commented:
“For example…does anybody buying IBM consider that IBM will have 25% of their employees in India by 2010? They are selling out their U.S. workers to beef up the bottom line and thus their own pay packages.”
I understand, but the job of IBM’s execs is to promote IBM business (which has always been global). That it fattens their pay packages is a coincidental, not necessarily an evil scheme.
Do you see an alternative?
Oh, what a tangled web we weave…
Why, exactly, is it necessary to have off Balance Sheet entities in the first place? I’ve heard a lot of excuses — including to mitigate risk. Anyone heard how that’s working out for, say Bear? (I figure they hocked “Stearns” by now, so I dropped it).
While I’m sure these entities were somehow a good idea at the time, I can’t invest in companies that use them, because — as I suspected, they cannot be assigned a value. All a body can do is rent these stocks, because of their Rube Goldberg structures — which are obviously rather delicate.
k
>> Warburg/Dillon Read Capital Management. This unit eventually became UBS’ internal hedge fund (it has since been shot down).
“Shot” or “shut” down? Actually…”shot” works well, too!
~~~
BR: Fixed!
EDF:
It is a difficult issue…the bottom line though, is if we want to be global, we will be importing the much lower standard of living from other countries as well, because an engineer in China and India may work for a fraction of what an American will work for. Just knnow that when you buy IBM, you should be fully aware of this and don’t care if an American’s job is shipped to India so IBM can earn a few more cents.
Would IBM ship jobs to India if, because of it, management’s salaries went down? High unlikely they would. Yet they will ship them to India even though their domestic employees will be fired, or the employees’ salaries will go down because of it. What would happen if the employees were making these decisions, and not management?
Having read the UBS document, I have to agree with Barry Ritholtz on the idea that these banks are just too unwieldy to operate in the areas they’ve branched into. These are essentially really huge hedge funds without a) the talent or b) the capital.
The smartest hedge fund managers I know realize there’s a finite limit to how far they can stretch themselves and their firms. This is why the very best start giving back the cash to investors and limiting the size and scope of their funds. Unfortunately, this model doesn’t work for public firms who feel the pressure to keep expanding at 10-15% each year….which of course is mathematically impossible for every company to accomplish.
I remember during the explosion of hedge funds in 2003-2006…talking to friends and concluding: There are just not that many bright people out there to manage all that capital. The lucrative world of hedge funds took the best people from the public firms and left behind second or third rate talent…
AT
“if we want to be global, we will be importing the much lower standard of living from other countries as well, because an engineer in China and India may work for a fraction of what an American will work for.”
Steve you are right on the money, except I don’t think ‘we’ have a choice. Companies are mandated to optimize, not sympathize. Not going global is not going to happen. Any yes, there really is no Diety granted reason that the people in the US will (should?) live better than others living elsewhere in a global world.
If this happened to UBS doesn’t this prove that US financial regulators weren’t at fault in this mess?
The UBS paper is a fairly honest account of the problems that are probably evident at many of the largest financial services companies. Many of these companies are too big, political and complex to manage. In my experience, most of these firms are suffering from the same problems with data, modeling and management incentives. Add in silly amounts of leverage and you really have some serious problems. This has always been about solvency IMO and only has fairly transitional liquidity elements.
«In my experience, most of these firms are suffering from the same problems with data, modeling and management incentives. Add in silly amounts of leverage»
There is only one problem: incentives, and the others are just symptoms. Given the incentives of the executive class, management maximize their income by assuming ridiculous leverage, making sure that the most adept data gets collected and models get defined.
«and you really have some serious problems.»
Who is “you” here? It is not the executive class, the guys who make the big economic decisions and “sponsor” the careers of the politicians who make the big political decisions like bailouts.
The executive class have no problems, except perhaps holding their sides while they laugh all the way to (foreign) banks where they have their personal fortunes; the political class sponsored by the executive class are much in the same situation. The “you” who have some serious problems are the losers and suckers who pay taxes, who pay rent, and who have to fill the holes left from the looting because of “too big too fail”.
«this has always been about solvency IMO and only has fairly transitional liquidity elements.»
When there are lots and lots mortgages around, $500,000 mortgages on $200,000 properties, yes, that’s a solvency problem. It is a problem for the greater fools who paid the $500,000 for the properties, and for the greater fools who paid near present value for the $500,000 mortgages.
It is surely not a problem for the winners who sold those properties and mortgages for $500,000…
«It is a difficult issue…the bottom line though, is if we want to be global, we will be importing the much lower standard of living from other countries as well, because an engineer in China and India may work for a fraction of what an American will work for.»
But it is not just that: you also import a much, much better lifestyle for asset owners, as the ratio of labor to capital increases. Whether importing a much better lifestyle for asset owners is more important than importing a much worse lifestyle for engineers is a political question, and it is asset owners who pay political campaign contributions, not engineers, and the outcome is then clear.
“What would happen if the employees were making these decisions, and not management?”
Good point. While IBM employees have no pension plan as of this past Jan 1, Sam Palmisanno still has his $10,000 a day pension.
It has nothing to do with skills. The more you train and retrain, the larger the differential the pay gap becomes.
FWIW, I linked to your post and my StatCounter tells me that Boston Consulting Group (Swiss URL origin) Googled UBS.