Tuesday, March 25, 2008

UBS no longer a haven

The Quote of the Month

“Please, God, just one more bubble!” quoted from Warren Buffet’s 2007 Letter to the Shareholders of Berkshire Hathaway

The Position of the Month

Stock: UBS
Position: Short

Basic Position Opening Price
Above $30
Basic Position Expected closing price
Below $15
Advanced Investor Position Opening Price
Buy UBS $35 Jan 09 puts at $8.50 / contract or lower
Advanced Investor Position Closing Price
Sell to Close at $19 / contract

The Summary

UBS is overleveraged and delaying an inevitable unwind. In the meantime, it is destroying centuries old customer confidence in Swiss banking.

Currently UBS is in a state of crisis. As Jim Cramer once said "Whenever you smell smoke, behind the door there is probably a giant conflagration!" The smoke is currently seeping out of UBS in the form of desperate measures to raise liquidity.

* UBS recently dumped $25B Alt-A mortgages due to liquidity concerns

“Analysts said they believed UBS had sold its Alt-A investments -- U.S. mortgages ranked between prime and subprime – to bond manager Pimco for 70 cents to the dollar, taking a deep discount on a 26.6 billion Swiss franc ($25.7 billion) portfolio.” Chris: A sure sign of cash concerns is bulk sales of loans.

* UBS still holds $400B in repurchase agreements for funding

“Analysts also said they expected the ailing bank making further writedowns on a massive 400 billion franc portfolio of repurchase agreements as it rushes to cut its exposure to the capital markets in general and to risky assets in particular.” Chris: This just shows how many assets they are holding out to avoid liquidating in an unforgiving market.

UBS tried to sell it’s Paine Webber brokerage arm to raise cash

“Swiss bank UBS, another bank suffering from the credit crunch, recently shopped its PaineWebber brokerage unit in an effort to drum up cash but failed to find the right buyer. (BAC, Wells Fargo and Barclays all declined).”

UBS needs to raise cash in a unforgiving market. There are tons competing assets sales, but all the potential customers are overleveraged and marketing the same securities themselves or prudent and choosier by the day. UBS needs to find solutions fast, while the clock on $400B in debt deteriorating in value is ticking away.

The Story

In the movie Die Hard, the evil villain says that after stealing $20m in bonds and lock safe baubles, he planned to store them in a “Swiss bank account and sit on the beach collecting 6%”. He might want to rethink that strategy.

For much of the 20th century Switzerland was considered the world’s safe haven for banking. African dictators, European despots, and Nazi war criminals all found it an oasis for savings in tumultuous times. In the latter part of the century, Swiss banking consolidated to two names, Union Bank of Switzerland and Credit Suisse.

At some point all this revere and sticky old money was not enough. The old money wanted higher returns and hedge funds came en vogue. UBS, providing the connections to the massive money of the old world, became a key prime broker to the hedge funds. Prime brokers are the home for hedge funds, housing them, executing their trades, finding investors, providing reports, cleaning up accounts, and even providing seed money and loans. This is very profitable considering 33% of volume in the market is hedge fund activity.

While times were good, the relationship was cozy. Now that the order of the day is deleveraging and the levered hedge funds, stuck in illiquid positions, are now more of a liability than an asset. The loans outstanding at UBS total more than $400B and cash on hand is $19B. Sounds impressive, but Bear had $17B on hand the day it folded. With the obvious implied leverage there is no doubt in my mind that UBS has been busy at the Fed discount window trading securities for treasuries that people will take for cash. The problem is that the Fed is lending only for 28 days. Every 28 days the value of the mortgage backed securities that UBS directly or indirectly is exposed to goes down in value. The house decline will not stop any time soon. So the predicament at UBS will continue to be more precarious as the weeks go by.

The Scorecard

Position #1: C

Direction: Short
Start Price: 27.3
Current Price: 23.78
Start Date: Jan 13, 2008

Position #2: UBS

Direction: Short
Start Price: Not reached yet
Current Price: 29.56

Start Date: TBD

Things are amiss in Gotham Citi

Quote of the Month

Proverbs 22:26-27 "26 Do not be a man who strikes hands in pledge or puts up security for debts; 27 If you lack the means to pay your very bed will be snatched under you"

Position of the Month

Position: Short
Opening Price: Above $27
Expected closing price: Below $16
Horizon: One year


Citi is unwinding leverage in the capital markets while facing a deteriorating consumer credit business.

Position of the Month:

The Citi is in trouble, and everyone knows it.

The previously largest bank by market capitalization in the world is trying to get hold of all the problems threatening the company. The unwinding of off balance sheet debt positions (think Enron) led to the ratings agencies attempting to downgrade to junk six of their seven off balance sheet companies. In the last minute before six of the seven SIV companies were downgraded to junk, the SIVs were adopted on to Citi’s balance sheet. What remains of the $100B of asset backed securities that Citi was caught holding the bag with, $43B of the securities still remain.

But that was the first issue. Citi seemed to lending to it’s citizens seems to be too lax. Citi also purchased two subprime insurers at the top of the market that continue to cause writeoffs as the loans deteriorate. In addition, Citi took positions is securities and derivatives that analyst William Tanona estimates gives the company 37B exposure to subprime mortgages. This issue will continue to haunt Citi as the market reprices homes from the top of the market.

The bottom line for Citi is that mortgage losses, credit losses, and derivative losses all draw cash away from the bank. Unhedged long term positions threaten to bring the banks capital ratios down below the capital requirement levels required. If the people of Citi think the bank cannot repay, they will be very likely to take their deposits elsewhere.

Ok things are bad, but what is next for Gotham?

From the transcript of the Citi 4th quarter conf call…

"The American consumer is losing net worth at phenomenal rate with the decrease in housing prices. The Case & Schiller index of home prices indicates we are only in the second year of five year retreat in home prices. Much of the consumer economy of the past ten years has relied on or was financed by the increase in home prices. As the prices fall companies like Citi will have larger and larger draws on it’s available cash from it’s consumer operations to fund it’s illiquid leveraged positions, managing bank capital ratios against decreasing asset values, and continuing losses from lax lending areas from auto loans to credit cards."

Economic Outlook:

“Pyramid schemes and chain letters collapse because there is no more credit to feed them. As the system of modern day levered shadow finance slows to a crawl, or even contracts at the edges, its ability to systemically fertilize economic growth must be called into question.”

Author William Gross, “Pyramids Crumbling”, Investment Outlook, January 2008



The current unwinding of financial markets is repricing risk from historically low levels. When price trends reach the end of a cycle and start retracing prices tend to overshoot, not revert to the mean. So we can expect significant increases in the cost of consumer credit over the next couple of years.

To support the point refer to the CFO of Citibank as reported in the New York Times (1)

“Mr. Crittenden, the chief financial officer of Citigroup, had a different message on Tuesday, as Citi disclosed an $18.1 billion write-down. He told analysts that Citi was raising rates on credit cards and tightening the amount of credit it would extend. Asked by an analyst whether credit card lending was an area where Citi might want to “pull back or increase pricing,” he responded, “All of the above.”

Crittenden continues...

"Low Federal rates of turn of the century led to a credit boom with lax lending standards. Now that lenders are getting burned, the spigot is being turned the other way. This bodes poorly for overextended consumers.

Again the NYT reports…
“Citi is not alone. While the tighter credit market has not stopped credit-worthy individuals or companies from obtaining loans, it has made loans more expensive for many of them, and left those with the greatest need for cash far less able to obtain it.”
“They are parceling out credit with a keen eye on the balance sheet,” said John Garvey, the head of the financial services advisory group at PricewaterhouseCoopers. “There is a flight to quality and a renewed focus on risk.”

(1) “An Effort to Stem Losses at Citigroup Produces a Renewed Focus on Risk” by Floyd Norris