Case Study: Equity Derivative Losses at UBS
In 1997, United Bank of Switzerland lost heavily in the equity derivatives market, with estimated losses pegged between $400 and $700 million. It is said to have lost $700 million in long positions in LTCM (Long Term Capital Management). The UBS case speaks strongly for strong internal risk control measures and adherence to the same.
UBS even at that time was extremely tight lipped about what really happened. It transpires that UBS equity derivatives department was an entity in its own right. An independent department that did not fall under the purview of the rules and regulations that one expects to be followed in a large bank like UBS. The positions of senior risk management and quantitative analytics was headed by the same individual. This meant that he was reviewing business decisions that he had generated. His bonuses and incentives were tied to his trades.This meant the scope for independent review was very slim.
The losses have been also attributed to a poorly developed financial model as compared to its competitors leading them to over-value and take long positions on many derivative positions. Sources within UBS at that time said that the bank had started implementing a Value at Risk system. Unfortunately the derivatives desk came last in the implementation, with one of the reasons being the team not providing adequate co-operation.
UBS had a portfolio choc-a-bloc with long dated options. British tax laws when they were changed hit all banks but particularly UBS on account of the size of its portfolio. The same was true in the case of Japanese warrants of which UBS held a much bigger portfolio than most other banks. But what UBS or anyone else could not anticipate was the fall of the Japanese economy which was considered one of the strongest. With the break of the Japanese warrants the losses mounted for UBS.
UBS had considerable positions in LTCM. 60% of the UBS investment was in the form of options and 40% as direct investment. Naturally in hindsight it is easy to say this was a bad decision. LTCM had the crème de la crème of the derivatives world (John Meriwether from Salomon Brothers, Myron Scholes and Robert C Merton of the Black Scholes and Merton model and Nobel prize winners). They had positions in the European, American and Japenese markets. Everyone wanted a piece of the LTCM pie. The fall of Russian bonds, Japanese bonds and the clampdown on LTCM when things went horribly wrong meant UBS was digging deeper into losses. The positions with LTCM were approved by Mathis Cabiallavetta the CEO of UBS. If this investment in this bundled format went through stress tests or other forms of risk assessment is not fully known.
In the end UBS had to be merged with the smaller Swiss Bank Corporation on their terms in 1997 with the LTCM debacle unfolding in 1998. The CEO came under much flak for selling rather than handling the crisis. The importance of assessing risk valuation models and controls through a risk department as well as external agencies are not for textbooks in finance alone but to be implemented and listened to with caution. Theoretically UBS did the best it could, but keeping their ear to the ground and not putting all their eggs in one basket was a lesson they learnt a little too late.
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