Risk concentrations

Auction rate certificates (ARCs) and variable rate demand obligations (VRDOs) are long-term securities structured to allow frequent reset of their coupon and, at the same time, the possibility for holders to redeem their investment or, in the case of ARCs, sell it in a periodic auction, giving the securities some of the characteristics of a short-term instrument in normal market conditions. They are typically issued by municipal entities and student loan trusts, and may be wrapped by monoline insurers.

Coupons paid on ARCs are determined by an auction at the beginning of each interest reset period, whereas VRDO coupons are adjusted on a periodic basis, the intention being to allow investors to earn a market rate of interest. VRDOs typically include a feature allowing an investor to sell the security to a liquidity provider, generally a bank. UBS sponsors student loan ARC and VRDO programs and, although it is not obligated to do so, has provided liquidity, from time to time, to these markets by submitting bids to ARC auctions and in the case of VRDOs by purchasing securities in the re-marketing period.

In first quarter 2008, as a result of the general deterioration of credit markets and exacerbated by concerns about the financial status of monoline insurers, the markets for ARCs and VRDOs - particularly those ARCs backed by student loans - were severely disrupted, resulting in illiquidity in the majority of student loan ARCs and certain VRDOs. In the early part of first quarter, UBS built up significant inventory through its support for these markets, which in the case of ARCs has since been discontinued and in the case of VRDOs is limited. The inventory was marked down to account for the market's illiquidity, resulting in a loss of USD 974 million in first quarter 2008, mainly in ARCs.

On 31 March 2008, UBS had student loan ARC positions in its trading inventory with a market value totaling USD 8.7 billion, of which USD 5 billion were monoline wrapped.