Risk management and control

A concentration of risk exists where: (i) positions in financial instruments are affected by changes in the same risk factor or group of correlated factors; and (ii) the exposure could, in the event of large but plausible adverse developments, result in significant losses.

The identification of risk concentrations necessarily entails judgment regarding potential future developments. This is because such developments cannot be predicted with certainty and may vary from period to period. In determining whether a concentration of risk exists, risk controllers consider a number of elements, both individually and in combination. These elements include: the shared characteristics of the instruments; the size of the position; the sensitivity of the position to changes in risk factors and the volatility of those factors; and the liquidity of the markets in which the instruments are traded and the availability and effectiveness of hedges or other potential risk mitigants.

If a risk concentration is identified, it is assessed to determine whether it should be reduced or the risk should be mitigated, and the available means to do so. Identified concentrations are subject to increased monitoring.

Based on UBS's assessment of the portfolios and asset classes where there is the potential for material loss in a stress scenario relevant to the current environment, the firm believes that the exposures shown below can be considered risk concentrations according to this definition.

There is clearly a possibility that material losses could arise on asset classes, positions and hedges other than those disclosed in this page, if for instance the correlations that emerge in a stressed environment differ markedly from those envisaged by UBS. The firm has, for example, exposures to other US asset-backed securities (ABSs), US prime mortgages, non-US residential and commercial real estate and mortgages (particularly the Swiss mortgage market), non-US ABSs, non-US reference-linked note (RLN) programs and structured credit programs, including the exposure to the Canadian commercial paper market. UBS is exposed to credit spread and default risk on its fixed income trading inventory, to idiosyncratic and correlation risks on both equities and fixed income inventory, and to emerging markets country risk in many of its trading activities. It has derivatives transactions and a significant prime services business through which it is exposed to the hedge fund industry. If UBS decided to support a fund that it manages or another investment that it marketed to clients, this might increase risks in certain asset classes. The possibility of material losses on such positions cannot be ruled out. For information concerning UBS’s efforts to address problems arising from the significant disruption that occurred in February 2008 in the US market for auction rate securities, including its settlement in principle with the SEC and state regulatory authorities on 8 August 2008, refer to the sidebar “Auction rate securities - recent developments" on page Group results of this report and Note 14 to the financial statements.

In the tables shown on this page, the size of the positions held by UBS is generally expressed as "net exposure", with gross exposures detailed in the footnotes where relevant. Net exposure for each instrument class represents long positions minus short positions where hedge effectiveness is considered to be high. If, at some future date, hedges are considered to have become ineffective, UBS's net exposures would increase.

From a risk management perspective, it is necessary to look beyond net exposure and consider important characteristics of the underlying assets and financial instruments - for example, factors such as vintages, delinquency rates and credit ratings in the underlying mortgage pools, differences in attachment points, timing of cash flows and control rights in the securities held, as well as basis risks and counterparty risk associated with the hedges.

Note: The indices and price movements in the charts above are presented for illustrative purposes only and should not be interpreted as an indication that they necessarily were or can be used in determining the market value of any securities owned by UBS, or that the value of any portion of UBS's portfolio will necessarily move in accordance with these indices or prices.

Positions related to US residential sub-prime mortgages

UBS's net exposure to sub-prime mortgages has been reduced by almost 60% since the end of first quarter 2008, to USD 6.7 billion at 30 June 2008, primarily through asset sales and, to a lesser extent, writedowns, hedging and amortizations. Writedowns were mainly recorded in super senior RMBS CDOs where average marks were substantially reduced. Significant asset sales were realized in RMBSs and also in super senior RMBS CDOs, where a significant sale of high grade CDOs took place in June. Certain short index positions were also reduced over second quarter 2008 due to active risk management of RMBS exposures.

On 30 June 2008, around 40% percent of UBS's remaining positions in super senior RMBS CDOs related to mortgage loans of vintage 2005 or earlier. The other 60% related predominantly to mortgage loans with 2006 vintages, with a small amount relating to 2007 vintages. These securities have a range of subordination levels and maturities. Rights upon events of default also vary.

At the same date, approximately 90% of sub-prime RMBSs related to mortgage loans with 2006 and 2007 vintages, while the remaining securities related to mortgage loans of 2005 or earlier vintages. On 30 June 2008, the overwhelming majority of these RMBSs were rated AAA and had an expected weighted average life of just less than two years.

Positions related to US residential Alt-A mortgages

UBS reduced its net exposure to US residential Alt-A mortgages by approximately 60% since the end of first quarter 2008, to USD 6.4 billion at 30 June 2008, mainly through asset sales. The vast majority of UBS's remaining Alt-A positions consists of AAA-rated RMBSs, backed by first lien mortgages, which amounted to USD 5.9 billion net exposure at 30 June 2008.

During second quarter 2008, Alt-A writedowns were mainly recorded in AAA-rated RMBSs backed by first lien mortgages.

Positions related to the US reference-linked note program

The structure of UBS's reference-linked note (RLN) program is explained in the sidebar below.

UBS has created ten US RLNs to date. The maximum permitted face values of the underlying reference pools total USD 16.9 billion notional value, and UBS holds total notional credit protection of USD 3.8 billion (on average about 23%). The market value of the remaining credit protection was USD 1.6 billion on 30 June 2008.

At 30 June 2008, the total net exposure to assets held by UBS in connection with the US RLN program was USD 7.8 billion, a reduction of USD 1.1 billion since the end of first quarter 2008.

Losses in second quarter 2008 totaled USD 480 million and related mainly to the sub-prime and Alt-A component of the US RLN program. As there are multiple RLN programs which reference different pools of underlying assets and credit protection is specific to each RLN program, credit protection may be fully utilized for certain asset classes in the individual programs. As a result, losses will not always be offset by a reduction in remaining credit protection. Similarly, remaining credit protection may also increase as a result of amortizations, adjustments to hedges and disposals.

Exposure to monoline insurers

The vast majority of UBS's direct exposure to monoline insurers arises from over-the-counter (OTC) derivative con- tracts - mainly credit default swaps (CDSs) purchased to hedge specific positions. On 30 June 2008, the total fair value of CDS protection purchased from monoline insurers against these positions was USD 4.0 billion after cumulative credit valuation adjustments (CVAs) of USD 5.5 billion. Of these totals, USD 3.0 billion represents the fair value of CDSs bought as protection for portfolios of US RMBS CDOs, after cumulative credit valuation adjustments of USD 4.6 billion.

Exposure under CDS contracts to monoline insurers is calculated as the sum of the fair values of individual CDSs. This, in turn, depends on the valuation of the instruments against which protection has been bought. A positive fair value, or a valuation gain, on the CDS is recognized if the fair value of the instrument it is intended to hedge is reduced.

The table below shows the CDS protection bought from monoline insurers to hedge specific positions. It illustrates the notional amounts of the protection originally bought, the fair value of the underlying instruments and the fair value of the CDSs both prior to and after credit valuation adjustments taken for these contracts. For risk management purposes, where hedges are deemed to be ineffective on 30 June 2008, the underlying US RMBS CDOs are treated as unhedged and are also included in the corresponding super senior RMBS CDO exposure. See Note 10 for further details on CVA valuation and sensitivities.

Other than credit protection bought on positions detailed in the table below, UBS held a small amount of direct derivative exposure to monolines of USD 146 million after CVAs of USD 288 million, of which USD 94 million related to a monoline insurer that defaulted on its obligation to UBS. In its trading portfolio, UBS also has indirect exposure to monoline insurers through securities which they have guaranteed ("wrapped") and are issued by US states and municipalities, US student loan programs and other asset-backed securities. These totaled approximately USD 9.8 billion on 30 June 2008 (approximately USD 14 billion on 31 March 2008).

Exposure to student loan asset-backed securities

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 acts as a re-marketing coordinator for certain student loan ARC and VRDO programs. Although it is not obligated to do so, UBS 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 second quarter 2008, the market for student loan ABSs continued to deteriorate and inventory was marked down accordingly to reflect this. This resulted in a loss of USD 454 million in second quarter 2008, mainly in student loan ARCs. For information concerning UBS’s efforts to address problems arising from the significant disruption that occurred in February 2008 in the US market for auction rate securities, including its settlement in principle with the SEC and state regulatory authorities on 8 August 2008, refer to the sidebar “Auction rate securities - recent developments" of this report and Note 14 to the financial statements. See Note 10 to the financial statements, for details on ARC valuation and sensitivities.

On 30 June 2008, UBS had student loan ARC positions in its trading inventory with a market value totaling USD 8.3 billion, of which USD 4.7 billion were monoline wrapped.

Positions related to US commercial real estate

At 30 June 2008, UBS had exposures to US commercial real estate (CRE) from three sources. The first was super senior commercial mortgage-backed securities (CMBS) CDOs amounting to USD 0.7 billion. The second category was trading inventory, which included CMBS cash and derivative positions, and positions held for securitization, amounting to a net exposure of USD 4.6 billion at 30 June 2008. Around 90% of CMBS positions are rated A or better. UBS continues to actively trade and risk manage this portfolio using relatively liquid derivatives on CMBS and CMBX indices. The increase in net exposure over second quarter 2008 reflects primarily a correction in the method of calculation of derivative trading exposures and an increase in value of positions. Gross and net exposures are not the only measures of risk used by UBS to manage these exposures, and other key measures include credit spread sensitivities.

The third category of CRE exposures consisted of direct loans and investments totaling USD 2.9 billion on 30 June 2008, of which USD 397 million are classified as equity investments. The assets in this category are diversified by sector and geography.

Exposure to leveraged finance deals

UBS had highly leveraged finance commitments that were entered into both before and after the market dislocation of July 2007. Transactions since July 2007 have typically had pricing terms and covenant and credit protection that are more favorable to underwriters and investors than those entered into in first half of 2007. From a risk perspective, on 30 June 2008, the fair value amount of commitments entered into by UBS before the dislocation ("old deals") was USD 2.1 billion, while those entered into subsequent to the dislocation ("new deals") totaled USD 4.0 billion. During second quarter 2008, UBS marked down its leveraged finance commitments by a further USD 152 million.