Credit risk

Credit risk is the risk of financial loss resulting from failure by a client or counterparty to meet its contractual obligations to UBS. This can be caused by factors directly related to the counterparty, such as business or management problems, or from failures in the settlement process, for example on foreign exchange transactions, where UBS has honored its obligation but the counterparty fails to deliver the counter-value (settlement risk). Alternatively, it can be triggered by economic or political difficulties in the country in which the counterparty is based or where it has substantial assets (country risk).

Sources of credit risk

Credit risk is inherent in traditional banking products – loans, commitments to lend and contingent liabilities, such as letters of credit – and in "traded products" – derivative contracts such as forwards, swaps and options, repurchase agreements (repos and reverse repos), and securities borrowing and lending transactions. The risk control processes applied to these products are fundamentally the same, although the accounting treatment varies – they can be carried at amortized cost or fair value, depending on the type of instrument and, in some cases, the nature of the exposure.

Many of the business activities of Global Wealth Management & Business Banking and the Investment Bank create credit risk. Global Wealth Management & Business Banking offers private and corporate customers in Switzerland and wealth management clients internationally a variety of credit products, although the majority of credit risks are well secured against financial collateral or other assets. The Investment Bank gives corporate, institutional, intermediary and alternative asset management clients access to the full range of credit and capital markets instruments across all product classes, and engages with other professional counterparties in its trading and risk management activities.

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Credit risk control organization and governance

Effective credit risk control is critical to UBS's safety and soundness. The credit risk control framework is based on the risk management and control principles, supported by credit policies. It has both qualitative and quantitative elements. UBS has established processes to ensure that risks are identified, assessed, pre-approved where necessary, and continuously monitored and reported. Measures and limits are applied to the credit risk of individual counterparties and counterparty groups, and the quality and diversification of portfolios and sub-portfolios are assessed, a key objective being to control risk concentrations.

The Group Chief Credit Officer (Group CCO), who reports to the Group Chief Risk Officer (Group CRO), is responsible for implementing and maintaining this framework, supported by independent credit risk control units in the business groups who report to the Group CCO functionally and who continuously monitor and control credit risk. Their responsibilities include assessing the creditworthiness of individual counterparties and the adequacy and effectiveness of any security or credit hedges, and evaluating credit risk in portfolios, sub-portfolios and other aggregations, including country risk.

The Chairman's Office delegates authority to the Group Executive Board (GEB) and approves delegations by the GEB ad personam to the Group CCO and the business group CCOs. Further delegations are made to credit officers in the business groups. The level of credit authority delegated to holders depends on their seniority and experience and varies according to the quality of the counterparty and any associated security. These authorities encompass all aspects of the approval of credit risk, including settlement risk, and the determination of allowances, provisions and credit valuation adjustments for any impaired claims.

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Credit risk control

Limits and controls

The primary objective of quantitative controls is to avoid, as far as possible, undue credit risk concentrations. Concentrations of credit risk exist if clients are engaged in similar activities, or are located in the same geographical region or have comparable economic characteristics such that their ability to meet contractual obligations would be similarly affected by changes in economic, political or other conditions. UBS has established limits to constrain exposure to individual counterparties and counterparty groups and at portfolio and sub-portfolio levels, wherever risk concentrations are identified, including exposure to specific industries and countries, where appropriate.

At the level of the individual counterparty and counterparty group, credit officers establish limits for all types of banking and traded products exposure, which cover not only the current outstanding amount and replacement values of contractual obligations but also contingent commitments and the potential future development of exposure on traded products. Credit engagements may not be entered into without the appropriate approvals and limits.

Limits are applied in a variety of forms to portfolios or sectors, where necessary, to restrict risk concentrations or areas of higher risk, or to control the rate of portfolio growth. In particular for higher risk engagements, such as the Investment Bank's leveraged lending portfolio, the impact of variations in default rates and asset values is assessed using stress scenarios, taking into account risk concentrations. Stress loss limits are applied to portfolios where considered necessary, including limits on exposures to all but the best-rated countries.

In establishing these controls, including the related authorities and approval processes, a distinction is made between those exposures which are to be held to maturity ("take and hold" exposures) and those which will be held only in the short term, pending distribution or risk transfer ("temporary exposures"). An example of temporary exposure is syndicated lending where the bulk of the original commitment will be distributed to other financial institutions or investors. For all exposures, the credit quality and cash flow generation capacity of the counterparty over the full term of the obligation are at the heart of the credit assessment. For temporary exposures, market liquidity and UBS's distribution capabilities are also key considerations in the approval process.

Risk mitigation

UBS employs risk mitigation techniques for most of its credit portfolios, typically by taking security in the form of financial collateral (cash or marketable securities) or other assets, or through risk transfers or the purchase of credit protection.

Taking security is the most common form of risk mitigation. Valuation standards are applied in assessing the mitigating effect of security. In lending to affluent private clients (lombard lending) the pledge of securities or cash is required. The Investment Bank also takes financial collateral in the form of marketable securities in much of its over-the-counter (OTC) derivatives activity and in its securities financing (securities lending / borrowing and repurchase / reverse repurchase) business. Where financial collateral is taken, discounts ("haircuts") are generally applied to the market value, reflecting the quality, liquidity, volatility – and in some cases complexity – of the individual instruments. Exposures and collateral positions are continuously monitored, and margin calls and close-out procedures are enforced when the market value of collateral falls below predefined levels relative to the exposure. Collateral concentrations within individual client portfolios and across clients are also monitored where relevant and may affect the discount applied to specific collateral. For property financing, a mortgage over the relevant property is taken to secure the claim, considering the ability of the borrower to service the debt from income, and in accordance with UBS's policy on loan to value ratios.

OTC derivatives business is conducted almost without exception under bilateral master agreements, which generally allow for the close out and netting of all transactions in the event of default by the other party. UBS has also entered into two-way collateral agreements with market participants, under which either party can be required to provide collateral in the form of cash or marketable securities when exposure exceeds a pre-defined level. The OTC derivatives business with lower-rated counterparties is generally conducted under one-way collateral agreements where the counterparty provides collateral to UBS. Under these agreements, only cash or very liquid collateral is accepted. UBS has standards for netting and collateral agreements, including assurance that contracts are legally enforceable in insolvency in the relevant jurisdictions.

UBS has also made use of credit hedging, in the form of risk transfers, securitizations and purchase of credit protection, as part of its active management of credit risk to reduce concentrated exposures to individual names or sectors or in specific portfolios. Most of this credit hedging is achieved by transferring underlying credit risk to high-grade market counterparties using single name credit default swaps, executed under bilateral netting agreements and generally also under collateral agreements. Credit-pooling vehicles are also used to transfer risk to outside investors via credit-linked notes. In the internal risk reporting processes, the gross exposure before hedging as well as net exposure is tracked. The benefit of credit hedges is only recognized in credit risk measures if they cover future exposure increases to a high level of confidence, and offer protection against a wide range of credit events, including failure to pay, bankruptcy and insolvency, restructuring and repudiation, and moratorium. Proxy hedges (credit protection on a different but correlated name) and index or macro hedges are not recognized.

The effectiveness of credit protection bought from a counterparty depends on the ability of the counterparty to meet any claim. Exposure to credit protection providers is monitored as part of overall credit exposure. Where there is significant correlation between the counterparty and the hedge provider (so-called "wrong-way risk") UBS's policy is not to recognize any benefit in credit risk measures.

Reporting

An essential element of the credit risk control process is transparent and objective risk reporting.

The credit risk control units in the business groups are responsible for risk reporting to business group management covering both exposure to individual counterparties from all products and activities, and portfolio risks. They also supply information to a central unit under the Group CCO, which provides consolidated reports of counterparty and portfolio risk and country risk to senior management, the GEB, the Chairman's Office, the Board of Directors (BoD) and regulators where applicable.

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Credit risk measurement

Credit risk measurement is an essential component of the credit risk control framework. The measurement of credit exposure from a loan which is fully drawn is straightforward. By contrast, the estimation of credit exposure on a traded product, the value of which varies with changes in market variables, interim cash flows and the passage of time, is more complex and requires the use of models. The assessment of portfolio risk also entails estimations of the likelihood of defaults occurring, of the associated loss ratios if they do, and of default correlations between counterparties.

UBS has developed tools to support the quantification of credit risk of individual counterparties, applying the three generally accepted parameters: probability of default, loss given default and exposure at default. Models are also used to derive portfolio risk measures – expected loss, statistical loss and stress loss.

Models are generally developed by dedicated units within the business groups. In line with UBS's internal governance standards and the requirements of the new regulatory capital framework (Basel II), the development and maintenance of models conforms to global standards, and the models and their components are subject to independent verification by a specialist team in Corporate Center before implementation. The model owners in the business groups are responsible for monitoring performance once the models are deployed. Models must comply with established measurement standards to ensure consistency and allow meaningful aggregation of credit risk across all businesses.

Credit risk parameters

Three parameters are used to measure and control individual counterparty credit risk:

– the "probability of default", which is an estimate of the likelihood of the client or counterparty defaulting on its contractual obligations. This probability is assessed using rating tools tailored to the various categories of counterparties. They are also calibrated to the UBS 15-class Masterscale, in order to ensure consistency in the quantification of default probabilities across all counterparties. Besides their use for credit risk measurement, ratings are an important element in setting credit risk authorities;

– the likely recovery ratio on the defaulted claims, which is a function of the type of counterparty and any credit mitigation or support (such as security or guarantee), from which the "loss given default" is determined;

– the current exposure to the counterparty and its possible future development, from which potential "exposure at default" is derived. For traded products such as OTC derivatives, the exposure at default is not a definitive number – it must be derived by modeling the range of possible outcomes. In measuring individual counterparty exposure against credit limits, UBS considers the "maximum likely exposure" measured to a high confidence level over the full life of all outstanding obligations, whereas in aggregating exposures to different counterparties for portfolio risk measurement, the expected exposure to each counterparty at a given time horizon (usually one year) generated by the same model is used.

These parameters are the basis for most internal measures of credit risk. They are also key inputs to the regulatory capital calculation under the Advanced Internal Rating Based approach of the new Basel Capital Accord (Basel II), which UBS has adopted from 1 January 2008, when the Accord came into force.

Expected loss

Credit losses must be expected as an inherent cost of doing business. But the occurrence of credit losses is erratic in both timing and amount, and those that arise usually relate to transactions entered into in previous accounting periods. In order to reflect the fact that future credit losses are implicit in today's portfolio, UBS uses the concept of "expected loss".

Expected credit loss is a statistically based concept which is used to estimate the annual costs that are expected to arise, on average, from positions in the current portfolio that become impaired. The expected loss for a given credit facility is a function of the three components described above – probability of default, loss given default and exposure at default. The expected loss figures for individual counterparties are aggregated to derive the expected credit loss for the whole portfolio.

Expected loss is the foundation of credit risk quantification in all portfolios. It is an input to the valuation or pricing of some products, and the determinant of credit risk costs charged to the business in the management accounts, which differs from the credit loss expense reported under International Financial Reporting Standards (IFRS). Expected loss is also the starting point for the measurement of portfolio statistical loss and stress loss.

Statistical loss

UBS uses a statistical model – Credit Value at Risk ("Credit VaR") – to estimate the largest potential loss on the portfolio over one year measured to a specified level of confidence. The shape of the modeled loss distribution is driven by systematic default relationships amongst counterparties within and between segments. The results of this analysis provide an indication of the level of risk in the portfolio, and the way it develops over time. It is also an important input to the overall risk measures Earnings-at-risk and Capital-at-risk.

Stress loss

Stress loss is a scenario-based measure which complements the statistical model. It is used to assess potential loss in various extreme but plausible scenarios in which it is assumed that one or more of the three key credit risk parameters deteriorates substantially according to a pattern that is typical for the chosen scenario. Stress tests are run regularly, and on an ad hoc basis as necessary, in order to identify adverse portfolio situations, particularly risk concentrations. All scenario results are monitored, and for certain portfolios and segments, stress loss is subject to limits.

Composition of credit risk (Group)

The measures of credit risk differ, depending on the purpose for which exposures are aggregated – financial accounting under IFRS, determination of regulatory capital, or UBS's own internal management view, i.e. the way credit portfolio risk is managed. The table below starts with the IFRS view ("maximum exposure to credit risk"), and shows the adjustments made to reach the internal view ("gross credit exposure"). The gross credit exposure shown in the table is broadly aligned with the regulatory capital view, but does not include the potential future exposure that can arise on traded products which is an additional component of both the internal and regulatory capital views, as explained below.

In general, none of the exposures in the table reflects the benefit of security held or other risk mitigation employed, such as hedging and risk transfers. The main differences between the internal and IFRS views of gross credit exposure are:

– within banking products, cash collateral posted by UBS against negative replacement values on derivatives and other positions is not considered to be credit exposure but, rather, is reflected in the assessment of counterparty risk on the underlying positions. On the other hand, in its internal risk control view UBS considers certain financing which is conducted, for legal reasons, under repurchase- / reverse repurchase-like agreements, and shown as such under IFRS, to be loans;

– the derivatives exposure shown under IFRS is the sum of all positive replacement values, offset by negative replacement values with the same counterparty only if the cash flows are intended to be settled on a net basis. Internally, UBS nets positive and negative replacement values with the same counterparty where the business is conducted under a bilateral master agreement which allows for close-out and netting of all transactions in the event of default by either party, and such agreements are judged to be legally enforceable in insolvency; and

– under IFRS, securities lending / borrowing and repurchase / reverse repurchase transactions are shown on the balance sheet as UBS's full claim on the counterparty without recognizing the counterclaim which the counterparty has for return of cash or securities on the same transactions. By contrast, for internal risk control purposes, the claims on and counterclaims from each counterparty are considered on each transaction on a net basis, and further netted across transactions where such netting is considered to be legally enforceable in insolvency.

Note that under US Generally Accepted Accounting Principles (GAAP) a greater degree of netting is permitted than under IFRS for OTC derivatives replacement values and for securities lending / borrowing and repurchase / reverse repurchase transactions. UBS's balance sheet figures for these types of transactions are not directly comparable to those of firms which report under US GAAP.

As explained in the Credit risk measurement section, UBS also measures, and generally applies limits to, credit exposure to individual counterparties and counterparty groups and measures risk across counterparties at various portfolio and sub-portfolio levels. In these calculations UBS also considers the potential development of replacement values of traded products over time as market risk factors change, interim payments are made and transactions mature, all of which can significantly alter the risk exposure profile over time. These potential developments are not reflected in the tables opposite and below, which reflect only the current exposures.

The credit risk exposure reported in the table opposite also excludes UBS's participation in the deposit insurance guarantee scheme under Swiss Banking Law, according to which Swiss banks and securities dealers are required to jointly guarantee an amount of up to CHF 4 billion for privileged client deposits in the event that another Swiss bank or securities dealer becomes insolvent. For the period 1 July 2007 to 30 June 2008, the Swiss Federal Banking Commission (SFBC) has established UBS's share in the deposit insurance as CHF 846 million.

Total gross credit exposure amounted to CHF 595.1 billion on 31 December 2007, an increase of CHF 31.1 billion since the end of the previous year. Almost half of this increase was due to higher balances with central banks, reflecting UBS's higher liquidity reserves towards year-end. The growth in loan exposure was entirely due to increased collateralized lending activity in Global Wealth Management & Business Banking. The Investment Bank actively reduced credit risk, where possible, in light of its exposure to US residential mortgage-related products and in conjunction with its management of balance sheet and risk-weighted asset usage.

The quality of the gross unimpaired credit portfolio improved as the investment grade component (internal rating grades 0–5) increased to 79.0% from the previous year's level of 73.5%.

The table below shows the gross credit exposure (i.e. without recognition of credit hedges, collateral or other risk mitigation) by business group.

The largest contributor to gross credit exposure at CHF 311 billion is the lending portfolio (Due from banks CHF 26 billion, Loans CHF 281 billion, and Financial assets designated at fair value CHF 4 billion) which represents 52% of total gross credit exposure and 73% of total banking products exposure. Within this lending portfolio, CHF 249 billion (80%) is attributable to Global Wealth Management & Business Banking. Traded products exposure is incurred predominantly by the Investment Bank. The sections below provide further details of products, industry and rating distributions in the business group portfolios.

In the portfolio of loans to affluent private clients secured by securities (lombard lending) there are no material risk concentrations, either within the overall collateral pool or with respect to the counterparties themselves.

The property financing portfolio is diversified and limits per counterparty ensure that no single property exposure presents an undue concentration.

Exposure to providers of credit protection, usually in the form of credit derivatives, is controlled by the overall credit limit for the counterparty, which is typically a high-grade financial institution, or else the exposure is fully funded, for example through a synthetic securitization.

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Composition of credit risk (business groups)

Global Wealth Management & Business Banking

Total gross banking products exposure of Global Wealth Management & Business Banking, which stood at CHF 277 billion on 31 December 2007, increased by CHF 32 billion or 13% from a year earlier. Both the amount and the proportion of the total portfolio classified as investment grade increased from the previous year. The distribution of the exposure across UBS's internal rating and loss given default (LGD) buckets as displayed in the table below shows that the majority of the exposure is from products attracting the lowest LGDs, demonstrating the continued improvement in the quality of this portfolio.

Global Wealth Management & Business Banking's gross lending portfolio (Due from banks and Loans) on 31 December 2007 amounted to CHF 249 billion, of which CHF 142 billion (57 %) was secured by real estate and CHF 78 billion (31%) by marketable securities. The pie chart above shows that exposure to real estate is well diversified with 38% of the gross lending portfolio being secured on single family homes and apartments which, historically, have exhibited a low risk profile. The 11% of exposure secured by residential multi-family homes consists of rented apartment buildings. Loans and other credit engagements with individual clients, excluding mortgages, amounted to CHF 99 billion and are predominantly extended against the pledge of marketable securities. The volume of collateralized lending to private individuals rose by CHF 15 billion or 24% from the previous year. The increasing demand for this product, as in 2006, reflects the continuing low interest rate environment.

The high quality of Global Wealth Management & Business Banking's lending portfolio is demonstrated by the table below, which shows newly impaired loans and related allowances and provisions in relation to the total gross lending portfolio at year-end for the last four years. Despite an increase in the total gross lending portfolio each year, the totals of new impairments and of new allowances and provisions have declined. Most of the newly impaired loans are secured by mortgages or other collateral so that new allowances are proportionately lower than the newly impaired positions.

The Swiss lending portfolio (excluding mortgages) within the Business Banking area amounted to CHF 22 billion, representing 8% of Global Wealth Management & Business Banking's total gross banking products exposure. It is widely spread across industries, with the largest exposures being to banks and financial institutions, followed by public authorities.

Investment Bank

A substantial majority of the Investment Bank's gross credit exposure falls into the investment grade category (internal counterparty rating classes 0 to 5), both for gross banking products (69%) and for traded products (94%). The counterparties are primarily banks and financial institutions, multinational corporate clients and sovereigns.

Banking products exposure

On 31 December 2007, the Investment Bank's total gross credit exposure from banking products amounted to CHF 151.3 billion or CHF 100.7 billion net, taking credit hedges into account. Of this net amount, CHF 31.3 billion was considered temporary exposure and CHF 69.4 billion take and hold exposure. The table below shows the composition of the Investment Bank's gross banking products exposure, the hedges and other risk mitigation and the net exposure in total and for the take and hold portfolio. Compared with the end of 2006, the net take and hold exposure fell by one-third as a result of active risk reduction and management of balance sheet and risk-weighted asset usage.

As described under "Risk mitigation" on page 16 of this section, the Investment Bank has engaged in a substantial credit risk hedging program and on 31 December 2007 had a total of CHF 50 billion in credit hedges in place against banking products exposure.

To illustrate the effects of credit hedging and other risk mitigation, the graph opposite shows the exposures by counterparty rating before and after application of risk mitigation.

Additionally, the matrix below shows the distribution of the Investment Bank's take and hold banking products exposure after application of risk mitigants, across UBS internal rating classes and LGD buckets. There is a concentration in the 26–50% bucket where most senior secured and unsecured claims fall. Sub-investment grade exposure – which in aggregate reduced by CHF 16 billion (–49%) – decreased mainly in the 0–25% LGD bucket as exposure to US mortgage originators was wound down. At the end of the year UBS had no credit risk exposure to any sub-prime mortgage originators. It should be noted that exposure distributions shown elsewhere in this section refer only to gross or net exposure and do not take recovery expectations into account.

Net banking products exposure after application of credit hedges continues to be widely diversified across industry sectors. At 31 December 2007, the largest exposures were to regulated banks (22%) and financial institutions (21%).

Settlement risk

Settlement risk arises in transactions involving exchange of value when UBS must honor its obligation to deliver without first being able to determine that the counter-value has been received. Market volumes have continued to rise year-on-year but UBS has expanded its own transaction volume without increasing settlement risk by the same proportion, through the use of multilateral and bilateral arrangements. In fourth quarter 2007, settlement risk on 78% of gross settlement volumes was eliminated through risk mitigation.

The most significant source of settlement risk is foreign exchange transactions. UBS is a member of CLS ("Continuous linked settlement"), a foreign exchange clearing house which allows transactions to be settled on a delivery versus payment basis, significantly reducing foreign exchange-related settlement risk relative to the volume of business. In 2007, the transaction volume settled through CLS continued to increase, although the proportion of UBS's overall gross volumes settled through CLS fell to 51% in fourth quarter 2007 from 55% in fourth quarter 2006. 71% of UBS's CLS volume was with other CLS settlement members and the remainder with third party members, who settle their eligible trades via CLS settlement members. While the number of CLS settlement members is relatively stable, in 2007 the number of third party members UBS dealt with again increased considerably year-on-year.

Risk reduction by other means – primarily account-account settlement and payment netting – increased to 27% of gross volumes in fourth quarter 2007 from 23% a year earlier.

The avoidance of settlement risk through CLS and other means does not, of course, eliminate the credit risk on foreign exchange transactions resulting from changes in exchange rates prior to settlement. Pre-settlement risk on forward foreign exchange transactions is measured and controlled as part of the overall credit risk on OTC derivatives.

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Country risk

UBS assigns ratings to all countries to which it has exposure. Sovereign ratings express the probability of occurrence of a country risk event that would lead to impairment of UBS's claims. The default probabilities and the mapping to the ratings of the major rating agencies are the same as for counterparty rating classes (as described under "Probability of default"). In the case of country rating, the three lowest classes (12 to 14) are designated "distressed".

For all countries rated three and below, UBS sets country risk ceilings approved by the Chairman's Office or under delegated authority. The country risk ceiling applies to all UBS's exposures to clients, counterparties or issuers of securities from the country, and to financial investments in that country. Country risk measures cover both cross-border transactions and investments, and local operations by UBS branches and subsidiaries in countries where the risk is material. In determining the size of a country risk ceiling, goodwill resulting from acquisitions is also taken into account. Extension of credit, transactions in traded products and positions in securities may be denied on the basis of a country ceiling, even if exposure to the name is otherwise acceptable. Within the group of countries subject to ceilings, those that have yet to reach a mature stage of economic, financial, institutional, political and social development or have significant potential for economic or political instability are defined as emerging market countries. The country data provided in this section cover only country risk exposures to emerging market countries.

Counterparty defaults resulting from multiple insolvencies ("systemic risk") or general prevention of payments by authorities ("transfer risk") are the most significant effects of a country crisis, but for internal measurement and control of country risk UBS also considers the probable financial impact of market disruptions arising prior to, during and following a country crisis. These might take the form of severe falls in the country's markets and asset prices, longer-term devaluation of the currency, and potential immobilization of currency balances.

The potential financial impact of severe emerging markets crises is assessed by stress testing. This entails identifying countries that might be subject to a potential crisis event and determining potential loss, making conservative assumptions about potential recovery rates depending on the types of transaction involved and their economic importance to the affected countries.

UBS's liquidity position could be adversely impacted by restrictions on, or major impediments to, cross-border transfers of funds, which might prevent a liquidity surplus in one country being used to meet a shortfall in another. This risk does not generally result from existing or foreseeable legal restrictions in specific countries but, rather, from unexpected economic stress situations or sovereign defaults, which might induce a government to limit or prohibit the transfer of funds outside the country. UBS assesses the potential impact on its liquidity position of potential transfer risk events in countries with a one-year probability of default of 5% or more as indicated by UBS's internal sovereign rating.

Country risk exposure

Exposure to emerging market countries amounted to CHF 41.3 billion on 31 December 2007, compared with CHF 30.6 billion on 31 December 2006. Of this amount, CHF 30.9 billion or 75% was to investment grade countries. The growth of CHF 10.6 billion in total emerging markets exposure arose to a large extent in Asia.

The pie chart opposite shows UBS's emerging market country exposures (excluding those which are of a temporary nature) on 31 December 2007, based on the main country rating categories. The table below analyzes emerging market country exposures by major geographical area and product type on 31 December 2007 compared with 31 December 2006. Temporary exposures arising from loan underwriting in these markets are separately shown in the table.

On 31 December 2007, UBS had net exposure totaling CHF 911 million to 29 countries with a one-year probability of default of 5% or more, of which CHF 556 million was to those with a probability of default of 8% or more. Only CHF 81 million was to distressed countries, which have a one-year probability of default of 13% or more and where restrictions are highly probable or have already materialized. This represents less than 0.2% of UBS's emerging markets exposure and the associated risk is immaterial.

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Impairment and default – distressed claims

UBS has a number of classifications for distressed claims.

A loan carried at amortized cost is considered to be "past due" when a significant payment has been missed. It is classified as "non-performing" where payment of interest, principal or fees is overdue by more than 90 days and there is no firm evidence that the claim will be settled by later payments or the liquidation of collateral; or when insolvency proceedings have commenced against the borrower; or when obligations have been restructured on concessionary terms.

Any claim, regardless of accounting treatment, is classified as "impaired" if UBS considers it probable that it will suffer a loss on that claim as a result of the obligor's inability to meet its obligations according to the contractual terms, and after realization of any available collateral. "Obligations" in this context include interest payments, principal repayments or other payments due, for example under an OTC derivative contract or a guarantee.

The recognition of impairment in the financial statements depends on the accounting treatment of the claim. For products carried at amortized cost, impairment is recognized through the creation of an allowance or provision, which is charged to the income statement as credit loss expense. For products recorded at fair value, impairment is recognized through a credit valuation adjustment, which is charged to the income statement through the net trading income line.

UBS has policies and processes to ensure that the carrying values of impaired claims are determined in compliance with IFRS on a consistent and fair basis, especially for those impaired claims for which no market estimate or benchmark for the likely recovery value is available. The credit controls applied to valuation and workout are the same for both amortized cost and fair-valued credit products. Each case is assessed on its merits, and the workout strategy and estimation of cash flows considered recoverable are independently approved by the credit risk control organization.

Portfolios of claims carried at amortized cost with similar credit risk characteristics are also assessed for collective impairment. A portfolio is considered impaired on a collective basis if there is objective evidence to suggest that it contains impaired obligations but the individual impaired items cannot yet be identified.

The assessment of collective impairment differs depending on the nature of the underlying obligations. In UBS's retail businesses, where delayed payments are routinely seen, UBS typically reviews individual positions for impairment only after they have been in arrears for a certain time. To cover the time lag between the occurrence of an impairment event and its identification, collective loan loss allowances are established, based on the expected loss measured for the portfolio over the average period between trigger events and their identification for individual impairments. Collective loan loss allowances of this kind are not required for corporate and investment banking businesses because individual counterparties and exposures are continuously monitored and impairment events are identified at an early stage.

Additionally, for all portfolios, UBS assesses each quarter – or on an ad hoc basis if necessary – whether there has been any previously unforeseen development which might result in impairments which cannot be immediately identified individually. Such events could be stress situations such as a natural disaster or a country crisis, or they could result from structural changes in, for example, the legal or regulatory environment. To determine whether an event-driven collective impairment exists, a set of global economic drivers is regularly assessed for the most vulnerable countries and, on a case by case basis, the impact of specific potential impairment events since the last assessment is reviewed. Again, the expected loss parameters of the affected sub-portfolios are the starting point for determining the collective impairment, adjusted as necessary to reflect the severity of the event in question.

Past due but not impaired loans

The table opposite provides an overview of the aging of past due but not impaired loans. These loans have suffered missed payments but are not considered impaired because UBS expects ultimately to collect all amounts due under the contractual terms of the loans or with equivalent value.

Compared with 31 December 2006, the past due exposure has decreased by CHF 1.1 billion, primarily as a result of improved processes to identify and settle overdue amounts.

Impaired loans, allowances and provisions

The table opposite shows that allowances and provisions for credit losses decreased by 12.6%, to CHF 1,164 million on 31 December 2007 from CHF 1,332 million on 31 December 2006. Note 9b in Financial Statements 2007 provides further details of the changes in allowances and provisions for credit losses during the year. In accordance with International Accounting Standard (IAS) 39, UBS has assessed its portfolios of claims with similar credit risk characteristics for collective impairment. On 31 December 2007, allowances and provisions for collective impairment amounted to CHF 34 million.

The gross impaired lending portfolio decreased to CHF 2,392 million on 31 December 2007 from CHF 2,628 million on 31 December 2006.

The ratio of the impaired lending portfolio to the total lending portfolio (both measured gross) improved to 0.6% on 31 December 2007 from 0.8% on 31 December 2006.

In general, Swiss practice is to write off loans only on final settlement of bankruptcy proceedings, sale of the underlying assets, or formal debt forgiveness. By contrast, US practice is generally to write off non-performing loans, in whole or in part, much sooner, thereby reducing the amount of such loans and corresponding allowances recorded. A consequence of applying the Swiss approach is that, for UBS, recoveries of amounts written off in prior accounting periods tend to be small, and the level of outstanding impaired loans as a percentage of gross loans tends to be higher than for its US peers.

Loans or receivables with a carrying amount of CHF 126 million and CHF 48 million were reclassified from impaired to performing during 2007 and 2006 either because they had been renegotiated and the new terms and conditions met normal market criteria for the quality of the obligor and type of loan, or because there had been an improvement in the financial position of the obligor, enabling it to repay any past due amounts such that future principal and interest are deemed to be fully collectible in accordance with the original contractual terms.

Collateral held against the impaired loans portfolio consists in most cases of real estate. It is UBS policy to dispose of foreclosed real estate as soon as practicable. The carrying amount of foreclosed property recorded in the balance sheet under Other assets at the end of 2007 and 2006 amounted to CHF 122 million and CHF 248 million respectively.

UBS seeks to liquidate collateral in the form of financial assets in the most expeditious manner, at prices considered fair. This may require that it purchases assets for its own account, where permitted by law, pending orderly liquidation.

The table above shows the geographical breakdown and aging of the impaired assets portfolio on 31 December 2007. This portfolio includes not only impaired loans, but also impaired off-balance sheet claims and defaulted derivatives and repurchase / reverse repurchase contracts, which are subject to the same workout and recovery processes.

The CHF 1,221 million of impaired assets shown against North America / Caribbean in the 0 to 90 day time band is a consequence of the recent US mortgage-related market dislocations. Two exposures make up the majority of the total. One is an exposure to a monoline insurer from whom UBS has purchased credit protection in the form of credit default swaps, predominantly on collateralized debt obligations backed by US residential mortgage-backed securities. A 90% credit valuation adjustment on this exposure was taken in fourth quarter 2007. The second is a loan to an Alt-A mortgage originator where the estimated liquidation proceeds of the collateral are only slightly below the outstanding loan amount.

CHF 1.5 billion, or 42% of the gross portfolio of CHF 3.4 billion, relates to positions that defaulted more than three years ago.

After deducting allocated specific allowances, provisions and credit valuation adjustments of CHF 1.9 billion and the estimated liquidation proceeds of collateral (to a large extent real estate) of CHF 1.1 billion, net impaired assets amounted to CHF 0.4 billion.

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Credit loss expense

UBS's financial statements are prepared in accordance with IFRS, under which credit loss expense charged to the income statement in any period is the sum of net allowances and direct write-offs minus recoveries arising in that period, i.e. the credit losses actually incurred. By contrast, for internal management reporting, credit loss expense is based on the expected loss concept described under "Credit risk measurement". To hold the business groups accountable for credit losses actually incurred, they are additionally charged or refunded the difference between actual credit loss expense and expected credit loss, amortized over a three-year period. The difference between the amounts charged to the business groups in the management accounts ("adjusted expected credit loss") and the credit loss expense recorded at Group level is reported in Corporate Center.

From first quarter 2008, as part of the transition to the new Capital Accord (Basel II), UBS will cease using the adjusted expected credit loss concept in management accounts and will no longer report adjusted expected credit losses in its quarterly reports. Expected loss as a risk measure will, however, continue to be a key part of the overall credit risk framework.

The discussion which follows covers only the credit loss expense recorded under IFRS.

In 2007, UBS experienced a net credit loss expense of CHF 238 million, compared with a net credit loss recovery of CHF 156 million in 2006.

The Investment Bank recorded a net credit loss expense of CHF 266 million for 2007, compared with a net credit loss recovery of CHF 47 million in 2006. The main component was valuation adjustments of CHF 131 million taken during fourth quarter 2007, reflecting spread widening (as opposed to credit impairment) on US commercial mortgages that had been carried at amortized cost and were securitized or sold at less than their carrying value.

Global Wealth Management & Business Banking reported a net credit loss recovery of CHF 28 million for 2007, compared with a CHF 109 million net credit loss recovery for 2006. The reduced level of net credit loss recovery was a consequence of the continued reduction in the impaired lending portfolio and related allowances to a level such that recoveries realized from work-outs continue to trend lower and no longer compensate for the ongoing need to establish new allowances. The US mortgage market dislocation had no impact on Global Wealth Management & Business Banking figures.

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Rating system design and estimation of credit risk parameters

Probability of default

UBS assesses the likelihood of default of individual counterparties using rating tools tailored to the various counterparty segments. Probability of default is summarized in a common Masterscale, shown below, which segments clients into 15 rating classes, two being reserved for cases of impairment or default. The UBS Masterscale reflects not only an ordinal ranking of counterparties, but also the range of default probabilities defined for each rating class, and in order to ensure consistency in determining default probabilities, all rating tools must be calibrated to the common Masterscale. This approach means that clients migrate between rating classes as UBS's assessment of their probability of default changes. The performance of rating tools, including their predictive power with regard to default events, is regularly validated and model parameters are adjusted as necessary.

External ratings, where available, are used to benchmark UBS's internal default risk assessment. The ratings of the major rating agencies shown in the table are linked to the internal rating classes based on the long-term average 1-year default rates for each external grade. Observed defaults per agency rating category vary year-on-year, especially over an economic cycle, and therefore UBS does not expect the actual number of defaults in its equivalent rating band in any given period to equal the rating agency average. UBS monitors the long-term average default rates associated with external rating classes. If these long-term averages were observed to have changed in a material and permanent way, their mapping to the Masterscale would be adjusted.

At the Investment Bank, rating tools are differentiated by broad segments. Current segments include banks, sovereigns, corporates, funds, hedge funds, commercial real estate and a number of more specialized businesses. The design of these tools follows a common approach. The selection and combination of relevant criteria (financial ratios and qualitative factors) is determined through a structured analysis by credit officers with expert knowledge of each segment, supported by statistical modeling techniques where sufficient data is available.

The Swiss banking portfolio includes exposures to a range of enterprises, both large and small- to medium-sized ("SMEs") and the rating tools vary accordingly. For segments where sufficient default data is available, rating tool development is primarily based on statistical models. Typically, these "score cards" consist of eight to twelve criteria combining financial ratios with qualitative and behavioral factors which have proven good indicators of default in the past, are accepted by credit officers and are easy to apply. For smaller risk segments with few observed defaults a more expert-based approach is chosen, similar to that applied at the Investment Bank. For the Swiss commercial real estate segment and for lombard lending, which is part of the retail segment, the probability of default is derived from simulation of potential changes in the value of the collateral and the probability that it will fall below the loan amount.

Default expectations for the Swiss residential mortgage segment are based on the internal default and loss history, where the major differentiating factor is the loan to value ratio – the amount of the outstanding obligation expressed as a percentage of the value of the collateral.

Loss given default

Loss given default or loss severity represents UBS's expectation of the extent of loss on a claim should default occur. It is expressed as percentage loss per unit of exposure and typically varies by type of counterparty, type and seniority of claim, and availability of collateral or other credit mitigation. Loss given default estimates cover loss of principal, interest and other amounts due (including work-out costs), and also consider the costs of carrying the impaired position during the work-out process.

At the Investment Bank, where defaults are rare events, loss given default estimates are based on expert assessment of the risk drivers (country, industry, legal structure, collateral and seniority), supported by empirical evidence from internal loss data and external benchmark information where available. In the Swiss portfolio, loss given default differs by counterparty and collateral type and is statistically estimated using internal loss data. For the residential mortgage portfolio, a further differentiation is derived by statistical simulation based on loan to value ratios.

Exposure at default

Exposure at default represents the amounts UBS expects to be owed at the time of default.

For outstanding loans, the exposure at default is the drawn amount or face value. For loan commitments and for contingent liabilities, it includes any amount already drawn plus the further amount which is expected to be drawn at the time of default, should it occur. This calculation is based on a "credit conversion factor", a fixed percentage per product type derived from historical experience of drawings under commitments by counterparties within the year prior to their default.

For traded products, the estimation of exposure at default is more complex, since the current value of a contract or portfolio of contracts can change significantly over time and may, at the time of a future default, be considerably higher or lower than the current value. For repurchase and reverse repurchase agreements and for securities borrowing and lending transactions, the net amount which could be owed to or by UBS is assessed, taking into account the impact of market moves over the time it would take to close out all transactions ("close-out exposure"). Exposure at default on OTC derivative transactions is determined by modeling the potential evolution of the replacement value of the portfolio of trades with each counterparty over the lifetime of all transactions – "potential credit exposure" – taking into account legally enforceable close-out netting agreements where applicable.

For all traded products, the exposure at default is derived from the same Monte Carlo simulation of potential market moves in all relevant risk factors, such as interest rates and exchange rates, based on estimated correlations between the risk factors. This ensures a scenario-consistent estimation of exposure at default across all traded products at counterparty and portfolio level. The randomly simulated sets of risk factors are then used as inputs to product specific valuation models to generate valuation paths, taking into account the impact of maturing contracts and changing collateral values, including the ability to call additional collateral.

The resultant distribution of future valuation paths supports various exposure measures. All portfolio risk measures are based on the expected exposure profile. By contrast, in controlling individual counterparty exposures UBS limits the potential "worst case" exposure over the full tenor of all transactions, and therefore applies the limits to the "maximum likely exposure" generated by the same simulations, measured to a specified high confidence level.

Cases where there is material correlation between factors driving a counterparty's credit quality and the factors driving the future path of traded products exposure – "wrong-way risk" – require special treatment. In such cases, the potential credit exposure generated by the standard model is overridden by a calculation from a customized exposure model that explicitly takes this correlation into account. For portfolios where this risk is inherently present, for instance for the hedge funds portfolio, UBS has established special controls to capture these wrong-way risks.