UBS exposure to subprime market (Q3 2007)
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For UBS, the area most severely affected by the market dislocation in third quarter 2007 was the inventory of securities related to the US sub-prime residential mortgage market. When these positions - which are sizeable - were taken, we entered into partial hedges designed to mitigate risk in normal and volatile market conditions. The deterioration of this sector in third quarter, however, was more severe and sudden than any such event in recent market history. The securitized credit markets became illiquid and UBS's positions, including securities with high credit ratings, lost substantial value. The valuations applied by UBS in its balance sheet on 30 September 2007 reflect the weakness in the US housing and mortgage market during the quarter.
Net losses during the quarter in the books with these positions were USD 4.4 billion (CHF 5.3 billion), made up of gross losses of USD 5.6 billion (CHF 6.7 billion) offset by gains on hedges of USD 1.2 billion (CHF 1.4 billion). Where possible, holdings are marked at the quoted market price (also known as "level 1" inputs in accounting terminology). For the positions related to the US sub-prime market, this was and is still not possible in present market conditions. UBS therefore mostly uses valuation techniques based on "observable inputs" derived from similar assets in similar and active markets, from recent transaction prices for comparable items or from other observable market data ("level 2" inputs). For positions where observable reference data is not available UBS uses econometric models with non market observable ("level 3") inputs. The inputs to these econometric models principally comprise remittance data from mortgage service companies. These are received towards the end of each month and relate to the preceding month's cash flows on the mortgages underlying the relevant mortgage backed securities. Our models assess the level of risk in the underlying mortgage portfolio and estimate the fair value of the positions we hold.
Although our models are proprietary and there is no single market standard model, our approach is similar to that used by other market participants. Our models are calibrated to transactions in similar instruments and are reviewed and updated from time to time. They do not necessarily contain sentiment or predictions that are implicit in active, liquid, level 1 transactions. Such models have inherent limitations, and different assumptions and inputs would generate different views.
UBS's main remaining positions at end September 2007 included:
holdings of sub-prime residential mortgage-backed securities (RMBS). These consist overwhelmingly of presently AAA-rated tranches, of which around 80% have an expected weighted average life of less than three years. Following this quarter's writedowns, the net exposure was USD 16.8 billion (CHF 19.5 billion).
about USD 1.8 billion (CHF 2.1 billion) net exposure to collateralized debt obligations (CDOs) held in warehouse lines and retained after securitizations. Most of the securities are currently rated investment grade, predominantly AAA, with the majority having an expected weighted average life of less than five years.
positions in super seniors, meaning AAA-rated tranches of CDOs. Super senior CDO debt ranks above other AAA tranches of the same issue in the event of default. The aggregate notional values of these securities are USD 20.2 billion (CHF 23.4 billion), although this does not necessarily indicate the risk exposure of this portfolio. These securities have a range of subordination levels, maturities and rights in the event of default. These positions are valued using level 3 methodology.
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The value of all these holdings in the future will, naturally, depend on developments in the underlying mortgage pools, changing loss assumptions, model enhancements and on the credit rating of the securities in question. UBS continues to manage, trade and hedge these positions as market conditions permit.
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