UBS AG: The Aftermath of a $48 billion Meltdown

'Millionaires are not attracted by just a cup of coffee; the events had to be sumptuous : golf competitions, regattas, opera evenings followed by dinner at the table of a renowned chef. Nothing was too good for the guests.... Each time, there were a large number of Swiss bank representatives present. They came from Basel, Geneva, Lausanne, Zurich; their mission was to get the millionaires.'

Stephanie Gibaud, La Femme qui en savait vraiment trop (the woman who knew too much)

Introduction

Swiss banking has always had a special place in the popular imagination. To some, it conjures images of wealthy individuals and their bankers enjoying all manner of bespoke experiences, from private networking sessions to dinner at the table of a celebrity chef, complete with the best wines. To others, Swiss banking evokes images of the quintessential Swiss banker at work: an individual striding purposefully across the hallowed halls of some centuries-old batiment, tending to the wealth of his clients with utmost discretion and diligence.

Nothing tells the story of Swiss banking better than the story of UBS Group AG ('UBS'), one of the largest and arguably the most well-known bank in Switzerland. To a large extent, the evolution of UBS over the years largely reflects the many changes that have shaped the financial services sector in Switzerland, a sector whose contributions have made the tiny landlocked country one of the most prosperous in Europe.

UBS AG traces its roots all the way back to 1854 when six private banking members in Basel, Switzerland resolved to cooperate and pooled their resources to establish the Bankverein, a consortium that functioned as an underwriting syndicate. In 1917, its name was changed to Swiss Banking Corporation.

In 1937, the bank adopted its three keys logo. Designed by Warja Honegger-Lavater, each of the three keys bore particular significance and meaning, as a whole conveying the bank's values of confidence, security, and discretion.

Figure 1: UBS Three Keys Logo

Image Credit: UBS AG

The present day UBS is the product of multiple mergers and acquisitions, emerging in its current form after the 1997 merger of Swiss Banking Corporation and Union Bank of Switzerland. During the mid-1990s, Union Bank of Switzerland was the second largest bank in Switzerland and was suffering from relatively low return on equity. This eventually drew the attention of activist shareholders, which included Martin Ebner, an outspoken activist who became the largest shareholder (through his investment trust) in Union Bank of Switzerland and pushed for its operations to be restructured.

The initial idea was for Union Bank of Switzerland to be merged with Credit Suisse, an idea fiercely resisted by the former's board of directors. This resistance would eventually lead to a shareholder revolt that resulted in the replacement of Robert Studer, then chairman of Union Bank of Switzerland, with Mathis Cabiallavetta, who promptly initiated merger discussions with Swiss Banking Corporation.

These discussions would eventually lead to the fusion of Union Bank of Switzerland and Swiss Bank Corporation, a union that created what was then the largest bank in Switzerland, with more than USD590 billion in assets. Following the later acquisition of American brokerage firm Paine Webber, the enlarged group settled on 'UBS' as its new identity.

Over the years, the new UBS would often find itself mired in controversy. During the 2008 global financial crisis, UBS had the dubious honour of reporting the highest losses among Swiss companies when it was forced to write down USD48 billion in subprime and other mortgage assets. 20,000 employees were let go and the bank was forced to suspend its dividend in order to maintain its capital ratio.

Shortly thereafter, UBS was accused by the US senate of enabling tax evasion, by helping high net worth Americans evade taxes through the use of confidential offshore accounts. Among the lurid accusations of corporate malfeasance levelled at UBS were the use of phony charitable trusts, secret coded language in internal emails, and foreign shell companies set up for the express purpose of evading tax.

Even though the bank initially denied the allegations, its reputation took a serious beating. UBS eventually entered into a deferred prosecution agreement on charges of conspiring to defraud the United States and agreed to pay USD780m in fines. The bank also announced that it would stop servicing US-domiciled clients through non-US regulated subsidiaries.

More than ten years have passed, and most observers would agree that UBS has since put these scandals behind the firm. As of 31 Mar 19, the aggregate market capitalization of UBS was at USD45.0 billion, with the universal bank recording invested assets of USD3.3 trillion. The number of employees working for the institution was 67,481, some 7.9% higher compared to the previous year.

UBS is a universal bank in Switzerland, in the sense that it provides the entire spectrum of banking products and services. The primary driver of its earnings can be considered to be its Global Wealth Management division, which accounts for over half of total revenue. In essence, Global Wealth Management caters to the banking needs of high net worth individuals around the world, providing them with a wide range of advisory and investment services.

The bank is also active in the traditional Personal and Corporate Banking segment, whose activities are primarily confined to UBS' domestic market in Switzerland. In addition, UBS is also renowned for its Asset Management and Investment Bank divisions. Asset Management offers specific equity, fixed income, and structured products related investment capabilities that are sought after by institutions with unique needs, and Investment Bank provides capital markets advisory, research and other trading capabilities.

As one of the country's largest banks, UBS owes much of its success to the broader development of the banking industry in Switzerland. We invite you, the reader, to join us as we take a tour of the Swiss banking landscape in the next section.

The Swiss Banking Landscape

Banks in Switzerland are generally divided into two categories: big banks and domestically focused banks. The big banks category includes UBS and Credit Suisse. These are the two main universal banks headquartered in Switzerland with a large international footprint, with each playing an important role in the global wealth management business.

As a result of their international focus, over 70% of their balance sheets are made up of foreign assets. It is estimated that each institution maintains a market share of the domestic credit and deposit business of approximately 20% and that each bank has a ratio of total exposure (as a measure of bank size) to Swiss GDP in excess of 130%.

The importance of UBS and Credit Suisse to the Swiss financial services sector was further underscored when both institutions were named as global systematically important banks ('G-SIBs') by the Swiss Financial Stability Board (FSB). The Swiss National Bank ('SNB'), Switzerland's central bank, also designated them as systematically important institutions.

Aside from UBS and Credit Suisse, Switzerland also plays host to a large number of domestically focused commercial banks. Financial institutions that fall into this category are those that maintain a share of domestic loans to total assets of more than 50% or play a notable role in the domestic deposit market. Collectively, these institutions control approximately 65% of the domestic credit market and half of the domestic deposit market. There are around 100 domestically focused commercial banks in Switzerland, with the top three players being PostFinance, Raiffeisen Group, and Zurich Cantonal Bank.

The last decade has been characterized by an environment of exceptionally low interest rates, a state of affairs which has not exactly been helpful to banks in Switzerland. This has meant ongoing pressure on net interest margins ('NIM'), which has weighed heavily on the earnings performance of many banks.

NIM broadly corresponds to the difference between what a bank earns on loans and the amount paid on borrowed funds. In the case of UBS, its net interest income declined from USD6.66 billion in 2017 to USD6.03 billion last year.

The reader's initial reaction to this observation could be one of disbelief. After all, it would seem fair to think that when interest rates decline, the cost of bank funding declines as well, thus helping to boost the bank's NIM. However, this conclusion would not be entirely accurate as banks do not rely entirely on wholesale funding (i.e. interbank borrowing).

In fact, banks like UBS and Credit Suisse maintain substantial retail deposits; funding costs (interest payable) on these deposits are more stable compared to wholesale funding. On the other hand, income on interest bearing loans (the asset side on a bank's balance sheet) depends largely on the prevailing interest rate environment. It is for this reason that most banks in Switzerland have been negatively affected by the low interest rate environment.

The Dramatic Rescue of UBS and Subsequent Imposition of New Regulations

The reader might recall that at the start of this article, we briefly evoked how UBS had to write down USD48 billion in US subprime and mortgage assets during the 2008 financial crisis. Left unanswered was the question of how UBS managed to extract itself from what was undoubtedly an immensely challenging situation.

On 16 Oct 08, the Swiss government announced the transfer of a maximum of USD60 billion in illiquid assets belonging to UBS to a special purpose vehicle, a 'stabilisation fund' directly supervised by the SNB. Concurrently, the Confederation infused no less than CHF6 billion into UBS to strengthen the bank's capital base.

At that time, the transfer of illiquid assets to the SNB stabilization fund represented approximately 10% of Swiss GDP, while the CHF6 billion cash infusion represented almost 10% of aggregate federal receipts. It was a significant gamble for the Swiss Confederation and its taxpayers; the justification offered at that time was that UBS was too big to fail, and that its failure would impair the proper functioning of the Swiss financial system and cause unfathomable disruption to the nation's economy.

In return for government assistance, UBS offered taxpayers a loss protection mechanism. An equity contribution from UBS was furnished for 10% of the assets transferred to the stabilization fund, while a warrant was issued granting the SNB the right to purchase 100 million UBS shares at nominal value (10 cents).

At the outset, it seemed that UBS had gotten the better end of the deal, for in the first nine months following the transfer of assets into the stabilization fund, the assets lost some USD7 billion in value. The timing of the transaction turned out to be propitious, for not only was confidence in UBS restored, the ensuing rebound in asset values resulted in the SNB making money on the transaction. Of the maximum USD60 billion in illiquid assets that the agreement provided for, just slightly half of that amount was eventually transferred.

Regulatory Reform in the Aftermath of the Financial Crisis

In mid-2016, the Federal Council of Switzerland announced amendments to prevailing too-big-to-fail (TBTF) provisions in relation to the nation's banks. The Helvetic nation had in 2012 imposed the first series of regulations governing banking conduct and the amount of capital that financial institutions had to maintain.

The new regulations provide for banks to hold sufficient capital to ensure continuity of service, with the view that should they become distressed or require restructuring, state support would not be required. Under the new regulations, G-SIBs the likes of UBS are subject to a minimum leverage ratio of 5%. The leverage ratio is the ratio of regulatory capital over unweighted total assets held by the bank.

For the leverage ratio 5% minimum, a minimum of 3.5% must be held as Common Equity Tier 1 ('CET1') capital, which for the most part consists of common stock and retained earnings. The other 1.5% may be held as other instruments that possess equity-like or conversion features. Some examples include AT1 contingent convertible bonds and preferred shares.

In addition to the above prescriptions, the Federal Council also introduced new 'gone-concern' capital requirements for systematically important banks. Each of these establishments has to maintain 5% of loss absorbing bail in capital, to be utilized in the event of impending insolvency.

In the next section, we will provide a brief overview of UBS' current financial situation.

UBS AG: Key Financial Highlights

For the quarter ending 31 March 2019, group operating income came in at USD7.22 billion, up 3.5% quarter-on-quarter ('QoQ') compared to previous quarter's USD6.97 billion. Significant cost savings were realized, resulting in operating expenses experiencing a 12.6% decline to USD5.67 billion for the first quarter of 2019, from USD6.49 billion recorded in the quarter ending December 2018. These cost savings are impressive considering that headcount actually grew from 66,888 to 67,481 during the period. Total operating profit before tax surged 221% on a QoQ basis to USD1.55 billion during the same period.

The sharp reduction in operating costs coupled with the group's strong top-line growth had a positive impact on UBS' various performance metrics. Notably, UBS' cost-to-income ratio declined 14 percentage points ('ppt') to 78.4% in the first quarter of 2019. Return on equity reached 8.6% for the quarter ending March 2019, significantly higher than the 2.4% recorded in the previous quarter.

During the same period, return on tangible equity came in at 9.8% in 1Q19, up 7.1ppt QoQ. Tangible equity refers to total shareholders' equity less preferred stock, goodwill, and other intangible assets.

Perhaps of greater importance to bond investors would be UBS' present solvency situation. On this front, the group has recorded significant improvements. The CET1 capital ratio remained stable at 13.0% for the quarter ending March 2019, whilst the going concern capital ratio improved to 18.5% in March 2019 from 17.5% the previous quarter.

CET1 capital broadly consists of the group's common stock and retained earnings. The calculation of going concern capital ratio encompasses the inclusion of all Tier 1 capital, which includes AT1 capital (which broadly corresponds to capital from contingent convertible debt instruments).

The liquidity situation of UBS also registered a marked improvement. The group's liquidity coverage ratio reached a high of 153% in March 2019. At the end of 2018, the liquidity coverage ratio was just 136%.

An In-Depth Look into UBS' Global Wealth Management Business

Considering that UBS' Global Wealth Management franchise accounts for some 55% of group operating revenue, the reader might find a more detailed analysis of this division useful. Let us take a few moments to go through some numbers.

The division's operating profit before tax came in at USD863m in 1Q19, which more than doubled from the previous quarter's profit of USD327m. In contrast, the International Wealth Management ('IWM') division of Credit Suisse grew by only 28% QoQ during the same period.

UBS' continued leadership in the wealth management business is amply demonstrated when we consider its success in attracting new assets. Net new money for the quarter ending March 2019 was USD22.3 billion, constituting some 0.8% of its current asset under management ('AUM') base of USD2.7 trillion (as of 31 Mar 19).

The performance of Credit Suisse's wealth management arm was more subdued in comparison. Its IWM division attracted USD1.3 billion in net new assets, some 0.4% of its current AUM base of USD356.4 billion in the first quarter of 2019.

UBS also outperformed its largest competitor in trimming operating expenses. The division's cost-to-income ratio came in at 78.4% for the quarter ending March 2019, a 13.4ppt decrease. In comparison, Credit Suisse's IWM division eked out a 7.2ppt reduction during the period.

The resilience of the UBS Wealth Management franchise is underpinned by its heavy reliance on recurring revenue, which is more stable and less susceptible to broader macroeconomic factors. For the quarter ending 31 Mar 19, UBS Wealth Management recorded recurring revenue as a percentage of revenue of 80.6%. In contrast, we estimate that Credit Suisse's IWM division derived only 64% of its revenue from recurring sources.

The Best Investment Opportunities in UBS Bonds

In this section, we will undertake a comprehensive analysis on how the bonds of UBS compare with bonds issued by industry peers. Specifically, we think it would be most useful if we were to compare bonds issued by UBS with those issued by Credit Suisse, which is the closest match in terms of size, business activities, and geographical proximity.

Figure 2 shows how the perpetual bonds of UBS and Credit Suisse compare in relation to their CET1 capital ratios, which is a key measure of solvency. On the x-axis, we have the variable 'CET1 Capital Ratio'. On the y-axis, we have the variable 'USD Perpetual Yield' which displays the yield to call of the respective bonds. We examined the UBS 5% USD perpetual bond in the case of UBS and the Credit Suisse 7.25% USD perpetual bond in the case of Credit Suisse.

The reader would observe that even though UBS maintains a higher capital ratio compared to Credit Suisse, this does not result in a lower bond yield. In fact, the perpetual bond yield of the UBS perp is much higher, above 8.5%, despite the lender's superior solvency position. Clearly, the UBS perpetual offers much greater value compared to the Credit Suisse perpetual.

Incidentally, the Credit Suisse perpetual bears a first call date in Sep 2025, when its coupon is adjusted to 4.332% + Prevailing swap rate. The UBS perpetual, which bears a first call date in Jan 2023, will see its coupon adjusted to 2.432% + prevailing swap rate, should it not be redeemed. Based on the today's rates and spreads, we think that both firms should be able to refinance the perpetuals with similar financing costs. Following this reasoning, we could speculate that Credit Suisse's bond would be redeemed at a later date than the UBS bond. While we think the UBS 5% perp carries substantially higher extension risk given its tight reset spread, we think the market has priced in too much of this risk, which is more than compensated by the resulting yields.

Figure 2: UBS and Credit Suisse Comparison: USD Perpetual Yield vs CET1 Capital Ratio

Moving on, we can study the relative attractiveness of UBS and Credit Suisse bonds by analyzing them in the context of their cost/income ratios, which is a measure of operational efficiency. The lower the cost/income ratio, the more efficient the firm is considered to be. To ensure that our analysis is aligned with the methodology which we used when we compared the firms in relation to the CET1 ratio, we utilized the same two perpetual securities [the UBS 5% perp (USD) and Credit Suisse 7.25% perp (USD)] issued by the respective banks.

Referring to Figure 3, we may observe that even though UBS has a lower cost-to-income ratio and may be considered by this measure to be operationally more efficient than Credit Suisse, its perpetual bond sports a higher yield and is more attractively priced.

Figure 3: UBS and Credit Suisse Comparison: USD Perpetual Yield vs Cost/Income Ratio

The informed reader might be aware that UBS has a SGD-denominated perpetual as well as USD-denominated perpetual notes. In this regard, there may be some doubt as to which would constitute a better purchase.

To address this question, we consider the yield spread between the UBS 5.875% Perpetual Corp (SGD) and the UBS 6.875% Perpetual Corp (USD). The gap between yields (yield to next call) on the two issues has narrowed significantly over the past year, and the spread recently turned positive. This may be interpreted to mean that the SGD issue has become significantly more attractive compared to previously.

Figure 4: UBS SGD 5.875% Perpetual vs UBS USD 6.875% Perpetual (Yield to Next Call Spread)

Conclusion

In many respects, the story of UBS is the story of Swiss banking. Over the centuries, there have been moments where the Swiss bank seemed to lose its way, only for it to quickly regain its footing and continue on the road of progress.

Investing in UBS is investing in a centuries-old franchise that has faithfully served investors and clients alike for generations. For bond investors, we think that the UBS 5.875% Perpetual Corp (SGD) provides a unique opportunity to buy into the unique franchise that is UBS, one that has withstood the test of time.

Related article: G8 Education's 5.5% Notes Are Maturing Next Month: Here Are Some Replacement Ideas

Appendix: Valuation of UBS Bonds by CDS Basis

Referring to credit default swap ('CDS') valuations allows investors to identify bonds that could potentially be undervalued at a given point of time. Readers who wish to gain an in-depth understanding of bond valuation through the CDS-bond basis may wish to refer to ''The Westpac Case Study: Bond Valuation Using Credit Default Swaps. ''

Relying on a similar methodology, we present three other undervalued USD-denominated UBS bonds based on their CDS basis:

 

Bond	Maturity	Ask Price	Yield to Maturity (Ask; %)	Z-Spread (Ask; bps)	CDS Basis (Ask; bps)
UBS 3.491% 23May2023 (USD)	23 May 2023	100.80	3.22	88	-39.6
UBS 4.125% 24Sep2025 (USD)	24 Sep 2025	103.97	3.42	105	-31.7
UBS 4.125% 15Apr2026 (USD)	15 April 2026	103.86	3.50	111	-31.3
Source: Bloomberg, iFAST compilations (Prices as of 29 Apr 2019)

 

Declaration:

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) has a principal position in UBS 5.875% Perpetual Corp (SGD). The analyst who produces this report own none of the above mentioned securities.