UBS FAILED RISK MANAGEMENT 101 (...BW Nov. 09, 1998)
In a world where investors large and small try to manage risk, you would think UBS, Europe's largest bank, would have the resources and the smarts tO do it right. Instead, when it came to the bank's dealings with Long-Term Capital Management, it was amateur night in Zurich.
The blunders cost about $700 million and four top executives--including Chairman Mathis Cabiallavetta--their jobs. The bank has acknowledged ''shortcomings'' in risk management. In fact, there was no risk management at all. Spokesmen for the bank declined to comment beyond their press releases.
But based on what the bank has disclosed, and on interviews with
derivatives specialists and with sources close to Long-Term Capital
Management, here's what happened. In the summer and fall of 1997, UBS sold LTCM's managers a serIes of call options on shares of their own fund. The options allowed the LTCM managers to benefit from the rise in the value of the fund over the next seven years without actually owning it.
TAX ANGLE. It's the same thing as an investor who is bullish on IBM buying an option on Big Blue stock. If the stock, now at 146, goes up to 200 during the life of the option, the owner sells the option and pockets the $54-a-share difference. With LTCM, the options covered shares worth about $800 million at the time UBS issued them. If the hedge fund prospered and the value of the options' underlying shares rose to say $4 billion, the managers could sell the options and profit from the difference between the $800 million original value and the $4 billion that they would now be worth--a $3.2 billion profit. For these options, LTCM managers paid UBS $266 million.
Why would the hedge fund's managers purchase call options on their fund instead of just putting the money in? For one, the options gave them three times the leverage of a conventional equity stake. If you're expecting to make a bundle, that magnifies the winnings. There's a tax angle, too. If the managers sold appreciated options before expiration, their gains would be taxed at the favorable long-term capital-gains rate. Had they invested that money in the fund directly, it would likely be generating short-term gains, taxed at much higher rates. That's the reason these sorts of options are often purchased by hedge-fund investors.
But UBS' behavior was anything but typical. True, the bank invested
$800 million in LTCM to assure that it could make good on the options. But most banks would have pocketed the $266 million fee. Instead, UBS rolled the dice. It had so much faith in the gurus of Greenwich that
it invested its fee in the hedge fund, putting a total of more $1 billion at risk in LTCM. What the bank failed to do was to protect itself against a decline in the value of LTCM. It violated the first rule of risk management--downside protection.
Some options traders say it is likely UBS never planned to protect its
downside. ''The bet was that LTCM would be worth more in seven years than it was today,'' says one specialist. ''That probably looked like a bet that didn't need hedging.''
Most pros can hardly believe that UBS would have made such a
one-sided bet. Robert N. Gordon, president of Twenty-First Securities
Corp., says his firm would have required the LTCM managers to sell it
put options that go up in value as the underlying shares go down. With
put options, the bank could have protected some of its downside by forcing LTCM to buy back the shares at a price that would have prevented too great a loss. ''I can't believe UBS didn't demand puts,'' says Gordon.
Of course, had UBS tried to exercise those puts, the financially
bludgeoned LTCM managers may have come up short in buying them out. But at least the experts at UBS could have argued there was some risk management in place.
By Jeffrey M. Laderman in New York
Copyright 1998, by The McGraw-Hill Companies Inc. All rights reserved. |
