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UBS Loss Leaves Gruebel Contemplating Smaller Investment Bank

Oswald Gruebel, departing chief executive officer of UBS AG. Photographer: Peter Frommenwiler/Bloomberg
Oswald Gruebel, departing chief executive officer of UBS AG. Photographer: Peter Frommenwiler/Bloomberg

Sept. 23 (Bloomberg) -- “We do know what we’re doing,” UBS AG Chief Executive Officer Oswald Gruebel told investors last year about plans to step up risk-taking to boost profit. “Risk is our business.”

Ten months later, Switzerland’s biggest bank revealed a $2.3 billion loss from what it called “unauthorized trading.” Kweku Adoboli, a 31-year-old trader at the company, appeared in court in London yesterday on charges of fraud and false accounting. Now UBS is the subject of probes by U.K. and Swiss regulators and is facing calls by investors and politicians to scale back its investment bank.

“The reputation is now at its limit,” said Guy de Blonay, a London-based fund manager at Jupiter Asset Management Plc, which oversees about 25 billion pounds ($39 billion), including UBS shares. “One more mistake and it could damage the reputation for good.”

Gruebel, 67, was hired out of retirement to stabilize the lender, the flagship for Switzerland’s wealth-management industry, after bets on U.S. mortgage-backed securities backfired. The bank posted the biggest loss in Swiss corporate history and took a capital injection of 6 billion Swiss francs ($6.6 billion) from the government. Born in East Germany, he spent 37 years at Credit Suisse Group AG, earning the moniker “Saint Ossie” for helping restore that bank’s profit and reputation, and for spotting the U.S. subprime debacle early.

At UBS, he has put on the brakes and stepped on the gas. He began by cutting more than 7,500 jobs and curbing risks -- and missed the 2009 boom in fixed-income trading that allowed competitors such as New York-based Goldman Sachs Group Inc. and JPMorgan Chase & Co. to profit.

Profit Target

Then, in November 2009, he set a target of reaching 15 billion francs in pretax profit by 2014. To get there, Gruebel ramped up the Zurich-based bank’s fixed-income unit under Carsten Kengeter, added 1,700 employees at the investment bank and took on more risk. By November 2010, Kengeter, 44, was in sole charge of the investment bank.

“We have to have risk to be able to make money,” Gruebel said at the investor presentation in London on Nov. 16. “If ever anything goes wrong, at least you will not hear any of us say we didn’t know.”

That’s just what UBS managers are saying now. The bank didn’t verify trades prosecutors say may date to 2008. Gruebel wasn’t available to comment, a spokesman said.

“It’s come at a horrendously bad time for UBS,” John Cryan, 50, who served as chief financial officer from 2008 until June, said in an interview. “They’re back to square one.”

‘Sorry Beyond Words’

The latest setback stemmed from unauthorized trading in stock-index futures, UBS said this week. Adoboli said through his lawyer he was “sorry beyond words” for his “disastrous miscalculations” when he appeared yesterday at the City of London Magistrates’ court. He wasn’t required to enter a plea and remains in police custody pending an Oct. 20 hearing. He faces a maximum 10-year jail sentence, according to the Crown Prosecution Service’s sentencing manual.

UBS shares have fallen 12 percent since the day the bank disclosed the loss and are down 37 percent this year compared with a 39 percent decline in the 46-member Bloomberg Europe Banks and Financial Services Index.

That the breakdown in controls accompanied a ramping up of risk doesn’t surprise Jupiter’s de Blonay.

“The two problems are linked,” he said. “You have a strategy where they want to bring the investment bank back to the top of the league table. You hire, you put the book back at risk and you try to get the numbers through. That means you have got to take more risk.”

Wealth Management

The trading loss adds to pressure on Gruebel to shrink the investment bank and move UBS back to its roots in asset management, where earnings are more stable, according to Lutz Roehmeyer, who helps manage about $14 billion at Landesbank Berlin Investment in Berlin, including UBS shares.

The wealth-management units, which generate 41 percent of UBS’s revenue, have been attracting net new money over the past year after clients pulled assets in the credit crisis. UBS managed 2.47 trillion francs for affluent individuals as of the end of June. It is the world’s third-largest private wealth manager, behind Bank of America Corp. and Morgan Stanley, according to data compiled by Scorpio Partnership.

“Our near-term concern is the impact the recent turmoil will have on customer confidence in wealth management, which had been staging a gradual recovery in recent quarters,” Matthew Czepliewicz, an analyst at Collins Stewart Hawkpoint Plc in London, wrote in a note to clients on Sept. 19.

History of Missteps

The $2.3 billion trading loss is the latest misstep UBS executives have made in the past 13 years as they sought to expand the bank’s reach outside Switzerland.

The 1998 combination of Union Bank of Switzerland with SBC Warburg allowed Marcel Ospel, then CEO of SBC, to turn UBS into the world’s largest wealth manager. The deal hit turbulence soon after it closed. The old UBS had made a $1 billion investment in Greenwich, Connecticut-based hedge-fund firm Long-Term Capital Management LP, which was rescued by a group of banks soon after the merger.

Ospel, seeking to expand the business in the U.S., paid $11.5 billion in 2000 for New York-based Paine Webber Group Inc., then the fourth-biggest U.S. retail brokerage. Ospel became chairman in 2001, and by 2002 the firm’s foreign-exchange and cash-collateral-trading division was investing in U.S. asset-backed securities. UBS posted writedowns of almost $2 billion in 2007 after the market for those instruments froze.

CDO Losses

Meanwhile, the bank’s fixed-income proprietary trading desk, which earned $700 million of pretax profit in 2005, was drawing attention. Under the leadership of John Costas, the firm spun off the unit as a UBS-backed hedge fund called Dillon Read Capital Management LLC. The operation’s losses swelled to 150 million francs by the first quarter of 2007 after losing bets on securities backed by U.S. subprime mortgages. In May of that year, UBS closed the fund.

The investment bank’s biggest bets came from the team that invested in collateralized debt obligations. CDOs pool bonds, loans and other fixed-income assets, channeling their income into securities of varying risk and return. The group, instead of just securitizing and selling the CDOs, was by early 2006 keeping the instruments on the bank’s books so they could profit from the yields. The CDO desk recorded two-thirds of UBS’s losses in 2007, or $12.5 billion.

‘Complacent’ Management

After its government rescue, UBS published two reports about its near-collapse, one in 2008 and a 2010 study by Tobias Straumann, a financial historian at the University of Zurich. He found the bank’s management “complacent” and criticized it for relying too much on internally produced risk-management reports.

UBS’s risk systems were “at fault” in 2007 and 2008 because they weren’t aggregating all the bank’s positions, Cryan said in an interview.

Ospel quit as chairman in April 2008, a period followed by asset sales, the bailout, restructurings and writedowns and losses that eventually totaled more than $57 billion.

Gruebel, UBS’s third CEO in less than two years, installed more stringent controls at the investment bank. He held weekly calls with top risk officers and monitored traders’ positions with Kengeter. The executives sought to reassure investors by saying UBS could take on more risks because it had a better handle on them.

Increasing VaR

The bank made bigger bets, increasing so-called value at risk, a measure of how much the firm could lose in securities markets on a single day. UBS’s average VaR for the second quarter climbed to 75 million francs from 48 million francs in the year-earlier period and 67 million francs for the second quarter of 2009, according to filings. By comparison, VaR at JPMorgan’s investment bank fell to $77 million in the second quarter from $90 million in the year-earlier period. At Deutsche Bank AG, it declined to 53 million euros ($71.4 million) in the second quarter.

The push in investment banking didn’t pay off. UBS slipped among underwriters of global stock sales, dropping to eighth this year from fourth in 2009, data compiled by Bloomberg show. In mergers, the firm rose to 10th this year from 12th in 2009, though the growth wasn’t sufficient to offset declining industry revenue as the European debt crisis worsened.

Pretax profit at UBS’s investment bank slumped to 376 million francs in the second quarter from 1.31 billion francs in the year-earlier period. The unit’s cost-to-income ratio, the highest among the nine biggest investment banks last year, rose to 86 percent in the quarter.

‘Cost Problems’

“We had cost problems in the investment bank, which has put pressure on UBS for months,” said Christian Hamann, an analyst at Hamburger Sparkasse in Hamburg, who has a “hold” rating on UBS. “UBS over-hired.”

The bank reversed course again, scrapping its profit target in July and announcing cost cuts after second-quarter net income dropped 49 percent because of a slump in earnings at the investment bank. UBS said last month it would cut 3,500 jobs, 45 percent of them in the investment bank.

The flaws in UBS’s back-office operations that led to the latest loss puzzle financial industry veterans. Traders expressed surprise that the bank failed to notice the trades sooner because of their size and because they would have been scrutinized by others: the lender’s counterparty risk managers, as well as credit-valuation-adjustment, audit, risk-management and compliance teams.

“It’s just too big a thing to not be noticed,” said Aaron Brown, chief risk manager at AQR Capital Management LLC in Greenwich, Connecticut, and author of the forthcoming “Red-Blooded Risk: The Secret History of Wall Street.” “You can hide a lot of stuff -- you’ve got millions of transactions every day. If somebody puts in 10 little fictitious transactions, that can be very hard to find. But things of this size, it’s just hard to believe that somebody wouldn’t notice them.”

Delta One

The loss came out of UBS’s Delta One desk in London, which helps clients speculate on or hedge against the performance of a basket of securities. Traders on the team bet with the bank’s own money as they put together packages and hedge risk. UBS was the third-ranked Delta One trader this year behind Bank of America and Morgan Stanley in the Thomson Extel Awards for excellence.

When a bank writes a futures contract for a client, it may hedge the cost by buying an exchange-traded fund, securities linked to illiquid or complex baskets of assets. The traders could profit from the cost and margin differences between derivatives and their underlying securities, and by timing the purchase and sale of each element.

‘Fictitious’ Positions

Delta One desks have triggered losses for banks before: Jerome Kerviel amassed 50 billion euros in unauthorized positions concealed with faked hedges before being discovered by his employer, France’s Societe Generale SA, in January 2008. The bets cost the bank 4.9 billion euros. A Paris court ordered him last year to repay the loss in full and sentenced him to three years in jail. He’s appealing the ruling.

UBS said its loss stemmed from trades in Standard & Poor’s 500, DAX and EuroStoxx index futures over the past three months. The positions had been offset by “fictitious, forward-settling-cash ETF positions, allegedly executed by the trader. These fictitious trades concealed the fact that the index futures trades violated UBS’s risk limits,” the bank said.

Financial risk management can’t be effective if there aren’t good operational controls in place, such as confirming trades, said Leon Metzger, a former executive with hedge-fund firm Paloma Partners LLC and now a lecturer at the Yale School of Management in New Haven, Connecticut.

Control ‘Failure’

“People are saying it’s a failure of financial risk management, but it sounds like it’s more a failure of operational controls,” Metzger said in a telephone interview. “There’s going to be a change as a result of this. Firms are going to be wary of trades that can’t be corroborated, whether the firms have reached this conclusion by themselves or because their investors will force them.”

Dealmakers in Europe can buy ETFs on the over-the-counter market, allowing them to bypass exchanges and to agree on later settlement dates than the three days required by exchanges, traders said. About half of ETFs are bought over the counter in Europe, the traders said.

Once a trader places an order, responsibility passes to the back office, which would then confirm and complete the transaction. Banks have teams of people who corroborate the existence of a trade with the other party before settling the contract. That process should have alerted risk officers to the phony trades, traders said. UBS may have been slow in confirming over-the-counter trades, they said.

Back Office

Employees in the back office, where Adoboli previously worked, may have been unwilling to challenge the front desk, said Sylvain Asimus, a former back-office worker at Credit Commercial de France who is now a technical analyst at research firm Phinamics Ltd.

“As a back-office employee, the one thing you are looking for is to move to the front desk, so you don’t want to annoy the traders,” Asimus said in an interview.

Some banks in Europe don’t confirm these types of cash ETF trades until they’re settled, according to a person familiar with the matter. In that case, the trader might have described his fake ETF trades as having been executed with those banks in order to avoid being asked questions by UBS controllers about the lack of confirmations, said the person, who wasn’t authorized to speak publicly because of the criminal probe.

‘Systems Weren’t Adequate’

“Obviously their systems weren’t adequate,” said Michael Dempster, founder of the University of Cambridge’s Centre for Financial Research. “In the best institutions, where risk officers on the desks are given real-time data, it would be very hard for this to happen.”

Risk at UBS has been overseen since January by Maureen Miskovic, who previously served as chief risk officer at State Street Corp. and held the same role at Lehman Brothers Holdings Inc. for six years until 2002. In June 2008, UBS hired Thomas Daula to run risk management at its investment bank. Daula had been chief risk officer at Morgan Stanley in 2007 when that bank wrote down $9.4 billion on wrong-way proprietary trading bets on mortgage-related securities.

Daula became chief operating officer at the investment bank in January, and Mark Sanborn became chief risk officer in April. Sanborn was head of global equity trading at Lehman Brothers before he left in 2003 to run two hedge funds. None of the three executives returned calls or e-mails seeking comment.

“UBS is strongly committed to improve its risk-control framework to prevent similar events from happening again,” the bank said in a statement to Bloomberg. “However, the nature of changes we will adopt to this end will be defined in detail only after the pertinent investigations will be concluded.”

Swiss Rules

The Swiss parliament next week will vote on proposals to strengthen the country’s biggest banks by making them hold capital equal to at least 19 percent of assets, more than required under new rules agreed to by the Basel Committee on Banking Supervision. The Swiss law will also allow regulators to split up banks that fail to manage their risk, Finance Minister Eveline Widmer-Schlumpf said last week.

“We already saw political pressure in Switzerland during the financial crisis on UBS being too-big-to-fail,” said Hamann of Hamburger Sparkasse. “This could increase the chances of a separation of the investment bank and wealth management.”

UBS is more likely to scale back the most capital-intensive parts of its investment bank and those that help its wealth-management units the least, other analysts said.

“The investment-banking businesses that make money for them are foreign exchange, equities, Asia and parts of Europe underwriting,” said Huw van Steenis, an analyst at Morgan Stanley in London. “Anything that is capital intensive, including the swaps business, the U.S. credit business and rates business, is where there’s very little synergy with the private bank.”

Singapore Scolding

UBS may be forced to shut parts of the investment bank because of a dearth of buyers, according to fund managers and analysts. HSBC Holdings Plc, Europe’s biggest bank, was interested in buying UBS’s wealth-management unit in late 2008, not its investment bank, according to a person with knowledge of the discussions. A spokesman for HSBC declined to comment.

Investors also may demand management changes once it becomes clear how the loss was incurred. Gruebel was this week criticized by the Government of Singapore Investment Corp., its biggest shareholder, which expressed “disappointment and concern about the lapses and urged UBS to take firm action to restore confidence in the bank,” according to a statement from the sovereign-wealth fund after its managers met with the CEO.

‘Gruebel’s Idea’

“It was Gruebel’s idea to beef up the investment bank, so if anyone should go it should be him,” said Florian Esterer, who helps oversee about $55 billion at Swisscanto Asset Management AG in Zurich and doesn’t own UBS shares.

Gruebel may keep his job for want of an obvious successor inside UBS, analysts said. Kengeter had been considered a candidate until the loss, according to Hamann.

“The investigation should go down the chain and establish where the fault lies,” said Chris Roebuck, visiting professor at the Cass Business School in London. “To call for the resignation of Gruebel and the head of the investment bank is absolutely premature.”

The CEO is scheduled to talk to shareholders at a Nov. 17 investor day. Analysts had expected him to announce a restructuring of the investment bank. He may have to do more now to keep both his job and the bank’s reputation intact.

To contact the reporters on this story: Ambereen Choudhury in London at; Elisa Martinuzzi in Milan at; Christine Harper in New York at

To contact the editors responsible for this story: Frank Connelly at; Edward Evans at

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